Economic Foundations Conclusion - Part 2

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

Transaction Cost Theory

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

Resource-Based View

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

Dynamic Capabilities

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

(Adapted from course notes)

(Flashcards and other resources here)

Economic Foundations Conclusion - Part 1

This week, I spent my time reviewing theories used in strategic management that were derived from economics or grounded in economic concepts.

In one of my classes, we were encouraged to summarize theories by looking at the assumptions they make, how they are similar to other theories, the unit of analysis, and the predictions that can be made.

I will conclude the review of economic foundations by describing the major theories in those terms:

Industrial Organization

• Key idea:
• Builds on the theory of the firm. Looks at the impact of structure (read: boundaries) of firms and markets.
• Assumptions:
• Adds "complications" to perfectly competitive market.
• Unit of Analysis:
• Industry, firm.
• Seminal papers and authors:
• Stigler (1965)
• Collusion is very difficult, even if firms want to do it.
• Caves & Porter (1977) 
• Entry barriers are both due to the structure, and also endogenous to the industry. Entry decisions to an industry depends on a firm's strategic position. 
• Demstez (1973) 
• Industries become concentrated due to their efficiency, not because of collusion.
• Gilbert (1989) 
• Industry structure is not strictly exogenous, but is endogenous as industry incumbents try to influence the behaviors of potential rivals by engaging in strategic entry deterrence behavior (either by forestalling entry or inducing exit).
• Shapiro (1989)  
• Overview of recent IO research that includes game theory; emphasizes the dynamics of strategic actions and the role of commitment in strategic settings, not possible to determine an overall theory of oligopoly.
• Arthur (1989)  
• Examine the dynamics of allocation under increasing returns in a context where agents choose between technologies competing for adoption.
• Similarity or relationship to other theories:
• Since it addresses boundaries of the firm, perhaps TCE can be a complement.
• What kind of predictions can be made:
• The structure of the industry can be used to create strategy for the firm.

Managerial Theories

• Key idea:
• There is a separation of ownership and control of the firm. Managers seek to maximize their own utility.
• Assumptions:
• Managers maximize their own utility.
• Unit of Analysis:
• Firm.
• Seminal papers and authors:
• Bearle & Means (1932)
• Separation of ownership and control of the firm.
• Marris (1963)
• The optimal growth level requires the rate of diversification and profit margin but also a growth-maximizing financial policy. However, because a financial policy is under the hands of managers, an optimal growth level and optimal value of fiscal policy are often set from the point of view of managers, not of shareholders. 
• Penrose (1965)
• Some diversified growth represents efficient use of underutilized firm resources that cannot be separated out for sale. Expansion itself provides an opportunity to further growth, an opportunity that did not exist before the expansion, due to unused resources available at no extra cost. However, due to lack of managerial services (imagination, insight, creativity, experimenting etc), all potential opportunities known and open to a firm are not exploited together. 
• Chandler (1985)
• Vertical integration is driven by a desire to keep firms’ core assets to efficiently employed (assurance of supply) while diversification is the realization of economies of scope
• Similarity or relationship to other theories:
• Since it discusses the separation of ownership and control, agency theory.
• What kind of predictions can be made:
• Features of the firm (diversification or vertical integration) as a result of managers.

Agency Theory

• Key idea
• Because of separation of ownership and control, problems arise aligning priorities of managers with priorities of owners.
• Assumptions
• "Economic man."
• Unit of Analysis
• Principal-agent relationship.
• Seminal papers and authors
• Jensen & Meckling (1976)
• Agency emerges as a response to managerial theory. 
• Fama (1980)
• Market for professional managers ‘disciplines’ managers to work for performance.
• Demsetz (1983)
• Corporate execs, while not often among the largest shareholders, receive incomes that are highly correlated with stock performance, and it forms a strong link between management and owner interests.
• Fama & Jensen (1986)
• Shows how organizations characterized by separation of ownership and control are so common and survive well despite of the agency problems. They show that such organizations control the agency problems by separating management (initiation and implementation) and control (reification and monitoring) of decisions. The common features of decision control system include mutual monitoring system, board of directors consisting of outsiders, decision hierarchies etc. 
• Jensen (1986)
• Debt reduces the agency costs of free cash flow by reducing the cash flow available for spending at the discretion of managers. Debt creation binds managers to keep their promise to pay the debts with future cash flow, in this sense it is an effective substitute of dividend.
• Similarity or relationship to other theories:
• Managerial theories of the firm. Agency theory came about as a direct response to that theory.
• What kind of predictions can be made:
• Behavior of managers based on different control tactics.

(Adapted from course notes)

(Flashcards and other resources here)

Dynamic Capabilities

Like the Resource-Based View, dynamic capabilities theory emerged in the field of strategy.

This theory is grounded in Neo-Austrian or Schumpeterian Economics which views competition as a process (Alchain, 1950; Schumpeter, 1950; Nelson & Winter 1982).

It is similar the RBV of the firm in that it views competitive advantage as the result of valuable capabilities (resources) that are a result of an enterprise’s history. In this theory, capabilities emerge over time as a result of learning from trial and error. They are a path dependent product of a firm’s history.

The arguments in this theory are as follows:

• Capabilities reside in the routines of an organization (Nelson & Winter, 1982) 
• Routines capture the knowledge base of an organization. 
• Routines have a substantial tacit dimension
• Organizations remember by doing. 
• Capabilities are not static; they evolve over time as a result of trial and error as enterprises learn – they are dynamic (Teece et al, 1997). 

Key articles on New-Austrian Economics and Dynamic Capabilities include:

• Alchain (1950)
• Schumpeter (1950)
• Nelson and Winter (1982) 
• Nelson & Winter (2002)
• Chandler (1992)
• Teece et al (1997)

(Adapted from course notes)

(Flashcards and other resources here)

Resource-Based View

The resource-based view (RBV) theory emerged in the field of strategy, however it is firmly rooted in economic concepts.

It draws on Penrose’s (1955) theory of the firm, transaction cost analysis (Williamson, 1985), and the Neo-Austrian work of Nelson and Winter (1982).

One of the core assumptions is that firms are heterogeneous. This, it is argued, is a consequence of the path dependent accumulation of organizational knowhow over time (Nelson & Winter, 1982). Furthermore, it argues that sustained competitive advantage comes from idiosyncratic resources (factors of production) that are:

• Owned by the enterprise 
• Valuable 
• Rare (path dependence assures this)
• Inimitable (uncertain imitability – Lippman and Rumelt, 1982)
• Non-substitutable
• Non-tradable (due to transaction cost issues) 

In this framework, organizations come into possession of valuable and rare resources due to luck, entrepreneurial perception, accumulation of skill over time (organizational learning), or private information. In addition, tacit know-how is often depicted as a rare, valuable, non-tradable and inimitable resource.

This theory can be presented as a “complementary” perspective to tradition IO as exemplified by Porter (1980).

The biggest criticisms of this theory include:

• It can be a tautology: resources are valuable because they are important to the organization; what makes a resource valuable? There is no independent criteria for this.
• It can become a collection of "just right" stories

RBV articles include:

• Lippman & Rumelt (1982)
• Wernerfelt  (1984)
• Barney (1986a, 1986b)
• Conner (1991)
• Barney (1991)
• Reed and DeFillippi (1990)

(Adapted from course notes)

(Flashcards and other resources here)

Transaction Costs

Transaction cost theory focuses on an organization's transactions. The central idea is that when organizations make decisions about their key operations, they either incur transaction costs or production costs. The transaction costs include costs and difficulties associated with the searching for the best supplier, as well as the creation implementation, and monitoring of a contract. Production costs, on the other hand, involve costs associated with the coordination of the people and processes inside a firm. The selection of one set of costs over the other is called the “make or buy” decision. Two factors associated with the choice to buy or make a key component of production is the level of uncertainty and the asset specificity. Both of these concepts are related to risk and the role it plays on a firm’s decisions.

This theory takes the transaction as the fundamental unit of analysis. This theory asks what determines if transactions are organized inside the firm (make, hirerchy) or outside the firm (buy, market). This is another way of thinking about the boundaries of an organization.

Seminal contributions have come from Alchain & Demsetz (1972), Coase (1937) and Williamson (1975, 1985). They hypothesize that there are costs associated with executing certain transaction via a market. Alchain & Demsetz, for instance, place an emphasis on measurement problems in cases of team production. Williamson emphasizes opportunism in contexts where undertaking exchange requires asset specific investments.

Transaction costs can be economized by internalizing the transaction within an organization, so long as the economic benefits of doing so exceed the bureaucratic costs of managing the transaction within a hierarchical setting (Jones & Hill, 1988).   Transaction cost theory assumes (as does agency theory) that in the long run, only firms that economize on transaction costs (or agency costs) will survive.

Product and capital markets perform a rough sort between the efficient and inefficient. This has implications for corporate strategy. A corporation may choose:

• Diversification (Teece, 1980, 1982; Jones & Hill, 1988)
• Vertical integration (Klien et al, 1978)
• Foreign direct investment decisions (Hill & Kim 1988),
• Quasi-integration (alliances – Hill, 1990).  

Several authors have attacked transaction costs and agency theory on grounds that:

• They shape behavior and become self-fulfilling prophesies (Ghoshal & Moran, 1996)
• They ignore the fact that economic transactions are embedded in social networks (Granovetter, 1985; Perrow, 1986), and that societal issues shape organization form.
• They make unrealistic assumptions about selection mechanisms (Robins, 1987). 
• They assume away the costs of internal hierarchy, and ignore the “fact” that a desire for market power drives much of corporate strategy (Perrow, 1986; Peffer & Salancik, 1978).

(Adapted from course notes)

(Flashcards and other resources here)

Agency Theory

Agency Theory emerged as a response to managerial theory (Jensen & Meckling, 1976). The core idea is the relationship between stockholders (owners, principals) and managers (agents). This is often described as the principal-agent relationship. This theory assumes that managers (agents) may pursue goals that are not always aligned with those of their principles (stockholders). As a result, there is a loss in efficiency. In order to avoid misalignment of principal-agent interests, governance mechanisms have evolved to limit managerial discretions. These include:

• Performance based compensation (stock options)
• The board of directors (a monitoring mechanism)
• Corporate debt
• Market for corporate control (takeover constraint)

The costs to deal with the principal-agent problem are called agency costs.

Collectively, agency theory believes that incentive alignment, monitoring, and enforcement mechanisms are generally sufficient to limit managerial discretion. This has a couple of implications:

• The scope for pursuing inefficient corporate strategies is limited. Management teams that do so will be replaced by teams that have the nest interests of owners in mind
• Organizational forms (franchising, vertical integration) may be a response to agency costs.  

Some key articles include:

• Jensen & Meckling (1976) 
• Fama (1980)
• Demsetz (1983)
• Fama & Jensen (1986)
• Jensen (1986)
• Eisenhardt (1989)

(Adapted from course notes)

(Flashcards and other resources here)

Managerial Theories

The managerial theories of firm growth are concerned with the role of management in the productivity and performance of the firm.

Some of the early work was conducted by Bearle & Means (1932). They discussed how in the modern corporation the control of the firm was no longer in the hands of the owners. Their argument revolved around managers having discretion over the goals and strategies of the enterprise. Most importantly, management does not have to maximize returns to owners.

A few of the main managerial theories come from Baumol (1968), Marris (1963), and Williamson (1964). They discuss how managers maximize a utility function that includes power, status, income, among other things. A large firm increases power, status, and income.

Therefore, management prefers growth maximizing rather than profit maximizing strategies. 

The managerial theories are often used to explain diversification, mergers and acquisitions. Furthermore, the emphasize how management often prioritizes maximizing the size of the empire.

This view has two implications.

• Economic Welfare Implication:
• Presumption against large diversified enterprises.
• Strategy Implication
• Much diversification may dissipate rather than create value.
• For example, the presumption against unrelated or conglomerate diversification (Rumelt, (1974)).

This theory also has counterpoints. Most notably:

• Penrose (1955): Diversified growth may represent the efficient use of under-utilized productive services (i.e. slack resources) that cannot be separated out for sale. 
• Firms have limited rate of growth and size due to the  limited supply of managerial services.
• Chandler (1962, 1977, 1985): Vertical integration was driven by a desire to keep core assets fully and efficiently employed (assurance of supply), while diversification was about the realization of economies of scope. 

(Adapted from course notes)

(Flashcards and other resources here)

Industrial Organization Economics

The Economic Foundations of Strategy post set the stage to discuss more deeply how economics has shaped the study of strategy. Here, I will discuss Industrial Organization Economics (IO).

In broad terms, IO examines the structure of the firm and market. In order to do so, researchers typically use the Bain/Mason Structure-Conduct-Performance Paradigm. The main takeaway for this paradigm is that the industry structure leads to certain enterprise conduct which leads to performance. For example:

• Structure: Industries became concentrated due to advantages of large firm size
• Economies of Scale, Product Differentiation, Strategic Behavior
• Conduct: In concentrated industries there was a tendency towards (tacit) collusion
• Price wars were to be avoided (prisoners dilemma)
• Price signaling, price leadership, emphasis on non-price competition
• Performance: Collusive behavior led to maximization of joint returns.  
• Implications: Underlay antitrust policy  

This paradigm was modified to look at how enterprise performance leads to industry structure which then leads to firm performance. Here the example is different:

• Conduct: Firms pursue strategies to build entry barriers, forestall entry, or limit competition in other ways (Gilbert, 1989; Shapiro, 1989).
• Limit pricing, product proliferation, credible investment commitments, strategic pre emption, etc.
• Vertical Integration to control access to inputs or limit access to distribution
• Diversification (cross-subsidization and multipoint competition)
• Structure:  Some industries become concentrated due to network effects (Arthur, 1989)

The key question in IO is "what industry structure is in the best interests of society." This is clearly an an economic welfare question. Porter, however, changed the question to “what strategies are in the best interests of the firm." This second question clearly looks at the conduct and performance link within an industry.

Not all economists agreed with the Structure-Conduct-Performance paradigm. Some relevant critics include:

• Demsetz (1973)
• Industries become concentrated due to enterprise efficiency, not anti-competitive practices.
• Stigler (1965)
• Even if firms want to collude, information costs and enforcement issues make collusion very difficult if not impossible.
• Schumpeter (1950)
• Competition is a process driven by the “perennial gale of creative destruction.”
• Christensen (1997)
• The advantages of large scale can be and are nullified by innovation.

Some papers that have been mentioned above and that are relevant to IO include:

• Caves & Porter (1977)
• Entry barriers can apply in subgroup structures; entry decisions involve strategies of targeting groups and moving into specific segments over time.
• Gilbert (1989)
• Strategic behavior can exploit mobility barriers to the advantage of an established firm.
• Shapiro (1989)
• Overview of recent IO research that includes game theory; emphasizes the dynamics of strategic actions and the role of commitment in strategic settings, not possible to determine an overall theory of oligopoly.
• Arthur (1989)
• Examine the dynamics of allocation under increasing returns in a context where agents choose between technologies competing for adoption.

(Adapted from course notes)
(Flashcards and other resources here)

Economic Foundations of Strategic Management

Strategy draws on many disciplines. As discussed in the Strategy Background post, two of the main influences come from sociology and economics.

Today I will focus on the economic foundations of strategy. This post will be a broad overview of how economics has shaped the study of strategy. Additional posts will discuss theories in much more detail.

Economists, particularly those focused on industrial organization, had been studying issues that are relevant to strategy. For example, they looked at market structure, competitive behavior, vertical integration, diversification, and mergers and acquisitions.

Their research centered around the economic welfare of society. Most importantly, economists had a large body of theory, methodology, and evidence that could be used to address strategy questions.

The leap from theorizing about the economy to the organization was not very difficult. Thus, people trained in economics began to enter this field.

Some of the theories in the field of economics had an immediate application to strategy:

• Industrial Organization Economics
• Managerial Theories of the Growth of the Firm
• Agency Theory
• Transaction Cost Theory
• Neo-Austrian Theories

Furthermore, some theories that have emerged in the field of strategy draw very heavily on economics:

• Resource Based View of the Firm
• Dynamic Capabilities
• Knowledge Based Theories of the Enterprise

(Adapted from course notes)
(Flashcards and other resources here)