Joanna Tyrowicz Limits of an enterprise

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 ++ + 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. k = 0 k = 0 k » 0 k » 0 k » 0 k » 0 k » 0 k » 0 k » 0 k » 0 k > 0 k > 0 k = 0 k = 0 k » 0 k » 0 A Wiliamsonian firm Vertically Integrate Core of the Firm Complex Contract Simple Contract

7. 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?

8. 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.

9. What are capabilities? • Main assumptions: Bounded rationality <=> 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.

10. 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

11. How do capabilities influence firm performance? • Capabilities yield superiorprofitability/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. Williamson’s (1999) response • Generic • How do alternative generic modes compare for purposes of organization transaction X? • Williamson’s traditional theory is capability neutral. • Particular • How should firm A, with its pre-existing strengths and weaknesses (i.e., competencies), organize transaction X? • Williamson (1991) made provision for pre-existing capabilities.

13. Accounting for pre-existing capabilities:The “shift” parameter Market Hybrid Hierarchy Governance Costs “Positive” capabilities reduce sum of transaction and production costs. k1 k2 Asset Specificity

14. 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

16. 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.

18. 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 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.

19. 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.

20. Low complexity solution landscapes:Decomposable problem Solution Value Knowledge Set B Knowledge Set A

21. Moderate complexity solutionlandscape:Nearly decomposable problem Solution Value Knowledge Set B Knowledge Set A

22. High-complexity Solution Landscape:Non-decomposable Problem Solution Value Knowledge Set B Knowledge Set A

23. 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.

24. Efficiently searching solution landscapes Relative benefit of trial ordering and selection by problem type ++ + 0 0 + ++

25. 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

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

27. 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.

28. 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.

29. Consensus-based hierarchy • Arrow—consensus utilizes specialized knowledge sets housed within the firm and can substitute for authority. • Consensus arises when knowledge transfer is inexpensive and actors have an overriding commonly valued purpose. • Instruments support heuristic not directional search. • Low-powered incentives attenuate knowledge appropriation hazard. • Supports horizontal communication channels and codes (and commonly valued purpose) for knowledge sharing. • Conflict resolution through social relations, which attenuates strategic knowledge accumulation hazard. • CBH is efficient for non-decomposable problems. • 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.

30. Comparative assessment of alternatives ++ 0 0* 0 Vertical Horizontal Contract law Authority Relational ++ + 0 0 + ++

31. Discriminating alignment of Governance alternatives Market ABH CBH Expected cost of finding a valuable solution Market ABH CBH K1 K2 Complexity *Holding N constant

32. 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

33. 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 ++ Does PSP add value?

34. 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

35. 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 door-to-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

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)