Trust in Networked Organization

Capitalist institutions are changing (Powell, 2001; Adler, 2001; DiMaggio, 2001) and adapting to the changes in information technologies. In Powell's (2001) account, the most significant economic outcomes of this process are:

1. An upsurge of startup companies, with their new products and services and new managerial practices;

2. The creation of global giants in a number of key industries;

3. The continuing merging of old and new companies at the global level;

4. The move from jobs to projects, with the downsizing of the stable workforce and the increased flexibility of work relationships;

5. The flattening of hierarchies in the organizations;

6. The increased networking of different organizations and the blurring of boundaries between the inside and the outside of organizations.

Behind the confusion and divergent trends, Powell (2001) discerns a fundamental change in the economy, namely the shift toward the rationalization of work, vertical integration and mass markets that calls decentralized capitalism. With this term he defines an economic world in which jobs disappear, projects increase their importance, design and production become simultaneous processes rather than orderly sequential steps, and competition is based on knowledge. He states that, "Power, to be sure, remains crucial, but it is employed to enhance reach and access and to compete in high-speed learning races" (p. 5).

Thus, regardless of whether cooperation is driven by efficiency exploitation goals, or by the need to explore new innovation frontiers (March, 1991), networking becomes crucial and positions in the networks become the drivers for sustainable success (Powell, Koput & Smith-Doerr, 1996). At the basis of this view of societal changes, there is a new knowledge-based conception of organizations (March, 1991; Vicari, 1991; Powell et al., 1996). Organizations are conceived as learning networks, whose core task is to access sources of knowledge rapidly and turn the partial, situated insights of individuals and communities into tangible products (Powell, 2001, p. 1). Apart from learning, flexibility has at least the same importance in networking. "Firms are coming to resemble a network of treaties because these multi-stranded relationships encourage learning from a broad array of collaborators and promote experimentation with new methods, while at the same time reducing the cost of expensive commitments" (Powell, 2001, p. 41). According to Powell, typical of this distributed capitalism is the flexibility and the dynamicity of the economic connections, more than the reciprocality of goals. However, informal cooperation is vital to form flexible organizations and construct adaptive, innovative and knowledge-sharing institutions.

Since the networked organization is considered the basis of the future society, understanding how this organization works, where it comes from, and what are its social and economic consequences, is strategic. In order to achieve this goal, it is useful to start from the different perspectives regarding the reasons why networks emerge, what value they add and for whom.

The Transaction Cost Approach

According to Williamson (1975, 1979) and the transaction-cost theory, organizations exist to economize on the cost of transactions, and therefore markets are substituting for organizations. Transaction costs are "the price of contract negotiation and renegotiation of contract" (Williamson, 1975, p. 60). Williamson claims that organizational hierarchies economize on transaction costs when there is high uncertainty, frequent or sequential transaction, transaction specific investments, and task idiosyncrasy. Where uncertainty combines with asset specificity and difficult metering, transaction costs will be lower in a stable hierarchical organization than in the market.

Markets fail, and require institutionalized coordination because humans have bounded rationality (Simon, 1972) and because they act under conditions of uncertainty due to the opportunistic orientation of their counterparts in transactions. Opportunism can be defined as "self-interest seeking with guile" (Williamson 1975, p. 26). In the original theory, opportunism tended to be viewed as a violation of an explicit contract. More recently, the original view of opportunism has been modified to include violations of so-called relational contracts (Wathne & Heide, 2000). The occurrence of opportunistic behavior in relationships has important practical implications. If the risk of opportunism is high, considerable resources must be spent on control and monitoring. This makes hierarchical organization more efficient.

In this theoretical framework the drivers of the hierarchical forms of governance are:

1. Lack of information or lack of ability to process all the available information (information asymmetry and uncertainty);

2. Lack of trust and social capital.

Transaction cost theory is conceptually linked to agency theory. The agency relationship is defined as a contract under which one or more persons, the principal(s), engages another person to perform some service on their behalf which involves delegating some decision making authority to the agent (Jensen & Meckling, 1976, p. 308). Agents can be linked to principals through organizational hierarchy (employees) or market. Like transaction cost theory, it assumes self-interested agents and informational asymmetries, but it focuses on risk. Agency costs are the sum of principal's costs for the information system to verify performance, bonding expenditures by the agent (cost to share risks) and residual loss, since perfect bonding is impossible. The goal is to tie compensation to performance through a governance structure (contract) which minimizes costs. Principal-agent relationships should reflect efficient organization of information and risk-bearing costs (Jensen & Meckling 1976, p. 308.)

Both theories state that given information and social uncertainty, hierarchies are more efficient than markets. Our preliminary claim (Mandelli, 1998) is that since the Internet increases uncertainty, the Internet may also increase the need for organizational hierarchy and agency. We also found some empirical evidence for these new hierarchies on the web (Mandelli, 2004). But we also believe that complexity makes hierarchies less efficient, when complexity itself burdens organizations with information overload and evolutionary patterns of social interactions and decision-making.

The limit of both transaction cost theory and agency theory is located in their rational-choice assumptions. Even further, agency theory considers information a commodity which can be bought. These theories remind us that there are costs concerned with transactions and agency, and that these costs can drive organizational hierarchies. However, the market-hierarchy dichotomy cannot help us fully explain the complex changes organizations and individuals face in the knowledge and connected economy. Challenging the frictionless paradigm has been necessary (Mandelli, 2004) for understanding the complexity of a network economy, but it does not mean that we can simply return to embrace the rational-bureaucratic paradigm.

Trust as a Coordination Mechanism

Corporations have increasingly used alliances to grow and expand their scope. The coordination hierarchy of a network can go from joint-ventures, in which partner firms share equity and have greater hierarchical mechanisms, to generic and temporary business alliances with almost no hierarchy. An alliance is defined as any voluntarily initiated cooperative agreement between firms that involves exchange, sharing, or co-development, including contributions by partners of capital, technology, or firm-specific assets. The governance structure of the alliance is the formal contractual structure participants used to formalize it (Gulati & Singh, 1998).

Also Gulati and Singh (1998) apply the explanatory framework of Williamson (1975). Hierarchy is justified by appropriation concern (risk of opportunism) and costs of the interdependence. The interdependence can be classified as: (1) pooled, when firms combine resources into a shared pool, (2) sequential, when the alliance establishes the sequence in which firms' activities are performed, and (3) reciprocal, when each unit is simultaneously dependent on the other (Gulati & Singh, 1998.) These three types are on a continuum, with the greatest coordination costs for reciprocal interdependence, the lowest for pooled interdependence, and sequential interdependence in the middle.

In this approach the concept of coordination form is separated from the concept of coordination mechanism. Besides price and hierarchical control, trust is the primary coordination mechanisms in economic relationships. However, alliances can include different hierarchical elements in their structures: (1) a command structure and authority systems, (2) incentive systems, (3) standards, (4) dispute resolution procedures, and (5) non-market pricing systems. Gulati and Singh's (1998) study on alliances in the sectors of biopharmaceuticals, new materials, and automobiles found that the more coordination costs alliances face, due to their interdependence, the more they require hierarchic control. Reciprocal relationships require more hierarchy than sequential relationships, and sequential relationships require more hierarchy than pooled resource relationships. They also showed that trust and social capital measured as "repeated ties" reduce the need for hierarchical control and that geographic proximity may have the same effect, though this phenomenon is culture-driven (it exists in Europe, less in Japan and does not exist at all in the US).

If the solution for complexity, namely the degree of interconnection of the system (Kaufman, 1990; Rullani & Vicari, 1999), is network cooperation, the relevant question becomes: "how do networks and network cooperation form?" According to Axelrod (1984), cooperation is motivated mainly by the need for resource-pooling and the need to respond to threat. The concept of social embeddedness of economic relations (Polanyi, 1972; Granovetter, 1973) addresses the complex relationship between social frictions and rational goals in markets. This is based on the idea that instead of analyzing rational calculations, we should turn to study trust and distrust in markets. If we want to go beyond the rationalistic approach and leverage the complexity of our increasingly connected economy, the answer might be at least partially linked to trust and trust building in networks (Castaldo, 2002). In this perspective trust becomes the basis not only for knowledge building but also for a new way of organizing, that is, for the new economic order.

Trust as the Basis for a New Capitalism

Networked institutions based on trust (Powell, 1990; Adler, 2001; Vicari, 2001; Castaldo, 2002) can envision a profound change in the capitalistic form of governance and development (Rullani & Romano, 1998; Powell, 2001; Adler, 2001). Adler (2001), following Powell (1990), proposes to go beyond the dichotomy between the market and the hierarchy concepts in organization for studying post-capitalism. Adler claims that networks are not just hybrids, but new ideal-typical forms of organizing including a new corresponding coordination mechanism: trust and social capital.

Since March's (1991) seminal work on organizational learning, we are aware of the trade-off between exploitation and exploration logics in learning networks, but now start to think that perhaps this is not a trade-off at the network-level (business-model level), but rather at the more fine-grained level. Browning et al. (1995) showed that also in highly cooperative endeavors, there still is competition.

Recent literature (Locke, 1995; Gulati & Singh, 1998; Grandori, 1999; Wathne et al., 2000, 2001; Staber, 2001; Dagnino & Padula, 2002) has called for a more fine-grained analysis of different formulas and performances of these new coordination forms. Far from being opposite concepts, opportunism and trust are behavioral variables generally coexisting in the same context to various degrees (Grandori, 1999). "Firms' interdependence is based on a variable-positive-sum game which may bring mutual, but not necessarily fair, benefits to the partners because of several competitive pressures of different nature that may undermine their coopetitive structure" (Dagnino & Padula, 2002, p. 13). This implies that in networks there are both fair and unfair exchanges; there are market opportunistic relationships and social hierarchies.

Sirdeshmukh et al. (2002) include economic value as a mediator of the trust-loyalty effect. They found non-social mechanisms that mediate the conversion of trust into loyalty. Studying the importance of the relational dimension of inter-firm exchanges, Wathne et al. (2001) found that interpersonal relationships between buyers and suppliers serve as a switching barrier, but these barriers are considerably less important than both firm-level switching costs and marketing variables.

In value networks there is competition within the network (Browning et al., 1995) and inter-networks. "Collaboration does not dampen rivalry, but instead shifts the playing field to sharp competition among rival networks with fluid membership" (Powell, 2001, p. 37). Thus networks also become the locus of competition. An economy, viewed from this perspective, is a combination of markets and social networks. Therefore, these recent conceptual accounts of inter-firm alliances question the view of networks as simply trust-based and relationally symmetric coordination forms. We need to change conceptual platform for explaining cooperation and trust without fair exchanges.

The economy of information networks (Shapiro & Varian, 1998) helps us explain this. Network participation is motivated by the economy of scale at the demand, in other words, at the node level. Network inclusion is motivated by the economies of scale at the supply, that is, at the network level.

We need to separate the concept of trust from the concept of fair exchange, reciprocity and symmetric relationships, building on Castelfranchi and Falcone's (1999) model of trust as a dynamic of delegation and applying it to network formation and the economics of relationships. Trust builds trust, and therefore it works both as strategic resource and as sunk cost in relationships. Trust is a social delegation. It is reduction of autonomy and variety, which has a relevant impact on economic value exchanges. The idea that trust can have different effects depending whether it emerges within previous communities (bonding trust) or in new encounters (bridging trust) can prove helpful when we address the formation of networks as complex social dynamics and complex re-combinations of semantic maps of the world (Rullani & Vicari, 1999; Vicari, 2001; see also Mandelli, 2004). We need to include an evolutionary view of trust, that is, of selection and delegation, into value creation and appropriation. Before that we will describe the shift of the focus from networks made of interactive fair exchanges coordinated by trust, towards conceiving networks as social competitive assets and cognitive structures for innovation and learning. Therefore, the idea that networks are cognitive networks, locus of innovation and cognitive strategic resources is introduced.

Traditionally, network theorists in sociology and organization theory have focused on the implications of network structure for value creation. The configuration of the network in terms of density and centrality (Freeman, 1979), the size of the network and the heterogeneity of its ties have been assumed to change network performance (Granovetter, 1973). Recently researchers have moved on to study the role of new governance mechanisms (Lorenzoni & Lipparini, 1999) and the importance of network resources and capabilities (e.g., Gulati, 1999) for value creation and performance (Burt, 1992; Grandori & Soda, 1995; McEvily & Zaheer, 1999; White, 2001; Adler, 2001). The premise is that in the value creation process, the network is a resource itself with its relational and learning assets and advantages. This new form of coordination and governance is driven by the need to face restless turbulence through continuous innovation and creativity. Learning becomes the source of competitive advantage and dynamic social ties become the pre-condition for ensuring continuous learning and adaptation (Powell, Koput & Smith-Doerr, 1996). For example, Staber (2001, p. 538) describes this as follows: "These relations are constituted by solidarity, trust and commitment, and may be highly localized, depending on the presence of a unique, historically embedded socio-cultural milieu. ... Inter-firm cooperation is expected to be effective especially when knowledge is not fully codifiable but nonetheless important for innovation and risk taking."

Social Network Theory, Resource-Based-View and the Learning Organization

The relationship marketing school has developed in the last few decades a new approach to marketing, which starts from the idea that only long-term loyal relationships build sustainable competitive advantage and that these kind of relationships are built only on trust (Reichheld & Schefter, 2000; Urban, Sultan & Qualls, 2001). This idea of trust as a relational capital (Kale & Perlmutter, 2000; Costabile, 2001) is consistent with a recent development in strategy management, called a resource-based view (Wernerfelt, 1984; Barney, 1991; Barney & Hansen, 1994; Vicari, 1991, 1995; McEvily & Chakravarthy, 2002).

The core claim is that a firm's resources can be a source of rent generation, if they are characterized by heterogeneous distribution among firms in the industry, imperfect mobility, and protection from competition both before and after rent achievement (Barney, 1991; Prahalad & Hamel, 1990, Fahy & Smithee, 1999). Barney (1991) proposes that advantage-creating resources must meet four conditions: value, rareness, inimitability and non-substitutability. From this perspective, the competitive assets are not the tangible ones, such as physical and financial resources, but rather the intangible ones, such as knowhow, human capital, reputation and social relationships. Competition is defined by the goal of building sustainable competitive advantage (Barney, 1991), that is, a relative concept — strategy is supposed to create differentiation from competitors, over relevant issues for customers (Fahy & Smithee, 1999). Sustainability does not refer to a certain period of time, but to the difficulty of imitation.

Trust conceived as relational capital, in the relationship marketing perspective, builds differential rent appropriation through the mediation of customer loyalty (Reichheld & Schefter, 2000; Urban, Sultan, & Qualls, 2001), which exploits economies of scope. Life Time Value of customers is proposed as the measure that captures both efficiency and efficacy of market relationships (Rust et al., 2000; Castaldo, 2002). Trust is linked to knowledge in the organization because only a deeper knowledge about customers is a precondition for trusted and loyal relationships (Busacca, 2000; Costabile, 2001).

Trust conceived as core capability is also linked to the social construction view of knowledge, envisioned as emergent from social interaction. Tacit knowledge transforms into explicit and usable knowledge through social learning (Nonaka & Takeuchi, 1994). Also the path-dependent view of innovation and learning, with its evolutionary approach to learning organizations (Nelson & Winter, 1982; Dosi & Malerba, 1996) addresses the problem of the social embeddedness of knowledge creation. Nelson and Winter (1982) propose to consider firms in terms of a hierarchy of practiced organisational routines from which innovation emerges.

As Yli-Renko et al. (2001) synthesize, the relational view is an extension of the resource-based view, by claiming that competitive advantage derives "not solely from firm-level resources but also from difficult-to-imitate capabilities embedded in dyadic and network relationships" (p. 1).

The common platform of all these approaches is the idea that knowledge is the source of competitive advantage in post-modern societies and networks are the sources of strategic knowledge (Rullani & Vicari, 1999; Kogut & Zander, 1992; Grant, 1996; Powell et al., 1996; Powell et al., 2002). In this perspective, learning is a social construction process and knowledge creation occurs in the context of an evolving community of collaboration. When environments are complex and sophisticated, the locus of innovation is found in networks of collaboration, rather than individual firms. Powell (2001, p. 38) describes this as, "Just as the changed conception of work as organized around project teams transforms firms internally, growing involvement in an intricate latticework of collaborations with 'outsiders' blurs the boundaries of the firm, making it difficult to know where the firm ends and the market or another firm begins. ... These organizations are neither hierarchies nor markets. They are based on mutual orientation and knowledge that each party has about the others, which dynamically drive communication and problem solving. Fixed contracts are thus ineffectual as expectations, rather than being frozen, change as circumstances dictate. At the core, then, of this form of relational contracting are the 'entangling strings' of reputation, friendship, and interdependence."

This strategic approach has been at the basis of the community business models on the Internet (Hagel & Amstrong, 1997; Hagel & Singer, 1999; Evans & Wurster, 2000; Amit & Zott, 2001). Intangible resources are considered particularly important in markets characterized by the sophisticated value expectations of the net-empowered customers and the interactivity of network relationships. Also, economies of scope and lock-in economies push toward the search of deeper relationships with customers. On the net, this implies the capability to respond to one-to-one value expectations and to build trust-based relationships in a world where the competitor is just a click away.

In this context the fostering community-based business models on the Internet (both Business to Consumer and Business to Business) has nurtured. The assumption of many of these projects was based around a simple version of the resource-based view of management. Since they promised to be better at producing strategic learning and trust-based relationships, they were considered better models for rent appropriation. They also assumed that competitive advantage built on trust and network externalities worked as entry barriers and sustainable competitive advantage for first-movers. But this vision and the business model proved at least optimistic. Many of these projects have failed to provide sustainable competitive advantage and rent appropriation (Latzer & Schmitz, 2001; Bughin & Zeisser). What the failed projects did not consider was that:

1. Trust is not a cost-free, easy-to-build resource, and trade-offs between reach and richness are still there (most projects were burdened with gigantic marketing costs; Bughin & Zeisser, 2001; Latzer & Schmitz, 2001);

2. Network externalities activate not on the basis of the size, but on the interconnection in the networks, that is, on the basis of effective cooperation;

3. Trust is not enough for building effective cooperation (motivation and opportunity are also required);

4. Cooperation may be not enough for building sustainable competitive advantage and positive economic results, because network externalities, economies of scope, and knowledge sharing are not the only competitive variables (as we will motivate in this chapter).

Besides these experiences that in a digital economy, the way of creating value can change dramatically compared to the traditional way of conducting business, one important rule does not change: value creation is not enough. Value must also be extracted from economic relationships. Superior resources must drive superior performance. At this stage, we must introduce the value appropriation perspective in the network economy.