08The Impact of Information Systems on Organizations and Markets-gurbaxani-1991(15)

8/10/2019 08The Impact of Information Systems on Organizations and Markets-gurbaxani-1991(15)

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O r g a n i z a t i o n s

a n d M a r k e t s

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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,



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



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.



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

Janu ary 1991/Voi.34, No.l/COMMUNICATIONS F THE

ACM



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.

COMMUNICATIONS OFTHE ACM January 1991/Vo1.31, No.1

63



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



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



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~



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



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

7 0

January 1991/Vol.34,No.I/COMMUNICATIONS OFTHEAGM



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

COMMUNICATIONS OF THE

ACM/January 1991/Vol.34, No.l

71



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

ACM/January 1991/Vol.34, No.l

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08The Impact of Information Systems on Organizations and Markets-gurbaxani-1991(15)

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