Testing Alternative Theories of the Firm, Transaction Cost, Knowledge-Based, and Measurement Explanations for Make-or- Buy Decisions in Information Services Authors: Laura Poppo and Todd Zenger Strategic Management Journal (1998), 19: Presented by: Bradley Skousen

Purpose: The purpose of this article is to develop and test competing hypotheses from the transaction cost, knowledge-based, agency, and measurement literature regarding boundary choice and governance performance. Each theory provides a different explanation for the boundary of the firm or governance choice. Examples TCE = Higher asset specificity triggers higher threats of opportunistic behavior that leads to higher transaction costs to safeguard against such threats. Knowledge-based Theory = Increasing asset specificity enhances efficiencies within internal governance (not a result of market failure or opportunistic behavior). Property Rights and Agency Theory = Have argued that boundary choice is reflective of measurement issues.

Purpose, Cont. Model to explicitly test the relationship between exchange attributes and performance of the firm and market: Critical assumption is that the firm will choose the governance mode with the highest performance through the minimization of transaction and production costs. The authors argue that past research has largely assumed the relationship between exchange attributes and performance but not tested it.

Data Authors performed a survey of top computer executives in regard to the performance, governance, and exchange characteristics of internally and externally sourced information services. Information services included: data entry, software application development, software applications maintenance, support for end users, and the design of data networks. Note: Exchange performance was measured as the degree of satisfaction with 1) the overall cost, 2) the quality of the output or service; and 3) responsiveness to problems or inquiries. Note: Boundary choice was measured by the percentage of outsourcing for each service (greater than 75% signified that it was wholly outsourced).

Hypothesis 1a Hypothesis 1a: Increases in the specificity of an activity may negatively affect the performance of governance through the market (Based on Transaction Cost). Exchange Attribute: Asset Specificity Supported: Managers become less satisfied with the cost, quality, and responsiveness of outsourced activities as information service activities become more firm specific.

Hypothesis 1b Hypothesis 1b: Increases in the specificity of an activity will positively affect the performance of governance through firm organization (Based on Knowledge-based Theory). Exchange Attribute: Asset Specificity Not Supported: Based on results, managers do not become more satisfied with performance as internal information service activities become more firm-specific.

Hypothesis 1c Hypothesis 1c: Increases in the specificity of an activity will have stronger positive effects on firm governance than market governance. Consequently, increases in the specificity of an activity encourage vertical integration (Based on Knowledge- based theory). Exchange Attribute: Asset Specificity Logic: TCE suggests that the effects of asset specificity may be negative and the knowledge-based view suggests that the effect of asset specificity on firm performance is positive. Supported: Results indicate that firm specificity has a strong negative effect on market performance and no clear effect on firm performance. Consistent results among all models.

Hypothesis 1d Hypothesis 1d: Increases in the specificity of an activity will have similar effects on firm and market governance. Consequently, increases in the specificity of an activity will be unrelated to the choice of boundary. Exchange Attribute: Asset Specificity Not Supported. Results indicate that hierarchies more effectively cope with asset specificity compared to markets. In sum, the governance choice matters.

Hypothesis 2a Hypothesis 2a: Increased difficulty in measuring the performance of an activity will negatively affect the performance of exchanges governed through the market (Based on Agency Theory & Property Rights). Logic: Ability to measure accurately is what defines the effectiveness of markets. Exchange Attribute: Measurement Difficulty Partially Supported. When information service managers could not easily measure the performance of an outsourced activity, they were less satisfied with the cost. No other support was found for quality and responsiveness to problems.

Hypothesis 2b Hypothesis 2b: Increased difficulty in measuring the performance of an activity will negatively affect the performance of exchanges governed through firm organization (Based on Agency Theory). Exchange Attribute: Measurement Difficulty Supported: Managers were less satisfied with cost, quality, and responsiveness of internal activities when performance was not easily measured.

Hypothesis 2c Hypothesis 2c: Increased difficulty in measuring the performance of an activity will have similar effects on market and firm performance. Consequently, changes in measurement accuracy will be unrelated to the choice of boundary (Based on Agency Theory). Exchange Attribute: Measurement Difficulty Not Supported. Results were unclear and the authors suggest that it may depend on the which performance dimensions managers place the most emphasis on.

Hypothesis 2d Hypothesis 2d: Increases in the difficulty of measuring an activity will have a weaker negative effect on the performance of internally governed exchanges than on market-governed exchanges. Consequently, increases in measurement difficulty increase the likelihood of vertical integration (Based on Institutional Agency Theory). Logic: Firms have the ability to substitute authority and behavioral monitoring whereas markets do not. Exchange Attribute: Measurement Difficulty Not Supported. Results were mixed. For example: Measurement difficulty has a greater negative effect on cost performance in markets than firms but a stronger negative effect on quality and responsiveness performance within firms than within markets.

Hypothesis 3a Hypothesis 3a: Increased technological uncertainty will negatively affect market performance (Based on Transaction Cost). Logic: Greater uncertainty will increase contracting costs. Exchange Attribute: Technology Uncertainty Not Supported. No support indicated that managers were less satisfied with performance when activities had higher levels of technological change for outsourced activities.

Hypothesis 3b Hypothesis 3b: Increased technological uncertainty will negatively affect firm performance (Based on Technological Obsolescence). Logic: Technological uncertainty increases the probability of internal capabilities and routines becoming obsolete. Exchange Attribute: Technology Uncertainty Not Supported. No support indicated that managers were less satisfied with performance when activities had higher levels of technological change for internal activities.

Hypothesis 4 Hypothesis 4: Increases in the scale of demand for an internally sourced activity will positively affect firm performance, but have no sizable effect on the performance of externally sourced activities. Consequently, an increase in the scale of internal demand for an activity increases the likelihood of vertical integration (Based on Production Cost). Logic: Firms produce internally that which they produce efficiently. Exchange Attribute: Economies of Scale Supported. A strong positive affect on satisfaction with the performance of internalized activities was identified and internal demand had no effect on the level of satisfaction with the performance of outsourced activities.

Hypothesis 5 Hypothesis 5: Increases in the magnitude of the skill set required to perform an activity will damage internal performance and positively affect market performance. Consequently, increases in the magnitude of skill sets increase the likelihood of outsourcing (Based on Production Cost). Exchange Attribute: Magnitude of Skill Set Supported. Results, however depend upon the model specifications. The relevant variance in skill sets appears to occur across, not within, information service functions.

Key Points TCE = Results strongly support TCE’s argument that higher asset specificity leads to diminishing effectiveness of market governance. In sum, markets are less efficient than firms in resolving coordination problems and opportunism that arise as exchanges become increasingly specialized. Knowledge-based Theory = Results did not support the Knowledge-based theory of the firm. Agency Theory and Property Rights = Results confirm the role of measurement difficulty as a determinant of governance performance in both markets and hierarchies.

Conclusion: The study suggests that boundary choice matters as each governance mode has different advantages. Results support TCE and agency theory and measurement explanations; however, measurement explanations are inconsistent in the direction of effect. The results are not informative on the role of technological uncertainty on governance performance and optimal boundaries.