Institutional environment, transaction costs, and the theory of interfirm guanxi.

ABSTRACT

Taking a new institutionalist and transaction costs approach, we argue that in such special institutional environments as China, where transactions are highly uncertain, opportunism is widespread, property rights-based contract laws are not well developed and enforced, and capital and managerial resources are scarce, economic exchanges conducted in both markets and hierarchies may entail high transaction costs. Therefore if intermediate forms are less costly, they will be chosen as an alternative way of organizing exchanges. Interfirm guanxi, the trust-based particularistic ties between the key personnel of independent firms to pursue mutual interest of firms, is the primary or at least supplementary governance mechanism of intermediate forms. Interfirm guanxi is backed by a series of special enforcement instruments, such as goodwill, reputation, and codes of ethics, etc. Therefore whether the intermediate forms have a transaction cost advantage is determined by the efficacy of interfirm guanxi, which is a function of economic calculus of gains and losses from cooperation, goal and product complementarity, information symmetry, and the efficiency of transmitting reputation across networks. We then identify several characteristics of interfirm guanxi: trust-based particularistic ties; reciprocity; long-term orientation; adaptability and incentive intensity, etc. Interfirm guanxi as a product of institutional environment evolves with institutional change. We conclude this paper with some suggestions for future research.

1. INTRODUCTION

In recent years, guanxi has attracted increasing attention from both popular press and academic circle. Such articles as "The Relentless Pursuit of Guanxi" and "Get Guanxi Out of Washington" frequently have appeared on influential magazines and newspapers. Meanwhile, sociologists and management scholars have tried to find out the origin, functions, and operational mechanisms of guanxi in Chinese business society (e.g., Redding 1990; Xin and Pearce 1996; Yang 1994; Yeung and Tung 1996). Among these pioneering works, only a few of them (e.g., Xin and Pearce 1996) have tried to specify the settings, ground their theory on empirical test and hence extract concrete results. Most of the other works deal with guanxi in an abstract and unspecified way. So there is still much room to improve our understanding of this important phenomenon.

In spite of its increasing importance and popularity, guanxi has been a complex and even elusive concept. Yang (1994) states that guanxi "means literally 'a relationship' between objects, forces, or persons. When it is used to refer to relationships between people, not only can it be applied to husband-wife, kinship and friendship relations, it can also have the sense of 'social connections,' dyadic relationships that are based implicitly (rather than explicitly) on mutual interest and benefit." However, it is the "social connections" aspect of guanxi that has attracted the interest of most scholars. For example, Yeung and Tung (1996) define guanxi as "the establishment of a connection between two independent individuals to enable a bilateral flow of personal or social transactions." Consistent with this definition, in this paper we will concentrate on the "social connections" aspect and further narrow guanxi down to interfirm level. By interfirm guanxi we refer to the trust-based particularistic ties between the key personnel of independent firms to pursue mutual interest of firms. What differentiates interfirm guanxi from purely interpersonal guanxi is that interfirm guanxi is basically used to pursue mutual interest and benefit of firms, not only individuals.

Previous literature has tried to explain the origin of interorganizational guanxi in Chinese business society. Some scholars simply attribute its origin to cultural factors such as Confucianism or collectivism (Redding 1990; Yeung and Tung 1996). Xin and Pearce (1996) clearly argue that guanxi is the product of a specific institutional environment. They suggest that Chinese private-company executives operating without the structural protection of governmental support develop guanxi as a substitute for the formal institutional protection government offers their counterparts--state-owned and collective-hybrid organizations. However, we still lack a concrete and comprehensive theory of interfirm guanxi. This paper intends to take a new institutionalist approach to explicating the attributes and functions of interfirm guanxi and explaining its origin from and evolution with the institutional environment. Our arguments are straightforward: Interfirm guanxi is rooted in specific institutional environment; it serves as a governance mechanism of intermediate forms to economize on transaction costs and is enforced by a series of special institutional mechanisms; Institutional change is a crucial determinant of the evolution of interfirm guanxi. The reminder of this paper starts with a discussion of the emergence of interfirm guanxi. We will explain the existence of barriers to both markets and hierarchies in the Chinese economy and how it induces development of interfirm guanxi as a governance mechanism for intermediate forms. In the following section we discuss the characteristics of interfirm guanxi in detail. Then we explore the relationship between institutional change and evolution of interfirm guanxi, which is followed by concluding remarks and future research directions.

2. AN NEW INSTITUTIONALIST AND TRANSACTION COST APPROACH TO INTERFIRM GUANXI

New institutional economics (NIE) has shed new light on the theory of the firm by introducing concepts such as institutions and transaction costs into economic analysis of organization, which has long been ignored by neoclassical economists. Generally, institutions are "the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction" (North 1990). Davis and North (1971) divide the new institutional economics into two parts--the institutional environment and the institutions of governance. While the institutional environment is the set of fundamental political, social and legal ground rules that establishes the basis for production, exchange and distribution, an institutional arrangement is an arrangement between economic units that governs the ways in which these units can cooperate and/or compete.

Then what is the relationship between the institutional environment and institutional arrangements? Williamson (1991) argues that we can treat the institutional environment as a set of parameters, changes in which elicit shifts in the comparative costs of governance. This argument serves as the theoretical foundation of this paper. But we will go beyond the received transaction cost economics in two ways: (1) We will take a closer look at the intermediate forms of transactional governance coordinated by "softer", more intangible and invisible mechanisms such as interfirm guanxi; (2) We will change the settings of transactions from well developed Western capitalism to non-Western societies such as China.

2.1. Transaction Cost Economics and Informal Constraints

Taking a comparative approach, Williamson (1975; 1985) argues that the characteristics of both transactions being conducted and people involved in the transactions determine the costs of contractual governance; therefore the governance structure with the least transaction costs will be chosen. For instance, if a transaction involves high level of uncertainty or transaction-specific assets, and the participants are subject to opportunism, then the transaction should be organized in a hierarchical structure rather than in market, because authority is believed to be a stronger mechanism than price to curb opportunism.

In Williamson's early works, market and hierarchy were basically the only two alternatives of governance structure. But researchers such as Richardson (1972) have noticed that such a dichotomy is too simplistic and does not apply to the real world. Gradually, Williamson realized this problem and admitted that transaction cost economics "deals with polar forms--markets and hierarchies--to the neglect of intermediate or hybrid forms" (Williamson 1991:269). However, this theory can go even further. Although Williamson incorporated intermediate forms into his theory, he has insisted that "each generic form of governance--market, hybrid, and hierarchy--needs to be supported by a different form of contract law" and "hybrid modes of contracting are supported by neoclassical contract law" (Williamson 1991). But empirical findings on the prevalent non-contractual relations in the American business world (Macaulay 1963) and the ethnically homogeneous middleman group (EHMG) in Southeast Asia (Landa 1994) suggest that Williamson's argument is not necessarily true. While some governance modes are supported by legal mechanisms, others can be backed by "informal constraints" such as norms, codes of ethics, reputation and goodwill, etc. Hamilton and Biggart (1988) point out that transaction-cost economics purports to have general application but has been developed almost entirely with reference to Western capitalist economies. However, as North (1990) suggests, informal constraints are everywhere even in modern capitalism. North's argument is supported by empirical results. For example, Macauley (1963) observed that "[b]usinessmen often prefer to reply on 'a man's word' in a brief letter, a handshake, or 'common honesty and decency'--even when the transaction involves exposure to serious risks." He further found that "contract and contract law are often thought unnecessary because there are many effective non-legal sanctions."

While informal constraints supporting economic exchange exist in both developed and developing, or Western and non-Western economies, they vary drastically in nature and depth. In this paper, we concentrate on the emergence, functions, and evolution of one of the informal constraints--interfirm guanxi, and in one specific institutional setting--China. We argue that in China, the widespread adoption of intermediate forms and their primary or supplementary governance mechanism--interfirm guanxi, is due to China's special institutional environment--there are high barriers to both markets and hierarchies. While neoclassical contract law is argued to support these intermediate modes of transaction (Williamson 1991), we doubt that without the backing of various informal constraints such as interfirm guanxi, the contract law on its own will function well. Furthermore, in present China even the neoclassical contract law is absent from many aspects of economic life. Therefore if we neglect the role of interfirm guanxi in coordinating intermediate forms of transaction, the firms facing high barriers to both markets and hierarchies will be in the Prisoners' Dilemma--namely, when intermediate forms are their only choice if they want to conduct business, and there exists no effective mechanisms to govern these transactions, firms will choose not to do business at all. But this is simply not the truth. Taking a game-theoretic approach, we will demonstrate in repeated games, interfirm guanxi helps firms to break Prisoners' Dilemma, facilitate intermediate economic exchanges, and eventually, save on transaction costs. Buchanan (1994) argues that relatively little attention has been paid to the institutional analogues to the well-functioning and largely impersonal laws and institutions of developed economies that have emerged, or may emerge, to facilitate complex contractual exchanges in non-Western settings. In this paper we attempt to fill this gap.

2.2. Barriers to Market and Hierarchy

China has been undergoing a dramatic transition from a centrally planned economy to a market economy. The transition economy, as Nee (1992) points out, is characterized by "weak market structures, poorly specified property rights, and institutional uncertainty", which increases relative cost of conducting market transactions. Mixed with the leftovers of central planning system and emerging marketized factors, the transition economy has shown unique attributes which are impressively different from those of Western economies or Eastern Europe and former Soviet Union. For example, Nee (1992) observed that the transition economy has given birth to a new diversity in organizational forms and a plurality of property rights. The spectrum spans the continuum from the formal and hierarchical state-owned enterprises to small family-owned firms run by peasant entrepreneurs. In such an economy, many formal constraints which facilitate market transactions are either absent or very weak (Peng and Heath, 1996). Under certain conditions, the institutional support for market transactions is so underdeveloped that the transaction costs become prohibitively expensive. Uncertainty has been deemed one of the main obstacles to market transactions. North (1990) points out that the costliness of information is the key to the costs of transacting, which consist of the costs of measuring the valuable attributes of what is being exchanged and the costs of protecting rights and policing and enforcing agreement. To effectively reduce uncertainty involved in market transactions, classical contract law has been designed and enforced in Western economies. Transactions are conducted strictly under the contract law; whenever disputes emerge, the terms or rules of contract law will be rigorously enforced.

According to Macaulay (1963), a contract involves two distinct elements: (a) rational planning of the transaction with careful provision for as many future contingencies as can be foreseen, and (b) the existence or use of actual or potential legal sanctions to induce performance of the exchange or to compensate for non-performance. These two elements induce ex ante and ex post transaction costs respectively, as identified by Williamson (1975; 1985). In the Chinese economy, there are plenty of uncertainties which induce high ax ante transaction costs. However, the institutional mechanisms to overcome these uncertainties are not sufficiently effective. Before a firm decides to involve in a contract, it has to know the ability and credibility of the other firms they are dealing with. In China, a market-oriented reform only started about two decades ago. Under the central planning system, as Kornai (1992) points out, with plenty of bureaucratic controls and regulations, there was little need for formal laws to define exchange relationships among economic actors. Many firms, especially the collective and private enterprises, only have a very short operating history (often less than ten to fifteen years). Therefore they still need time to accumulate credibility and reputation. Meanwhile, a well-functioning accounting and auditing system is still absent. Many firms can partially disclose, distort, and even forge information for transaction or taxation purpose with low risk of being caught. Banks often process commercial loans and collect debits in a preferential way, so it is difficult to get a firm's credit evaluation. Furthermore, the overall market condition has been unstable and often been exposed to government interventions. In addition, a stable supply of many raw material can not be easily guaranteed, which increases uncertainty and adversely affects the production of many other firms.

There also exist uncertainties prompting ex post transaction costs. Among them the most prominent is the lack of a well defined and enforced property rights-based contract law (Boisot and Child 1996; Nee 1992; Peng and Heath 1996). Nee (1992) observed that hybrids in reforming state socialist societies lack a well-specified structure of property rights and, therefore, effective autonomy. For this reason, the socialist hybrids must rely more on personal ties than on legal contracts to provide assurances that the terms of a transaction will be met by both parties (Carroll, Goodstein, and Gyenes, 1988). Under such a property rights structure, uncertainty increases because the power to enforce the contract is weak. Economists have noticed that due to the complexity involved in a transaction, and the bounded rationality inherited in human nature, it is costly and often infeasible to specify every contingency and term of a contract (Klein, Crawford and Alchian 1978; Williamson 1975, 1985). But even if a contract is complete, high transaction costs still occur when enforcement is not sufficiently effective. Poorly defined property rights will further increase the transaction costs. In addition, as Peng and Heath (1996) point out, the lack of a property-rights-based legal framework is also accompanied by the lack of political certainty in transition economies. For example, in a survey conducted by Tan and Litschert (1994), the state regulatory regime is perceived by the Chinese managers as the most influential, most complex, and least predictable variable among eight environmental factors. Park and Luo's (2001) study has also confirmed the influence of government agencies on Chinese firms' strategy and performance.

Then a crucial question arises. Since certain market transactions are so costly to conduct in China, why don't firms organize those transactions inside a hierarchical structure? Williamson (1975) argues that markets and firms are alternative instruments for completing a related set of transactions and whether a set of transactions ought to be executed across markets or within a firm depends on the relative efficiency of each mode. However, due to the lack of formal institutional support in capital market, property rights market and managerial resources, there are very high and sometimes even unconquerable barriers to hierarchies in the Chinese economy. Peng and Heath (1996) have observed that firms in planned economies in transition do try to internalize the transactions. However, being denied the routes of growth through internal expansion and/or acquisitions, they have to take a different route to internalize transactions, namely, through forming networks of firms, a growth strategy that can be characterized as networking or boundary blurring."

2.3. A Game-theoretic Analysis of the Functioning, Depth and Stability of Interfirm Guanxi

The above analysis has shown that in many cases, transactions will be overwhelmingly costly to organize in both markets and hierarchies in China's special institutional environment. Then firms will be forced to consider alternative ways of conducting exchanges. Intermediate forms seem to be the only choice. But if as Williamson (1991) argues, intermediate forms are governed by neoclassical contract law which is characterized by high flexibility and loose enforcement, then we argue that these modes of contractual governance will still be exposed to high risk of opportunism and hence elicit high transaction costs. Then firms will find themselves in the classic Prisoners' Dilemma: If Firm A and Firm B choose to cooperate, they will both gain more than if they choose not to cooperate; But if Firm A (B) trusts Firm B (A) and chooses to cooperate and Firm B (A) abuses trust and chooses not to cooperate, then Firm B (A) will gain more but Firm A (B) will lose more than if both firms choose not to cooperate. The Nash equilibrium of this game is that both firms choose not to cooperate. This model simply predicts that firms operating in China's special institutional environment will cease exchanges. This is not the reality.

The game described above is a one shot game. In this game all firms behave opportunistically to maximize their profits; identity and reputation do not bear any meanings. However, in reality firms often conduct transactions with other firms repeatedly, and try to do business continuously. Therefore, they maximize their profits on a long-term, rather than short-term basis. If the discounted loss from future transactions exceeds the gain from deviation, a firm will choose to cooperate according to its profit-maximization goal. So it is in the repeated games that firms are helped out of Prisoners' Dilemma. Then identity and reputation really matter. In Kreps' (1986) theory of corporate culture, the firm is a wholly intangible object--a reputation bearer.

When firms find it extremely costly to organize certain transactions in both markets and hierarchies in such institutional environment as in the Chinese economy, they will adopt intermediate forms as an alternative mode of transactional governance. These intermediate forms are partly supported by neoclassical contract law, but primarily by interfirm guanxi. As we have mentioned above, interfirm guanxi refers to the particularistic ties between the key personnel of independent firms to pursue mutual interest and benefit of firms. Essentially, interfirm guanxi is a form of implicit contracting; the involved firms maximize their joint wealth on a long-term horizon; it is trust-based and reciprocal; it helps intermediate forms to be less uncertain than markets and more adaptive than hierarchies; and it is supported by a series of non-legal institutional mechanisms. The characteristics of interfirm guanxi will be discussed in detail in the following section. We first discuss the functioning, depth and stability of interfirm guanxi.

While price and authority are the coordinating instruments of markets and hierarchies respectively, interfirm guanxi, along with neoclassical contract law, is the coordinating mechanism of intermediate forms. The way price and authority function will affect the comparative transaction costs of markets and hierarchies. Similarly, the way interfirm guanxi works will have an impact on the comparative transaction costs of intermediate forms. Basically, the functioning, depth and stability of interfirm guanxi is a function of the following variables:

Comparative Gains and Losses from Opportunistic Behavior Interfirm guanxi seems to be a "soft", intangible and invisible mechanism. But it is more concrete than usually perceived because its generation, depth and stability are based on economic calculus by self-interested top managers of the involved firms. Interfirm guanxi starts when all involved firms can benefit from cooperation. But firms bounded by interfirm guanxi may occasionally attempt to deviate from cooperation, if deviation is more profitable that cooperation in the long-run. If the firms realize that cooperation is more beneficial than deviation, than the guanxi built between firms will be stable. Several factors enter into the calculative model: expected gains from current and future cooperation; expected gains from deviation; discount factor; frequency of exchanges; probability of continuity of exchanges. If a firm chooses to cooperate, it will continuously gain profits from future transactions, with the future gains being discounted into present value. But if it deviates, then it will very likely be punished by its trade partner and lose business opportunity with this partner forever. Therefore if the expected gains from continuous exchanges are relative large, and exchanges are very likely to be continued with high frequency, then firms will stick to the interfirm guanxi, meet the expectations of their partners and try to stabilize and strengthen the guanxi between them. Conversely, the stability of the interfirm guanxi will be in jeopardy.

Complementarity of Goals and Products It is easier for the firms with mutually beneficial or complementary goals to build strong and enduring guanxi than firms with conflicting goals, because firms with complementary goals will be less likely to compete with each other even when they are pursuing self-interested objectives. But if two firms are competing in the same industry, it is difficulty to generate and sustain interfirm guanxi between them because they have a high probability to clash in the marketplace, sooner or later. When two firms make complementary products, they are involved in a high level of interdependency; therefore they have a stronger incentive to maintain good guanxi with each other to remain competitive.

Information Symmetry The distribution of information held by two parties in intermediate forms also affects the depth and stability of interfirm guanxi. Ideally, if firms have complete information about each other's credibility and their strategic moves, then the guanxi between them will be stable, because if one firm deviates, it will be quickly detected and disciplined by its partner. This may probably bring the firms back to Prisoners' Dilemma and is certainly not the optimal state. But if one firm holds more information than its partner, or its deviation is not easily observable, then the firm with more information may take advantage of it. If the other firm knows that its partner is better informed than itself, then it will choose not to cooperate or cooperate with some reservation. Under such conditions, the interfirm guanxi between them, if ever exists, will be limited and unstable.

The Tightness of Networks and Efficiency of Communicating Reputation across Networks In Chinese business society, every firm operates in invisible networks. The top managers of these firms often exchange information about the performance and reputation of the firms within and across networks. This can happen in both formal and informal occasions, such as in trade association meetings, clubs, banquets, and personal chats. It is this kind of informal constraints that monitor the firms' behaviors, identify the firms with good reputation, and discipline the deviators. A firm will find it very difficult to continue doing business if its opportunistic behavior is detected and known to other members in the same interfirm network. Such social sanctions might be even more effective than legal mechanisms, when the networks are tight, and communicating reputation across networks is efficient.

Beyond rational calculus of present and potential economic gains and losses, the strength and durability of interfirm guanxi is certainly influenced by other variables, such as macro-culture and personal identities. When collectivism is deeply institutionalized into the culture and hence manifested in the daily life of Chinese people, it is easier for firms operating under such a culture to build stable guanxi with other firms than their Western counterparts operating in a culture dominated by individualism. Since interfirm guanxi functions through personalistic ties between top managers of individual firms, the characteristics of the top managers and their existing relationship will certainly have impacts on the nature of interfirm guanxi. We will discuss it more in the following section.

3. THE CHARACTERISTICS OF INTERFIRM GUANXI AN ITS EVOLUTION WITH INSTITUTIONAL CHANGE

3.1. The Characteristics of Interfirm Guanxi

Interfirm guanxi is trust-based personalistic or particularistic ties between the top managers of individual firms to serve mutual interest and benefit of firms. Because interfirm guanxi is built upon personalistic ties, the identity and reputation of the top managers, along with their prior knowledge about each other, will play a critical role in developing interfirm guanxi. In China, repeated transactions between two firms often start from the personal relationship between their top managers, which is distinguished from the impersonal nature of transactions conducted in a developed market economy. Since the Chinese institutional environment is full of uncertainties, prior knowledge and personal relationship help to build mutual trust, reduce uncertainties and curb opportunism effectively. When personal relationship does not exist in the beginning of a transaction, the top managers will attempt to use the identities of their business partners as reliable and less costly signals of reputation or credibility. Landa (1994) argues that identity matters for traders operating in an environment characterized by contract uncertainty where the legal framework for the enforcement of contracts is not well developed, hence the importance of trust embedded in particularistic exchange relations such as kinship or ethnicity in protecting contracts.

Having personal knowledge and relationship with the top managers of a partner firm, or relying on identity signals of the top managers helps firms to build trust and hence save on both ex ante and ex post transaction costs. Trust comes from personal knowledge and experience, reliable identity signals, and the belief that firms will behave rationally in the long-term. If a firm believes it is doing business with a trustworthy trade partner, it will reduce its efforts to negotiate and specify contingencies and terms of a contract, and therefore save on ex ante transaction costs. An honest business partner also saves the firm on costs of monitoring and enforcing the execution of a contract, which economizes on ex post transaction costs. Similarly, Kreps (1986) argues that in transactions where one side must trust the other, the reputation of the trusted party can be a powerful tool for avoiding the transaction costs of specifying and enforcing the terms of the transaction. Indeed, when the contingencies upon which the terms are based are observable but not verifiable, reputation may be the only way to effect the transaction.

Interfirm guanxi is reciprocal, long-term oriented, and aimed to reach joint wealth-maximization. The game-theoretic analysis has proved that only in long-run repeated games and with sufficient future gains, can firms faced with high uncertainty avoid Prisoners' Dilemma and conduct transactions. Interfirm guanxi is generated to reach joint wealth-maximization and must be reciprocal or mutually beneficial. If only one side benefits from the interfirm guanxi, while the other side gains minimal profit, then there is no strong incentive for the less benefited firm to maintain the guanxi.

Interfirm guanxi as a governance mechanism makes intermediate forms less uncertain than market exchanges, and more adaptive than hierarchies. In the previous sections, we have discussed that interfirm guanxi effectively reduces uncertainties and curbs opportunism through a series of social-sanction-based enforcement instruments. While intermediate forms entail interdependency to some extent, the parties preserve autonomy and flexibility. Therefore firms bear full gains and losses from their own decisions, which elicits strong incentive to reduce costs and adapt efficiently (Williamson 1991).

3.2. The Evolution of Interfirm Guanxi with Institutional Change

Williamson (1991) suggests that parameters in institutional environment determine the relative transaction costs of different governance structures: markets, hierarchies, and intermediate forms. Accordingly, changes in institutional environment will elicit changes in the relative transaction costs of those governance structures. Interfirm guanxi, as the governance mechanism of intermediate forms, will certainly be affected by institutional changes. For instance, Nee (1992) explains the rapid growth of hybrid forms and private enterprise in the Chinese economy as the consequence of "expanding relative scope of market institutions in coordinating the economy, changes in the structure of property rights, and the incremental shift from a redistributive to a regulatory state." The rapid growth of hybrid forms is accompanied by extensive use of interfirm guanxi. Just as market exchanges and hierarchical organizations both involve transaction costs, intermediate forms governed by interfirm guanxi do not come without a cost. While markets and hierarchies are supported by price mechanism and authority respectively, interfirm guanxi as the governance mechanism of intermediate forms is supported by softer and more intangible instruments, such as social norms, code of ethics, goodwill, and reputation, etc. Therefore the effectiveness of these enforcement instruments determines the efficacy, depth, and durability of interfirm guanxi, which eventually affects the transaction costs of intermediate forms. Landa (1994) has observed that the importance of the institutional arrangement of the ethnic trading networks in Southeast Asia's Chinese communities, as an alternative to contact law, is due to the existence of informal social norms or codes or behavior, embedded in particularistic exchange relations, which function as the equivalent to contract law in deterring traders from breach.

But it should be noticed that the well-functioning of such ethnic trading networks is based on the tightness of these networks and the efficiency of communicating reputation across networks. When a society such as the current Chinese business society is becoming more and more mobile, tight and extensive networks will be more difficult to establish and maintain. As a consequence, reputation of traders will not be easily accumulated and communicated. Loosening networks will induce more opportunism, since deviations are more difficult to be detected, and social sanctions are more difficult to be carried out effectively. Under such conditions, firms will face more difficulty in establishing and maintaining interfirm guanxi. Consequently, the intermediate forms will entail higher transaction costs.

When the intermediate forms become costly, firms will have to consider alternative ways of conducting transactions. We predict that in the areas where economic orders are being established, property rights-based contract laws are being specified and effectively enforced, and political interventions are minimal, market exchanges involve lower transaction costs than hierarchies and intermediate forms. In such areas, market transactions will be prevalent and hence interfirm guanxi will be less effective. As China continues to improve its capital market, property rights market, and trains more and more capable managers, it will be more effectively and efficiently for the firms to conduct complex and asset-specific transactions internally. Under such conditions, we can also expect a diminishing role of interfirm guanxi. One example is that with the improvement of China's economic, political and legal infrastructure, more and more foreign companies doing business in China now prefer to build wholly owned ventures instead of establishing joint ventures with Chinese firms.

4. CONCLUDING REMARKS AND FUTURE RESEARCH DIRECTIONS

Taking a new institutionalist and transaction costs approach, we argue that in such special institutional environments as China, where transactions are highly uncertain, opportunism is widespread, property rights-based contract laws are not well developed and enforced, and capital and managerial resources are scarce, economic exchanges conducted in both markets and hierarchies may entail high transaction costs. Therefore if intermediate forms are less costly, they will be chosen as an alternative way of organizing exchanges. Interfirm guanxi, the trust-based particularistic ties between the key personnel of independent firms to pursue mutual interest of firms, is the primary or at least supplementary governance mechanism of intermediate forms. Interfirm guanxi is backed by a series of special enforcement instruments, such as goodwill, reputation, and codes of ethics, etc. Therefore whether the intermediate forms have a transaction cost advantage is determined by the efficacy of interfirm guanxi, which is a function of economic calculus of gains and losses from cooperation, goal and product complementarity, information symmetry, and the efficiency of transmitting reputation across networks. We then identify several characteristics of interfirm guanxi: trust-based particularistic ties; reciprocity; long-term orientation; adaptability and incentive intensity, etc. Interfirm guanxi as a product of institutional environment evolves with institutional change.

Boisot and Child (1996) suggest that China's special institutional environment is giving rise to a distinctive institutional form--network capitalism. While interfirm guanxi is prevalent and deeply embedded in Chinese business society, by no means it is China-specific. Interfirm guanxi exists worldwide under different names, and varies only in scope and depth. The theory of interfirm guanxi presented in this paper may contribute to our understanding of an elusive phenomenon embedded in China and other countries. For the first we systematically examine the economic rationale, institutional origins, functions, characteristics, and evolutionary patterns of interfirm guanxi. This theory may also improve transaction costs economics by identifying interfirm guanxi as a governance instrument of intermediate forms, which has never been recognized in the previous literature. We can also draw practical implications from this theory. Interfirm guanxi is most deeply embedded and widely practiced in East Asian countries, such as China, Japan, Korea, and Singapore, where miraculous economic growth has been witnessed and Western companies are rushing in. With better knowledge of interfirm guanxi: Its development, maintenance, and evolution, Western managers may avoid pitfalls and eventually benefit from it when they try to build constructive relationship with their East Asian counterparts.

Although we have developed a theory of interfirm guanxi, much work remains ahead. We have examined interfirm guanxi primarily from a new institutionalist and transaction cost economics perspective. By incorporating sociological and anthropological views into our theory, we may be able to better explain the complexity and richness of interfirm guanxi. Empirical tests and longitudinal studies are also badly needed to test our theory. Interfirm guanxi needs to be defined and measured, probably with a multiple-item measurement. Then we can examine how and in what situations interfirm guanxi is generated, developed, and eventually diminished or dissolved; by what types of institutional and personal characteristics the depth and stability of interfirm guanxi is affected; how changes in the institutional environment induce changes in the patterns of interfirm guanxi; and how interfirm guanxi varies across networks, regions, and countries, etc. In sum, with more efforts to be made in future research, we can expect to see a more comprehensive and concrete theory of interfirm guanxi.

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Dr. Yongliang "Stanley" Han earned his Ph.D. at University of Southern California in 2002. Currently he is an assistant professor of strategic management at California State University, Sacramento.