ON STRATEGIC NETWORKS

CARLOS JARILLO J Strategic Management Journal pg. 31

(1986-1998);

Jan/Feb 1988; 9, 1; ABI/INFORM Global

Strategic Management Journal, Vol. 9. 31-41 (1988)

ON STRATEGIC NETWORKS
J. CARLOS JARILLO
Instituto de Estudios Superiores de la Empresa (lESE), Universidad de Navarra,

Barcelona, Spain

In parallel with a theoretical acceptance of the importance of the laws of competition to formulate strategy, the realization is growing that cooperative behavior among firms is at the root of many success stories in today's management. This situation calls for an effort to develop a theoretical framework to study both aspects of firm behavior (cooperative and competitive) as compatible, complementary aspects of a unique reality. Indeed, the cooperative relationships' of a firm can be the source of its competitive strength. This paper develops the concept of strategic network, as a tool to understand those cooperative relationships and their role in the strategy of the firm. There are three main tasks of the paper: first, to show that strategic networks are but a 'mode of organization'; second, to study the economic conditions of existence of a network; finally, to analyze the conditions of existence of a network from the point of view of its internal consistency. In afinal section some of the most obvious strategic implications of the framework are outlined.

Networking is a fashionable topic. It is receiving increasing interest in popular management publications, as well as specialized academic journals. Throughout this article the reasons for such an increased interest will become apparent. But, important as the topic may be, it lacks a generally accepted conceptual framework, with enough theoretical depth to help understand the plentiful anecdotal evidence, and particularly to put the phenomenon in a context consistent with the overall strategic paradigm. The reason for such 'lack of depth', from a strategic point of view, might be found in the fact that the concept of network was coined outside the strategy field. Thus, the seminal work on inter-organizational relationships was performed by researchers in the organizational theory tradition (Evan, 1966; Aldrich and Whetten, 1981; Levine and White, 1961; Hall et

organizations. This is an important consideration:

0143-2095/88/010031-11$05.50 C) 1988 by

John Wiley & Sons, Ltd.

al., 1972; Benson, 1975; Van de Ven, 1976; Van de Ven and Ferry, 1980). The empirical research was, in all instances, conducted in non-profit

strategy scholars have had little use for the concept of networks. They do not use the network construct precisely because it is very hard to harmonize with the basic postulates of competitive behavior. This 'problem' to conceptualize the realities of networks has been probably aggravated by the preeminence of models of strategy based on microeconomic theory (Porter, 1981). And yet the anecdotal evidence of phenomena classifiable as networking abounds. Among the best-known cases is the use of suppliers by Japanese manufacturing firms (Twaalfhoven and Hattori, 1982; Imai, Nonaka and Takeuchi,

1985). Practically all studies of industrial suppliers and industrial markets touch on this point. Von Hippel (1985, 1986) has shown how a close relationship with suppliers and customers provides firms with the most important source of inno vation. There is little in the way of formal empirical studies, however. In my opinion the reason is precisely that the construct of networks is difficult to fit within the basic paradigm of competitive strategy. The questions about
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Received 11 December 1986

networking then, are not even asked (Kuhn, 1970). . In spite of this conceptual difficulty, scholarly articles are appearing on the topic, mostly from Europe, and ideas are emerging that can be used as building blocks in a theory of strategic networks. We will discuss briefly these developments now, before proceeding to elaborate the basic framework being sought.
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Thorelli (1986) sees networks as something between markets and hierarchies. Firms act in a complex environment, where no firm can really be understood without a reference to its relationships with many others. He recognizes that, instead of network, he could have used the term 'system', but thought it was a 'tired term' (p. 39). In this sense he is basically describing reality, more than conceptualizing it. Johanson and Mattson (forthcoming) use the concept of network to define industrial markets. Networks are seen as complex arrays of relationships between firms. Firms establish those relationships through interactions with each other. These interactions imply investments to build the relationships, which gives consistency to the network. Competing is more a matter of positioning one's firm in the network than attacking the environment. The care of the relationships becomes a priority for management. Along similar lines, MacMillan and Farmer (1979) talk about expanding the theory of the firm to include what they call 'managed economic systems' (p. 284). Lorenzoni (forthcoming) goes a step further. He bases his work on the changes which have occurred in the textile industry in northern Italy (Lorenzoni, 1982). A strong process of deintegration is documented, whereby 700 firms in 1951 `deintegrate into 9,500 in 1976, with a decrease in average employment per firm from 30 to 5. Total employment has more than doubled: the industry is very healthy, the most competitive in the world' (p. 2). Analyzing the phenomenon, he describes the rich web of relationships that constitute the networks of small firms ('constellations'), and how these networks go from a phase of 'reaction' (realized constellation), to one of efficiency (rationalized constellation) to its current phase of effectiveness (planned constellation). The step made by Lorenzoni over the previous work is that he sees the network, in this last step, as the product of a determined entrepreneur, bent on obtaining the best (most efficient) organizational arrangementto compete in his or her chosen market. In this sense, Miles and Snow (1984: 27) have written about

'dynamic networks' as the most efficient form of organization for today's economic circumstances. This understanding of the network arrangement as something that entrepreneurs use purposefully to obtain a competitive advantage for their firms, instead of as a 'metaphor' to describe business transactions, constitutes the theoretical thrust of this paper. In this paper, networks are conceptualized as a mode of organization that can be used by managers or entrepreneurs to position their firms in a stronger competitive stance. That is why the term 'Etrategic' has been added to 'networks': I see strategic networks as long-term, purposeful arrangements among distinct but related forprofit organizations that allow those firms in them to gain or sustain competitive advantage vis-vis their compeCtors outside the network. Firms in the network are independent along some dimensions (i.e. they are not completely dependent on each other). Otherwise they would fall into a case of 'vertical quasi-integration' (Blois, 1972). The Telationships enjoyed by the firms in the network are, however, essential to their competitive position. It is a mode of organization that is not based strictly on the price mechanism, or on 'hierarchical fiat' (Williamson, 1975: 101), but on coordination through adap tation (Johanson and Mattson, forthcoming). Essential to this concept of strategic network is that of 'hub firm', which is the firm that, in fact, sets up the network, and takes a pro-active attitude in the care of it. The main theoretical difficulty is that networks do not fit well the basic models of strategy, as has been said. Firms are normally regarded as 'complete entitites', operating in an environment that is implicitly defined in a rather negative way, as 'everything that is not the firm'. The problem of establishing the 'boundaries of the organization' has always vexed the 'open system model' (MacMillan and Farmer, 1979). And yet real-life firms, particularly in some highly relevant contexts, are very far from that prototypical 'firm' that buys raw materials, processes them and sells them in an almost completely isolated way. The theoretical thrust of this paper consists of trying to understand the economic basis for the relationships established in a network, how those

relationships can enhance the competitive stance of the particular firms involved in the network, and what the conditions for the stability of the relationships are. Briefly, we must understand under which circumstances a network arrangement can be more efficient than both a purely 'market' relationship or an integrated solution; that is, we must look at the 'differential efficiency of alternative organizational forms' (Masten, 1984: 403). If it is more efficient, it can easily be turned into strategically superior. The preceding paragraph points out the first theoretical element to be sued in this conceptualization of networks. The by now ubiquitous characterization of markets and hierarchies (Williamson, 1975) will serve as a starting point. NETWORKS AS A MODE OF ORGANIZATION Williamson's main insight, derived from Coase (1937), was to see 'markets' and 'hierarchies' as two alternative modes of organizing economic activities. It is assumed that the most efficient mode, for a particular kind of transaction, will prevail. In the classical theory the advantages of a total `deintegration' seem clear. So much so that the original question posed by Coase was, indeed, why are there firms at all, instead of just a market of separate economic atomistic units. Stiegler (1968), gives an example used by Wiliamson (1975: 16). Consider a firm that contemplates different cost curves in the different sub-components that make up its final product. Some of these curves fall indefinitely, some go up, and some are U-shaped. If there are several firms in the market producing the same good, the (a priori) most efficient way to organize production would consist of one firm specializing in one of the subcomponents of the product that has a descending cost curve, and supplying it to the other firms, which would get it at a lower cost than if they had to perform that function by themselves. Why does this not happen? Williamson's answer is that there are transactions costs associated with such an arrangement, that make it actually more expensive than the production of the subcomponent by each firm. In this particular case it is not difficult to imagine what these costs are: opportunism, early-Mover advantages, and other strategic considerations.

The other firms simply cannot let one of their competitors take care in a monopolistic fashion of an activity that is needed for their smooth functioning.'
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In a word: by definition, in the absence of transactions costs, firms would not integrate functions. That would allow them not only to reap economies of scale, as in Stiegler's example, but also all the well-known benefits of internal focus, plus the flexibility to switch suppliers whenever technological or market developments so advised. If, however, there are transactions costs, firms will integrate activities that could have been subcontracted. But if an entrepreneur is able to lower those transactions costs (relative to its competitors), the resulting firm will be less integrated and more efficient (ceteris paribus): the firm can concentrate exclusively on its comparative advantages. There is, of course, an assumption here, not discussed by Williamson: transactions costs can be affected by conscious actions of the entrepreneur. We shall see that this is the case, and how this is the foundation for the concept of `strategic network'. It cannot be taken for granted that a 'hierarchical relationship', from a practical point of view, avoids the theoretical transactions costs, however. We see, for instance, many managementlabor relationships that 'should' fit into the hierarchical mode and are not different from any armslength market relationship with a non-cooperative supplier. Thus Williamson's distinction, although extremely useful from a theoretical point of view, cannot be navely translated into actual corporate realities. Ouchi (1980) has addressed this problem. He proposed to break 'hierarchies' down into two different categories: 'bureaucracies' and 'clans'. The first type would have some of the characteristics of markets: the 'congruence of goals' could be very low, but the organizational form would still be that of a firm. Clans, on the other hand, would be much closer to eliminating transactions costs, because the congruence of goals would

But this phenomenon , s indeed happening. In industries where the economies of scale in assembling are very important, like consumer electronics, more and more American firtas are subcontracting part of their productsor even the whole manufacturing functionto Japanese or Korean competitors. See 'The hollow corp', Business Week, 3 March 1986, pp. 53-75.

Approach to the Relationship

Zero-Sum Game Non Zero-Sum Game

E
Is. tr)
e.)

In a very similar vein, Imai and Itami (1984) have written about markets and firms as both being 'arenas' and 'principles' of coordinating economic activity. The 'market principle' penetrates the 'organizational arem' and vice-versa. Reproduced with permission of the copyright owner. Further reproduction prohibited without permission.

Classic Market Bureaucra cy

Strategic Network Clan

F i g u r e 1 . T h e f o u r m o d e s o f o rg a n i z i n g e c o n o m i c activity

allow the firm to do without much of the supervision inherent in a 'bureaucratic' company. The main 'transaction cost' avoided by a clan would be the need to ascertain how much each participant should get paid. Since it is impractical, in many settings, to do that through a market mechanism, because there is joint effort, a hierarchical arrangement is arrived at. But we can go a step further. 'Markets' can also be broken down into two different categories, according to the 'approach' both parties take to the relationship (to their degree of 'goal congruence', or, in other words, to the perceived opportunity for joint value creation). Whether the relationship is seen by the two parties as a zero-sum game (competitive) or not (cooperative) is the criterion which cuts across the two kinds of legal organization, 'markets' and 'hierarchies'. Figure I represents the four possibilities.2 Thus the different 'modes' of organizing complex economic activity come determined by two variables: the 'legal' organization (i.e. whether the entities act as separated units) and the 'kind of relationship' (i.e. where there is goal congruence, inseparability of returns). Of course, the two extremes of these variables must be seen as poles in a continuum. Thus, more than four 'pure' forms, we have four 'prototypes'. The upper-left corner of the matrix thus formed would truly be what Williamson called 'markets', i.e. an organizational arrangment where many players interact on a spot basis. The lower-left quadrant would be exemplified by the antagonistic labormanagement relationship. It is, from a formal point of view, a hierarchical organization,

but many of its characteristicsparticularly those referring to transactions costsare those of an open market. The third quadrant, 'clans' as Ouchi called it, is probably the closest thing to what a Williamsonian hierarchy would be in real life: long-term relationships, carried out through nonspecified contracts within the formal environment of an organization. Finally, I have called the upper-right quadrant 'strategic networks'. In them, a 'hub' firm has especial relationships with the other members of the network. Those relationships have most of the characteristics of a 'hierarchical' relationship: relatively unstructured tasks, long-term point of view, relatively unspecified contracts. These relationships have all the characteristics of 'investments', since there is always a certain 'asset specificity' to the know-how of, say, dealing with a given supplier instead of a new one. And yet the 'contracting parties' remain as independent organizations, with few or no points of contact along many of their dimensions. In a recent article, Maitland, Bryson and Van de Ven (1985) have compared Ouchi's and Williamson's points of view. Their conclusion is that 'any union between the two perspectives is bound to be scientifically barren' (p. 64). The reason would be the radical incompatibility of assumptions: for Williamson opportunism is the key motivator; for Ouchi it would be 'fairness'. But this is a simplistic, deterministic view. All these factors, and more, are at play. I contend that the entrepreneur can affect the way the relationship is shaped and, the same way a conscientious manager can create a 'clan' atmosphere, an inter-organizational relationship can be based on perceived goal congruence and trust. When the relationship is viewed as valuable in itself because of future, unforeseen developments, keeping it alive becomes much easier. We will expand on this in the remaining sections. HOW CAN A NETWORK BE ECONOMICALLY EFFICIENT?

We have explained so far what a strategic network

is. The task now is to understand how can it be efficient, in the competitive sense; i.e. how can it be more efficient than any other mode of organization. This takes us back to Williamson's

original question of why economic activitites are organized along different modes. In order to understand the way firms structure themselves (which activities are integrated and which are farmed out) we must break up the firm into smaller units of analysis. In this section a framework is provided to look at those decisions from a strategic point of view, analyzing the optimum possible combination, thus leading the way to see why networks can be extremely efficient. The concept of the value chain (Porter, 1985) is very useful in this effort to break up the firm. Distinguishing different activities within the firm that are, to some extent, independent although interrelated, is important b, - 1 , ilsc it reflects reality much better than thin.;--lz c. 1 he firm as a one-dimensional production fzulc:ion or a 'typical integrated manufacturing firm'. Viewing firms as 'value chains', i.e. collections of activities that add value between suppliers and customers, makes it possible to apply Williamson's concepts with the necessary rigor, for he refers transactions costs to specific 'activities' easily assimilable tu 'functions' (or subcomponents of them) of the value chain. These two theoretical developments fit admirably well with each other:for the concept of value chain does not but decompose the firm in distinct 'activities', while the 'transaction costs' approach makes of the transaction (the specific kind of repeated activity) the unit of analysis. Obviously, it is the final (total) cost for a given activity that matters, be it performed internally or subcontracted. In the case of an internal activity we will call it internal cost (IC); in the case of subcontracting it is the external cost (EP, the price charged by the supplier) plus the transactions cost (TC). The total external cost will then be called EC, and it is EP + TC (Farmer and MacMillan (1976) introduce this distinction between price from a supplier (what it is charged) and cost to the buyer (once the transactions costs are added). An activity will be integrated (thus shaping a hierarchy) when EP + TC > IC. This, obviously, can hold even in the case of EP < IC, as we saw in Stiegler's example above. Remember that TC is dependent on structural characteristics (assets specificity, small numbers bargaining, etc.). It is expected, then, that all competitors will make a similar choice and integrate, or else be driven out of business.
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supplied to (or by) his or her firm. If TC is lowered up to a point where EC + TC < IC, the entrepreneur will not integrate that actvity and, precisely by doing so, will be more efficient than its competitors. This is the essence of the effectiveness of the network arrangement. The hub firm in the network can enjoy lowei costs because it captures economies of scale (or whatever source of efficiency) from its associated firms, that other competitors cannot obtain because TC forces them to integrate. Obviously, this will be the case if and only if EP < IC (a technological consideration) and TC can in fact be lowered enough so that (part of) the savings can be realized by subcontracting. Thus the condition for the economic efficiency of a network is that EP be lower than IC, for some activities necessary for the production of the good delivered by the network. Of course, without a lowering of TC the network will not exist (or will be competed out of the matket). But this point will be dealt with in the next section. The strategic implications of a network arrangement are important. It allows a firm to specialize in those activities of the value chain that are essential to its competitive advantage, reaping all the benefits of specialization, focus and, possible, size. The other activities are then farmed out to members of the network, that carry them out more efficiently than the 'hub' firm would, since they are specialized in them. At the same time, all the firms in the network enjoy the added flexibility of not having fixed commitments to activities which are not essential to them. A very important benefit of a networking arrangement over an integrated solution is, according to MacMillan and Farmer, that efficency is fostered because 'the market test is still applicable. No matter how close the relationship between buyers and seller:, no matter how long it has endured, if better trading terms (considering quality, quantity, timing and price) can be obtained elsewhere, there is no permanent tie to stop either party making alternative arrangments' (1979: 283). Thus networking introduces a cost discipline that may be absent in an integrated firm, with its captive internal markets. Finally it must be remarked that, by farming out activities to other members of the network, a firm can lower its costs for those activities it

But let us assume for a moment that a given entrepreneur can in fact lower TC for activities

keeps inside, because it can reap economies of scale and develop distinctive competences. Thus, when deciding the allocation of an activity (assessing internal and external costs), the real complete internal cost must be calculated. It is often higher than it seems at first look, because performing a given activity inside may imply a loss of efficiency for the overall firm. This is well known to many successful real-life entrepreneurs who refuse to be distracted by activities other than the essential ones. HOW CAN A NETWORK BE CREATED AND SUSTAINED? The conditions for the existence of stable networks are the same as the conditions for the existence of organizations, using this word now in the traditional sense of organization theory. Since Barnard (1968), it has been accepted that, at a maximum level of abstraction, an organization has to meet two characteristics to come into existence, and then survive: it must be effective and it must be efficient. An organization is effective if it achieves the desired end. It is efficient if it does so while, at the same time, offering more inducements to the members of the organization than efforts they have to put 'alto it. In his words: 'the efficiency of a cooperative system is its capacity to maintain itself by the individual satisfactions it affords' (p. 57). This can directly be translated to interorganizational relationships (Farmer and MacMillan, 1976). That a networking arrangment can be effective has been argued in the previous section. In fact it can be the most effective arrangement in many circumstances. The basic condition for effectiveness is technological (that external costs be lower than internal costs), plus the possibility of lowering transactions costs. But to actually come into existence and, especially, to survive, a network must be efficient in Barnard's sense. The basic condition for efficiency is that the gain to be accrued by being part of the network is seen as superior, over the long term, to the profits that can be obtained by going along (or by establishing short-term, changing relationships). This can be achieved through the realization of two points: first, that belonging to the network gives superior performance (thus there is more pie to share, because the network
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is effective); and second, that the sharing mechanisms are 'fair'. We thus go back to the basic dilemma of Ouchi's, only having firms instead of individuals. Efficiency and effectiveness are, then, the basic conditions of existence of networks. We shall see now what mechanisms are used by actual entrepreneurs to ensure that those conditions apply. It will be remembered that Williamson argues that markets fail, and therefore hierarchies have to be established to perform their functions, because of costs that make market transactions inefficient. Those costs stem from four reasons: man's 'bounded rationality', uncertainty about the future, the presence of a 'small number' of players for a given kind of transaction, and the possibility of 'opportunistic behavior' on the part of (at least) some of the players. These are precisely the reasons why trust might be lacking in a relationship. In other words, lack of trust is the quintessential cause of transactional costs: 'Opportunism is a central concept in the study of transaction costs' (Williamson, 1979: 234), for it poses a real danger whenever there are 'appropriable quasi-rents of specialized assets' (Klein, Crawford and Alchian, 1978) a situation intrinsically characteristic of networks, as we have seen. Being able to generate trust, therefore, is the fundamental entrepreneurial skill to lower those costs and make the existence of the network economically feasible. Thorelli (1986: 38) has defined trust as 'an assumption or reliance on the part of A that if either A or B encounters a problem in the fulfillment of his implicit or explicit transactional obligations, B may be counted on to do what A would do if B's resources were at A's disposal.' Observe that trust dissolves the need to specify unforeseeable consequences, for it is assumed that the decision rule to be followed will be identical to my own decision rule The same can be said of the problem of 'fair sharing'. Thus trust is a critical component of both effectiveness and efficiency. The importance of trust for the smooth and effective functioning of organizations has been argued, among many others, by Barnes (1981). Driscoll (1978) found evidence that a trustful environment is more important for work satisfaction than participation in decision-making. Zand (1972) found empirical evidence, confirmed by

Boss (1978), that an atmosphere of trust is actually conducive to more efficient problemsolving. The reason is that, in such as atmosphere, information is exchanged freely, and more solutions to a given problem are explored, since the decision-makers do not feel they must protect themselves from the others' opportunistic behavior. These arguments deal with the function of trust within organizations, but they can be easily applied to networks. In the words of Williamson (1979: 241), 'other things being equal, idiosyncratic exchange relations [i.e., transactions involving specific assets] which feature personal trust will survive greater stress and display greater adaptability'. How can trust be generated? Let us take the situation of the btisinessperson who needs to generate trust in order to build a network, i.e. in order to lower TC arising from opportunism and asset-specificity. He or she will have to act on two variables: the assumptions of the owner of the resources (the other party) regarding the entrepreneur's motivations and intrinsic situation. The first variable can be addressed through choosing carefully the partners to the different relationships, searching explicitly for people the entrepreneur can 'relate to', i.e. with similar values. This identity of values and motivations will certainly facilitiate the emergence of trust. The second variable is the intrinsic situation. The entrepreneur cannot expect 'blind trust' if it means the members of the network must put themselves at high risk. Trustful behavior can only be generated by showing that the entrepreneur would be worse off if he or she behaved opportunistically. A typical way of doing this is by showing a track record, a reputation that i s va l ua bl e and ha s t o be protected. T he entrepreneur, it is assumed, will behave correctly because, even if in this particular circumstance he or she could gain from opportunistic behavior, such behavior would destroy his or her reputation, thus making the total outcome of the opportunistic behavior undesirable (see Kreps (1984) for a detailed elaboration of the role of 'reputation' in the efficient establishment of relationships).
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theory that shows that long-term contracts are easier to enforce than spot ones (Fama, 1980; Lambert, 1983; Radner, 1981, 1985). It can be shown that the possibility of playing future valuable games (i.e. obtaining new contracts if performance is good) can modify the solution for a 'prisoner's dilemma' in a cooperative way (Jarillo and Ricart, 1987). An obvious reason why it lowers the problems of fair-sharing is that each instance of the relationship is less important, since it is assumed that what matters is to keep it for the long run. Thus all parties can be expected to show flexibility in their demands. The situation is self-reinforcing. It is also stable because the investments made by the firms in their relationships (Johanson and Mattson, forthcoming) lead them to try, at least over the short run, to use the 'voice' mode of negotiation, instead of the pure 'exit' (Hirschman, 1970). STRATEGIC IMPLICATIONS Much work has been done on analytical tools to help a firm analyze the attractiveness of a given market, i.e. to help them choose where to compete. But it is much more important to decide which segments of the value chain of a given product or sets of products are to be emphasized in a firm, and which ones are to be downplayed or even subcontracted altogether. Whether a firm is a low-cost manufacturer or a niche marketer within the same industry is, at least, as radical a distinction, with as many implications, as whether the firm is competing in a given market, or another similar to itconcentrating on the same activities of the value chain. Shaping the value chain is really shaping the firm. A good example of this point can be seen in the huge success many Japanese corporations have had diversifying widely in their product ranges, going from cameras to office equipment to electronics (Canon). It is contended that a reason for that successso elusive for many Western corporationsmay be that they have concentrated on their 'distinctive competences' (Selznick, 1957), those being the activities of the value chain where the firm excels. The amount of subcontracting by those firms tends to be very large, again compared with their Western counterparts (Twaalfhoven and Hattori, 1982).

An emphasis on long-term relationships is also essential to the development of trust, because it makes it clear that the relationship itself is considered valuable. Therefore, opportunistic behavior, which would cause a severance of the relationship, will be considered less likely. Thisis consistent with work in the fi;.1c1 of agency

Snow and Hrebiniak (1980) found that firms concentrating on a distinctive competence consistent with their chosen strategy outperformed competitors. Establishing an efficient network implies the ability to lower transactions costs, for it is precisely those costs that lead firms to integrate, shunning the flexibility offered by a market relationship, together with the advantages of specialization, both their own and their El9pliers'. This ability is, then, considered a critical element of success when managing. After all, what the 'hub firm' is doing is establishing an external relationship for a set of transactions that other firms must internalize, given the high cost for them of having those transactions performed outside. The flexibility and focus that result from deintegration, made possible by the existence of a network that takes care of the other functions, can be extremely powerful competitive weapons, especially in environments that experience rapid change, due to increasingly rapid technological pace, globalization of competition, or the apparition of new, flexible, focused, deintegrated competitors (Porter, 1986).
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As we saw above, the critical component that makes a relationship take the shape of 'strategic network', instead of that of a 'typical market' is the high degree of (perceived) 'opportunity for joint value creation' between the two organizations. An important component of that perception is the time frame being considered. The relationship of a supplier with a customer is, for a given transaction, a zero-sum game: each dollar gained by the supplier is a dollar lost by the buyer. But, over the long term, the situation may be different: the success of the supplier may be l i nke d t o t he suc c e ss of the buye r. A clear case of this is the relationship between management and a trade union or a car dealer and the automobile manufacturer. A given contract may be viewed as a zero-sum game but, over the long run, the destinies of both parties are intertwined. Thus, specific actions must be implemented to ensure that the firm is taking the appropriate long-term outlook, and that it is being seen to do so. The need to build and maintain a reputation in order to be able to establish relationships that can result in an overall decrease of costs has specific implications for management, and can seriously alter priorities. It has been said that subcontracting practicesare simply a mechanism by which large firms

would export some of their risk in business to smaller, defenseless subcontractors. 3 The larger firms would, for instance, keep production inhouse when there is a slack in demand, thus avoiding lay-offs. The agency relationship would then be based on the exporting of all the risk to the ' subcontractors. That would certainly go against the trust-building practices that we should expect in efficient networks. In a real networking arrangment the 'principal' should take on some of the risk of the relationship, through an agreement that shifts (at least) part of the random variance in the subcontractor's costs to the principal, i.e. there should be a factor a that represents the share of variance taken up by the principal. Thus, if a = 0, then the subcontractor bears all the risk (it is a purely fixed-price contract); if a = 1 the principal bears all the risk (it is a cost-plus contract). The problem with a = O is that there is no real network relationship (it would be the case of buying something at a given, fixed price, with no further involvement between the firms). The problem with a = 1 is that there is no incentive whatsoever for the subcontractor to be efficient. Efficient networks, therefore, should show a fact 1 > cx> 0. There is some evidence of this. Kawasaki and McMillan (1986) examine a large sample of subcontracting arrangments among Japanese firms, and find the following: first, the subcontractors are indeed risk-averse (as may be expected from their small size, compared to the principals); second, the contracts have the principal absorbing some of the risk on behalf of the subcontractor (a > 0); third, a grows, among other things, with the degree of risk-aversion of the subcontractor a.ild the size of the fluctuations in costs; finally, the average a is 0.69, with many of them being above 0.75. This means that the contracts are closer to the cost-plus end of the spectrum. Although an in-depth analysis of Japanese subcontracting practices is clearly outside the scope of this paper, and would have to include considerations from many different fields, the previous points let us realize that some of the most successful industrial networks do behave in a way consistent with the previous analysis. Thus the risk-sharing agreement is basic to the long3

The following material is covered in more detail in Jarillo and Rican, 1987.

term success of the relationship, and the 'principal' has to be willing to take it. The supposed 'exploitation' is certainly nowhere to be found. The arrangement gives flexibility to the large firm while the subcontractor is better off because of the risk absorbed by the big firm, presumably more neutral with respect to it. An area where the use of networks is of the utmost importance is in entrepreneurship. Too often, entrepreneurship is viewed in too narrow a way, as just the starting of new firms, instead of taking the more general view of Schumpeter (1934), to whom entrepreneurship was the introduction of innovation in the economic cycle. But in any case it is an essential characteristic of entrepreneurs to end up using more resources than they control, for they are motivated primarily by the pursuit of opportunity, rather than feeling constrained by using the resources they control (Stevenson, 1983). Networking is, in lost instances, the method entrepreneurs use to get access to external resources, necessary in the pursuit of their opportunities (Jarillo, 1986). Thus the realization of the importance of networking, and the widerstanding of the skills involved in making it succeed (Birley, 1986), are two of the most important 'entrepreneurial skills' that can be taught and developed. Something similar can be said of the process of `professionalization' of the entrepreneurial firm, once it has succeeded in the start-up phase. The risk of losing the 'entrepreneurial spirit' through paying too much attention to what has already been achieved goes together with the tendency to do more and more things inside, losing the initial advantages that served the firm so well (Stevenson and Jarillo, 1986). SUMMARY This paper presents a framework to incorporate the undeniable realities of networking to the dominant model of basiness competitive strategy. The basic point is to realize that 'firms' are not monolithic entities, that the activities necessary to the production of a given good or service can be carried out either by an integrated firm or by a 'network' of firms. If a firm is able to obtain an arrangement whereby it 'farms out' activities to the most efficient supplier, keeps for itself that activity in which it has a comparative
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advantage, and lowe rs transac tions cost s, a superior 'mode of organization' emerges: the strategic network. This mode of organization enjoys some of the properties of markets and some of the properties of hierarchies. The network is economically feasible because the specialization of each supplier makes the final total cost lower. It can be sustained because longterm bonds, that generate trust, lower transactions costs. A 'fairness' in the sharing of the valued added is achieved, through the mechanism of trust and through valuing the relationship in itself, which makes it easier to solve specific problems. The resulting model lacks the cleanliness of the purely competitive model, or its adaptations, but it is much closer to the murkier realities of business behavior, with its concomitant aspects of competition and cooperation. In Riordan and Williamson's words, 'hybrid modes [cf organization] are much more important than had hitherto been realized' (1985: 376). ACKNOWLEDGEMENTS The helpful comments of E. Ballarin of IESE, S. Ghoshal of INSEAD, A. Hax of the Sloan School (MIT), H. Stevenson of the Harvard Business School, and two anonymous referees are gratefully acknowledged. REFERENCES
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