Jackson Nickerson

Transaction and Competences Approaches to the Theory of the

Firm

Jackson NickersonProfessor of Organization and Strategy

John M. Olin School of Business

Jackson Nickerson

Agenda

Two minutes on “Traditional” transaction cost economics (TCE) and the theory of the firm.

Capabilities/competencies and theory of the firm.

Intersection of Competencies and TCE. TCE responds….

New perspective and new questions. Conclusion.

Jackson Nickerson

Two-minute TCE

“Commons triple” describes the unit of analysis. Conflict, mutuality, and order.

Unit of analysis Transaction … …in its entirety.

Behavioral assumptions Actors are intendedly rational but limitely so

• Boundedly rational.• Actors attempt to be far-sighted.

Actors may behave opportunistically.

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“Traditional” TCE

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.

How should the transaction be organized?

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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 structural alternatives

Market Hybrid HierarchyGovernance Costs

k1 k2 Asset Specificity

Market Hybrid Hierarchy

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k = 0k > 0 k » 0

k » 0

k » 0k = 0k » 0

k » 0

A Williamsonian firm

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.

(Setting appropriability concerns aside.)

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Criticisms of “Traditional” TCE

How does TCE account for the possibility of capabilities?

How does TCE account for “learning”? What is the theory of value creation?

Which transactions are undertaken?

Application of TCE is problematic for pre-paradigmatic/entrepreneurial applications.

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Capabilities/Competencies

Key questions: 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?

Sometimes called capabilities, dynamic capabilities, or competences. Collectively Knowledge-based view of the firm (KBV).

Resources consist of know-how that can be traded, financial or physical assets, human capital.

Capabilities are the capacity to deploy resources. Main assumptions:

Bounded rationality.• Knowledge is “sticky”.

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How do capabilities arise?

How capabilities arise has received little attention.

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… …rather than from incentives, opportunism, and

transaction costs. Basic proposition is that hierarchy is a “creator of a

positive” instead of an “avoider of a negative.”

Main prediction: Internalize activities that can be carried out at lower (production) cost than other firms. “Dynamic transaction costs” indicates teaching is costly. Internalize those activities that rely on “core

competencies.”

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How do capabilities contribute to the theory of the firm?

Firms economize on the exchange of knowledge rather than 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 are likely to yield

different marginal benefits. Invest in capabilities that yield the greatest marginal

returns to investment.

(Setting appropriability concerns aside.)

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Critical concerns

Should KBV assumptions omit opportunism? What is the unit of analysis? How can competencies be operationalized? 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” parameterMarket 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? Strategizing

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?

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New perspective?

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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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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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).

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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

Simon and NK models. 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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Knowledge formation hazards

Knowledge appropriation Arrow information paradox (asymmetric information

and zero marginal cost). Knowledge hoarding or embedding knowledge in

products. Contaminates effort to promote knowledge sharing

needed for heuristic search.

Strategic knowledge accumulation Actors have an incentive to accumulate specialized

instead of co-specialized knowledge—strategic manipulation of trial ordering.

Leads to conflict over trial ordering for heuristic search.

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Analysis of governance alternatives

Instruments of governance Assignment of decision rights over the path of solution

search and corresponding conflict resolution mechanisms.

Communication channels to support knowledge transfer. Incentive to motivate search.

Comparative assessment of governance alternatives for overcoming knowledge formation hazards.

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Three organizational archetypes

Markets – the use of contracts. Hierarchy

Authority-based hierarchy: • 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.

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CBH failure

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

Instead of explaining why firms exist, PSP explains when firms exist and in what form.

PSP reconciles contradictory knowledge-based explanations for the existence of firms.

PSP is based on probabilistic assessment of solution discovery, thus aligning governance does not guarantee discovery. serendipity is possible. multiple valuable solutions are possible and

continuing search depends on a cost benefit analysis.

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Discussion

PSP implicitly assumes successively chosen problems are independent—this is not the case. 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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New questions?

Manager’s/Entrepreneur’s role is to match problem opportunities with solution opportunities. What problems should managers choose? How do knowledge acquisition and experience shape

cognitive frame for identifying and choosing problems? How does manager’s (incomplete) knowledge of

accumulated trials shape problem choice? How do managers shape expectations over the value of

problem opportunities? How do managers shape expectations of likelihood and

cost of solution opportunities?

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Other extensions?

How does the number of knowledge sets impact complexity and organizational choice?

What are the tradeoffs in substituting acquisition, accumulation, and application of manager’s knowledge sets for CBH?

What factors determine the choice of various “hybrid” modes of governance?

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How to assemble and organize 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

Jackson Nickerson

In conclusion …

I reviewed “traditional” discussions about knowledge and competency-based theories of the firm.

I tried to be controversial by offering a new perspective on a knowledge-based theory of the firm.

I hope this material leads to useful discussions.

Thank you for the opportunity to share my thoughts with you.