Joanna Tyrowicz

1

• Joanna Tyrowicz
• Limits of an enterprise

Institutional Economics
2
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
• Intersection of competencies and TCE
• Problem solving perspective
• New perspectives and new questions
• Correcting for endogeneity
• Bringing the market inside the firm
• Example of research truck transport industry in
  US
• Conclusions

3
What do we think about an enterprise?

• Behavioral assumptions
• Actors want to be rational but there are limits
• Boundedly rational
• Actors attempt to be far-sighted
• 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

4
Comparative assessment of discrete structural
alternatives
Governance Mode Governance Mode Governance Mode
Market Hybrid Hierarchy
Instruments
Incentive intensity
Administrative Controls
Contract Law
Performance Attributes
Adaptation (A)
Adaptation (C)
strong, semi-strong, 0 weak, Williamson (1996, 103) strong, semi-strong, 0 weak, Williamson (1996, 103)
0
0
Classical Neoclassical
Forbearance
0
0
5
Alignment of discrete alternatives
Market
Hybrid
Hierarchy
Governance Costs
Market
Hybrid
Hierarchy
k1
k2
Asset Specificity
6
A Wiliamsonian firm
Vertically Integrate
Core of the Firm
Complex Contract
Simple Contract
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Implications for firm performance

• Main predictions
• Vertically integrate in response to deep
  co-specialization
• Hybrid in response to moderate levels of
  co-specialization
• Market in response to low levels of
  co-specialization
• Aligning transactions in an economizing way
  yields superior firm performance (profitability,
  survival)
• Firms presumably invest in asset specificity
  because it creates value
• Capabilities/competences
• What are capabilities?
• How do capabilities arise?
• What is the capabilities-based theory of the
  firm?
• How do capabilities influence firm performance?

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What are capabilities?

• 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.

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What are capabilities?

• Main assumptions Bounded rationality ltgt
  knowledge is sticky.
• Two views
• Myopic view
• Passive spillovers from tacit and endogenous
  learning-by-doing processes.
• Path-dependent evolutionary process.
• Largely informal processes of accumulation.
• Farsighted view
• Deliberate and sustained investment of financial
  and managerial resources generate capabilities.
• Largely formal processes of accumulation.

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What is the KBV theory of the firm?

• Theory of firm derives from knowledge-based
  considerations
• 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 gt 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

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How do capabilities influence firm performance?

• 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?

12
Williamsons (1999) response

• Generic
• How do alternative generic modes compare for
  purposes of organization transaction X?
• Williamsons traditional theory is capability
  neutral.
• Particular
• How should firm A, with its pre-existing
  strengths and weaknesses (i.e., competencies),
  organize transaction X?
• Williamson (1991) made provision for pre-existing
  capabilities.

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Accounting for pre-existing capabilitiesThe
shift parameter
Market
Hybrid
Hierarchy
Governance Costs
Positive capabilities reduce sum of
transaction and production costs.
k1
k2
Asset Specificity
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Further refinement opportunities

• Fixed niche
• How do the pre-existing competencies of Firm A
  compare to rivals with respect to market niche
  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?

15
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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What is the Problem Solving Perspective?

• Knowledge-based objectives of a manager and
  choosing problems to solve.
• Solution landscapes and complexity
• Different ways to search landscapes for solutions
• Knowledge formation hazards
• Alternative governance structures
• Markets
• Authority-based hierarchy
• Consensus-based hierarchy
• Discriminating alignment

17
Problem-solving perspective (PSP)

• Focuses on the creation of new knowledge.
• Uses a comparative governance logic.
• Assume bounded rationality and opportunitsm.
• Predicts not only firm boundaries but also
  alternative internal organizational structures
  (discriminating alignment logic).
• Competencies are generated from the theory.
• Makes explicit provision for path dependence.
• Utilizes a unit of analysis new to TCE.
• Potentially informs choice of problems.
• Relates to an entrepreneurial theory of the firm.

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Knowledge-based objectives of a manager

• 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 solutions 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.

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Dimensionalizing solution landscapes

• Decomposable problems
• value of solutions depends very little on the
  interaction among knowledge setslow interaction.
• Nearly decomposable problems
• value of solutions depends somewhat on the
  interaction among knowledge setsmoderate
  interaction.
• Non-decomposable problems
• value of solutions is highly dependent on
  interaction among knowledge setshigh interaction.

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Low complexity solution landscapesDecomposable
problem
Solution Value
Knowledge Set B
Knowledge Set A
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Moderate complexity solution landscapeNearly
decomposable problem
Solution Value
Knowledge Set B
Knowledge Set A
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High-complexity Solution LandscapeNon-decomposab
le Problem
Solution Value
Knowledge Set B
Knowledge Set A
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How can we find a high peak?

• Search is uncertain Central issue is the pattern
  of trials to undertake.
• Pr(val.sol.)0 if problem complex and trial
  choice random.
• Directional search
• Expected value of a particular trial is
  determined by reference to one or more nearby
  trials.
• Heuristic search
• Expected value of a trial depends on developing
  heuristics about knowledge set interaction.
• Bounded rationality and distributed knowledge
  makes heuristic search more costly than
  directional search.

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Efficiently searching solution landscapes
Relative benefit of trial ordering and selection
by problem type
Attributes of Knowledge Formation Attributes of Knowledge Formation Attributes of Knowledge Formation
Decomposable Nearly Decomposable Non-decomposable
Trial Ordering and Selection Mechanism
Directional Search
Heuristic Search
0
0
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Three organizational archetypes

• Markets the use of contracts
• Hierarchy
• Authority-based hierarchy (ABH)
• Vertical communication and codes
• Design rules
• Direction to subordinatesmanager orders trials
• Consensus-based hierarchy
• Horizontal communication and codes
• Commonality of goal
• Group decision makinggroups order trials

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Markets

• Hayekmarkets are a marvel for transferring
  knowledge.
• Instruments support directional not heuristic
  search.
• High-powered incentives to specialize and exploit
  knowledge.
• Weak supports for investments in knowledge
  sharing or language to facilitate knowledge
  sharing.
• Weak conflict resolution (classical contract law)
  over trial ordering.
• Markets are efficient for decomposable problems
  but fail as landscapes become increasingly
  complex.

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Authority-based hierarchy

• Demsetzauthority serves to economize on the
  transmission and handling of knowledge.
• Instruments moderately support directional and
  heuristic search.
• Low-powered incentives attenuate knowledge
  appropriation hazard.
• Supports vertical (not horizontal) communication
  channels and codes to facilitate central figure
  acquiring, accumulating, and applying knowledge
  to guide search.
• Conflict resolution through authority dampens
  strategic knowledge accumulation hazard.
• ABH is efficient for nearly decomposable problems.

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ABH failure

• ABH fails for non-decomposable problems because
• central figure can not acquire, accumulate, and
  apply requisite knowledge to develop necessary
  heuristics.
• it does not support horizontal communication
  channels.
• central figure contaminates trial ordering due to
  meddling.
• ABH fails for decomposable problems because
• number of knowledge sets is beyond managers
  cognition.
• central figure contaminates trial ordering due to
  meddling.
• weak incentives limit specialized knowledge
  formation.
• excessive costs of knowledge sharing.

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Consensus-based hierarchy

• Arrowconsensus 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 firms capacity
  to absorb new forms of knowledge and hence lead
  to inferior solutions.

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Comparative assessment of alternatives
Governance Mode Governance Mode Governance Mode
Hierarchy Hierarchy
Market ABH CBH
Instruments
Incentive intensity
Communication codes and channels
Dispute resolution regime
Performance Attributes
Directional search
Heuristic search
0 0
0 Vertical Horizontal
Contract law Authority Relational
0
0
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Discriminating alignment of Governance
alternatives
Market
ABH
CBH
Expected cost of finding a valuable solution
Market
ABH
CBH
K1
K2
Complexity
Holding N constant
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Discussion about PSP

• 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

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Does PSP add value?

• Criticisms of KBV and TCE
• Is opportunism considered?
• Is the unit of analysis operational?
• Can it account for capabilities?
• Can competencies be operationalized?
• How are capabilities created?
• Is learning accounted for?
• Is value creation considered?
• Are deficiencies of hierarchy described?
• Is there a discriminating alignment?
• Which transactions are undertaken?
• Does in inform entrepreneurship?
• Which competencies are valuable?
• Does it unpack path dependence?

• KBV TCE PSP
• 0
• 0
• 0
• 0
• 0
• 0
• 0
• 0
• 0
• 0 0
• 0
• 0

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How to assemble and organise knowledge?
Firm Boundary
Opportunity cost of acquiring knowledge
Joint- ventures
Complex contracting
Consensus- based hierarchy
Authority- based hierarchy
Simple contracting
Problem complexity
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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 gt large investment needs, LT
  door-to-door gt 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

36
Bringing the market inside the firm

• 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)