Transaction Cost Economics: An Introduction

Professor Oliver E. Williamson, University of California, Berkeley.

It has been a while since I've been able to get back to a normal level of research. If you recall we were had begun a very large review of the "Laboratory of Economics and Management Sant'Anna School of Advanced Studies" or LEM Working Paper Series. This group of papers has many worthwhile documents to review, and our interest in them falls primarily on the topic of innovation, and as an extension to the work we have done in reviewing Professor Giovanni Dosi. We are also the majority of the way through Professor Langlois' works with 26 blog entries so far. And finally we had just completed the 2006 ESNIE conference presentations of Langlois' and Professor Sydney Winter, and were to review a document of Professor Oliver Williamson and a number of papers and slide presentation of Professor Giovanni Dosi. Last but not least I have one more blog entry to complete for Professor Dosi's "Sources Procedures and Macroeconomic Effects of Innovation" which was the cornerstone paper of my thesis. This entry is the sole working paper presented by Professor Williamson at the 2006 ESNIE Conference.

Now back to Williamson's "Transaction Cost Economics (TCE): An Introduction". With this review I hope to show that much of the past history in the oil and gas industry systems development area has been compliance and governance. SEC regulations, Tax Regulations and Royalty Regulations are what consume most of the managements time in an oil and gas company. This compliance focus is the fault, in my opinion, of the software provided to the industry by SAP, Oracle and IBM. The business of the energy business has been ignored, more or less, by the software vendors focus on compliance and governance.

Nonetheless the culture of the industry continued to evolve, with the methods and means of getting the work done existing within the working interest ownership groups. These processes to a large extent were required for the interaction between the oil and gas producers, as represented in the Joint Operating Committee. This area of how the business of the energy business operates has largely been excluded by the competition of this software development proposal. It is this culture of the Joint Operating Committee that is the natural form of organization in oil and gas. If we define the JOC as the key organizational construct, and support it through this software development proposal. The compliance and governance aspects of the producers interests can be automated and actively support the work that is the key and necessary aspects of the business of the energy producer at the Joint Operating Committee.

A few introductory comments from Professor Williamson.

This overview of transaction cost economics differs from prior overviews to which I have contributed in two respect: it presumes little previous knowledge of the transaction cost economics (TCE) literature; and it is organized around the "Carnegie Triple" - be disciplined; be interdisciplinary; have an active mind. It is partly autobiographical on that account. p. 1

As I have discussed elsewhere (2002a), the lens of contract divides into two related branches: public ordering and private ordering. The latter further divides into ex ante incentive alignment (agency; mechanism design, property rights) and ex post governance branches. Although these two are related, TCE focuses predominantly on the governance of ongoing contractual relations. pp. 2 - 3

..."the ultimate unit of activity ... must contain in itself the three principles on conflict, mutuality and order. this unit is a transaction" (Commons, 1932, p. 4). This prescient two sentence statement prefigures the study of governance in two respects: not only does the lens of contract / governance take the transaction to be the basic unit of analysis, but governance is viewed as the means by which to infuse order, thereby to mitigate conflict and realize mutual gains. This is a recurrent theme. p. 3

Hmm, Williamson must have done some work in oil and gas.

The third quotation goes to the importance of economizing, broadly in the spirit of Frank Knight's observation that (1941, 0. 252; emphasis added): "Men in general, and within limits, wish to behave economically, to make their activities and their organization "efficient" rather than wasteful." p. 3

I read this last point as the motivation and manner that people have created the "work-around" between the ERP system and actually getting the job done. Or as I have stated, the natural way of getting things done in the oil and gas business. If we reflect back to the work that Professor Langlois concluded, where the boundaries of the firm and market, taken in the larger scope of defining where the transaction should occur. And the division of labor necessary to achieve the greatest level of efficiency. The balance would appear to be dictated by a fulcrum of innovation, and I am stating that this efficiency and innovativeness can be captured and enabled within this software development proposal. And this is also reflected in the next quotations from Williamson's paper.

Of the various forms that economizing can take, TCE is predominately concerned with economizing on transaction costs - drawing inspiration from Ronald Coase (1937, 1960) in this respect. p. 3

and

Herbert Simon: "Nothing is more fundamental in setting our research agenda and informing our research methods than our view of the nature of the human beings whose behavior we are studying" (1985, p. 303) p. 4

and

Jon Elster's dictum that "explanations in the social sciences should be organized around (partial) mechanisms rather than (general) theories (1994 p. 75 emphasis in original). p. 4

People, Ideas & Objects is the name of this software development proposal. A modification of Professor Paul Romer's Economic Growth theory of "People, Ideas and Things". I think that I have captured some of the brilliance of the work that has been done in the area of organizational economics, and specifically the many ideas in which we are able to stand on the shoulders of.

TCE shares a good deal of common ground with game theory (Kreps, 1999, p. 127), in that the parties to a contract are assumed to have an understanding of the strategic situation within which they are located and position themselves accordingly. TCE nevertheless differs in that contractual incompleteness sets in as the limits on rationality becoming binding in relation to transactional complexity. Also, TCE views governance as a means by which to relieve the oppressive logic of "bad games," of which the prisoner's dilemma is an exemplar. p. 5

Pragmatic methodology

In many ways what I am suggesting with this software development process is that an energy producer do away with their current systems through a long process of atrophy. As this software development initiative replaces the needed functionality and capability to do their work. Using today's new technologies, with an energy industry focused technological vision, and based on the simpler methods of doing "the business of the energy business" through the Joint Operating Committee as the key organizational construct.

Describing himself as a native informant rather than as a certified methodologist, Robert Solow's "terse description of what one economist thinks he is doing" (2001, p. 111) takes the form of three precepts: keep it simple: get it right; make it plausible. Keeping it simple is accomplished by stripping away inessentials, thereby to focus on first order effects - the main case, as it were - after which qualification, refinements, and extensions can be introduced. Getting it right entails working out the logic. And making to a plausible means to preserve contact with the phenomena and eschew fanciful constructions. p. 6

I believe the track that current systems are on is one that leads to a systemic meltdown of both the application (such as SAP) and the client companies. The complexity of operating the systems has already reached an excessive point and the future only sees more of the same technical solutions to the technical problems and the business of the business falls further from the focus of the systems providers.

Solow Observes with reference to the simplicity precept that "the very complexity of real life ... [is what] makes simple models so necessary"(2001, p.111). Keeping it simple requires the student of complexity to prioritize: "Most phenomena are driven by a very few central forces. What a good theory does is to simplify, it pulls out the central forces and gets rid of the rest" (Friedman, 1997, p. 196). Central features and key regularities are uncovered by the application of a focused lens. p. 6

So yes, I am the current author of the idiotic and irresponsible comments of starting over with the systems used in oil and gas. But maybe I am also the first to tell the Emperor he has no clothes. The latter naturally seems more probable from my point of view. And more and more of the users that are being subjected with the types of work-arounds that I have discussed in this blog are beginning to see and appreciate the alternate perspective discussed here. Professor Williamson now emphasizes the need to get this right, and I will assert the role of the user in making, assuring and demanding that these systems are appropriate for the oil and gas producers.

Getting it right "includes translating economic concepts into accurate mathematics (or diagrams, or words) and making sure that further logical operations are correctly performed and verified" (Solow, 2001, p. 112). p. 6

For it is the user, who understands the job at hand and what is required. It is the user that can best define their needs and ensure that what is developed meets those needs. SAP may be able to formulate good software in Germany but their understanding of the geology, engineering and administrative aspects of an oil and gas producers pipeline, drilling, miscible floods and NGL business are very limited. And lastly my primary concern is that large gaping holes in SAP's understanding of the oil and gas business may lead to further operational failures of the type that BP has experienced in the last two years.

Plausible simple models of complex phenomena ought "to make sense for 'reasonable' or 'plausible' value of the important parameters" (Solow, 2001, p. 112). Also, because "not everything that is logically consistent is credulous" (Kreps, 1999, p. 125), fanciful constructions that lose contact with the phenomena are suspect especially if alternative and more veridical models yield refutable implications that are congruent with the data. p. 7

And it is my assertion that SAP would not be able to pass this simple test. To me this software development project should be self evident, and although a bit before its time, the ultimate demand will surface as a result of a failure of "business as usual" to meet the demands of energy consumers. Do we need to prove the failure is real before we proceed with the development of this software?

This last brings me to a fourth precept: derive refutable implications to which the relevant (often microanalytic) data are brought to bear. Nicholas Gergescu-Roegen had a felicitous way of putting it: "The purpose of science in general is not prediction, but knowledge for its own stake," yet prediction is "the touchstone of scientific knowledge" (1971, p. 37). p. 7

Most of my career I have found the contradictions and conflicts within the work I did in the oil and gas industry, frustrating. It was clear why things needed to be done from a systems point of view when the abilities of the technology, and the real constraints of the organizations where evident. When things get stressed to the limits, as I believe they are close too now, will those conflicts and contradictions compel people to deal with these problems as I have done. Where the time, energy and money necessary to start over, pales in comparison to the resource demands necessary to continue on with the futile systems of yesteryear. This reality also considers the sustained inability to increase the organizational performance in terms of time and innovativeness. One that is unable to adopt the ideas prescribed in this blog, based on the advanced research of the Economists we follow. A future where change and innovation within the producer organizations is desperately needed.

Most social scientists know in their bones that theories that are congruent with the data are more influential. Milton Friedman's reflections on a lifetime of work are pertinent: "I believe in every area where I feel that I have had some influence it has occurred less because of the pure analysis than it has because of the empirical evidence that I have been able to organize. p. 8

Be interdisciplinary

Professor Williamson brings the topic of being interdisciplinary to the economist. I would like to add to his list of disciplines the information technologies that are a foundation and enabler of these concepts. The browser's of the Internet have brought sophisticated information to the user. The future Information Technologies see an extension and continuation in the underlying concepts of the Internet. Concepts that are critical to the user to fully understand and comprehend. The list of technologies is too long for the purposes of this blog entry. I would suggest that each individual begin the long-term critical review of the Information Technologies that are available today, and continue with that curiosity / sense of discovery in the future.

The injunction to "be interdisciplinary" actually overstates. The qualified version is this: be prepared to cross disciplinary boundaries if and as this is needed to preserve contact with the phenomena. Being interdisciplinary is conditional, therefore, on a perceived need and is introduced strictly in a pragmatic way. Such conditionality not withstanding, training in one or more of the contiguous social sciences is instructive for all students of economic organization. The pragmatic reason for such training is this: economists who lack an appreciation that some of what is going on out there has non-economic origins will be neglectful of or will misinterpret forces that are responsible for consequential regularities that ought to be taken into account. As hitherto indicated, TCE joins economics with organization theory and selected aspects of the law (especially contract law).

Organization theory

In this next section Professor Williamson ties Transaction Cost Economics (TCE) in with organization theory. The two disciplines fit together and are inherently related. I would point to this software development proposal as evidence of the relationship. Professor Williamson now brings in Human actors as a further related item and clarifying the assumptions about those actions.

Human Actors: Attributes of human actors that bear crucially on the lens of contract / governance are cognition, self-interest, and foresight (where the last can be considered an extension upon cognition). Human actors are described as boundedly rational, by which I mean "intendedly rational, but only limitedly so" (Simon, 1957, p. xxiv). So described, boundedly rational human actors lack hyper-rationality but are neither non-rational nor irrational. Rather, such human actors are attempting rationally to cope. For TCE purposes, the key ramification of bounded rationality for the study of contract is that all complex contracts are unavoidably incomplete. The analytically convenient fiction of complete contracting is thus disallowed. p. 9

and

Self interest is described in a two part way. Routine events are described as benign - in that most people will do what they say most of the time and some will do more. Outliers, however, pose tensions. The spirit of cooperation that facilitates ongoing adaptations to routine disturbance prospectively gives way to a more calculative orientation as the stakes increase. The hazard of opportunism - defection from the spirit of cooperation in favor of the letter of the contract - thus arises. p. 9

and

Boundedly rational human agents who possess feasible foresight will thus attempt to mitigate contractual hazards in cost effective degree, as a result of which the efficacy of contracting is extended over a wider range. Fewer transactions are taken out of markets and organized internally on this account. p. 10

My perception of how this system is built reflects that the oil and gas "market" is the Joint Operating Committee. The bureaucracy, or hierarchy or what remains of it as a result of the changes to the "Military Command & Control" styled structure, is responsible for the "Compliance & Governance" of the market operations, and the "Knowledge & Research Module". I believe the need to move or adapt to this definition is necessary to facilitate the speed and innovativeness that the energy market is now demanding of the producers. Here Professor Williamson suggests two types of "Coordinated Adaptation".

Coordinated Adaptation: Adaptation is taken to be the main problem of economic organization, of which two kinds are distinguished: autonomous adaptations in the market that are elicited by changes in relative prices, as described by the economist Friedrick Hayek (1945), and coordinated adaptations of a"conscious deliberate, purposeful kind" accomplished with the support of hierarchy, as described by the organization theorist Chester Barnard (1938). Conditional on the attributes of transaction, adaptations of both kinds are important - which is to say that TCE examines markets and hierarchies in a combined way (rather than persist with the old ideological divide between markets or hierarchies). Explicating the differential efficacy of alternative modes of governance - whereby markets enjoy the advantage in autonomous adaptation respects, the advantage shifts to hierarchy as transactions pose a greater need for consciously coordinated adaptations, and hybrid modes are a compromise mode that display adaptive capacities of both kinds (albeit in intermediate degree) - is central to a predictive theory of governance. p. 10

I take this to be explicit validation of the boundaries of the firm as determined by the analysis reflected in this blog. And the means and mechanisms to this change is this software development proposal. And I am certain that the power within these ideas have the capacity to exercise these adaptations with or without the current organizations in the oil and gas industry. That is to say I can see building this software in a number of different ways.

Awaiting a demonstration that superior feasible and implementable alternatives can be devised, social scientists need to come to terms with, rather than denounce, unwanted path dependent outcomes. p. 12

Contract Law

A key understanding of the implications of contract law, TCE and markets / firms is made by Professor Williamson.

Whereas the details of firm and market organization are scanted under lens of choice setups, the lens of contract / governance describes each generic mode of governance (market, hybrid, hierarchy) as a distinct syndrome of attributes, each of which differs in incentive intensity, administrative control, and contract law respects. These differences give rise to different adaptive strengths and weaknesses. p. 12

Thus, whereas the contract law of markets is legalistic (corresponds to the ideal transaction in both law and economics, whereby disputes are settled by court-ordered money damages, after which each party goes its own way), hybrid transactions and especially, hierarchical transactions are ones for which continuity is valued. The common view of contract as legal rules thus gives way to the more elastic concept of "contract as framework," where the framework "never accurately indicates real working relations, but ... affords a rough indication around which such relations vary, an occasional guide in cases of doubt, and a norm of ultimate appeal when the relations cease in fact to work." (Llewellyn, 1931, p. 736). p. 13

Not only does TCE hold otherwise, but the contract law differences that TCE associates with alternative modes of governance are among the reasons why governance structures differ in discrete structural ways. p. 14

Obviously the legal profession has dealt with these differences many times. These differences were evident to them, however, now the general population of users within the oil and gas industry will need to recognize these subtle differences. The Compliance and Governance module will have to incorporate these changes. As it is responsible for all three domains (market, hybrid and hierarchy) in terms of how things get done in the industry.

Operationalize

Key to the redefinition of the energy industry is the boundary between the firm and market. It is here where the definition of the market is the Joint Operating Committee begins and ends. No individual is truly an employee of a JOC, they are seconded from the various producers who hold a financial interest. The majority of the work that is conducted is of a large capital nature and specialized type, or, operational and require a finite skill set that is spread out over a number of JOC's. It is the market definition that is the driving element of the energy producer. The JOC is where the business of energy exploration and production is conducted. To support this business with the software development and collaborative information technologies, the market definition can be the driving element in Compliance & Governance.

Ronald Coase's 1937 paper on "The Nature of the Firm" expressly confronted an embarrassing lapse: whereas the distributing of activity between firm and market had been taken as given by economists, the boundary of the firm should be derived from the application of economic reasoning to the make-or-buy decision. pp. 15 - 16

Using this definition of the boundary of the firm, no one would suggest the JOC's of a petroleum producer make the drilling rigs and such used in the industry. Purchasing and using contractors is the only way a producer can effectively operate. This is among the most common sense and application in oil and gas. What has been missing in my opinion, is the compliance and governance frameworks dictating the management time and focus away form the business of the energy business. Compliance and Governance should be automated to the level of what the SEC is implementing in their new XBRL framework. This is the purpose of developing this software, to define the market and firm, Professor Williamson now summarizes these benefits for business in general.

Both the longstanding neglect of transaction costs and ad hoc-uses of transaction cost reasoning were unsatisfactory. What to do? The unmet need was to operationalize the concept of transaction cost, broadly with reference to the four precepts of pragmatic methodology. Addressing the issues in a comparative institutional way with applications to specific phenomena facilitated operationalization efforts. Comparative analysis, moreover, relieves the need to take absolute measures of transaction cost, since the object is to ascertain the factors that are responsible for differential transaction costs as between alternative modes of governance. Efforts that begun in the 1970's continue to this day. As elaborated elsewhere, key operationalizing moves include the following: p. 16

1) Rather than proceed in a fully general way, TCE focuses on specific phenomena, of which vertical integration (the make-or-buy decision) is the paradigm problem. This choice had two advantages: it addresses the puzzle to which Coase (1937) referred; and transactions in intermediate product markets are less beset by contractual complications (such as asymmetries of information, resources, expertise, and risk aversion) than are other transactions. pp. 16 - 17

2) The transaction is made the basic unit of analysis and is thereafter dimensionalized (with emphasis on asset specificity, contractual disturbances (uncertainty), and frequency). p. 17

3) Alternative modes of governance are described as internally consistent syndromes of attributes to which distinctive strengths and weaknesses - in autonomous and coordinated adaptation respects - accrue. p. 17

4) Economizing on transaction cost is taken to the cutting edge, where this is implemented through the discriminating alignment hypothesis, to wit: transaction, which differ in their attributes, are aligned with governance structures, which differ in their cost and competence, so as to effect a transaction cost economizing outcome. p. 17

5) The basic regularities are captured in the simple contractual schema (see the Appendix), to which many other contractual phenomena can be interpreted as variations on a theme. Indeed, any issue that arises as or can be re-conceptualized as a contracting problem can be interpreted to advantage in transaction cost economizing terms. p. 17

6) Empirical test of the predictions of the theory have ensued. By contrast with theories of economic organization that yield few refutable implications and / or are very nearly non-testable, transaction cost economics invites and has benefited from empirical testing. Indeed, "despite what almost 30 years ago may have appeared to be insurmountable obstacles to acquiring the relevant data [which are often micro-analytic and require primary data], today transaction cost economics stands on a remarkably broad empirical foundation" (Geyskens, Steenkamp, and Kumar, 2006, p. 531). There is no question but that TCE is more influential because of the empirical work that it has engendered. pp. 17 - 18

7) Public policy has been transformed by working up the efficiency / inefficiency ramification of TCE for complex contract and economic organization. p. 18

Conclusions

Professor Williamson's paper provides clear and unequivocal support to the ideas of using the JOC as the key organizational construct of the market definition in oil and gas. I would reiterate that the need to develop systems first is a necessary and critical aspect of the ways and means of society and its people function. Holding out, as the industry has done, and denying the validity of the theories that I speak of here will only permit greater failures of the organization on which people and society depend upon. This may seem like an author who is over-reaching in expressing his ideas and views, or maybe not. Your choice.

Although still undergoing development in fully formal modeling respects (Bajari and Tadelis, 2001; Tadelis 2002; Levin and Tadelis, 2004; Tadelis and Williamson, 2007), the combination of semi-formal models (Riordan and Williamson, 1985), diagrams (such as the simple contractual schema), and a widely shared verbal understanding of the logic of discriminating alignment have provided the impetus for the numerous TCE application described elsewhere (Williamson, 1990, pp. 192 - 194; 2005b; Macher and Richman, 2006). Indeed, the move from words to diagrams to mathematical models is what the natural progression contemplates. p. 18

Using words and diagrams I have started the process of building this software brick by brick, and stick by stick. Join me, please.

Headway in the future will be realized as it has in the past - not by the creation of a general theory but by proceeding in a modest, slow, molecular, definitive way, placing block upon black until the value added cannot be denied. It is both noteworthy and encouraging that so many young scholars have found productive ways to connect. TCE, moreover, has benefited from rival and complementary perspectives - especially those that subscribe to the four precepts of pragmatic methodology. Such pluralism brings energy to the elusive ambition of realizing the "science of organization" to which Chester Barnard (1938) made reference to almost 70 years ago. As the forthcoming Handbook of Organizational Economics (Gibbons and Roberts, 2007) reveals, the economics of organization, of which TCE is a part, is a vibrant research agenda. pp. 18 - 19

Appendix
The Simple Contractual Schema

This appendix has significant value in verifying the JOC is able to function effectively in this market and firm definition of their boundaries. Professor Williamsons analysis in this appendix is definitively able, in my opinion, to document why the JOC is able to function in the manner described through out this blog.

The paradigm transaction for TCE is vertical integration (or, in more mundane terms, the make-or-buy decision). Not only is vertical integration the obvious candidate transaction (Coase, 1937), but, because it is less beset with asymmetries of information, budget, legal talent, risk aversion, and the like than are many other transaction, it is simpler. Not only are transaction cost features more transparent for the make-or-buy decision, but the simple contractual schema described below applies (with variation) to the study of transactions more generally. p. 20

Thus assume that a firm can make or buy a component and assume further that the component can be supplied by either a general purpose technology or a special purpose technology. Letting k be a measure of asset specificity, the transactions in Figure 1 that use the general purpose technology are ones for which k = 0. In this case, no specific assets are involved and the parties are essentially faceless. Transactions that use the special purpose technology are those for which k > 0. Such transaction give rise to bilateral dependencies, in that the parties have incentives to promote continuity, thereby to safeguard specific investments. Let s denote the magnitude of any such safeguards, which include penalties, information disclosure and verification procedures, specialized dispute resolution (such as arbitration) and, in the limit integration of the two stages under unified ownership. An s = 0 condition is one for which no safeguards are provided; a decision to provide safeguards is reflected by an s> 0 result. p. 20

Node A in Figure 1 corresponds to the ideal transaction in law and economics: there being an absence of dependency, governance is accomplished through competition and, in the event of disputes, by court awarded damages. Node B poses unrelieved contractual hazards, in that specialized investments are exposed (k >0) for which no safeguards (s = 0) have been provided. Such hazards will be recognized by farsighted players, who will price out the implied risks. pp. 20 - 21

Added contractual supports (s > 0) are provided at Nodes C and D. At Node C, these contractual support take the form of inter-firm contractual safeguards. Should, however, costly breakdowns continue in the face of best bilateral efforts to craft safeguards at Node C, the transaction may be taken out of the market and organized under unified ownership (vertical integration) instead. Because added bureaucratic costs accrue upon taking a transaction out of the market and organizing it internally, internal organization is usefully thought of as the organization form of last resort: try markets, try hybrids, and have recourse to the firm only when all else fails. Node D, the unified firm, thus comes in only as higher degrees of asset specificity and added uncertainty pose greater needs for cooperative adaptation. p. 21

Note that the price that a supplier will bid to supply under Node C conditions will be less than the price that will be bid at Node B. That is because the added security features at Node C serve to reduce the contractual hazard, as compared with Node B, so the contractual hazard premium will be lowered. One implication is that suppliers do not need to petition buyers to provide safeguards. Because buyers will receive goods and services on better terms (lower price) when added security is provided, buyers have the incentive to offer credible commitments. p. 21

Technorati Tags: Genesys, Williamson, Market, Firms, ESNIE, Organization

Peak Oil goes mainstream.

As we move closer to higher then $100 oil, many of the organizations that have looked down upon the peak oil theorists, have revised their opinions on the pending energy problem. The Wall Street Journal and IEA are both noting that things have not gone as they should. Life has a remarkably effective way of dealing with plans made by humans. The first article is written by Dave Cohen at ASPO and discusses the IEA's recent comments.

The Paris-based International Energy Agency has issued its World Energy Outlook 2007 — China and India Insights. The release provoked the usual firestorm of hand wringing and protest. "I am sorry to say this, but we are headed toward really bad days," IEA chief economist Fatih Birol told Time Magazine this week. "Lots of targets have been set but very little has been done. There is a lot of talk and no action." Lest the peak oil people feel justified by the bad news, Birol made sure to divorce the IEA's position from any possible connection with peak oil (see David Strahan's Supply Crunch is not Peak Oil — IEA, November 7th, 2007). Oh my! Rather than explain the intricacies of everyone's position here, let's talk about the human love affair with cars as a way of understanding the IEA's annual report.

The second article of note comes from Tom Whipple of ASPO and noted in the Energy Bulletin in which he comments about the Wall Street Journal.

This make-believe world finally came crashing down on Monday when the Wall Street Journal published a front-page story admitting there was a big, big problem with oil production just ahead. Now the flagship of economic journalism does not come to such a decision lightly. To admit that you have been dead wrong in ignoring the most important economic issue the world is likely to face in the next century certainly strains your journalistic credibility.

Now lets be clear, the current situation within the energy markets was to have never appeared. Why, because they had the excellent research from Cambridge Energy Research Associates to assure them there would be an unprecedented increase in the energy industries production volume. The head of that soon to be defunct organization is none other Dr. Daniel Yergin and his comments in the Washington Post two years ago. I'm still waiting to hear some clarification from Yergin, and at least an admission that he was wrong, dead wrong.

The situation should be clearly evident to anyone who has worked in oil and gas in the past 10 years. And have seen the increasing level of difficulty and risk in the business. I saw what was required, a much higher intensity of engineering and earth science effort / barrel of oil, could not and would not be resolved by the traditional hierarchy. It is too slow, and as I diagnosed then, too focused on the compliance and governance of the regulations of the business, and all but ignored the legal, financial, cultural and operational decision-making frameworks of the Joint Operating Committee.

It should also be clear that the competitive offerings to this software development proposal are also unaware of the JOC. SAP, Oracle and Qbyte don't recognize it. Therefore in order to change to systems, other then manual systems, an oil and gas producer needs to build software that defines and supports the organization, first. Otherwise they will remain organizationally constrained and will re-visit this situation same time next year. It's like the IEA says "Lots of targets have been set but very little has been done. There is a lot of talk and no action."

The oil and gas industry has to decide to fund these software developments in order to eliminate the hierarchy and bureaucracy and unleash the speed and innovativeness that can be captured and organized through the Joint Operating Committee. The logic for this is compellingly documented in this blog's 500,000+ words that extend and enhance my original thesis.

Ideas like how an enhanced division of labor will provide growth with the resources we have today. How the JOC is the natural form of organizations for oil and gas. How people use networks naturally to do their work. And finally the accountants capture the month-to-month changes in the voucher as a natural part of their work. Yet based on the over the top and violent response I have received from the bureaucracies, they will have none of it. For they see no issues whatsoever, business is good (with $100 oil) and they are not motivated to do anything about it.

So I continue on with my quest of how and what this software needs to make it real. The financial resources locked up in the bureaucracies, with no concern for what is happening just outside their office doors. Oh well, I'm sure the oil volumes won't decline too quickly, or maybe we'll have a recession, or maybe even Santa can take care of it.

Technorati Tags: Genesys, Peak-Oil, Call-to-Action

Sun Identity Podcasts

I've recently taken the time to subscribe and listen to a Sun Microsystems Podcast stream on the topics of Security, Access and Federated Identity. Click on the title of this entry to be taken to the Sun page. This podcast discusses many of the important topics that are being addressed in the development of the "Security & Access Module" of the People, Ideas & Objects application.

If we are to provide the security needs of the producers, vendors, customers, employees, and contractors that choose to use this system, we need to offer the highest level, state of the art, Service Oriented Architecture security environment. This level of security is necessary for the purpose of our users and their needs to access accurate and timely information, where ever and when ever they need. Additional demands include the ability to search their domain for the information they want and need, based on access control. And finally, represent the resources of the user in a global network of oil and gas users. Where People will be able to market their skills to that global network. This latter point is easily attained by having Google's recently announced OpenSocial API incorporated in the user's identity.

This "Security & Access Module" is a distinct competitive advantage of this application development over the current software offerings of SAP, Oracle or Qbyte. Starting off with the security framework puts the cart behind the horse. Application modules developed with the security framework defined and built first, limits the development surprises when leaks of information are found in legacy systems retrofitted with new security environments.

Entertaining, candid and humorous, this podcast is a worthwhile summary of the risks and opportunities in this subject. In terms of the quality of the discussion it provides information about various initiatives such as LDAP, Identity Governance Framework, OpenID, OpenSSO, OpenDS, Web Access Control, Web Access Management, Federation and a number of various other cryptic acronyms. The point that I take away from these discussions is that security and access are the next big area of Java development. Companies such as Sun and Oracle are very focused here. And they are obviously moving to provide the services and infrastructure to handle, and manage the security for applications such as People, Ideas & Objects. Ultimately accessing these services as a part of a service offering that they can provide for an annual fee of $x.xx / user.

Finally two talks that highlight how the perspective of security has changed in these products. The SSO (Single Sign On) is able to guarantee that three password attempts and you out means, three strikes and the user is out on a global basis. And an excellent discussion about the scope of the role of the CISO (Chief Information Security Officer) or CIO is the CISO Leslie Lambert of Sun.

Technorati Tags: Genesys, Sun, Security, Software, Developments

Mises Institute Daily Article

A few days ago an article was published at the Ludwig von Mises Institute that talked about my favorite term "Creative Destruction". It got me thinking about the situation we face in the energy and software industries, and made me wonder whom is being "Creatively Destroyed" by the concept of using the Joint Operating Committee as the key organizational construct? The oil and gas business, or the software business.

"Creative destruction (Joseph Schumpeter's phrase) occurs when innovations - new technologies or business models - demolish the capital structures of well established industries, industries that have lost the ability to satisfy the urgent wants of customers."

Some may think that the energy industry is being attacked by this concept. I think its also the software industry. If, as Professor Carlotta Perez states, we are now entering the Information and Communication Technologies "deployment" phase. I think it is clear the software that is available from established vendors is fundamentally flawed. Microsoft can't keep up with Linux, let alone Mac OS X and Solaris. This applies to the larger ERP type of vendors as well. SAP has an application that is badly constrained by > 14 million lines of procedural code and over 1 million customers. Change is an impossibility. The technologies that are available today are so much more efficient then when SAP locked into their technologies in the late 1970's. These new ICT technologies will replace the SAP's and Microsoft's of the world. The changes that can be exercised, and their efficiencies, are so tangible, there really is no choice to make.

"This process can happen almost over night, such as when the vinyl record industry collapsed in the wake of digital music. Or, the process can slowly run its course, similar to the decades - long crumbling of a building's foundation. Here the process is akin to the way moss attaches to surface imperfections and degrades - over decades - the strength and resilience of concrete."

This latter quote accurately captures the process of creative destruction in oil and gas. During the 1970's and 1980's the seven sisters (Shell, BP, Exxon, Mobil, Chevron, Amoco, and Texaco) were responsible for the majority of the oil production in the world. Collectively they, Exxon Mobil, BP, Shell and Chevron, produce less then fifteen percent of the worlds production of oil and gas. Long gone are Texaco, Amoco and Mobil as legal entities. The remaining four producers serve no role of significance in exploration or production. Independents and national interests have moved into the exploration business and have consistently out produced the "majors". Peak Oil, and the era of expensive and difficult to produce oil, accurately emulates the long term process of the moss attaching itself to the concrete. The remaining "majors" may have finally proceeded to the point where their resilience and strength are not enough to sustain the organization.

Technorati Tags: Genesys, Organization, Change, Schumpeter

Google's Android

Two articles out today are talking about the implications of Google's new phone operating system Android. The first is from IT Managers Journal, which discusses the business implications regarding Androids use. The second article is a detailed description of how Google has changed the Java framework in unexpected ways.

Lisa Hoover of IT Managers Journal lists five reasons why we should pay attention to Android.

1) Using computer software with open source code can be enough of a minefield.

I don't subscribe to the ability of hackers being able to damage open source software projects by installing malicious code. The trust and volumes of eyeballs on a project make this risk next to impossible. (The second article opens a very interesting twist on the open source licensing of Java.)

2) Hoover anticipates and expects CIO's to equate an open source platform and API's, with custom mobile applications built by the firm.

Whether that is the case or not is not what I am debating, the ability for any organization to develop and enhance its software is a competitive necessity. The problem is the scope and scale of the knowledge necessary to be effective cannot be built within each producer. The ability to organize this within each company I don't think is possible. The industry should have a software vendor available as an inherent capability it can draw upon. Such that the software developers can make the changes and enhancements for any company within an industry. Every company is unique and is made up of differing assets, to think that they all can fit the SAP mold has been tried and proven unacceptable. Companies need to begin thinking that a software development capability is a competitive necessity and not a competitive advantage. In oil and gas the basis of competition is on the land base and their geo-technical abilities, not their software development capacity.

3) The cost of Android based phones will be lower, making their use ubiquitous fairly quickly.

No argument here, although the budget for these may, as the author suggests, fall on the IT department. Irrespective of who pays for them I think both Apple and Google are developing the next major platform for business to exploit. The smart phone has capabilities that are comparable to desktop systems. The ability to exploit the use of these devices is something that is inherent in the Technical Vision of this project.

4) Google may be able to make bigger strides in the phone market then either RIM or Apple.

Again, no argument here, the competition in the phone market is changing very quickly. I would not count Apple out of this game at this point.

5) It's 3:00 do you know where your developers are?

Google is offering $10 million as prize money for developers to make the best applications for Android. This is in my opinion, only representative of how the changes in the open source development model are affecting businesses. Good developers have become more or less a gun for hire in this economy. Working from project to project enables them to exercise their value in their own best interests. I would not be interested in a developer that does not adopt this type of attitude and routine.

The second article is from "Google Blogoscoped" and is a difficult one to analyse. The author is an MIT researcher, yet appears to have no respect for intellectual property. Possibly the individual is unable to discern where his bread is buttered. He suggest through some legal slight of hand Google has breached a major tear in the Java security model and hijacked the environment for their own benefit. I don't think I subscribe to the thinking that Java can be had in such a manner, but the author offers an interesting hypothesis. Google is operating in the best interests of the Java platform, and hence will attain greater benefit by the independent developers ability to focus on both Apple and Google handsets. To do as the author is suggesting would have Google move over to the evil side of the ledger.

The point in writing this entry was to tie these new devices into the scope of what we are developing here. These phones will be critical in making this software better and more usable by the people who work in oil and gas.

Technorati Tags: Genesys, Capabilities, Software, Development

Modularity, Transactions, and the Boundaries of Firms: A Synthesis.

Carliss Y. Baldwin, Harvard University

Published September 2007

Following on the user vision I posted recently, the module specification, and boundary of the firm definitions, we begin a comprehensive review of Professor Baldwin's paper. A synthesis of modularity, transactions and boundaries of the firm is timely for a number of reasons. First we have reviewed an extensive volume of Professor Langlois' work and specified a modular definition that, secondly, I think accurately captures the scope of the People, Ideas & Objects application. My primary objective in this posting is to move this discussion forward, and to do that, is to document what the role and responsibility of the user is in making the decisions and ensuring the accuracy of building this application.

I mentioned earlier that SAP does not know about miscible floods, pipelines, completions, production facilities or any specific or tacit knowledge of the oil and gas industry, the users do, and that is why they need to be involved in this software's design from the very start. This project, I can assure you, will not proceed without abundant user representation. I also want to re-introduce a concept that was discussed very briefly at the beginning of this blog. The concept is a Voucher and its unique treatment in this application. Lets begin with Professor Baldwin abstract;

Several novel implications arise from this work. Among these: Modularization's create new module boundaries, hence new transaction locations where entry and competition can arise. Areas in the task network where transfers are dense and complex should not be modularized. Instead these areas should be located in transaction free zones so that the costs of transacting do not overburden the system. The boundaries of transaction free zones constitute breakpoints where firms and industries may split apart. p. 2

I am particularly focused on that last sentence where firms and industries split apart. We are after all talking about the Joint Operating Committee (JOC), which I propose will be the key organizational construct of the industry. A definition which will redefine the boundaries between the industry (the JOC) and the firms role. The firms role in this application is enhanced by these changes. The firms specification is fundamentally different with different paradigms and methods of work being done. How this work is defined, and the transactions that support the modular specification are the purpose of Professor Baldwin's paper and it is here she introduces the analytical methods of how our users could define the applications needs and where, in markets or firms, the transactions occur.

Introduction

I would like to go back to much of the work that we had done in transaction costs. Recall these are the costs of conducting business, or the "friction" that is created in getting things done. The associated cost of processing transactions for work done by a contractor vs. the cost of asking an employee to do their job. In the past it was much lower of a cost to ask the employee to do it, as there was no associated transaction to process other then the bi-weekly check. Today the advantages reside with the market, not the firm. The ability to manage the job has grown beyond the ability of the superbly slow bureaucracy. The market is expected to fulfill the expectations of it in anticipation of the demand, so that things move more smoothly as they should. And the costs of the transactions in these markets is much lower primarily as a result of harnessing the Information Technologies available today.

For the last thirty years economists have used the concepts of "transaction," "transaction cost," and "contract," to illuminate a wide range of phenomena, including vertical integration, the design of employment, debt, and equity contracts, and the structure of industries. These concepts are now deeply embedded in the fields of economics, sociology, business and law. But although economists and management scholars have explored the design of transactions in a wide variety of settings, in most of this literature, it is assumed that a pre-existing division of knowledge and effort makes a transaction possible at a particular place in the larger productive system. The theories explain how to choose between different forms of transactional governance, but they almost never ask why the opportunity to have a transaction occurs where it does. As a result, the forces driving the location of transactions in a system of production remain largely unexplored. p. 3

Well put Professor Baldwin, when it comes to actual implementation of the transaction theory there is a dearth of available examples. This is also why I insist that the user be involved, analyze, determine, decide, and 100 other adjectives in the designing and building of this software. After all this is not SAP, it will be the system they use to make their living from and do their job.

Literature Review

Professor Baldwin goes through the history of transaction costs and the three main frames of thought. Each one helps to describe the terminology and overall conceptual framework of the theory. I will leave it to her to summarize and synthesis the three theories.

Transaction Cost Economics and Imperfect Contract Theories

The literature on transaction costs and the theory of the firm originates with Coase (1937). He observed that there were costs of using the market, and that "firms will emerge to organize what would otherwise be market transactions when their costs were less than the costs of carrying out the transactions through the market" (Coase, 1988: p. 7). Coase quite consistently defined transaction costs as the "cost of using the price mechanism" or "the costs of market transactions," but he was also the first to assert that transactions occur within firms. In defining transactions this way, Coase made the important point that the stages of a production process can be designed to take place within one firm or across several firms. But he also implicitly assumed that a production process involves (only) a simple sequence of stages. In fact, Coase's view was based on the paradigm of mass production, which envisioned organization in terms of simple flow lines of material goods (Chandler, 1977; Abernathy, Clark and Kantrow, 1983; Hounshell, 1985). p. 7

In contrast to Coase, who considered many types of transaction costs, Williamson (1985) focused on the harm that transactors can do to one another. Williamsonian transaction costs are the measure of such harm. But though he changed the definition of transaction costs, Williamson adopted Coase's sequential view of production and continued the practice of treating all transfers, both within and across firms, as transactions. Formally, he defined a transaction as "a transfer across a technologically separable interface", Notably, he did not define "technologically separable interface," but simply asserted that such places were fairly common in most systems of production. pp. 7 - 8.

Knowledge - based Theories of the Firm

Knowledge-based theories of the firm incorporate the idea of shifting boundaries in ways that transaction cost economics and imperfect contract theory do not. However, these theories are not capable of determining the location of transactions, nor of predicting how the locations will shift in response to new knowledge. p. 8

Knowledge based theories of the firm are diverse, but have in common that : (1) they focus on what goes on inside of a firm or organization: (2) they agree that value (or "advantage") derives from things that a firm can do -- variously labeled routines, competencies, or capabilities -- that are not easily imitated or purchased; (3) they recognize that these routines, competencies or capabilities are based on knowledge, which is distributed across individuals and must be assembled and reconfigured in various ways. p. 9

Recall the modular definitions that I have specified of Knowledge & Learning and Research & Capabilities. The division of these two similar modules is based on the need for similar definitions for both the market and the firm. The logic of this division is somewhat supported in Professor Baldwin's following comments.

Changing routines, competencies or capabilities based on knowledge must cause firms to have shifting knowledge boundaries. The span or scope of knowledge available to a firm will change over time as required by its changing activities. But theories based on knowledge cannot directly explain the location of transactions. First, the domain of transactions is a domain of action: goods are made; services are performed; compensation is paid and received. But actions enter the knowledge based theories only indirectly: knowledge begets capability and capability begets action. The actions themselves lie outside the scope of these theories. p. 9

and

Moreover, a firms knowledge is generally not coterminous with its actions. Recent studies by Brusoni et al (2001), Brusconi and Prencipe (2001), Sako (2004), Staudenmayer et. al. (2005), and Ethira (2007) have demonstrated quite conclusively that firms generally "know more than they do." Therefore a theory about the boundaries of a firms knowledge cannot at the same time be a theory of the location of transaction for that firm. The two boundaries are related, but they are not the same. p. 9

Modularity Theory

The gap in knowledge-based theories can be addressed by modularity theory, which focuses directly on actions and their dependencies. Modularity theory is rooted in the design theories of Herbert Simon (1962; 1969) and Christopher Alexander (1964). The modern literature can be traced back to three seminal contributions: Henderson and Clark's (1990) paper on product architecture; von Hippel's (1990) paper on task partitioning; and Langlois and Robertson's (1992) paper on the innovative potential of industries based on modular products. p. 10

A key element of these and all subsequent papers in the modularity literature was a principle I will call the "mirroring hypothesis." Henderson and Clark (1990) applied the concept of mirroring to product development groups: "We have assumed that organizations are boundedly rational, and hence that their knowledge and information processing structure come to mirror the internal structure of the product they are designing" (p. 27). Sanchez and Mahoney (1996) expanded this concept to encompass whole firms. p. 10

The mirroring hypothesis specifically links an organization's task structure to the actions of making and selling specific products. It implies that one can "see" the transactional boundaries of a firm by looking at its product and process designs - indeed, technically, the firms transactional boundaries are subsumed in those designs (Fine and Whitney, 1996; Fine, 1998). Thus as product and process designs change, so will transaction boundaries. pp. 10 - 11

The Three Strands Come Together

Professor Baldwin comes in with a strong statement on the influence of Langlois in this area. I have found his work exceptional for the purposes that are proposed in this software development. Why I feel this way is captured eloquently by Professor Baldwin.

Although they invoked the mirroring hypothesis, early modularity theorists had little to say about the location or form of transactions. Langlois (2002, 2003) was the exception, and thus was in the vanguard of those who used modularity to explain changing industry structure. He first proposed that the economy was "modularized by property rights" and that organizations were "de-modularizations" in response to a need for interactions in the underlying technological processes (Langlois, 2002). He then challenged Chandler's (1977) thesis that managerial hierarchies were necessary to coordinate large scale productive systems. Contra Chandler, Langlois argued that in the late 20th Century, modular product and process architectures made hierarchical coordination unnecessary in many venues. As a result, Chandler's "visible hand" was "vanishing," and firms that had previously been vertically integrated were splitting apart (Langlois, 2003). p. 11

I recently reviewed Professor Langlois "Vanishing Hand" here. Its also at this point that I want the user to begin to understand their role in defining the organizations modules, tasks, and areas where transactions will occur. And, begin to layer the complexity of the Joint Operating Committee's interactions to show the logic of using the organizational construct and the critical need of the users involvement.

This theory explained how new knowledge, incorporated into new design, could change the modular structure of actual products and processes. But Baldwin and Clark were unable to derive a strong version of the mirroring hypothesis form their theory of design evolution. Applying their theory to the computer industry, they were forced to conclude that changes in the modular structure of computers were necessary but not sufficient to explain the changing vertical structure of that industry (Baldwin and Clark, 2000, pp. 272-275). p. 11

I am primarily concerned with the modular definition of this specific software application, however, the larger picture includes how the market forms and the interfaces between the different modules are developed. These may be new and different means of organizing the market more efficiently. In the computer example noted (Figure 2) it is only natural that the industry modularize the hard drive as its own "module" to be used in the component definition of the computer. Here Professor Baldwin begins the process of analyzing the various aspects of an industry to determine the modular makeup of the industry. It is here that the role of the user will have the broader impact of reflecting on the transaction costs and modular makeup of the energy industry. What I am saying here is that the energy industry will have application modules that will aid in managing the transactions, and will de-modularize the physical industry to a more efficient makeup.

By considering the implications of inter-dependencies for vertical integration / disintegration, these works deepened the theoretical linkages between modularity theory and transaction cost economics. And because they viewed organizations essentially as problem-solving entities, they also brought modularity theory into the realm of knowledge based theories of the firm. pp. 11 -12

and

Taken as a whole, modularity theory and related empirical research suggested a new level of observation for studies of the boundaries of firms. In modularity theory, the basic unit of analysis is not a "stage" in a sequential production process, nor is it "knowledge" that contributes to a routine, a competency, or a capability. Instead the primitive units of analysis are decisions, components, or tasks and their dependencies. Decisions, components and tasks are more microscopic than stages, but more concrete and directly observable than knowledge. And the dependencies between decision, components or tasks can be represented in terms of a network as described in the next section. pp. 12 - 13

and

At the deeper level of analysis suggested by modularity theory, the job of transaction design change. It is no longer enough to choose a governance form at a pre-specified location between two stages of production. The larger task involves: (1) locating transactions in the task network; (2) designing each transaction to suit the task network's local structure; and, often, (3) modifying the network's structure to better accommodate the transaction. I address these issues in sections 4, 5 and 6 below. p. 13

One can see the complexity and diverse nature of the analysis necessary for this type of work. Whom is capable of this type of analysis? I think there is only one group, made up of users, augmented by a strong software development team, who can see and perceive the importance of the detail and the irrelevance of the noise. Users guided by a comprehensive vision, years of industry experience, extensive collaborative and analytical tools that can conduct this analysis and determine the optimal points of where and how transaction costs should occur, forming the module definitions and industry structure.

Definitions

The Task Network

This project is big. I don't know if its my ambition or naivete' that has brought me to this point, but this is a big project. The number of developers will total in the hundreds, the number of users will total in the thousands, easily. The scope of the undertaking is not something to downplay, but at the same time I think that the purpose of making innovation the key competitive advantage of oil and gas producers is worth trying. With Jeffery Immelt's comment that technology and innovation now have value, the costs will be returned in enhanced revenues and profits. This "task" is also clearly reflected in Professor Baldwin's next quote.

The basic unit in the design of any production process is a task (Galbraith, 1977; Tushman and Nadler, 1978; Marengo and Dosi, 2005). Tasks must be carried out by agents, but, because of physical and cognitive limitations, no single agent is capable of carrying out all tasks (March and Simon, 1958). Thus it is necessary to transfer various things - material, energy and information - from agent to agent in a productive system. Taken as a whole, the tasks, the agents, and the transfers make up a vast network of activity, in which tasks-cum agents are the nodes and transfers are the links. p. 13

Using the modular breakdown that I have specified for this project, I think helps to shed the past ways and means, and allows the user to foresee the way that it should be, or what is the optimal way. This being managed by a "task network" based on Professor Baldwin's definition. If through this software development we are able to create the type of "task network" environment that the users and the software developers can work together and towards building these things. A related point is Adam Smith's division of labor. To increase the capacity of the economy requires a further division of labor. The industry therefore needs to have the tasks and agents defined in this way in order to define a greater level of division of labor.

On the one hand, one can think of the task network representation as a way of "zooming in" on the sequence of stages in prior modules in order to see what is going on in detail. At the same time, representing production as a network of tasks allows us to model new patterns of dependency and interaction, including parallel flows (of information and material), backward flows (feedback), and iterative and uncertain flows (trial and error). These more complex patterns cannot be modeled as a "sequence of stages," but they do arise - frequently - in real production processes. p. 14

The tasks and transfers in the network are people with local knowledge, local authority, local property rights, and local incentives (Hayek, 1945). Because of intrinsic cognitive limits - what Simon (1969) called "bounded rationality" - a single individual, team or company can only work on a subset of the network and on interfaces between subsets. Transactions, we will see, are a way to create efficient interfaces between subsets of tasks. pp. 14 - 15

Professor Baldwin will show how this analysis is done and the simple interface that is needed to identify the tasks and designate them within one module or the other. The key point to note here is that the corporate view is too shallow for this type of analysis. This analysis must be industry wide and consider the transactions and interactions of the JOC. The JOC being the legal, financial, cultural and operational decision making frameworks of the industry will benefit greatly by the work that has been done by CAPL, COPAS, and other associations, and use these prior works to detail the interactions and transactions.

I want to start the discussion of how I perceive Vouchers operating in this system. Vouchers manage the inter-modular transactions, and maintain the integrity of the system in balance and compliance to the rules and regulations handled in the Compliance and Governance module. A Voucher, to my way of thinking in this software development project, has a strong analogy to the Google Doc's product. Google Doc's allows you to share a document with as many people as you need. Each individual may or may not have read / write privileges to the document, and their exists only 1 copy, the Google Doc's copy of the document located in the cloud. This ensures that all changes are recognized and addressed without the laborious need to edit 20 versions of the same document. This is the manner in which I see the Voucher within this system architecture operating. One version accessible by those JOC producers, those designated as authorized by the producers, and those that are in the need to know. Where the systems integrity of debits and credits and / or material balance are enforced with compliance to all accounting standards. A Voucher being a key interface of the systems and users in this task network.

Transactions

A definition of what is a transaction is provided by Professor Baldwin. Note the differences between her definition and that of Coase.

I define a transaction to be a mutually agreed-upon set of transfers between two or more parties with compensatory payment. This definition breaks with tradition: what I call a transaction is what Coase sometimes called an "exchange transaction" in contrast to "internal transactions" that take place within firms (Coase, 1937, pp. 393-398). p. 15

In oil and gas, this classification of transactions is very broad. If we include transaction's between the JOC and field operations, internal transfers, and company to company transfers, this definition would include the majority of transfers that occur in the industry. We can assume that 100% of the scope of transactions is covered by this definition and that is what I am intending to include in this synopsis. Weather the transaction cost could be further classified as a Dynamic, Exchange or any other type of transaction is irrelevant to the focus of this discussion.

As indicated, in comparison to Coase, Williamson, and the contract theorists, I model production as it is seen closer up - as a network of many complex transfers. At this new, more microscopic level of observation, transaction are not the "basic unit of analysis" (Commons, 1934, cited by Williamson, 1985, p. 3), but are instead embedded in a more complex network structure. On this view, a transaction (or "exchange transaction" in Coase's terminology) is more than a simple transfer. It is a reciprocal exchange based on some degree of mutual understanding. p. 15

How this voucher is implemented is through an evolving template. Starting a new relationship or property is the beginning of the voucher and the beginning of automating the associated tasks. As time passes changes in the voucher mirror the understanding of the JOC participants. This being the reason the user is so important to this development. Users and developers working together to build the base modules with all the process and data elements defined and available, and the vouchers, containing many possible transactions, used to build these processes and data elements into the demands of the JOC's.

Sources of Mundane Transaction Costs

Although we are attempting to include the entire scope of transactions of the producer, and we don't want to get to deep into the parsing of what a transaction cost is, Professor Baldwin notes the following which will be of interest later on.

To be the basis of a reciprocal exchange, a transfer (or set of transfers) must be (1) defined; (2) counted; and (3) compensated. Definition, counting and compensation are needed to create the "common ground" on which transactors establish a mutually agreeable exchange (H. Clark, 1996). But creating this common ground involves work: it adds new tasks to the network. Thus a transaction is a transfer (or set of transfers) embellished with several added and costly feature. I call these costs the "mundane transactions costs" of the transaction to distinguish them from the "opportunistic transaction costs" of Williamson and the contract theorists. My theory of the location of transactions is based on the argument that mundane transaction costs are low in some places in the task network and high in others. p. 15

Definition provides a description of the object(s) being transferred. It places the objects of the transaction into a defined category that is recognized by both parties. Defining adds the costs of describing, communicating and (sometimes) negotiating to the system. In contract theory, if both parties agree on the definition of what is transferred ("this is indeed a satisfactory widget"), the transfer is called "observable." If third parties can be brought in and also agree ("anyone can see this is a satisfactory widget"), the transfer is "verifiable." These implicit costs of observing and verifying are mundane transaction costs under my definition. Contract theorists maintain that such costs are the underlying cause of contractual incompleteness, but treat them as axiomatic, hence outside their theory (cf,. Hart, 2995, pp. 23 - 24). p. 16

Definition and dissemination of the terminology used in the energy industry is standardized. The COPAS, CAPP and other organizations have had to define a shared meaning for the industry to use. These shared meanings are systemic in the industry and make up a large portion of the definition of what a JOC is. As Professor Baldwin notes as the sources of mundane transaction costs, the energy industry can see these costs are already well defined and specified. Hence, within the global energy industry it would be very easy to achieve a consensus as to what is "observable" and "verifiable" means between a variety of any JOC's. The costs of these mundane transactions are therefore minimal and the large volume of costs associated with the definition have been retired long ago, however, Professor Baldwin goes on to note;

Counting associates with the transferred object a quantity - a number, weight, volume, length of time, or flow. Definition is a pre-requisite to counting, because one can only count or measure objects within a class or category. Economics generally takes the existence of these predefined categories to be axiomatic. In other words, goods are defined outside of economics, while prices and quantities are determined inside of economics. When I say that transacted goods must be "counted,: I do not mean to imply that transactions always involve aggregation of goods, like bushels of wheat or tons of steel. Unique goods can be transacted - their count is simply "one". My definition of "counting" also subsumes all measuring processes that are used to verify the quality of the transacted object. For example, a complex good, such as a chemical plant, is a unique item (Brusoni and Prencipe, 2001). But the contract between the buyer and supplier of the plant will contain pages of detailed conditions, all of which must be met before the transaction is complete. These conditions define the transacted good. Verifying the conditions involves measurement, hence is a mundane transaction cost of counting. p. 16

Lastly Professor Baldwin notes the difficult task of counting for mundane transaction costs, and hence, for the assigning of the value to each producer. In terms of the regular transactions that are incurred the value is easily determined. In the Partnership Accounting Module specification I had detailed the effects of this costing and noted that the overhead allowances that are earned by the operator should be considered a thing of the past. In the future the actual costs incurred by the pooled resources of the Joint Operating Committee will cause the costing of all the participants "mundane transactions" be realized and costed to the joint account.

Finally, compensation involves the backward transfer of "consideration" from the recipient to the provider of the transacted object. This in turn requires systems for valuing the object and paying for it. Modern market economies have highly efficient institutions and bodies of knowledge in each of the domains. Whatever the form of compensation, for a transaction to take place, two valuations must occur (one by the buyer and one by the seller), and a payment must be made. The costs of these valuations and payments are mundane transaction costs of compensation. p. 17

The Determinants of Mundane Transaction Costs in the Task Network.

Professor Baldwin now embarks on the actual analysis of determining the tasks and transactions within the "task network". It is at this point that we are able to quantify and qualify many of the theoretical inputs from Langlois that are inherent in our module specification and determination of the boundaries of the firm. Figure 1 below shows the transactional analysis of how a pot hook is made and sold to a kitchen.

As indicated, part of the job of designing a task network is to locate the transactions among the tasks. In this section I argue that mundane transaction costs are low at the boundaries of modules and high in the interiors. Thus given a choice between placing a transaction at the boundary or in the interior of a module, one should always choose the boundary. However, to understand the relationship between module boundaries and mundane transaction costs, we must look at the task network itself in more detail. For this purpose I introduce two concepts from modularity theory: information hiding and thin crossing points. p. 17

Information Hiding, Thin Crossing Points and Modularity

These concepts were originally learned from Professor's Baldwin and Clark in a January blog entry. There it was also learned the related impact of Adam Smith's division of labor theory and the starting point of the majority of the organizational economics papers we have reviewed. A review of the application of these theories to oil and gas is contained in the entry here.

Professor Baldwin defines these terms further, key to this discussion is how the intellectual property of a producer is maintained;

An economical transfer of a good from its producer to a user constrains the surrounding transfers of information quite dramatically. The user cannot know everything about how the thing was made: if that information were necessary, the user would have to produce the thing himself, or at least watch every step of production. The efficiency of the division of labor would then collapse. By the same token, the producer cannot know everything about how the thing will be used, for then she would have to be the user, or watch the user's every action. Thus, fundamental to the efficient division of labor is substantial information hiding (Parnas 1972). This information hiding in turn supports what Aoki (2001, p. 96) calls the "division of cognitive labor." The user and the producer need to be deeply knowledgeable in their own domains, but each needs only a little knowledge about the other's. This is in fact the core assumption of the knowledge based view of the firm. p. 18

and

If labor is divided between two domains and most task relevant information hidden within each one, then only a few, relatively simple transfers of material, energy and information need to pass between the domains. The overall network will then have a thin crossing point at the juncture of the two sub-networks. p. 18

and

In modularity theory, a module is a group of elements - in this case, tasks - that are highly interdependent on one another, but only minimally dependent on what happens in other modules (Baldwin and Clark, 2000, p. 63). By definition, modules are separated from one another by thin crossing points - in Simon's (1962) terminology, they are "near decomposable." p. 18

and

Mundane transaction costs are the costs of defining, counting, valuing and paying for things transferred. At thin crossing points between modules, there are, by definition, fewer and simpler transfers than within modules. Mundane transaction costs will be thus low at thin crossing points. It follows that transactions are best located at thin crossing points, i.e., at the boundaries of modules, not in their interiors. pp. 18 - 19

The JOC is the legal, financial, operational decision making and cultural frameworks of the energy industry. Using the JOC as the base construct or organization of the market in this software leads to a wholly different perspective of how the industry functions. The tacit means of the industry operations has been developed and shared amongst the users in the business. The ability to see how the industry operates through this construct, the modular specification of this software, the boundaries of markets and firms and finally the Voucher leads to a greater fit and alignment in operating an oil and gas producer. It is at this point that I want to list the module specification of the People, Ideas & Objects application so that users can see this last point of Professor Baldwin's in their own environment;

• Compliance and Governance
• Access Control & Security
• Financial Marketplace
• Petroleum Lease Marketplace
• Resource Marketplace
• Partnership Accounting
• Research & Capabilities
• Knowledge & Learning
  

An Example: The Production and Use of an Iron Pot Hook.

Keep in mind the 8 modular definitions that have been specified for this application. Defining the interaction between them and the various producers is a task that the user community will be highly involved in during the analysis for this applications development. If for example, an interaction between the Financial Resource Marketplace Module and Petroleum Lease Module (the purchase of a new P&NG Lease) would need to be mapped in a similar manner to Professor Baldwin's Smithy and Kitchen example.

The matrix shows that, in terms of tasks, the smithy and the kitchen are almost, but not quite, independent. The two establishments are materially connected by pot hooks and other iron implements, which are made in the smithy and used in a kitchen. And they are informational connected by a set of common definitions of pot hooks and other iron implements. In the language of modularity theory, the common definitions serve as design rules, and, by convention, the appear as a vertical column on the left-hand side of the matrix (Baldwin and Clark, 2000). The design rules are the "common ground" of the two establishments, thus we have labeled them "CG." (H. Clark, 1996; Srikanth and Puranam, 2006). Given this common ground, the two establishments can support one another without a lot of ongoing interaction. Hence this particular pair of sub-networks displays almost perfect information hiding. p. 20

It is relatively easy to turn the completed pot hook transfer into a transaction. Because of their common ground, a smith and a cook both know what a pot hook is, and can agree on its salient features (size, thickness, shape). In this fashion, the object being transferred is easily defined. Pots hooks are discrete material objects, thus easy to count. And cooks know what to do with completed pot hooks: they can easily value them and know what they are willing to pay. Defining, counting, and paying for the pot hook add a few more tasks to the network, but not many. Thus the mundane transaction costs at this location are relatively low. pp. 20 - 21

In this matrix, transfers of design information are denoted by "x"s.

The Minimal transaction Design

as operator. And a variety of smaller field service companies are involved in making the operations run smoothly. Most of the R&D in this area is done by the tier 1 vendors and little outside of the earth science and engineering effort is conducted by the Oil and gas is a unique industry and business. The makeup of a firm is classified in terms of exploration, drilling, production, and operations is unique of all businesses. The majority of the operations are undertaken through contracts to tier 1 type vendors like Precision, Halliburton, Schlumberger, and BJ Services. Second tier vendors are also engaged through contract with the producer representing the JOC's operator. I suggest in the Partnership Accounting Module that a pooling of the resources of the partners within the JOC will contribute what resources they have available. This pooling will help to mitigate the shortfall in human resources. It will however open a new dynamic between the partners around the Asset Specificity theory of Oliver Williamson.

Thus design interdependency is a form of Williamsonian asset specificity (Williamson, 1985). As is well known, given asset specificity, once Upstreams costs are sunk, Downstream can unilaterally set a low price, causing Upstream to lose its investment. Or in another hold up scenario, if the demand for laptops is unexpectedly high, upstream might demand a higher price in return for timely shipments. In the presence of these opportunistic threats, each party has reason to make defensive investments in the spirit of Grossman and Hart (1986) and Hart and Moore (1990). For example, the drive firm might spend money to make its drives compatible with other systems and the laptop firm might look for second source suppliers. But such ex ante defensive actions reduce the value of the entire systems even if ex post bargaining is efficient. pp. 24 - 25

In an ideal world the partners of the JOC would all be of like mind and equally motivated. That of course is not true. Weather they are interested in the project or not can lead to differences of opinion to those that see the area as a core facility in their organization. The dynamic introduced here has many permutations and combinations. The default or penalty alternatives being well defined in the culture of the industries operating procedures. Nonetheless, Williamson's asset specificity is a risk that manifests itself in areas where thin crossing points occur. How much of the dynamic of these strategies are put in play may be minimal due to the unique nature of the industry and the methods that it uses to mitigate risks, and how a shared understanding has been defined in CAPL, COPAS and others.

In short, a minimal transaction at a thin crossing point is a hotbed of opportunistic behavior. There is no direct compensation to either firm for transferring information, and there is no promise of a future relationship to provide indirect compensation. Self interested agents will then skimp on information transfers: ex post holdups are likely; and defensive investments (on both sides) are rational and prudent. p. 25

And here is the area where the risks of asset specificity may become negligible in this "pooling scenario". Contracts play a large role in mitigating the risks of asset specificity, however the mundane transaction costs are high.

Reducing opportunistic behavior in a transaction like this requires a contract, either formal or relational. A formal contract defines the responsibilities of each party; measures compliance; and establishes multi-dimensional compensation. Thus a formal contract reduces opportunistic transaction costs by increasing mundane transaction costs. pp. 25 - 26

Professor Baldwin notes that relational contracts are also effective in reducing opportunistic behavior between the JOC. How many of the drilling, equipping, completing and operational costs are not under contract in oil and gas? Almost none. The behavior of the industry participants has been dealt with over time and the culture of the industry has identified and standardized many of the contracts and requirements of their partners and the groups that are employed by the JOC.

Relational contracts also incur mundane transaction costs, but in less obvious ways. To control opportunistic behavior, a relational contract creates "a shadow of the future" and provides a means of ex post settling up to make the distribution of gains more fair (Baker, Gibbons and Murphy, 2002). But relational contracts don't just happen: like any form of contract, they must be designed and manged (Sako, 1992, 2004). Two strangers cannot immediately arrive at a relational contract: there are numerous tasks (e.g., meetings) and transfers (e.g., conversations involved in defining the relationship. In addition, costs of counting, valuation and payment arise in the course of adjudicating ex post settlement. p. 26

When transfers of information are complex, uncertain and iterative- as is always the case in design processes - the burden of defining, counting and paying for transfers becomes overwhelming. Thus a maximal transaction design weighs down the productive system with a lot of extra overhead. And (as if that were not enough) if design-information transfers are counted and compensated, there is a risk - indeed a certainty - that unproductive transfers will take place, not because they add value but because they add or subtract "points" to a compensation scorecard (Kerr, 1975; Holmstrom and Milgrom, 1994 Baker, 2002). Thus with a maximal transaction design, information transfers will go from being skimped on to being overproduced. p. 27

It will need to be determined to what extent the ability to cost the overhead items of meetings and time of each producers' representatives is eligible to be costed to the joint accounts. It would be easy in this day and age to cost all activity being conducted for a specific joint account amongst the producers involved. Much like Lawyers are able to bill their time and services, each resource of the producer or JOC can be easily tracked and charge out rates, or the detailed costs can be attributed to the appropriate property. This will be a question for the producers to answer in detail at what level do they wish to continue with overhead allowances and move to a more direct costing system. I would assume that with the volume of engineering and earth science incurred per barrel of oil, the direct costing method of these transaction costs would be in the industries and producers best interests.



Although Figure 3 looks frighteningly complex, the idea is simple. There is an optimal level of transactions that should be undertaken within and between firms. The oil and gas producer is unable to use most of this analysis due to the culture of the industry involving partnerships, or JOC's, for a variety of reasons. Whether it is for mitigation of risk or the need to cooperate with producers in the area, transactions through the joint account are a necessary part of the industry and little to nothing can be done about that. Here Professor Baldwin describes the cost behaviours of more complex transactions and their associated thicker crossing points. This discussion inevitably leads to the relational contracts that are used to deal with the higher associated transaction costs of think crossing points.

The horizontal axis denotes "transaction complexity" the more transfers that are defined counted and paid for in the contract, the more complex it is. Maximum complexity, denoted by the breadth of the horizontal axis, depends on the thickness of the crossing point. Thicker crossing points have combinatorially higher maximum complexity than thin crossing points because (1) there are more transfers to define, measure and pay for; (2) many transfers of design information are unstructured, and each has uncertain and open ended consequences; and (3) in the presence of iteration and trial and error problem solving, there are many more potential paths, i.e. sequences of transfers. p. 29

The black lines in the figure indicate the costs of formal contracts of varying complexity. Mundane transaction costs rise as a function of complexity and are indicated by a linear function. As more transfers are defined, counted and paid for, however, opportunistic costs go down, until, at some point, perverse incentives set in. Thus, opportunistic transaction costs are a U-shaped function of complexity. Total transaction costs are the sum of the mundane and opportunistic transaction costs. pp. 29 - 30

A transaction is worthwhile if its benefits exceed its total costs. In the figure, this occurs in the middle range of transaction complexity. A formal contract of intermediate complexity thus has positive value, but contracts with more or less complexity have negative value and should be avoided. In other works, the two firms would be better off vertically integrating (hence losing the benefits of having the transaction) rather than operating under a poor transaction design. p. 30

1992; Introducing relational contracts changes the graph in two ways, as indicated by the grey lines in the figure. First, relational contracts are adaptive in the sense that many types of transfers will be counted and paid for ("settled") only if their cost deviates out of some normal band. The adaptiveness of relational contracts causes the mundane transaction cost line to flatten out at higher levels of complexity; the parties can achieve a more complex contract more cheaply in the context of an ongoing adaptive relationship. Second, the "shadow of the future" reduces opportunistic transaction costs, including inventive to "game" the contract. Hence the opportunistic transaction cost line is lower for all levels of complexity, and may flatten instead of curving upward. Total transaction costs(denoted by the highest grey line) are thus generally lower for relational contracts than formal contracts for all degrees of complexity. Net transaction benefits are correspondingly higher and thus relational contacts are generally to be preferred over purely formal contracts at thick crossing points. However, relationships are based on prior knowledge and trust hence relational contracts are not always an option for transactors (SakoGulati, 1998). p. 30

With Figure 3 we can see how the costs associated with transactions are incurred. To analyze the transactions involved in both the firm and the market of the industry (based on the modular definitions) will help to understand the cost implications of certain activities. To summarize then, the analysis conducted in Figure 1 and 2 will provide the ability to map the transactions between producers and contractors to their optimal system configuration. This analysis will also provide, through the use of thick crossing points and relational contracts, ways to mitigate certain costs, if deemed desirable. Recall the industry operates with partners and that is the case in more then 90% of all activity. Oil and gas is therefore unique and much of the transaction costs will be incurred as a result of the culture of the industry.

To summarize, at thick crossing points in the task network, relational contracts dominate formal contracts of intermediate complexity, which in turn dominate minimal and maximal transaction design. If possible, transactions at thick crossing points should be structured as a relational contracts, and, failing that, as formal contracts of intermediate complexity. If those alternative fail, the transfers should be internalized within a single firm. pp. 30 - 31

Modularizing the Network

Professor Baldwin introduces the concept of time and how the interactions between the tasks can change. Recall the review of Professor Langlois' Dynamic Transaction Costs where transactions whose costs were incurred during times of change. Professor Baldwin brings in the process of modularizations and the ability to design them based on using either natural, or a method of design rules. The module specification that has been specified here, consists of the eight defined modules that are able to, based on my experience in oil and gas, manage the process of oil and gas exploration, production and exploitation. Anything within these standard oil and gas classifications can be managed within an individual module or the interaction between modules.

As I indicated in my last post, the Joint Operating Committee is the natural form of organization for oil and gas. Employees are using informal networks to complete their work in a way that occurs naturally. The "natural" way of doing things is the overall design concept used in developing the eight modules. I want to raise this point as Professor Baldwin seems to be stating that the ability of users to rely wholly on design rules will be an effective means of design. And for the purposes here, I want to stress the natural way of getting work done through the modules is the key to maintaining the natural way of doing things. If an individual cannot see where and how a certain element of the oil and gas business is captured in the modules they should ask, as the logic may not be as transparent as it is to others.

Up to this point, I have assumed that the task network's structure is fixed. In this section I consider the possibility of making a thick crossing point thinner through the process of modularization. We have seen that thinner crossing points have lower total transaction costs, thus firms wishing to transact may modularize their task networks to support the transaction. However, modularization can also be undertaken for other reasons. Regardless of their intended purpose, modularization creates new module boundaries with low transaction costs. Competition at the new boundaries may ensue. p. 31

In general, however, it is impossible to say whether it is better to design a contract around a given "natural" set of dependencies or to modularize the dependencies using the method of design rules. Each approach involves different costs and benefits. Modularization, in particular, requires detailed prior knowledge of dependencies - knowledge that might not exist when the parties design their transaction. Thus while modularization is always an option, it is not always a good option. p. 34

Recall we are writing software that supports the industries ways, and the ways that people need to do their work. The implications of this change to the Joint Operating Committee are far reaching. As Professor Baldwin begins to discuss the effects these types of changes will have in the industry.

In general, as knowledge about a particular set of technologies grows, the corresponding task networks may be redesigned and modularized for a number of reasons. Such modularization necessarily create new module boundaries, and vertically integrated firms may split apart or new firms may enter at those points. In this fashion, an industry may devolve into several sub-industries coordinated by common design rules (standards) and bridged by intermediate product markets (Baldwin and Clark, 2000; Jacobides, 2005). However, as Chandler (1977) and Fixson and Park (2007) have shown, it is also possible for task networks to become more integral (i.e., less modular) over time. Hence there is no process of technological determinism at work driving the task network toward ever-higher levels of modularity. Instead, the modular structure of the task network at a particular point in time results from the interplay of firms strategies, their knowledge and the physical constraints of specific technologies. Strategies, knowledge and technologies all change over time, and as they do, the location of transactions will change pari passu. p. 37

The interactions and transactions that occur within a module may not be a transaction in the sense that we are talking about here. Professor Baldwin introduces the idea of transaction-free zones.

Transaction-free zones are physical or virtual spaces where, by convention, a designated set of transfers occurs freely. the smithy and the kitchen were transaction-free zones, as were the disk drive, laptop, plastic, auto and mold-making companies. Indeed transaction free zones are common in human affairs: every time we strike up a conversation, we are in effect creating temporary transaction-free zone for the transfer of information. p. 39

And this may best be described as the collaborative interactions between people who are getting the job done.

Transaction-free zones in which agents freely access and transfer valuable materials and information are necessary for most forms of efficient production. But a transaction-free zone designed to hold things of value can't have any holes or leaks. Thus modern market economies have developed sophisticated institutions that provide for the encapsulation of transaction-free zones within the boundaries of legally constituted corporations. p. 40

Corporations: Transaction-free Zones Encapsulated By Transactions.

In this section we learn that the method of organizations, the corporation, provides us with the means to protect and develop our interests. And just as some interactions are carried out in the interest of those corporations, not all transactions can be captured, counted and monetized. Transaction free zones become the means in which the corporation captures their value.

Bringing labor or capital into a transaction-free zone is harder, however. In medieval times, labor would often enter a zone via birth or bondage: the smith's assistant would be his son or his slave (Bloch, 1961). Capital would enter via marriage, inheritance, or as trade credit attached to a goods transaction (Braudel, 1982). In contrast, today, in modern economies, people are hired and capital is raised via transactions. p. 40

By definition, it is impossible to precisely define, measure, and pay for all transfers within a transaction-free zone. Hence the transactions that bring labor and capital into the zone cannot perfectly reflect what happens inside. But the legal form of a modern corporation makes it possible to (1) completely surround a transaction-free zone with transactions; (2) protect the zone from transient disruptions; and (3) determine whether the zone should survive in the larger system of production. These goals are achieved via a complex social technology (Nelson and Sampat, 2001), which I call transactional encapsulation. p. 40

Transactional encapsulation involves creating a legal entity - a corporation - with property rights, whose boundaries are defined by its transaction with customers, suppliers, employees, and investors. By design, many transfers within the boundaries of the corporation are complex and difficult to measure and pay for. Such transfers are economic only if they take place with a transaction-free zone. Property rights allow valuable things - capital equipment, intellectual property, inventory and receivable - to be held within the zone, without disruption, for as long as the technology demands. pp. 40 - 41

Thus in a modern economy, a firm that is legally constituted as a corporation can be completely segregated (hence protected) from its owners' affairs. This in turn means that transaction-free zones can be set up to correspond to the modular structure of the tasks network, rather than being agglomerations of unrelated holdings linked by common ownership. p. 42

This last group of transfers satisfies my definition of a transaction. In this sense, Coase, Williamson and the contract theorists are right: some transactions are internal to firms. But at the task network level of analysis, internal transaction are a very small subset of all the transfers that take place within a firm. Furthermore, I contend, the role of firms and corporations in the economy is precisely to provide transaction-free zones, where complex, but necessary transfers can take place without weighing down the system with the costs of defining, counting and paying for them (Motnteverde, 1995). p. 43

Conclusion

As Professor Paul Romer of Stanford says, "Ideas need to be discovered to maintain growth. As economies increase in size, more ideas are required." How, in what is generally agreed is the most difficult and complex of businesses, will the new ideas of the earth scientists and engineers benefit society and the companies that employ them. There is a belief that "meta ideas" or idea discovery systems are the means to make these organizations perform as they should. I have consistently stated that the current hierarchy is unable to accommodate these changes, and at the same time I have offered an alternative vision or model that provides those possibilities with the means to become realized opportunities.

In this paper Professor Baldwin, and over the past year Professor Langlois have enabled our understanding of how this type of transaction and task networks are analyzed and can be made real in the software. But key to making this real is the software development capability that is available for the users and companies. We have seen time and again that businesses change. I think the oil and gas industry is changing in major directions every 18 months, or even faster. This is a fluid process of change that needs to be mirrored by the software, the developers and the systems development capability as proposed here in People, Ideas & Objects, led by the users and driven by their demands for the most effective way of doing their jobs.

The paper makes four contributions to theories of the firm. First, it views systems of production as networks of tasks. Although not completely new, this view is more microscopic than is typical in transaction cost economics or contract theory. At this more microscopic level of observation, transactions are no longer the basic units of analysis but instead are located in more complex network structure. The task network itself provides both thin crossing points (module boundaries) and thick crossing points (module interiors). Although transactions can be placed in both types of locations, transaction costs are lower at module boundaries. p. 46

I propose that these transactions and task networks be managed by the firm through the monthly accounting voucher. A concept that I have reintroduced in this blog entry. Vouchers are different from month to month, that is their "nature". The accounting elements that they are documenting are different in some material way each and every month. The voucher is the tool that enables the user and the developer to accommodate the changes that are occurring in the business, and also those changes within the modularity and its associated transactions and tasks.

The second contribution of this paper is to show that many of the opportunistic transaction costs identified in prior work can be traced to the same underlying phenomenon - thick crossing points in the task network. Thick crossing points are places where transfers are complex, numerous and interdependent. Paths of action and flows of information are consequently uncertain and iterative. We have seen that interdependence gives rise to asset specificity. Iterative paths cause some transfers to take place again and again, hence have high frequency. And when iterative paths arise in the process of trial and error Williamsonian (1985) transaction costs. In terms of contract theory (e.g. Hart, 1995), when transfers are complex numerous and interdependent, it is impossible to define, measure, and value each one. Hence any contract written on these transfers will necessarily be incomplete. Furthermore, even when participants can observe and judge what actually happened, third parties must rely on indirect evidence. Such transfers are observable, but not verifiable. Finally, thick crossing points imply that agents are producing multiple, interdependent outputs, hence they are multi-tasking (Homstrom and Milgrom, 1994). p. 47

Adam Smith's theory of the division of labor has proven economic growth occurs through an ever increasing division of labor. What the effect of these changes has on the makeup of the oil and gas industry is not known at this time. What we do know is that this is an accelerating process. In ten years the changes may be all that people are concerned with. Nothing will be the same twice. This process of change to enhance the division of labor is something the writings of Professor Langlois has noted. The structured hierarchy and the makeup of the service industry in the oil and gas sector are going to be subjected to many changes. I hope that they are able to foresee the need to address these changes and begin the development of this software in a timely fashion. We have many years ahead of us that will be consumed in the preliminary stages of software development.

This paper's third (and most important) contribution is a theory of technological change that explains and predicts changes in the location of transaction, hence the structure of industries. Indeed, the prediction is very simple: Modularization's, whatever their stated purpose, create new module boundaries with (relatively) low transaction costs. Modularization's thus make transactions feasible where they were previously impossible or very costly. Therefore firms desiring to transact may modularize the task network at the point of their transaction. And firms that modularize their task networks for other reasons should be prepared to face entry and competition at the new module boundaries. p. 47

The paper's fourth contribution is the concept of transaction-free zones as places in the task network where numerous, complex, interdependent, and iterative transfers can take place economically without the cost burden of transactions. Firms can move valuable items into and out of transaction-free zones via transactions, and corporation can set up zones that are legally encapsulated by transactions. However, un-encapsulated transaction-free zones, such as online and open source communities, thrive in the absence of transactions. Such communities produce non-rival goods, hence for them opportunistic transaction costs are naturally low, and almost any level of mundane transaction cost may be too high. pp. 47 - 48

The overall picture that emerges from this analysis is that of an economy wide tasks network where densely connected clumps of tasks take place within transaction-free zones. The zones can be (but are not always) encircled by transactions, which provide defined, counted and compensated transfers between zones. Transactions will tend to be located at the thin crossing points of the network, some of which are created, via modularization, expressly for this purpose. However, transactions at thick crossing points are possible, too, especially when the parties have a longstanding relationship. Speaking metaphorically, this picture is reminiscent of Robertson's view of an economy in which firms are "like lumps of butter coagulating in a pail of buttermilk" (Robertson, quoted by Coase, 1937, p. 388). pp. 48 - 49

As Furubotn observes, there is no guarantee that a system like this will reach anything approaching global optimality or even constrained Pareto efficiency. But each firm participating in the network will have inexhaustible opportunities to gain advantage by redesigning the portions of the task network it controls and the transactions it influences. At the same time, new firms can quite easily attach themselves to the network at the boundaries of modules. As a result, the network's structure and the location of transaction will be ever-changing. p. 49

Well stated Professor Baldwin. After all I think Curtis Pavel got it right when he said "People are the killer app of the Internet." And Frederick von Hayek wrote "Societies course will be changed only by a change in ideas."

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