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Information Aggregation, Matching and Radical Market-HierarchyHybrids: Implications for the Theory of the Firm

TEPPO FELIN

Marriott SchoolBrigham Young University587 Tanner BuildingProvo, UT 84602801 422-3478 (o), 801 422-0539 (f)

teppo.felin@byu.edu

TODD R. ZENGER

Olin Business SchoolWashington University, Campus Box 1133One Brookings DriveSt. Louis, MO 63130-4899314 935-6399 (o), 314 935-6359 (f)

zenger@wustl.edu

Forthcoming in

Strategic Organization

* Thanks to Joel Baum and the editors of

Strategic Organization

for theirdevelopmental comments. We would also like to thank Alph Bingham, Nicolai Foss,Amit Gal, Peter Klein and Gordon Smith for their feedback. Central arguments fromthis essay were also presented at the University of Virginia (Darden), University of South Carolina and Lund University, Sweden—feedback from these presentationshelped improve our arguments. The usual disclaimers apply.

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Information Aggregation, Matching and Radical Market-HierarchyHybrids: Implications for the Theory of the Firm

More than sixty-five years ago Friedrich Hayek parenthetically remarked thatwhile "man has learned to use [the market]...he is still very far from having learned tomake the best use of it" (1945: 528). The ensuing years have seen significantinnovation in the structure and use of markets, including the infusion of marketmechanisms into organizations (Zenger and Hesterly, 1997). However, the focus inextant scholarship has largely been on the market’s high-powered incentives. Butmarkets—as we will argue—have additional features, such as information aggregationand matching. These novel features of markets have recently begun to receivemanagerial attention as organizations experiment with market-like practices such ascrowdsourcing, information and prediction markets, and open innovation. While weare

descriptively

learning much about these market-like practices and forms,nonetheless the

theoretical

foundations behind them, their implications for

comparative

governance (market versus hierarchy), their possible forms (market-hierarchy hybrids) and implications for strategy and competitive advantage have yet tobe fully vetted in the organizational literature.

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The purpose of this essay, then, is to step back and theoretically discuss thecommon threads that unite innovative practices such as prediction markets andcrowdsourcing, and more importantly, to discuss their comparative implications formarkets and organizations, as well as market-hierarchy hybrids. We specifically focuson two, relatively neglected features of markets as a governance form—features thatgive markets an advantage over firms and hierarchy: information aggregation andmatching. We provide a contrast of the informational and matching-relatedassumptions associated with coordinating economic activity via the market’s pricemechanism versus hierarchy and organization, and highlight the potential gains frominfusing the information aggregation and matching-related features of markets intoorganizations.While organizational scholars have certainly focused on the importance of information in organizations (Stinchcombe, 1990), and economists have highlightedthe role that information plays in markets (e.g., signaling, information asymmetry,Spence, 1973; Stiglitz, 1961), nonetheless the market’s capacity for informationaggregation and matching has not been well integrated into our theories of the firm—specifically, questions of comparative governance and radical market-hierarchy hybridforms of organization. Based on our discussion, and in the spirit of the SO! SoapboxForum, we also speculate on possible areas of future research for the field of strategicorganization.

Information Aggregation in Markets

Information aggregation and prices are the sine qua non of markets. The “marvel of the market”—as Hayek put it—is that prices embody the aggregate information of dispersed actors. Prices signal opportunities and thus “act to coordinate the separateactions of different people” and “spontaneously” direct resources (1945: 526). In

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markets, economic actors—with differing expectations and information about thevalue of activities or resources—come together and prices dynamically coordinatetheir actions and interactions. If an economic actor deems the price of a proposedactivity or asset as too costly, she foregoes the activity or the purchase. Theinformation that this choice provides—along with the choices of myriad others—isaggregated and this information is dynamically reflected in updated prices. Theseupdated prices then, in turn, shape future choices. Overlal, market prices essentiallyrepresent the aggregation of idiosyncratic and local knowledge and expectations aboutthe value of resources, strategies and paths of action.Hierarchy provides a quite distinct alternative to markets and prices as a meansof governance and as a form of information aggregation. Firms emerge because pricesin markets fail to provide adequate information about opportunities or fail toadequately support, enable, or safeguard the pursuit of exchange (Williamson, 1985).Under these conditions, hierarchy and authority “take the place of the pricemechanism in the direction of resources” due to the costs associated with transacting(Coase, 1937: 388). As articulated by Coase (1937), within firms an “entrepreneur-co-ordinator directs resources” and more generally “coordinates production.” Hierarchyrelies on top-down coordination through fiat. As noted by Coase, an employee doesnot take actions within a firm “because of a change in relative prices, but

because he isordered to do so

” (Coase, 1937: 387). In contrast, the market form is inherently more“spontaneous” and bottom-up in nature, as actions and choices are coordinated byinformation held by agents and information embedded in prices. Changes in pricestrigger changes in the behavior of actors.But while we understand much about the role of prices and information inmarkets as a governance form, the loss of aggregate information that occurs astransactions are internalized—as fiat replaces price—has been underemphasized in thecomparative institutional approach of transaction cost economics. Instead, the focushas been on the loss of high-powered incentives (Williamson, 1985; also see Zengerand Hesterly, 1997). But, in moving from market to hierarchy we also experience adramatic loss in the aggregate information that markets provide—the dispersedinformation of numerous individuals. The market, again, effectively filters andaggregates information from a vast array of heterogeneous actors.By comparison, authority and fiat are informationally more centralized (Foss,2002). The burden to assemble and process information within hierarchy is placedmore directly on a manager or entrepreneur (and their discretion)—where it is, insome measure, implicitly assumed that hierarchy and management are endowed withthe necessary expertise to make decisions (or even second-order decisions about whoshould make decisions). Therefore, at a very basic level, the choice between the useof market and hierarchy involves an assessment of whether the entrepreneur-manager(or a delegate) possesses adequate information and expertise to select a course of action or whether information in the form of proposals and prices from the vast anddisparate resources in the market is preferred.Transaction cost economics’ relative neglect of the market’s role ininformation aggregation stems partly from the focus that it has on the governance of