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The Transaction Cost Advantage of Guanxi-Based Business Practices Stephen S. Standi? rd R. Scott Marshall The purpose of this paper is to provide a theoretical explanation of the perpetuation of China’s guanxi-based business practices. As a complement to the social embeddedness- and resource-based explanations, we seek to demonstrate the perseverance and relevance of guanxi in terms of the transaction cost advantages it offers. Speci? cally, we argue that guanxi-based business practices offer certain transaction cost advantages over existing structural alternatives identi? d in transaction cost theory. Where the guanxi network is well developed, the transaction cost advantages of guanxi-based exchange are suf? cient to warrant the integration of guanxi- and market-based exchange mechanisms. n the third quarter of 1996, China surpassed Japan as the country with the largest U. S. trade imbalance. On July 1, 1997, China regained control over Hong Kong and in the process gained control over the world’s eighth largest stock exchange (Barnathan, 1996) and the world’s most pro? table exchange over the last 20 years (T. Rowe Price, 1996).

China’s increased assertion in the world market demands more attention Stephen S. Standi? rd, College of Business and Economics, Western Washington University, Bellingham, WA 98225-9077, USA. Tel: 360650-7440; Fax: 360-650-4844; E-mail: stephen. standi? [email protected] edu R. Scott Marshall, Lundquist College of Business, University of Oregon, Eugene, OR 97403-1208, USA. Tel: 541-346-1343; Fax: 541-346-3341 E-mail: [email protected] uoregon. edu I be given to the unique aspects of conducting business in China. One speci? c aspect that has received attention recently is the practice of guanxi.

In short, guanxi involves cultivating personal relationships through the exchange of favors and gifts for the purpose of obtaining goods and services, developing networks of mutual dependence, and creating a sense of obligation and indebtedness (Yang, 1994). The purpose of this paper is to provide a theoretical explanation of the perpetuation of guanxi-based business practices. Speci? cally, our primary thesis is that guanxi-based business practices offer certain transaction cost advantages over existing structural alternatives identi? ed in transaction cost theory.

Subordinate to this arguGuanxi-Based Business Practices 21 ment is the position that the signi? cance of guanxi will not diminish, as some researchers have suggested (Nee, 1992; Xin & Pearce, 1994; Luo & Chen, 1996) even with the transformation to a more market-based economy. The enduring strength of guanxi lies in the conducting of moderately asset speci? c activities such as long-term supplier relations for industrial machinery. These types of exchanges will continue to be performed via the guanxi network whereas less asset speci? c functions, such as equipment leasing, will be performed through market-based exchange.

Granovetter (1985) posits that institutional structures such as guanxi maintain continuity due to their deep embeddedness in particular cultures. Supportive to this argument, Solinger (1989) revealed how transactions, in the Chinese providence Wuhan, were founded on longstanding economic relationships between individuals within the organizations studied. Further, Tsang (1998) asserts that guanxi can provide individuals and ? rms with an imperfectly imitable resource that provides a distinct competitive advantage over others in modern day China.

As a complement to, rather than an argument against, the social embeddedness- and resource-based explanations, we seek to demonstrate the perseverance and relevance of guanxi in terms of the transaction cost advantages it offers. We begin with a detailed discussion of what guanxi is and more speci? cally what guanxi is not. We then outline the current theoretical explication of transaction cost economics. Next, we present transaction cost economics as an argument favoring the continuation of guanxi-based exchange. Finally, we dis22 Journal of World Business / 35(1) / 2000 uss implications for both research and practice. AN OVERVIEW OF GUANXI-BASED BUSINESS PRACTICES Guanxi De? ned Contrary to common perception, guanxi is more than the exchanging of gifts in order to procure favorable business exchange. As Luo & Chen (1996: 298 –299) point out, “many Western business people are often in danger of overemphasizing the gift-giving and wining-and-dining components of a guanxi relationship, thereby coming dangerously close to crass bribery or to being perceived as ‘meat and wine friends,’ which is a Chinese metaphor for mistrust. Guanxi is ? rst and foremost about the cultivation of long-term personal relationships. In these terms, guanxi does not appear to be unique, and in fact it exists to some extent in every human society. Chinese society is distinct because guanxi is ubiquitous and plays a central role in daily social and business life. Guanxi may viewed as “friendship with implications of continued exchange of favors” (Pye, 1992). Guanxi is established when one party does something (often more symbolic than substantive) for another party thereby developing an unpaid obligation.

This unpaid obligation or renqing is the ? rst step in a series of exchanges, which ultimately lead to the formation of a guanxi-based relationship. Thus, the instrumental value of guanxi is the reciprocal obligations of the parties involved with respect to the acquisition of resources. As noted by Joseph Denaro, general manager of Xerox of Shanghai, “(Xerox) has the best dealer network in the country. It is based on a lot of friendships that have been developed over time. We have 42– 43% of the market share in this country.

We are number one in this country because of our dealers” (Batson, 1994: 95). Because guanxi is transferable from person to person, the development of individual links ultimately leads to a network of relationships. Once embroiled in a network, one maintains face or mianzi by reciprocating favor for favor. Face is a key element in the development and maintenance of guanxi. The concept of face, although highly abstract, is treated by the Chinese as something that can be quanti? ed and measured (Ho, 1976). How much face an individual has depends partly on their guanxi network.

Failure to follow the rules of reciprocity and equity in a guanxi-based relationship results in loss of face and the identi? cation as being untrustworthy (Luo & Chen, 1996). The effects are quite different than the loss of reputation. With the damaging of reputation, future exchange partners become cautious and are more likely to erect safeguards before engaging in an exchange relationship. With the loss of face, the possibility of any future exchange within the guanxi network is threatened. As suggested above, guanxi is dynamic and certain social guanxi is transferable.

Thus, if person A wants to make a request of person C with whom A has no guanxi, A may seek out a member of his or her guanxi network, person B, who has guanxi with C. Given B provides A the introduction to C, a guanxi relationship may be established between A and C (Tsang, 1998). The transferability of guanxi is exempli? ed by the statement of Chon-Phung, general manager of Hewlett-Packard South Asia. Chon-Phung (1999: 9) suggests that “a person who brings a buyer and seller together is more than a middleman – he vouches for the reputation of the one he introduces.

Thus, strangers doing business become strangers no more. ” According to Victor Fund, Chairman of the Hong Kong investment bank Prudential Asia, “If you are being considered for a new partnership, a personal reference from a respected member of the Chinese business community is worth more than any amount of money you could throw on the table” (Kraar, 1994: 92). Importantly, transference of guanxi does not occur easily or quickly and person B likely would take great care in introducing someone to his or her own guanxi network.

As suggested by Kwek Leng Joo, a senior executive with the Hong Leong Group in Hong Kong, “Who I know in China and whether I have some network there is exclusive information. I hardly make it known even to my closest friends” (Kraar, 1994: 108). This cautious approach to network inclusion comes from concerns of potential damage to existing guanxi relationships as well as the potential of infusing competition for the same resources. Loss of face results in the degradation and possible dissolution of the guanxi relationship. Because guanxi serves as a lubricant for exchange, the Guanxi-Based Business Practices 3 loss of guanxi can result in the loss of exchange opportunity with a speci? c network participant. The loss of exchange opportunity with one network participant can easily result in the offending party’s banishment from the network altogether. The mere threat of network ostracism serves as a strong incentive for commitment to the individual exchange relationship. Many have attempted to depict practices such as guanxi as trust-based exchange (e. g. , Hill, 1995). However, trust appears to play little role in a guanxi whereas assurance appears to be critical.

According to Yamagishi & Yamagishi (1994:132), trust is “an expectation of goodwill and benign intent. Assurance, on the other hand, is de? ned here as an expectation of benign behavior for reasons other than goodwill of the partner. Trust is based on the inference of the interaction partner’s personal traits and intentions, whereas assurance is based on the knowledge of the incentive structure surrounding the relationship. ” Stated differently, trust exists where one party believes the other party will not act opportunistically regardless of external variables or future interactions.

Assurance exists where one party believes the other party will not act opportunistically speci? cally due to external constraints and the expectation of future exchange. Research by Fock and Woo (1998) illustrates the differentiation between assurance and trust in guanxi networks. They ? nd that relatively more sophisticated foreign managers in China are competent and skillful at manipulating the exchange of favors/bene? ts, information, and social activities with their 24 Journal of World Business / 35(1) / 2000 Chinese business counterparts. Executives with signi? ant experience in China perceive “exchange of favor” and “mutual cooperation” as essential to maintaining guanxi networks. Thus, these executives manage business relationships based on the knowledge of the incentive structure surrounding the relationships (i. e. , assurance) rather than relying on inferences of the personal integrity of the individual (i. e. , trust). Less experienced foreign managers perceive guanxi in a more “Western” interpretation—trust based on a personal relationship. The loss of face associated with opportunistic behavior spreads quickly through the guanxi wang (guanxi network).

Opportunistic behavior with one exchange partner can easily be interpreted as opportunistic behavior with the entire network. Opportunistic behavior becomes an attractive option when the expected pay out from opportunistic behavior outweighs the expected costs. In a guanxi network, the cost of opportunism is the potential loss of exchange opportunities with all members of the network. The larger and more richly connected the guanxi network, the greater the assurance that an individual exchange partner within the network will not risk the potential network ostracism that could result from opportunistic behavior.

The mere threat of network expulsion provides increased assurance that one’s exchange partner will not act opportunistically, thereby replacing the need for trust in the exchange relationship. The importance of maintaining face is well illustrated in the example of Motorola. Motorola spent many years cultivating relationships with Chinese bureaucrats. Former CEO Robert Galvin took his ? rst trip to China in October 1986, and since that time, Motorola identi? ed and befriended three generations of potential top leaders. In 1989, Motorola was set to build its ? rst factories in Tianjin.

The Tiananmen Square massacre lead the U. S. government to sever diplomatic relations with China. A corresponding withdrawal by Motorola of its commitment to build in China would have caused the numerous Chinese bureaucrats working with Motorola to lose face. In order to re-enter the Chinese market, Motorola would have had to start completely anew rebuilding the guanxi network it so carefully nurtured. Although Motorola delayed construction of the factories for two years, it never withdrew its commitment to do so. According to Maney (1997: 3), “in the realm of guanxi, China never has forgotten Motorola’s loyalty. By 1997, Motorola’s investment in China was $1. 3 billion, double the next largest U. S. investor, Atlantic Rich? eld (Maney, 1997). A TRANSACTION COST PERSPECTIVE Theoretical Overview Transaction costs are the “costs of running the system” and include such ex ante costs as drafting and negotiating contracts and such ex post costs as monitoring and enforcing agreements. A transaction cost analysis (TCA) approach uses differences in transaction costs to explain the advantages associated with certain governance structures. The ? rm and the market are identi? d as the primary structural alternatives for organizing economic activity. Tables 1 and 2 present de? nitions and explanations of the key concepts and underlying assumptions of TCA as well as illustrative examples. Coase (1937) proposes that under certain conditions, the costs of conducting economic exchange in a market may exceed the costs of organizing the exchange within a ? rm. The magnitude of market-based transaction costs as compared to the transaction costs of internalization via the ? rm determine whether a function will be performed within the ? rm or through market-based exchange.

Where the transaction costs of exchanging through the market are relatively low, a ? rm is more likely to buy supplies from others than produce the supplies internally. Conversely, where the transaction costs of exchanging through the market are relatively high, a ? rm is more likely to produce supplies internally. Two key assumptions of transaction cost analysis are bounded rationality (Simon, 1947) and opportunism (Williamson, 1975; 1985). Bounded rationality implies that human actors as well as ? rms are incapable of perfect contracting. As such, certain environmental and behavioral uncertainties inevitably arise.

Ex ante environmental uncertainty is characterized by an inability to specify the exact conditions of the exchange to take place in the future. This form of uncertainty leads to a governance problem of adaptation, where the screening of potential partners and negotiating of contracts insuf? ciently covers all possible contingencies that may Guanxi-Based Business Practices 25 Table 1 The Basic Components of the Transaction Costs Analysis Framework Transaction Costs: The “costs of running the system” including such ex ante costs as drafting and negotiating agreements and such ex post costs as monitoring and enforcing agreements.

Governance Structures Market versus Hierarchy: Markets (where transactions are conducted between ? rms, e. g. manufacturer and wholelsaler) and Hierarchies (where transactions are conducted within a ? rm, e. g. vertically integrated supply chains) are compared for their relative ef? ciency in sustaining recurrent trading relationship. (Williamson 1978) Assumptions Regarding Human Nature (1) Bounded Rationality (2) Opportunism Decision-makers intend to be rational, but are constrained by their limited information processing and communication abilities.

Given the opportunity, decision-makers may unscrupulously seek to serve their self-interests, and it is dif? cult to determine a priori who is trustworthy and who is not. Problematic when an inter? rm relationship is suported by speci? c assets (degree of asset speci? city) whose values are limited outside the focal relationship. arise in the future. Direct transactions costs in this case might include communication, negotiation and coordination costs. Opportunity transaction costs include maladaptation or failure to adapt to unforeseen exigencies.

Behavioral uncertainties linked to bounded rationality arise both ex ante and ex post to any agreement. Ascertaining the true character of a potential partner prior to any agreement is nearly impossible, regardless of the depth of due diligence. Following the signing of a contract, it can be costly to monitor and verify the performance of one’s partner. Thus, the governance problem of performance evaluation arises as certain monitoring and contract enforcing mechanisms are put in place to ensure compliance with agreed upon obligations. Direct ex ante transaction costs 26 Journal of World Business / 35(1) / 2000 rising from behavioral uncertainty include the costs of screening and selecting partners. Direct ex post transaction costs are related to the processes put in place to measure a partner’s performance. Opportunity transaction costs include the failure to identify the appropriate (best) partner (ex ante) and the possible productivity losses accruing from adjustment efforts (ex post). 1 Opportunism is the assumption that, given the occasion, decision-makers may seek “with guile” to serve their own interests (Williamson, 1985), and that it is dif? cult to know a priori who is trustworthy and who is not (Barney, 1990). Opportunism leads to the governance problem of asset speci? city. Asset speci? city exists where certain business relationships maintain a high degree of unique, dedicated assets that Table 2 Sources, Types, and Examples of Transaction Costs (Adapted from Rind? eisch and Heide (1997)) ASSET SPECIFICITY SOURCES OF TRANSACTION COSTS Nature of Governance Problem ENVIRONMENTAL UNCERTAINTY BEHAVIORAL UNCERTAINTY Safeguarding Arises when a decisionmaker deploys speci? c assets to an exchange and fears its partner may opportunistically exploit these investments.

Adaptation Arises when a decisionmaker, limited by bounded rationality, has dif? culty modifying agreements in the face of environmental uncertainty. Performance Evaluation Arises when a decisionmaker, limited by bounded rationality, has dif? culty assessing the contractual compliance of its exchange partner in the face of behavioral uncertainty. TYPES OF TRANSACTION COSTS Direct Costs Costs of crafting safeguards. Communication, negotiation, and coordination costs. Screening and selection of partner costs (ex ante). Measurement and monitoring costs (ex post).

Failure to identify appropriate partners (ex ante). Productivity losses through effort adjustments (ex post). A ? rm seeking a potential foreign joint venture partner will incur transactional costs when hiring an outside company to perform due diligence on potential partners in the selected foreign market. Opportunity Costs Failure to invest in productive assets. Maladaptation; Failure to adapt. EXAMPLES A manufacturer of a trademarked brand will incur transactional costs in its attempt to set up exclusive international distribution channels to protect the image value of its trademark.

Negotiating agreements in a foreigh culture generally incurs higher transactional costs due to unfamiliarity with the legal system, business procedures and cultural traditions. are not transferable outside the partnership. Thus, ? rms may be inclined to establish mechanisms for safeguarding investments in the focal relationship. A mutual hostage situation may arise in which both partners make idiosyncratic investments into the relationship to discourage opportunistic behaviors. The cost of crafting safeguards represents direct transaction costs. Failure to invest in productive assets represents an opportunity transaction cost of asset speci? ity. Where asset speci? city is low, markets provide increased discipline and information through market-based pricGuanxi-Based Business Practices 27 ing mechanisms. The clarity of information and the reduced dependency on individual exchange partners provided by competitive markets eliminates the need for safeguards against opportunistic behavior. However, as asset speci? city increases, the potential for opportunistic behavior rises because market competition no longer serves as a restraint. Internalization of an activity curbs opportunistic behavior by 1) reducing incentives to suboptimize, 2) allowing for the invocation of ? t (authority), and 3) increasing the ability to access information to resolve disputes. Internalization through the use of hierarchy occurs at the point at which the combined savings associated with market-based production and transaction become zero. Transaction costs within the organization are not assumed to be insigni? cant as is sometimes indicated in critiques of TCA (e. g. , Perrow, 1981; 1990). Grossman and Hart (1986) argue that integration of two ? rms shifts, but does not eliminate, incentives for opportunistic behavior. We do not claim that transaction costs are reduced to zero under full integration, nly that the contractor-contractee relationship maintains higher transaction costs under situations of high asset speci? city than the employer-employee relationships due to the need for on-going discussions of the allocation of residual rights of control. 3 That is, transaction costs within the organization are assumed to be signi? cantly lower than market transaction costs at high levels of asset speci? city. Even assuming constant production costs, increased market transaction costs (as compared to inter28 Journal of World Business / 35(1) / 2000 al transaction costs) associated with increased asset speci? city would eventually dictate the internalization of an activity. The above discussion assumes two structural alternatives: internalization via hierarchy or market-based exchange. Williamson (1991) suggests a third alternative in which relational contracts are used to ? ll the gap between the polar extremes of markets and hierarchies. This third alternative, the hybrid form, relies on contractual safeguards and increased information disclosure to reduce opportunistic behavior. At moderate levels of asset speci? ity, the hybrid form incurs fewer transaction costs than market-based exchange by reducing incentives to act opportunistically. At low levels of asset speci? city, the threat of opportunism is minimal, making markets the most transaction costef? cient structural alternative. As asset speci? city increases, the cost of opportunism increases dictating the need for increased structural protection. The hybrid form reduces opportunistic behavior as compared to markets but maintains some aspects of market discipline. Thus, the hybrid form emerges as the most cost-ef? cient transaction at moderate levels of asset speci? ity. High levels of asset speci? city result in high costs of opportunistic behavior. Hierarchies are superior in their ability to reduce the threat of opportunism. Consequently, hierarchies emerge as most transaction cost ef? cient at the highest levels of asset speci? city. Quali? cations to Existing Theory Transaction cost economics has been criticized for failing to recognize the importance of institutional environments (Robins, 1987). Williamson’s (1991) discussion of the hybrid form is a direct response to such criticisms. Still, predictions concerning the hybrid form all revolve around the xistence of contract law (Williamson, 1991) and the hybrid structure is viewed as an exception to general practice (Granovetter, 1985). Contract law is assumed to characterize institutional structures. The lack of contract law is assumed to represent a lack of institutional structure (Nee, 1992; Xin & Pearce, 1994). Given TCA’s preoccupation with contract law, structural alternatives such as guanxi-based exchange have received insuf? cient attention. Institutional structures represent humanly devised constraint systems designed to facilitate economic and social exchange (North, 1990).

Two conditions appear critical in identifying a constraint as institutional. First, a constraint must attain a sense of cultural persistence (Zucker, 1991). Second, a constraint must transcend interpersonal relationships (Zucker, 1986). The historical roots of guanxi extend some 2000 years. Codi? ed societal rules and values speci? ed by Confucius during the sixth century B. C. provide the framework for guanxi-based practices. The fact that the same basic tenets speci? ed by Confucius during the sixth century B. C. still dominate guanxi-based exchange in the twentieth century A. D. af? rms guanxi’s cultural persistence.

The transferability of guanxi allows guanxi-based exchange to transcend the realm of interpersonal relationship. The loss of face with any individual in the guanxi network can result in the loss of face with the entire guanxi network. This loss of face can result in the offending party’s banishment from all network exchange. The core of guanxibased exchange begins with the individual relationship. However, the loss of face with the individual can result in system wide pecuniary effects. These system wide effects which transcend the interpersonal relationship are indicative of an institutional constraint.

Cultural persistence combined with the systemic pecuniary aspect of guanxi-based exchange suggests that any serious discussion of China’s economic environment must include a discussion of guanxi as an institutional constraint. Unlike the hybrid form, guanxi-based exchange is not based on the presumption of contract law. Yet, the guanxi-based transactional arrangement appears to have signi? cant latent strengths by allowing for the reconstitution of transactions to meet new opportunities and changing circumstances (Boisot and Child, 1996). Therefore, the guanxi network or uanxi wang must be included as an independent structural alternative if we are to truly understand the transaction cost implications of guanxi-based business practices. Ouchi (1980) suggests that clans represent yet another alternative governance structure to markets and bureaucracies. Speci? cally, he suggests that the normative and informational requirements of various governance structures differ and that each offers transaction costs advantages based on the degree of and the means for attaining goal congruence between transacting parties.

Whereas markets are founded on the basis of reciprocity directed by Guanxi-Based Business Practices 29 price-setting mechanisms, and bureaucracies rely on reciprocity and legitimate authority guided by explicit rules, the clan structure relies on reciprocity, legitimate authority and common socialized values and beliefs steeped in long held traditions. We differentiate guanxi from Ouchi’s clan structure by positing that guanxi functions based on common traditional social agreements and reciprocity, similar to clans, but that legitimate authority is implicit and dynamic, that is, more in line with the market structure.

Thus, guanxi is similar to the hybrid form suggested by Williamson, in which relational contracting is supported by the historically based and future-orientated perspectives of partners. Further, the guanxi network provides a measure of discipline in how obligations are made and paid. This supposition suggests that legitimate authority in guanxi is endogenous to the relationship, and continually evolves based on the nature of obligations between partners.

The Transaction Cost Advantages of Guanxi-Based Exchange A detailed comparison of structural transaction costs can now be presented treating guanxi-based exchange as a structural alternative to markets, hierarchies, and the hybrid form. The advantages of the various structural alternatives are found in the way each deals with uncertainties created by bounded rationality and opportunistic behavior. The transaction cost advantage of guanxi-based exchange speci? cally lies in the way guanxi deals with governance prob30 Journal of World Business / 35(1) / 2000 lems associated with bounded rationality and opportunism.

Bounded rationality and the resulting inability to construct comprehensive contracts is an important component of TCA. In nonintegrated situations, close relationships (Heide & John, 1990) may enjoy commonalties in knowledge and modes of communication (Conner & Prahalad, 1996) that permit more ef? cient adaptation than does market governance. Knowledge of individual face or mianzi is transmitted through the guanxi network. This increased transfer of knowledge appears to reduce bounded rationality by providing broad information concerning an individual’s character as an exchange partner.

However, the speci? city of knowledge transferred is suf? cient to warrant only a declaration of the reduction, not elimination, of uncertainty. The assumption of bounded rationality suggests that we are incapable of perfect contracting due to unforeseen future contingencies. The broad information provided by guanxi addresses some of the problems related to the governance problem of adaptation. Speci? cally, the operational process of guanxi development (i. e. , the transferability of guanxi) permits a fairly sophisticated, although implicit, means for screening potential partners.

The ? exible and socially-based nature of guanxi also permits members of a guanxi network to deal with unforeseen contingencies arising after agreements are reached. Because the spirit of contract takes precedence over the letter of contract in guanxibased relationships, the problems associated with ex post adaptation are substantially reduced. Thus, guanxi possesses the capacity to reduce transaction costs associated with environmental uncertainties, such as communicating, negotiating and coordinating transactions, as well as maladaptation and/or a failure to adapt.

Davies et al. ’s (1995) survey of Hong Kong Chinese executives regarding the importance of guanxi relationships addresses the role of guanxi in reducing transaction costs associated with environmental uncertainties. They found that the businessmen believed that once good guanxi had been established, a number of bene? ts would follow. These bene? ts included the smooth running of routine business operations, greater access to information about government policies, and quicker receipt of administrative approvals.

Xin and Pearce (1994) found a similar effect when observing that private company executives made more extensive use of guanxi, and maintained deeper business connections as a way of reducing environmental uncertainty than did the more institutionally secure state-owned company executives. Bjorkman and Kock’s (1995) interviews of foreign and Chinese marketing managers active in joint activities revealed that Western companies had very limited access to information regarding who might be potential customers and where they were located.

The key to unlocking the ? ow of this information to the Western companies appears to lie in possessing guanxi networks. Wal-Mart’s successful entry into China illustrates the way in which the guanxi network can be used to reduce the transaction costs associated with environmental uncertainties. To facilitate initial entry, Wal-Mart teamed up with the Charoen Pokphand Group of Thailand (Kraar, 1994). At the time of the initial venture, Wal-Mart had no operational experience outside the Western Hemisphere. Conversely, the Charoen Pokphand Group had signi? ant experience in China, with 55 ventures in operation at the time of the initial joint venture with Wal-Mart. As suggested by Don Shinkle (Kraar, 1994: 102), Wal-Mart’s vice president for corporate affairs, “There’s not a heck of a lot that we know about retailing in China, so we found an outstanding teacher. ” In addition to the information intrinsic to the Charoen Pokphand Group, Wal-Mart was able to make use of the extrinsic information associated with the Charoen Pokphand Group’s well-developed guanxi network.

Proposition One Transaction costs caused by environmental uncertainties related to bounded rationality will be lower in situations in which guanxi wang (guanxi network) is well developed than in situations in which the guanxi network is less developed. Guanxi also reduces transaction costs associated with behavioral uncertainties that arise on account of bounded rationality. Because of the interlocked nature of a guanxi network, a failure to uphold obligations is destructive to all members. Thus, a guanxi network allows a member to ascertain, with a fair degree of con? ence, the true character of potential partners ex ante to any transaction. In other words, the transaction costs derived from screening and Guanxi-Based Business Practices 31 selecting partners are reduced because of the latent strength of the guanxi network. In addition, the alacrity of information ? ow within the guanxi network provides rapid feedback, directly and indirectly, on the performance of a partner. Thus, to a lesser degree than in the case of ex ante screening, but no less certainly, ex post transaction costs of measurement are reduced.

Finally, the tightly woven information network provided by guanxi reduces opportunity transaction costs related to failure to identify the appropriate partner. The experience of AST Research in China illustrates the ability of guanxibased exchange to reduce the transaction costs associated with behavioral uncertainties. As of 1994, AST was ? fth in market share among computer makers in the U. S. , but was ? rst in China because of early entry and mature relationships (Pitta, 1994). AST cofounders Albert Wong and Thomas Yuen (both Chinese) leveraged their ancestral heritage to overcome the Chinese mistrust of foreigners.

AST moved early and aggressively to establish links with government agencies. According to Richard Fade, VP of Far Eastern operations for Microsoft, AST has “. . . the distribution, . . . the relationships, . . . and the market share” (Pitta, 1994: 12). AST established a joint venture manufacturing operation with state-owned Tianjin Economic-Technological Area Business Development Corporation. Through the networks it had established, AST also identi? ed a capable and trustworthy state-owned distributor, Legend Technology. Costs associated with ? nding and examining potential partners (i. . , costs associated with be32 Journal of World Business / 35(1) / 2000 havioral uncertainties) were relatively low for AST because of the established relationships between Wong and Yuen and key government and business of? cials. Proposition Two Transaction costs caused by behavioral uncertainties related to bounded rationality will be lower in situations in which the guanxi network is well developed than in situations in which the guanxi network is less developed. Guanxi-based exchange provides some assurance of exchange partner behavior. Speci? ally, the pecuniary threat of network ostracism associated with opportunistic behavior leads to a reduction of opportunism where the guanxi network is well developed. The loss of face with a single exchange partner is transmitted throughout the guanxi network. Opportunistic behavior with one exchange partner can be easily interpreted as opportunistic behavior with the entire network. Opportunistic behavior can be an attractive option if the pay out from opportunistic behavior outweighs potential costs. In a guanxi network, the cost of opportunism is the potential loss of exchange opportunities with all members of the guanxi network.

Therefore, the more developed the guanxi network, the greater the assurance that the individual exchange partner within the network will not act opportunistically due to the potential costs of network ostracism. The level of development is taken here as the level of network membership and the scope of network activities. The mere threat of expulsion from the well-developed guanxi network provides increased assurance that one’s exchange partner will not act opportunistically. Luo and Chen (1996) examined a number of key business variables in terms of their importance in business activities in China.

They found that credit granting was highly correlated with guanxi relationships. In China, where the guanxi network is deliberately nurtured and the preservation of amity is of the utmost importance, sellers will make every effort to avoid embarrassing customers who confront temporary cash shortages. Credit is extended as a way for both the seller and buyer to maintain an amicable relationship. The probability that those receiving credit will act opportunistically towards those extending credit is attenuated by the socially-constructed face preservation mechanism associated with the well-developed guanxi networks.

Proposition Three Opportunistic behavior will be less prevalent in situations in which the guanxi network is well developed than in situations in which the guanxi network is less developed. Guanxi-based exchange offers the advantage of reduced opportunistic behavior. However, the threat of opportunistic behavior diminishes as asset speci? city decreases. Where asset speci? city is low, markets provide increased discipline and information through market pricing mechanisms. The clarity of information provided in competitive markets eliminates the need for safe- uards against opportunistic behavior. Future exchange contingencies can be resolved by referring to market pricing. The ability to rely on market pricing reduces the overall cost of transacting. Therefore, at low levels of asset speci? city, markets outperform all other structural alternatives including guanxibased exchange. The experience of General Motors in its joint venture with state-owned Jinbei Automotive illustrates the dominance of markets in low asset speci? city circumstances. GM set up a $97. million joint venture with Jinbei in 1992, the latter taking a 70% equity stake (Murray, 1994). Part of GM’s incentive for establishing the joint venture was to access business channels more easily accessed by the state-owned ? rm. As Jinbei transitioned from state-owned to private status, low asset speci? c inputs such as plant and equipment leasing were priced by the basic market principles of supply and demand despite Jinbei’s guanxi connections thereby reducing the transaction cost advantages of the strategic alliance. Proposition Four Transactions low in asset speci? ity will be conducted using market-based exchange no matter how welldeveloped the guanxi network. As asset speci? city increases, markets fail in their ability to provide safeguards through accurate pricing (Coase, 1937). The hybrid form suggested by Williamson (1991) serves as an intermediary between markets and hierarchies and is most ef? cient at moderate Guanxi-Based Business Practices 33 levels of asset speci? city. The increased ef? ciency of the hybrid form over the market occurs due to the hybrid’s ability to reduce opportunistic behavior.

Opportunistic behavior is reduced through the use of long term contracts supported by contract law and increased information disclosure. The assumption of bounded rationality suggests that we are incapable of complete contracting. Therefore, the hybrid form is limited in its ability to discourage opportunistic behavior. The hybrid form assumes a well-developed system of contract law through which formal disputes can be resolved. However, increased documentation and the cost of litigation both detract for the transaction cost advantage of the hybrid form.

Guanxi-based exchange also has the advantage of reducing threats of opportunism. However, the magnitude of reduction is a function of the network development, not contract law. Unlike the hybrid form, the guanxi network does not require extensive documentation or litigation. The primary transaction cost associated with guanxi-based exchange is the cultivation of personal relations. Entrance into a guanxi network requires the cultivation of an individual relationship. The level of cultivation necessary is independent of network development.

Once this initial relationship is established, additional relationships within the network can be established at minimal cost due to guanxi’s transferability. The transaction costs associated with membership in a well-developed guanxi network are only marginally different than the transaction costs associated with membership in a less devel34 Journal of World Business / 35(1) / 2000 oped network. However, the threat of opportunistic behavior decreases significantly as the guanxi network increases in size and scope. The reduced threat of opportunism comes from two sources: (1) the reluctance to sacri? e the sunk investments in an existing guanxi relationship, and (2) the near impossibility of reentering a guanxi relationship that has been severed (Yau, 1988). Therefore, the transaction cost advantage of guanxi-based exchange increases with increased network development. Once suf? ciently developed, the increased ability to reduce opportunism combined with fairly constant maintenance costs make the well developed guanxi network a superior alternative to the hybrid form. The less developed guanxi network incurs similar maintenance costs as compared to the welldeveloped network but does not share the same reduced threat of opportunism.

Therefore, the inability to significantly reduce opportunism combined with fairly constant maintenance costs make the less developed guanxi network an inferior alternative to the hybrid form. A well-developed guanxi network in China can assist the manager carry out at least three moderately asset speci? c value chain activities. First, guanxi provides an avenue for building sales through long term accounts payable. Luo and Chen (1996) found that, in business dealing underscored by guanxi, both buyers and sellers bene? t. The seller bene? ts by providing favorable credit terms with extended payment periods resulting in concordant sales growth.

The buyer bene? ts from more favorable cash ? ow circumstances and increase operational ? exibility. This form of buyer-seller relationship would depend on contractual arrangements in the absence of guanxi, but in the presence of guanxi it is conducted through the obligatory reciprocity inherent in guanxi networks. Second, companies interested in selling industrial and consumer goods reliant on personal selling will greatly bene? t from strong guanxi relationships. Particularly in the early stage of activity in China, the guanxi of a Chinese partner can assist with sales contracts and distribution access (Shaw and Meier, 1994).

In services such as insurance and banking, guanxi relationships provide important sources of commercial security. Chubb Insurance, an American insurance provider, treats networking as a form of protection against environmental uncertainty (Economist, March 29, 1997, p. 24). With no clear forecast of when, and if, rules and regulations in the Chinese insurance industry will emerge, maintaining guanxi networks provides Chubb Insurance with a sense of security through reliable relationships with current commercial clients. Third, a ? m needs to nurture guanxi relationships to keep abreast of changes in relevant policy, to garner the necessary licenses, permits, and approvals, and to have access to government procurement contract offerings. Koll, an American real estate services company, relies heavily on the long-established guanxi connections of its partner, Charoen Pokphand Group (Singapore), to manage its $300 million shopping mall project in Pudong. By piggybacking on the relationships that CP has with government of? cials in Shanghai, building permits and other requisite licenses were placed on the bureaucratic fast track (Yatsko, 1997).

The bureaucracy access provided by guanxi can play a part in everything from import license applications, to securing electricity for production operations, to approval of billboard advertisements. Each of these value chain activities, credit policy, relationship-related sales, and management of policy issues, is moderate in asset speci? city. In a Western context, such activities would be conducted through long-term contractual arrangements, that is, the hybrid form. However, in China these activities are largely dependent on guanxi networks and can be used to advantage by Western ? ms motivated to develop such networks. Proposition Five Where the guanxi wang (guanxi network) is well developed, transactions moderate in asset speci? city will be conducted using the guanxi wang (guanxi network). Proposition Six Where the guanxi wang (guanxi network) is not well developed, transactions moderate in asset speci? city will be conducted using the hybrid form. The relationship speci? ed in propositions ? ve and six is illustrated in Fig. 1. At a constant level of asset speci? city, the transaction costs associated with the hybrid form remain constant regardless of network size and scope.

The transacGuanxi-Based Business Practices 35 FIGURE 1 Transaction Costs of the Guanxi Network and Hybrid Form Assuming Varying Network Development and Constant Asset Speci? city tion costs associated with the guanxi network decrease as network size and scope increase. Point A represents the point at which the difference between transaction costs of the guanxi network and transaction costs of the hybrid form equals zero. Point B represents the level of network development above which the guanxi network incurs lower transaction costs that the hybrid form. Transactions moderate in asset speci? ity will be conducted using the guanxi network where the existing guanxi network is of size and scope B or greater. Hierarchies are superior to the hybrid form in their ability to (1) reduce the need for documentation, (2) reduce the cost of arbitration, (3) gain access to information, (4) resolve disputes internally, and (5) invoke additional incentives such as career advancement and pro? t sharing (Williamson, 1991). Guanxi networks do not incur the costs of documentation or arbitration associated with the hybrid form. As a result, the well-developed guanxi network can 36 Journal of World Business / 35(1) / 2000 andle an increased level of asset speci? city as compared to the hybrid form. However, the guanxi network is not able to access information, resolve disputes internally, or invoke additional incentives as can be done in hierarchies. Thus, hierarchies are superior at reducing transaction costs as compared to the guanxi network at high levels of asset speci? city. Recent investments by Motorola and Samsung Electronics support this supposition. Both companies recently decided to establish semiconductor manufacturing plants in China, Motorola’s valued at $360 million and Samsung’s at $140 million (Science Center International, Ltd. 1996). Semiconductor manufacturing is an inherently highly asset speci? c operation, where highly trained personnel and advanced, proprietary processing and product technologies are uniquely committed to the task of semiconductor production. Motorola was the ? rst foreign ? rm to insist on full-ownership for a manufacturing operation (Maney, 1997). Thus, even in the midst of China’s guanxi social/ business system, Western ? rms are opting for fully integrated (or, whollyowned) operations where idiosyncratic investments are kept strictly in-house. Proposition Seven Transactions high in asset speci? ity will be conducted using hierarchies no matter how well developed the guanxi wang (guanxi network). In short, guanxi-based exchange is a viable structural alternative with distinct advantages over markets, hierar- chies, and the hybrid form. Markets and hierarchies still emerge as superior at the extremes of asset speci? city. However, the well-developed guanxi network serves as a functional substitute for the hybrid form at moderate levels of asset speci? city. IMPLICATIONS FOR RESEARCH The transaction cost advantage of guanxi-based exchange depends on the guanxi network’s ability to reduce opportunistic behavior.

The ability to reduce opportunistic behavior is a function of network development. Key variables in determining a network’s level of development include network size and scope. Size is broadly de? ned at the number of network participants and could be measured either in absolute terms (e. g. , roughly 10 participants) or in terms of shared market dominance (e. g. , 20% of the overall market participants). Network scope includes the breath of activities covered by a speci? c network and could be measured by the variety of tasks completed by network participants. A large network in terms of scope would cover such diverse tasks as general ? ance and metal fabrication while a more restricted network would focus on a narrow band of related activities. Explicating more exact measures of network development would be the ? rst task of any empirical investigation concerning the transaction cost advantages of guanxi-based business practices. A combination of increased membership size and scope of activity is presumed to reduce the threat of opportun- ism by increasing the penalty of network ostracism. The way in which these two variables interact to curb opportunism is not explicitly discussed in this analysis.

Further insight concerning the potential resilience of guanxi-based business practices can be gain by explicating the ways in which size and scope interact to restrain opportunistic behavior. The exact level of development necessary to reduce opportunism to the point where the guanxi network outperforms the hybrid form (point B in Fig. 1) is a question of empirical research. The range of asset speci? city over which the guanxi network outperforms markets and hierarchies also depends on the level of network development and can be best determined through empirical investigation.

The transaction cost analysis outline above assumes a self-interested individualistic predisposition of certain exchange partners. The transaction cost advantage of guanxi-based practices as discussed in this paper relates to the ability of network participants to penalize individualistic opportunistic behavior through network ostracism. Social pressures independent of business transactions may also serve to reduce opportunistic behavior in a more collectivistic society such as China (Chen, Chen, & Meindl, 1998).

Therefore, the tendency towards collective behavior could serve to further increase the transaction cost advantage of guanxi-based practices. The purpose of this paper is to show the transaction cost advantages of guanxibased exchange independent of the individualistic or collectivistic assumptions. Still, greater insight into the potential advantages of guanxi-based Guanxi-Based Business Practices 37 exchange could be ascertained by further investigating the ability of collectivistic predispositions to reduce opportunistic behavior.

The above discussion is restricted to a transaction cost explanation of guanxi’s continuity. An alternative explanation involves the cultural embeddedness of guanxi-based business practices. A cultural embeddedness argument suggests that guanxi-based exchange has been taken for granted as necessary and appropriate (Zucker, 1986). With a cultural embeddedness argument, the practice of guanxi is seen as being fully institutionalized exhibiting a sense of persistence beyond what would be expected based on the technical aspect of the task at hand (Davis, Diekmann, & Tinsley, 1994).

Cultural embeddedness may, in fact, explain some portion of guanxi’s persistence. Further research is needed to clarify the possible contribution of the cultural embeddedness argument. The primary contribution of this discussion is to show that the steadfast nature of guanxi-based business practices can be explained regardless of cultural embeddedness effects. Our intention is to disclose the utility of transaction costs analysis in elucidating the transactional bene? ts of the distinctly cultural and historical phenomenon of guanxi.

In doing so, greater conceptual clarity is added to the transaction cost analysis argument by demonstrating how social and economic factors in? uence the design and implementation of transactions in different cultural settings. An argument suggesting persistence based on cultural embeddedness would only serve to reinforce the prediction of con38 Journal of World Business / 35(1) / 2000 tinuity suggested by the transaction cost-based explanation discussed. IMPLICATIONS FOR MANAGEMENT The overriding managerial implication of the proceeding analysis is the recognition of guanxi’s continued in? ence on business transactions amid China’s market reforms. The failure to appropriately assess the perseverance of guanxi-based business practices can have a devastating effect on managers attempting to enter the Chinese market. Each business interaction must be treated not as an independent event but as a building block for future exchange. The failure to do so could result in network ostracism even where market dynamics are well established. Conversely, guanxi has signi? cant potential to facilitate the building of inter? rm and ? rm– government relationships in China’s increasingly market-oriented environment.

Thus, Western ? rms investing into China may bene? t more from seeking long-term partnerships through the gradual development of guanxi networks than from relying strictly on the more familiar contract-based agreements. Speci? c managerial implications can be considered in terms of a sequence of involvement in the Chinese market. At the Initial Entry stage, it is suggested that a foreign ? rm enter slowly by way of established distribution channels if possible. Find a Chinese national or overseas Chinese to act as your interface person in order to establish contacts with relevant government and business organizations.

Provide ‘gifts’ to distribution partners, including wining and dining, items with company logo, and so forth, but do not consider these as end-alls in building the relationship. Guanxi can have limiting implications at this stage. Given a ? rm has successfully set up distribution of its product and it satis? ed with sales, further commitment to the market may be pursued in the Engagement stage. In order to continue to build guanxi, it is suggested that the ? rm provide clear signals to the business partners of the greater level of commitment. This commitment may be communicated by establishing (1) a subsidiary of? e, (2) assembly operations, and/or (3) local (Chinese) sources of supplies (raw materials, component parts). Additionally, greater personal involvement should take place through face-to-face meetings with your interface person, higherlevel company executives, Chinese government of? cials, and other business partners. At this point, the ? rm’s executives should be aware of the possibility that their activities may be constrained in terms of access to the market and government agencies by the single interface person and his or her existing guanxi network.

Therefore, never pass up an opportunity to meet new people and start establishing one’s own guanxi without causing your interface person to lose face. At some point, a manager may want to consider full commitment. At this juncture, it is suggested that a foreign manager work with a Chinese partner identi? ed earlier to establish a full-scale manufacturing operation. Control is not as critical as access. In other words, do not seek a greater equity control at the expense of greater knowledge of the market, access to additional channels of distribution and the goodwill of one’s government and business partners.

Finally, a manager should continue to nurture his or her existing guanxi relationships by engaging in such activities as bringing government of? cials and business partners for training and visits to the company’s domestic (e. g. , U. S. ) headquarters (an activity that could occur earlier in the process depending on the aggressiveness of the ? rm’s market entry strategy). In general, the development of a guanxi network reduces costs associated with searching for partners, and negotiating contracts. Managers should maintain a long-term horizon with the short-term objectives focused on nurturing the development of a network.

Short-term transaction costs associated with development of the network may be equal or even exceed costs associated with the more familiar Western search mechanisms. But, long-term transaction costs reduction will come from your ability to rely on your partner, your partner’s ? exibility in face of unforeseen contingencies, and the ability to continually build a larger guanxi network at relatively lower costs. Thus, foreign executives should not focus so much on the formalities of traditional Western search for partners (formal business plan, etc. , but on the integrity and abilities inferred through relationships. This is not to suggest that the manager should forgo the use of contracts altogether. Relying strictly on guanxibased exchange creates its own source of organizational inef? ciencies. For example, over reliance on relational exchange can impede outside monitoring Guanxi-Based Business Practices 39 efforts and decrease the organization’s ability to response to speci? c circumstances of opportunistic behavior. Clearly, some level of contractual safeguard is appropriate.

On the other hand, over-reliance on contractual agreements reduces the organization’s ability to adjust to unforeseen contingencies. Instead, the individual manager should strive to attain a balance. Contractual arrangements should be seen as a starting point, incorporating a relatively high degree of ? exibility through relational exchange established via the guanxi network. the well-developed guanxi network will continue to serve as a functional substitute for the hybrid form at moderate levels of asset speci? city. From a managerial perspective, this implies a continued in? uence on business transactions amid China’s market reforms.

The failure to appropriately assess the perseverance of guanxi-based business practices can have a devastating effect on a company’s ability to successfully operate in the Chinese market. Conversely, ? rms willing to recognize and embrace the importance of the guanxi network should see transactional cost advantages unattainable by those who fail to develop such networks. Acknowledgments: An earlier version of this paper was presented at the 1997 Academy of Management meeting in Boston, MA. We would like to thank Dan Moshavi, Rick Mowday, and the two anonymous reviewers for their insightful comments on previous versions of this manuscript.

CONCLUSION From a transaction cost perspective, guanxi-based business practices offer certain advantages over existing structural alternatives. The transaction cost advantage of guanxi can only be seen when guanxi-based exchange is recognized as a distinct structural alternative independent of contract law. Where the guanxi network or guanxi wang is well developed, the transaction cost advantages of reduced environmental and behavioral uncertainties and opportunistic behavior are enough to warrant the integration of guanxi- and market-based exchange.

Guanxi-based business practices will not diminish in importance to the extent previously predicted. Instead, guanxibased exchange will remain as a viable structural alternative with distinct advantages over markets, hierarchies, and the hybrid form. Markets and hierarchies may emerge as superior at the extremes of asset speci? city. However, 40 Journal of World Business / 35(1) / 2000 NOTES 1. TCA’s original framework supposes an interaction effect between environmental uncertainty and asset speci? city (Rind? eisch & Heide, 1997). For conceptual clarity, this paper will address both of these issues separately.

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