The Embeddedness Theory of Granovetter

Governance structure is always an important issue in organizational research. Most of the previous research, however, explored how to select between market and hierarchy as two governance modes. According to the transaction-cost school represented by Williamson, for example, the dynamic effects of humanity and the transaction environment in the process of transactions cause market failure, difficulties in market transactions and extremely high transaction costs. The relative transaction costs constitute an important factor for determining the form of governance structure. Williamson takes network as a hybrid form of market and hierarchy. A subsequent series of studies all refer to network as a type of intermediate organizations while overlooking the existence of a third governance mode characterized by self-organization.

Nonetheless, Granovetter noted that Williamson's theory fails to notice an important thing – the trust-based relationships in economic actions. He said in his famous embeddedness theory that all economic actions are embedded in social networks. On the one hand, basic trust is required for any transaction, because no economic action can occur without it. On the other hand, trust is an important factor for deciding transaction costs and will change the selection of governance structure.

First of all, trust is a must and can never be replaced by institutions. I refer to this as the issue of ―minimal trust.‖ Although institutional design can reduce uncertainties and transaction costs, transactions can occur only when there is minimal trust between relevant trading parties. In an environment where nothing is trustable, nobody dare make transactions however perfectly designed the institutions are. For example, a Chinese person in an Africa country may even have no confidence in such transactions as renting a hotel room for a few days and, instead, must rely on the travel agency to transact for him/her. Doubts about local laws and the honesty of businesspersons in a totally strange culture will make it difficult for Chinese visitors to transact for themselves, even if they have signed contracts with the hotels and there are local laws that protect such contracts.

Secondly, trust-based relationships can replace institutions to a certain extent. Opportunistic tendencies and bounded rationality of people will result in higher transaction costs. Nonetheless, mutual trust between people, in addition to institutional constraints, can reduce these costs. Excessive contracts, lawyers and cumbersome supervision/examinations become less necessary if there are goodwill and high trust between both parties to a transaction. In addition, even if either party is found, in a post-transaction supervisory action, to have violated the contract, the other party will less likely file an immediate lawsuit for resolution. Instead, he/she probably will remain benevolent and settle the matter through private negotiations – that is, replacing the high lawyer fees with goodwill, whenever possible, so as to reduce the transaction costs.

Granovetter's analysis has shifted people's attention to social relationships and personal trust from the cold institutions, regulations and cost calculation. Since trust is indispensable on the one hand and can replace institutions and thus affect governance structure on the other, people should not rely solely on regulations and institutions in the process of management, but also value the effects of trust and relationships. In other words, they should balance between the ―hard‖ institutions and the ―soft‖ trust.

 
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