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According to the sociological perspective business relations are embedded² in social structures, which refer ‘to the extent to which economic action is linked to or depends on action or institutions that are non-economic in content, goals or processes’ (Granovetter, 2005, p. 35).³ The focus on the atomized and purely self-interested, utility-maximizing individual is perceived as an ‘undersocialized’ (Granovetter, 1985) conception of business action. Embeddedness of market exchange ‘reflects social conditions that help actors in addressing underlying problems of coordination’ (Beckert, 2007, p. 14). In this respect, trust, reputation and reciprocity are considered as important issues to be examined (Uzzi, 1997; Powell, 1990; Sako, 1991). Trust is regarded as crucial to resolve problems of cooperation.

Trust can be defined as the ‘mutual confidence that no party to an exchange will exploit another’s vulnerabilities’ (Barney and Hansen, 1994, p. 176). Vulnerabilities exist due to risk factors such as adverse selection, moral hazard or hold-up problems. According to Kollock (1994) and Fehr (2009), however, it is not belief but behaviour that proves the existence of trust. Thus, defining trust as an action that increases one’s vulnerability to another person whose behaviour is not under one’s control (Kollock, 1994) goes beyond the first, purely ‘belief-based’, definition in that it requires exposure to some level of risk for trust to develop. As risk provides opportunities for opportunism, abstaining from exploiting another person’s vulnerability creates trust (Barney and Hansen, 1994; Kollock, 1994; Fehr, 2009). According to the sociological perspective, social relations are the most important driver for trust in business relationships.

2 The concept of social embeddedness has its roots in the work of Karl Polanyi (1957), though the concept has undergone a great transformation. Since Granovetter’s (1985) work on inter-firm networks the approach of adopting sociology concepts in economic theories became more acknowledged. Therefore, the idea of embeddedness of business relations also often traces back to Granovetter’s work.

3 Several forms of systematization of the embeddedness concept are discussed in the literature (Beckert, 2007;

Rooks et al., 2000; Halinen and Törnroos, 1998). For instance, Halinen and Törnroos (1998) distinguish between temporal, spatial, social, political, market and technological embeddedness. Though all of these elements have a different focus, social embeddedness is always perceived to be the most elemental part highly intervened with the other dimensions.

All businesses can be considered to be socially embedded since the individuals working in these firms have social ties beyond but also directly linked to their work. These individuals work as members in organizations and interact individually, or as a group of employees, with colleagues of their own firm as well as with members of other enterprises (Ahrne, 1994). Hence it is necessary to investigate the relevance of social embeddedness for understanding the governance as well as the economic outcome of inter-organizational relationships.

Governance of inter-organizational relations: the relevance of social structure

Depending on the characteristics of the exchange, social embeddedness is of varying relevance for business relationships. Assuming that no exchange hazards exist, there is no opportunity to exploit any vulnerability. In this case neither trust established by social ties nor the establishment of specific governance forms (e.g., contracts) is of relevance for safeguarding transactions. In fact, due to the lack of risk there is no test for trust and thus the characteristics of the market rather than those of the exchange partner lead to the occurrence of transactions (Kollock, 1994; Williamson, 1991; Granovetter, 1985).

In cases where significant vulnerabilities such as moral hazards exist, market transactions can nevertheless take place if appropriate market or contractual governance devices are implemented or trust is generated due to social ties. Market-based governance devices do not rely on third-party intervention but are self-enforcing. In a situation in which economic hostages are created intentionally (e.g., through symmetric investments in specialized assets), thus motivating the exchange partner to behave in a ‘cooperative’ way (Dyer and Singh, 1998) voluntary compliance results. Market-based government devices are sufficient if the gain from violation is assumed to be smaller than the expected future net benefits from adherence. Assuming selfish actors, the risk of being exploited is reduced or even eliminated, as is the necessity for trust to backup transactions.

Transaction cost economics assumes that in the case of strong vulnerabilities such as hold-up problems, opportunism can be best prevented by contractual safeguards (e.g., explicit contracts). Such safeguards cover issues of conduct and the respective penalties in case of non-compliance which are enforced by the State or a legitimate organization authority and thus rely on third-party enforcement (Dyer and Singh, 1998).⁴ However, in a complex and highly unpredictable world, exchange partners will find it difficult and prohibitively expensive to foresee all possible contingencies, to write contracts that cover them and finally to enforce these contracts. This holds even more when outcomes are unobservable or difficult to verify by a third party (Hart, 1995; Guo and Jolly, 2008). As a consequence, formal contracts are in general not only costly, but also remain incomplete and thus give rise to ownership rights which refer to so-called residual rights that cannot be specified in advance as part of an enforceable contract (Grossman and Hart, 1986). If the cost of an explicit contract outweighs the potential benefits of the transaction, social embeddedness of inter-organizational relationships is a pre-condition for transactions to take place. Social ties are the most important driver for creating trust in business

4 A second mechanism to safeguard against risk factors such as hold-up problems often proposed by transaction costs economics is vertical integration. However, in this chapter we are interested in discussing inter-organizational relationships so this governance form will not be further considered.

relationships. It can complement or substitute for unenforceable formal contracts, thereby reducing transaction costs (Granovetter, 1985).

According to the sociological view, trust will emerge due to social interactions among exchange partners with key contact people often being crucial to develop and maintain social structures (Bendapudi and Leone, 2002).⁵ Over time, trustworthiness is backed by positive reciprocity,⁶ which implies that in a relationship, knowledge, resources and/or other valued items are given and received (Portes and Sensenbrenner, 1993; Rooks et al., 2000). Reputation will grow if promises made in the past are honoured, allowing trustworthiness to increase with the length and depth of a relationship (Uzzi, 1997; Powell, 1990; Sako, 1991; Beckert, 2007; Granovetter, 1985; Gulati, 1995; Dyer and Chu, 2000;

Malecki and Tootle, 1996).

While positive reciprocity leads over time to a high level of trustworthiness of a business partner, negative reciprocity – punishing harmful acts – serves as an important safeguard. Various types of social sanctions can be imposed on business partners that behave in an opportunistic way. Substantial economic opportunity costs arise for an actor that for example gains the negative reputation of being a cheater. Even more, opportunistic behaviour can lead to high social costs for individuals or businesses that are deeply embedded in social networks if non-compliance leads to a withdrawal of respect and prestige or puts networks of relations at risk (Dyer and Chu, 2000; Barney and Hansen, 1994).

Trustworthy behaviour thus might only exist because actors aim at preventing the social or economic costs that could arise following opportunistic behaviour. Trustworthy behaviour, however, can also be motivated by internalized social norms.⁷ The wish to prevent negative feelings such as failure or guilt rather than the desire to avoid externally imposed sanctions encourage this conduct (Barney and Hansen, 1994). Trustworthy businesses or individuals of this ‘strong’ type will not exploit their partner even if social ties are absent. In the context of business relationships, social embeddedness, however, still plays a considerable role. As for leading to a competitive advantage (see discussion below) it is essential that businesses are able to identify trustworthy exchange partners of this

‘strong’ type. Otherwise they need to rely on economic governance devices to prevent fraud. Developing social ties for example by past experiences with the exchange partner are crucial to reduce the costs of identifying these kind of trustworthy actors (Barney and Hansen, 1994).

The expositions above indicate that social structures influence the governance of inter-organizational relationships if vulnerabilities from adverse selection, moral hazard and/or hold-up exist. Other things being equal, social embeddedness will reduce the need for market and contractual governance devices as positive reciprocity strengthens trustworthiness leading eventually to the development of a positive reputation. Negative

5 Employee turnover on the other hand can put inter-organizational relationships at risk (Bendapudi and Leone, 2002).

6 The social norm of reciprocity is discussed in more detail in the section ‘Relevance of ‘homo reciprocity’’, below. In general, it refers to the fact that people respond kindly to beneficial acts (positive reciprocity) while harmful behaviour induces retaliation (negative reciprocity).

7 Social norms can be defined as: ‘(i) behavioural regularity that is (ii) based on a socially shared belief how one ought to behave which triggers (iii) the enforcement of the prescribed behaviour by social sanctions.’ (Fehr and Gächter, 1998). ‘Internalized’ social norms imply that behaviour is not motivated by the sanction in the case malfeasance but by the personal belief regarding the value of the norm.

reciprocity, however, is as important, as it serves as an important safeguard since malfeasance can induce high economic and social costs. Finally, social structures facilitate the identification of trustworthy individuals or businesses, thus making economic governance devices redundant.

Benefits of social embeddedness for inter-organizational relationships

Several studies about the complex-product industry (e.g., the automobile sector) in Japan found that this country reached international competitiveness in different sectors through a system of highly embedded enterprises. It seems that a stronger group orientation than in Western societies exists, for cultural reasons (Hill, 1995), which makes the establishment of different types of mutual trust in inter-organizational relationships easier (Dyer and Chu, 2000; Dyer, 1996; Sako, 1991).

These, and other studies, indicate that social embeddedness can be a potential source of competitive advantage if social ties are different between competitors, and vulnerabilities from for example adverse selection, moral hazard and hold-up exist in the market (Barney and Hansen, 1994). This is for several reasons. First, companies with stable business relations have cost advantages, because of a reduced necessity to monitor, renegotiate and bargain as has been discussed above (Barney and Hansen, 1994; Hoang and Antoncic, 2003; Hill, 1995).⁸ Second, as own experiences are considered the most reliable source of data, networks of business relationships generate the most secure information. A third positive effect of social embeddedness is the fact that exchange relations may be much deeper and richer than if they (exclusively) rely on contracts (Uzzi, 1997; Hoang and Antoncic, 2003) with the main rationale for this being summarized in the literature review of Dyer and Singh (1998).⁹ Based on this review as well as more recent studies, three core reasons can be identified for the competitiveness-enhancing effect of social structures (e.g., Dyer and Singh, 1998; Hoang and Antoncic, 2003; Podolny and Page, 1998; Duschek, 2004):

(1) Inter-organizational relationship-specific assets. Organizations can realize routines and processes which are crucial sources of competitive advantage through the growing working experience with their exchange partner (Duschek, 2004; Dyer and Singh, 1998).

Several studies show that the greater the willingness of organizations to make relationship-specific investments the greater is the potential to reap relational rents and thus competitive advantage for collaborating enterprises (see Dyer and Singh, 1998 and the references cited therein).

(2) Inter-organizational knowledge-sharing. Organizations can generate relational rents by developing patterns of inter-organizational interactions that allow the transfer, recombination and/or creation of specialized knowledge (Dyer and Singh, 1998; Duschek,

8 Though social forms of governance imply no or fewer direct costs, they are linked to opportunity costs as relying on social forms of governance reduces the number of potential exchange partners.

9 It should be mentioned that the authors are proponents of the relational view – the newest branch of strategic management theory that focuses on dyad and network routines and processes as important determinants of competitive advantage (Dyer and Singh, 1998). ‘The relational view is based more or less implicitly on ideas of the social network perspective’ (Duschek, 2004). Dyer and Singh for example talk about the ‘network of relationships in which a firm is embedded’. Due to the fact that the discussion in the framework of the relational view in strategic management theory has a common ground with the social structure theory, they provide interesting insights regarding the benefits of social embedded inter-organizational relationships.

2004; Powell et al., 1996; Valkokari and Helander, 2007). Inter-organizational knowledge-sharing routines rely on a high level of transparency and reciprocity. They can lead to the creation of tacit knowledge – a highly inimitable resource and thus an important source of competitive advantage. Firms are especially successful in utilizing such outside sources of knowledge if they have high absorptive capacity. This is the case if partners have been successful in building up an overlapping knowledge base as well as routines that allow for a high frequency and intensity of information sharing and ‘socio-technical’ interactions (Dyer and Singh, 1998). Thus, social embeddedness is not only a precondition for sharing tacit knowledge between organizations but the depth of the relationship, in addition, determines whether organizations can make use of such knowledge that leads to highly inimitable resources.

(3) Complementary endowments with resources and capabilities. Organizations can generate relational rents by combining distinctive strategic resources and capabilities owned by business partners that collectively are more valuable, rare and difficult to imitate than if used individually (Dyer and Singh, 1998; Duschek, 2004). As synergies can be captured Aristoteles’ statement ‘the whole is more than the sum of its parts’ holds. The higher the organizational and cultural ‘fit’ between business partners, the more synergy-sensitive resources and capabilities exist, and the more successful partners are in identifying them, the more advantageous is the inter-organizational relationship for its members (Duschek, 2004; Dyer and Singh, 1998).

Social embeddedness of inter-organizational relationships based on trust, reliability and reciprocity are able to create the discussed intangible and mostly inimitable resources.

Market and contractual governance devices (alone) could not totally stabilize uncertain expectations and thus the fear that vulnerabilities could be exploited would remain. As a consequence, for example the generation of tacit inter-organizational knowledge would not take place (Granovetter, 1985; Ullrich, 2004). Therefore, it can be concluded that social embeddedness can lead to social capital – in the form of intangible and mostly inimitable

‘resources’ (Nahapiet and Ghoshal, 1998) – which are a crucial source of competitive advantage (Sorama et al., 2004).

Finally, it should be noted that the benefits of embedded business relationships often go far beyond purely monetary gains. Social embeddedness of transactions also implies intrinsic or process benefits in the form of personal relationships, grant and the pursuit of regard (Sage, 2003).