INTERACTION OF TECHNOLOGICAL AND INSTITUTIONAL

CHANGE IN THE DEVELOPMENT OF AN ELECTRONIC

COMMERCE SYSTEM IN CHINA’S PHARMACEUTICAL

DISTRIBUTION CHAIN

A Transaction Cost Perspective

Kai Reimers

Faculty of Business and Economics, RWTH Aachen University, Johanniterstr. 22-24, 52064 Aachen, Germany

Mingzhi Li

School of Economics and Management, Tsinghua University, 100084 Beijing, P.R. China

Keywords: Electronic commerce, pharmaceutical industry, transaction costs, institutional change.

Abstract: In this paper, we describe the introduction of electronic commerce into the drug distribution industry in

China. This case is especially interesting because massive institutional changes coincide with the introduc-

tion of a new technology. For these reasons, it becomes possible to study the interaction of technological

and institutional change in real time and in their real-life context. We use two alternative transaction cost-

theoretic perspectives on the interaction between institutional and technological change as our theoretical

framework. The case study suggests that the rationale which motivates introduction of a new technology in

the context of institutional change may be different from the rationale which underlies the practices which

develop on the basis on the newly introduced systems and institutions.

1 INTRODUCTION

Studying the interaction of institutional and techno-

logical change in real time is generally a difficult

endeavour because of the slow speed at which insti-

tutions typically change. For this reason, scholars

have focused on two empirical strategies, namely

historical studies with respect to large-scale institu-

tional changes, usually on the national level, and

studies of institutional change on the level of indi-

vidual companies (where institutions are changed

more easily and thus more quickly). Prominent rep-

resentatives of these two approaches are Alfred

Chandler and Oliver Williamson respectively.

Large-scale institutional changes become visible

only after a substantial period of time has elapsed so

that only historical analysis is feasible; studies on

the level of individual organizations such as firms

can only reveal small-scale institutional changes.

While both approaches have yielded impressive re-

sults, studying the interactions between institutional

and technological changes on an intermediate level

in real time would be desirable for the following

reason. While institutions exist on multiple levels so

that institutional change can also be studied on mul-

tiple levels, new technological systems are generally

not developed on both the national scale and the

level of individual firms but on intermediate levels.

This is because development of new technological

systems typically requires the cooperation among

several organizations, not only because resources

and capabilities of individual organizations are too

limited but also because application of new systems,

at least in the initial stages, requires close coopera-

tion of users and suppliers who are thus actively

involved in the design and development process

(von Hippel, 1978).

However, institutional changes occurring on the

intermediate level are seldom observable in real time

because of the slow speed of institutional change on

this level. One exception to this rule can be found in

fast developing countries which actively experiment

with medium-scale institutional changes. China may

be the most interesting and relevant context in this

regard and within China, the healthcare sector is the

Reimers K. and Li M. (2008).

INTERACTION OF TECHNOLOGICAL AND INSTITUTIONAL CHANGE IN THE DEVELOPMENT OF AN ELECTRONIC COMMERCE SYSTEM IN

CHINA’S PHARMACEUTICAL DISTRIBUTION CHAIN - A Transaction Cost Perspective.

In Proceedings of the First International Conference on Health Informatics, pages 3-12

 SciTePress

one which currently receives the most attention by

policy makers due to its economic as well as social

and political importance.

Theoretically, the interaction between technical

and institutional change has been addressed from a

number of perspectives, including transaction cost

theory. However, as North and Wallis (1994) have

shown, existing institutional approaches -- including

those by Chandler and Williamson -- only consider

institutional change as a passive response to techni-

cal change. North and Wallis trace this traditional

limitation back to an assumption that transaction

costs cannot be observed or measured which has

prevented scholars from appreciating an important

mechanism through which technical change can also

contribute to proactive institutional change. Ac-

cording to North and Wallis, in this tradition it is

generally assumed that new technology requires

institutional adaptation in order to be implemented

which, however, will increase unit transaction costs

even though the transaction cost minimizing institu-

tional arrangement will be chosen. In contrast, if one

accepts that transaction costs can be empirically ob-

served, one will be naturally led to look for those

parts of the economy which directly express the

level of transaction costs existing in an economy at

any given moment in time. North and Wallis have

identified this sector as the ‘transaction sector’ and

used it to measure the existing level of transaction

costs in an economy (Wallis and North, 1986). By

this approach they can show how institutions can be

changed proactively as a result of a lowering of unit

transaction costs through technical change. Thus,

North and Wallis demonstrate two ways in which

technical change can lead to institutional change: (1)

in order to accommodate the requirements of a new

technology, new institutions may have to be created

which, however, increase unit transaction costs in an

economy; since transformation costs are lowered

simultaneously (through technical change), the over-

all effect can still be beneficial; (2) technical change

can lower unit transaction costs and thus enable the

creation of new institutional forms.

In this paper we want to explore this dual rela-

tionship using the case of a massive institutional

reform of the distribution of drugs in China which

coincided with the rise of e-commerce and led to a

new way of selling and distributing drugs in which

both elements of institutional and technological

change are intertwined. We want to investigate to

which extent emergence of this new structure fol-

lows the Williamson-Chandler pattern -- new tech-

nology needs new institutional forms which result in

higher unit-transaction costs -- and to which extent it

can be explained as a result of transaction-cost re-

ducing technological change according to North’s

framework.

2 THEORETICAL FRAMEWORK

Transaction cost economics takes the transaction as

its unit of analysis and therefore operates on an

analytical level suitable for studying technological

change affecting interaction among economic

agents. Williamson (1993) has used a three-layer

model to locate and motivate the analytic strategy of

transaction cost economics. The focal layer concerns

the governance of transactional relationships which

is influenced by factors residing on a macro and a

micro layer. On the macro layer, institutions such as

contract law, property rights and norms and customs

affect the comparative costs of governance. Changes

on this layer may therefore lead to adjustments of

governance structures as some forms of governance

become relatively more cost advantageous while

others become more costly. On the micro-level, be-

havioural traits of individuals influence governance

forms. Prominent among them in Williamson’s

analysis are opportunism and bounded rationality.

For example, governance forms need to prevent

economic agents from exploiting one another should

the possibility for such behaviour arise due to unan-

ticipated changes in the economic environment.

While Williamson has not specifically developed

his transaction cost-theoretic framework for the pur-

pose of analysing its impact, technological change

can be relatively easily incorporated into this

framework through the notion of asset specificity.

This notion refers to investments the value of which

depends on the identity of one’s business partners.

As a consequence of such investments, one can be-

come hostage to threats by that business partner to

break up a business relationship. Specially designed

governance forms need to anticipate and accommo-

date this situation. While creating these special gov-

ernance forms is costly -- increasing unit transaction

costs -- creating them can still be worthwhile since

these governance forms allow for degrees of asset

specificity which, in turn, may reduce transforma-

tion costs substantially. There are several types of

asset specificity such as specificity of location, hu-

man skills and machinery. For example, locating

one’s production facilities close to one’s customer’s

own production facilities may allow for superior

logistical organization (such as Just-in-time delivery

arrangements) which, however, creates a substantial

degree of asset specificity since the value of that

investment would be much reduced if the customer

would sever the business relationship. Technological

change can then be incorporated as investments in

new machinery. Since initially such innovative ma-

chinery still follows proprietary or unproven de-

signs, it may well be tailored to the specific needs of

one business partner and therefore increase the de-

HEALTHINF 2008 - International Conference on Health Informatics

gree of asset specificity in a business relationship.

These concepts are summarized in Figure 1 which

extends and slightly modifies a figure presented in

Williamson (1993).

Institutional environment

Governance of

transaction relationship

Behavioural

assumptions

New

technology

Contract law, property

rights, customs etc. affect

comparative costs of

governance

Asset specificity

requires dedicated forms of

governance, thus increasing

unit transaction costs

Opportunism and bounded

rationality make governance

necessary

Institutional environment

Governance of

transaction relationship

Behavioural

assumptions

New

technology

Contract law, property

rights, customs etc. affect

comparative costs of

governance

Asset specificity

requires dedicated forms of

governance, thus increasing

unit transaction costs

Opportunism and bounded

rationality make governance

necessary

Figure 1: Technological change in a Williamsonian

framework (modified from Williamson (1993) excluding

feedback and indirect effects and adding the effect of new

technology).

The Northian framework combines elements of

neoclassical economic theory and transaction cost

economics. North is not directly concerned with

explaining or describing forms of governance but

rather analyses development of macro entities such

as whole economies/societies or sectors within one

economy. In order to compare his approach to that

of Williamson and to make it relevant for our analy-

sis, it therefore needs to be ‘mapped’ onto the trans-

actional level. In North’s (1990) framework forms of

governance are treated as behaviour of organizations

on economic markets which is influenced by formal

and informal institutions through affecting levels of

transaction costs (organizations are the players, in-

stitutions are the rules of the game). Some organiza-

tions engage in the production of new knowledge

which, if incorporated into products, becomes tech-

nological change on economic markets. In addition,

some organizations also engage in activity on politi-

cal markets in order to affect institutions (and thus

the rules of the game played on economic markets).

Whether such political activity results in transaction

cost reducing or increasing changes of the institu-

tional framework largely depends on ideology

(which thus becomes a major force in explaining rise

and decline of whole societies). In analogy to the

entrepreneur who drives technical progress on eco-

nomic markets, North (1981) also introduces the

political entrepreneur who drives change on political

markets (which activity is in addition to the political

activity of organizations). (North has incorporated

some more elements in his framework such as mar-

kets for knowledge creation which we suppress here

in order to keep complexity on a level allowing for

comparing the two frameworks; for a more detailed

description and analysis, cf. Reimers (1995), pp. 11-

18).

When mapped onto Williamson’s three layer

model, the role of institutions is mostly identical to

that assigned by Williamson to them. They act as

“shift parameters” (Williamson, 1993) affecting the

costs of doing business on the economic markets, i.e.

transaction costs. However, changes on this level are

incorporated into the analysis and are thus given a

more active role while in Williamson’s framework

institutional changes are treated as exogenous

events. Thus, actions of organizations or entrepre-

neurs to affect institutions and thus indirectly be-

haviour on economic markets (including design of

governance forms) is included in the framework.

While such behaviour is affected by many factors,

North assigns a prominent role to ideology which

can be viewed as located on the micro-level in Wil-

liamson’s three layer model (cf. Figure 2 for a sum-

mary of those elements of North’s framework which

are relevant from the perspective of Williamson’s

three layer model).

Institutional environment

Governance of

transaction relationship

Behavioural

assumptions

New

technology

Political entrepreneurs

and organizations create

new rules which affect

governance forms

Transaction cost lowering

technology enables new

governance forms

Ideology shapes governance

forms indirectly through

influencing political action

Institutional environment

Governance of

transaction relationship

Behavioural

assumptions

New

technology

Political entrepreneurs

and organizations create

new rules which affect

governance forms

Transaction cost lowering

technology enables new

governance forms

Ideology shapes governance

forms indirectly through

influencing political action

Figure 2: Technological change in a Northian framework

(as mapped onto Williamson’s three layer model).

The main difference between the two frame-

works -- apart from the different roles new technol-

ogy plays in them -- consists in the effect ascribed to

behavioural assumptions. In Williamson’s frame-

work, behavioural assumptions necessitate creation

of dedicated governance structures which thus take a

prominent place in the framework and generally

increase unit transaction costs. In North’s frame-

work, behavioural assumptions affect behaviour on

political markets (which take centre stage in the

framework) which then affects transaction costs on

economic markets. Technological change enters

through different routes too, albeit in both cases in-

directly. In Williamson’s framework, technology

appears as a special form of asset specificity (thus,

by necessity, increasing unit transaction costs); in

North’s framework, technological change enters as

‘technical progress’ created on ‘knowledge markets’

(given the right ideology has emerged stimulating

INTERACTION OF TECHNOLOGICAL AND INSTITUTIONAL CHANGE IN THE DEVELOPMENT OF AN

ELECTRONIC COMMERCE SYSTEM IN CHINA’S PHARMACEUTICAL DISTRIBUTION CHAIN - A Transaction

Cost Perspective

the demand for ‘productive’ knowledge; in Figure 2,

this relationship between new technology and

knowledge markets in not expressly modelled).

The question arises how these two explanations

can be empirically tested. While it would be temp-

ting to approach the problem in a direct manner by

estimating the effect of new technology on transac-

tion costs (whether it lowers or increases unit trans-

action costs), such an approach would not be accept-

able from a Williamsonian perspective since by as-

sumption -- as pointed out and criticized by North --

transaction costs cannot be measured directly ac-

cording to that perspective. However, it should be

possible to observe for which purpose new technol-

ogy is being used, taking use as an indication for its

effect (on transaction and/or transformation costs).

According to a Northian interpretation, new technol-

ogy which coincides with the emergence of new

governance structures should be used for purposes of

preparing, negotiating, or monitoring contracts

while, according to a Williamsonian perspective,

new technology which coincides with the creation of

new governance structures should be used for trans-

formative purposes (making production and/or dis-

tribution/logistics more efficient).

In addition, certain characteristic differences

should be observed. While institutional changes (i.e.

changes in the institutional environment as defined

by the three layer model) are not mandatory for new

technology to have its predicted effects, they can co-

exist with technological change. However, from a

Williamsonian perspective, technological change

and institutional change, should they both be ob-

served simultaneously, would have independent ef-

fects on governance structures except for the case of

institutionally mandated technological change.

While institutional change may increase or decrease

transaction cost levels technological change will

always increase unit transaction costs. Thus, tech-

nological change will only occur if the resulting in-

crease in unit transaction costs is accompanied by an

even larger reduction in transformation costs or if

changes in the institutional environment lead to the

adoption of governance structures which are re-

quired to accommodate the technological change. In

contrast, from a Northian perspective, one would

expect political entrepreneurs or economic organi-

zations to lobby for institutional change which

would exploit the transaction cost lowering proper-

ties of new technology if such technology should

become available. Thus, institutional change would

have a different character in both cases. From a

Williamsonian perspective, it would have the char-

acter of enforcing new governance structures (or be

completely independent of technological change)

while, from a Northian perspective, it would have

the character of being enabled by technological change.

Finally, behavioural assumptions would play dif-

ferent roles in the two theoretical frameworks and

thus in any explanation of empirical phenomena.

Specifically, from a Williamsonian perspective, they

would underlie the design of governance structures;

from a Northian perspective, they would shape po-

litical behaviour by political entrepreneurs and/or

economic organizations.

The discussion can be summarized by the fol-

lowing two propositions:

Proposition 1 (Williamsonian interpretation):

Technological change which coincides with institu-

tional change and affects the governance of trans-

actional relationships leads to systems which in-

crease efficiency of logistical and/or production

processes. In addition, institutional change takes on

the character of enforcing the new governance

structure which, in turn, will reflect behavioural

traits of agents.

Proposition 2 (Northian interpretation): Tech-

nological change which coincides with institutional

change and affects the governance of transaction

relationships leads to systems which are used for

lowering relevant transaction costs. In addition, in-

stitutional change takes on the character of being

enabled by the technological change while behav-

ioural traits of agents are reflected in the institutional

change.

3 DESCRIPTION OF THE CASE

3.1 Description of Data Sources and

Method

We used a single case study design for our research.

Use of the case study research method is justified

because our questions concern the ‘how’ and ‘why’

of an organizational phenomenon which cannot be

studied outside its real-life context and which in-

volves interaction of a large number of variables

(Yin, 2003). Use of a single case design is justified

because of the uniqueness of the case -- massive

institutional change on an industry level coinciding

with technological change -- and the difficulties of

obtaining empirical data in that context (ibid.).

Specifically, the healthcare industry in China is ex-

posed to an intense public debate about its practices

because of a widespread dissatisfaction with health-

care services and the difficult situation of central

HEALTHINF 2008 - International Conference on Health Informatics

government in this discussion. For these reasons, it

is very difficult and time-consuming to gain access

to key informants in the industry. We have therefore

focused our research on the case of drug distribution

in Beijing.

In total, 12 interviews were conducted with 15

informants between September 2004 and May 2007.

Informants represent manufacturers, wholesalers, e-

commerce intermediaries, a so-called bidding centre

(a government agency), the Ministry of Health, and

the key person driving the introduction of e-com-

merce into drug distribution in China. That person

was interviewed four times over the research period,

allowing us to follow the evolution of the techno-

logical and institutional change over three years. In

addition, documented material -- mostly in the form

of Chinese websites -- was used for supplementing

our data.

All information presented in the case description

below has been triangulated by at least two inter-

view sources except in cases where informants re-

presented the subjective view of their organizations;

such instances are explicitly in1dicated in the fol-

lowing description when they occur.

3.2 The Problem which Triggered

Institutional Action

The reform of economic structures in China started

in the late 1970s has not only led to the emergence

of business organizations and economic markets but

also deteriorated existing economic organizational

structures. One characteristic of these previously

dominating structures was the tight integration of

work organizations and social services such as

housing, education and healthcare. These integrated

units -- called dan wei -- were not only internally

integrated but, to a large extent, externally insulated.

Workers would seldom leave the compounds on

which all facilities required for everyday life existed.

The main connection with the economic environ-

ment consisted of flows of intermediate goods

among these organizations (Walder, 2000). Thus, the

functional separation that came with the emergence

of dedicated business organizations -- as opposed to

these integrated work organizations -- implied that

social services would have to either be provided as a

commercial service as well or by government. To

some extent, both of these directions were pursued,

especially with regard to healthcare. Specifically,

while, through a reform of the health insurance sys-

tem in 1998, all workers in cities are covered by a

governmental insurance system, rural families re-

ceive practically no any health insurance coverage

(cf. Dou, 2003, and IMS Health, 2004). Most medi-

cal expenses need to be paid out of pocket by rural

families (ibid.). At the same time, governmental

health insurance for urban workers covers only basic

services so that a large number of privately-based

insurance schemes has sprung to live covering addi-

tional health risks (ibid.).

While this situation was not satisfactory for most

people and organizations involved in healthcare, it

continued to function to the extent that healthcare

costs could be kept low. The healthcare system

started to be defunct, however, once the drug prices

started to increase significantly. While one cause of

the rise in drug prices was the entering of multi-

national pharmaceutical firms into the Chinese mar-

ket and the accompanying rise of branded drugs --

alongside the much cheaper so-called ethnic drugs,

i.e. drugs based on traditional Chinese medicine --

the root cause for this development was the chronic

under-financing of hospitals. In order to survive in

the new economic environment, hospitals took to

earning most of their income (on average 80%)

through the selling of drugs which naturally created

incentives to sell expensive drugs with high margins.

Central government initiated several institutional

measures to mitigate the situation. For example, it

kept prodding provincial and local governments to

improve healthcare provisioning and to develop in-

surance schemes for the rural population. It also in-

stituted that all business organizations operating in

the distribution of drugs had to be certified by the

year 2004. The reason for this measure was an in-

tention to cut down on the huge number of distribu-

tors, wholesalers and other intermediaries which,

around the year 2002, was estimated to be between

16 and 17 thousand (Dou, 2003). This large number

of intermediaries in the distribution of drugs was

supposed to create inefficiencies through fragmenta-

tion (lack of economies of scale) and multiple mark-

ups (each intermediary would add a mark-up to the

price). Moreover, central government required hos-

pitals to separate their internal pharmacy accounts

from their other accounting processes in order to

increase transparency regarding the extent to which

hospitals financed themselves through the sale of

drugs; a second institutional reform concerned the

introduction of a centralized bidding process through

which hospitals were expected to purchase drugs.

There has also been some efforts to promote the de-

velopment of an independent retail pharmacy sector

because it was assumed that through this process the

monopoly power hospitals traditionally held over the

sale of drugs could be broken or at least diminished.

All these measures are very recent, beginning in

the year 2000, and government is continuing to ex-

periment with new approaches. However, govern-

ment is severely restricted in enforcing its policies

INTERACTION OF TECHNOLOGICAL AND INSTITUTIONAL CHANGE IN THE DEVELOPMENT OF AN

ELECTRONIC COMMERCE SYSTEM IN CHINA’S PHARMACEUTICAL DISTRIBUTION CHAIN - A Transaction

Cost Perspective

for two reasons. First, it depends upon the services

of hospitals, a fact which came to light during the

SARS epidemic in 2003. Therefore, government

cannot afford to let a large number of hospitals go

out of business. Second, government is not a unified

force but internally highly fragmented along vertical

and horizontal lines. Specifically, regulatory and

administrative powers regarding the healthcare sec-

tor were, in 2002, distributed across nine govern-

mental agencies and ministries (Dou, 2003) some of

which were later merged. Vertically, government

power is spread across central and provincial gov-

ernments, for example with respect to inspecting and

certifying drug manufacturing.

In the following, we will focus on the introduc-

tion of the centralized purchasing process since this

was the main force shaping the development of

electronic commerce systems in drug distribution

but also consider the effects of the other measures

since they are all interdependent.

3.3 An Early Experiment

In order to curb corruption related to the problems

outlined above, the provincial government in Henan

province centralized all drug procurement related to

hospital demand in 1993. Resistance by hospitals to

this measure, however, lead to the discontinuation of

the practice two years later. The person in charge of

implementing this measure, Mr. Li, then visited the

US in order to study drug distribution there and be-

came convinced that centralization of drug procure-

ment was the “direction for the future of China” but

that this was only possible by using e-commerce.

After two years of preparation, an e-commerce sys-

tem for procuring drugs commenced operations,

initially with good results -- according to Mr. Li --

but which was closed down after just half a year of

operations upon being declared illegal by central

government under then premier minister Mr. Zhu

Rongji because business operations had to be sepa-

rated from their regulation. The system was then

sold to a private company -- Haihong -- which

would re-launch it in Henan and introduce it to sev-

eral other provinces, among them Guangdong,

Hainan, and Beijing.

3.4 How the System is used in Beijing

In Beijing, a centralized, e-commerce-based pro-

curement system for drugs began operations in 2004.

However, institutional reforms preparing for that

system go back to the year 2000 when the ‘Beijing

Bidding Centre’ was set up as a joint effort by nine

government agencies involved in the regulation of

drug distribution to hospitals. These agencies in-

clude, for example, the Beijing Health Bureau

(which has a role similar to a national Ministry of

Health albeit on a provincial level), the Beijing Price

Bureau and the Beijing Traditional Chinese Medi-

cine Bureau. Based on experiences with similar

systems in other provinces, most of them supported

by Haihong’s software and services, a process for

drug procurement was established; while the core

elements of this process are similar across the whole

country some elements show distinct characteristics

distinguishing the process from those implemented

in other provinces. In general, drug distribution is

still a highly localized business; distributors who are

fierce competitors in one province may therefore be

business partners in 1another province. The

following account focuses on the practices

associated with the e-commerce system in Beijing.

Preparing list

of agents

Public Tender

Manufacturers

apply for

participation

Manufacturers

are evaluated

and invited

Bids are

submitted

electronically

Data are

cleansed and

formatted

Bids are

evaluated

Winning bids

are published

Contracts

between

hospitals and

manufacturers

are closed

Preparing list

of agents

Public Tender

Manufacturers

apply for

participation

Manufacturers

are evaluated

and invited

Bids are

submitted

electronically

Data are

cleansed and

formatted

Bids are

evaluated

Winning bids

are published

Contracts

between

hospitals and

manufacturers

are closed

Figure 3: The bidding process (bold boxes indicate steps

supported by the e-commerce system).

The bidding centre usually initiates a bidding

process once per year. The process steps are de-

picted in Figure 3. The core step consists of evalu-

ating competing bids by manufacturers on individual

pharmaceutical agents (chemical substances) ac-

cording to multiple criteria, including price and ser-

vice quality of distributors (which must be assigned

by manufacturers in advance and which often take

over the paperwork associated with participation in

the bidding process). The list of agents comprises

about 15 thousand items on which manufacturers

can bid. Evaluation is done by a group of experts for

each of the province’s -- Beijing is a province as

well as a city -- six hospital groups which have been

set up according to certain differences in their de-

mand for drugs. Once bids have been selected, hos-

pitals are required to place purchase orders for drugs

only among the winning bids. The main purpose of

this process is to ensure that hospitals use high qual-

ity drugs while controlling drug prices.

HEALTHINF 2008 - International Conference on Health Informatics

The bidding process is facilitated by a number of

intermediaries which have been certified for that

purpose. While seven intermediaries have received

such certificates, only three are active. Each hospital

group selects one of them to help them with operat-

ing the bidding process. The largest among them --

serving four hospital groups -- is Haihong. The re-

quirements according to the certification process

also include ownership and operation of an e-com-

merce system. Regarding the bidding process itself,

that system collects all documents which need to

accompany a bid and which have to be submitted

electronically. The intermediaries then pass these

data -- after some data cleansing and format adjust-

ments -- on to the bidding centre. Once winning bids

have been selected, the results are published on the

e-commerce systems.

The more important role which these e-com-

merce systems play, however, concerns the ordering

process. Hospitals are required -- according to

stipulations by the Beijing Health Bureau -- to sub-

mit orders through these systems. For that purpose,

they log onto the system over a web interface and

enter their orders directly into the system. Distribu-

tors then download order data from the system --

also by logging onto the system through a web inter-

face -- and hospitals are automatically informed that

distributors have downloaded order data. However,

distributors cannot confirm or change purchase or-

ders.

The express purpose of this use of e-commerce

systems is to facilitate the monitoring of compliance

with the rules of the bidding process. Specifically,

the bidding centre is charged with the task of moni-

toring hospital purchasing activity in order to ensure

that hospitals only buy ‘from the list’, i.e. do not

circumvent the drugs which have been selected in

the evaluation process.

The percentage of drugs sold/procured through

these systems has increased continuously since their

inception in 2004 and was estimated to be close to

100% in 2006. Use of the system is accredited with

having caused a significant drop in the number of

distributors in Beijing which fell from around 200 in

2004 to about 120 at the beginning of 2007.

The e-commerce system replaces a practice in

which distributors took drug orders from hospitals

by phone (orders by distributors to manufacturers

continue to be placed over the telephone or by fax).

The services of intermediaries complement the e-

commerce system’s functionality, mostly by offering

a ‘screening service’; if a distributor does not re-

spond to an order, the intermediary will help the

hospital to procure the drugs through other channels.

The intermediaries also improve the efficiency of the

ordering process by harmonizing data. For example,

hospitals often use internal codes to identify drugs.

These codes are matched to standard drug identifiers

defined by the China Food and Drug Administration

(FDA) so that distributors can use the FDA codes for

their internal processes rather than having to cope

with multiple proprietary codes used by hospitals.

While some of the data used for the ordering and

for the bidding processes are identical, the systems

are separated (including separate databases) because

they are regulated by different government agencies

(as a side-effect of this separation, the ordering sys-

tem could also be used by other organizations who

do not have to participate in the bidding process

such as independent pharmacies; because of capacity

problems, however, use of the system is currently

limited to hospitals). Operational efficiencies of us-

ing the e-commerce system for supporting the bid-

ding process are minor as compared to the ordering

process. The main benefits concern ease of selecting

and evaluating drugs which facilitates the work of

the expert group who selects bids. Again, this re-

quires harmonization of data supplied by manufac-

turers (or distributors acting on behalf of manufac-

turers) which is done by the intermediaries.

The vision of Mr. Li, who continues to advise

Haihong regarding further development of its e-

commerce system, is to provide a comprehensive

platform for managing the whole drug supply chain

from manufacturers to hospitals. However, currently

only the order process is supported by the system

and even this support is rather limited (as evidenced

by a lack an order confirmation or change function).

For example, it was intended to use the system for

enabling zero-inventories in hospital pharmacies.

However, hospitals were not interested in such a

capability because they do not have to pay manu-

facturers for unsold inventories. While Haihong’s

system was the first to be developed, the systems of

all three intermediaries are rather similar in terms of

functionality and capacity and do not constitute a

main competitive differentiator for them.

Thus, while the operational scope of the three e-

commerce systems is rather narrow, they are indeed

used for improving operational efficiency of the or-

dering process. For example, while, in 2004 the as-

sociation of drug wholesalers and pharmacies re-

ceived broad support by its constituency when sub-

mitting a petition to government objecting introduc-

tion of the e-commerce-based distribution system,

that support is waning as large distributors (whole-

salers) are discovering operational benefits of the

system and because the system has led to a consoli-

dation of the industry favouring the larger players.

Hospitals have to contract with the intermediary

as well as with manufacturers. Each hospital group

INTERACTION OF TECHNOLOGICAL AND INSTITUTIONAL CHANGE IN THE DEVELOPMENT OF AN

ELECTRONIC COMMERCE SYSTEM IN CHINA’S PHARMACEUTICAL DISTRIBUTION CHAIN - A Transaction

Cost Perspective

selects one intermediary which, however, charges

fees to manufacturers as stipulated by the Beijing

Health Bureau. The licenses of intermediaries need

to be renewed each year but the relationship between

a hospital group and an intermediary tends to be

stable and long-term. Upon conclusion of the bid-

ding process, hospitals have to contract with manu-

facturers that have succeeded in the bidding process.

Occasionally, hospitals also negotiate with manu-

facturers again before placing orders on the e-com-

merce system in order to receive discounts. In the

evaluation process, it is also possible that the bid-

ding centre negotiates with manufacturers who have

participated in the bidding process. This occurs

when for a specific agent (chemical substance) only

one bid has been submitted. In addition, manufactur-

ers use sales agents and other wholesalers to market

and also sell their drugs to hospitals. However, these

agents, who may receive the drugs at a discounted

price, still have to use the licensed distributors for

delivering the drugs to hospitals.

The specific governance structure used for oper-

ating e-commerce systems through intermediaries is

justified by two rationales. First, the main benefit of

the system is seen in the ease of monitoring compli-

ance with the bidding rules. This is considered cru-

cial since hospitals have very strong incentives to

circumvent these rules in order to increase their in-

come through the sale of branded and therefore

high-margin drugs. Second, Mr. Li argues that e-

commerce in China is only viable if facilitated by

third parties. He points to an effort in Shanghai

where wholesalers have tried to build e-commerce

systems to directly connect with hospitals. These

efforts have failed because of the fragmented market

structure (hospitals typically deal with around 30

different distributors), fierce competition among

distributors (forestalling cooperation among them)

and low trust among all parties.

The e-commerce systems, however, are not used

for the purpose of monitoring compliance with the

bidding rules. Specifically, the bidding centre does

not make any use of its ability to log onto the sys-

tems in order to check hospitals’ compliance with

the bidding rules (as reflected in their ordering be-

haviour). While the bidding centre claims that 50-

60% of all purchasing transactions are reported to it

by intermediaries, it turns out that this feedback is

based on aggregated data which are provided by

intermediaries to the bidding centre on paper and

this only upon request which occurs infrequently and

usually only once per year. The intermediaries sug-

gest that the bidding centre lacks the technical skills

required for making sense of the data provided by

the systems directly. The bidding centre itself indi-

cates that its ability to sanction hospitals (through

exposing non-compliance) is rather limited because

it is difficult to tell violations of rules from “market

behaviour”, a view shared by Mr. Li. It was also

frequently mentioned that hospitals often have suffi-

cient “market power” to resist any sanctioning ef-

forts. Mr. Li cited yet another reason for the failure

of the bidding centre to directly use the e-commerce

systems to monitor purchasing behaviour of hospi-

tals. The data in the systems cannot be easily ana-

lysed because of a lack of data standards (apart from

the use of proprietary product codes by hospitals

mentioned above, other data such as names of manu-

facturers are not standardized either). Moreover,

some hospitals ask intermediaries to provide them

with so-called ‘soft systems’ for their data input

which are tweaked so as to make it even more diffi-

cult to monitor their purchasing behaviour.

4 CASE ANALYSIS

Referring to the two propositions developed in the

theory section, it becomes clear that the e-commerce

systems described above have been developed with a

Northian intention. The main idea of Mr. Li -- who

can be viewed as the political entrepreneur described

by North -- was that centralization of the procure-

ment process -- i.e. a specific instance of institu-

tional change -- was only possible if accompanied

by an e-commerce system. He assumed that elec-

tronic commerce would facilitate the monitoring of

hospital drug purchasing behaviour which was a

central element in the introduction of the bidding

process. These costs are an instance of transaction

costs since they concern the monitoring of a con-

tract, albeit one imposed on the participants in the

market. Thus, the e-commerce system’s ability to

reduce transaction costs would be exploited for the

purpose of institutional reform. Also, the organiza-

tions active on the economic market -- mostly dis-

tributors and hospitals -- tried to prevent the institu-

tional reform through lobbying activity.

The bidding process centralized all negotiations

between hospitals and manufacturers while the e-

commerce system centralized ordering and delivery

(for a small group of hospitals in Beijing, govern-

ment has actually taken over all procurement activi-

ties, thus reversing the earlier decree by central gov-

ernment to separate regulation and business activ-

ity). Also, the very idea of solving the problems

characterizing drug distribution through taking over

HEALTHINF 2008 - International Conference on Health Informatics

central control of the process seems to be in line

with the overall ideology of economic policy in

China. Thus, all elements suggested by a Northian

interpretation of the interaction between institutional

and technological change -- technology-enabled in-

stitutional change, activity on political markets to

bring about or prevent the institutional change, a

‘national’ characteristic trait of the intended institu-

tional reform -- seem to be in place.

However, the e-commerce system is not used for

the intended purpose (facilitating institutional

change through reducing the costs of monitoring

compliance with the new rules); yet, the main actors

in the industry continue to offer the rationale of fa-

cilitating monitoring of hospital drug purchasing

behaviour as an explanation for continued use of the

e-commerce systems. While there are several rea-

sons for the factual avoidance of using the system

for monitoring hospital transactions, including bar-

gaining power of hospitals and lack of alternative

funding schemes, the fact that the e-commerce sys-

tems are not used for their intended purpose allows

us to reject the Northian interpretation of this case.

The new institutional process -- the bidding process

-- was not enabled by a reduction of transaction

costs -- in this case monitoring costs -- through use

of the e-commerce system; continued existence of

the new institutional arrangement can only be ex-

plained by government’s use of sanctions and ad-

ministrative force. In addition, significant violation

of the rules stipulated by the bidding process was

tolerated by government agencies which may have

reduced resistance to the new institutional order.

Regarding a Williamsonian interpretation, it

seems reasonable to argue that the e-commerce sys-

tems did not reduce transaction costs but probably

contributed to increased efficiency of the ordering

process. For example, distributors do not have to

handle multiple systems for identifying drugs

through proprietary product codes while hospitals

can place orders to distributors in one process rather

than sending individual orders to each distributor

separately. (Note that costs associated with placing

orders are not transaction costs since they neither

concern the costs of negotiating contracts -- this has

been done through the bidding process resulting in

bilateral contracts between hospitals and manufac-

turers -- nor do they constitute costs of monitoring

contracts; if the supply chain would be controlled by

one organization, it would still be necessary to create

(internal) orders for replenishing inventories in hos-

pital pharmacies.)

On the other hand, transaction costs associated

with the new governance structure may well have

been increased because the bidding process intro-

duced new costs into the distribution system; e.g.,

the expert groups have to evaluate bids on 15 thou-

sand agents (chemical substances) by multiple sup-

pliers. While the e-commerce systems provide some

support for this process, the main work is manual. In

addition, multiple other channels for negotiating

between hospitals and manufacturers continue to be

used. Finally, bilateral contracting between hospitals

and manufacturers is still necessary, although these

contracts are based on the prices quoted in the bid-

ding process. In any case, hospitals would prefer to

bilaterally negotiate with manufacturers even so they

do not have to pay for the work of the bidding centre

(which is completely funded by the Beijing govern-

ment). Also, mandatory use of the new inter-

mediaries did impose some new costs on the distri-

bution system. Presently, these are carried by the

manufacturers (who must -- by law -- be charged for

the intermediaries’ services -- although they serve

the hospital groups). It was anticipated that hospitals

would effectively oppose any efforts to make them

pay for the services of intermediaries, e.g. by asking

manufacturers to take over these fees ).

The governance structure used for facilitating

set-up and operation of e-commerce systems also

seems to display typical ‘Chinese characteristics’ as

these systems are developed and operated by third

parties rather than within a bilateral governance

structure typical for Western EDI-based models of e-

commerce. Thus, all elements suggested by a Wil-

liamsonian interpretation can be identified in the

way these systems are actually used. The govern-

ance structure underlying operation of the e-com-

merce systems is likely to have increased overall

transaction costs in the distribution of drugs between

distributors and hospitals. However, operational ef-

ficiencies in the ordering process could (partly)

compensate for these increased transaction costs. As

the operational efficiencies become clearer, resis-

tance towards using the e-commerce systems wanes

(this fading resistance seems also to be related to

recognition among the main players that the systems

are not used for monitoring their market behaviour).

However, because of a lack of hard data, a Wil-

liamsonian interpretation cannot be proven. More-

over, this lack of hard data could well be implied in

the approach itself, a problem which motivated the

critique of North and Wallis in the first place. Yet,

we find that the Northian interpretation explains the

motives behind the political initiative to create a

centralized, e-commerce-based drug procurement

process while actual use of the system contradicts

such an interpretation.

INTERACTION OF TECHNOLOGICAL AND INSTITUTIONAL CHANGE IN THE DEVELOPMENT OF AN

ELECTRONIC COMMERCE SYSTEM IN CHINA’S PHARMACEUTICAL DISTRIBUTION CHAIN - A Transaction

Cost Perspective

5 CONCLUSIONS

In exploring two alternative transaction cost-based

explanations of the interaction of institutional and

technological change in the case of China’s drug

distribution system, we have found evidence that a

Northian interpretation -- which suggests that trans-

action cost reducing technological change enables

institutional change -- does not apply to the actual

practice of distributing drugs based on new institu-

tional rules and an e-commerce system but does ac-

curately describe intentions and political behaviour

which has resulted in these new arrangements. Ac-

tual use of the e-commerce system and its govern-

ance structure seems to be more in line with a Wil-

liamsonian interpretation which suggests that insti-

tutions and governance structures need to be adapted

to enable implementation of new technology in or-

ganizational systems, resulting in increased opera-

tional efficiency, albeit at the expense of increased

transaction costs.

We therefore conclude that development and use

of new technology as well as intentions associated

with an institutional change and the practices based

on these changes may well follow different ration-

ales. More generally, while a certain perceived inter-

action between technological and institutional

change may motivate these changes, the practices

which result from these changes could follow a dif-

ferent logic of interaction. This result is reminiscent

of early formulations of neo-institutional theory

(Meyer and Rowan, 1977). These formulations sug-

gested that organizations maintain a ‘gap’ between

their internal operational processes and their exter-

nal, symbolic justification of these processes. While

these early propositions have been strongly criti-

cized by institutional theorists themselves (Powell,

1991), our results suggest that such a gap could be

the result of an implementation process in which the

rationales that motivated technological and institu-

tional change continue to exist as a ‘distant echo’ in

actual practices. However, actual practices have

adapted to a different rationale.

While our results are not sufficient to accept or

reject one transaction cost-theoretic interpretation

over the other, they suggest that further exploration

of these two explanations in settings which study the

interaction of technological and institutional change

on an intermediate level between that of individual

organizations and whole economies is a worthwhile

effort. Moreover, our study shows that the two ex-

planations could account for different phases in the

evolution of that interaction, a result which was not

expected at the outset of this study.

ACKNOWLEDGEMENTS

The first author would like to acknowledge support

by the Deutsche Forschungsgemeinschaft (grant

number 1328/2-2); the second author would like to

acknowledge support by the China Natural National

Science Foundation (grant numbers 70621061 and

70672007) and the China MOE Project of the Key

Research Institute of Humanity and Social Sciences

at Universities (number #06JJD630014).

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HEALTHINF 2008 - International Conference on Health Informatics