03 Mar 2011Working Paper Summaries

How Firm Strategies Influence the Architecture of Transaction Networks

by Jianxi Luo, Daniel E. Whitney, Carliss Y. Baldwin and Christopher L. Magee

In business, an "ecosystem" refers to a group of firms that work together through a series of shared transactions to provide a complex product or service. Using data from the disparate Japanese electronics and automotive sectors, this paper tackles the following questions: Do hierarchies of interfirm transaction networks vary across different ecosystems? What practices explain the difference in hierarchy across these two ecosystems? How do firms' strategies influence hierarchy? And what environmental factors explain the differences in the largest firm's strategies in each ecosystem? Research was conducted by Carliss Y. Baldwin of Harvard Business School and Jianxi Luo, Daniel E. Whitney, and Christopher L. Magee of the Massachusetts Institute of Technology. Key concepts include:

There is a much lower degree of hierarchy in the electronics sector than in the automotive sector, due to the numerous interfirm transaction cycles in the former.
Many electronics firms have adopted the strategy of "vertically permeable boundaries," meaning that they allow goods to flow from division to division within the firm, but at the same time, internal divisions can buy from and sell to external suppliers and customers. This strategy, which apparently leads to an increase in transaction cycles and innovation, is virtually nonexistent in the automotive sector.
Several environmental factors explain the difference in strategy at these firms. Electronics firms face short product life cycles, low transaction costs, and low levels of asset specificity (meaning investments initially meant to support one transaction are likely to retain their value even if they are used for a different transaction). Automotive firms, on the other hand, have long product life cycles, high transaction costs, and high levels of asset specificity.

Author Abstract

A hierarchy is a generic structure in which entities such as firms are ordered with respect to a specific relationship. Thus, if A sells to B, which sells to C, then A, B, and C form a hierarchy with respect to transactions. Prior industry studies often suggest a hierarchical form of organization in which firms are ordered, from "upstream" to "downstream," according to the sequence of production processes. However, little is known about whether transactional hierarchy varies across industry sectors, and if so, what causes such variation. In this study, we use network-based methods of analysis to define and measure the degree of hierarchy in two industry sectors in Japan: automotive and electronics. Our empirical results show that the electronics sector exhibits a much lower degree of hierarchy than the automotive sector due to the existence of numerous interfirm transaction cycles. Transaction cycles in turn can only arise if a subset of firms have two-way "vertically permeable boundaries." Such firms (1) participate in multiple stages of the industry value chain (hence are vertically integrated); (2) purchase goods for downstream units from other firms in the sector; and (3) sell goods from upstream units to other firms in the sector. We conjecture that having two-way vertically permeable boundaries may allow firms designing innovative system products to advantageously access knowledge in their component divisions, while maintaining the competitiveness of those divisions by selling goods to external customers.