Joanna Tyrowicz

Limits of an enterprise

Institutional Economics

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“But I thought you were going to talk about econometrics?!”

Two minutes on transaction cost economics (TCE) and the theory of the firm Capabilities/competencies and theory of the firm Intersection of competencies and TCE Problem solving perspective

New perspectives and new questions Correcting for endogeneity Bringing the market inside the firm

Example of research: truck transport industry in US

Conclusions

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What do we think about an enterprise?

Behavioral assumptions Actors want to be rational but there are limits:

Boundedly rational Actors attempt to be far-sighted

Actors may behave opportunistically Asset specificity is the “big locomotive”

Investments that produce cost savings or quality benefits for a one or small number of potential customers (quasi-rents)

Frequency and uncertainty also matter Main focus is on ex post maladaptation problems

Hold-up Underinvestment Measurement issues are implicated

Fundamental (intertemporal) transformation alters exchange from market to bilateral monopoly

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Comparative assessment of discrete structural alternatives

Governance Mode

Market Hybrid Hierarchy

Instruments

Incentive intensity

Administrative Controls

Contract Law

Performance Attributes

Adaptation (A)

Adaptation (C)

++ strong, + semi-strong, 0 weak, Williamson (1996, 103)

++ + 0

Classical Neoclassical Forbearance

++ + 0

0 + ++

0 + ++

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Alignment of discrete alternatives

Market Hybrid HierarchyGovernance Costs

k1 k2 Asset Specificity

Market Hybrid Hierarchy

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A Wiliamsonian firm

k = 0k > 0 k » 0

k » 0

k » 0k = 0k » 0

k » 0

Vertically Integrate

k » 0

k » 0

k » 0k » 0

k » 0

k > 0Complex Contract

Simple Contract

k = 0

k = 0

Core of the Firm

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Implications for firm performance Main predictions:

Vertically integrate in response to deep co-specialization Hybrid in response to moderate levels of co-specialization Market in response to low levels of co-specialization

Aligning transactions in an economizing way yields superior firm performance (profitability, survival)

Firms presumably invest in asset specificity because it creates value

Capabilities/competences What are capabilities? How do capabilities arise? What is the capabilities-based theory of the firm? How do capabilities influence firm performance?

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What are capabilities? Capabilities = dynamic capabilities = competences

Knowledge-based view of the firm (KBV)

Resources = KH (tradedable), financial or physical assets, HC.

Capabilities = the capacity to deploy resources.

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What are capabilities? Main assumptions: Bounded rationality <=> knowledge is

“sticky”. Two views:

Myopic view Passive spillovers from tacit and endogenous

learning-by-doing processes. Path-dependent evolutionary process. Largely informal processes of accumulation.

Farsighted view Deliberate and sustained investment of financial

and managerial resources generate capabilities. Largely formal processes of accumulation.

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What is the KBV theory of the firm?

Theory of firm derives from knowledge-based considerations… not the incentives, opportunism, and transaction costs hierarchy is a “creator of a positive” not only an “avoider of

a negative.” Main prediction: internalize activities that can be carried out at

lower (production) cost than other firms “Dynamic transaction costs” => teaching is costly Internalize those activities that rely on “core competencies”

Firms economise on the exchange of knowledge not on opportunism. Two competing claims:

Hierarchy economizes on knowledge transfer Authority avoids the need to transfer knowledge

Hierarchy facilitates knowledge transfer Shared language and identity facilitate transfer

Capabilities lead to firm heterogeneity

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How do capabilities influence firm performance?

Capabilities yield superior profitability/survival. Different capabilities likely to yield different marginal

benefits. Invest in capabilities that yield the greatest marginal

returns to investment. Should KBV assumptions omit opportunism? What is the unit of analysis? How can competencies be operationalised? What are the deficiencies of hierarchy?

KBV fails to predict when hierarchies supplant markets and vice-versa.

What is the theory of value? Which competencies are valuable? Which competencies should be invested in?

How does KBV apply to entrepreneurship?

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Williamson’s (1999) response Generic

How do alternative generic modes compare for purposes of organization transaction X?

Williamson’s traditional theory is capability neutral. Particular

How should firm A, with its pre-existing strengths and weaknesses (i.e., competencies), organize transaction X?

Williamson (1991) made provision for pre-existing capabilities.

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Accounting for pre-existing capabilities:

The “shift” parameter

Market Hybrid HierarchyGovernance Costs

k1 k2 Asset Specificity

“Positive” capabilities reduce sum of transaction and production costs.

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Further refinement opportunities Fixed niche

How do the pre-existing competencies of Firm A compare to rivals with respect to market niche 1?

Variable niche How do the pre-existing competencies of Firm A

compare with rivals with respect to many niches? Repositioning

How should firm A, with its competencies, reposition for the future in relation to its strategic situation?

Strategising If firm A possesses monopoly power, how can it best

deter and discipline actual and potential rivals?

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Nagging concerns Need a theory of value for further refinements. Which transactions should managers choose? What guidance do we have for generating and using

knowledge/capabilities? How are capabilities created? How does TCE apply in a knowledge economy? Is the transaction the “best” unit of analysis when thinking

about knowledge? How should knowledge be organized inside the firm?

PROBLEM SOLVING PERSPECTIVE

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What is the Problem Solving Perspective?

Knowledge-based objectives of a manager and choosing problems to solve.

Solution landscapes and complexity Different ways to search landscapes for solutions Knowledge formation hazards Alternative governance structures

Markets Authority-based hierarchy Consensus-based hierarchy

Discriminating alignment

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Problem-solving perspective (PSP) Focuses on the creation of new knowledge. Uses a comparative governance logic. Assume bounded rationality and opportunitsm. Predicts not only firm boundaries but also alternative

internal organizational structures (discriminating alignment logic).

“Competencies” are generated from the theory. Makes explicit provision for path dependence. Utilizes a unit of analysis new to TCE. Potentially informs choice of “problems”. Relates to an entrepreneurial theory of the firm.

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Knowledge-based objectives of a manager

1. Choose problems with potential solutions high in value.2. Organize to optimize likelihood, speed, and cost with

which valuable solutions are discovered.3. Appropriate a portion of the solution’s value. Set aside (3), focus on (2) for different types of (1).

Solution landscapes Innovative solutions to complex problems arise from

recombinations of existing technology/knowledge. Solution landscape: Set of all possible combinations of

relevant existing knowledge. Terrain of landscape changes with interdependency of

knowledge sets. Value of the global maximum rises but average peak

declines as interdependency increases.

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Dimensionalizing solution landscapes

Decomposable problems: value of solutions depends very little on the

interaction among knowledge sets—low interaction. Nearly decomposable problems:

value of solutions depends somewhat on the interaction among knowledge sets—moderate interaction.

Non-decomposable problems: value of solutions is highly dependent on interaction

among knowledge sets—high interaction.

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Low complexity solution landscapes:

Decomposable problem

0

0.75

1.5

2.25 3

3.75

4.5

5.25 6

6.75

7.5

0

1.5

3

4.5

6

7.5

Solution Value

Knowledge set B

Knowledge Set A

Knowledge Set B

Solution Value

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Moderate complexity solution landscape:

Nearly decomposable problem

0

0.5 1

1.5 2

2.5 3

3.5 4

4.5 5

5.5 6

6.5 7

7.5 8

0

1.5

3

4.5

6

7.5

Solution value

Knowledge set A

Knowledge set B

Knowledge Set A

Knowledge Set B

Solution Value

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High-complexity Solution Landscape:

Non-decomposable Problem

0

0.5 1

1.5 2

2.5 3

3.5 4

4.5 5

5.5 6

6.5 7

7.5 8

0

1.5

3

4.5

6

7.5

Solution value

Knowledge set A

Knowledge set A

Knowledge Set A

Knowledge Set B

Solution Value

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How can we find a high peak? Search is uncertain: Central issue is the pattern of trials to

undertake. Pr(val.sol.)~0 if problem complex and trial choice

random. Directional search:

Expected value of a particular trial is determined by reference to one or more nearby trials.

Heuristic search: Expected value of a trial depends on developing

heuristics about knowledge set interaction. Bounded rationality and distributed knowledge makes

heuristic search more costly than directional search.

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Efficiently searching solution landscapes

Attributes of Knowledge Formation

Decomposable

Nearly Decomposable

Non-decomposable

Trial Ordering and Selection Mechanism

Directional Search

Heuristic Search

++ + 0

0 + ++

Relative benefit of trial ordering and selection by problem type

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Three organizational archetypes Markets – the use of contracts Hierarchy

Authority-based hierarchy (ABH): Vertical communication and codes “Design rules” Direction to subordinates—manager orders trials

Consensus-based hierarchy: Horizontal communication and codes Commonality of goal Group decision making—groups order trials

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Markets

Hayek—markets are a “marvel” for transferring knowledge. Instruments support directional not heuristic search.

High-powered incentives to specialize and exploit knowledge.

Weak supports for investments in knowledge sharing or language to facilitate knowledge sharing.

Weak conflict resolution (classical contract law) over trial ordering.

Markets are efficient for decomposable problems but fail as landscapes become increasingly complex.

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Authority-based hierarchy

Demsetz—“authority … serves to economize on the transmission and handling of knowledge.”

Instruments moderately support directional and heuristic search. Low-powered incentives attenuate knowledge

appropriation hazard. Supports vertical (not horizontal) communication

channels and codes to facilitate central figure acquiring, accumulating, and applying knowledge to guide search.

Conflict resolution through authority dampens strategic knowledge accumulation hazard.

ABH is efficient for nearly decomposable problems.

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ABH failure ABH fails for non-decomposable problems because

central figure can not acquire, accumulate, and apply requisite knowledge to develop necessary heuristics.

it does not support horizontal communication channels. central figure contaminates trial ordering due to

meddling. ABH fails for decomposable problems because

number of knowledge sets is beyond manager’s cognition.

central figure contaminates trial ordering due to meddling.

weak incentives limit specialized knowledge formation. excessive costs of knowledge sharing.

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Consensus-based hierarchy Arrow—consensus utilizes specialized knowledge sets housed within the firm

and can substitute for authority. Consensus arises when knowledge transfer is inexpensive and actors

have an overriding commonly valued purpose. Instruments support heuristic not directional search.

Low-powered incentives attenuate knowledge appropriation hazard. Supports horizontal communication channels and codes (and commonly

valued purpose) for knowledge sharing. Conflict resolution through social relations, which attenuates strategic

knowledge accumulation hazard. CBH is efficient for non-decomposable problems. CBH fails for problems with moderate to low complexity because

of excessive costs of maintaining communication channels. social attachments may misguide and bias search. social attachments may limit the firm’s capacity to absorb new forms of

knowledge and hence lead to inferior solutions.

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Comparative assessment of alternatives

Governance Mode

Hierarchy

Market ABH CBH

Instruments

Incentive intensity

Communication codes and channels

Dispute resolution regime

Performance Attributes

Directional search

Heuristic search

++ 0 0*

Contract law Authority Relational

++ + 0

0 + ++

0 Vertical Horizontal

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Discriminating alignment of Governance alternatives

Market ABH CBHExpected cost of finding a valuable solution

K1 K2 Complexity

Market ABH CBH

*Holding N constant

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Discussion about PSP Instead of explaining why firms exist, PSP explains when firms exist and

in what form PSP reconciles contradictory knowledge-based explanations for the firms PSP is based on probabilistic assessment of solution discovery, so:

aligning governance does not guarantee discovery serendipity is possible multiple valuable solutions are possible and continuing search

depends on a cost benefit analysis Implicitly and wrongly assumes successively chosen problems

independent Extant knowledge sets within firm shape problem choice

knowledge development and protection a concern not currently considered in our governance choice logic

While PSP focuses on a single problem, impetus for path dependence is inherent in model Boundaries may change in response to problems chosen Problems have their life-cycles Change problems or change knowledge and organization

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Does PSP add value? Criticisms of KBV and TCE

Is opportunism considered? Is the unit of analysis operational? Can it account for capabilities? Can competencies be

operationalized? How are capabilities created? Is “learning” accounted for? Is value creation considered? Are deficiencies of hierarchy

described? Is there a discriminating alignment? Which transactions are undertaken? Does in inform entrepreneurship? Which competencies are valuable? Does it unpack path dependence?

KBV TCE PSP 0 ++ ++ 0 ++ + + + + + 0 + + 0 ++ + 0 + + 0 ++ 0 + ++ 0 ++ ++ + 0 + 0 0 + + 0 ++ + 0 ++

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How to assemble and organise knowledge?

Problem complexity

Complex contractingComplex

contracting Authority-based

hierarchy

Authority-based

hierarchy

Consensus-based

hierarchy

Consensus-based

hierarchySimple

contractingSimple

contracting

Opportunity cost of acquiring knowledge

Firm BoundaryJoint-

venturesJoint-

ventures

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Example: US truck transport industry

Paper by Hamilton and Nickerson (ASQ) Compare LT and LTL, for-hire trucks in US

How they differ LTL hub-and-spoke => large investment needs, LT

door-to-door => less... LT as one-to-one, LTL as one-to-many solutions

(more need for coordination in LTL) LTL should be one, LT can be dispersed (little

benefits from internalisation) Question: how is profitability affected by driver

missalignment? Answer: those, who misalign have lower profits

ceteris paribus

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Bringing the market inside the firm

Baker, Gibbons and Murphy (AER) Theoretical model:

Upstream party, downstream party and assets Transaction contains contractible (court-enforceable) and

noncontractible (bargaining, hold-up, etc.) components Compare spot employment and spot outsourcing

Conclusions: Informal spot markets cannot be replicated within firm Relational employment can improve both spot alternatives via

providing adequate incentive structure (separating equilibrium) Why important?

Selective intervention can provide a viable alternative to „infinitely huge” firms

Sometimes selective intervention impossible Relational contracts are important inside firms because they

improve on market outcomes (and not because they replicate spot-market payoffs)