The music companies also favor the network model over discrete market transactions because the relationship with the user is more likely to be sustained into the future. In other words, users are less likely to take their business elsewhere, as they would were they to enter into a discrete market-exchange transaction. That’s why automobile companies such as General Motors and DaimlerChrysler, if they had their way, would never sell another car again. They would much prefer to keep the car and have the user pay for access to the driving experience through a leasing agreement. This way, they create a relationship with the client that is more likely to be sustained than if the buyer purchased an automobile. At Ford, the renewal rate for leasing cars is nearly 50 percent, while 24 percent of customers who bought their last car from Ford are likely to buy their next car from the company.
1
Transaction costs and margins also come into play in the shift from market-exchange models to network models. In a market-exchange economy, sellers make profit on their margins, and margins are dependent on transaction costs. But most corporate executives I work with tell me that their margins are continuing to go down, mainly because of the introduction of new communications and production technologies, as well as new methods of organization that are reducing their transaction costs. When transaction costs approach zero, margins virtually disappear, and market exchanges are no longer viable ways of conducting business.
Book publishing is a case in point. In a market, I sell my book to a publisher, who then sends it to a printer. From there, it is shipped to a wholesaler and then to a retailer, where the customer pays for the product. At each stage of the process, the seller is marking up the cost to the buyer to reflect his or her transaction costs. But now, an increasing number of publishers—especially of textbooks and research books, which require continuous updating—are bypassing all the intermediate steps in publishing a physical book and the transaction costs involved at each stage of the process. While Encyclopedia Britannica still charges $1,395 for its twenty-two-volume set of books, the company sells far fewer physical books. Instead, the company puts the books’ contents on the World Wide Web, where information can be updated and accessed continuously. Users now pay a subscription fee to access the information over an extended period of time. Encyclopedia Britannica eliminates virtually all the remaining transaction costs of getting the information to its subscribers. The company has made the transition from selling a physical product to a buyer to providing the user access to a service over time. How does a physical book compete with an online book in the future, when the latter has reduced the transaction costs so dramatically? The same process is at work across many industries. (See
The Age of Access
for a more detailed analysis.)
In every industry, there are scattered operational examples of “pure” network models. There are many more instances in which partial networks already exist. In these cases, multiple parties come together to share expertise, knowledge, research facilities, production lines, and marketing channels. The idea behind the networks is to pool resources and share risks while improving quality and reducing the time necessary to get goods and services to end users.
What all these networks have in common is a way of doing business that differs fundamentally from the market-exchange model articulated by Adam Smith and the classical economists and their neoclassical successors in the twentieth century. The operational assumptions that guide networks turn much of orthodox market-based economic theory on its head and open up a new window for rethinking political governance as well.
Recall, Adam Smith argued that the superiority of a market-exchange economy lies in the ability of each individual to pursue his or her own self-interest. In
An Inquiry into the Nature and Causes of the Wealth of Nations,
Smith writes:
Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of society which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to the society.
2
Markets, by their very nature, are adversarial forums. They are arm’s-length exchanges where each party enters into the negotiation with the idea of maximizing his own self-interest at the expense of the other party. Buy cheap, sell dear, and
caveat emptor
—let the buyer beware—have been guiding behavioral principles from the very beginning of modern market relations.
Networks operate on an entirely different principle. Each party enters into the relationship based on the supposition that by optimizing the benefits of the other parties and the group as a whole, one’s self-interest will be maximized in the process.
Networks are made up of autonomous firms that give up some of their sovereignty in return for the benefits of sharing resources and risks in an extended field of operations. In a network, each party is dependent on resources controlled by another party. The parties become, in effect, a single entity engaged in a common task for a period of time.
The film industry was one of the first to shift into a network way of conducting business. The big studios disaggregated their operations in the late 1940s and early 1950s. Skilled craftsmen and creative personnel, who were previously employed in-house, set up their own independent companies. Now, when a film is done, the major movie studios partially finance the film and market it, while the executive producers bring together all of the individual subcontracting firms—the cinematographers, set designers, editors, etc.—in a short-lived network to make the movie. Often, the risks are distributed among the key entities, and they each share in the revenue stream once the film is released.
Sociologist Manuel Castells identifies five primary kinds of networks: supplier networks, in which firms subcontract for a range of inputs from design operations to the manufacturing of component parts; producer networks, composed of companies that pool their production facilities, financial resources, and human resources to expand their portfolio of goods and services, broaden geographic markets, and reduce up-front risk costs; customer networks, which link together manufacturers, distributors, marketing channels, value-added resellers, and end users; standard coalitions, which bring together as many firms as possible in a given field with the purpose of binding them to the technical standards established by an industry leader; and technology cooperation networks, which allow firms to share valuable knowledge and expertise in the research and development of product lines.
3
The keys to a successful network are reciprocity and trust. Each member of the network operates out of a sense of “goodwill,” feeling an obligation to cooperate and assist rather than take advantage of the other parties. Trust is at the core of network relationships. Caveat emptor is replaced with the notion that none of the parties “will exploit the vulnerabilities that partnerships create.”
4
When companies enter into networks, they give up some of the control they enjoy in markets. They have to share knowledge, make their operations transparent, and allow their partners to know a lot more about how they conduct business. In short, they give up some of their autonomy to become part of an extended commercial activity. In the process, they become exposed and vulnerable. In the market arena, by contrast, sharing knowledge and making one’s operations transparent would be seen as an error in judgment, allowing competitors to take advantage of one’s weaknesses. In a network, however, vulnerability is considered a strength, not a weakness, a signal of trust and a willingness to work together to everyone’s mutual benefit.
Networks rely as much on the informal social ties of the participants as on the formal arrangements between the parties. The more embedded individual players become with each other, the more likely they will be willing to open up and share valuable knowledge, expertise, and often vital business data with others. One prominent CEO put the value of embeddedness this way:
Of course [opportunism] can be a problem, but do you think that I would ever have made such a close relationship with this guy over so many years if I thought he would screw me if he had a chance? That’s why he has so much business. I can trust him.
5
The close relationships between the players in a network often give them the lead over companies engaged in old-fashioned adversarial arm’s-length market exchanges. Brian Uzzi, writing on the value of structured embeddedness in the
American Sociological Review,
notes,
Embedded ties promote, and enable the greatest access to, certain kinds of exchanges that are particularly beneficial for reducing monitoring costs, quickening decision-making, and enhancing organizational learning and adaptation. These benefits not only accrue to the individual firms of a network connected via embedded ties, but to the network as a whole.
6
The advantages of embeddedness become apparent when many companies work together on a common project that is complex and requires putting everyone’s heads together. The more each knows about the others’ expertise, perspectives, and approaches, and the more each member is willing to share his or her own ideas, the greater the likelihood of success. In cutting-edge high-technology industries and in the retail sector, where being first to market with an innovation is critical to success, being able to pool knowledge among a broad group of players, each of whom understands a specific part of the process, can result in quicker problem-solving. Said another CEO,
When you deal with a guy you don’t have a long relationship with, it can be a big problem. Things go wrong and there’s no telling what will happen. With my guys [referring to embedded ties], if something goes wrong, I know we’ll be able to work it out. I know his business and he knows mine.
7
Networks also facilitate the exchange of vital industry information that would not necessarily be available to a firm operating as an autonomous agent in an adversarial market. Uzzi reports on one manufacturer who “passes on critical information about next season’s hot sellers only to his close (network) ties; thus giving them an advantage in meeting future demands.”
8
In a global economy where competition is stiff and the difference between success and failure often hinges on subtle variations in the quality of goods and services, networks often enjoy an advantage over individual market players. One clothing manufacturer said,
If we have a factory that is used to making our stuff, they know how it’s supposed to look. They know a particular style. It is not always easy to make a garment just from the pattern, especially if we rushed the pattern. But a factory that we have a relationship with will see the problem when the garment starts to go together. They will know how to work the fabric to make it look the way we intended.
9
A sense of indebtedness is at the heart of the network model. It’s the feeling that “we’re all in this thing together” and need to go the extra mile to support others in the network, in good times as well as bad. One CEO explained what indebtedness means in his own firm’s relationships with its network partners.
I tell them [subcontractors] that in two weeks I won’t have much work. You better start to find other work. [At other times] . . . when they are not so busy we try to find work . . . for our key contractors. We will put a dress into work . . . to keep the contractor going . . . where we put work depends on [who] needs to work [to survive].
10
What’s ultimately driving the shift to a network model is time scarcity. Organizational theorists Candace Jones and Stephen Borgatti of Boston College and William Hesterly of Utah’s David Eccles School of Business observe that the old economic model that relies on sequential market exchanges between clients, suppliers, and distributors to coordinate complex tasks and get new products to end users is just too slow and outdated. Networks that coordinate the expertise of all the players in the commercial mix, from suppliers upstream to distributors and even end users downstream, in a single team approach, have the clear edge in reducing the lead time in getting new products and services out the door. Certainly that has been the case in the semiconductor, computer, film, and fashion fields, where product life cycles are often measured in weeks and months rather than years. Networks are also better positioned to reduce costs in competitive markets like the auto industry.
11
Networks spawn greater creativity and innovation for the simple reason that they have a larger pool of the best minds to draw from. Walter W. Powell says that when one compares the advantages and disadvantages of the various business models, it becomes clear that
passing information up or down a corporate hierarchy or purchasing information in the marketplace is merely a way of processing information or acquiring a commodity. In either case the flow of information is controlled. No new meanings or interpretations are generated. In contrast, networks provide a context for learning by doing. As information passes through a network, it is both freer and richer; new connections and new meanings are generated, debated, and evaluated.
12
When commercial transactions were fewer, when the lead time for a new product introduction was longer, and when there was still plenty of untapped and unexploited consumer market potential, market exchanges and hierarchical ways of organizing business made sense. Giant, vertically configured companies with hierarchically controlled management could produce standardized products with long life cycles, allowing them to amortize their costs while maintaining centralized control over research and development, production schedules, and distribution channels. And the slow pace of discrete and discontinuous market exchanges was still sufficient to keep up with consumer demand.