Economic Foundations Conclusion – Part 2

This is the second part of the review of the Economic Foundations of Strategic Management. Part 1 here.

Transaction Cost Theory

  • Key idea:
    • There are costs associated with having operations inside the firm (hierarchy) or outside the firm (market).
  • Assumptions:
    • Self-interested behavior, bounded rationality.
    • Uncertainty and risks.
  • Unit of Analysis:
    • Transaction Costs.
  • Seminal papers and authors:
    • Coase (1937)
      • There are costs to use market transactions. 1) costs of discovering what the relevant prices are 2) negotiating and concluding a separate contract for each 3) difficulties of specifying all in a contract. By forming an organization and allowing some authority (entrepreneur) to direct resources, certain costs are saved.
    • Alchain & Demsetz (1972)
      • They emphasize measurement problem in team production. They examined the difficulty of metering output in team production in which union or joint use of inputs yields a larger output than the sum of the products of the separately used inputs. They view a firm as a contractual structure arises as a means of efficiently organizing team production.
    • Klien, Crawford & Alchain (1978)
      • Contracts are open to serious risks. In the presence of appropriable quasi-rents, the possibility of post-contractual opportunistic behavior is real. This can be solved through vertical integration or contracts, with vertical integration being more likely.
    • Williamson (1985)
      • Unlike Alchain and Demsetz (1972), Williamson highlights the problem of opportunism in the context where executing transaction requires specific investments. According to him, transaction costs refers to negotiating, concluding and enforcement costs associated with transactions taking places in the market place. There are six main factors that produce transaction difficulties. 1) bounded rationality 2) opportunism 3) uncertainty and complexity 4) small number trading relationships 5) asset specificity 6) information impactedness. The joining of the different pairs of the factors generates particular transaction difficulties and they become serious especially when specific investments are required and information asymmetry between two parties is substantial. In theory, it is possible to use the market transaction if a comprehensive contingent claims contract is made; but in practice, it is almost impossible or prohibitively expensive to specify all the conditions, let alone monitoring such complicated contacts.
    • Jones & Hill (1988)
      • Transaction costs should be incurred in order to use market transactions and they can be economized if the economic benefits of internalizing the transaction exceeds the bureaucratic costs of organizing transactions using a hierarchy. There are three ways to realize economic benefits from internalization. Economic benefits from vertical integration occurs when concerns about opportunism in small number trading relationships and information asymmetry between two parties is substantial. Economic benefits from related diversification are generated when inputs are shared or utilized in complete congestion. It is very difficult to realize such synergistic gains through market transactions due to transaction costs. Economic benefits from unrelated diversification have to do with the market failure as well as information asymmetry. Compared to external market investors who are at the disadvantage of information asymmetry and control disadvantage, the head office has overcome such weaknesses through its relationship with operating units. By acquiring a firm and exposing it to the discipline of efficient internal market competition, the head office, compared to external market investors, is at advantage of allocating resources more efficiently and thus increases performance.
    • Teece (1982)
      • Diversification is driven by excessive capacity and its creation, market imperfection, and the peculiarities of organizational knowledge, particularly its fungibility and tacit nature.
    • Hill (1990)
      • Even when asset specificity is high, the problems of opportunism may be mitigated by systems of market in which selection favors actors with good reputation concerning trusting and cooperating relationship. However, transaction cost theory ignores a dynamic evolutionary process for such behavioral repertoire, and in this regard, their rationale for vertical integration may be overstated.
  • Similarity or relationship to other theories:
    • Agency theory makes similar assumptions to human behavior and human limits.
  • What kind of predictions can be made:
    • Make-or-buy decisions.

Resource-Based View

  • Key idea:
    • Sustained competitive advantage comes from idiosyncratic resources.
  • Assumptions
    • Tacit know-how resides in organizational routines.
  • Unit of Analysis:
    • Resources.
  • Seminal papers and authors:
    • Lippman & Rumelt (1982)
      • Uncertain imitability. This concept allows us to deal with causal ambiguity that exists when a link between resources controlled by a firm and its sustained competitive advantage is not understood perfectly.
    • Wernerfelt (1984)
      • He introduced the idea of analyzing the firm with a resource-product matrix instead of growth-share matrix. Also, diversification is discussed as a dynamic resource management. Acquisition is seen as a purchase of bundles of resources in a highly imperfect market.
    • Barney (1986a, 1986b)
      • For a firm’s resources to have sustained competitive advantages, they should have following attributes: 1) Valuable: resources should make the firm to exploit opportunities and/or neutralize threats in a competition. 2) Rare (path dependency assures this) among a firm’s competitors. 3) Inimitable (uncertain imitability Lippman and Rumelt 1992) -valuable and rare resources can be a source of sustained competitive advantage only when they are inimitable by competitors, and this is often true because a firm’s ability to acquire and exploit such resources depend on a firm’s unique historical conditions( place in time and space).
    • Conner (1991)
      • He argues that RBV provides an alternative rationale for the questions like why a firm exists and what determines a firm’s scale and scope. He maintains that heterogeneous firms continue to exist because the assets with which firms will come be mated are themselves heterogeneous, making each other a better fit than other firms. The theory views a firm as “a creator of unique productive value” instead of “an avoider of negative”. The scale and scope of a firm depends on a degree of to which new projects are specific to a firm’s current resource base. He also compares the RBV with other five traditional industrial organization economics. As the neoclassical view of the firm, RBV views a firm as an input-combiner but it does not include the assumptions of neoclassical views. Like the Bain-type IO, the RBV agrees that it is possible to make above-normal earnings but the profits come from idiosyncratic, immobile resources of a firm, not from the artificial reduction of industry outputs. As Schumpeter, the RBV recognizes the power of creative destruction (innovation) to shift market structure, but the RBV does not need large-scale industry incumbents for such initiative. Finally, like the Chicago school but unlike the Bain-type IO, the RBV sees such rents coming from luck or acumen of entrepreneurs in acquiring, combining and deploying such resources (conduct), not from the structure of the industry in which firms operate.
    • Barney (1991)
      • Building on the assumptions that strategic resources are heterogeneously distributed across firms and that these differences are stable over time, this articles examines the link between firm resources and sustained competitive advantage. Four empirical indicators of the potential of firm resources to generate sustained competitive – value, rareness, imitability, and substitutability – are discussed.
    • Reed and DeFillippi (1990)
      • Argues that causal ambiguity is a function of tacitness, complexity, and specificity of competency
  • Similarity or relationship to other theories:
    • Dynamic capabilities – RBV looks at resources, DC looks at capabilities.
  • What kind of predictions can be made:
    • Impact of resources on firm performance, strategy.

Dynamic Capabilities

  • Key idea:
    • Sustained competitive advantage comes from capabilities.
  • Assumptions:
    • Competition as a process (Neo-Austrian economics).
  • Unit of Analysis:
    • Capabilities.
  • Seminal papers and authors:
    • Alchain (1950)
      • Like the biologists, the economist can predict the effects of environmental changes on the survival class of living organisms.
    • Schumpeter (1950)
      • The essential character of capitalism is its evolutionary process driven by a perennial gale of creative destruction
    • Nelson and Winter (1982)
      • Evolutionary relies on a cumulative learning-based view of organizational competence in the face of exogenous changes in the economic subsystem. Evolutionary theory explains how particular organizational forms come to exist in specific kinds of environments. The process is not necessarily efficient and path-dependent process can often lead to an outcome other than those implied by historical efficiency. Capabilities are captured in the organizational routines. Routines are the result of trial and error as organizational learn. Routines reflect the knowledge base of organizations. We can predict how organizations will behave in the future according to their routines, and even a high-level of complex problem solving efforts may fall into a quasi-routine pattern.
    • Nelson & Winter (2002)
      • Building on the assumptions that strategic resources are heterogeneously distributed across firms and that these differences are stable over time, this articles examines the link between firm resources and sustained competitive advantage. Four empirical indicators of the potential of firm resources to generate sustained competitive – value, rareness, imitability, and substitutability – are discussed.
    • Teece et al (1997)
      • Dynamic capabilities framework (Efficiency-oriented): Stresses exploiting existing internal and external firm-specific competences to address changing environment. Conclusions: 1) Private wealth creation in regimes of rapid technological change depends in large measure on honing internal technological, organizational, and managerial processes. 2) Identifying new opportunities and organizing effectively and efficiently are more important than strategizing.
  • Similarity or relationship to other theories:
    • RBV looks at resources, DC looks at capabilities.
  • What kind of predictions can be made:
    • Impact of capabilities on firm performance, strategy.
(Adapted from course notes)
(Flashcards and other resources here)

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