Joanna Tyrowicz
Limits of an enterprise
Institutional Economics
“But I thought you were going to talk about
econometrics?!”

Two minutes on transaction cost economics (TCE) and the theory of
the firm

Capabilities/competencies and theory of the firm
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Intersection of competencies and TCE

Problem solving perspective
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New perspectives and new questions
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Correcting for endogeneity
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Bringing the market inside the firm
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Example of research: truck transport industry in US
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Conclusions
2
What do we think about an enterprise?
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Behavioral assumptions
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Actors want to be rational but there are limits:
 Boundedly rational
 Actors attempt to be far-sighted
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Actors may behave opportunistically
Asset specificity is the “big locomotive”

Investments that produce cost savings or quality benefits for
a one or small number of potential customers (quasi-rents)

Frequency and uncertainty also matter

Main focus is on ex post maladaptation problems
 Hold-up
 Underinvestment
 Measurement issues are implicated
Fundamental (intertemporal) transformation alters exchange from
market to bilateral monopoly
3
Comparative assessment of
discrete structural alternatives
Governance Mode
Market
Hybrid
Hierarchy
++
+
0
0
+
++
Instruments
Incentive intensity
Administrative Controls
Contract Law
Classical
Neoclassical
Forbearance
Performance Attributes
Adaptation (A)
++
+
0
Adaptation (C)
0
+
++
++ strong, + semi-strong, 0 weak, Williamson (1996, 103)
4
Alignment of discrete alternatives
Market
Governance
Costs
Market
Hybrid
Hybrid
k1
Hierarchy
Hierarchy
k2
Asset Specificity
5
A Wiliamsonian firm
k»0
k»0
Complex
Contract
k=0
k»0
Core of the Firm
k>0
k=0
k»0
Vertically
Integrate
k»0
Simple
Contract
6
Implications for firm performance

Main predictions:

Vertically integrate in response to deep co-specialization

Hybrid in response to moderate levels of co-specialization

Market in response to low levels of co-specialization

Aligning transactions in an economizing way yields superior firm
performance (profitability, survival)

Firms presumably invest in asset specificity because it creates value

Capabilities/competences

What are capabilities?

How do capabilities arise?

What is the capabilities-based theory of the firm?

How do capabilities influence firm performance?
7
What are capabilities?

Capabilities = dynamic capabilities = competences

Knowledge-based view of the firm (KBV)

Resources = KH (tradedable), financial or physical assets, HC.

Capabilities = the capacity to deploy resources.
8
What are capabilities?

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Main assumptions: Bounded rationality <=> knowledge is “sticky”.
Two views:

Myopic view
 Passive spillovers from tacit and endogenous learningby-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.
9
What is the KBV theory of the firm?




Theory of firm derives from knowledge-based considerations…

not the incentives, opportunism, and transaction costs
 hierarchy is a “creator of a positive” not only an “avoider of
a negative.”
Main prediction: internalize activities that can be carried out at
lower (production) cost than other firms

“Dynamic transaction costs” => teaching is costly

Internalize those activities that rely on “core competencies”
Firms economise on the exchange of knowledge not on
opportunism.

Two competing claims:
 Hierarchy economizes on knowledge transfer
 Authority avoids the need to transfer knowledge
 Hierarchy facilitates knowledge transfer
 Shared language and identity facilitate transfer
Capabilities lead to firm heterogeneity
10
How do capabilities influence
firm performance?







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Capabilities yield superior profitability/survival.
Different capabilities likely to yield different marginal benefits.

Invest in capabilities that yield the greatest marginal returns
to investment.
Should KBV assumptions omit opportunism?
What is the unit of analysis?
How can competencies be operationalised?
What are the deficiencies of hierarchy?

KBV fails to predict when hierarchies supplant markets and
vice-versa.
What is the theory of value?

Which competencies are valuable?

Which competencies should be invested in?
How does KBV apply to entrepreneurship?
11
Williamson’s (1999) response

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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.
12
Accounting for pre-existing capabilities:
The “shift” parameter
Market
Governance
Costs
Hybrid
Hierarchy
“Positive”
capabilities
reduce
sum of
transaction
and
production
costs.
k1
k2
Asset Specificity
13
Further refinement opportunities




Fixed niche
 How do the pre-existing competencies of Firm A compare to
rivals with respect to market niche a1?
Variable niche
 How do the pre-existing competencies of Firm A compare with
rivals with respect to many niches?
Repositioning
 How should firm A, with its competencies, reposition for the
future in relation to its strategic situation?
Strategising
 If firm A possesses monopoly power, how can it best deter and
discipline actual and potential rivals?
14
Nagging concerns

Need a theory of value for further refinements.
Which transactions should managers choose?
What guidance do we have for generating and using
knowledge/capabilities?
How are capabilities created?
How does TCE apply in a knowledge economy?
Is the transaction the “best” unit of analysis when thinking about
knowledge?
How should knowledge be organized inside the firm?

PROBLEM SOLVING PERSPECTIVE

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15
What is the Problem Solving Perspective?





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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
16
Problem-solving perspective (PSP)
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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.
17
Knowledge-based objectives of a manager
1.
2.
3.


Choose problems with potential solutions high in value.
Organize to optimize likelihood, speed, and cost with which
valuable solutions are discovered.
Appropriate a portion of the solution’s value.
Set aside (3), focus on (2) for different types of (1).
Solution landscapes

Innovative solutions to complex problems arise from
recombinations of existing technology/knowledge.

Solution landscape: Set of all possible combinations of
relevant existing knowledge.

Terrain of landscape changes with interdependency of
knowledge sets.

Value of the global maximum rises but average peak declines
as interdependency increases.
18
Dimensionalizing solution landscapes



Decomposable problems:

value of solutions depends very little on the interaction
among knowledge sets—low interaction.
Nearly decomposable problems:

value of solutions depends somewhat on the interaction
among knowledge sets—moderate interaction.
Non-decomposable problems:

value of solutions is highly dependent on interaction among
knowledge sets—high interaction.
19
Low complexity solution landscapes:
Decomposable problem
Solution Value
Solution Value
7.5
6
4.5
Knowledge Set B
Know ledge set B
7.5
6.75
6
5.25
Knowledge Set A
4.5
1.5
3.75
3
2.25
1.5
0.75
0
3
0
20
Moderate complexity solution landscape:
Nearly decomposable problem
Solution Value
Solution value
7.5
6
4.5
Knowledge Set B
Know ledge set B
0
8
7.5
7
6.5
6
5
5.5
Knowledge
Set A
Know ledge set A
4.5
4
1.5
3.5
3
2.5
2
1.5
1
0
0.5
3
21
High-complexity Solution Landscape:
Non-decomposable Problem
Solution Value
Solution value
7.5
6
4.5
Knowledge Set B
Know ledge set A
0
8
7.5
7
6.5
6
5
5.5
Knowledge
Set A
Know ledge set A
4.5
4
1.5
3.5
3
2.5
2
1.5
1
0
0.5
3
22
How can we find a high peak?

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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.
23
Efficiently searching solution landscapes
Relative benefit of trial ordering and
selection by problem type
Attributes of Knowledge Formation
Decomposable
Nearly
Decomposable
Nondecomposable
++
+
0
0
+
++
Trial Ordering and
Selection Mechanism
Directional Search
Heuristic Search
24
Three organizational archetypes


Markets – the use of contracts
Hierarchy

Authority-based hierarchy (ABH):
 Vertical communication and codes
 “Design rules”
 Direction to subordinates—manager orders trials

Consensus-based hierarchy:
 Horizontal communication and codes
 Commonality of goal
 Group decision making—groups order trials
25
Markets


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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.
26
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.
27
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.
28
Consensus-based hierarchy



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Arrow—consensus utilizes specialized knowledge sets housed within
the firm and can substitute for authority.

Consensus arises when knowledge transfer is inexpensive and
actors have an overriding commonly valued purpose.
Instruments support heuristic not directional search.

Low-powered incentives attenuate knowledge appropriation
hazard.

Supports horizontal communication channels and codes (and
commonly valued purpose) for knowledge sharing.

Conflict resolution through social relations, which attenuates
strategic knowledge accumulation hazard.
CBH is efficient for non-decomposable problems.
CBH fails for problems with moderate to low complexity because

of excessive costs of maintaining communication channels.

social attachments may misguide and bias search.

social attachments may limit the firm’s capacity to absorb new
forms of knowledge and hence lead to inferior solutions.
29
Comparative assessment of alternatives
Governance Mode
Hierarchy
Market
ABH
CBH
++
0
0*
0
Vertical
Horizontal
Contract law
Authority
Relational
++
+
0
0
+
++
Instruments
Incentive intensity
Communication codes
and channels
Dispute resolution regime
Performance Attributes
Directional search
Heuristic search
30
Discriminating alignment of
Governance alternatives
Market
Expected
cost of
finding a
valuable
solution
Market
*Holding N constant
ABH
ABH
K1
CBH
CBH
K2
Complexity
31
Discussion about PSP

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Instead of explaining why firms exist, PSP explains when firms exist and in
what form
PSP reconciles contradictory knowledge-based explanations for the firms
PSP is based on probabilistic assessment of solution discovery, so:

aligning governance does not guarantee discovery

serendipity is possible

multiple valuable solutions are possible and continuing search depends
on a cost benefit analysis
Implicitly and wrongly assumes successively chosen problems independent

Extant knowledge sets within firm shape problem choice
 knowledge development and protection a concern
 not currently considered in our governance choice logic
While PSP focuses on a single problem, impetus for path dependence is
inherent in model

Boundaries may change in response to problems chosen

Problems have their life-cycles

Change problems or change knowledge and organization
32
Does PSP add value?

Criticisms of KBV and TCE

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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
0
0
+
+
+
+
+
0
0
+
0
+
+
TCE
++
++
+
0
0
0
0
+
++
0
0
0
0
PSP
++
+
+
+
++
+
++
++
++
+
+
++
++
33
How to assemble and organise knowledge?
Opportunity
cost of
acquiring
knowledge
Jointventures
Complex
contracting
Authoritybased
hierarchy
Firm
Boundary
Consensusbased
hierarchy
Simple
contracting
Problem complexity
34
Example: US truck transport industry

Paper by Hamilton and Nickerson (ASQ)

Compare LT and LTL, for-hire trucks in US
 How they differ
 LTL hub-and-spoke => large investment needs, LT doorto-door => less...
 LT as one-to-one, LTL as one-to-many solutions (more
need for coordination in LTL)
 LTL should be one, LT can be dispersed (little benefits
from internalisation)
 Question: how is profitability affected by driver
missalignment?
 Answer: those, who misalign have lower profits ceteris
paribus
35
Bringing the market inside the firm

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Baker, Gibbons and Murphy (AER)
Theoretical model:

Upstream party, downstream party and assets

Transaction contains contractible (court-enforceable) and
noncontractible (bargaining, hold-up, etc.) components

Compare spot employment and spot outsourcing
Conclusions:

Informal spot markets cannot be replicated within firm

Relational employment can improve both spot alternatives via
providing adequate incentive structure (separating equilibrium)
Why important?

Selective intervention can provide a viable alternative to
„infinitely huge” firms

Sometimes selective intervention impossible

Relational contracts are important inside firms because they
improve on market outcomes (and not because they replicate
spot-market payoffs)
36