BY LIISA VALIKANGAS AND GARY HAMEL

How Markets Remedy Failure

arkets are no panacea: they may be too fickle to support the development of capital-intensive innovation that requires long-term R&D investment. Nor can markets easily build deep competencies that benefit from stable resource constellations and fixed complementary assets — the transaction costs of such an endeavor would probably prove prohibitive in a market-like setting (Williamson, 1975). Markets are also susceptible to hype and may fail — from the Dutch tulip mania to the recent Internet bubble people have taken their cues from other people's behavior and suspended better judgment, or just hoped to exit before the eventual crash.

So what are markets anyway? Economists treat markets as a hypothetical, abstract construct for purposes of theory building (e.g., North 1977, Demsetz, 1982, Coase 1988). Sociologists have studied markets as social structures and have attempted to give empirical content to the ideal of exchange (see Swedberg 1994 for a review). However, economists lack the ability to empirically describe a market and sociologists seem hesitant to distinguish between a market and, say, a social network. Markets, it seems to us, perform at least the following, somewhat overlapping, functions.

· A forum for exchange: This is perhaps the most classical definition of a market: It is to enable buyers and sellers to find each other. Town bazaars and stock markets would fall under this label.
· An arena for competition: The structure of competition may of course vary depending on the number of buyers and sellers (Chamberlin, 1933) but the primary function of a market appears to be the cultivation of sufficient amount of competition to ensure economic efficiency.
· An avenue for choice: Economic efficiency is only meaningful to the extent people can exercise choice — markets allow individuals, at least in theory, to make the kind of consumption choices they prefer. Prices capture this information and direct the production of goods and services.
· A process for endorsement/external validation: Markets are powerful mechanisms for endorsing and validating (or rejecting) product and service offerings. Markets gather information from a number of individuals and aggregate this information (e.g. Spence 1974).
· A mechanism for resource allocation: Due to the signaling effects of markets, resources become allocated toward their most efficient use. Although in theory the allocation processes are continuous, in practice corporate strategic planning and capital budgeting cycles render such decision making an annual event hence slowing down resource allocation adjustments in the market place.
· A kind of social network: Markets exist within the social context of a particular culture, defined by a set of institutions, and historical evolutions. To function, markets are supported by social networks of brokers, financial and other intermediaries, buyers, and sellers (see Burt 1982, Baker 1981).

To consider how markets in some disguise might remedy some of the innovation handicaps of corporate hierarchies, let us consider the three impediments identified earlier. The overall observation is that markets are an antidote: they don't necessarily have the kind of structures that generate, fund, or otherwise enable innovation, but they do cure hierarchies of some of the most severe impediments to innovation as discussed earlier.

How Do Markets Enlarge the Option Set for Innovation?

The ultimate limit to any discovery is imagination. In a market, new ideas surface to the extent they can be imagined and envisioned, and to the extent rewards to these ideas are visible. Markets may not necessarily have any generative mechanisms for discovery per se, but the absence of restraint from existing power structures and vested interests is a clear advantage once an idea has surfaced. The idea can thus be acted on without fear of retribution, if it receives enough traction in the marketplace to attract funding and other resources.

How Do Markets Re-Price Resources?

By eliminating the corporate discount, resources can more accurately be assessed as to their marginal utility. Future uses of these resources are likely to be important as markets have less commitment to the past than hierarchies. And resources are free to move as they are not "owned" or coerced by particular vested interests. Markets allow experimentation on different combinations of skills and assets to see which ones are viable. Entrepreneurial flair is still needed, however. Markets offer but the possibility for — and the dream of — economic success. Markets are also good at tapping information from many sources and not just relying on a single decision-maker. Finally, markets are not bounded by strategic considerations so important to many acorporate managements.

How Do Markets Unleash Creativity?

Creativity may come in different forms, and in this context, we focus on the kind of creativity that has economic potential. Markets offer people a chance to reflect on their contribution to the enterprise and search for their strengths and weaknesses. It is likely that an enterprise one has chosen to pursue arouses more passion than the one commanded by a superior.

"Ideal" markets are open to newcomers; they are apolitical, they organize "on demand"; they attract resources rather than allocate or assign them (Hamel, 1999); and they involve participants based on their individual judgment and avocation. Markets also exist within an institutional framework that defines some of the meta-rules such as property rights, contract law, conflict resolution, legitimate business routines — these metarules are critical to the effectiveness of markets as an economic institution (see Yergin and Stanislawski, 1998). To the extent hierarchies wish to create internal markets, a discussion on such meta-rules becomes important. Overall, markets amount to a behavioral logic that is radically different from that of a hierarchy: markets are the result of human actions but not of human design (Hayek 1945). It is this lack of overall integrative and coercive design that we propose will help remedy some of the hierarchical shortcomings in innovation. This is not to claim, surely, that markets alone are the prototype solution to the resource allocation problem between exploitation and exploration (March, 1991). Rather, as discussed in the next chapters, we promote hybrid organizational forms that combine the logics of a hierarchy and a market.

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