A sociological view on hierarchical failure: The effect of organizational rules on exchange performance in buyer-supplier transactions

The classic Transaction Cost Economics view is that a key reason for firms to exist is that they offer a way to overcome problematic market transactions. If it is too complicated, expensive, or risky to buy a good on the market, consider hiring employees to make it in-house - especially if it is a good that you (and others) might need often. The implicit argument is that, for this reason, firms are a potentially rational response to less advantageous markets. However, firms are rational responses only when they themselves are organized in a way that is efficient enough to outperform the market. We consider firms’ hierarchical efficiency by analyzing the existence and consequences of rules and procedures, effectively testing two competing arguments. On the one hand, rules and procedures are one way in which firms can achieve efficiency, through specialization and formalization of what a firm has learned. On the other hand, rules can be imprecise and rigid, a nuisance to deal with, and just coincidental traces of what has gone wrong in the past. Using a database of more than 800 transactions in which German small and medium sized businesses buy ICT products and services, we consider the role of rules and procedures in a large-scale quantitative way. It turns out that rules show a pyramid-like structure where some firms have less and others have more codified rules. Our results furthermore suggest that rules might not be the clotted efficiency they have been argued to be. A high rule-density goes with increased investments in contracting (“thicker contracts”) and not with decreased ex post transaction problems, questioning the benefits of rules as a way to favor firms over markets.