BY

Radoslav P. Kotorov
Program in Institutional Theory and History
Department of Applied Philosophy
Bowling Green State University
310 Shatzel Hall
Bowling Green, OH 43403
Fax: 419/372-8191
E-mail: rkotorov@notes.bgsu.edu

Abstract

The concept of virtual organization is part of the broader concept of the firm and its economic function.  It is a new concept brought into existence by developments in computer networks, which are changing the workplace in no less significant way than the factory did during the Industrial Revolution.  If the 18^th century firm moved the worker from his home to the factory, today, computer networks are moving the workplace back to the homes of workers.  The increased centralization of the firm prior to the emergence of virtual organization is attributed to three main causes: (1) physical location of machines in factories, (2) need for better coordination due to increasing division of labor, and (3) high transaction costs of market exchange.  Information technology creates countervailing effects, and thus, poses the question whether the firm cannot be decentralized completely.  To answer this question a model of the firm is presented in which the limits of decentralization are set by the costs incurred to collect, develop, and control the dissemination of competitively valuable information that is vital for the profitability of firms.

Introduction

The concept of virtual organization is part of the broader concept of the firm and its economic function.  It is a new concept brought into existence by developments in computer networks, which are changing the workplace in no less significant way than the factory did during the Industrial Revolution.  If the 18^th century firm moved the worker from his home to the factory, today, corporate computer networks are moving the workplace back to the homes of employees.  Thus, the firm as an institution appears to be in transition, and hence, the relevant question is how future firms will differ from today’s firms.  More precisely, the issue is what will be the internal organization of firms and how decentralized they will be, because virtualization implies the vanishing of the formal and spatial boundaries of firms.  By internal organization I mean processes that are carried within the firm as opposed to processes that are carried on via market exchange with subcontractors.  What processes are internalized and what are carried through the market is determined not just by consideration of production and transaction costs, but also by whether or not the internalization contributes to the protection of competitively valuable information, the proprietary use of which gives the firm competitive edge, and secures the realization of its profits.  Thus, whether the firm has more than one employee is contingent upon the need of labor inputs in internal processes, which implies that hierarchy is not a necessary condition for the existence of firms, but may be strategically chosen to enhance the competitiveness of firms. To view the firm as a set of processes, it  is helpful to understand both the push for subcontracting and the limits of decentralization, but is in sharp contrast with the pre-existing conceptions of the firm, which see it as a collectivity of managers and employees.

Prior to the emergence of virtual organization the firm was perceived as a centralized organization both in terms of control and in terms of physical location of its assets.  The centralized or hierarchical organization is as an alternative of market exchange, and the difference is that within the firm command directs the use of resources, while at the market prices direct the use of resources.  Since firms participate in market exchange as unitary agents, the question is what justifies the suspension of the market mechanism, and the transfer of exchanges to processes within the firm. Historically, centralization was seen as necessary for three reasons.

First, the physical location of machines, it can be argued, necessitates centralization, which in turn, generates benefits from specialization in labor, or vice versa.  Alternatively, one can argue that the division of labor leads to development of machines, which in turn determine the organization of production processes in factories.  (Adam Smith 1776)  There is controversy regarding the direction of the causal process, but it is irrelevant for the present paper.  On this particular view the firm is characterized by its production function, which is to say that its internal organization is not shaped by market forces, but by the nature of the production process and the technology employed in it.  Thus, the emergence of large centralized enterprises, with which we associate mass manufacturing, is determined by technological developments.

Second, hierarchy emerges when the costs of using the market mechanism exceed the costs of internal organization. (R.H Coase 1937)  The costs to use the market mechanism include (1) ex atne marketing costs, (2) bargaining costs and (3) ex post contract enforcing costs.  (Williamson 1985)  Many people refer to this causal explanation of the firm as the transaction costs paradigm, but we have to be careful, for transaction costs are only a subset of the costs associated with the use of the price mechanism.  The Coasian model of the firm can be described as a post-industrial-revolution model, for it provides explanation of the firm at time when large enterprises were established, and when much restructuring was taking place in order to reduce the cost of organizational overhead.

The third explanation of the existence of centralized firms traces its lineage to F. Knight (1921), according to whom market uncertainty is the organizing factor.  At the core of Knight’s view is the notion of responsible management, according to which the role of management is to forecast human wants and to decide how to fulfill them.  Implementation is the responsibility of management because according to Knight human nature is unreliable.  Implicit in Knight’s notion of centralization is that any decentralized method of implementation will lead to bottlenecks due to human error or opportunistic behavior, i.e., when agents break away from their previous agreements in pursuit of higher gains.

Since Knight’s work on Risk, Uncertainty and Profit the idea of uncertainty has penetrated deeply the capabilities based approaches to understanding the firm.  On these accounts accumulation of resources (E. Penrose 1959) or capabilities (A. Chandler 1990, D.J. Teece 1996) are means to cope with the uncertain future.  The primary source of market uncertainty is competition.  As firms introduce new products and new methods of production the market life of existing products is shortened, and more so, of products that are manufactured with less cost-effective methods.  Thus, uncertainty weighs on the shoulders of producers because competition can cause production losses, assets obsolescence, and can force firms out of the market.  A central point in the present paper is that producer’s will incur costs to reduce competitive uncertainty, which I will call protection costs, in order sustain their position on the market, and the cost of internal organization is in some cases one of the costs that contributes to the reduction of competitive uncertainty.

Protection costs

The understanding of protection costs allows us to combine the tenets of the Knightian and the Coasian approaches especially in view of the development of information technology.  That is to say that the costs to reduce competitive uncertainty can be viewed as a subset of the costs of using the market mechanism.  Why are such costs necessary? Why don’t agents just use the price mechanism?  Simply because the market is a cheep communication network, in which goods and prices transmit information about profitable opportunities, and thus, invite competition.  (Hayek 1945)  In turn, competition, and more specifically cost competition, depletes profitable opportunities, and in some cases leads to production losses and assets obsolescence.  This potential danger is increased because advanced R&D methods, coupled with strategic techniques such as reverse engineering, allow production methods to be inferred from the properties of products, and thus facilitate development of alternative solutions when the imitated processes and products are protected by intellectual property rights. Hence, the market process facilitates not simply imitation but creative imitation, which is more dangerous where it adds benefits to the consumer by introducing improvements to the imitated product or process.

Based on this understanding of the sources of market uncertainty, when firms use the market process protection costs will be incurred for the following purposes.  First, costs will be incurred to protect and control the use and dissemination of competitively valuable information, such as the costs to obtain patents or to maintain trade secrets, the costs to protect marketing data, organizational costs, etc.  These costs reduce competitive uncertainty for they increase the costs to competitors to obtain or develop their own competitively valuable information.  Second, costs will be incurred to collect competitively valuable information regarding the plans and products of competitors, for by in this way producers can adjust their plans accordingly and avoid any adverse effects of the actions of competitors.  Third, costs will be incurred to develop competitively valuable information, in the form of investments in R&D, in order to stay ahead of competition.  Finally, some costs, such as corporate identity and brand advertising, are incurred to give the firm time to respond to competitive innovations that threaten its market position.  Consumer loyalty, which the last two types of advertising secure, means that consumers do not switch brands immediately after other firms introduce more innovative products.  In turn, this gives the beneficiary of the consumer loyalty time to develop alternative innovations.

In general, protection costs reduce competitive uncertainty by either improving appropriability or sustainability conditions, and they achieve this result by protecting directly product information or market position of the firm.  Appropriability conditions are the factors that contribute to the maximization of the profits from single products, while sustainability secures the long-term position of the firm on the market.  Along these two dimensions the following taxonomy of protection costs can be offered:

Model of the firm

Costs are incurred in the process of fulfilling concrete functions.  For instance production costs are incurred when inputs are transformed into outputs.  Transaction costs are incurred when contracts are negotiated or enforced.  Thus, the question is what are the functions that maximize the protection of the market position of the firm, functions, then, with which we can associate protection costs?

Based on the analysis given in the previous section we can define three functions: (1) development of competitively valuable information (DI), (2) collection of competitively valuable information (CI) and (3) protection of competitively valuable information (PI).  On this view uncertainty seems to amount to nothing more but a “special case of incomplete information”  (M. Fransman 1992: p.150)  Putting special emphasis on the connection between uncertainty and information need not appear strange.  First, the value of most industrial property is in the knowledge embodied in it.  Know-how, machine design, and knowledge of processes are all examples of competitively valuable information.  Second, production losses, assets obsolescence, and bankruptcy occur because firms either lack or are unable to develop competitively valuable information.  Further more, I will say that the three functions form the core of the firm and are inalienable.  Let me draw a Venn diagram to show the core of the firm, and to make the last point clear:

According to the present model a market agent called a firm exists when it performs simultaneously the three functions, i.e., at the ICDP intersection.  If any one of the functions is outsources the competitive uncertainty increases and sooner or later the firm is forced out of the market.  Let me explain why this is the case.

How a firm may cease to be a firm is most obvious in subcontracting, especially when a large firm purchases the entire output of its supplier.  In this case the subcontractor has low competitive uncertainty, especially when the contract is long-term, and thus it may begin to work entirely according to specifications of its customer.  This is to say that the supplier may begin to rely on its customer for at least partial fulfillment of the three functions.  If for any reason the customer changes suppliers, the original subcontractor may be at competitive disadvantage both in terms of finding new customers and in terms of relevance of its competitively valuable information.  Since, however, firms have assets that can be used as a resource for transition, subcontractors who loose their sole customer do not disappear from the market immediately.  They can use the available resources to reconfigure their resources and to begin to fulfil the above mentioned three core functions.  The abandonment of the functions does not need to occur because of opportunistic behavior or because of moral hazard.  More often than not the absence of knowledge of protection costs leads to actions from ignorance.  This is to say that the savings in the interdependent relationship between a client and a supplier often come from savings in protection costs, which in turn weaken both the alliance and the market position of the members of the alliance.

One last question needs to be clarified before I turn to discuss the application of the present model to the virtualization of firms, which is the question why special emphasis is put on the protective function rather than on firms’ capabilities, to use the term coined by G. B. Richardson.  According to Richardson capabilities, or in other words “appropriate knowledge, experience, and skills” (1972: p. 886) are what firms need in order to carry out certain activities.  Evidently, a capable firm is one that is able to sustain its position on the market.  Hence, a firm can be described as a set of core capabilities.  So far so good.  But as T. Reve tells us: “In a changing world a strategic core which secured a competitive advantage last year, may be of little economic value this year.” (1990: p.141)  He proceeds to give two examples.  The first one is the failure of Swedish Facit, a firm that dominated the market for mechanical calculators but failed to adapt when electronic calculators were invented.  Second, Swiss watch manufacturers found themselves in the same position when electronic Japanese watches were introduced.  This line of though can be traced back to Schumpeter’s idea that discontinuous innovations strike at the foundations of firms, i.e., they eliminate existing market opportunities.  (See Schumpeter 1936)  If core capabilities can be changed completely, do such changes have a discontinuous effect on the firm?  It seems that the answer is “No”, for as firms change what they do and how they do neither is the firm liquidated nor a new firm is established.  Therefore, it can be said that the development of core capabilities is the result of the fulfillment of the three protective functions which secure the continuity of firms over time.  Having in mind the present model we can return to discuss virtual organization and the limits of its decentralization.

The question about the decentralization of firms

Why talk at all about the virtualization of firms?  The seeds of this discussion can be found in R.H. Coase’s article The Nature of the Firm.  In it he foresees two factors that contribute to the growth of firms: (1) inventions that reduce the cost of organizing spatially, such as the telephone and computer networks, and (2) improvements in managerial techniques, which also tend to reduce the cost of organization. However, in a footnote Coase makes it clear that innovations that reduce the cost of organizing may also reduce the cost of using the price mechanism:

“It should be noted that most inventions will change both the costs of organizing and the costs of using the price mechanism.  In such cases, whether the invention tends to make firms larger or smaller will depend on the relative effects on these two sets of costs.  For instance, if the telephone reduces the costs of using the price mechanism more than it reduces the costs of organizing, then it will have the effect of reducing the size of the firm.”  (p. 46)

Two of the costs associated with using the price mechanism are transaction and marketing costs.  Electronic bidding procedures make the cost of outcontracting negligible and thus eliminate the savings associated with hierarchical organization.   Electronic search engines also reduce marketing costs of companies that use the Internet.  Consequently, these two sets of costs are insufficient to explain the continued existence of centralized firms.  They suffice to explain spatial decentralization but not why hierarchical decentralization does not occur.  That is to say that we can have spatial decentralization, without having dissolution of hierarchy, as well as vice versa.  In other words, there are two dimensions to organization and the four distinct possibilities, as well as the type of firms that in reality correspond to them, are given in the table below:

Let me briefly explain the reasons for assigning particular firms in their places in the table:

• Low-H/Low-S corresponds to the neoclassical firm described by Adam Smith because both method of production and coordination process impose spatial and hierarchical centralization.
• High-H/Low-S corresponds to small partnerships and some family businesses that usually have flat organizations, but are spatially centralized either because of the nature of the production process, or because of the nature of the relationship among its members.  Such firms are often created to provide income to family members, and in turn keep the family members closer together.  As Alchian and Demsetz (1972) point out the lack of transparency of labor inputs often creates incentives for shirking and sooner or later such firms become centralized.
• High-H/High-S is simply the market mechanism where independent producers sell to one another products and services, and the ideal virtual firm falls within this category.
• Low-H/High-S centralization represents the quasi-virtual firm modeled in this paper.

Even though the term “virtual organization” has no settled upon meaning virtual firms have been placed along the Low-H/High-S or Low-S dimensions.  For instance, according D.J. Teece: “The distinguishing features of such firms are that they will possess a change culture upon which there is great consensus.  They will have shallow hierarchies and significant local autonomy.  Such firms will resist the hierarchical accouterments of seniority and rank … and they will resist functional specialization which restricts the flow of ideas and destroys the sense of commonality and purpose.”  ( 1996: p. 123)  Such firms are inherently unstable first because of the monitoring problems indicated by Alchian and Demsetz (1972), and second, because as incentives become greater opportunistic behavior tends to increase.  But it can be said that all organizations face these problems regardless whether they are virtual or not, and traditional partnerships are the paradigm case.    Thus, the question that comes to mind is why virtual organization would increase this problem, if it indeed does?  In fact it seems that there is no single factor in the use of communication technology that makes this problem any worse.  On the contrary, labor-tracking software increases transparency of inputs, and various contracts, such as confidentiality agreements, decrease the possibility of opportunistic behavior.  If anything, virtual organization has increased the possibility of decentralized control, which is why we see more spatial decentralization.

Limits of decentralization

So far I have insisted that communication technology has increased the possibilities for hierarchical decentralization.  Now I have to show what are the limits.  To do so I will ask the reader to perform a thought experiment about how an ideal virtual firm does business.  This is a conceptual point, but it helps us understand how the proposed model can be applied to evaluate the internal organization of firms.  An ideal virtual firm is one in which all processes that require additional labor inputs are subcontracted.  Thus, all unitary agents are dissolved into individual market agents, which leaves no logical possibility for hierarchy.  Ergo, the market and its high power incentives have triumphed over command and hierarchical organization.  When the relationships among individual market agents are highly impersonal, all coordination is indeed achieved simply through the price mechanism in a Hayakian manner.  It emerges spontaneously as prices transmit information to market agents, and thus, cause immediate adjustments of individual plans.

The ideal virtual organization just described requires that independent market agents bid to supply all inputs necessary for its operations.  But what are the implications of such organization?  More precisely, the question is whether one can request bidding for development of competitively valuable information and for collection of competitively valuable information, and whether it is wise to do so.  If a software developer posts on his website all the components which he needs in order for other programmers to bid for the jobs he is in fact making public the architecture of his product.  This is equivalent to making blueprints, R&D plans, etc. public knowledge.  In turn, it increases the competitive uncertainty for any other agent can use the information to develop a similar product, and if they do it faster the virtual firm will be at competitive disadvantage—the competitor will have secured a first mover advantage.  It can be concluded that the ideal virtual firm is perfectly unprotected against the actions of competitors for competitive bidding cannot be organized virtually without producers giving out important information.

The alternative to bidding for the supply of products and services is bidding for jobs.  The benefit of this process is that the employer does not need to disclose the details of the job, and hence competitively valuable information is better preserved.  Thus, employment contracts can be virtualized with significantly less risk of the dissemination of competitively valuable information.  In fact, we see substantial amount of job postings on the Web.  Employment, however, is not cheap to the employer, and involves different types, but equally substantial risks and costs.  For instance, the employee may not be the right one for the job, and at the same time, the relationship often cannot be terminated immediately, which means that wages are sunk cost to the employer.  Hence, it can be said that if it is not for the impossibility firms to subcontract certain processes without increasing their competitive uncertainty, firms will not hire any workers.

The conclusions that can be drawn is that processes which contribute to the collection, development, and protection of competitively valuable information will not be outsourced since outsourcing increases the dissemination of information, and as it becomes available to competitors the competitive uncertainty increases too.  On the other hand, process that do not contribute in any aspect to the management of competitively valuable information will be outsourced for their internalization utilized managerial resources, which is one of the most costly inputs in the firm.  Given these considerations the boundaries of the quasi-virtual firms can be compacted within the ICDP intersection on Fig. 1.

The Virtualization of Firms: The Case of Ford Motor Company

Let us see now whether the ICDP model for organizational design can be applied in practice, which is to say whether the virtualization of firms takes place in accordance with the predictions of the model.  Implicit in the ICDP model is the assumption that as technology changes the relative contributions of different processes to the collection, development, and protection of competitively valuable information will change too.  Consequently, internal structure of firms will be continuously adapted to what best serves the reduction of competitive uncertainty.  In this aspect Ford Motor Company’s recently adopted new business model provides a starting point to see whether the adaptive strategy of firms to the virtual economy conform with the predictions of the ICDP model.  The Ford Motor Company case is even more relevant given that the company has transformed itself many times over the course of its existence.  Its transformations not only occurred parallel to the changes in the conceptions of the firm, but may be viewed as a test about the validity of these theories.

According to the new business model Ford Motor Company will transform itself from a mass producer of cars into a consumer-products and services company.  This is to say that Ford does not see production to be its core activity in the future.  In fact, what classifies the change in Ford as revolutionary is that Ford is the first car manufacturer to outsource final assembly.  (The Economist August 7^th, 1999)  The outsourcing of final assembly is a new trend that is exactly the opposite of what happened historically in the automotive industry.  Vertical integration in the automobile industry proceeded in the direction in which final assemblers, such as GM, bought out their part suppliers.  (A.D. Chandler 1962)  Thus, Ford’s decision to outsource final assembly appears as a reversal of history.   More so, given the fact that what Ford Motor Company is today is partially due to the invention of the assembly line by H. Ford.  Further more, Ford Motor Company aims not only to subcontract final assembly but also to make subcontractors responsible for maintenance, property management and utility supplies in its factories.  At first glance it appears that that Ford Motor Company has jumped on the subcontracting bandwagon, and that by opening widely its factory doors it is making its manufacturing blueprints publicly available, and is, thus, exposing itself to competitive risks.  But is it?  Unlike in the early days of the company, when improvements in the assembly process were key to the firm’s competitiveness, today external vendors provide the assembly machines, and thus, there is little competitively valuable information in this process. Hence, whether Ford Motor Company keeps or outsources assembly does not affect in anyway its competitive position on the market, for there is no dissemination of competitively valuable information when the doors of its factories are opened for subcontractors, nor a threat that subcontractors may move into car production.

Let us look now at the activities that will be retained in the company, and that will sustain Ford’s position as the number one car company in the world.  According to the new business model Ford Motor Company will concentrate in the future on the following core activities: (1) product development and research, i.e. car design and engineering, (2) branding, and (3) marketing and service operations.  (Financial Times August 4^th,1999)  It is not difficult to see that these three activities contribute directly to the collection, development, and protection of competitively valuable information.  The first and the third activity can be directly mapped to the ID and IC functions on Fig. 1.  Taking into consideration that most of the information developed by R&D is protected through patents and trade secrets, and that most of the information collected by marketing and service departments is also protected through trade secrets and confidentiality agreements, we can conclude that information protection is implicit in these functions, and their retention within the company only reinforces this protection.  Branding, on the other hand, is retained within the company because the massage that it conveys is closely related to the strategic plans of firms, which no firm wants to expose to the risk of being found out by its competitors.

As it is evident, the virtualization of Ford Motor Company is carefully guided by considerations about which processes contribute to the collection, development, and protection of competitively valuable information.  The analysis of the outsourcing and retention decisions indicates that the internal organization of Ford Motor Company is compacted towards the core of the ICDP model.  This is a controlled process of virtualization, which stands in contrast to the process of uncontrolled virtualization adopted by IBM in 1981 for the development of its PC.  IBM gained a short-term advantage from outsourcing key processes to Intel, Microsoft, and other vendors, for it was able to launch the PC on the market within 15 months and with minimum investment.  In the long-run, though, Intel and Microsoft intensified IBM’s competition by supplying its competitors, such as Compaq for example.  (D.J. Teece 1998)  Whether the process of controlled virtualization is the outcome of learning from the mistakes of others is not known to me, but as the analysis indicates the approach is consistent with the desire of companies to reduce competitive uncertainty.

Conclusion

In the present paper I have argued that there is another set of costs associated with the use of the market mechanism, i.e., the costs of reducing competitive uncertainty.  Such costs, which I called protection costs, are incurred to collect, develop and protect competitively valuable information, which value is determined from the ability of firms to use it proprietarily.  On this account, full understanding of the internal organization of firms can be gained only if all costs, i.e., production, transaction and protection costs, are considered.  I proposed a model for the virtualization of firms according to which processes that contribute to the collection, development, and protection of competitively valuable information will be internalized in order to secure its proprietary use.  When the cost to retain processes within the firm is higher than the cost to transact in the market, organizational costs are protection costs.  On the other hand, processes that do not contribute to the reduction of competitive uncertainty will be outsourced to save on organizational costs.  Finally, it can be added that the spatial boundaries of quasi-virtual firms will be set by the cost of the firewalls around corporate networks.

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Conceptual Analysis, virtual organization