1. Jackson Nickerson Transaction and Competences Approaches to the Theory of the Firm Jackson Nickerson Professor of Organization and Strategy John M. Olin School of Business

2. Jackson Nickerson Agenda  Two minutes on “Traditional” transaction cost economics (TCE) and the theory of the firm.  Capabilities/competencies and theory of the firm.  Intersection of Competencies and TCE.  TCE responds….  New perspective and new questions.  Conclusion.

3. Jackson Nickerson Two-minute TCE  “Commons triple” describes the unit of analysis.  Conflict, mutuality, and order.  Unit of analysis  Transaction …  …in its entirety.  Behavioral assumptions  Actors are intendedly rational but limitely so Boundedly rational. Actors attempt to be far-sighted.  Actors may behave opportunistically.

4. Jackson Nickerson “Traditional” TCE  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.  How should the transaction be organized?

5. Jackson Nickerson Comparative assessment of Discrete structural alternatives Governance Mode MarketHybridHierarchy Instruments Incentive intensity Administrative Controls Contract Law Performance Attributes Adaptation (A) Adaptation (C) ++ strong, + semi-strong, 0 weak, Williamson (1996, 103) +++0 Classical Neoclassical Forbearance +++0 0 + ++

6. Jackson Nickerson Alignment of Discrete structural alternatives Market HybridHierarchy Governance Costs k1k1 k2k2 Asset Specificity MarketHybridHierarchy

7. Jackson Nickerson k = 0 k > 0 k » 0 k = 0k » 0 A Williamsonian firm Vertically Integrate k » 0 k > 0 Complex Contract Simple Contract k = 0 Core of the Firm

8. Jackson Nickerson 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.  (Setting appropriability concerns aside.)

9. Jackson Nickerson Criticisms of “Traditional” TCE  How does TCE account for the possibility of capabilities?  How does TCE account for “learning”?  What is the theory of value creation?  Which transactions are undertaken?  Application of TCE is problematic for pre- paradigmatic/entrepreneurial applications.

10. Jackson Nickerson Capabilities/Competencies  Key questions:  What are capabilities?  How do capabilities arise?  What is the capabilities-based theory of the firm?  How do capabilities influence firm performance?

11. Jackson Nickerson What are capabilities?  Sometimes called capabilities, dynamic capabilities, or competences.  Collectively  Knowledge-based view of the firm (KBV).  Resources consist of know-how that can be traded, financial or physical assets, human capital.  Capabilities are the capacity to deploy resources.  Main assumptions:  Bounded rationality. Knowledge is “sticky”.

12. Jackson Nickerson How do capabilities arise?  How capabilities arise has received little attention.  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.

13. Jackson Nickerson What is the KBV theory of the firm?  Theory of firm derives from knowledge-based considerations…  …rather than from incentives, opportunism, and transaction costs.  Basic proposition is that hierarchy is a “creator of a positive” instead of an “avoider of a negative.”  Main prediction: Internalize activities that can be carried out at lower (production) cost than other firms.  “Dynamic transaction costs” indicates teaching is costly.  Internalize those activities that rely on “core competencies.”

14. Jackson Nickerson How do capabilities contribute to the theory of the firm?  Firms economize on the exchange of knowledge rather than 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.

15. Jackson Nickerson How do capabilities influence firm performance?  Capabilities yield superior profitability/survival.  Different capabilities are likely to yield different marginal benefits.  Invest in capabilities that yield the greatest marginal returns to investment.  (Setting appropriability concerns aside.)

16. Jackson Nickerson Critical concerns  Should KBV assumptions omit opportunism?  What is the unit of analysis?  How can competencies be operationalized?  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?

17. Jackson Nickerson 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.

18. Jackson Nickerson Accounting for pre-existing capabilities: The “shift” parameter Market HybridHierarchy Governance Costs k1k1 k2k2 Asset Specificity “Positive” capabilities reduce sum of transaction and production costs.

19. Jackson Nickerson Further refinement opportunities  Fixed niche  How do the pre-existing competencies of Firm A compare to rivals with respect to market niche  1 ?  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?  Strategizing  If firm A possesses monopoly power, how can it best deter and discipline actual and potential rivals?

20. Jackson Nickerson 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?

21. Jackson Nickerson New perspective?  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.

22. Jackson Nickerson 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.

23. Jackson Nickerson Knowledge-based objectives of a manager 1.Choose problems with potential solutions high in value. 2.Organize to optimize likelihood, speed, and cost with which valuable solutions are discovered. 3.Appropriate a portion of the solution’s value.  Set aside (3), focus on (2) for different types of (1).

24. Jackson Nickerson 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.

25. Jackson Nickerson Dimensionalizing solution landscapes  Simon and NK models.  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.

26. Jackson Nickerson Low complexity solution landscapes: Decomposable problem Knowledge Set A Knowledge Set B Solution Value

27. Jackson Nickerson Moderate complexity solution landscape: Nearly decomposable problem Knowledge Set A Knowledge Set B Solution Value

28. Jackson Nickerson High-complexity Solution Landscape: Non-decomposable Problem Knowledge Set A Knowledge Set B Solution Value

29. Jackson Nickerson 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.

30. Jackson Nickerson Efficiently searching solution landscapes Attributes of Knowledge Formation DecomposableNearly Decomposable Non- decomposable Trial Ordering and Selection Mechanism Directional Search Heuristic Search +++0 0 + ++ Relative benefit of trial ordering and selection by problem type

31. Jackson Nickerson Knowledge formation hazards  Knowledge appropriation  Arrow information paradox (asymmetric information and zero marginal cost).  Knowledge hoarding or embedding knowledge in products.  Contaminates effort to promote knowledge sharing needed for heuristic search.  Strategic knowledge accumulation  Actors have an incentive to accumulate specialized instead of co-specialized knowledge—strategic manipulation of trial ordering.  Leads to conflict over trial ordering for heuristic search.

32. Jackson Nickerson Analysis of governance alternatives  Instruments of governance  Assignment of decision rights over the path of solution search and corresponding conflict resolution mechanisms.  Communication channels to support knowledge transfer.  Incentive to motivate search.  Comparative assessment of governance alternatives for overcoming knowledge formation hazards.

33. Jackson Nickerson Three organizational archetypes  Markets – the use of contracts.  Hierarchy  Authority-based hierarchy: 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.

34. Jackson Nickerson 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.

35. Jackson Nickerson 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.

36. Jackson Nickerson 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.

37. Jackson Nickerson 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.

38. Jackson Nickerson CBH failure  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.

39. Jackson Nickerson Comparative assessment of alternatives Governance Mode Hierarchy MarketABHCBH Instruments Incentive intensity Communication codes and channels Dispute resolution regime Performance Attributes Directional search Heuristic search ++00* Contract law AuthorityRelational +++0 0 + ++ 0 Vertical Horizontal

40. Jackson Nickerson Discriminating alignment of Governance alternatives Market ABHCBH Expected cost of finding a valuable solution K1K1 K2K2 Complexity MarketABHCBH *Holding N constant

41. Jackson Nickerson Discussion  Instead of explaining why firms exist, PSP explains when firms exist and in what form.  PSP reconciles contradictory knowledge-based explanations for the existence of firms.  PSP is based on probabilistic assessment of solution discovery, thus  aligning governance does not guarantee discovery.  serendipity is possible.  multiple valuable solutions are possible and continuing search depends on a cost benefit analysis.

42. Jackson Nickerson Discussion  PSP implicitly assumes successively chosen problems are independent—this is not the case.  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.

43. Jackson Nickerson 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++

44. Jackson Nickerson New questions?  Manager’s/Entrepreneur’s role is to match problem opportunities with solution opportunities.  What problems should managers choose?  How do knowledge acquisition and experience shape cognitive frame for identifying and choosing problems?  How does manager’s (incomplete) knowledge of accumulated trials shape problem choice?  How do managers shape expectations over the value of problem opportunities?  How do managers shape expectations of likelihood and cost of solution opportunities?

45. Jackson Nickerson Other extensions?  How does the number of knowledge sets impact complexity and organizational choice?  What are the tradeoffs in substituting acquisition, accumulation, and application of manager’s knowledge sets for CBH?  What factors determine the choice of various “hybrid” modes of governance?

46. Jackson Nickerson How to assemble and organize knowledge? Problem complexity Complex contracting Complex contracting Authority- based hierarchy Authority- based hierarchy Consensus- based hierarchy Consensus- based hierarchy Simple contracting Simple contracting Opportunity cost of acquiring knowledge Firm Boundary Joint- ventures Joint- ventures

47. Jackson Nickerson In conclusion …  I reviewed “traditional” discussions about knowledge and competency-based theories of the firm.  I tried to be controversial by offering a new perspective on a knowledge-based theory of the firm.  I hope this material leads to useful discussions.  Thank you for the opportunity to share my thoughts with you.