Testing Alternative Theories of the Firm: Transaction Cost, Knowledge-Based, and Measurement Explanations for Make-or-Bu

1. Testing Alternative Theories of the Firm: Transaction Cost, Knowledge-Based, and Measurement Explanations for Make-or-Buy Decisions in Information SystemsLaura Poppo (Virginia Tech) Todd Zenger (Washington University)(1998)Strategic Management Journal Group 3: Jason Franken Prasanna Karhade Hsiao-Ching Lee Jennifer Shen Marko Madunic

2. GOALS AND OBJECTIVES • Strategic management seeks to explain how and why there are differences in firms’ economic performances • Poppo and Zenger’s paper represents transaction-cost economics explanation of firm boundaries • TCE – not an exhaustive tool for analyzing boundary choices • Compare transaction cost, knowledge-based, and measurement cost explanations of make-or-buy choices • TCE has been a popular framework for analyzing the efficiency of inter-organizational boundary decisions

3. Then, why should a firm buy knowledge on a market when it has the capacity to build it internally? • Knowledge is built as coordination and communication mechanisms emerge and become embedded in some shared identity (Kogut and Zander, 1996) • This common identity lowers the cost of communication for future search • “As an activity becomes more specific to the firm, it increasingly accesses and develops a common organizational communication code which both codifies knowledge and facilitates its efficient dissemination and protection ”

4. Then, why should a firm buy knowledge on a market when it has the capacity to build it internally? • Knowledge-based reasoning suggests that firms with superior capabilities tend to have more efficient production • Efficiencies are sensitive to scale, firms with greater production volume tend to internalize functions through vertical integration • STRATEGIC IMPORTANCE OF KNOWLEDGE WITHIN FIRM • (RBV and knowledge based view) – firms will control particular knowledge source when strategic importance is high • Firms adopt the knowledge acquisition mode of internalization

5. Asset specificity • TCE: Assumption that efficient production necessitates investments in physical and human assets that are transaction specific (Williamson, 1979) • TCE logic assumes that firm specific assets reduce costs, these assets are also hypothesized to damage the performance of simple market governance as a result of costly contractual safeguards to protect from opportunist behavior (Williamson, 1981, 1985) Resources and capabilities • The resource-based perspective is similar to TCE theory because asset specificity is related to the nature of firm resources • RBV focuses on the firm’s competencies and capabilities of coordinating productive resources that are not transaction specific

6. SAMPLE AND METHODS • Authors study the governance of nine information services at 152 companies, resulting in a sample 1,368 observations • Survey data were gathered using a key informant technique from chief information service officer or the manager of information technology DEPENDENT VARIABLE • Information technology support services that require specialized skills were used as a dependent variable • The dependent variable has been defined as dichotomous, reflecting a yes/no decision toward outsourcing • Information systems – highly specific functions, involving tacit knowledge were less likely to be outsourced

7. Results and findings: • Authors found that contrary to the RBV hypothesis (hypothesis 2) managers do not become more satisfied with performance as internal activities become more firm specific (page 867). • Firm specificity has a strong negative effect on market performance and no clear effect on firm-level performance • TCE view is corroborated as empirical test clearly shows that asset specificity triggers governance choices because hierarchies more effectively cope with asset specificity than markets • Routines, language and embedded forms of knowledge are thus rigid mechanisms that hamper performance

8. Results and findings: • Decision to vertically integrate when information services are firm specific are more determined by performance dissatisfaction with using market governance (outsourcing) rather than performance satisfaction with using internal governance (internal sourcing) • Therefore, boundary choices should be a function of the possession and composition of rare and inimitable resources that are a source of competitive advantage • Risk of obsolescence is better managed by external suppliers

9. Results and findings: • Firm size • Contrary to the scale economies hypothesis, larger firms are inclined to outsource their IT activities more • Increasing management costs, linked to more complex organizational structure, are major determinant of the outsourcing of non-core activities • IT: Information systems are generally viewed as non-core activities, and difficult to manage internally • Firms will outsource IS functions, the more comprehensive the demands for personnel with extensive knowledge and skills

10. TCE LIMITATIONS • The dynamics of rapidly evolving information technology exposed theoretical shortcomings of TCE research • Authors question overemphasis in TCE on asset specificity, without sufficient consideration of the firm’s competencies and capability of coordinating productive resources that are not transaction specific • If competitive advantage emanates from valuable and inimitable resources (Barney, 1991) then boundary choices should be explained by the possession and composition of resources that are a source of competitive advantage