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. 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

5. 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.

6. 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.

7. 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.

8. 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.

9. Alignment of discrete alternatives Market Hybrid Hierarchy Governance Costs Market Hybrid Hierarchy k1 k2 Asset Specificity

10. 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

11. Comparative assessment of discrete structural alternatives ++ + 0 0 + ++ Classical Neoclassical Forbearance ++ + 0 0 + ++

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

13. 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?

14. 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.

15. 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.

16. 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

17. 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

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

19. 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

20. 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

21. 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)