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journal of Management Studies 3 1 2 March 19940022-2380

THEORIES OF TH E FIRM: IMPLICATIONS FOR STRATEGYRESEARCH*

ANIU ETHUniversip of HoustonHOIVARIIH O h l A S

University of Illinois at Urbana- Champaign

A B S T R A C T

Theories of the firm provide a perspective for thinking about organizationalobjectives and a framework for analysing important research problems. Here,we demonstrate the usefulness of several economic theories of the firm forguiding strategy research. We evaluate the relevance of each theory withregard to how the underlying conceptualization of the firm permits us toinvestigate issues of substantive interest to strategy researchers, and howcompatible the assumptions contained within the theory are with the traditio-nal strategy framework. We also examine the relevance of the theories fromthe viewpoint of philosophical methodology. We argue that, because of theintegrative nature of strategy research, it is imperative for researchers toadopt multiple frameworks represented by different theories for the advance-ment of the field.

I N T R O D U C T I O NThere is continuing interest in establishing the boundaries of the strategydiscipline and identifying models which can promote promising researchinitiatives. It is useful to categorize two broad areas of theory developmentin the field, namely ( 1 ) strategy formulation research and (2) strategyimplementation research (Schendel and Hofer, 1979). Theoretical develop-ments in these areas have differentially drawn from various disciplines,depending on where there are most natural overlaps regarding the researchphenomenon of interest: strategy formulation research from economics, andimplementation research from organization theory, sociology an d psychology.Since these underlying disciplines themselves approach the study of organiza-tions with widely differing paradigms, i t is not surprising that researchersacross the subfields of strategy have differing orientations to the process oftheorizing. However, as the strategy area matures and there is an accompany-ing increase in the range and depth of strategy research in both subfields, theAddressJbr reprints: Anju Seth, Depa rtment of Man ageme nt, College of Business Adm inistrat ion,University of Houston, Houston, T X 77204-6283, USA.0 asil Blackwell Ltd 1394. Publis hed b) Blackwell Publishers, 108 Cowley Road, Oxford OX4 ],IF,UKa n d 238 M ~ i ntreet, Cambridge, M A 02142, U SA .

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166 ANJU SETH A N D H O W A R D T H O M A Sdifferences in these orientations will become even sharper and increase debateabout their comparative relevance. I n this context, an important issue arises:what are the appropriate boundaries of the strategy discipline? This issueimplicitly pervades the intellectual environment faced by strategy resear-chers: i t is an (often unstated) criterion used to judge the value of researchpapers in formal or informal reviews.

The purpose of this article is to examine the boundary issue in the specificcontext of the relevance of economics and finance for theory development instrategy. The questions we consider are, Can different perspectives in theeconomics and finance literatures be utilized fruitfully by strategy resear-chers? What are useful criteria to apply in ascertaining the relevance of theseperspectives?

The first step we take towards addressing these questions is to explain thedifferent frames of reference typically adopted by economists. These framesof reference are captured in alternative theories of the firm. Specific questionsaddressed by these theories include Why do firms exist? What factorsdetermine the scope and size of the firm? What is the function of the firmand its managers? Each theory consists of a logically consistent network ofconcepts and assumptions regarding not only the goals of the firm but alsothe behaviour and motivation of managers. An important role of the theoryof the firm is to provide a way of conceptualizing the business enterprise inorder to investigate some phenomena of interest and particularly, issues ofcompetition.

The relevance of theories of the firm from the economics and financeliteratures is judged according to two criteria. In the first place, the theoriesmay be relevant on substantive grounds, i.e. with reference to the conceptsthey contain and the relevance of these concepts to the issues of interest forstrategy researchers. T o examine this, we briefly describe mainstream ver-sions of the theories and link these to the phenomena they were constructedto investigate. It is clear that economics and strategic management have, inLaudans (1984) terminology, different research traditions, with differentcognitive values, aims and methodologies: the difference in research traditionsidentifies that these are in fact separate fields of inquiry. T he questions askedby strategy researchers differ in general from those asked by economists(though, as we shall show, the boundaries a re becoming diffuse).To evaluate the implications of the theories for strategy, we investigate theparallels between the domains of interest of economic theorists and strategyresearchers. We also discuss the extent to which the assumptions underlyingthe economic theories are compatible with those of strategy research. Practi-cal considerations preclude us from being comprehensive with respect to thedepth of our description of the various theories. The interested reader isreferred to the original authors cited for more detailed discussions. Similarly,we restrict our discussion to a selective list of the theories, those which in ourview are particularly useful to examine in the context of the overall goals ofthe article.

In discussing the substantive relevance of the economics theories of thefirm, we use as a guidepost the following definition of strategy: A strategy isthe pattern or plan that integrates a n organizations major goals, policies and0 asil Blackwell Ltd 1994

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T H E O R I E S OF T H E FIRM IN STRA TEGY RESEARCH 167action sequences into a cohesive whole. A well-formulated strategy helps tomarshal and allocate an organizations resources into a unique and v iab leposture based on i ts relat ive inter nal competencies an d shortcom ings, antici-pated changes in the environment, and contingent moves by intel l igentopponents (Q uin n, 1980, p. 5; see also Rum elt , 1984 an d Teece, 1984). Th isdefinition implies that an organization is a purposive and entrepreneurialentity with specialized un ique resources w hich interacts with its environ m entto maintain long-term viabil i ty. We propose that a theory of the f irm mustbe consistent with these elements to serve as a useful backdrop for strategyresearch. We highlight broad topics of research interest where differenttheories of the firm provide useful insights.The relevance of the economic theories of the firm for strategy research isalso addressed from the perspective of philosophical methodology. We sug-gest that theory-building in strategy has typically followed an inductive andnormat ive appro ach; in economics, on the o ther hand , the do m inan t philo-sophical ap pro ach is deductive an d positive. W e examine th e implications ofthese differences in philosophical methodology for cross-fertilization betweenthe fields.A central proposition of our article is that the research tradition ineconomics is consonant with th at of strategic manag emen t. While the econo-mic theories of the firm therefore have the potential to inform strategyresearch, the potential will be most usefully utilized in the context of theunique app roac hes of the strategy research tradition.Finally, we explore the question of whether a common theory of the firm,one that is subscribed to by all strategy researchers across both the strategyformulation and implementation areas is possible to develop, and indeed,whether such a theory is necessary. To wh at extent is i t useful to circumsc ribethe boundaries of the field in the interests of maintaining a shared f ram e ofreference? If boundar ies expand, is there a d ang er of losing the un iqu e ( an dwe claim, valuable) general management perspective characteristic of stra-tegy research? These are controversial issues with no easy answers. Ourperspective is: given the evolving and diverse nature of strategy research, i tis difficult to construct an all encompassing theory of the firm, and alsopremature to select a single theory to the exclusion of all others. Multipletheories of the firm a re necessary to answer the variety of research question sof interest to the field. However, i t is simultaneously imperative to m ainta inthe uniqu e genera l ma nage me nt perspective of strategy research, wh ich seeksto overcom e the narrowly functional focus of som e other b ran ch es of organiza-tional theory.

TH E N EOC LASSICA L T H EO R Y OF T H E F I RM

The theory of the firm in neoclassical economics was constructed to investi-gate the way in which prices an d the allocation of resources am on g differentuses are determin ed, an d is pa rt of the wider theory of value (Penro se, 1 959).In this context, the appropriate model of the firm describes the forces thatdetermine the prices and quantities produced of particular products by the0 asil Blackwell Ltd 1994

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T H E O R I E S OF T H E F I RM IN STRATEGY RESEARCH 169individua l firm. T h e firm is represented by a produ ction function wh ichcaptures the underlying technology used to employ the forces of labour andcapital for the purposes of generating goods and services. This underlyingtechnology is typically assumed to be subject first to increasing returns toscale, which imply a declining average cost curve, and then to decreasingreturns to scale, which d rive average cost up. T h u s the conventional averagecost curve is assumed to be U-shaped and the optimum size of the f irm isindicated as the lowest point of the average cost curve for its given product.T h e key assum ptions of neoclassical theory a nd of the ot he r theories of thefirm discussed below are summarized in table I . In the discussion of thetheories below, we highlight the differences between these assump tions, an ddiscuss their compatibility with strategy research.The Firm in Traditional Industrial Organization EconomicsA similarly instru m en tal view of the firm was taken by th e early indus trialorganization (10) econom ists following the traditional Bain-M ason stru c-ture-conduct-performance par adig m . T his l i terature has a normative orien-tation towards explaining inter-industry differences in performance, whereperformance is the extent to which the profitability of firms in the industrydep arts from the Pa retian al locative efficiency ideal . I n this app roac h, exoge-nous dem and and supp ly condit ions determine industry s t ructure . T he re isa unidirectional causal flow from stru ctur e thro ugh condu ct to performance.Typ ically conduc t is either ignored entirely or else profit-maxim ization un de rzero conjectural variation is assumed (where conjectural variation refers tohow the firm conjectures that its rivals will respond to i ts actions) (Reid,1987). The essential form of the model is that performance depends uponvarious properties of the industry including the degree of concentration,diversification, ba rriers to entry, the presence of scale economies , and produ ctdifferentiation.Tra dit io nal I 0 theory differs from neoclassical theory in the followingbroad terms:

(1) T h e focus in neoclassical m icroeconomics is the theory of price an d intraditional I 0 the theory of market s tructu re. A new se t of explan atorystructure variables is introduc ed by the I 0 approach;(2) I 0 economics has a normative orientation towards the shaping ofpublic policy rather than the predominantly positive orientation ofneoclassical microeconom ics;(3 ) I 0 economics has a more empirical flavour.However, in both views the firm is characterized by the same black boxmetaphor. That is , these frameworks in general do not al low for f irmheterogeneity within an industry except as regards scale.

Another important assumption of neoclassical and tradit ional theories ofthe f irm, a nd of m any othe r theories of the f irm discussed below, is tha t ofeconomic Darwinism. T h e basic argu m ent is that the environment rew ardswith survival those firms which select strategies which happen to be optimal;firms which deviate from optimal behaviour will tend towards extinction0 asil Blackwel! Ltd 1994

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170 ANJU SEIH A N D H O WA R D T H O M A SUensen, 1983). Each theory implicitly or explicitly makes reference to someset of environmental variables which managers are expected to perceive andrespond to in selecting their actions.What are the implications of this assumption for evaluating the role ofeconomic theories to strategy content research? To address this, i t is usefulto make a distinction between what we here call strong-form and moderateeconomic Darwinism. Strong-form Darwinism indicates that the environmentis an immutable given, and firms merely react to environmental forces. Thereis one-way causation between the attributes of the environment (in thecontext of the neoclassical theory, these variables include supply and demandconditions with or without the moderating effects of market structure) andfirm conduct. A more moderate form of economic Darwinism treats outcomesas a result of the subtle interactions of the continued striving by purposefulindividuals and the natural selection properties of the environment Uensen,1983, p. 322, our emphasis). This viewpoint makes allowance for mutualfeedback effects between structure, conduct and performance.We suggest that those theories which assume firm homogeneity and strong-form economic Darwinism will have limited relevance for strategy research.Both the neoclassical and traditional I 0 economics views typically treat thefirm as a product of deterministic forces and ignore interfirm differences. Thisfocus on the featureless reactive firm in the industry or in the economy isappropriate for developing price theory or investigating industry structure inthe context of public policy issues. However, this view is incompatible withthe typical strategy perspective of the entrepreneurial firm which makesproactive decisions to optimally utilize its unique specialized resources. Wesuggest, however, that the moderate Darwinist viewpoint is consistent withthe key ontological components of strategy research since it allows recursiveeffects of firm behaviour on the environment.We earlier proposed that strategy research necessarily posits the firmexisting in some environment. To the extent that the different theories of thefirm make reference to a richer set of variables in characterizing the environ-ment, the enriched theories will probably be more fruitful for strategyresearch. Indeed, the major contribution of I 0 economics to strategy research(relative to neoclassical microeconomics) in fact stems from the more com-plete specification of relevant environmental variables the firm contends within making strategic decisions.Applying the criteria of substantive content and relevance posited earlier,we propose that there is a major limitation of the neoclassical and traditionalI 0 theories of the firm in the context of strategy research, and that arisesfrom the silence of those theories in discussing .issues of firm conduct andheterogeneity. We recognize that the strategy area has borrowed a numberof important concepts from traditional economics towards development of itsown theory. For instance, a significant contribution of microeconomic theoryto strategy research comes from the explication of cost concepts such aseconomics of scale and demand concepts such as price elasticity of demand.At least one major research topic in strategic management - hat of diversifi-cation - has partly drawn upon and far extends a limited literature fromtraditional I 0 economics. However, these analytic concepts typically are0 asil Blackwell Ltd 1994

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THEORIES OF T H E F I RM I N STRATEGY RESEARCH 171applied independently of the traditional black box conceptualization of thefirm. Indeed, the concepts have been applied in the context of the typicalstrategic management view of the entrepreneurial firm with specializedresources.

THE NEW INDUSTRIAL ECONOMICSIn contrast to traditional industrial economics which followed an empiricaltradition, recent developments in industrial economics focus on formaltheoretical analyses of the structure and behaviour of firms. There is a strongbusiness strategy component to the new industrial economics; the structureand behaviour of firms, including market strategy and internal organizationis of central interest (Tirole, 1988). From the viewpoint of the questions ofsubstantive interest, the boundaries between this branch of inquiry in econo-mics and the field of strategy are blurred. Th e new I 0 economics approachto the firm has been described as follows,

In the struggle to create, maintain and expand favorable market positions,firms actions are intended not only to affect the current conduct of rivalsdirectly, but also to have an indirect effect by altering market structure ina way which constrains the rivals subsequent actions. In this dynamicprocess, market strategies or conduct (the control variables) interact withmarket structure (the state variable) and current conduct can becomeembedded in future market structure through strategic investments madeby firms to bar entry and reduce intra-industry mobility (Encaoua et al.,1986, p. 55).The new developments in I 0 economics arose in part due to the increasingimportance of non-co-operative game theory as a mathematical tool for theanalysis of strategic conflict (Green, 1986). Game theory offers a method formathematically analysing conflict and competition, under the scenario thatthe players of the game are conscious that their actions affect each other.Games represent a powerful heuristic device for analysing situations ofinterdependence between firms, such as in the case of oligopolistic industries.Unlike traditional methods of analysing oligopoly using calculus, the focusin game theory is on the strategic behaviour of the players of the gametowards maximizing their payoffs. The central concept of strategy in a game-theoretic context is the ar t of outdoing an adversary, knowing the adversaryis trying to do the same to you (Dixit and Nalebuff, 1991, p. ix).It is beyond the scope of this article to describe in detail the methodologyof game theory (see Rasmusen, 1989, for an excellent treatment). We onlynote that the broad procedure is to make specific assumptions about the

payoff functions, production functions, and endowments of the players, andthe structure of information contained in the game. Game theory offers a wayof modelling situations with a variety of information structures along thedimensions of certainty about outcomes, symmetry of information betweenthe players, and completeness of information. The modeller then uses a0 asil Blackwell Ltd 1994

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172 A N J U SEIH A N D H O W A R D T H O M A Sdeductive process to determine what happens when players maximize theirpayoffs subject to the constraints of production functions, endowments, andinformation.

In game theory, the firm is viewed as a player who makes rational andintelligent decisions. The actions taken by firms in a game will be intendedto maximize their payoffs (in general, payoffs are equivalent to profits); allplayers recognize that other players will act to maximize payoffs (the mutualrationality assumption). The strategy of a firm consists of a rule indicatingwhich action to take at each instant of the game, depending on the pastactions of nature and of the other players as contained in the information set.A central concept in game theory is that of equilibrium strategy, which is astrategy combination consisting of a best strategy for each of the players inthe game. Various equilibrium concepts are used to define a best strategy.A commonly used solution concept is the Nash equilibrium, where eachplayer has an optimal strategy such that a unilateral change by any singleplayer cannot possibly improve his or her profit. Games can be endowed withvery rich and complex structures, involving two to an infinite number ofplayers who make decisions at each point in continuous time.

Shapiro (1989) provides a survey of the various kinds of strategic actionsby firms in concentrated industries which have been analysed using gametheory. Such actions include investment in physical capi tal , investment inintangible assets, strategic control of information, horizontal mergers, etc. Aparticularly useful application of game theory is in the barriers to entryliterature (e.g. Dixit, 1980; Salop, 1979; Spence, 1977). The central results ofthese models highlight the importance of credible commitments by theincumbent firm to retaliate, under an explicit recognition of the interdepen-dent sequential decisions that the issue of entry involves.

The lessons of game theory have entered the mainstream of strategicmanagement thought, most notably in the work of Michael Porter (1980,1985). Researchers have explored the implications for strategic managementfrom work in economics on such important issues as reputation formation a ndexploitation (Weigelt and Camerer, 1988), first-mover advantages (Lieber-man and Montgomery, 1988), and commitment (Ghemawat , 1991).However, as Saloner (1991) states, the impact on strategy has mainly beenthrough importing relevant implications from economics (p . 120).

The use of game theory has been criticized on the grounds that there is alack of isomorphism between game situations and naturally occurring con-flicts to which generalizations are made (Schlenker and Bonoma, 1978). Thepredictions of game-theoretic models are considered to be simplistic andhighly sensitive to the specification of firms strategies. In our view, thesecritiques represent a challenge to strategy researchers: to use the insightsafforded by game theory to develop workable models of strategic phenomenawhich are subject to empirical testing. As Shapiro (1989) points out, whilegame theory has permitted theoretical investigation of strategic issues whichallow the formulation of predictions of industry behaviour and performance,greater gains will be achieved in the future by combining the traditionalempirical approach, and perhaps even the models of experimental economics(see Plott, 1982) with the theoretical approaches.0 asil Blackwell Ltd 1994

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T H E O R I E S OF T H E F I RM IN S T RAT E GY RE S EARCH 173The theories of the firm described so far contain strong assumptions

regarding managerial rationality and motivation. The profit maximizationassumption of these models implies that decision-makers are assumed to berational and are subject to no uncertainty, i.e. that the environment can bepredicted with perfect foresight and managers have unlimited information-processing ability (Cyert and Pottinger, 1979). In addition, managers areassumed to act in the firms best interests towards maximizing its profits.W e postpone our discussion of the compatibility of these assumptions withstrategic management research to the next section, after we describe howother theories of the firm, which were ar ticu lated to focus attention on in tra -firm phenomena, are framed around alternative assumptions. These theoriesexamine how the in ternal structure of firms can affect conduct and perform-ance, and propose that conduct and performance might conceivably, in turn,affect market s tructure. In part icular, the theories discussed below accommo-date the desirable assumptions of interfirm heterogeneity and moderateeconomic Darwinism as viewed from the perspective of a strategy researcher.

T H E B E H A V I O U R A L T H E O R Y OF T H E F I R MThis model rejects the motivational and cognitive assumptions underlyingthe rationality of economic man and instead seeks to build inductive theoryrelying upon observations of overt behaviour. The focus of the behaviouraltheory of the firm is to predict price, output and resource allocation decisionsof the firm but also with an explicit emphasis on the actual process oforganizational decision-making as its basic research commitment (Cyert andMarch, 1963, p. 19).

Simon (1957) attacked the traditional microeconomics view that the goalpursued by an organization is essentially synonymous with the profit-maximizing goal of the entrepreneur. Instead, he argued, organizationsshould be viewed as collections of individuals with multiple goals who operatein a defined structure of authority. In decision-making, these multiple goalsact as constraints or limits on a course of action if it is to be acceptable, andthese multiple constraints act as a complex goal. Simultaneously, managerialbehaviour is characterized by limited ability to formulate comprehensivemodels of the world and to process information: thus maximizing behaviourbecomes impossible. Since managers are characterized by bounded rational-ity in the face of uncertainty, behavioural rules replace profit maximizing.On e such rule is satisficing: the firm at tempts to achieve a satisfactory levelof profits, rather than to maximize profits. Such satisficing rules may berevised as the manager acquires more knowledge and understanding: thedecision-making process is thus a sequential one characterized by learning.Similarly, Cyert and March (1963) developed a positive theory describinginternal organizational behaviour and the behaviour of oligopolistic marketsusing organizational goals, expectations, choice and control in framing thecharacteristics of the empirical firm. In the determination of prices, outputsand resource allocation, the decision-making process is adaptively rational,with multiple objectives and continuing organizational learning.

@ Basil Biackwdl Ltd 1994

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174 ANJU SETH A N D H O W A R D T H O M A SAs observed by Stigli tz a nd M athewson (1986), the contempo rary ex ten-sion of behavioural theory lies in the evolutionary theory of economic change(Nelson an d W inter, 1982). Th is theory was developed to characterize a n dexplain phenom ena tha t involve disequilibrium in fun dam enta l ways, for

examp le, significant unforeseen technological ch an ge represen ted by S ch um -peterian competition. Evolutionary models seek to explain the dynamicprocesses of adjustment of f i rms, ra ther than the behaviour of firms inequilibrium, and derive their predictions from carefully specified selectionmechanisms. The firm is characterized by the routines it deploys which actas decision-making rules. These routines have been acquired through pastsearches, but not all routines are retained in the organizations repertoire.Thus the f irm is capable of adaptive learning but has an imperfect memory.T hre e types of routines ar e stan dard operating procedures which determ ineinput and output , rout ines that determine search behaviour and rout ineswhich determine investment behaviour. Those firms survive and prosperwhich select the best routines in their choice of actions along these threedimensions,An essential difference between the behavioural/evolutionary theories an dmore orthodox theories lies in the treatment of rationality and uncertaintycontained therein. At this stage, i t is important to contrast the differentapproaches towards assessing how these might be differentially compatiblewith strategy research. R ational economic m an (R E M ) in neoclassical theoryhas

a stable, consistent and well-ordered set of preferences which is clearlydefined over all possible states of the w orld, a n d m akes com plete use of allinformation to select the course of action which gives him the greatestfeeling of happiness (M acfady en, 1986).REM in the presence of uncertainty calculates expected values on the basisof ex-ante probabil i t ies contingent on observed information. Managers makedecisions based on their probability evaluation s to maximize expected u tility.T hi s formulation has been further extended by some models to take specificaccount of imperfections such as information, se arch , an d transaction costs.The use of maximizing criteria is reffered to as substantive rationality(Sim on, 1978 ). Wh ile recognizing the obvious em pirical unreality of thesubstantive rationality assumption, economists have defended it on thegroun ds t ha t it is a reasona ble specification of the behaviour of the represen-tative individual. And as long as i t allows useful predictive models to bederived, there is no need to worry about the validity of the assumption asapplied to real individua ls.In behavioural theory, o n the oth er han d, the real individual enters cen trestage. Th re e broad interpretations of the satisficing rule of bounded rat ional-i ty an d its implications have been suggested. So m e theorists h ave argued tha tbounded rationality collapses into substantive rationality under conditions ofcostly information-processing and computational resources (e.g. Baumol and0 asil Blackwell L td 1994

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T H E O R IE S O F T H E F IR M I N STRATEGY RESEARCH 175Quandt, 1964). Others (see Will iamson, 1985) have proposed a semistrongform of rationality close in spirit to Simon: economic man is viewed asintendedly rat ional but only so to a limited extent because of cognitivelimitations. Nelson a n d W int er (1982) in their evolutionary theory of the firmpropose a weak version of rationality as more representative of economicreali ty. T he y suggest th at there is a fun dam enta l difference between a l imitedinformation model, in which there is uncertainty about knowing which stateof the world is true, and a model in which decision-makers have limitedcognitive abilities which preclude knowledge of which states are possible.In our view, the various approaches to rat ionali ty and uncertainty arecompatible with theory-building in strategy, though differentially acrossdifferent areas of research. We note that all versions of rationality discussedabove have in common that economic agents are viewed as purposeful andintelligent, and assumed to follow reasonable and logical procedures inmaking decisions. Some version of rationality underlies all econom ic exp lan a-tion, to allow prediction of the relevant outcomes of the decision-makingprocess: if economic agents are permitted arb itrary behaviour, the outcomesof their actions are necessarily inde termin ate. R ath er, the essential differencelies in the types of decision-rules they are assumed to use: maximizing,satisficing, or habit. Further, the type of rule which is assumed to operate isinextricably linked to the hypothesized nature of the decision-makingenvironment faced by the agents, which is turn fundamentally related to thespecific economic problem being addressed. In the maximization caseenvironmental complexity is assumed to be comprehensible and can becompletely incorporated into in the decision-making process; the focus is onthe na tur e of the equil ibrium. W e concur with Langlois (1986) tha t the twinassumptions of maximizing behaviour an d a comprehensible environment areappropr ia te when it also can be reasonably assumed that the outcomes ofinterest do not d epe nd crucially on a few pivotal individuals (o r f irms) w hoare free from system constraints. In strategy content research which seeks toformulate generalizable models of strategic outcomes under tight systemconstraints, the assumption of substantive rationality can facilitate predic-tions of unique outcomes. As an example, Hill et al. (1990) seek to explainthe choice of international encty mo des by multination als using a n optim izingframew ork un der t ight system constraints, with the qualification tha t assum-ing tha t global markets a re reasonably competi tive, in the long ru n com peti-tive forces will select out those M N C s that choose entry modes inconsistentwith value maximization (p. 126).In contrast , the theories of the f irm in behavioural and evolutionaryeconomics carry un mistak able force from th e viewpoint of realism in describ-ing decision-making processes. Accordingly, these are valuable a s a back dropfor process research of how strategic outcomes are arrived at , as well as forcontent research u nd er conditions which the na tur e of the process has a non-trivial effect on the outcome. For instance, the bounded rationality conditionis a foundation of the transactions cost framework, which addresses therationale u nderlying com parative institutional forms (W illiamson , 1985, dis-cussed further below ), an d leads to the proposition tha t , ceteris paribus, f irms

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176 ANJU S E T H A N D H O W A R D T H O M A Schoose modes of governance which make fewer demands on cognitive compe-tence.

T H E M A N A GE R IA L V I E W A N D R E S O U R CE - B A SE D V I E W OF T H E F IR MWhile the behavioural theory of the firm focuses on empirically validbehaviour and the decision-making processes of managers, the managerialapproach has challenged the motivational assumptions underlying the neo-classical theory of the firm. The origin of this approach was contained in thework of Berle and Means (1932), who addressed the problems associated withthe separation of ownership from control in the large, publicly-held firm.Given diffused share ownership by large numbers of shareholders whodelegate control to professional managers, but who lack the means or theindividual incentives actively to monitor their actions, management has greatpower and considerable discretion to pursue activities which are beneficial tothem at the expense of shareholders interests.

Under the managerial approach, the assumption of profit-maximizingbehaviour is rejected, to answer the call for greater realism in the treatmentof managerial motivation. The assumptions of self-interest and rationalbehaviour suggest a general approach for introducing managerial motivesinto a theory of the firm. I n general, however, the typical managerialistapproach still subscribes to a black box view of the firm, different fromstandard neoclassical approaches only in that a profit-maximizing maximandis replaced by one which represents managerial utility. Managerial utility ispostulated to be a function of variables such as sales (Baumol, 1962) or therate of change of the size of the firm (Marris and Mueller, 1980). Williamsons(1964) model proposes an objective function which combines staff expenses,expenditures on emoluments, and funds available for discretionary invest-ment.

The notable exception to this managerial marginalism approach (Mach-lup, 1967), though still in the managerialist spirit, is the work of Penrose(1959). Penrose proposed that the nature of the internal organization and theadministrative apparatus becomes important when it is recognized that a firmreplaces market co-ordination by internal organization for the purposes ofsupplying goods and services to the economy. However, the firm is muchmore than an administrative unit; it is also a collection of productiveresources utilized in the firms operations. The productive resources of thefirm are imperfectly divisible, such that a firm has the incentive to expandto enhance the productivity of the resources. T h e expansion of a firm canarise from greater output of an existing product line or through diversifica-tion, depending on the nature of the unutilized resources and demandconditions. Growth is only constrained by the productive opportunitiesavailable to the firm. Penroses analysis of managerial motives concludes tha tthere is no real conflict betweeii the goals of profit maximization and growth:both become equivalent for the selection of investment programmes.

Penroses conceptualization of the firm as a collection of productiveresources is particularly relevant for strategy content research. Her insights

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T H E O R I E S OF T H E F IRM IN STRATEGY RESEARCH 177provide the foundation for what has been termed the resource-based view ofthe firm in the strategic management literature. From a n analytical perspec-tive, this view implies that a firms distinctive competence is based on thespecialized resources, assets and skills it possesses, and focuses attention onoptimum utilization of these to build competitive advantage and thus econo-mic wealth. The specialized resources of the firm could be in the form oftangible assets, such as patented production processes (an example is Xeroxsownership of xerographic patents through the first few decades of the intro-duction of xerography). Alternatively, the resources could be in the form ofintangible assets such as brand-name recognition, reputation for high productquality, or specialized managerial skills. The theory of the firm as a bundleof productive resources has the important result that firms expand to makebest use of their pre-existing skills and resources. It therefore has significantimplications for strategy formulation research issues concerning the scope ofthe firm, the direction of its growth, and diversification and acquisitionstrategies.

Strategy scholars have developed the linkage between the resource positionof the firm and its sustainable competitive advantage. Lippman and Rumelt(1982) and Rumelt (1984) examine the effects of resource heterogeneity oninterfirm differences in efficiency. They develop a formal model of rivalrywhich predicts persistent interfirm profitability differentials as a characteris-tic of industry equilibrium. In the model, all firms act to maximize netexpected wealth and there is free entry. Each new entrant into an industryreceives a cost function, the relative efficiency of which is determined bychance, and there is causal ambiguity as to what factors of production areresponsible for success or failure. The model essentially proposes thatefficiency differences persist between firms in a n industry because of uncerta inimitability which obtains when the creation of new production functions isinherently uncertain and when either causal ambiguity or property rights inunique resources impede imitation and factor mobility (Lippman an dRumelt, 1982, p. 1.21). To make the model analytically tractable, resourceheterogeneity is treated as an outcome of luck rather than of proactivepurposeful behaviour, whereas the typical strategy viewpoint regards theaccumulation of productive resources as resulting from a combination ofpurposeful strategic behaviour and stochastic processes. Nevertheless, thework represents a significant attempt to reconcile the strategy perspectivewith the neoclassical economic theory of the firm in that i t provides aframework for simultaneously handling resource heterogeneity and uncer-tainty in searching for predictions of competitive equilibrium.

An issue which has been debated recently in the strategy literature is therelative usefulness of the I 0 framework and the resource-based view inunderstanding the sustainable competitive advantage of the firm (see, forinstance, Barney, 1986, 1991; Conner , 1991 ; Dierickx and Cool, 1989).Sustainability, as discussed above, is clearly a function of factors that arerelated to the firms access to unique resources and the immobility of thesefactors. However, given that a firm has access to some unique specializedresources, what makes these valuable in the context of the firms environ-


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178 A NJU S L T H A ND H O W A R D T H O M A Sm en t? How ar e these resources converted to a position of sus tain ab le com peti-t ive advantage? W e suggest tha t I 0 f rameworks , which a im at identifyingthe com petitive characteristics of pro du ct-m ark ets, provide useful insightsinto exploring this issue. T hu s, a firm can be viewed as a b un dle of resourcesas well as a bundle of market act ivi t ies . The duali ty of product-marketactivit ies on the on e han d an d resources an d skills on th e other ha nd suggeststhat a firms competitive position needs to be studied with respect to bothdimensions. This is noted by Dierickx and Cool (1989) as follows:

A nu m be r of scholars have expressed the concern tha t mu ch of the s trateg yliterature focuses too narrowly on privileged product market positions asa basis for competi t ive advantage and above-normal returns (e .g. Gabel ,1984; W ernerfelt , 1984; Barney , 1986). T h e fact tha t resource bu ndles needto be deployed to achieve or protect such privi leged p rodu ct -m ar ke tpositions is often overlooked (p. 1504).We suspect tha t grea ter ga ins towards unders tanding the na ture of thecompetitive advantage of the firm will be achieved by treating the resource-based view of the firm and the I 0 view as complementary ra ther than asopposing perspectives. Strategy researchers could gain from focusing on thenature of specific resources (e.g. R & D capabilit ies, specialized humanresources, etc.) and seeking to identify how these resources ar e trans late d int osustainable long-run competitive advantage in a range of competitive con-texts. T h e competitive context specifies the co nditions of com petitive rivalry

which the firm confronts, and different contexts represent different resourcedeployment opportunities available to firms. The competitive context of thefirm may be usefully defined at the indu stry as well as at the s t ra tegic grou plevel (M cG ee an d T ho m as , 1986). Fo r example, i t is likely t ha t R&D flowsar e converted to valuable strategic assets (which confer susta ina ble comp eti-tive advantage) differentially across a range of low to high technologycontexts within a single industry .

A G EN C Y T H E O R Y A N D T H E F I R M : T H E F IN A N C IA L E C O N O M I C S V I E WA com mon criticism of the theories of the firm developed in th e neoclassicaltradition is that they fail to consider risk along with profitability explicitly indefining the objective function of the firm. The financial economics viewassumes th at the f irm maximizes the discounted va lue of future expected cas hflows, i.e. i ts net pres ent value ( N P V ), rath er th an profi ts . This view of theobjective function of the firm has the advantage that i t focuses on the long-term economic value of the firm to the residual riskbearers, i .e. the share-holders of the f i rm. I n ad dit ion , the N PV app roac h m akes explicit recognit ionof the specialized n atu re of the p roductive resources of the firm. T h e possibil-i ty that posi t ive NPV investment opportunit ies are avai lable to a firmrequires tha t i t has som e special adv antag e (Breeley an d M yers, 1988). Th isad va nta ge arises when the firm possesses unique specialized resources which0 asil Blackwell Ltd 1994

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T H E O R IE S O F T H E F IR M I N S T RAT E GY RE S EARCH 179are not costlessly appropriable by other firms. Factors which prevent thecostless diffusion of specialized resources include impediments to informationtransfer, governmental regulatory constraints, differential levels of manage-rial skills not fully reflected in managerial compensation differentials, andother rigidities in the labour market, the market for real factors of production,or output markets (Ang and Lewellen, 1980). Financial economics has notbeen concerned with developing theory on the sources of competitive advan-tage, as is the field of strategy. However, the explicit recognition of theimportance of competitive advantage and the firms specialized resources increating economic value, and the long-term perspective, make the financialeconomics view particularly consonant with strategy research.

Given the centrality of the shareholder-wealth maximization assumption,financial economists have paid particular attention to describing the contract-ing relationships between principals (the shareholders) an d their agents (thefirms managers) which constrain managerial discretion and promote actionsin the shareholders best interests. The primary orientation of agency theoryas developed in financial economics is positive and empirical (Jensen, 1983).This theory describes the effects of a variety of factors in the contractingenvironment on the contractual relations that arise in the firm. These factorsinclude uncertainty, information asymmetry, risk and effort preferences ofagents, capital intensity, degree of specialization of assets, capital markets,characteristics of internal and external labour markets, and costs of monitor-ing and bonding devices. However, there are also important normativeaspects of a parallel branch of agency research. In this branch, calledprincipal-agent research (Jensen, 1983), theorists use mathemat ical tools anddeductive methodology to investigate optimal contracting relationships whichalign the interests of principals and their agents, and their welfare implica-tions.

In the positive agency literature, the firm is considered to govern aproductive activity in a manner similar to markets. Firms come into existencebecause of the advantages of team production (Alchian and Demsetz, 1972).However, the activities of the firm are governed not by authority but by aseries of contractual relationships. Organizations represent a nexus of con-tracting relationships between individuals who often have conflicting objec-tives (Jensen and Meckling, 1976). Contractual relations exist not only withrespect to employees but also with suppliers, creditors, customers and otherstakeholders.

In modern corporations, the principals (stockholders) delegate decision-making authority to the agents (managers). Th e divergence of interestsbetween the agents (who are motivated by self-interest) an d the principals(whose aim is the maximization of their wealth) gives rise to the potential foragency problems. This potential for the existence of agency problems can bemitigated by using various devices to align the interests of managers andstockholders, such as monitoring, bonding, and the design of incentivepackages. Thus, ownership of equity by the firms managers (Jenson andMeckling, 1976) and the internal structure of organizations (Fama andJensen, 1983) can reduce the agency problem. Such devices are internal tothe firm. Agency costs then include monitoring and bonding costs together


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180 ANJ U SETH A N D H O W A R D THOMASwith the residual loss, the irreducible reduction in the firms value from theseparation of ownership and control.

The agency literature also has identified various kinds of external discipli-nes over managers discretionary actions. These include competition inproduct markets when environments are correlated (Ha rt , 1983), by themarket for corporate control (Grossman and Har t, 1980), or by the manage-rial labour market (Fama, 1980). Since managers contribute undiversifiablehuman capital to the firm they may have an even greater stake in the successof the firm than shareholders. Managers are thus likely to act to minimizeagency costs in their own interests.

In sum, an argument often made in the positive agency literature is thatwhile there is a possibility of divergence of the goals of managers andshareholders which leads to the presence of agency costs, these will bereduced by external and internal mechanisms discussed above. Therefore theeffective objective of the firm is to maximize the wealth of stockholders. Somestrategy researchers have argued that this view is incompatible with strategyresearch: the firm should be viewed in terms of a coalition of stakeholders,and that the task of the organization is to maintain itself by negotiatingresource exchanges with external interests (see, for instance, Hirsch et al.,1990). In our view, there is no real inconsistency between the shareholder-wealth maximization objective and the task of the firm as proposed in thestrategy literature: these are in fact complementary perspectives. Usingagency theory terminology, the stakeholders of the firm are paid the fairmarginal wage for their efforts, and the residual profits belong to the owners,i.e. the shareholders, who bear the risks associated with ownership. Thus , allstakeholder groups a re provided with reasonable inducements for theircontributions.

We propose that the nexus of contracts view of the firm is particularlyinsightful in the context of strategy research because it highlights the politicaland bargaining aspects of interactions among stakeholders of the firm whohave conflicting interests. This focus of the agency-theoretic approach isuseful to investigate a variety of issues of corporate governance, includingcorporate ownership structure, compensation s tructure, organizational moni-toring and control systems. Additionally, i t provides a valuable backdrop forresearch in the areas of corporate acquisitions and corporate restructuring.It is, therefore, relevant for both strategy formulation and implementationresearch. Eisenhardt (1989) provides a review of research in strategy whichdraws upon agency theory.

T H E TRANSACTIONS COST F R A M E W O R KAnother approach to challenge the traditional assumptions of the theory ofthe firm is the market failures framework (Williamson 1975, 1985), whichbuilds on Coases (1937) seminal work on the theory of the firm. From thisperspective, the organization form that develops in an exchange situationdepends on the efficiency of that form for completing necessary transactions.In effect, markets and firms are alternative instruments or governance0 .isil Blachwrll Ltd lW 4

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T H E O R I E S OF T H E F IR M I N S T R A T E G Y R E S EA R C H 181structures for completing a set of contracts. The framework assumes that twobasic characteristics of decision-makers are opportunism (defined to meanself-interest seeking behaviour with guile) and bounded rationality. Thesecharacteristics interact with critical properties of the transaction in determin-ing whether the market will he supplanted by a firm in conducting thetransaction.

The key characteristics of transactions between firms and consumers whichimpact how the exchange process will be conducted are asset specificity,uncertainty and frequency (Williamson, 1981, 1985). Assuming tha t somedegree of uncertainty is typical of all transactions, the most critical factor ofthese is asset specificity because, once the investment in assets which arespecific to an transaction has been made, the buyer and seller are effectivelycommitted to the transaction for some period of time. Greater asset specificityimplies that investment in transaction-specific or special purpose technologyis required to service the transaction, and is therefore most efficient forservicing steady-state demand . Under these circumstances, the continuity ofthr relationship between buyers and sellers is highly valued. The contractingprocess is characterized by complex forms of market contracting or eveninternal organization, rather than simple market contracting. However, whenthe productive assets are non-specific (which is the case for most consumermarkets for consumablcs and standardized products) , a market contractingprocess is efficient. Thus, this framework provides strong insights into issuesof firm existence and boundaries: which activities will be performed insidethe firm, which outside, and why.

The transactions cost perspective has also approached the problem of howthe problem of divergence of managers and shareholders interest might beresolved, though in a different vein from agency theory. These dissimilarapproaches to the problem derive from the differences between the transac-tion cost view compared with the agency theory view of the essential natureof the in ternal relationships within the firm. Williamson (1975) proposes thatthese relationships are characterized by a structure of authority which istypically embodied by some form of hierarchy. This hierarchy involvespyramidal controls with employees at higher levels exercising control overemployees at lower levels. Accordingly, the mechanism for resolution ofconflict between shareholder and managerial motives rests in the hierarchicalarrangement, with the multidivisional form of organization most effective incontrolling discretionary behaviour on the part of managers. In this form oforganization, there is an administrative interface in the form of a generaloffice between operating divisions and stockholders in place of a marketinterface. The general office acts as an agent of stockholders and efficientlyhandles the tasks of goal pursuit , monitoring, staffing and resource allocation.

Thus, transaction cost economics considers the firm as a governancestructure which is crafted to economize on transactions costs. I n the agencytheoretic approach, on the other hand, the firm is a nexus of contracts withthe focus on designing efficient contracts to minimize agency costs (seeWilliamson, 1988 for a comparison of the two approaches). In our view, thetransaction-cost view and agency view are best viewed as complementaryperspectives with regard to how internal activities of the firm are organized

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182 ANJU S E T H AN D H O W A R D T H O M A Swith each providing insights on different angles of the problem. Such asynthesis is attempted by Mahoneys (1992) investigation of the choice oforganizational form, vertical ownership versus vertical integration. DavidTeeces work on economies of scope (1980) and the role of asset specificity(extended to the concept of cospecialized assets where the dependencebetween the firm and its resources is mutual) in generating benefits fromtechnological innovation (1986), are notable examples of how the combina-tion of the transactions-cost approach with strategic management can extendknowledge in both fields. A feature of this research is its theoretical pluralismwhich provides very rich explanations of the phenomena being investigated,drawing also from insights from the resource-based view of the firm and I 0economics.

T H E O R I E S OF T H E F IR M A ND P H I L O S O P H IC A L M E T H O D O L O G YSo far, we have briefly described the economic theories of the firm andexamined their relevance for strategy research from a substantive perspective.In doing so, we have outlined broad areas of strategy research which can befruitfully combined with the economics perspectives. Next, we explore twoimportant dimensions of philosophical methodology and examine whethertraditions in economic theorizing are intrinsically contrary to traditions instrategy.Inductive versus Deductive TheorizingThe inductive method of theorizing is the process of starting with highlywarranted (or well agreed upon) observational statements about specificevents and inferring a generalization (Churchman, 1971, p. 94). Thus,observations are the very basis of the theory. On the other hand, thedeductive mode is the process of using a set of assumptions to prove atheorem by some standard set of rules of inference (Churchman, 1971, p.94). In this method, the role of initial observations is to provide a basis forspeculation about the phenomenon, which is then followed by developmentof assumptions and the hypothetical model from which generalizations arededuced.Theory-building in the strategic management field has often relied on aninductive mode based on empirical evidence rather than using deductivelogic. Typically, the unit of analysis is the empirical firm rather than thetheoretical firm, and the importance of adhering closely to realism in analys-ing managerial motives and behaviour has been paramount. The relevanceof deduction as a mode of theorizing for policy research has come under heavyattack from some researchers (see, for instance, Hirsch et al., 1990) but hasbeen promoted by others (e.g. Camerer, 1985, 1991). The critics raise alarmsabout the so-called simplistic nature of deductive models and argue that therichness of strategy research will be lost if such models gain currency.However, such criticism may be inappropriate. Theory development hasas its ultimate objective both the explanation and prediction of phenomena.In our view, it is useful to view the pure inductive method and the pure0 asil Blackwell Ltd 1994

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T H E O R I E S OF T H E F I R M I N S T RAT E GY RE S EARCH 183deductive method of building theory as representing two extremes of acontinuum. We propose that methods falling along all points of the con-tinuum, including the deductive method, represent valid ways to generatetheory. While inductivism has been the primary mode of strategy theorizinghistorically, there is no clear reason why this must be normatively true. Theresearch question and the phenomenon of interest dictate whether moreinductively oriented techniques with their greater emphasis on the role ofinitial observations, or more deductively oriented techniques are likely to beappropr iate and useful (Seth and Zinkhan, 1991).

We agree that deductive models must be capable of generatingtestablehypotheses or predictions to be classified as good theory. I n order to developrigorous predictive models, however, i t is often necessary to make simplifyingassumptions. In strategy research, i t is not useful to strive for mathematicalelegance for its own sake; however, i t is extremely useful to approach researchwith the rigour that derives from a deductive approach. Such an approachhas the advantage of enabling the development of principles of strategicbehaviour which are robust in their application, as opposed to the develop-ment of theories for special cases and contingencies, which is a possibledanger if inductive theory building is used exclusively.Normative versus Positive TheoryThe field of strategy formulation arose from a concern with the job of thegeneral manager in integrating the organizations activities. It has sought toidentify decision rules which facilitate the achievement of such organizationalobjectives as efficiency, effectiveness, profitability or value creation.Strategy researchers have typically been required to generate managerialapplications from their research findings (Montgomery et al., 1989).As such,the field has typically adopted a normative perspective towards analysingwhat organizational decision-makers ought to do. This focus on prescriptiveanalysis contrasts with the primarily positive focus of much economic theoriz-ing, which aims to describe what is, rather than to prescribe what should bedone.

Note that the positive/normative dichotomy that we refer to here is notentirely synonymous with the facthalue dichotomy that has been the subjectof much debate among philosophers of science. We do not believe thattheorizing in the social sciences can be completely value-free. Rather, peerorientations, dominant research paradigms, and available tools and methodsshape belief systems of scientists to hinder achievement of the scientific idealof pure objectivity. The shape of the theory derived is intricately bound upwith the experiences of the researcher. Therefore positive theorizing is nothere considered to be value-free theorizing; the belief systems of economistsinfluence theoretical developments in the field in much the same way as thebelief systems of strategy researchers. An analogue can be drawn from thefield of journalism (Hun t, 1983). A news report of a speech by an aspiringpolitical candidate might focus on his or her economic trade policies ifreported by an economist, or alternatively might focus on inner-city urbanhousing policies if reported by a political scientist. Both reports mightapproach objectivity, but simultaneously reflect the belief systems of the two


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184 ANJU SETH A N D H O W A R D T H O MA Sreporters: both would be considered positive statements in our sense of theterm. In contrast, an editorial about the speech which presents opinions toinfluence what voters should do necessarily reflects a desired political direc-tion, and is a normative statement.

The question of interest here is whether the primary task of the strategyresearcher is to editorialize, to persuade managers to follow some desiredcourse of action? O r there a role for reporting objective news? A normativephilosophical approach to theory-building necessarily reflects values inherentin the choice of desired objectives of the firm or what the manager ought todo. For example, a key question of corporate strategy, What businessesshould the firm be in? is a normative issue which reflects some desiredobjective of the firm. Depending upon whether the researcher proposes long-run value creation or short-run profit maximization as the desired objectiveof the firm, very different normative prescriptions could result from ananalysis of the conditions favouring different types of strategies. However,prescriptive answers to these questions must necessarily draw upon meaning-ful positive theories. For instance, we must know what is the profitabilityassociated with different types of diversification strategy, which is a positiveissue, in order to answer the question posed above. A positive theoryheuristically assumes some objectives which the firm attempts to achieve,rather than propounds these objectives as universally desirable. To furtheradvance strategy research, we must recognize the value of positive researchwhich may not have immediate practical or normative applications, butwhich is an important first step to generating an understanding of strategicphenomena. We must also question, as do Montgomery e t al. (1989) whetherall strategy researchers should necessarily propose normative guidelines inreporting results in theory development or empirical research.

C O N C LU SIO N SThis article has examined the relevance of the various economic theories ofthe firm for strategy research. We highlight the differences in approach andassumptions among the various theories of the firm and discuss their rele-vance to the field of corporate strategy. We propose that theories which maketwo substantive assumption, i.e. strong-form economic Darwinism and firmhomogeneity, are unlikely to function as useful backdrops for research instrategy as they assume away the phenomena of interest to strategy resear-chers. Other heuristic assumptions, for instance those of rationality, oppor-tunism, or the degree of risk aversion of managers which are often made bythe various theories of the firm can be usefully incorporated in to the formula-tion of strategy theory. None of these assumptions violate the fundamentalnature of strategy theorizing.A recent dialogue between Donaldson (1990) an d Barney (1990) concern-ing the relevance of organizational economics to management theory touchesupon some of these issues. Donaldson takes strong exception to the manage-rial self-interest assumption of agency theory and transaction-cost economics,interpreting this as accusing managers of cheating, lying and slacking0 asil Blackwell Ltd 1994

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T H E O R I E S OF THE FIRM IN STRATEGY RESEARCH 185(Donaldson, 1990, p. 398). This assumption is contended to be inappropria tefor organization theory development on the grounds that, first, it is unrealisticand second, the cynical view of humanity i t represents is offensive. However,the agency theory and transaction-cost frameworks are constructed to facili-tate investigation of the phenomena of alternate governance and contractualmechanisms under conditions of stakeholder conflict, and the self-interestassumption is adopted to allow tractability to studying these phenomena. Wewould further suggest that average conditions of organizational conflict areas real as average conditions of organizational co-operation; each al ternateset of assumptions allows us to study different phenomena. For instance, ascorrectly pointed out by Donaldson, more macroscopic analysis of otherphenomena may consider the willingness of constituent actors to cooperatetowards organizational goals unproblematic (p . 37 1) . In essence, Donald-sons critique of organizational economics reflects a particular set of beliefsabout which questions are most valuable to have asked and answered inorganizational research, i.e. a boundary debate, which is ultimately resolvedas a matter of consensus by the community of researchers. While our ownviews regarding the usefulness of economic theory in organizational researchmore closely resemble those proposed by Barney, we very much appreciatethe spirit of the debate. It is discussions such as these which promote criticalre-evaluation of our tenets, and thereby strengthen them or cause them to bedisplaced, thus furthering our scientific endeavours.

In sum, we contend that from a substantive and a philosophical methodo-logy perspective, the various economic theories of the firm offer rich potentialfor strategy researchers. In fact, this potential is being actively realized inrecent years. The resource-based framework has been utilized by a numberof theoretical and empirical research studies which examine diversificationand acquisition strategy (see, for instance, Singh, 1984; Wernerfelt andMontgomery, 1987). The agency framework, with its key elements of risk an deffort aversion on the part of managers, informational asymmetries, anduncertainty, has provided a useful framework for analysing issues of corporategovernance such as the composition of boards of directors and executivecompensation contracts (see Kosnik, 1987; Singh and Harianto, 1989). Thetransactions-cost perspective has been used to examine of the scope ofactivities performed internally by a firm (see, for example, Teece, 1981;Walker and Weber, 1987).

We would encourage further cross-fertilization between the fields of stra-tegy and economics. This is not to say that strategy researchers should adopteconomic paradigms blindly but rather when these paradigms are useful infurthering our scientific understanding of the phenomena of interest. Aparamount objective should be to translate economics into first-rate strategyresearch and not to second-rate economics. Our broader prescription forcontinued development of the field is for theoretical pluralism. We believethat the phenomenon of interest should dictate which theories are used instrategy research, rather than preconceived notions of appropriate bound-aries. It really does not matter whether the original theoretical contributionoriginated in sociology or in economics; if it can be usefully applied instrategy, it should be applied. However, strategy researchers must approach


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186 ANJU SETH A N D H O W A R D T H O M A Sinterdisciplinary research with rigour, with a firm grounding and understand-ing of the relevant theories and techniques from other fields which they seekto integrate with strategy.

Do W e Need a n Integrated Theory of the Firm?We have suggested that the theories of the firm contained in the newindustrial economics, behavioral theory, evolutionary theory, the resourcedependence view, agency theory and transactions cost theory all allow forproductive theory building in strategy; however, they provide frameworks forsolving different problems across the strategy formulation and implementa-tion areas. The question we now raise is: should we seek some sort ofintegrated theory of the firm? In the ideal case, such a theory would be broadenough to function as a frame of reference for all possible research issues inthe field of strategy. We do not believe that such a focus is useful to pursueat this stage of development of strategy theory.Certainly the existence of a shared paradigm facilitates communication anddissemination of research, and focuses research efforts; this thereby speedsthe progress of development of science. However, a caveat exists: adoption ofa single paradigm may actually hinder the creative process of research, byimposing blinders that inhibit lateral thought processes. As Kuhn (1970)points out, paradigm debates always involve the question: Which problemsis it more significant to have solved?

This is a particularly difficult question to answer in the context of thestrategy field. Strategy research is necessarily multidisciplinary in nature,because i t is inherently concerned with integrating views across differentfunctional areas concerned with the science of organizations. The researchissues which are in the domain of strategy are considerably more varied andbroader than those associated with other disciplines of organizational science.In order to explore fruitfully the variety of research issues, multiple researchframeworks are necessary.

This is not to say that the problem of lack of communication betweenresearchers because of a lack of shared paradigms, or an incomplete under-standing of alternative paradigms, is a minor one. There is always thepossibility that integrat ing more sophisticated concepts and methodologiesfrom economics and finance into strategy content research might lead to awidening chasm between the so-called process and content researchers.However, one root cause of the difficulty is while theorists approach theirsubject from a frame of reference based on assumptions that are taken forgranted, these assumptions are not always made explicit. An obvious firststep towards overcoming these difficulties is to recognize that the conflictexists: this can only happen if researchers are particularly sensitive to thevarious assumptions underlying their frames of reference, the utility of theseassumptions in framing theory, and to communicating these. As Rorty (1983,p. 562) writes, what really matters is

our ability to engage in continuous conversation, testing one another,discovering our hidden presuppositions, changing our minds because wehave listened to the voices of our fellows.


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T H E O R I E S OF T H E F I R M I N STRATEGY RESEARCH 187An Example: Coexistence of Dzfferent Theories of the FirmLet us consider an example of an area of investigation which could fruitfullycombine different methodological approaches and different theories of thefirm, i.e. acquisitions.

( 1 ) One research question could be posed as follows: Wha t are the differentsources of value creation associated with different acquisition strategies? Toanswer this, for instance, Seth (1990) builds a mathematica l model to developmeasures of the different sources of value creation in acquisitions, anddeductively develops empirically testable propositions of the relative import-ance of these across different acquisition strategies. The underlying frame-work of the theory of the firm assumes that managers are motivated tomaximize expected stockholder wealth, and that their behaviour reflectsrational decision-taking and risk-aversion. In this model, the firm is viewedas possessing various assets or resources, and managers seek to make the bestuse of these resources in order to maximize stockholder wealth. No doubtthese assumptions are simplistic and do not conform in all cases to empiricalreality. However, they permit the development of propositions which can betested empirically, and which, when empirically validated, can be used toderive generalizations about the economic effects of acquisition activity.(2) A second research question which might be pursued is: Are gains tostockholders in acquisitions true synergistic gains or do they merely repre-sent a transfer of wealth from one of the other stakeholders of the firm suchas employees? To address this, the assumption that managers act to maximizeshareholder wealth becomes the focus of analysis. It is unclear that deductivelogic would be fully adequa te for researching this; more likely, a combinationof deductive and inductive approaches would be required (and a goodtheoretical conversation is likely to emerge). To pursue this question, theunderlying motivational and behavioural assumptions regarding managerialactions could probably arise in the first instance from agency theory. Theunderlying theory of the firm is that of a nexus of contracts among a numberof different stakeholders including stockholders, managers, customers, sup-pliers, etc.(3 ) A third research question is as follows: What is the process by whichacquisitions are implemented by managers? When empirical investigations ofvalue creation are conducted based on models drawn from financial econo-mics, they typically examine the existence of positive potential value creationas judged by the capital market. Th e assumption is made that the capitalmarket forms unbiased expectations of this potential on average. However,it is also useful to examine how managers actually transform this potentialin actual synergy. In order to investigate this, an inductivist route must betaken, where behavioural, evolutionary and managerial theories are likely toprovide useful frameworks.

Such questions can be particularly well addressed by strategy researchersbecause of the breadth of the domain of the field and the tradition oftheoretical and methodological pluralism which has characterized the field.In conclusion, we feel i t is unproductive for strategy researchers to seek a

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188 ANJU S E T H A N D H O W A R D T H O M A Ssingle theory of the firm to serve as the framework for all research in the area.Given the nature of the field, which is necessarily integrative across thefunctional areas of business, the answer does not lie in embracing one theoryand rejecting all others. Such a route is likely to lead to premature closureand could choke off the development of potentially rich avenues of investiga-t ion. Rather, the answer lies in developing an intimate knowledge of thedifferent theories of the firm and their underlying assumptions, and usingthese to develop a multidimensional approach to strategic managementresearch.

N O T E* We would like to thank the anonymous reviewers, Edward A. Blair, MichaelBradley, Constance E. Helfat and Sarabjeet Seth for valuable comments on earlierdrafts of this article. The usual disclaimer applies.

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