Strategic Rents and Transaction Costs
in the Theory of thE Firm
Josef Windsperger
Center for Business Studies
University of Vienna
Brünner Str. 72
A-1210 Vienna
Austria
Tel.: 00431-4277-38180
Fax: 00431-4277-38174
E-mail:
Vienna, October 2003
Abstract:
The objective of this paper is first to explain the existence of the firm as knowledge-creating institution by developing a strategic efficiency criterion. Starting from Connor and Prahalad’s view, we critically comment on the resource-based theory of the firm and show that a strategic efficiency criterion is missing in the previous literature. Second, we show that the existence of the firm as a knowledge-creating and knowledge-exploiting governance structure can be only explained by combining transaction cost and resource-based reasoning because rent-yielding resources and capabilities are closely intertwined with asset specifity and transaction costs. Finally, we argue that ‘economizing is more fundamental than strategizing’ (Williamson) because the transaction cost theory of the firm can be established in a zero strategic rent world, but a strategic theory cannot be formulated in a zero transaction cost world.
Key-words: Transaction Cost, Rents, Strategic Theory, Resource-based Theory.
Strategic Rents and Transaction Costs in the Theory
of thE Firm
1. Introduction
During the last decade the theory of the firm has made important progress. On the one hand, contractual approaches of the firm have reached a new stage of development through the new property rights theory (Grossmann and Hart 1986, Hart and Moore 1990, Hart 1995). In addition, the application of the transaction cost theory was very successful in economics, law, organization and marketing (Rindfleisch and Heide 1997, Anderson 1996, Macher and Boerner 2001). On the other hand, an alternative paradigm has been evolving since the 1980-ies - the strategic theory of the firm (Wernerfelt 1984, Rumelt 1984, Connor 1991, Barney 1991, Mahoney and Pandian 1992, Grant 1996, Kogut and Zander 1996, Teece et al. 1997, Barney et al. 2001, Priem and Butler 2001, Nickerson and Zenger 2001). Based on Penrose's resource-based theory (Penrose 1959) and Porter's activity-based approach (Porter 1980, 1985), the strategic theory of the firm investigates the influence of the market structure and internal resources and capabilities on the firm strategy and organization. Hence it tries to explain the efficient strategy-structure relationship. However, previous literature in the strategic theory of the firm has not incorporated a strategic efficiency criterion to evaluate the competitive advantage of organizational modes. Strategic efficiency refers to the realization of sustainable competitive advantages as strategic rents of the firm. Depending on the origin of competitive advantage, different strategic rents can be realized. If the competitive advantage primarily results from monopolistic advantages, as argued by Porter (1980, 1985), the strategic choice depends on the generation of monopolistic rents. If the competitive advantage is primarily based on knowledge advantages due to specific resources, capabilities and competencies, Ricardian and Schumpeterian rents can be realized (Peteraf 1993, Winter 1987).
Starting from Wernerfelt (1984), Winter (1987) and Barney (1991), Kogut and Zander (1992, 1996) as well as Connor and Prahalad (1996) presented a resource-based view of the firm. The firm is less a contractual network economising on transaction costs but more a rent-yielding bundle of resources and capabilities. They differentiate their approach from the transaction cost theory by emphazising that knowledge-based advantages do not require the assumption of opportunism to explain the existence of the firm. As Kogot and Zander formulated, firms exist because of their „higher order organizing principles“ (1992, p. 384). Under the resource-based view this means that knowledge-based competitive advantages can be more easily created when specific and tacit resources are internally combined to build up organizational capabilities and core competencies (Grant 1991, 1996). This view is also compatible with Nickerson and Zenger’s knowledge-based theory of governance choice. Nickerson and Zenger (2001) developed a theory of alignment that predicts under which problem-solving conditions market supplants hierarchy as knowledge formation mechanism. Their theory can be summarized by the following proposition: The governance mechanism as knowledge formation mechanism depends on the complexity and decomposability of problems. The more complex and non-decomposable the organizational problems, the higher is the tendency toward hierarchy as consensus-based system. On the other hand, Nickerson and Zenger’s theory does not include a knowledge-based efficiency criterion for the governance choice. To summarize the previous literature we may conclude, that the main difficulty of the existing resource-based theories lies in the missing efficiency criterion to evaluate the governance mode as knowledge creation mechanism. Starting from this gap in the literature, the primary objective of our paper is to develop a strategic efficiency criterion and to use this concept to explain the existence of the firm as knowledge-creating institution. Furthermore, we develop an integrative view of the firm and show that the existence of the firm as knowledge-creating and knowledge exploiting mechanism is inseparably intertwined with strategic rents and transaction costs. This simultaneity issue has not been featured in previous resource-based theories of the firm, except Madhok’s discussion of the alignment hypothesis (Madhok 2002).
The paper is organized as follows: Section two criticizes Connor and Prahalad's resource-based view of the firm and develops a resource-based theory of the firm by incorporating strategic rents as efficiency criterion to evaluate the governance modes. In section three we show that the transaction cost theory of the firm can be constructed without assuming that the transactors have heterogeneous resources and capabilities. Section four presents an integrative approach by combining the transaction cost and resource-based view. Finally, we argue that a strategic theory of the firm cannot be formulated without transaction costs, but a transaction cost theory of the firm can be established in a zero strategic rent world.
2. Resource-based Theory of the Firm
2. 1. Connor and Prahalad's View
Connor and Prahalad’s theory (Connor and Prahalad 1996) is the most sophisticated version of the resource-based theory developed in the last years. In the following, we summarize and criticize their view. Their resource-based approach of the firm is based on the knowledge substitution and flexibility effect of the organizational mode:
(a) Knowledge substitution effect: If Y (as supplier) and Z (as final goods producer) have certain resources and capabilities, both have two possibilities to influence the other‘s actions: Firm organization and market contracting. The knowledge substitution effect exists when one party (in Connor and Prahalad’s case Z) directs the action of the other party (Y). Hence it refers to the hierarchical mode of coordination. Under this mode, Z can require Y to act according to Z’s judgement. This effect results in a competitive advantage if Z has a specific knowledge base that cannot be internalized by market contracts. In this case, internal organization better enables knowledge creation without full knowledge absorption. This is compatible with Demsetz' view that „[d]irection substitutes for education“ (1991, p. 172). The greater the initial difference in knowledge due to higher skills and capabilities, the larger the knowledge substitution effect.
(b) Flexibility effect: „The flexibility effect accounts for the relative cost, under the two organizational modes, of altering the parties’duties and responsibilities on an ongoing basis, in order to incorporate learning or unexpected opportunities...“ (Connor and Prahalad, p. 486). Hence it refers to the dynamic capabilities of the firm. The more dynamic and competitive the environment, the more often changes in skills, duties and responsibilities are required favouring the firm organization, because under market contracting it will be difficult to provide for unanticipated acquisition of new knowledge. However, the flexibility advantage of firm organization only exists if it is assumed that Z has higher learning or knowledge-upgrading capabilities than Y. This flexibility effect is compatible with Langlois’s concept of dynamic transaction costs as learning costs (Langlois 1992).
Which resource-based predictions can be derived from Connor and Prahalad's approach? According to Connor and Prahalad, the firm existence is more likely, the higher the knowledge substitution and flexibility advantages are. Consequently, the firm will arise as knowledge-creating institution if the net value of the knowledge substitution and flexibility is higher than under market contracting. Connor and Prahalad’s approach can be criticized as follows:
First, the main critics refers to the missing knowledge-based (resource-based) efficiency criterion: They compare the organizational modes according to the knowledge substitution and flexibility effects without explicitly incorporating a strategic efficiency criterion. Oliver Williamson (1999) also criticized this point, but he does not propose a solution. Hodgson proposes a dynamic efficiency criterion for the resource- or competence-based theories. Dynamic efficiency refers to „learning and innovations“ (Hodgson 1998, p. 188). This is an important starting point to distinguish transaction cost and resource-based approaches. However, Hodgson does not operationalize this efficiency concept.
Second, as already criticized by Foss (1996), Connor and Prahalad assume that the knowledge substitution and flexibility effects are primarily realized under firm organization. This need not be the case. For instance, as shown by Argyres (1996), market contracting may result in strategic advantages if the supplier has higher organizational capabilities.
Third, Connor and Prahalad present a comparison of the resource-based theory with the transaction cost approach as the opportunism-dependent approach (Connor and Prahalad, p. 489). The problem of this comparison is that they do not specify the conditions under which the predictions are possible. The restriction of the transaction cost theory to the opportunism-based view as a reference theory cannot be justified, because transaction cost theory is more than the opportunism-based view. This comparison neglects the information processing view of the firm as an important component of transaction cost theory because – as already argued by Coase 1937, McManus 1972, and Casson 1994 – bounded rationality is sufficient to move from market to hierarchy due to information cost savings. In a world of bounded rationality/zero opportunism the firm exists as an information processing mechanism due to high market coordination costs. The extent of information processing advantage of the firm depends on the degree of environmental uncertainty. If high environmental uncertainty exists, frequently new information arises resulting in high search, bargaining and adjustment costs under market contracting. In this case, the firm organization may lower the coordination costs by installing a higher information processing capacity.
2.2. A Resource-based Approach of the Firm
Starting from the Connor and Prahalad’s approach we develop a resource-based theory of the firm by incorporating strategic rents as efficiency criterion to evaluate the organization modes. As discussed in section 3.1., Connor and Prahalad developed a knowledge-based approach for the existence of the firm. They argue that the firm’s existence can be explained on the basis of the transactor’s knowledge advantages resulting from firm-specific resources and dynamic capabilities. The first refers to the knowledge substitution effect and the latter to the flexibility effect under changing environmental conditions. In the following, we argue that knowledge substitution and flexibility effects are only relevant for a resource based theory of the firm, when they are closely related to the rent-generating potential of organizational mode.
As argued by Barney (1991), Amit and Schoemaker (1993) and Alvarez and Busenitz (2001), the firm's resources, capabilities and competencies (as strategic assets) may generate a sustainable competitive advantage if rarity, imperfect imitability and nonsubstitutability exist. Under this resource-based view of the firm, strategic rents (including Ricardian and Schumpeterian rents) are the efficiency criteria to evaluate the firm’s competitive advantage. Ricardian rents result from knowledge advantage due to differences in existing firm-specific resources and "static capabilities" (Fujimoto 1998, p. 17), and Schumpeterian rents result from knowledge creation due to differences in dynamic or innovation capabilities (Teece et al. 1997, Penrose 1959, p. 85). This organizational learning refers to the knowledge-leveraging capabilities to strengthen the firm’s competitive advantage in the future. This concept of strategic rents is also compatible with Putterman’s “information rents” (1995, p. 379), but Putterman does not differentiate between rents due to static and dynamic capabilities.
In the following, we show that the resource-based theory explains the firm as knowledge-creating institution due to its higher strategic efficiency, compared to market contracting. We differentiate between two strategic criteria: Ricardian rents (RR) due to static resource advantages and Schumpeterian rents (SR) due to dynamic capabilities (innovation capabilities) advantages. The results of the comparison of the rent-generating effect of the firm organization and market contracting are summarized in figure 1. Based on Connor and Prahalad’s analysis, we use Y as supplier and Z as buyer (final goods producer) and investigate the strategic efficiency of the organizational modes from Z’s point of view. We differentiate four cases:
Insert Figure 1
(1) The firm organization results from Z’s static resource advantages and Z's more efficient organizational learning due to its higher innovation capabilities. Thus Z can realize both higher Ricardian and Schumpeterian rents by internal bundling of resources and capabilities.
(2) In this situation, the firm organization arises if Z's Schumpeterian rents due to its higher innovation capabilities are not compensated by Z's static resource disadvantage.
(3) The firm organization will arise if Z's Ricardian rents due to its static resource advantages exceed the lower Schumpeterian rents (higher learning costs) due to Z's lower innovation or dynamic capabilities compared to Y.
(4) Market contracting is more efficient from Z’s strategic point of view, because Z can leverage its resources and capabilities by acquiring and exploiting Y’s static resource and innovation capabilities advantage.
Consequently, the firm will arise as a knowledge-creating institution (Nonaka et al. 2000), if the sum of Ricardian and Schumpeterian rents from internal bundling of resources and capabilities are higher than under market contracting. Therefore, a resource-based explanation of the existence of the firm is only possible if the rent-yielding potential of resources under internal organization is higher than under market contracting. The resource-based theory can be summarized by the following proposition:
The firm organization (F) as a knowledge creating institution is more efficient than market contracting (M), if the knowledge-based rents (Ricardian and Schumpeterian rents) under internal organization exceed the rents under market contracting (RF – RM > 0).
3. A Transaction Cost View of the Firm