Nicolai J. Foss Strategy Economic Organization and The Knowledge Economy - The Coordination of Firms and Resources 2005

Strategy, Economic Organization, and the Knowledge Economy
The Coordination of Firms and Resources

A thought-provoking effort at integrating organizational economics and business
strategy, based on an unusually profound knowledge and respect for both
research traditions. A precious contribution to the development of an emerging
new field of study between economics and management
(Anna Grandori, Bocconi University)
This book is timely. The role of knowledge in the modern economy has been the
subject of considerable woolly thinking. Nicolai Foss brings to the area an
economist’s clarity of thought together with a remarkable breadth of scholarship.
The result is a substantial contribution to our understanding of organizational
theory, the theory of the firm, and the nature of business strategy.
(Robert Grant, City University, London)
With a keen eye, Nicolai Foss scrutinizes the foundations of the knowledge-based
theory of the firm, offering an analysis that is at once critical and constructive.
This will be an essential book for anyone working at the cross-roads of organ-
izational economics and strategy.
(Richard N. Langlois, University of Connecticutt)
Nicolai Foss brings critical and integrative insights to organizations and man-
agement. Those interested in understanding new developments in strategic
management will find this book compelling.
(David J. Teece, University of California, Berkeley)
Strategy, Economic
Organization, and the
Knowledge Economy
The Coordination of Firms and Resources
NICOLAI J. FOSS
1
3
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Strategy, economic organization, and the knowledge economy : the coordination of ﬁrms and resources /
Nicolai J. Foss.
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Includes bibliographical references (p. ) and index.
1. Industrial organization (Economic theory) 2. Strategic planning. 3. Knowledge management. I. Title.
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For Kirsten and Elisabeth
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Preface and Acknowledgments
We are regularly told by politicians, high-ranking bureaucrats, CEOs, the busi-

ness press, and many business administration academics that the emergence of
the ‘knowledge economy’ both prompts and necessitates dramatic changes not
only at the macro level of technology, science, and education policies, but also at
the micro level represented by firms.
Thus, firms, it is argued, are increasingly becoming players in a ‘hyper-com-
petitive’ game (D’Aveni and Gunther 1994), and engaging in extensive knowledge
sourcing from all sorts of knowledge producers—whether they be suppliers,
customers and clients, universities, or employees controlling critical know-
ledge—to support the ‘knowledge-based’ strategies that are appropriate for the
‘new competition’ (Best 1990). Strong implications for the organization of firms
in terms of firm boundaries, organizational structure, and the employment
relation are argued to follow. For example, firms are said to be increasingly
‘knowledge intensive’ (Starbuck 1992) and therefore increasingly dependent on
expert talent in the form of ‘knowledge workers’ (Newell et al. 2003); to be
shrinking their boundaries, yet still have an increasing number of technologies
in-house (Brusoni, Prencipe, and Pavitt 2001); to be flattening their structures and
delegating decision rights to employees to an increasing degree in order to foster
local responsiveness and entrepreneurship (Cowen and Parker 1997); and to be
increasingly reliant on softer forms of organizational control, such as ‘clan’ organ-
ization (Ouchi 1980; Adler 2001). Often the boundary conditions of such
claims are not transparent. It is not clear to which firms in which industries the
claims are supposed to apply. Mechanisms are black-boxed in the sense that it is not
clear how propositions about the knowledge economy are connected to proposi-
tions about economic organization or firm strategy. There is little systematic
empirical evidence that speaks directly to the issue of how the knowledge economy
impacts on organization and strategy.
Moreover, the reach of existing theorizing in economics and business admin-
istration with respect to grappling with these issues is unclear. There is a
diversity of perspectives, but relatively little shared theoretical ground. To use an
evolutionary metaphor, there is rather substantial variation, but weak selection
mechanisms. This volume is a modest attempt to grapple with some of the
foundational issues that pertain to theorizing on organization and strategy in
the knowledge economy. It is (one of ) the result(s) of more than ten years
of research into the theory of economic organization, and in particular into
how this body of theory connects to knowledge issues in strategy. It is therefore
also the result of more than ten years of interaction with other researchers. While
viii preface and acknowledgments
I myself internalize all the costs in the form of blame for obscurities, misinter-
pretation, errors, lack of coherence, etc., I do not want to appropriate all of the
benefits. Thus, portions of the book have been presented at seminars at Zürich
University, the Norwegian School of Economics and Business Administration
(NHH), Bergen, Copenhagen Business School, Freiburg University, Caén Uni-
versity, Erasmus University, Rotterdam, Pisa University, Paris University I (the
Sorbonne), Paris University X (Nanterre), and the Max Planck Institute for
Research in Economic Systems, Jena, and I am grateful for comments and
discussion from the seminar audiences.
Numerous people have provided comments on portions of this manuscript in
various incarnations. In particular, Eric Brousseau, Bruno Frey, Robert Gibbons,
Anna Grandori, Geoff Hodgson, Margit Osterloh, George B. Richardson, Svein
Ulset, and Ulrich Witt have commented directly on portions of the text. Anna
Grandori, Peter G. Klein, and Thorbjørn Knudsen have provided particularly
helpful comments and discussion on a number of occasions. I am also grateful to
a number of colleagues for stimulating discussions, notably Keld Laursen,
Torben Pedersen, and Henrik Lando, and I thank Nicolai Pedersen for very
efficient research assistance. I am extremely grateful to David Musson at OUP for
his very considerable patience. My greatest thanks go to my wife, Kirsten, not
only because she has been willing to internalize the hefty negative externalities of
a husband struggling with a book, but also because her sharp mind has, I hope,
helped me to avoid the worst blunders.
Many of the ideas set out in this book have appeared in previously published
work. Most chapters are based on one or two already published articles. The
relevant articles have, however, been rewritten, and much new material has been
added, so most chapters are to a large extent original pieces of work.
Chapter 1 (‘Strategy and Economic Organization in the Knowledge Econ-
omy’) has been written for this volume.
Chapter 2 (‘The ‘‘Strategic Theory of the Firm’’ ’) uses excerpts from
‘Research in the Strategic Theory of the Firm: ‘‘Integrationism’’ and ‘‘Isolation-
ism’’ ’, Journal of Management Studies, 36 (Nov. 1999): 725–55, and ‘Compe-
tence and Governance Perspectives: How Much Do They Differ? And How Does
It Matter?’ (with Kirsten Foss), in Nicolai J. Foss and Volker Mahnke (eds.),
Competence, Governance, and Entrepreneurship (Oxford: Oxford University Press,
2000). I am grateful to Blackwell for permission to use excerpts from the former
paper.
Chapter 3 (‘The Resource-based View: Aligning Strategy and Competitive
Equilibrium’) uses excerpts from ‘The Resource-based Tangle: In Search of
Sustainable Foundations’ (with Thorbjørn Knudsen), Managerial and Decision
Economics, 24 (2003): 291–307. I am grateful to Wiley for permission to
reproduce excerpts from this paper.
preface and acknowledgments ix
Chapter 4 (‘Knowledge-based Views of the Firm’) uses excerpts from
‘Bounded Rationality and Tacit Knowledge in the Organizational Capabilities
Approach: an Evaluation and a Stocktaking’, Industrial and Corporate Change, 12
(2003): 185–201.
Chapter 5 (‘Strategy, Resources, and Transaction Costs’) has been written for
this volume.
Chapter 6 (‘Economic Organization in the Knowledge Economy’) uses ex-
cerpts from ‘Coase vs Hayek: Economic Organization in the Knowledge Econ-
omy’, International Journal of the Economics of Busines, 9 (2002): 9–36. I am
grateful to Abingdon for permission to use substantial parts of this paper.
Chapter 7 (‘Internal Organization in the Knowledge Economy: The Rise and
Fall of the Oticon Spaghetti Organization’) draws on ‘Selective Intervention and
Internal Hybrids: Interpreting and Learning from the Rise and Decline of the
Oticon Spaghetti Organization’, Organization Science, 14 (2003): 331–49, and is
reprinted by permission of the copyright holder, the Institute for Operations
Research and the Management Sciences, 901 Elkridge Landing Road, Suite 400,
Linthicum, MD 21090 USA.
Chapter 8 (‘Performance and Organization in the Knowledge Economy:
Innovation and New Human Resource Management Practices’) uses large parts
of Keld Laursen and Nicolai J. Foss. ‘New HRM Practices, Complementarities,
and the Impact on Innovation Performance’, Cambridge Journal of Economics, 27
(2003): 243–63.
Chapter 9 (‘Cognitive Leadership and Coordination in the Knowledge Econ-
omy’) uses excerpts from ‘Leadership, Beliefs and Coordination’, Industrial and
Corporate Change, 10 (2001): 357–88.
Contents
List of Figures xii

List of Tables xiii
List of Abbreviations xiv
1 Strategy and Economic Organization in the Knowledge Economy 1
Part I: Strategy: Critical Perspectives

2 The ‘Strategic Theory of the Firm’ 23
3 The Resource-based View: Aligning Strategy and

Competitive Equilibrium 61
4 Knowledge-based Views of the Firm 81
5 Strategy, Resources, and Transaction Costs 98
Part 2: Organization: Critical Perspectives

6 Economic Organization in the Knowledge Economy 121
7 Internal Organization in the Knowledge Economy:

The Rise and Fall of the Oticon Spaghetti Organization 157
8 Performance and Organization in the Knowledge Economy:

Innovation and New Human Resource Management Practices 187
9 Cognitive Leadership and Coordination in the Knowledge Economy 211
References 241
Index 277
Figures
3.1a/b Sustained competitive advantage in Barney (1991)

and Peteraf (1993) 64
4.1 Explanation in the organizational-capabilities approach 94
5.1 Pricing and value creation 111
9.1 Coordination games 221
Tables
2.1 A taxonomy of theory relations 43

2.2 The knowledge-based approach and organizational economics:
explananda and key contributions 44
7.1 Oticon financial and technological performance 164
7.2 Market organization and the spaghetti simulation 165
8.1 Descriptive statistics for a set of DISKO variables 197
8.2 Factor loadings for nine organizational variables 198
8.3 Ordered-probit regressions, explaining innovative
performance across 1,884 Danish firms 200
8.4 Correlations among HRM systems and the firm’s sectoral affiliation 203
8.5 Marginal effects from Table 8.3, models (i)–(iii) 210
9.1 The role of leadership under alternative assumptions about
common knowledge and communication 228
Abbreviations
AT&T American Telephone and Telegraph Company

CA Competitive advantage
CEO Chief Executive Officer
EPR Economics of property rights
HRM(P) Human-resource management (practices)
IBM International Business Machines
ICT Information and communication technologies
KBV Knowledge-based view
OE Organizational economics
OECD Organization for Economic Cooperation and Development
OS Organization studies
R&D Research and development
RBV Resource-based view
SCA Sustained competitive advantage
SCP Structure-conduct-performance
SWOT Strengths, weaknesses, opportunities, and threats
TCE Transaction-cost economics
TQM Total quality management
1
Strategy and Economic Organization
in the Knowledge Economy
Introduction: The Knowledge Economy as Context

Ours is a knowledge economy. This claim has become increasingly prevalent, not
only among politicians, journalists, bureaucrats in organizations such as the
OECD, and fashionable philosophers, but also, though somewhat reluctantly,
among academic economists, and, much less reluctantly, management academ-
ics. The terminology may differ; for example, the OECD has flirted with the
‘learning economy’ (OECD 1996), a notion introduced by Lundvall and John-
son (1994; see also Tomlinson 1999). Of course, the ‘new economy’ was all the
rage until a couple of years ago, although this concept is only partly congruent
with that of the knowledge economy, and now appears to have fallen into
disgrace, no doubt as a result of the dot.com bust.1 Sociologists increasingly
use the notion of the ‘network society’ to cover similar tendencies (Castells
1996). And, of course, there is the ‘new information economy’ (e.g. Halal and
Taylor 1998).
Such notions are perhaps all examples of those concepts that, because they are
ill-defined at the core and fuzzy at the edges yet clearly seem to capture real
phenomena, attract a great deal of scholarly effort from diverse fields and
disciplines, from the stratospheric speculations of a Jean-Francois Lyotard or
Jacques Derrida to painstaking econometrics exercises on the productivity impact
of information and communication technologies. This book is much concerned
with the impact of the knowledge economy on the knowledge production of
management studies, broadly conceived.
More specifically, it is concerned with important parts of the theorizing that
has emerged within the strategy and organization fields to accommodate the
emergence of the knowledge economy, or, more precisely, accommodate those
tendencies that we may think of as characterizing the knowledge economy.2
Among these—real, alleged, and imagined—tendencies is the increasing import-
ance of human-capital inputs, the generally increasing importance of immaterial
assets and scientific knowledge in production, the increasing importance of
immaterial products, the need to control in-house an increasing number of
technologies (even if product portfolios are shrinking) (Brusoni, Prencipe, and
2 strategy and economic organization
Pavitt 2001), and in general to tap an increasing number of knowledge nodes,
not just internally but also through an increasing number of alliances and
network relations with other firms as well as public research institutions (Doz
et al. 2004). These tendencies—that in turn co-evolve with a host of other
tendencies that may be placed under the knowledge-economy heading, such as
increasing competitive pressure and an increasing extent of the market stemming
from increased deregulation and internationalization (Rajan and Zingales 2001),
increasing technological modularity (Langlois 2002), improved methods of
measurement and cost allocation (Zenger and Hesterly 1997), and the increasing
importance of ICT (Brynjolfsson, Hitt, and Yang 2002; Paganetto 2004)—
profoundly impact on economic organization and competitive advantages.
Reflecting this, management academics have firmly stressed the role of organ-
izational factors in the process of building knowledge-based strategies that will
bring sustained competitive advantage (Nonaka and Takeuchi 1995; Grant
1996; Myers 1996; Brown and Eisenhardt 1998; Day and Wendler 1998). For
example, firms are said to adopt ‘network organization’ (Miles and Snow 1992)
and engage in ‘corporate disaggregation’ (Zenger and Hesterly 1997), so as to
become the ‘information age organizations’ (Mendelsson and Pillai 1999) that
can build the ‘dynamic capabilities’ that are required for competing in the
knowledge economy.
It is hard to overestimate the impact that the tendencies that are typically
associated with the notion of the knowledge economy and its diverse aliases have
had on business administration.3 In fact, business-administration scholars them-
selves have been among the most eager proponents of such notions (e.g. Halal
and Taylor 1998; Drucker 1999). The impact manifests itself in a number of
ways. Most visibly, perhaps, it has led to a whole new field in business admin-
istration, appropriately titled knowledge management, which has emerged partly
to reflect the changed competitive and organizational realities (Grant 2002).
However, it has also led to strong changes of focus in more established disciplines
in business administration, such as strategy (e.g. Grant 1996; Brown and Eisen-
hardt 1998), organization (e.g. Brown and Duguid 2002), and international
business and management (e.g. Doz, Santos, and Williamson 2001).4 The
impact has also been felt in such areas as accounting, industrial marketing, and
business law. The favorite concepts of the knowledge movement—that is, no-
tions of ‘competence’, ‘capabilities’, ‘dynamic capilities’, ‘core competence’,
etc.—are becoming generally adopted outside their original strategy and organ-
ization context. Indeed, it is fair to say that a knowledge movement has been
sweeping across business administration since the beginning of the 1990s, almost
attaining the character of a Kuhnian paradigmatic shift. While the knowledge
theme may occasionally have been oversold by its advocates, there is little doubt
that the change in business administration is profound and and that many of the
intellectual changes induced by the knowledge movement will be irreversible.
strategy and economic organization 3
However, these kinds of major intellectual changes are usually quite messy.
The Keynesian revolution is a somewhat comparable example. Keynes (1936)
swept through the economics profession and led to a massive wave of conver-
sions, an entirely new vocabulary and a new field (macro-economics). The
reasons for this conversion still occupy economic methodologists and doctrinal
historians, but there is probably little doubt that external circumstances (the
Depression) played a major role. However that may be, the economics profession
adopted virtually overnight an approach that was characterized by unclear
constructs (e.g. ‘aggregate demand’), unclear or non-existent micro-foundations
(e.g. consumption seemed to be treated in an ad-hoc manner), unclear causal
relations (e.g. How exactly did investments influence aggregate production?),
and unclear policy implications (e.g. What was the role of monetary policy?).
Sorting all this out occupied the creative energies of macro-economists for more
than three decades. Some of the issues may still not have found a fully satisfactory
solution (e.g. the micro-foundations issue).
There is no reason to think that the intellectual puzzles introduced by the
emergence of the knowledge economy will take any shorter time to resolve. In fact,
the puzzles are not unlike each other, as the knowledge movement in business
administration also suffers from unclear constructs (e.g. What exactly is a ‘cap-
ability’?), unclear micro-foundations (What is assumed about the motivation and
information of agents?), unclear causal relations (e.g. How exactly do capabilities
relate to competitive advantage and economic organization?), and unclear ‘policy’
recommendations (e.g. Are flat organizational structures necessarily more condu-
cive to the development of dynamic capabilities than more traditional hierarchical
ones?). Moreover, the external phenomenon that has partly prompted the emer-
gence of the new approach is not identified with as much precision as one could
wish. Economic historians still debate the root causes of the Great Depression.
Relatedly, knowledge of the knowledge economy appears to be rather unsystem-
atic and anecdotal. The following section discusses this in some detail.
What Do We Know about the Knowledge Economy?

Continuity and Discontinuity
One of the striking features of much talk of the knowledge economy is what may
be called the ‘discontinuity thesis’; to wit, that the knowledge economy represents
a qualitative leap in a number of dimensions relative to earlier economies. For
example, in a recent paper (2003) one of the key scholars behind the develop-
ment of the notion of ‘national systems of innovation’ and a former high-ranking
OECD bureaucrat, Bengt-Åke Lundvall, argues that what he calls the ‘learning
economy’ is indeed such a historical discontinuity, because it represents a
significant change in ‘techno-economic paradigm’.5
One well-known problem with this kind of historical-stages thinking is that
what may look like revolutionary change is actually an accumulation of incre-
mental change; that is, the ancient problem of the ‘conversion of degree into
kind’. Indeed, as Lundvall rightly points out, the perception of change is partly
determined by discipline, (economic) historians and economists being sceptical
of talk of ‘new’, ‘knowledge’, ‘learning’, etc. economies (e.g. Nakamura 2000:
15), and management scholars and sociologists typically embracing such talk
much more eagerly.6 Of course, at a sufficiently high level of abstraction (or lack
of precision), there is very little change that is qualitatively new. Those who have
been present at conferences where the notion of ‘new organizational forms’ has
formed the subject of debate will know this. If such forms are characterized by
extensive delegation and high-powered performance incentives, are conglomer-
ates that are organized with divisions as profits centers ‘new organizational
forms’—even though this form is decades old? Of course, exactly the same can
be said of the notion of the knowledge economy. Isn’t it the case that all
economies, past and present, have been ‘knowledge economies’? For example,
didn’t the aboriginal economy in Australia prior to the advent of the Europeans
rely on much knowledge that was extremely specialized and sophisticated relative
to the problems faced by this social group? And so on.
Such debates are usually not productive, and they will be eschewed here by not
taking a stand on whether the tendencies that we may associate with the
knowledge economy are new ones or rather intensifications of existing ones.
Rather, if, as is the case in this volume, the purpose is to examine how the advent
of the knowledge economy has prompted the emergence of a set of theories that
place knowledge centrally as an explanatory concept, and to examine the result-
ing explanations, it is simply not necessary to take a stand in the continuity/
discontinuity debate. For example, one can ask about the micro-foundations of
the knowledge-based view of the firm, how the growing importance of human
capital impacts on organizational control, or how the increasing diversity of
technological inputs in a large number of products impacts on firm boundaries
quite independently of this debate.
The Knowledge Economy as Vision

In an academic context the significance of recent talk of the knowledge economy
and its many partial and complete aliases may lie in the overall vision they supply
for work of a much more detailed nature. When sifting through databases and
identifying scientific papers on the basis of whether they make use of these
concepts, it becomes apparent that relevant papers usually do not present
much evidence for a ‘knowledge economy’ (or new techno-economic paradigm)
per se, but rather adopt the notion in a taken-for-granted manner to frame an
argument at a lower level of analysis. For example, Carmuffo (2002) uses the
concept to frame an argument concerning the ‘new employment relation’; Ewing
(2002) applies it to an argument about the importance of ‘employment brand-
ing’; Garicano and Rossi-Hansberg (2003) use it to frame an argument about
how information technology influences wages and organization; Adler (2001)
uses it as the context for an argument concerning how trust influences economic
organization; and so on. Indeed, this volume, too, uses the notion of the
knowledge economy to frame a number of specific arguments that relate to
firm strategy and organization. However, because I am more specifically con-
cerned (particularly in Part II) with how the knowledge economy influences firm
strategies and organization, it will not do simply to take the notion for granted.
Therefore, below I briefly survey some of those tendencies that we may place
under the heading of the knowledge economy.
More comprehensive attempts to define the notion of the knowledge econ-
omy usually take place at the level of policy and policy advice, and academic
papers and books often simply adopt such definitions. However, it is also the case
that policy-level definitions of the knowledge economy—such as OECD defin-
itions of the knowledge economy as ‘an economy based on knowledge’ and ‘an
economy that is established directly on the basis of the production, distribution,
and utilization of knowledge and information’ (OECD 1996)—serve as devices
to frame lower-level policy recommendations, for example on regional policy or
educational policies. Therefore, definitions remain ambiguous and broad. For
example, the World Bank defines the knowledge economy ‘in terms of four
major pillars that support any knowledge economy’:
An economic and institutional regime that provides incentives for efficiently creating,
acquiring, disseminating, and using knowledge to promote growth and increase welfare
[ . . . ] An effective innovation system, including a system of research centers, universities,
think tanks, consultants, firms and other organizations that can tap into a growing stock
of global knowledge, assimilate it and adapt it to local needs, and create new knowledge;
[ . . . ] A dynamic information and communication infrastructure that facilitates the
effective dissemination and processing of information. An educated and well-trained
population that can create, acquire, disseminate and use knowledge.7
There are several problems with such conceptualizations. First, the ‘knowledge
economy’ is simply taken as an overall framing argument—or, in the case of
policy-making bodies, a desirable state for ongoing policy initiatives—about
which it is implicitly assumed that agreement exists. Second, the definitions
may be severely mis-specified or incomplete. Third, we are not given information
about any possible causal relations between the ‘major pillars’, which indeed seem
to refer to outcomes as much as to drivers.
More generally, getting to grips analytically with the knowledge economy
would seem to require an identification of relevant endogenous and exogenous
variables, but such an identification is seldom forthcoming, mainly because of
the tendency in both academic and policy-oriented work to treat the knowledge
economy as an overall framing vision. Modeling the knowledge economy is, to
put it mildly, an undertaking of very considerable complexity, because the
number of relevant variables would seem to be overwhelming and causality
would seem to be so complicated that any model can only capture select
mechanisms.8 Therefore, it is perhaps not surprising that model-oriented social
scientists have typically refrained from taking on the knowledge economy in its
forbidding complexity. However, although the knowledge economy may well
best be treated under rubrics such as ‘co-evolution’ or ‘cumulative causation’
(concepts that often cover for ignorance), the existing academic contributions
do suggest that certain tendencies may, in a shorter-run perspective, best be
understood as drivers, while other tendencies are best understood as outcomes.
Below I discuss the knowledge economy briefly in such terms.
Information and Communication Technologies

Virtually all discussions of the knowledge economy invoke recent information
and communication technologies (ICT) as a main driver and primary character-
istic of the knowledge economy. In addition to the apparently mandatory
mention of Moore’s Law, discussions often point to the extremely high annual
growth rates in western countries of real investments in ICT, the explosion of e-
commerce, the surge in the number of Internet hosts, the household adoption of
computers, etc. However, it is often overlooked that much of this may well have
been driven by substantial government funding of key ‘new-economy’ technolo-
gies (the Arpanet being the most familiar example). Moreover, the increase in
ICT investments may at least partly have been driven by structural changes in the
organization of R&D towards more open standards and a more important role
for smaller firms connected in networks, as well as changes in financing towards a
greater role for venture capital (and therefore a higher propensity to engage in
perhaps more risky investments in ICT) (Klein 2001). In other words, it is
somewhat unclear what is driving what in this case.
Still, much work proceeds on the assumption that ICT is a fundamental driver
and that what is fundamentally new about the knowledge economy relative to
earlier historical stages is the digital revolution. The importance of ICT to
discussions of the knowledge economy is, of course, that many see it as the
technology that the knowledge economy revolves around in the sense that ICT
make information cheaper to process, store, and transmit; that is, as the heartbeat
that animates the knowledge economy. For example, arguments are put forward
that ICT drive productivity increases, facilitate the formation of networks
between and inside firms, flatten hierarchies, reduce overall firm size, facilitate
(external and internal) scale economies, ease the modularization of production,
and so on.
Carefully gathered evidence lags somewhat behind such claims, however,
although there is now evidence that ICT, when coupled with certain organiza-
tional practices, have had significant consequences for (US) productivity (Bres-
nahan, Brynjolfsson, and Hitt, 2002; Brynjolfsson, Hitt, and Yang 2002) and
have impacted negatively on firm size (Brynjolfsson et al. 1994; Garicano and
Rossi-Hansberg 2003; Paganetto 2004) and vertical integration (Culnan, Arm-
strong, and Hitt 1998).9
While there is evidence of ICT’s transformative implications, this does
not rule out that other drivers are also important, and perhaps as important.
However, the conspicuous nature of the digital revolution may have drawn
attention away from such other drivers. For example, rather little attention has
been devoted to the ‘quality revolution’, notably in the form of total-quality
management, of the last twenty years. There are reasons to believe that this
has had implications for economic organization, such as the tendency for
organizational units to decrease in size and to offer more high-powered incentives
inside firm hierarchies (Zenger and Hesterly 1997). The reason is that methods
such as TQM make it possible to measure the output performance of small units,
easing benchmarking of such units against each other and the rewarding of
performance based on precise measures. Also, advances in accounting, such as
activity-based costing, allow for better measures of the true profitability of
organizational units, easing benchmarking and perhaps leading to spin-offs of
lacking units. There is an identification problem here, because a number of the
organizational outcomes that are often claimed to be driven by changes in ICT
may equally well be driven by changes in how quality is measured and costs are
allocated.10
The Increasing Importance of Human Capital

Given the context of ‘knowledge economy’, it may seem more reasonable to look
at those tendencies that are ‘knowledge’ rather than ‘information’ related. Many
writers have stressed the distinction between information and knowledge (Non-
aka and Takeuchi 1995; Spender 1996; Boisot 1998; Teece 2001). Knowledge is
seen as a partly tacit and context-dependent capacity to select, interpret, and
aggregate information, which in turn is explicit and less contextual. As Teece
(2001: 130) puts it: ‘A Bloomberg or Reuters newsfeed is information. The
opinions of the leading analysts and commentators, putting the news into
context and enabling it to be used to create value, are more akin to knowledge.’
The information/knowledge distinction is one of the key dogmas in the know-
ledge movement in business administration, and is usually defended on epi-
stemological grounds. From an economic perspective, however, what matters
are the costs of absorbing, transferring, storing, and processing information/
knowledge (Demsetz 1991; Jensen and Meckling 1992; Casson 1997). Below,
the convention is adopted of referring to information that is costly to absorb,
etc. as ‘knowledge’ and information that is inexpensive to absorb, etc. as ‘infor-
mation’.
Given this distinction, the knowledge economy is indeed remarkable for
the growing importance of not only information, but also of knowledge.
A manifestation of this is the strongly growing importance of human capital.
Acquiring human capital is largely a matter of reducing the costs of selecting,
interpreting, and aggregating information and knowledge. A number of studies
and indicators suggest that the importance of human capital has increased
massively. Thus, in terms of general statistics the proportion of ‘knowledge
workers’, such as managers, professionals, and technical workers, increased
from 10 per cent of the US workforce in 1900 to 17 per cent in 1950 to 33
per cent in 1999. ‘Creative workers’, such as engineers and architects, artists and
entertainers, increased from 1 per cent in 1900 to 2 per cent in 1950 to 5.7 per
cent in 1999. Large-scale econometric studies provide the same message. Jorgen-
son and Fraumeni (1995) show that in the US economy human capital over-
whelms physical capital in terms of contributing to value added, and that
its weight has been continuously increasing. Machin and van Reenen (1998)
present evidence that the relative demand for skilled labor increased in the
1990s in the seven OECD countries they investigated. Berman, Bound, and
Griliches (1994) find a similar tendency in the US economy, as do sector- and
industry-specific studies. For example, Demsetz (1996) shows that the share of
high-skilled employees in US banking has strongly increased (around 8 percent-
age points from 1983 to 1995)—the most pronounced increase in any US
industry.
In business administration the increasing importance of human capital
has been reflected in notions of ‘knowledge workers’ (Zuboff 1988) and ‘know-
ledge-intensive firms’ (Starbuck 1992); that is, ‘organizations staffed by a high
proportion of highly qualified staff who trade in knowledge itself ’ (Blackler
1995: 1022). According to current influential thinking, such firms may be
differentiated from ‘traditional’ firms in terms of organizational control in that
they rely less on direction through the exercise of authority, eschewing high-
powered performance incentives, and embracing ‘culture’ and ‘clan’ modes of
organizational control (Adler 2001; Child and McGrath 2001). This kind of
thinking can increasingly be found outside management studies. Thus, corporate
finance scholar and organizational economist Luigi Zingales (2000: 1641)
argues that:
in 1994 a firm like Saatchi and Saatchi, with few physical assets and a lot of human capital,
could have been considered an exception. Not any more. The wave of initial public offerings
of purely human capital firms, such as consultant firms, and even technology firms whose
main assets are the key employees, is changing the very nature of the firm.
‘Software’
In a discussion of the issues under consideration here Paul Romer (1998) argued
against the idea of the knowledge economy as representing a novel historical
stage. As he points out, the transition from a mechanized economy to one based
on ‘software’ in a broad sense (not just the software underlying computer-assisted
manufacturing and computer-aided design) is characteristic of economic devel-
opment over the last hundred years or so. The notion of ‘software’ is deliberately
chosen for two reasons. First, because it implies the notion of program, and
Romer maintains that arguably the most important (in terms of contribution to
economic growth) ‘programs’ (he calls them ‘recipes’) are firm routines and
specific ways of organizing economic activities, such as business-format franchis-
ing, Wal-Mart’s retailing system. Knowledge protected by intellectual property
rights presumably also falls within the software category. Thus, scientific know-
ledge is also an instance of software, although it may need adaptation to become
truly ‘software-like’; that is, practically applicable and replicable.
Second, it is characteristic not only of computer software but also of software
in this broad sense that it may have high initial costs of production, but will
typically have much lower costs of replication. These characteristics yield the
increasing returns that have often been heralded as the fundamental economic
driver of the knowledge economy. They have pervasive implications for firm
strategies, introducing dynamic complementarities (accessing, processing, etc.
knowledge improves the ability to access, process, etc. future knowledge), making
standard-setting an important competitive weapon, etc. (Shapiro and Varian
1999; Leibold, Probst, and Gibbert 2002).
Distributed Knowledge and Innovation

While information is becoming continuously cheaper to process, store, and
transmit (Garicano and Rossi-Hansberg 2003), an increasingly influential argu-
ment asserts that the knowledge needed to create value is becoming increasingly
dispersed, either in direct geographical terms (e.g. Doz, Santos, and Williamson
2001) or in terms of technological disciplines (Granstrand, Patel, and Pavitt
1997; Matusik and Hill 1998; Coombs and Metcalfe 2000; Brusoni, Prencipe
and Pavitt 2001). The division of labor is becoming increasingly complex,
particularly in the generation of science and technology (e.g. Coombs and
Metcalfe 2000: 209). Firms need to build and maintain an increasing number
of ‘knowledge nodes’ with lead users, universities, technical-service institutes,
user communities (e.g. Hippel 1988; Granstrand, Patel, and Pavitt 1997; Hodg-
son 1998; Coombs and Metcalfe 2000; Smith 2000; Wang and Tunzelman
2000; Brusoni, Prencipe, and Pavitt 2001; Jeppesen 2002). Because firms
increasingly need to rely on a growing number of knowledge specialists, be they
employees or outside knowledge agents, they also need to have the absorptive
capacity to be able potentially to source an increasing number of technologies. In
fact, it is arguable that many knowledge nodes, particularly to universities, are
established in order to create this absorptive capacity (Pavitt 1991). The tendency
for many firms to have an increasing number of technological disciplines in-
house, even if product portfolios are shrinking, may also be a reflection of the
need to increase absorptive capacity in the face of an increasingly complex
division of labor in science and technology (Brusoni, Prencipe, and Pavitt 2001).
The notion of ‘distributed knowledge’, coined in computer science just over a
decade ago (Halpern and Moses 1990), has fast become a household concept in
various branches of business administration as a handy way of framing these
tendencies. Loosely, ‘distributed knowledge’ is knowledge that is not possessed by
any single mind, but ‘belongs to’ a group of interacting agents, somehow emerges
from the aggregation of the (possibly tacit) knowledge elements of the individual
agents, and can be mobilized for productive purposes. While a division of labor
will almost always imply that knowledge is distributed (Hayek 1945),11 recent
contributions actually assert that in some sense knowledge has become more
distributed.
This tendency is seen as having strong transformative implications for eco-
nomic organization; notably, the employment relation, internal-organization
structure, and the boundaries of the firm. For example, the increasing reliance
on ‘knowledge workers’, specialists, expert talent, etc. that is seen to accompany
the increasingly distributed nature of productive knowledge challenges trad-
itional authority relations (because knowledge workers have much more bargain-
ing power; Rajan and Zingales 2001) and makes extensive delegation of decision
rights necessary in firms’ internal organizations (so as to co-locate rights with
knowledge; Mendelsson and Pillai 1999). With respect to ‘external organization’
(to use Marshall’s phrase (1920)), firms increasingly engage in relational forms of
contracting that can simultaneously keep opportunism at bay and create the rich
interfaces that are necessary for sharing and integration of complementary
knowledge (Helper, McDuffie, and Sabel 2000; Heimann and Nickerson
2002). Thus, a picture is emerging of a new kind of firms that ‘tend to be
non-vertically integrated, human-capital-intensive organisations that operate in a
highly competitive environment’ (Zingales 2000: 1643), yet are still strongly
networked to other firms and to knowledge institutions. Some of these charac-
teristics are discussed very briefly below.
Changing Internal Organization

Virtually all of those who have written on the subject agree that tasks and
activities in the knowledge economy need to be coordinated in a manner that
is very different from the management of traditional manufacturing activities (as
portrayed in (e.g.) Chandler 1962). Variations on the following account (Cowen
and Parker 1997: 28) are very common:
[M]arket changes are moving manufacturing farther and farther away from steady-state,
low variety, long-batch production runs, relevant to Taylorist methods, to high variety
and small runs [ . . . ] Organizations are adopting new forms of decentralization to cope
with the instability, uncertainty, and pace of change of the market-place [ . . . ] In clusters
of network working, employees of undifferentiated rank may operate temporarily on a
certain task or tasks in teams. The clusters are largely autonomous and engage in
decentralized decision-making and planning [ . . . ] They are conducive to individual
initiative (‘intrapreneurship’) and faster decision-taking. They facilitate organizational
flexibility.
The notion of ‘new organizational forms’ is often used to capture these
phenomena. The notion began to gain currency about a decade ago (e.g. Daft
and Lewin 1993). It was propagated as shorthand for what was seen as a surge of
firms experimenting with their governance of transactions; that is, adopting new
ways of structuring their boundaries and their internal organization. This surge
was related to but followed in the wake of the corporate refocusing wave; much of
it consisted in a strong increase in the adoption of organizational practices such as
total-quality management, business process re-engineering, and outsourcing
(Bowman and Singh 1993), and it was probably to some extent inspired by
organizational practices characteristic of recent Japanese economic organization
(Aoki and Dore 1994). The concept was quickly adopted by those management
thinkers who embraced concepts such as the ‘knowledge economy’ (e.g. Halal
and Taylor 1998), and who argued that the advent of the Internet would have
revolutionary implications for the organization of transactions (Tapscott 1999).
New organizational forms were seen as a characteristic way of ‘organizing in the
knowledge age’ (Miles et al. 1997). The ‘virtual organization’, ‘shamrock firm’,
‘the boundary-less organization’, and ‘intelligent organization’ quickly became
household words in the discourse of management studies.
However, while many scholars have agreed that there is a marked tendency
towards increased decentralization and that this may be caused by attempts to
foster ‘individual initiative (‘intrapreneurship’) and faster decision-taking’, there
is a fair degree of divergence in the accounts of what exactly is involved in the
‘new organizational forms’.
Thus, some argue that ‘traditional’ coordination mechanisms such as price,
authority, routines, standardization, etc. will diminish in relative importance,
because knowledge-intensive production requires the increased use of mechan-
isms such as trust, communication, community, democratic procedures, etc. that
can better cope with the particular metering problems and exchange hazards that
are characteristic of knowledge transactions, and thus stimulate the emergence of
knowledge management (in a broad sense) capabilities (Zucker 1991; Ghoshal,
Moran, and Almeida-Costa 1995; Kogut and Zander 1996; Adler 2001; Grand-
ori 2001). The new organizational forms are characterized as relying upon cross-
functional processes, extensive delayering, and empowerment (Child and
McGrath 2001: 137). The aim is to create highly specialized and motivated
units by means of extensive delegation of discretion. Cross-functional processes
substitute for hierarchy in the coordination of tasks.
Scholars promoting this view will tend to see the boundaries of firms blurring
and employment relations undergoing dramatic change as a result of knowledge
networks increasingly cutting across the boundaries of the firm and participative
governance being increasingly adopted. Moreover, they will tend to question the
traditional allocation of economic activities to discrete governance structures
(notably markets and hierarchies), pointing out instead that governance mechan-
isms increasingly seem to be combined in such a way that much of the ‘discrete-
ness’ of governance structures is disappearing and that this reflects the increasing
volume of knowledge transactions (see particularly Grandori 1997, 2001).
Others take a more hard-nosed and less rosy view of the ongoing changes in
economic organization. An important part of the tendencies constituting the
knowledge economy is an intensification of competition as industry boundaries
are eroded, and as internationalization and liberalization increase. In response to
such competitive pressures, as Paul Adler (2001: 220) points out, ‘firms are fine-
tuning their management structures and planning processes, demanding greater
accountability at every level, and enforcing more discipline in the planning and
execution of operations’. As Zenger and Hesterly (1997) note, improved methods
of cost allocation, more widespread use of ICT, and better measures of input and
output performance have decreased the costs of monitoring employees and
organizational units, in turn promoting a tendency to smaller organizational
units that face more high-powered incentives (i.e. ‘corporate disintegration’).
These diverging accounts may well reflect the fact that the knowledge econ-
omy is pushing the employment relation, and the internal organization it
is embedded in, in different directions. There is impressive evidence of the
increasing application of ‘high-performance work practices’ (e.g. Ichniowski
et al. 1996; Capelli and Neumark 2001; Goddard and Delaney 2001), by
which reference is made to employee involvement in teams, quality circles,
total-quality-management initiatives, and other more cooperative and participa-
tive ways of mobilizing employees’ services. On the other hand, there is also
considerable evidence that firms increasingly provide high-powered incentives,
not only to their CEOs, but also to middle management and workers on the shop
floor (Lawler, Mohrman, and Ledford 1998). And there is some evidence
(Laursen 2002; Chs. 7 and 8 in this book) that high-performance work practices
designed to foster innovation and/or knowledge management capabilities matter
most (perhaps only really matter) if they are applied as parts of a complementary
system together with high-powered performance incentives. In other words,
ongoing changes in internal organization, including the employment relation,
may reflect attempts simultaneously to reap different kinds of benefits. This
introduces complicated trade-offs and will probably be very challenging to
management. The story in Chapter 7 below of the rise and fall of the famous
‘spaghetti organization’ in the Danish hearing-aid producer Oticon illustrates a
number of these challenges.
Changing Firm Boundaries

The same kind of seemingly diverging tendencies found in the case of the
employment relation may also be operative with respect to the boundaries of the
firm. According to Langlois (2003: 373), ‘[v]ertical disintegration and specializa-
tion is perhaps the most significant organizational development of the 1990s’.
Everybody is familiar with the anecdotal evidence, such as AT&T spinning off its
equipment division (now Lucent Technologies), IBM selling off its data-network-
ing division (Global Networks), and other instances of ‘reshaping of the supply
chain’, but there is also rather compelling quantitative evidence for this phenom-
enon (e.g. Feenstra 1998 and the reference therein), as well as some excellent
historical studies (e.g. Langlois and Robertson 1995; Jacobides 2002).
Economists, economic geographers, and management scholars ponder the
causes of the phenomenon. For example, to the international economists the
‘rising integration of world markets has brought with it a disintegration of
the production process. . . . This represents a breakdown in the vertically inte-
grated mode of production—the so-called ‘‘Fordist’’ production, exemplied by
the automobile industry—on which American manufacturing was built’ (Feen-
stra 1998: 31). Organizational economists argue that the increasing relative
importance of human capital causes the break-up of the vertically integrated
firm (Rajan and Zingales 2001), because the growing importance of human
capital weakens the control conferred by the ownership of non-human capital. To
the extent that innovations in ICT lower external costs of coordination more
than they lower internal costs of coordination, this is a force pulling in the
direction of vertical disintegration (Culnan, Armstrong, and Hitt 1998; Langlois
2003). Corporate-finance scholars may stress the increased emphasis on share-
holder value as an independent force that prompts specialization and vertical
disintegration. Many business-administration scholars and sociologists argue that
the hierarchy ‘encounters enormous difficulty in the performance of innovation
tasks requiring the generation of new knowledge’ (Adler 2001: 216), so that in an
innovation-rich economy hierarchies will be selected against. The question is
what all these tendencies (that may possibly be highly complementary) select for.
As in the case of the employment relation, predictions here range from the rosy
to the hard-nosed, to some extent depending on disciplinary orientation. Thus,
economists may stress the overall Smithian theme of how an increasing demand
causes vertical disintegration into market relations. Sociologists and business-
administration scholars, on the other hand, may counter that this view neglects
the fact that markets are inefficient governance structures for the knowledge-
intensive transactions, the increasing importance of which is one of the defining
characteristics of the knowledge economy. Instead, networked and trust-based
forms of inter-firm relations emerge to handle such transactions (Powell 1990:
304; Liebeskind et al. 1995: 7). These trust-based forms do not fall in-between
markets and hierarchies, as hybrids do in the Williamsonian scheme (Williamson
1996); rather, they cut across discrete governance structures and blur the bound-
aries of the firm: ‘The ethos of common destiny that underpins trust blurs the
allocation of accountability and decision rights at the heart of both hierarchy and
market forms’ (Adler 2001: 223; also Helper, MacDuffie, and Sabel 2000).
Others assert that the ‘central tendency’ is not the emergence of trust-
based (‘community’-based) forms of organization but that ‘the buffering func-
tions of management are devolving to the mechanisms of modularity and
the market—informational decomposition, flexibility and risk spreading’
(Langlois 2003: 376). This does not necessarily imply that the boundaries of
firms ‘blur’; rather, firms specialize and disintegrate. Also, while a modular
system often internalizes knowledge-intensive transactions in modules, it is
entirely consistent with innovative efforts (Langlois and Robertson 1995).
Thus, the information and knowledge richness associated with innovative efforts
does not necessarily imply trust, rich information and knowledge transfer be-
tween firms, etc.
Again, the truth of the matter may well be that rather diverging forces are
pushing the boundaries of firms. In some industries at specific periods of time
the ‘mechanisms of modularity’, including standards and stable interfaces,
may indeed push vertically integrated structures towards market-governance
structures. In other industries products may possess so much ‘integrality’ that
trust and continuous knowledge and information transfer between firms become
necessary.
Implications
The preceding pages have set the stage for much of what will follow. The
emergence of those tendencies that, taken together, constitute the knowledge
economy has been reflected in intellectual innovations, or sometimes rediscov-
eries of earlier thinking, in the social sciences. In economics, the new growth
theory has dressed up earlier ideas of Thorstein Veblen, Allyn Young, and Joseph
Schumpeter in formal garb (Romer 1986, 1990; Foss 1998b), models of network
externalities and network competition have become an important part of the
antitrust toolbox for a knowledge-based economy (Shapiro and Varian 1999),
and the measurement of human capital for purposes of national income account-
ing has become a major issue (Laroche, Mérette, and Ruggeri 1999). Prompted
by the emergence of the knowledge economy, many sociologists have engaged in
speculative flights of fancy (e.g. Castells 1996) or have delighted in the new
potential for revitalizing such concepts as ‘marginalization’ as the knowledge
economy increases the need for the workforce to adapt.
Organization and Strategy

Business administration is certainly no exception, as several new literatures and
approaches have emerged since the end of the 1980s to address the changed
business realities implied by the above tendencies.12 There is a general debate in
the history of ideas about the extent to which the emergence of new ideas can be
explained by societal developments (Blaug 1985), but in the case of a field so near
to practice as business administration (or ‘management studies’) it is hardly
controversial that developments in practice play a major influencing role in
intellectual development. This is particularly the case in the strategy and organ-
ization fields, the two fields to which this book primarily relates.
Seen in this light, the appearance in business administration over the last
decades of a host of new approaches that all somehow place knowledge center
stage is non-spurious. In fact, quite often knowledge-economy phenomena are
invoked to motivate theory development. Thus, in the strategy field it has been
argued that various manifestations of the knowledge economy (e.g. technological
convergence) wreak havoc with traditional industry boundaries and that firms
must begin strategic analysis from their existing resource portfolio rather than
from industry analysis. The resource-based view of the firm (Barney 1991;
Peteraf 1993) has been taken as the theoretical underpinning of this stance. Of
course, this view also provides much of the intellectual discipline for ideas that
firms should pursue corporate specialization. A parallel development at the end
of the 1980s was the emergence of ‘competence’ or ‘capabilities’ perspectives and
then, slightly later, the ‘knowledge-based view of the firm’. ‘The essence of the
firm in the new economy’, says David Teece (2000: 29), ‘is its ability to create,
transfer, assemble, integrate, protect, and exploit knowledge assets’. The increas-
ing interest in real options (e.g. Sanchez 1993) reflects an interest in explaining
competitive advantages in volatile environments (Coff 2003). The interest in
modular production and organization (e.g. Langlois 2002, 2003) reflects an
increasingly distributed innovation environment.
As discussed above, in the organization field the knowledge economy has given
rise to substantial debate about the emergence of trust-based forms of organiza-
tion, the blurring of firm boundaries, new organizational forms, etc. Moreover,
debate has arisen about which analytical perspectives are the most appropriate
ones for dealing with organization in the knowledge economy. In particular,
many writers have been quite explicit that the advent of the knowledge economy
increasingly questions the relevance of Coasian organizational economics (e.g.
Boisot 1998; Helper, MacDuffie, and Sabel 2000). Organizational economists
themselves have been forced to question some of their traditional assumptions
(Zingales 2000). For example, Cowen and Parker argue that, contrary to the
traditional views of governance structures as discrete structural alternatives
(Coase 1937; Williamson 1985, 1996a),
firms and markets are not exactly the same, but rather they differ in empirical terms. They
refer to different means of organizing economic activity, albeit means that do not differ
substantially in kind. [ . . . ] This [ . . . ] view does not seek to find a clear-cut distinction
between firms and markets. Rather the difference between the firm and the market as a
resource allocator involves what might more usefully be viewed as subtle differences
relating to contracting. (Cowen and Parker 1997: 15)
And two leading organizational economists, Bengt Holmström and John Roberts
(1998: 90) observe that
Information and knowledge are at the heart of organizational design, because they result
in contractual and incentive problems that challenge both markets and firms [ . . . ] In
light of this, it is surprising that leading economic theories [ . . . ] have paid almost no
attention to the role of organizational knowledge.
The Need for Foundational Inquiry

As quotations such as the one immediately above indicate, the ongoing discussion
has the potential to become a truly interdisciplinary dialog on foundational issues.
Indeed, such a dialog appears to be not only strongly needed, but also natural,
given the long history of interaction between economics and management (Coff
2003). It is strongly needed, because the diversity of perspectives is too large and
there is too little shared theoretical ground (cf. Pfeffer 1993). A consequence is
that the selection mechanisms that eliminate the weak ideas do not work with
sufficient force.13 This implies not only that there will be substantial variation in
what is being asserted, which may be welcomed, but, more seriously, that the
scientific status of many of the claims that are made will be and remain rather
uncertain.
This uncertainty may be most conspicuous in the empirical dimension. Thus,
there is rather little empirical knowledge of how and to what extent knowledge
assets generally drive competitive performance, although work exists on how
product-development capabilities and patents influence performance. Empirical
knowledge about organizational control in knowledge-intensive firms is rather
scant, with very different accounts being given, as argued earlier. The fact that
relatively little rigorous empirical work exists on such issues is to a large extent
caused by difficulties of conceptualizing and operationalizing such notions as the
‘knowledge economy’ and ‘knowledge-intensive firms’ (cf. Starbuck 1992), and
therefore pinpointing what exactly is driving the alleged changes in the strategies
and organization of which firms. However, it is also a matter of lack of under-
standing of how ongoing societal change toward the knowledge economy is
affecting organization and influencing the contents and sources of strategies
that firms engage in.14
Since basic conceptual and theoretical work is often a requirement for empirical
work, the upshot is that clarification of foundations is necessary. What is needed is
fundamental conceptual and theoretical thought on the tendencies that are placed
under the heading of knowledge economy and how it impacts on economic
organization and the content and sources of firm strategies. This is certainly not
to say that theoretical speculation has not taken place. As shown earlier, the
emergence of the knowledge economy has witnessed a proliferation of theorizing
on the nature of firm strategy and organization in such an economy. However,
much of this work originated very recently, largely within the last decade, and
even much of the academic work is like buildings put up by a few key contractors on
a tight completion deadline and on the basis of somewhat different inputs. The
pilings, foundations, and actual structures themselves may not fit perfectly, and the
theoretical structures may show some crevices, making repair efforts necessary,
perhaps even amounting to additional piling of the foundations, or, in some cases,
a demolition attempt (for the latter, see Thompson 2004).
About this Book

The present volume is offered as a modest contribution to these foundational
issues. It is very much in the nature of a set of critical essays (Part I being more
critical than Part II) that are, I hope, bound together by some shared concerns.
One overall theme is the one flagged in this introductory chapter; namely, that
there is reason to think that many of the societal tendencies encompassed by the
portmanteau concept of the ‘knowledge economy’ are very real ones that are
likely dramatically to impact on firm strategy and organization, that we know
rather little about the relevant mechanisms, but that strategic and organizational
theorizing need to get to grips with this. These issues are explicitly framed and
addressed in Chapter 6 (‘Economic Organization in the Knowledge Economy’),
which sets the stage for Part II of the book. Implications of the knowledge
economy for organizational-design issues are addressed in Chapter 7 (‘Internal
Organization in the Knowledge Economy: The Rise and Fall of the Oticon
Spaghetti Organization’), while Chapter 8 addresses the innovation-performance
effects of those ‘high-performance work practices’ that are often associated with
the knowledge economy (‘Performance and Organization in the Knowledge
Economy: Innovation and New Human Resource Management Practices’).
Finally, Chapter 9 (‘Cognitive Leadership and Coordination in the Knowledge
Economy’) addresses the coordination problems introduced by the knowledge
economy and how cognitive leadership may cope with these.
A more specific overall theme, present in all of the chapters in Part I and in
some in Part II, concerns resolving the existing tension between ‘competence’ and
‘governance’ approaches to organization and strategy (Williamson 1999; Foss
and Mahnke 2000). The debate in the strategic-management field on ‘The
Strategic Theory of the Firm’ is the subject of Chapter 2. Sub-themes in this
debate here include the importance of transaction cost. A second sub-theme is the
need for proper micro-foundations and the general usefulness of a rational-
choice perspective for illuminating a number of ‘knowledge issues’. This theme
is addressed in Chapter 4 (‘Knowledge-based Views of the Firm’). A third theme
is the role of the competitive-equilibrium model with respect to furthering
thinking in strategy. In Chapter 3 (‘The Resource-based View: Aligning Strategy
and Competitive Equilibrium’), the argument is developed that the currently
highly influential resource-based view of strategy is at the core founded on a
patched-up version of the competitive-equilibrium model, and that this may be
hindering the progress of the view. The three themes are clearly related, for
transaction-cost economics supplies highly useful and alternative micro-founda-
tions for much thinking in strategy and organization, as is argued in Chapter 5
(‘Strategy, Resources, and Transaction Costs’).
Other themes are, first, the importance of doctrinal history. While doctrinal
history is generally held in rather low esteem, and has almost entirely disappeared
from the modern economics or management curricula, some knowledge of a
field’s past is often quite useful for understanding contemporary currents (par-
ticularly in the management field, where most important ideas are recycled on a
twenty-five-year basis). The argument in Chapter 3 that strategy’s dominant
‘resource-based view’ has been founded on the competitive-equilibrium model
has already been mentioned. Another example is that a number of the weak spots
in the knowledge-based view, notably the above-mentioned absence of proper
micro-foundations for that view, can be traced back to what is arguably the
seminal contribution to this line of thought, namely Nelson and Winter (1982).
A final, overall theme, and perhaps the most important one, is the need to
embrace ‘integrationist’ thinking and eschew ‘isolationism’, to use concepts from
Chapter 2; that is, to engage in disciplined and focused work that transcends
compartmentalization. Getting to grips with strategy and organization in the
knowledge economy requires such an approach.
Notes
1. Specifically, the notion of the ‘new economy’ was a strange amalgam of ideas, notably
the ‘end of the business-cycle hypotheses’, an emphasis on the increasing role of
information technology and new business practices (e-commerce, increased reliance
on intangible assets, and markets with network effects), and a claim that productivity
growth had jumped discretely, presumably because of information technology and
new business practices.
2. Not treated here is ‘knowledge management’. See Foss and Mahnke (2003) for a
discussion of knowledge management that is broadly in the spirit of this volume.
3. In economics the impact is manifest in the ‘new growth theory’ (Romer 1986, 1990,
1998) and in the resurgence of the evolutionary-economics research program since
the mid 1980s (Nelson and Winter 1982; Dosi 1988).
4. Tallman has recently drawn attention to a ‘transition of the dominant conceptual
model of the multinational firm from the market failure approach of internalization
theory and transaction cost economics theory to the market imperfections approach
of capabilities or knowledge-based theories of the firm’ (2003: 495) that took place
during the 1990s. Mutatis mutandis, something similar may be said of the strategy
and organization fields.
5. Originally launched by Brazilan political economist Carlota Perez (1983), a techno-
economic paradigm is a ‘set of interrelated technical and organizational innovations
[that] gradually comes together as a best-practice model . . . capable of guiding the
diffusion of each specific technological revolution. As it spreads, this new paradigm
gradually takes root in collective consciousness, replacing the old ideas and becoming
the new ‘‘common sense’’ of engineers, managers and investors for the most efficient
and ‘‘modern’’ productive practice across the board’ (<http://www.carlotaperez.org/
papers/2-technologicalrevolutionsparadigm.html>).
6. But for a highly skeptical view from a business-administration position see Thomp-
son (2004).
7. Taken from <http://www.worldbank.org/wbi/knowledgefordevelopment/k4d
community/whatis_ke_k4dcomm.html>.
8. Still, modeling exercises such as Milgrom and Roberts (1990b), while not directed at
modeling the ‘knowledge economy’ per se, may still capture many relevant mech-
anisms and variables.
9. For a transaction-cost interpretation of these tendencies see Picot, Ripperberger, and
Wolff (1996).
10. Adding to the complexity, ITC and such practices as TQM and activity-based costing
may be complementary with respect to their impact on economic organization.
11. Save, perhaps, for some primitive societies.
12. Here, too, much of the relevant work is rather strongly indebted to older economists,
perhaps particularly the Austrians (Morck and Yeung 2001: 61). For example,
ideas on creative imagination (Shackle 1972), competition as rivalry (Hayek 1948;
Mises 1949), tacit knowledge (Hayek 1948), and entrepreneurship (Mises 1949;
Kirzner 1973) have become increasingly prevalent in firm-strategy research (e.g.
D’Aveni and Gunther 1994; Hamel and Prahalad 1994; Hunt 2000). The recent
‘resource-based view’ in strategy research (see Ch. 4) has even been characterized as
an ‘Austrian theory of strategy’ (Jacobson 1992). (However, see Lewin and Phelan
(2000) for a discussion of the presumed Austrian character of the resource-based
view.) Many contributions to the related ‘capabilities view’ (Langlois 1992; Foss
1997) or the ‘knowledge-based view’ (Nonaka and Takeuchi 1995; Grant 1996) bear
a strong Austrian imprint. For an attempt to read the Austrians, mainly Hayek and
Mises, as anticipating key currents in economics and business administration see Foss
(1994).
13. A possible example is the notion of ‘hyper-competition’, originally proposed by
D’Aveni and Gunther in 1994, and invoked in countless studies in business admin-
istration since then. However, in the single existing rigorous empirical test of the
notion (McNamara et al. 2003), published almost ten years after its launch, the
notion does not do well empirically.
14. To give an example, it is often argued that one consequence of the knowledge
economy is that the knowledge bases to which firms must secure access increasingly
take a ‘distributed’ form (Rooney et al. 2003: 10), and that this is a key driver of
ongoing changes in economic organization (e.g. Coombs and Metcalf 2000). How-
ever, the notion of distributed knowledge is seldom defined with much precision (if
at all). And it is not made clear how distributed knowledge impacts on economic
organization. This issue is discussed further in Ch. 6.
Part I
Strategy: Critical Perspectives

2
The ‘Strategic Theory of the Firm’
Introduction
Strategy research has been increasingly, and heavily, influenced by economic
theories of the firm; notably, modern organizational economics (henceforth,
‘OE’)1 and a host of currents that may be placed under the umbrella term of the
‘knowledge-based view of the firm’ (henceforth, ‘KBV’).2 The main message of this
chapter is that there has been a tendency in strategy research, narrowly to draw on
only one of these two approaches—what is here called ‘isolationism’—and to
neglect the fact that it may be productive to join key insights of the two ap-
proaches—what is here called ‘integrationism’.
Perhaps the first detailed arguments that (the then relatively recent) OE may
be helpful in a strategy context were made by Caves (1980) and Rumelt (1984).
Caves argued that in general corporate-strategy issues should be framed as
constrained-optimization problems, and that recent work in the OE would be
helpful in adding detail to such exercises. Rumelt claimed that ‘it appears obvious
that the study of business strategy must rest on the bedrock foundations of the
economist’s model of the firm’ (ibid. 557). More specifically, he argued that by
building on the work of Coase (1937) and Williamson (1975) the strategy field
could arrive at a ‘strategic theory of the firm’. Echoing Rumelt (1984), Williamson
(1991, 1998) has more recently argued that the transaction-cost brand of OE
aspires to become such a ‘strategic theory of the firm’.
However, critical voices have pointed to the inability in the modern OE
adequately to incorporate bounded rationality, limited cognition, and other
phenomena of crucial interest to strategy scholars (Zajac 1992; Langlois and
Foss 1999). In fact, during the last decade accumulating frustation in the
strategy field with the modern OE has resulted in the gradual crystallization
of a knowledge-based view of competitive advantage and economic organi-
zation (for a recent summary see Kaplan et al. 2001). This view is seen by
many of its proponents as a rival to OE (e.g. Kogut and Zander 1992; Madhok
1996) and has (partly for this reason) been surrounded by a good deal of
enthusiasm in the strategy field. Thus, there is controversy concerning what
type of theory of the firm should be ‘the bedrock foundation’ for the study of
strategy.3
24 strategy: critical perspectives
In fact, much has happened with respect to the issue of the strategic theory of
the firm since Caves (1980) and Rumelt (1984), and it is increasingly pertinent
to perform a stocktaking and evaluation of the existing contenders and the
options open to researchers in the field. However, this discussion does not have
a retrospective and expository purpose per se.4 Rather, it is an attempt to take a
more forward-looking position and identify, criticize, and compare the research
options that exist in the field of the strategic theory of the firm. Thus, this chapter
aims to help researchers to make informed theory choices.
To be more specific, I identify two broad and archetypal research strategies
that, as already indicated, I call ‘isolationism’ and ‘integrationism’. The first
research strategy—which I shall argue is often seriously incomplete—implies
that the strategic theory of the firm should be founded either on the KBV or on
OE. Thus, it consists of two mutually exclusive sub-strategies. While seldom
found in pure forms, many contributions come close to taking the isolationist
position (e.g. Kogut and Zander 1992; Grant 1996; Madhok 1996). In all cases
it is certainly productive to discuss it, because it is a benchmark. The second
research strategy, ‘integrationism’, implies that research on the strategic theory of
the firm should be based on ideas from both OE and the KBV. Having criticized
the isolationist research strategy, I state and defend the integrationist position.
In particular, I argue that when there are interaction effects (trade-offs or
complementarities) between governance and knowledge considerations, there is
a strong argument in favour of integrationism, while isolationism is likely to
produce too biased a view. Finally, I suggest some integrationist paths along
which research in the strategic theory of the firm may proceed. Many of the
themes described and developed in this chapter will also emerge in later chapters
in different guises.
The Strategic Theory of the Firm: Meaning and Relevance

Following Rumelt (1984) and a number of other writers (e.g. Grant 1996), I take
a ‘strategic theory of the firm’ to mean a theory that addresses the following four
issues:
1. The existence of the firm—that is: Why do firms exist as distinct mechanisms
for resource allocation in a market economy?
2. The boundaries of the firm—that is: What explains why certain transac-
tions are governed in-house while others are governed through market rela-
tions?
3. Internal organization—that is: Why do we find different types of (formal and
informal) organizational structure and accompanying phenomena, such as
internal labor markets, job ladders, profit centers, etc.?
the ‘strategic theory of the firm’ 25
4. Competitive advantage—that is: Which factors account for superior rent-
earning capability? Ultimately, this issue concerns why firms are heteroge-
neous.
To fully qualify as a strategic theory of the firm a candidate theory must be
comprehensive in the sense that it addresses all four issues. This requirement
simply has to do with the fact that a strategic theory of the firm brings together
issues from the theory of economic organization (issues 1, 2, and 3) with issues
from strategy (issue 4); if a theory fails to do this, it cannot be a strategic theory of
the firm.
In this chapter I shall use the comprehensiveness criterion to evaluate the KBV
and OE.5 Intuitively one might expect the latter to be strong on issues 1, 2, and
3, and to be weak on issue 4, whereas the opposite might be expected to hold in
the case of the knowledge-based view. The fact that this expectation is confirmed,
as we shall see, no doubt has something to do with the historical development of
the two approaches. Thus, whereas OE historically began with issues 1–3
(existence, boundaries, and internal organization of the firm) and then moved
on to be applied to issue 4 (competitive advantage), the KBV began with the
analysis of issue 4 and has during the last decade (or even less) moved on to
consider the other issues.
The fact that these intellectual developments have taken place, and have taken
place in a practice-related field such as strategic management, may in itself be
taken as an indication of both the theoretical and empirical relevance of the
project of constructing a strategic theory of the firm. At any rate, it is hard to
disagree with the proposition that issues 1–3 in the above deal with themes that
are crucial to strategy research (by definition issue 4 is crucial). Consider Rumelt,
Schendel, and Teece’s discussion of firm strategy (1994b: 9):
Because of competition, firms have choices to make if they are to survive. Those that are
strategic include: the selection of goals; the choice of products and services to offer; the
design and configuration of policies determining how the firm positions itself to compete
in product markets (e.g. competitive strategy); the choice of an appropriate level of scope
and diversity; and the design of organization structure, administrative systems, and
policies used to define and coordinate work [ . . . ] It is the integration (or reinforcing
pattern) among these choices that makes a set a strategy.
On this understanding, the issues of where to draw the boundaries of the firm
and how to design internal organization are among a firm’s important strategic
choices. More specifically, the issue of the boundaries of the firm, for example,
relates to a number of strategic issues, such as the firm’s sourcing of resources (e.g.
internal or external procurement of technology), supplier relations, the terms on
which resources are acquired (e.g. the firm may internalize activities if it can carry
them out more cost-efficiently), appropriation of rents (e.g. internalization may
be an appropriation strategy), etc. To put it briefly, virtually all issues of corporate
strategy, and many of business strategy, involve the boundaries of the firm.
Therefore, theory that illuminates the issue of the boundaries of the firm is
also likely to be helpful for understanding strategic choices. Quite similar
arguments may be put forward in connection with the issue of internal organ-
ization.
However, this is certainly not to say that all strategic choices can be
neatly linked to the issues of existence, boundaries, and internal organization
of the firm and interpreted using organizational economics insights. For ex-
ample, choices relating to the selection of goals, the choice of products and
services to offer, as well as the issue of how to establish ‘the integration (or
reinforcing pattern) among these choices that makes a set a strategy’ are hard
to link directly to these issues. Thus, positioning and organizational coordi-
nation are not easy to comprehend through the lens provided by OE. It is
ironic given Coase’s status as the precursor of the modern economics
of organization that these are issues that he saw as crucial in a retrospective
comment (Coase 1988) on his seminal 1937 paper. Coase argued that eco-
nomists have tended to neglect the main activity of a firm, namely org-
anizational coordination. He himself had neglected this issue in the 1937
paper:
I did not investigate the factors that would make the costs of organizing lower for some
firms than for others. This was quite satisfactory if the main purpose was, as mine was, to
explain why there are firms. But if one is to explain the institutional structure of
production in the system as a whole it is necessary to uncover the reasons why the cost
of organizing particular activities differs among firms (ibid. 47)
Thus, the mature Coase suggested that the questions traditionally considered in
the economic theory of the firm be extended to also include the issues of
differential organizing capability, and, at least by implication, competitive
advantage (see Madhok 2002 for a more extensive discussion). It is to those
contributions to the economics of organizations that have taken their cue
from Coase’s early work (Coase 1937) that I now turn. The aim is to discuss
the extent to which OE is a satisfactory strategic theory of the firm.
Isolationist Strategy No. 1: Organization Economics as a Foundation for the

Strategic Theory of the Firm
Organizational Economics
Williamson (1994: 401) argues that what is needed in the strategy field is a ‘core
theory’; that the ‘microanalytic, comparative institutional, economizing orienta-
tion of transaction cost economics deals with many of the key issues’ of the field;
and that what is needed to make transaction-cost economics ‘even more germane’
is more effort, extensions, and refinements. In other words, given sufficient time
and research efforts, transaction-cost economics is likely to develop into a full-
blown strategic theory of the firm. On all relevant indicators OE has in fact had a
steadily increasing impact on the strategy field, and indeed on management
studies in general. There is an increasing number of readers and textbooks,
aimed at an audience consisting of management students and practising man-
agers, and based on and presenting the main texts or the main principles of OE.6
The journals present a similar picture. Inspection of randomly selected copies of
the major journals from recent years reveals that OE is indeed a strong voice in
the conversation. Nevertheless, it will be argued here that although OE has
yielded valuable insights and asked interesting questions (cf. ibid. 381–2), it
does not constitute a satisfactory strategic theory of the firm.
As already indicated, it is conventional to trace the origin of OE back to
Coase’s landmark 1937 essay on ‘The Nature of the Firm’. In this paper Coase
argued that the reason for the existence of firms ultimately had to be traced to
some market failure, so that there would be a ‘cost to using the price mechanism’
(ibid. 390). At an overall level, all modern theories of the firm begin from
roughly the same premise that Coase began with: It is necessary to introduce
some spanners into the works of the perfectly competitive model (e.g. Debreu
1959), whether these be imperfect foresight, small-numbers bargaining, haggling
costs, private information, cost of processing information or inspecting quality,
increasing returns, etc., in order to tell a convincing story about economic
organization. With perfect and costless contracting it is hard to find room for
anything resembling firms (even one-person firms), since consumers could
contract directly with factor owners and would not need the services of the
intermediaries known as firms.
Ironically, these insights began to surface at exactly the time that Coase (1972:
63) lamented that his 1937 essay had been ‘much cited and little used’; namely, in
the work of Williamson (1971) and Alchian and Demsetz (1972). These two
contributions helped found different approaches within the modern economics
of organization. Thus, Williamson’s work pointed the way not only to his own
(as well as various associates’) work on transaction cost economics but also to the
more formal recent work of, notably, Oliver Hart and associates (Grossman and
Hart 1986; Hart and Moore 1990; Hart 1995). Alchian and Demsetz’s work, in
turn, pointed the way to later work on the principal–agent relation (e.g. Holm-
ström 1979, 1982; Holmström and Milgrom 1991, 1994).
These two traditions typically differ with respect to which spanners in the
works of the perfectly competitive model they focus on, where the relevant
spanners have to do with contracting (Holmström and Tirole 1989; Maskin
and Tirole 1999; Tirole 1999). In the perfectly competitive model it is assumed
that (1) agents can foresee all future contingencies and can costlessly write
contracts that cover all contingencies (so that there are no incomplete contracts),
and (2) there is symmetry of information concerning ‘states of nature’ (so that
there are no principal–agent incentive problems of either the moral hazard or
adverse-selection variety). It is these two basic assumptions that are challenged in
incomplete contract theories and principal–agent theories respectively. I briefly
discuss these two theories in terms of how well they meet the requirements of a
strategic theory of a firm.
Incomplete Contract Theories

Incomplete contract theories are founded on the assumption that it is for some
reason costly to draft complete complex contracts, and that there is therefore a
need for ex post governance—a key theme in the work of probably the most
influential follower of Coase, Oliver Williamson (1985, 1996a). In spite of the
richness of Williamson’s narrative, it is fair to say that there is one central
character in his story: asset specificity. Assets are highly specific when there is a
substantial difference between their value in present (best) use and next best use.
This opens the door to opportunism. Once the contract is signed and the assets
deployed, one of the parties may threaten to pull out of the arrangement—
thereby reducing the value of the specific assets—unless a greater share of the
surplus of joint production finds its way into the threatener’s pockets. Fear of
such a ‘hold-up’ ex post will affect investment choices ex ante. In the absence
of appropriate contractual safeguards, the transacting parties may choose less
specific—and therefore less specialized and less productive—technology. Often
the parties to a contract do incorporate such safeguards or other mechanisms
(such as reputation effects) to keep opportunism at bay. But for transactions
characterized by very high levels of asset specificity not even this may be
sufficient; pooling capital in a single enterprise may be the chosen solution, a
solution that partly removes the incentives for opportunism, and may also imply
(other) benefits in terms of ex post governance; notably, a superior ability to effect
adaptive, sequential decision-making in the face of unforeseen contingencies
(Williamson 1996a). Thus, Williamson’s basic story addresses central points in
a strategic theory of the firm, such as existence, boundaries, and internal organ-
ization. What is not, however, treated in his story—at least in any systematic
way—is the issue of competitive advantage, since there is little in the transaction-
cost story that allows us to say much about sustained inter-firm differences.
The work of Oliver Hart and various associates (Grossman and Hart 1986;
Hart and Moore 1990; Hart 1995)—usually called ‘the property-rights
approach’—is often seen as a formal version of Williamson’s work, although
there are subtle but important differences (Kreps 1996). This work distinguishes
two types of rights under contract: specific rights and residual rights. The latter
are generic rights to make production decisions in circumstances not spelled out in
the contract. The choice between market contracting and internal organization
reduces to a question of the efficient allocation of the residual rights of control
when contracts are incomplete and assets highly specific. If, again, assets are
specific it may be efficient to place the residual rights of control in the hands of
only one of the parties by giving that party ownership of both sets of assets. In
general, the owner ought to be the party whose possession of the residual rights
maximizes incentives to invest, which typically means the party whose contribu-
tion to the joint surplus of cooperation is greater. Hart and his colleagues hold that
the possession of the residual rights of control necessitates ownership of the firm’s
capital assets and that the boundaries of the firm can be defined in this way.7
Although it is often seen as a formalization of (and improvement on) William-
son’s work, the property-rights approach actually leaves out much of the richness
in his work (see Kreps 1996), and is even less suitable than the transaction-cost
approach as a strategic theory of the firm. In contrast to Williamson’s work, there
is very little in the property-rights theory about ex post governance and about
issues of internal organization. Some of this may relate to the different behavioral
assumptions that underlie the two theories. Incomplete-contract theorists expli-
citly deny the need in the theory of the firm for a notion of bounded rationality
(cf. Hart 1990). To Williamson contractual incompleteness is clearly derived
from bounded rationality, whereas to the property-rights theorists it is a matter of
an assumed non-contractability of the use of the assets in a relation. In the latter
case a welfare improvement may be brought about by reallocating residual rights
of control; however, changes in organization structure and other information
channels are not likely to have welfare consequences. To Williamson, on the
other hand, organization structure and information channels strongly influence
the boundedness of rationality. By economizing on bounded rationality, organ-
ization structure (which may be influenced by integration) may have welfare
consequences for the agents involved with the firm. Moreover, to Williamson the
incompleteness of contracting shifts some of the burden of efficient economic
organization on to ex post governance, including management—something that
is notable by its absence in the work of the property-rights theorists.8 Thus, it
may be argued that the inclusion of bounded rationality in Williamson’s work
allows him to stay closer to the traditional concerns of the strategy field than the
property-rights theory. Moreover, in principle, bounded rationality opens the
door for a theory of firm heterogeneity (cf. Nelson and Winter 1982); this,
however, is a theme that Williamson has not pursued.
Complete Contract Theories

Complete contract theories break with the assumption that information con-
cerning states of nature is symmetric. Thus, they allow agents to write elaborate
contracts characterized by ex ante incentive alignment, but only under the
constraints imposed by the presence of asymmetric information and (divergent)
risk preferences. The agency problem (in its moral hazard manifestation) basic-
ally stems from a conflict between insurance and incentives. Sharing profit
between a risk-neutral principal and a risk-averse agent—the standard assump-
tions about risk preferences in the literature—has the risk-neutral principal
bearing all of the risk. This leads to the so-called ‘first-best outcome’. However,
this is only so if incentive issues are set aside (or the agent has no choice of
action). In the standard bilateral setting the principal in fact cannot propose a
first-best contract to the agent because the agent’s action cannot be observed by
the principal. The asymmetric information in question may be a matter of either
hidden action or hidden knowledge (i.e. the principal does not know some
characteristics of the agent that are relevant to the relation). The (moral hazard)
problem then is that the agent selects an action which has random consequences,
and those consequences can be ascertained by the principal, but the action and
the state of nature (that both ‘produced’ the consequences) cannot. In this case
risk-sharing and incentive considerations will interact. The contract specifies a
reward schedule so that the agent is paid by the principal as a function of the
verifiable consequences. In general, such a contract will only be second-best. The
first-best (output maximizing) contract would be to let the agent compensate the
principal with a fixed lump-sum payment and be awarded the residual; however,
risk aversion on behalf of the agent will rule out this solution.
Principal–agent theory has produced many insights that are helpful for
understanding contractual arrangements in general and the internal organization
of firms in particular.9 However, strictly speaking, these theories are not theories
of the firm per se. Principal–agent theory is probably best understood as an
extension of the neoclassical theory of the firm that inquires into the incentive
conflicts that may hinder the firm from reaching its production-possibility
frontier. However, the reward schedules that may modify the effects of asym-
metric information are independent of any particular organizational structure. In
principle, a reward schedule for a legally independent supplier firm may be
completely identical to an employee reward schedule. Thus, principal–agent
theory doesn’t allow us to discriminate between inter-firm and intra-firm trans-
actions. Thus, it does not address the issues of the existence and boundaries of the
firm, nor, we may add, that of competitive advantage. Principal–agent theory
cannot aspire to the title of a strategic theory of the firm.
Why Organizational Economics is Not a Strategic

Theory of the Firm
So far, it has been argued that organizational economics fails to meet the criteria
for qualifying as a strategic theory of the firm that were presented above (p. 24)
(although some theories failed more than others). In this section I want to
examine more closely the deeper reasons why economics-of-organization theories
are not strategic theories of the firm.
Whatever their differences may be, one heuristic is characteristic of the various
contributions that constitute OE: an overriding emphasis on conceptualizing
virtually all problems of economic organization as problems of reducing incen-
tive conflicts through ex ante contractual alignment and through ex post govern-
ance mechanisms. The role—the potentially very important role—of cognitive
frames, routines, and capabilities as coordinating devices is neglected in this
literature (Langlois and Foss 1999). Thus, the set of possible coordination
problems, as well as the set of mechanisms for alleviating coordination problems,
is very narrowly defined (Grandori 2001).
A specific example of this heuristic can be found in a recent paper by Rotem-
berg and Saloner (1994). They address one of the key ideas of the corporate-
strategy and knowledge-based literature; namely, that firms may be best off
choosing narrow strategies. Specifically, Rotemberg and Saloner use the incom-
plete-contract framework to argue that a firm may choose a narrow strategy (and
thus ignore profitable opportunities) because strategic breadth leads to imple-
mentation problems ex post that distort ex ante incentives. They do note (p. 1131)
that ‘increasing returns to specialization’ (because of learning advantages) from
concentrating on well-defined knowledge-based may be an independent reason
for narrow strategies, but they do not investigate that possibility—because this
would mean breaking with the heuristic of reducing all problems of economic
organization to problems of aligning incentives.
In a later paper (1995) the same authors discuss ‘overt inter-functional
conflict’, which they exemplify by conflicts between production and market-
ing-and-sales functions. Conflicts sometimes arise between these functions,
because ‘production’ prefers long, uninterrupted runs, while ‘sales and marketing’
prefers to be able to offer customers diversity. In the story Rotemberg and Saloner
tell, these preferences are motivated by employees’ wanting the firm to make
particularly extensive use of their accumulated human capital, so that their
bargaining position can be improved and they can increase their salary. Again,
the authors do mention that an alternative explanation may have to do with
different world-views among people in production and sales and marketing, but
choose not to inquire into this.
A third, more general, example concerns the argument in the property-rights
literature that strongly complementary assets should for reasons of efficient
governance be under common ownership (Hart and Moore 1990; Hart 1995).
In terms of the logic of the model, this conclusion is, of course, impeccable. But
the model basically overlooks the argument, pointed out more than thirty years
ago by George Richardson (1972), that although assets may be strongly com-
plementary, they may still be dissimilar—in which case there is the possibility
that governance by separate organizations is superior.
These examples are not isolated ones. Rather, they are representative of the
explanatory stance characterizing OE. In this logic, factors such as differential
cognition, values, routines, capabilities, etc. that may often be crucial to the
traditional organization or strategy scholar when addressing, for example, core
competencies, inter-functional conflict, or the organization of dissimilar capabil-
ities do not enter the argument at all. The only explanatory mechanisms
considered relate to the alignment of incentives. The problem is not that
the explanatory logic pursued by OE is faulty, given its assumptions. It is not.
Rather, the issue is empirical; it concerns whether the explanatory mechanisms
identified in OE are plausible explanations of the phenomena under study.
In fact, it is quite likely that the mechanisms underneath, for example, the
narrow firm strategies that Rotemberg and Saloner (1994) talk about have little
or nothing to do with the alignment of incentives, and have everything to do with
limited knowledge, understanding, and perception.10
However, one may argue that whether narrow strategies ultimately turn on
incentives or on capabilities is essentially an unsettled empirical question, and
that therefore reformulating traditional organization and management issues in
terms of OE is a respectable scientific activity. This may be granted. On the other
hand, one may also validly argue that to translate the basic assumptions of
organizational economics into an exclusive and near universal research strategy
arguably closes off a range of plausible alternative explanations of what firms are
and do, and of the activities of managing and strategizing.
Indeed, the claim here is that its full commitment to the narrow incentive-
alignment research strategy is one reason why OE cannot, at least at the present,
aspire to the role of a comprehensive strategic theory of the firm. First, it means
that a very biased view is produced of a number of phenomena. For example, OE
is characterized by relative inattention to issues of management, strategizing, and
leadership (Coase 1988; Miller 1992)—all of which become reduced to merely a
matter of providing the right incentives.11 Moreover, it neglects those determin-
ants of economic organization that are not related to incentive conflicts, such as
information processing and organizational ‘codes’, ‘languages’, etc. (Radner
1996; Wernerfelt 1997). Second, but relatedly, the narrow research strategy of
the modern economics of organization means that a number of issues that are
crucial to the strategy field are not considered at all. These omissions include
issues relating to positioning (but see Nickerson 1997); path-dependency (but
see Williamson 1998)—which may lead the theorist to think of organizations as
much more flexible than they in reality are (Winter 1991; Rumelt 1995)—and
organizational learning (cf. Williamson 1998), as well as other dynamic phe-
nomena and issues, such as innovation (Williamson 1985).
While a satisfactory strategic theory of the firm certainly does not have to take
all this into account, it is clear, on the other hand, that issues such as path-
dependency, organizational learning, differential capabilities, and the like have
been very much present in the discourse of the strategy field within at least the
last decade, and that the inability of the economics of organization to come to
grips with them may be seen as a problem. Most seriously, their neglect in OE
means that it becomes very difficult to account, within this body of thought, for
systematic and sustained differences among firms.12 In fact, this is the decisive
objection against viewing OE as a strategic theory of the firm, for without a
theory addressing the sources and persistence of heterogeneity among firms it is
hard to tell a convincing story of (sustained) competitive advantage (Barney
1991).
One important reason why it is so hard to treat heterogeneity within OE is that
this body of thought does not challenge the basic theory of production in eco-
nomics; that is, ‘the production function view’ (Nelson and Winter 1982). In other
words, it is implicitly accepted that the production function and its attendant
assumptions tells us what we need to know about production. However, in basic
economics technological knowledge is seldom portrayed as asymmetric, let alone
tacit; on the contrary, it is assumed to be explicit, freely transmissible, and easily
encapsulated in blueprints.13 Thus, it is next to impossible to rationalize hetero-
geneity and competitive advantages in terms of different underlying capabilities,
and, moreover, the governance choice cannot hinge on differential capabilities.
The relative suppression of production in the modern economics of organization
may simply be a pragmatic methodological postulate (Williamson 1985: 88), and
differential production costs may eventually be more fully treated in OE (e.g. Lewis
and Sappington 1991; Williamson 1998). But it is still a good approximation to
say that in OE it is not recognized that (1) knowledge may be imperfect in the
realm of production, and (2) firms may play the role not only of mitigating
incentive conflicts but also of linking existing imperfect knowledge and of making
knowledge less imperfect through learning.14 I now turn to a body of theory that
tries to make provision for these points.
Isolationist Strategy No. 2: The Knowledge-based View as a Foundation

for the Strategic Theory of the Firm
Penrose and the Knowledge-based View
The conceptualization of the firm that underlies the KBV is often attributed to
Penrose (1959). ‘The firm’, Penrose says, ‘is . . . a collection of productive resources
the disposal of which between different uses and over time is determined by
administrative decision’ (ibid. 24). She points out that allocation by means of
‘administrative decision’ is fundamentally different from allocation by means of
the price mechanism (ibid. 20), thus establishing a link to Coase.15 But whereas
Coase (1937) was eager to emphasize that he was simply extending existing
economic analysis, Penrose makes an explicit break with mainstream economics.
Hers is a constructivist and disequilibrium theory of the firm.16 In Penrose’s story,
the management team holds images of the external environment and of the firm’s
internal resources (this is the constructivist part of her analysis). She further argues
that these images are produced through internal learning processes. Moreover, they
determine the constantly changing ‘productive opportunity set’ of the firm (this is
the disequilibrium part of her story); that is, the productive possibilities that the
firm’s ‘ ‘‘entrepreneurs’’ see and can take advantage of ’ (Penrose 1959: 31).
Thus, Penrose explicitly begins from a theory of (limited) cognition. In contrast,
modern contributions to the knowledge-based view typically begin merely from
the empirical generalization that firm-specific knowledge is ‘sticky’, distributed,17
and tacit, without arguing this on the basis of a theory of individual cognition and
knowledge.18 This is not an unimportant point, for the problem of missing micro-
foundations is a severe one in the knowledge-based view. However, both starting
points imply that organizations are necessarily limited in what they know how to do
well. These characteristics of productive knowledge are often summed up by means
of the concept of ‘capabilities’, and basic ideas on capabilities form the backdrop to
an analysis of firm heterogeneity, competitive advantage, and differential rents.
Differential capabilities imply differences in terms of the efficiency with which
resources are deployed, which yield rents that, in turn, may be long-lived because
the inherent characteristics of capabilities make them hard to imitate (Lippman
and Rumelt 1982; Wernerfelt 1984; Barney 1991; Peteraf 1993). I shall not spend
more time here rehearsing these familiar arguments. What is important in the
present context, however, is the increasingly influential idea that the characteristics
of capabilities that make them interesting for the study of competitive advantage
are actually also crucial for the study of the main issues in economic organization
(Conner 1991; Langlois 1992; Kogut and Zander 1992; Foss 1993; Langlois and
Robertson 1995; Conner and Prahalad 1996; Grant 1996; Kogut and Zander
1996; Madhok 1996). Thus, in prospect, we are being told, is a strategic theory of
the firm derived from knowledge-based considerations rather than from incen-
tives, opportunism, and transaction costs.
The Knowledge-based View as a Theory of Economic Organization

As a theory of economic organization the KBV may be reconstructed along
the following lines. In a (Penrosian) world of bounded rationality and tacit,
sticky, and distributed knowledge—that is, of differential capabilities—produc-
tion and transaction costs are arguably cast in a different light relative to the
modern economics of organization. First, in such a world firms will not confront
the same production costs for the same type of productive activity, primarily
because they are unlikely to control the same stocks of tacit knowledge (Nelson
and Winter 1982). Second, and as a consequence of the first point, the costs of
transacting may go beyond those that arise in the course of safeguarding against
opportunism or reducing moral hazard problems through monitoring or incen-
tive contracts. In particular, economic activity may be influenced by costs related
to the process of gathering, coordinating, and communicating knowledge (Dem-
setz 1991; Langlois 1992; Foss 1993; Langlois and Robertson 1995; Casson
1997).
In such a setting the costs of making contacts with potential partners, of
educating potential licensees and franchisees, of teaching suppliers what it is one
needs from them, etc. may influence where the boundaries of firms will be placed.
Likewise, the internal structure of firms may not just reflect incentive alignment
but may also reflect the costs of transmitting knowledge (Radner 1996). This
suggests, albeit loosely, that the KBV may be interpreted as an emerging alternative
theory of economic organization, for the sort of costs of transacting that are
highlighted in the KBVare not comprehensively treated in the modern economics
of organization. As Jean Tirole (1988: 49), a key contributor to the modern
economics of organization, admits, ‘[n]eoclassical theory pays only lip service to
the issue of communication’.
The idea that a knowledge-based view may have implications for economic
organization is not quite new. In what is still one of the best contributions to the
literature, G. B. Richardson (1972) suggested that we begin not from the
Coasean idea of transaction costs but from the idea that production can be
broken down into various activities, not unlike the treatment of Porter (1985).
Some activities are similar, in that they draw on the same general capabilities, and
activities can also be complementary, in that they are connected in the chain of
production, and similarity and complementarity may obtain to varying degrees.
The main point in Richardson (1972) is that economic organization is strongly
influenced by these dimensions of activities. For example, closely complementary
and similar activities are best undertaken under unified governance, whereas
closely complementary but dissimilar activities are normally best undertaken
under some sort of hybrid arrangement (to use Williamson’s terminology
(1996)). Thus, Richardson’s basic point clearly is that capabilities may be
determinants of the boundaries of the firm, a point that was later elaborated by
Kogut and Zander (1992) and Langlois (1992). They argued that differential
capabilities would typically give rise to different production costs, and that such
cost differentials may crucially influence the make or buy decision. Thus, firms
may internalize activities because they can carry out these activities in a more
production- not transaction-cost-efficient way than other firms are capable of
(see also Madhok 1996).
In economics the next major knowledge-based critique (after Richardson
1972) of OE is probably Demsetz (1991), who argues that firms may exist for
reasons of economizing on expenditures on communicating and coordinating
knowledge. Thus, the employment contract, and hierarchy more generally, may
exist because it is efficient to have the less knowledgeable being directed by the
more knowledgeable.19 Within the strategy field, a number of knowledge-based
contributions have echoed Demsetz’s points about the firm existing for reasons of
superior ability to coordinate knowledge (Conner 1991; Conner and Prahalad
1996; Grant 1996). For example, Conner and Prahalad (1996) argue that the
existence of firms can be explained in terms of the superior flexibility relative to
market contracting that the authority relation may confer and in terms of
economizing with the communication of knowledge, thus combining Coase’s
ideas (1937) about authority with Demsetz’s ideas (1991) about conserving on
expenditures on communicating knowledge. Whereas market contracting may
require prolonged haggling and sharing of knowledge, firms may save on
haggling costs and costs of communicating knowledge, and may exist for this
reason.
A possible conclusion on this section is that the KBV is in fact reaching
for a distinct perspective on economic organization, since it appears that expla-
natory mechanisms that are different from those of OE are emphasized.
Specifically, the perspective begins from many of the ideas that were develo-
ped in order to understand competitive advantage, such as heterogeneous,
firm-specific, path-dependent, and hard-to-imitate production and organiza-
tion knowledge, and tries to build a theory of economic organization on
this basis, specifically a theory that addresses the existence and boundaries of
firms.
Weaknesses of the Knowledge-based View

There is, it is fair to say, an optimistic tone to the new knowledge-based approach
to economic organization. The reason is easy to detect: it is an approach
to economic organization that avoids (what its proponents may regard as) the
worst excesses of the modern economics of organization,20 and it deals directly
with strategy issues, staying in close contact with both behavioral perspectives
and more content-oriented strategy perspectives (cf. Zajac 1992). Thus, part
of the optimism may have to do with a conviction that in prospect is a distinct
theory of the firm that will largely be developed within the strategy field rather
than merely being imported from economics. However, there are reasons to curb
enthusiasm somewhat. In fact, the purpose of this section is to identify a number
of weaknesses that beset the KBV. Whereas the view is at its strongest when
it comes to the analysis of firm heterogeneity and competitive advantage, its
approach to economic organization appears at present considerably more shaky,
particularly considering that many of the weak points have been dealt with
rather convincingly by the modern economics of organization. For example,
I shall argue that the KBV has difficulties accounting for the existence of the
firm. In addition to these difficulties of explaining economic organization,
there are also difficulties of a more methodological nature, such as the
view’s lack of clear micro-foundations and its inability to put forward clear
predictions.
Economic Organization: The Existence of the Firm, Asset Ownership,

and the Boundaries of the Firm
Perhaps the strongest arguments that the KBV can successfully address the issue
of the existence of the firm have been put forward by Conner (1991), Kogut and
Zander (1992), and Conner and Prahalad (1996), Grant (1996). The arguments
fall in two different categories. First, there is an argument that firms exist because
they can create certain assets—such as learning capabilities or a ‘shared con-
text’—that markets purportedly cannot create.21 Second, a different (but perhaps
complementary) argument is that firms exist because of their superior flexibility
relative to market contracting; for example, they may be more flexible when it
comes to deploying assets because they can rely on the authority mechanism
rather than on the haggling that characterizes market contracts. However, the
problem with both views is they that do not sufficiently characterize firms.
Markets can cultivate learning capabilities and shared context (as in industrial
districts), and markets can certainly be flexible, too; indeed, superior flexibility
has often been invoked as very much part of their rationale (e.g. Hayek 1945).
Likewise, the literature on user–producer interaction (e.g. Hippel 1988) makes
essentially the same claims for cooperative relations between legally independent
firms.
To illustrate further what is wrong with these views, consider the much cited
Kogut and Zander (1992) paper. They are representatives of the view that firms
exist because they can create certain assets that markets cannot create. As they
argue,
organizations are social communities in which individual and social expertise is trans-
formed into economically useful products and services by the application of a set of
higher-order organizing principles. Firms exist because they provide a social community
of voluntaristic action structured by organizing principles that are not reducible to
individuals (ibid. 384)
—a view, they claim, that ‘differs radically from that of the firm as a bundle
of contracts that serves to allocate efficiently property rights’ (ibid.). Firms’
advantages over markets derive from their being able to supply ‘organizing
principles that are not reducible to individuals’, and in which the members of
the organization are embedded.22 Markets (inherently?) cannot supply these
principles. Thus, according to Kogut and Zander, the efficient development of
capabilities and the full creation of the values of assets/resources can only take
place within firm organization, because firms offer embeddedness (shared codes,
knowledge, expectations, etc.) advantages that markets cannot offer. Presumably,
this is what some writers have called ‘the organizational advantage’ (Ghoshal and
Moran 1996; Nahapiet and Ghoshal 1999).
The basic problem with this reasoning is that embeddedness of the sort that
these authors talk about does not require firm organization. Thus, in a moral
utopia, characterized by the absence of opportunistic proclivities, the gains from
embeddedness could be realized in the market. Agents could simply meet under
the same factory roof, own their own pieces of physical capital equipment or rent
them to each other, and develop value-enhancing ‘organizing principles’ (to use
Kogut and Zander’s term) among themselves, or in other ways integrate their
specialized knowledge (as a team) (Putterman 1995; Foss 1996a). Firms would
not be necessary. Even in an opportunism-prone world there may be much
embeddedness ‘outside’ firms, as it were; for example, in single industries, in
firm networks, industrial districts, etc., depending on the presence of various
control and enforcement mechanisms.
The OE critique of the embeddedness argument is that in the absence of
opportunism (or incentive conflicts more generally), the first-best (efficient)
outcome can always be realized in the market and firms are strictly unnecessary.
But there is another knowledge-based argument that cannot be killed by this
critique. This is put forward by Conner (1991) and Conner and Prahalad
(1996). They argue that firms derive their raison d’être from their superior
flexibility relative to markets, particularly with respect to creating and redeploy-
ing knowledge, an advantage that is very closely connected to the incompleteness
of the employment contract and the existence of authority. Admittedly, Conner
and Prahalad (ibid.) go some way towards an improved understanding of the
bargaining- and communication-cost advantages of the employment contract,
and Wernerfelt (1997) presents an interesting formalization of a related idea. The
problem here is whether the employment contract sufficiently characterizes the
firm. According to a number of theorists, now including Coase (1988) himself, it
does not.
As argued by Williamson (1985, 1996a), Grossman and Hart (1986), and
many others, the key to defining the firm lies in asset-ownership rather than in
the employment relationship. In fact, the latter is derived from the former. In this
tradition the firm is defined as the collection of assets that the firm’s owners/
managers control. One reason why asset ownership matters is that it allows us to
understand bargaining power and hence the derived concept of authority: the
owner/manager, who controls assets, can threaten the employee with depriving
him of the assets with which he is currently working (here is the link to the
employment contract). We may disagree with the idea that the pattern of asset
ownership is indeed the essence of the firm,23 but it is hard to disagree with the
proposition that the pattern of asset ownership is a crucial aspect of the firm, and
that any comprehensive theory of the firm must address this issues. Knowledge-
based theories of the firm do not in their present version address it.24
In spite of this, many contributions to the knowledge-based view (e.g. Kogut
and Zander 1992; Madhok 1996) present it as an alternative and general
25
perspective on economic organization. One interpretation of what it means for
the KBV to be a general theory is that observed economic organization—always
and everywhere—must be predominatly explained using knowledge-based ideas,
and that economics-of-organization ideas enter the explanation in a secondary
way (if at all).
The starting point of the KBV, we have seen, is differential capabilities and
derived knowledge problems. But what if capabilities are not that ‘dissimilar’ (in
Richardson’s terminology (1972)), as, for example, they may not be in an industry
characterized by a mature underlying technology. In such an industry, one may
conjecture that incentive-conflict considerations will dominate differential cap-
abilities, in which case an OE perspective is appropriate. If it is conceded that the
knowledge-based view is complementary (rather than rivalrous) to the modern
economics of organization, reasoning that allows the analyst to be more precise
about when capabilities matter and when they don’t is still needed. It may be
argued that the ‘balance’ between capabilities and incentive/governance consid-
erations hinges on the degree of overlap in the technological knowledge under-
lying firms’ activities, but this does not go significantly beyond the formulation of
Richardson (ibid.). Of course, it is possible to provide some rationalizations of
differential capabilities; for example, by pointing to path-dependency, tacitness,
and team-based knowledge (Winter 1991; Foss 1993; Langlois and Robertson
1995; Argyres 1996). But to some extent this begs the question, for we are still not
much wiser about how capabilities are influenced by these factors and how this
translates into knowledge dimensions such as ‘similarity’ (Richardson 1972).
Knowledge of these links seems, however, to be required to make the KBV
predictive. The virtual absence of theorizing here indicates a broader problem;
namely, the lack of clear micro-foundations and modeling heuristics.
Methodological Problems: Lack of Predictive Power and Modeling Heuristics

The KBV is certainly not without empirical content; however, as it now stands
the KBV is more of an explanatory than a predictive approach. That is to say, it
allows the analyst to tell an ex post story about the causes of the success of a given
firm, or why the boundaries of that firm are placed where they are, but it is
considerably weaker with respect to predicting future success or future patterns of
economic organization (Argyres 1996). This may be contrasted with the sub-
stantial base of empirical support that OE has now accumulated (on which see
Klein and Shelanski 1995). What makes this comparison pertinent is not only
that the KBV and OE may be seen as theoretical rivals. It is also that they both
make heavy use of concepts—capabilities and transaction costs respectively—
whose empirical counterparts are not immediately apparent.
However, in fairness it should be noted that it has taken OE two decades to
accumulate its present base of empirical support, and one may argue that there is
nothing in the KBV that makes it inherently non-predictive. Any theory contains
terms and concepts that are not testable and, indeed, are not meant to be tested at
all. And it is often held that what should be tested are the implications of the
theory, not its assumptions (Machlup 1955). However, capabilities hardly par-
take of the role of assumptions; rather, they are crucial explanatory variables, so
the issue of operationalization is hard to avoid. In particular, operationalization
must proceed so that it is possible to distinguish between competing hypotheses.
This is a problem with the one quantitative empirical study that comes out
unambiguously in favor of the KBV as it applies to economic organization,
namely Kogut and Zander (1993). This paper is essentially an application to
the multinational corporation, with an accompanying test, of the reasoning in
their 1992 paper. In their story, the raison d’être of the multinational corporation
lies in its superior ability to transfer tacit knowledge across borders, rather than in
any market failures. They present quantitative evidence for the proposition that
the harder to codify and teach a given technology is, the more likely is it that the
technology will be transferred by means of wholly owned operations. Thus, the
boundaries of the multinational firm are shown to depend on knowledge
considerations. However, Kogut and Zander do not control for a possible
competing transaction-cost explanation; namely, that tacit technologies may
also tend to be more proprietary and therefore at greater risk of expropriation
by contractual partners. Thus, an alternative micro-explanation can rationalize
the finding that such technologies are not transferred over the market but
through wholly owned subsidiaries. It is worth exploring the issue of micro-
foundations, and relatedly, modeling heuristics, further.
Because it is largely derived from mainstream economics, OE is characterized
by rather unambiguous micro-foundations and modeling heuristics. Basically,
one may say that there is agreement that the aim is to explain economic
organization (patterns of property rights, incentives, and monitoring) as an
equilibrium outcome of interaction among self-interested agents in a setting
characterized by asymmetric information (principal–agent theory) and/or in-
complete contracting (incomplete contracts, transaction-cost economics). This
heuristic guides almost all work done within OE. In contrast, there is no
agreement on the micro-foundations of the KBV, and, what is worse, very little
interest in providing such micro-foundations.26
A further, but related, problem is that how knowledge considerations relate to
more economic considerations is seldom made clear. This is because the micro-
logic of the arguments is very seldom spelled out. (More on this in Chapter 4.) To
what extent can knowledge-based arguments about economic organization be
interpreted in terms of information costs? What exactly is the relation between,
for example, tacitness and complexity, on the one hand, and information and
communication costs on the other? Moreover, how do we build up from
assumptions about individual behavior and cognition to firm-level outcomes?
Is the knowledge-based view consistent with equilibrium or does it adopt other
principles for making sense of the outcomes of interactions? In other words, clear
modeling heuristics are lacking. Arguably, this problem besets the whole know-
ledge-based literature, and it is easy to agree with Williamson (1996a: 357–8)
when he observes that ‘ ‘‘[c]ore competences’’, which is an elusive but important
concept in the recent corporate knowledge-based literature [ . . . ] should be
conceptualized more rigorously’.
The Knowledge-based View as a Strategic Theory of the Firm?

As the preceding sections indicate, there are reasons seriously to doubt whether
the KBV can pretend to be a strategic theory of the firm in the sense in which that
term is being used here. There are deep substantive as well as methodological
problems. Thus, there are problems with the explanatory logic of the view,
particularly as it applies to issues of economic organization; moreover, the view
is non-formal and non-predictive. While these latter characteristics do not
constitute grounds for rejection (or perhaps even critique) per se, they do imply
that the KBV in important ways runs counter to both the strong formalistic
tendency of OE and the positivistic tendency of the strategy field. One may
seriously question for how long a theory can survive in environments in which
formalization and the production of testable hypotheses appear to be important
selection criteria.
The KBV has to a large extent been developed within the strategy field, and one
may argue that it is characterized by the weaknesses (ambiguous terminology, little
cumulative theory development, etc.) that have been claimed to characterize this
field. This may in itself explain its continued existence, since it may not be such a
weak theory after all—if seen in the context of its environment. Thus, while
economists may wish to give short shrift to the perspective, the tolerance of
management scholars may be considerably greater. In a more friendly interpret-
ation, however, the KBV has emerged and continues to develop because it is up to
something that is (1) interesting and (2) not treated in the modern economics of
organization. Before this can be seen, it is necessary to undertake a more systematic
analysis of the relations between the two bodies of theory in terms of their
explanatory apparatuses. This is done in the following section.
A Theory-of-science Perspective
As already stated, the relation between the KBV and OE is often seen as one of
rivalry. For example, Kogut and Zander (1992: 384) argued that their view ‘differs
radically from that of the firm as a bundle of contracts that serves to allocate
efficiently property rights’. One would perhaps expect such inter-theory conflicts
to be settled through empirical tests. One problem here is that empirical work that
aims at testing the predictions of the KBV (Kogut and Zander 1993) does not
control for a possible competing OE explanation, and vice versa (Klein and
Shelanski 1995).27 Indeed, empirical work in this area is fraught with severe
difficulties in defining and operationalizing key concepts.
Possible Theory Relations

In order to be able to discuss the relation between the KBV and OE in a more
precise manner, I rely on Krajewski (1977). He suggested a useful framework for
classifying and discussing relations between different theories. The taxonomy in
Table 2.1 reflects this framework. Krajewski’s framework and taxonomy are here
used as a heuristic tool. The aim is not unambiguously to place KBV and OE in
one of the categories of Table 2.1. Rather, the taxonomy provides useful insights
with respect to the dimensions in which theories may differ.
The taxonomy maps possible relations between two theories, T1 and T2 , in
terms of their domain of application (D) (i.e. their explanandum) and their
theoretical language (V) (i.e. their explanans). The domain of application refers
to what the theory is designed to explain. For example, OE is designed to explain
the existence, boundaries, and internal organization of firms (cf. Coase 1937;
Alchian and Demsetz 1972; Williamson 1985, 1996a; Hart 1995). Initially, the
KBV was developed to address competitive advantage (Wernerfelt 1984; Barney
1986), but it has, as we have seen, increasingly expanded its explananda phe-
nomena to also include those traditionally considered in OE (see Table 2.2).
Table 2.1 reveals that the KBV and OE have overlapping domains of appli-
cation (D1 \ D2 6¼ Ø). They are therefore commensurable, which is a precon-
dition for comparing them. Given commensurability, there are then several
possible relations between the KBV and OE, of which the extreme possibilities
are equivalence and contradiction. The possible relations between the theories all
intimately involve the question of the relation between the respective theoretical
languages. The concept of theoretical language refers to the explanatory frame-
work of the theory, including terminology, explanatory variables, behavioral
assumptions, and type of explanation. For example, while OE relies on an
explanatory framework largely derived from mainstream economics, the KBV
relies instead on a framework drawn from strategy, organizational, and behavioral
research and emphasizes bounded rationality, routines, capabilities, and the like,
rather than incentives, asymmetric information, property rights, and contracts.
A key question then is what is the relation between these theoretical languages.
For example, can equivalence be established through translation of KBV lan-
guage into OE language or vice versa? If this cannot be done, this still leaves us
with numerous other possibilities. For example, the theories may be contradict-
ory, as asserted by some proponents of the KBV (e.g. Kogut and Zander 1992;
Madhok 1996). In terms of Table 2.1, this means that while the domain of
Table 2.1. A taxonomy of theory relations
Theoretical
Type Domain language Relation
Commensurability D1 \ D2 6¼ Ø — —
Equivalence D1 ¼ D2 V1 $ V2 T1 ¼ L1 (T2 )
T2 ¼ L2 (T1 )
Reduction:
Homogeneous D1 D2 V1 V2 T1 ^ A ) T2
Heterogeneous D1 D2 V1 ! V2 T1 ^ A ^ S ) T2
Contradiction D1 ¼ D2 V1 6¼ V2 T1 ) :T2
T2 ) :T1
Correspondence:
Homogeneous D1 D2 V1 ¼ V2 T2 ) aT1 in D1
T2 ) : aT1 in D2 D1
Heterogeneous D1 D2 V1 ! V2 As above
Note: The notation is standard notation; however, some of the expressions used deserve explanation: ‘$’
means that there is a one-to-one correspondence (so that double translation between two theories is
possible); ‘L’ is a translation operator (metaphorically speaking, a sort of ‘dictionary’); ‘!’ is used to
indicate a one-sided correspondence (so that double translation is not possible); ‘)’ refers to implications
of a theory (e.g. ‘T1 ) :T2 ’ means that the negation of T2 follows from T1 ); ‘A’ refers to supplementary
hypotheses; ‘S’ are bridging principles (e.g. principles of aggregation); finally, ‘a’ means ‘approximates’.
Source: Reproduced from Krajewski (1977: 67) with modifications.
application (D) of the theories is the same, the theories work with different
untranslatable languages (V), and their implications with respect to the domain
of application contradict each other (i.e. T1 ) :T2 and T2 ) :T1 ). This
would seem to make integrationism untenable, and isolationism the only pos-
sible approach. However, such a conclusion may be too hasty.
In order to find out what is the true relation between the KBV and OE, one
can begin by examining to what extent it is possible to arrive at the same insights
by trying to translate the theoretical language of the KBV into OE language (or
vice versa). This allows for an identification of not just ‘semantic’ differences, but
genuine theoretical differences.
We may begin by asking whether a reduction is possible? Two general types of
reduction may be distinguished. First, a homogeneous reduction is obtained if it
is possible to show that the KBV is a special-case theory of organizational
economics (or vice versa), in the sense that one can obtain OE by adding
hypotheses (A) to the KBV, and that the theoretical language of the KBV is a
subset of OE. Second, in the case of a heterogeneous reduction we also need
bridging principles (S), which generally refer to how one moves from one level of
analysis to another one. For example, there may be principles that explain how
the notion of ‘routine’ is obtained from aggregating individual actions.
Table 2.2. The knowledge-based approach and organizational economics: explananda and
key contributions
Explanandum Knowledge-based Organizational-economics

phenomenon contributions contributions
Why do firms exist? Conner (1991), Alchian and Demsetz

Conner and Prahalad (1972), Coase (1937)
(1996), Grant (1996),
Kogut and Zander (1996)
What factors determine Kogut and Zander (1992, Hart (1995), Hart and
firms’ boundaries relative to 1993), Madhok (1996), Moore (1990), Williamson
the market? Penrose (1959), Richardson (1985, 1996a)
(1972), Winter (1991)
What determines firms’ Dosi and Marengo (1994), Barzel (1997), Holmstrom
internal organization? Ghoshal, Moran and (1982), Holmstrom and
Almeida-Costa (1995), Milgrom (1991),
Ghoshal and Moran (1996) Putterman (1995)
What determines Barney (1986, 1991), Kreps (1990a), Williamson
competitive advantage? Peteraf (1993), Wernerfelt (1994)
(1984)
Note: Some of the contributions address more than one of the explananda phenomena. However, they have
been classified according to their main thrust.
Finally, there is the possibility of correspondence. In a homogeneous relation of

correspondence the two theories apply identical explanatory apparatuses, and T1
is an adequate approximation to T2 within D1 , while the more general theory T2
corrects T1 in D2 D1 by taking into account new variables, assumptions, etc. A
final possibility is the heterogeneous relation of correspondence, which differs
from the homogeneous relation by taking into account differences in theoretical
languages.
The basic KBV position seems to be that because OE does not conceptualize
economic organization in knowledge-based terms it cannot come to grips with
either the analysis of competitive advantage or the knowledge-based determin-
ants of economic organization (e.g. Madhok 1996). However, many of the
explanatory concepts and insights of the KBV can be given an OE interpretation,
or at least be further illuminated by this approach, as exemplified below.28
Translating the Knowledge-based View: Some Examples

Perhaps the key explanatory insight of the KBV is resource heterogeneity,
particularly heterogeneity of knowledge resources. Ultimately, it is heterogeneity
that explains performance differences between firms and why, for example,
different firms organize different activities (i.e. the boundaries of the firm)
(Madhok 2002). Can OE handle heterogeneity and economic organization in a
way that does justice to KBV insights?
Resource heterogeneity. Resource (input) heterogeneity is in fact a key theme

in organizational economics (e.g. Alchian and Demsetz 1972; Barzel 1982;
Williamson 1996a). Not only do different resources have many and different
uses, but even assets of the same type are heterogeneous. In fact, if resources were
homogeneous, there wouldn’t be room for the contracting problems that are
central in organizational economics, save, perhaps, for very trivial agency prob-
lems. This insight is explicit in the Alchian and Demsetz (1972) theory of the
firm. They argue that resource heterogeneity is a necessary condition for the
existence of the team problem for which firm organization provides an efficiency-
enhancing solution. They go on to argue that sometimes ‘gains from specializa-
tion and cooperative production may better be obtained within an organization
like the firm’ (p. 75), because continuity of association among resource owners
and specialized monitoring services reduce the costs of ascertaining quality
differences across heterogeneous resources. Both depend on the specific alloca-
tion of property rights inside firms. First, continuity among resource owners is a
matter of the duration of contracts. Second, the manager is in a unique position
to acquire superior information about the diverse services that can be extracted
from heterogeneous resources of variable quality, because he has the right to
monitor employees. Based on this information he is also able to specify property
rights—that is, specify the rights and obligations of employees—in ways that will
yield the highest returns. Given this, efficiency differences between firms are ‘a
result not of having better resources but in [sic] knowing more accurately the
relative productive performances of those resources’ (ibid. 94; emphasis in the
original). Thus, an important source of competitive advantage lies in such
‘organization capital’ (Prescott and Visscher 1980). It is hard to see how such
reasoning as this could in any essential way be at variance with KBV reasoning;
on the contrary, it may be seen as contributing parts of a much-needed micro-
foundation for the KBV (more on this in Chapters 4 and 5).
The boundaries of the firm. A common argument in the KBV literature (e.g.
Kogut and Zander 1992; Langlois and Foss 1999) is that what ultimately sets the
KBV apart from OE is that the former is much more explicit about productive
knowledge that cannot be specified in blueprints (i.e. tacit, skill-like knowledge).
Such knowledge, it is argued, holds the key to understanding the boundaries of
the firm. However, it is not made clear why the coordination mechanisms
characterizing firms are more efficient than markets in making use of tacit,
skill-like knowledge. In order to understand this, we can employ property rights
arguments. Thus, we may associate tacit, skill-like knowledge with imperfectly
specified rights to valuable attributes of assets, notably the human capital of
employees. Given the high costs of writing explicit contracts over such know-
ledge, the firm may have advantages relative to market contracting, because its
property-rights system allows it to make less costly use of the services that tacit
human capital may yield. This is because the continuous association between the
employee and the firm allows the manager to extract information about the true
skills of employees, as argued above. Finally, the firm is particularly efficient in
enforcing the implicit elements of contracts (Williamson 1996a), such as the
norms and conventions that emerge from the continued interaction among
employees.
Which Theoretical Relations Obtain?

The two brief examples above amount to a suggestion that key KBV insights in
fact may be reformulated in terms of, or at least furthered by means of, OE
insights. This raises the question of how we can use the taxonomy in Table 2.1 to
cast light over the relation between OE and the KBV.
To begin with, note that OE and the KBV attempt to address the same
domain of application (the same explananda; see Table 2.2). However, I have
suggested that the KBV does not provide convincing independent explanations of
the existence and internal organization of firms, because KBV arguments here can
be recast as OE arguments. If generalized, this suggests that the true domain of
application of the KBV is a subset of the domain of application of OE. It is more
complicated to sort out the relations between the KBV and OE with respect to
how they explain the boundaries of the firm and competitive advantage. Note
that the KBV explanation of these relies on concepts—such as routines and
capabilities—that are not part of the OE language (explanans). This then raises
the question of the relation between the languages used in OE and the KBV.
Essentially, it has been suggested that the language of the KBV (V 1 ) may to
some extent be translated into the language of OE (V 2 ). This is because concepts
such as routines, capabilities, and heterogeneity can to some extent be given an
OE interpretation. Therefore, the KBV explanation of the boundaries of the firm
and competitive advantage may be translated into OE insights, but only after first
translating insights about routines and capabilities into OE insights. Thus, OE
may provide a sort of micro-foundation for these more aggregate concepts. Note
that in order to build up from OE insights to KBV insights one needs bridging
principles (S) that help us to move from one level of analysis to another level. For
example, routines may be seen as emergent properties of interaction between
agents constrained by transaction costs and the property-rights system of the
firm. On the other hand, it does not seem possible to translate the other way
around; that is, translate OE language into KBV language. This is because there
are no bridging principles that will allow one to go from routines and capabilities
to property rights, asymmetric information, transaction costs, etc. As a first
approximation, this means that there is a ‘one-sided correspondence’ between
the two languages (V1 ! V2 ).
The reasoning so far points to either a heterogeneous reduction or a hetero-
geneous correspondence (see Table 2.1) as the ‘true’ relation between KBV and
OE. In the case of the heterogeneous reduction, the theories have the same
implications (T1 ^ A ^ S ) T2 ), provided one of them is supplemented with
additional hypotheses (A) and bridging principles (S). In the case of the hetero-
geneous correspondence, one of the theories approximates the other one in the
latter’s domain of application (T2 ) a T1 in D1 ), while adding some new
implications that cannot be reached by the latter theory (T2 ) : a
T1 in D2 D1 ). In the view espoused here, the true relation between OE and
the KBV comes closest to that of the heterogeneous correspondence, because OE
has implications with respect to competitive advantage, and the existence,
boundaries, and internal organization of the firm that cannot be reached by
the KBV. However, it may be argued that we have only been able to reach these
conclusions by implicitly sidestepping issues such as bounded rationality, learn-
ing, and (differential) cognition—in short, ideas that relate to the endogenous
creation of heterogeneity. Can these ideas be reduced to OE insights? And are
they important to the KBV?
Knowledge-based Challenges to Organizational Economics?

There are, in fact, important concepts and insights in the KBV that cannot be
reduced to OE insights, and may in fact challenge OE. Some of these are briefly
discussed here.
Bounded rationality and learning. According to KBV writers (e.g. Ghoshal,

Moran, and Almeida-Costa 1995; Conner and Prahalad 1996; Grant 1996;
Spender 1996), one strength of the KBV relative to OE is its (somewhat) more
explicit treatment of bounded rationality and learning.29 The treatment of
bounded rationality in OE (Williamson 1985, 1996a) is arguably narrow,
since it at best figures as a constraint on a decision problem.30 Changing bounds
of rationality through, for example, satisficing search activities is not inquired
into. And learning only appears in OE as changes in human-asset specificity (‘the
fundamental transformation’; ibid.), while the learning process itself is largely
neglected. However, OE is not inherently cut off from treating learning and
bounded rationality (see Foss 2001).
For example, learning by doing requires the exercise of use rights over assets.
One may even suggest that the more well specified and easily monitored use
rights are, the less can asset users experiment, and the more constrained will their
learning be (Foss and Foss 2002). Experimentation is important as a way of
finding solutions to coordination problems (e.g. finding the optimal sequence of
activities). Managers holding residual use rights over assets are able to conduct
controlled experiments without continuously having to renegotiate contracts,
and it is by exercising residual rights that managers change the conditions under
which skills, conventions, norms, and other types of socially shared knowledge
emerge. This suggests one way in which OE may better come to grips with the
knowledge processes that are central in the KBV. But obviously much more needs
to be done here.
Cognition. OE follows virtually all of economics in assuming cognitive homo-

geneity (that is, agents hold the same, correct, model of the world) and cognitive
constancy (that is, agents’ model of the world does not change (see further Foss
2004)). In contrast to the narrow view of learning in OE, learning in firms is also
a social process of cognitive development in which cognitive categories (e.g.
business conceptions) arise and are adopted and possibly changed (Penrose 1959;
Bandura 1977; Dosi and Marengo 1994; Witt 1999; Lindenberg 2003). This
goes significantly beyond both the information processing view and conventional
views on bounded rationality (Foss 2003a). If indeed such an emphasis on
cognition is key in the KBV (consult Kogut and Zander 1996; Spender 1996;
Witt 1999; Teece 2001: ch. 4; Lindenberg (2003) for different variations
on the cognitive theme), then it should be acknowledged that here is a genuine
challenge to OE.
It is possible that a cognitive view may have important implications for the
understanding of the main explananda of OE and the KBV; namely, competitive
advantage, and the existence, boundaries, and internal organization of the firm
(see further Witt 1999). One we may think of the distribution of competitive
advantages in an industry as stemming from both the resources that firms control
and the cognition of managers—for example, with respect to how resources
should be deployed (cf. Penrose 1959) and how elements in the external envir-
onment should be categorized (Teece 2001: ch. 4). Moreover, it may be conjec-
tured that a cognitive perspective has implications also for the remaining
explananda. For example, internal organization may be understood in terms of
conflicts and disagreements stemming from different cognitive categories, and a
major organizational-design problem may actually be to create shared cognitive
categories, and in general to manage. It should be noted that such a cognitive
perspective may both further OE (Williamson 1998) and itself be furthered by
OE insights. Thus, on the one hand, the property rights system of the firm may,
by defining the social relations and positions of individuals (Jones 1983),
crucially influence the processes of interaction that may lead to shared cognitive
categories. On the other hand, problems stemming from the delegation of rights
may arise from differential cognition inside the firm, as well as from transaction
costs (Miller 1992). In practice, it may be difficult to separate organizational
problems stemming from differential cognition from those stemming from
opportunism (a problem that the courts are all too familiar with).
Opportunism. It has been argued that a main difference between the KBVand OE
lies in the KBV not being dependent upon the assumption of opportunism
(Conner and Prahalad 1996; Madhok 1996). It is true that much of the modern
economics of organization builds on this assumption, and that it is often held
within this approach that it is not possible to explain much of observed economic
organization without this concept (Foss 1996a/b; Williamson 1996a). It is also true
that the assumption has served theorists well, and that many new insights have been
produced building on this assumption. Nevertheless, KBV critics are right in
asserting that aspects of economic organization that do not turn on incentive
conflicts have been overly neglected. For example, Hart (1995) argues that in the
absence of incentive conflicts the optimal outcome can always be realized. But this
claim requires the theorist to abstract from misallocation caused by misunder-
standings, communication costs, different cognition, etc. Opportunism is not the
sole cause of management problems (e.g. Loasby 1991; Hendry 2002).
However, it should be noted that many contributors to OE are actually
uncomfortable with the notion of opportunism, because it is not precisely
defined compared to the ordinary assumption of self-interest (e.g. Hart
1985; Barzel 1989). And Williamson (1985, 1996a), who is the inventor of
the concept of opportunism, tends to use it in connection with the hold-up
situation only. Moreover, not all contributors to OE have made the assumption
of opportunism. Instead, they have focused attention on opportunism-independ-
ent costs, such as measurement costs (Barzel 1989), costs of communicating
(Segal 1996; Wernerfelt 1997), search costs (Casson 1994), and costs of storing,
retrieving, and processing information (Marschak and Radner 1972; Bolton and
Dewatripont 1994). As these OE theorists point out, it is possible to say a good
deal about economic organization without relying on the assumption of oppor-
tunism. For example, Casson (1994) argues that decision rights within firms will
be distributed according to who has important (‘decisive’) tacit knowledge and
the costs of communicating this knowledge. Segal (1996) argues that under-
standing the managerial task requires that we take account of communication
costs. If all computations and observations can be communicated without any
cost, it will never pay to concentrate managerial effort (i.e. appoint a manager).
Finally, Wernerfelt (1997) argues that the choice between markets, hierarchies,
and intermediate forms also reflects economizing on costs of communication.
These are promising avenues of research that help correct a strong bias in OE.
Moreover, in various ways they link up with the KBV. For example, an emphasis
on communication costs fits naturally with the KBV. This is because it is largely
specific and tacit knowledge that gives rise to communication costs which, in
turn, produce coordination problems (Langlois and Robertson 1995). This, we
believe, is one way to interpret the KBV theory of the boundaries of the firm (e.g.
Richardson 1972; Kogut and Zander 1992): Because of firm-specific and tacit
knowledge in firms, it may be more costly to communicate across the boundaries
of the firm than inside the firm. Efficient boundary choice may therefore reflect
communication costs (Monteverde 1995).31
Integrationism in the Strategic Theory of the Firm

Taking Stock
The argument so far can be summarized as follows. In searching for a strategic
theory of the firm, we are confronting two different and imperfect contenders.
To put it briefly, while OE is of considerable relevance to the strategy field, and
while it is characterized by relative explanatory elegance and simplicity, it is also
likely to misrepresent many strategy issues because of the heuristic that these
issues must always and everywhere be framed as turning on problems of aligning
incentives. On the other hand, while the KBV may in some respect be truer to the
traditional interests and concerns of the strategy field, it is at present much too
unclear in various dimensions to serve as a strategic theory of the firm.32
The extreme complexity of the issues involved partly explains why no existing
theories of the firm are satisfactory strategic theories of the firm. For example, the
very framing of the issue of, for example, the existence of firms is, as we have seen,
complex.33 And if a strategic theory of the firm must also explain competitive
advantage (cf. Grant 1996), ideally it should address all strategic choices and how
they interact in functional and/or dysfunctional ways. Thus, we are talking about
complex sets of variables, and even about interaction among these sets. This is
very much—and perhaps much too much—to ask of a single theory. What we
need, given this complexity, are focused views that work from key aspects.
Arguments may thus be advanced in favor of the proposition that isolationist
research strategies economize on the scarce mental resources of strategy and OE
scholars. And nobody is in the position to claim that either the KBV or OE
may not eventually develop into full-blown strategic theories of the firm; we
simply do not know. The argument here has rather been that as they stand
presently both theories are handicapped in some, widely different yet important,
respects. Given this, there is a third possibility; namely, to pursue an integra-
tionist research strategy that aims at combining key ideas of the KBV and OE.34
Below I discuss, first, which arguments may be advanced in favor of integration-
ism, and, second, what an integrationist research strategy might look like.
Why Do We Need Integrationism?

A number of writers have already suggested that a fuller integration of know-
ledge-based and OE perspectives is something to be striven for (e.g. Mahoney
1992; Seth and Thomas 1994), although they have not fundamentally explained
why such a fuller integration is desirable. However, if the starting point is that we
are interested in assumptions and explanatory insights that take us better into ‘the
deep structure of economic organization’ (Williamson 1996b: 49), it seems that
it is possible to advance both methodological and substantive arguments in favor
of an integrationist research strategy.
At the methodological level one could argue that a problem with isolationist
strategies is that they suffer from an implicit and narrow essentialism; that is, they
are founded on the basic idea that ‘the essence of the firm’ lies either in knowledge
considerations or in incentive-alignment considerations. Such essentialism is
pointless. First, there are no criteria for determining what is really the immutable
essence of the firm. We can safely say that firms are indeed both contractual and
knowledge-bearing entities, but they possess a good deal of other characteristics
as well (some of which we may not even know). Second, the appropriate
conceptualization of the firm depends on the purpose at hand. For some
purposes a knowledge-based conceptualization may be the most appropriate
one; for other purposes it may be an OE conceptualization; and for other
purposes again (discussed later), it may be a combined view that is appropriate.
A somewhat different methodological argument is that a benefit of a coopera-
tive effort between economists of organization and knowledge-based scholars is
that knowledge-based arguments may be placed on the same footing as the one
that characterizes OE. Assuredly, the benefits of formalization may often be
exaggerated, and organizational economists may argue that it is hard (if not
ultimately impossible) to formalize the phenomena that occupy the minds of
knowledge-based theorists. Of course, strategic-management scholars should not
let their conceptualizations of phenomena be wholly dictated by what formal
tools are available (as is arguably the tendency among mainstream economists).
Moreover, formalization often leads to a loss of content, so that subtle points are
lost (Kreps 1996). But some formalization exercises may lend a much needed
discipline to the KBV. What sort of game forms does the perspective work with?
What is assumed about the timing of the relevant games? About the distribution
of information? About information-processing capacities? And so on. Such
questions are useful to ask, not because the Holy Grail of the strategic theory
of the firm is to be found in fancy formal models, but simply for the sake of
clarification and precision, not least with respect to understanding what are really
the micro-foundations of the KBV and whether existing (verbal) knowledge-
based ideas on, for example, the existence of the firm really hold water. This
attempt is likely to require the efforts of organizational economists and to draw
on their insights and heuristics.35
With respect to substantive arguments that may be advanced in favor of an
integrationist program, these primarily turn on considerations of understanding
real phenomena that are hard to comprehend through the lens provided by either
the knowledge-based view or the economics of organization, or that may be
significantly more illuminated by a combined view. Notably, there may be
interaction effects (trade-offs or complementarities) between governance and
knowledge considerations, so that adopting only one view is likely to lead to a
biased understanding.
One such phenomenon may very well be what Coase (1988: 47) called ‘the
institutional structure of production’; that is, the issue of why specific firms
undertake specific productive tasks. Understanding this, Coase argued, requires a
theory of differential organizing capabilities as well as the established insights of
the modern economics of organization. In fact, the very concept of organizing
capability may be a phenomenon whose full understanding requires a coopera-
tive effort between knowledge-based scholars and organizational economists.
While organizing capability may be a matter of shared context, cognition, and
of routines (see Nahapiet and Ghoshal 1999), it is also a matter of the allocation
of incentives and property rights in an organization (Putterman 1995; Foss and
Foss 2000a); fully understanding the phenomenon requires bringing both per-
spectives to bear on it.
It is possible to invoke many other empirical phenomena whose understand-
ing may be furthered by a combined view. The dynamics of diversification may
be one such view, because knowledge-based considerations help us understand
the production of excess resources (Penrose 1959) and organizational-economics
insights help us understand the organization of those resources (Teece 1982;
Dosi, Winter, and Teece 1992). Another example may be understanding out-
sourcing in a dynamic context (Jacobides and Winter 2003), and in particular
the perils that may accompany excessive outsourcing, such as the loss of learning
capability (Bettis, Bradley, and Hamel 1992). Clearly, the strategic dangers of
excessive outsourcing are hard to comprehend through a pure organizational-
economics lens, in much the same way that the incentive benefits of outsourcing
(i.e. getting access to the ‘high-powered incentives’ of the market) are hard to
comprehend through a pure knowledge-based lens. Similar arguments may be
invoked in connection with understanding phenomena such as the organization
of the innovative process, incentives for R&D, the role of the corporate head-
quarters, and the shifting of the locus of learning from markets to firms and vice
versa (Langlois and Robertson 1995). All of these arguably involve both know-
ledge and governance considerations, and their understanding may be furthered
by a combined view. However, rather than continue to drop examples and merely
note that these involve both governance and knowledge considerations, is it
possible to generalize further and more precisely?
The key point seems to be that the phenomenon in question not merely
involves both knowledge and governance considerations, but that these interact
in essential ways. Important instances of ‘interaction’ are trade-offs (in the usual
sense) and complementarity, in the sense of activities or asset stocks feeding on
each other (Milgrom and Roberts 1990b, 1995). Both may be defined in an inter-
temporal context. For example, there are likely (inter-temporal) interaction effects
between the provision of incentives and the production of knowledge, although
those effects are not simple (Holmström and Milgrom 1991; Ghoshal and Moran
1996). Thus, the conjecture may be formed that it is particularly profitable to
adopt a combined KBV/OE view when dealing with phenomena where there are
strong interaction effects between knowledge and governance, and in particular
where this interaction is characterized by complementarities and has an inter-
temporal dimension. Without interaction effects a combined view is unnecessary.
Since a strategic theory of the firm is particularly likely to involve interaction
between knowledge and governance considerations, a combined view would
appear to be particularly natural here.36
What Might Integrationism Look Like? Some Entry Points

When pondering what integrationism might look like in theorizing and in
application, we are not completely left in the dark, for some broadly integra-
tionist work does exist (e.g. Teece 1982; Reve 1990; Dosi, Winter, and Teece
1992; Langlois and Robertson 1995). Reflection and generalization from these
papers indicate that one attractive form that modeling efforts may take has to do
with constraints on contracting. More specifically, knowledge-based consider-
ations constrain the contracting space by influencing, for example, what princi-
pals know about agents and what assets and activities can be contracted for.
Along these lines, the following entry points for modeling may be suggested.
Agency problems and capabilities. Arguably, cognitive factors are important

aspects of capabilities (Dosi and Marengo 1994). Firms will often be character-
ized by a distinct ‘way of doing things’—that is, shared problem-solving
heuristics—which is shared among input owners and which arises through
continuity of association among agents in the firm. This shared-knowledge
aspect of capabilities may significantly reduce agency problems, by making
asymmetric-information problems less severe. In turn, rents are produced that
may be sustainable to the extent that the relevant knowledge is hard to imitate.
The other side of the coin—that less shared knowledge may worsen agency
problems—is captured in the next point.
Capabilities and the scope of the firm. Casual empiricism confirms that almost
no firm has integrated the entire value chain, the common explanation being that
the firm confronts increasing diseconomies of scope as it integrates activities
that demand capabilities that are increasingly dissimilar to the firm’s own
capabilities (Coase 1937; Richardson 1972). However, a contracting-cum-
capabilities view suggests the following story. As the firm moves increasingly
away from its core business, it confronts increasingly severe adverse-selection and
moral-hazard problems, as management becomes increasingly unable efficiently
to monitor employees or evaluate their human capital. Agency costs rise corres-
pondingly, producing the net-profitability disadvantage associated with further
integration.
Agency problems and learning capabilities. Although the presence of capabilities

may reduce the severity of agency-type contracting problems, the accumulation
of new capabilities is often fostered by a diversity of preferences, beliefs, and
knowledge. In turn, this diversity may produce agency problems, so that there is
(at least in the short run) a trade-off between learning (dynamic efficiency) and
incentive alignment (static efficiency).
Capabilities, clustered transactions, and asset specificity. Winter (1991: 178–9)

argues that knowledge-based considerations suggest ‘that the concept of human
asset specificity is central to understanding the functioning of the firm as a
repository of knowledge. For understanding to progress, however, the idea of
‘‘specificity’’ must be refined and linked to the broader context in which quasi-
rents to various sorts of productive knowledge are determined’ (see also Klein
1988). Knowledge-based theorists often have a detailed understanding of this
‘broader context’ (e.g. Nahapiet and Ghoshal 1999), and their knowledge is
likely to further the understanding of clustered transactions involving human
capital to a significant extent.
Heterogeneity of transactions. To many KBV writers the import of capabilities

clearly lies in their limitations; because of what are essentially cognitive limita-
tions, firms must specialize (e.g. Richardson 1972). To put it differently, the
heterogeneity of activities and transactions matters to economic organization.
Because of its likely impact on economic organization, heterogeneity needs to be
treated as a dimension of transactions. For example, a loose, possible conjecture is
that there may be trade-offs between heterogeneity and asset specificity.37 How-
ever, at present we know precious little about how to operationalize ‘the degree of
heterogeneity’ of activities and transactions, and about how this connects to
economic organization. One possible reason why heterogeneity of transactions
matters turns on communication costs. Heterogeneous transactions may be
heterogeneous precisely because (or, in the sense that) communicating about
them is costly.
Admittedly, all these points in a sense take the OE perspective as given and
merely ask how ideas on capabilities can be used to formulate specific constraints
on various optimization problems. This is somewhat akin to the program for
orienting transaction-cost economics more towards the concerns of the strategy
field that has been sketched by Williamson (1999). Thus, he suggests that instead
of asking in a standard way which generic mode of economic organization
(markets, hybrids, firms) best organizes a particular transaction, the interesting
question to ask in a strategy context is how a particular firm, with particular
strengths and weaknesses, organizes a particular transaction. However, one may
also look at the matter from a different angle, taking the KBV as given, and
asking how OE insights complement knowledge-based ideas. For example, to
what extent may understanding of ‘the organizational advantage’ (Nahapiet and
Ghoshal 1999) be furthered by OE insights in the provision of incentives,
reputations, hostage taking, etc.? There is reason to believe, however, that the
former rather than the latter integrationist strategy may be the most productive,
at least in the shorter run. The reason is that OE provides a more precise and
coherent framework into which it is easier to introduce knowledge-based insights
rather than the other way around.
Conclusion
This chapter has had two overall and closely related aims. First, I hope to have
demonstrated that in searching for a strategic theory of the firm we confront
rather imperfect alternatives that, moreover, are imperfect in different ways.
Admittedly, both alternatives, OE and the KBV, may be on their way to
becoming strategic theories of the firm in the sense of the term employed here.
Thus, both have things to say about the four issues that enter into the construc-
tion of such a theory; that is, the existence, organization, boundaries, and
competitive advantage of the firm. It has also been pointed out, however, that
these four issues are quite complicated and that substantial theoretical imperfec-
tion is therefore a predictable state of affairs.
Given this situation, two overall possible research strategies immediately come
to mind: to develop further OE or the KBV in isolation; or to pursue a strategy of
combining the good ideas of both approaches in focused ways. The fact that OE
is weak on the analysis of competitive advantage and firm heterogeneity and
strong on issues of economic organization, and the opposite holds true for the
KBV, in itself weakly suggests a possibility for integrative efforts. The existence of
focused work with an integrative ambition (e.g. Teece 1982; Langlois and
Robertson 1995; Argyres 1996; Silverman 1999; Coff 2002; Nickerson and
Zenger 2002) gives somewhat stronger indications that such work may be
fruitful.
This chapter has set the stage for much of the discussion that will follow.
Thus, all of the subsequent chapters are taken up with the central issue in the
discussion of the strategic theory of the firm: How can the knowledge consider-
ations of strategic management be aligned with the issues highlighted in the
economics of organization. Thus, the next two chapters (3 and 4) subject
resource-based and knowledge-based theories to more critical scrutiny. In the
spirit of the integrationism defended in this chapter, Chapter 5 develops a
number of ways in which ideas on transaction costs and property rights may be
integrated with the resource-based view of strategy. And all of the chapters in the
second part of this volume in different ways explore links between knowledge
and economic organization.
Notes
1. In strategy research, organizational economics is usually associated with transaction-
cost economics (Williamson 1996a), principal–agent theory (Jensen and Meckling
1976), and the nexus-of-contracts approach (Alchian and Demsetz 1972; Cheung
1983). In this chapter and the rest of this volume I take modern organizational
economics to also include contributions to contract economics, such as Holmström
(1979, 1982), Grossman and Hart (1986), Hart and Moore (1990), Holmström and
Milgrom (1991, 1994), Hart (1995), Maskin and Tirole (1999), and Tirole (1999), to
mention some representative and seminal contributions.
2. In this case, too, a broad set of theories is involved, including ‘the evolutionary theory
of the firm’ (Nelson and Winter 1982; Marengo 1995; Foss 1997b), ‘the competence
perspective’ (e.g. Foss 1993), ‘the knowledge-based view’ (Loasby 1991; Langlois and
Robertson 1995), ‘the dynamic-capabilities perspective’ (Teece, Pisano, and Shuen
1997), ‘the resource-based approach’ (Wernerfelt 1984), and ‘the knowledge-based
theory of the firm’ (Grant 1996; Spender 1996). Note that in later chapters I explicitly
distinguish between resource-based and knowledge-based theories (discussed in Chs. 3
and 4 respectively).
3. Issues of the Strategic Management Journal (special winter issue 1996, vol. 17),
Advances in Strategic Management, (1992, vol. 8), and Organization Science (1996,
no. 5, vol. 7) have been devoted to this.
4. In this respect Mahoney (1992) and Seth and Thomas (1994) cover more material
than this chapter, although they do not go much into recent contract theory. However,
they argue in favor of pluralism, but do not show in which ways the various theories
may be combined or why this produces intellectual added value.
5. Obviously, a discussion of how good alternative theories are at addressing these issues
requires that the relevant theories possess the same understanding of key terms,
notably ‘the firm’. Of course, it is also required that they are commensurable in the
sense of Thomas Kuhn (1970)—which Mahoney (1992) convincingly argues that
they in fact are. However, we may imagine a knowledge-based theorist and an
organizational economist being in disagreement about whether a certain entity is
really ‘a firm’ (Grandori and Kogut 2002). I will disregard this difficulty (primarily
because so far the participants in the debate have not been troubled by it) and think of
economic organization as ‘firm-like’ when decision rights are relatively concentrated
(cf. Coase 1937; Jensen and Meckling 1992; Demsetz 1995; Hart 1995) (although
this is not entirely unproblematic; cf. Aghion and Tirole 1997).
6. For example, Barney and Ouchi (1986) and Rubin (1990).
7. It is perhaps worth mentioning that although the literature has tended to focus on
physical assets, non-physical assets, such as client lists, patents, and the like, may play
the same role in the story. However, human-capital assets cannot do this, because
human-capital assets are not alienable.
8. Actually, the more formal a contribution to the literature is, the less emphasis there is
on ex post governance and the more on ex ante incentive alignment.
9. However, sometimes the theory has been helpful in a rather paradoxical way; namely,
in pointing to phenomena that are clearly anomalous to economic reasoning and
which therefore represent a challenge. An example is provided in Holmström
and Milgrom (1991, 1994). They wonder why the payment schemes that are
actually established by firms are often so different (usually much simpler) from
what theory would predict. For example, why are incentives in firms often ‘low-
powered’ (to use Williamson’s terms (1985)), and why do firms rely so much on fixed
wages, even when good output measures are seemingly available? The answer
essentially turns on agents working on multidimensional tasks or agents working
on multiple tasks. In this situation incentive pay not only influences efforts and
allocates risk; it also directs the effort of agents among tasks. Some possibly essential
tasks (or dimensions of a task) may be very costly to measure for the principal; as a
result, the principal risks the agent allocating all his effort to tasks (dimensions of a
task) that are easier to measure. If principals want agents to allocate effort to all tasks
(dimensions of a task), they may be better off offering a fixed wage; that is, low-
powered incentives.
10. Interestingly, Milgrom and Roberts (1988: 450), two of the leaders in the modern
economics of organization, made the following observation and prediction ten years
ago: ‘The incentive based transaction costs theory has been made to carry too much
of the weight of explanation in the theory of organizations. We expect competing and
complementary theories to emerge—theories that are founded on economizing on
bounded rationality and that pay more attention to changing technology and to
evolutionary considerations.’
11. Williamson (1998: 11) argues that although he does not ‘claim that the firm-as-a-
governance structure makes adequate provision for management, it certainly makes
significant provision for management’.
12. While bounded rationality may be related to, for example, causal ambiguity and
other barriers to imitation (as in Williamson 1998), this is in no way systematically
done in the literature.
13. However, note that the basic idea of the production (or transformation) function
certainly does not rule out tacit knowledge, and that the critique may be more
justified as a critique of production functions in macro-economics and growth theory
than in micro-economics. See Nelson and Winter (1982: ch. 3) for a discussion of
these issues.
14. It is true that Williamson has modified his basic ‘efficiency hypothesis’ so that it now
reads: ‘align transactions, which differ in their attributes, with governance structures, which
differ in their costs and competencies in a discriminating (mainly, transaction cost econo-
mizing) way’ (Williamson 1991: 79; emphasis in the original). However, the word
‘competencies’ as used by Williamson does not mean the same thing as it means to
knowledge-based theorists. Rather, it means that there are things that some governance
structures can do that others can’t because of their transaction cost properties.
15. Although her book was apparently written in ignorance of Coase (1937).
16. How well this aligns with the so-called ‘resource-based view of the firm’ of which
Penrose is often seen as an important precursor will be discussed in Chapter 3.
17. That is, the relevant knowledge can only be mobilized in the context of carrying out a
multi-person productive task, and is not possessed by any single agent. More on
‘distributed knowledge’ in Chapter 6.
18. This is illustrative of a wider problem of missing micro-foundations in this approach,
to be discussed further in Chapter 4.
19. One can speculate about the extent to which this is consistent with another key
knowledge-based idea; namely, that firms will avoid integrating ‘dissimilar’ stocks of
knowledge (Richardson 1972).
20. For example, it is ‘opportunism-independent’ (Conner and Prahalad 1996; Ghoshal
and Moran 1996; Madhok 1996). Indeed, opportunism appears to be the major
point of contention in the debate (see Williamson’s response (1996b) to Ghoshal and
Moran 1996). However, it is not entirely clear how important opportunism, in
Williamson’s sense, really is to the modern economics of organization. What is
important is incentive conflicts, but incentive conflicts are something much broader
than opportunism.
21. The most radical version of this argument can be found in Lazonick (1991).
22. It is not entirely transparent what these organizing principles may be, but from the
discussion they would seem to include ‘shared coding schemes’, ‘values’, ‘a shared
language’, as well as ‘mechanisms by which to codify technologies into a language
accessible to a wider circle of individuals’ (Kogut and Zander 1992: 9).
23. Holmström and Milgrom (1994) argue that the great theoretical challenge in the
theory of the firm is not so much to understand separately (1) the employment
contract versus independent contracting, (2) issues that relate to ownership of
assets, and (3) monitoring and compensation issues. Taken separately, these issues
are relatively well understood. Rather, it is to understand how these choices are
intertwined, and why they are intertwined in the ways characteristic of real-world
firms.
24. This is not to say that we cannot tell a story about ownership that begins with
capabilities. For example, we can tie knowledge and ownership together via the
classic arguments that knowledge is a good that is particularly prone to market
failures (Nelson 1959; Arrow 1962). Along such lines, Foss (1993) and Casson
(1997) argue that those who discover new knowledge have an incentive to use it
themselves because of the transaction costs of knowledge transfer, and that there is a
general tendency for resource ownership to move to the knowledge source (rather
than the other way around), because knowledge is harder to trade than most other
resources. In general, ownership of resources is acquired by those who have
a complementary, non-tradable resource, which may often be a knowledge-
related resource, such as, perhaps, a firm capability. See Brynjolfsson (1994) for an
incomplete-contracts perspective on related issues, and Jensen and Meckling (1992)
for the nexus-of-contracts perspective on these matters.
25. However, some KBV writers (e.g. Conner and Prahalad 1996) think of it as
complementary to the modern economics of organization.
26. This is argued in greater detail in Chapter 4.
27. However, at least three studies empirically confront the relevant theoretical con-
tenders; namely, Poppo and Zenger (1998), Knott and McKelvey (1999), and
Schilling and Steensma (2002).
28. Chapter 5 of this book shows how the resource-based view, which shares some key
ideas with the KBV, may be illuminated by ideas on transaction costs and property
rights.
29. However, in Chapter 4 it will be argued that the KBV does not actually give much
attention to bounded rationality as an individual-level construct.
30. See Foss (2003a) for how, in organizational economics, bounded rationality has been
much cited but little used. In formal contract theory bounded rationality is either
entirely absent (Holmström 1979) or simply a rhetorical device designed to make
contractual incompleteness plausible (Grossman and Hart 1986).
31. This is something of a rational reconstruction; KBV writers are not entirely forth-
coming about these causal mechanisms, as is argued in greater detail in Chapter 4.
Monteverde (1995) may represent the KBV contribution that is most detailed in its
treatment of ‘technical dialog’ as a potential motive for vertical integration.
32. As already suggested, one possible route that proponents of the knowledge-based
approach may take is relentlessly to pursue and elaborate the idea that economic
organization to a large extent turns on those costs of transacting that are independent
of considerations of incentive conflicts. Existing work here (such as Demsetz 1991;
Monteverde 1995; Conner and Prahalad 1996; Grant 1996) has concentrated on the
costs of acquiring, communicating, and coordinating knowledge, the underlying idea
being that within the firm it is possible to generate more and, in some sense, richer
coordinative activity than can be obtained in markets, and that firms may indeed
exist because of this coordination gain. In order to develop this more rigorously, it
may be productive to link up with efforts in team theory (e.g. Bolton and Dewa-
tripont 1994; Radner 1996).
33. Thus, do we simply refer to explaining the presence of employment contracts in a
market economy? To a specific pattern of property rights to assets? To the presence of
low-powered incentives in institutions called ‘firms’? Or, to the presence of employ-
ment contracts and property rights to assets and low-powered incentives in a
complementary way, so that what we really address are alternative three-tuples (cf.
Holmström and Milgrom 1994)?
34. To repeat, like isolationism, integrationism is, of course, an archetype. Some existing
integrationist work may be rather close to the modern economics of organization
(e.g. Putterman 1995; Nickerson and Zenger 2002; Nickerson and Silverman 2004),
while other integrationist work may lie closer to the knowledge-based view (e.g.
Langlois and Robertson 1995; Monteverde 1995; Teece 2003).
35. Whether they will actually take an interest is a different matter. Mahoney (1992:
104) rightly notes that intellectual pluralism is valued (or, at least, allowed) to a
greater extent in the strategy field than in economics, and suggests that the integra-
tion of knowledge-based views and the economics of organization is more likely to
take place within the strategy field than within economics.
36. A final argument that may be invoked in favor of integrationism is that incentive
conflicts are, whether we like it or not, facts of the real world. To the extent that the
knowledge-based approach insists on abstracting from them (e.g. Kogut and Zander
1992), it simply does away with important determinants of economic organization,
in the same way that organizational economics may be criticized for doing away with
differential capabilities as determinants of economic organization.
37. Thus, one may speculate that a firm may avoid integrating transactions characterized
by high asset specificity, because they are too heterogeneous and the management
costs would be prohibitive.
3
The Resource-based View:
Aligning Strategy and Competitive Equilibrium
Introduction
The key issue in strategic management is usually seen as the creation and
sustainability of firm-level competitive advantage. Increasingly, sustained com-
petitive advantage is interpreted as earning (efficiency) rents in equilibrium.
Although this framing of the field’s central concern is now conventional, it is
also relatively recent. In fact, it was not until the advent of the resource-based
view of the firm (henceforth the ‘RBV’) that the issue became thus framed. Until
then, the strategic-management field entertained a much less focused approach
with a less clear hierarchy of research issues (see (e.g.) Hofer and Schendel 1978).
Partly as a result of its relatively clear conceptualization of strategy’s central
concern and the development of clear and simple schemes designed to handle
this concern (Barney 1991; Peteraf 1993), and partly because of a strong
marketing effort, the RBV has become the dominant contemporary approach
to the analysis of sustained competitive advantage, and therefore the dominant
strategic-management approach. Hardly an issue is published of the Strategic
Management Journal, the field’s leading periodical, without at least one paper that
applies the RBV. The view is clearly dominant in the Academy of Management’s
Business Policy and Strategy Division.
An aspect of the RBV so successfully capturing the space of strategic-manage-
ment discourse is that it has attracted rather little critical examination (but see
Lewin and Phelan 1999; Priem and Butler 2001a/b; Bromiley and Fleming 2002;
Foss and Knudsen 2003). The purpose of this chapter is to look critically at the
RBV.1 Specifically, the discussion will concern the role that economic equilib-
rium, particularly in the form of ‘competitive equilibrium’ (i.e. equilibrium
under perfectly competitive conditions), plays in the RBV.
The competitive-equilibrium model has long been recognized as a useful
benchmark in strategy; thus, according to Knott (1998: 3), ‘[t]he field of strategy
is concerned with the conditions under which the microeconomic equilibrium of
homogeneous firms with zero profits can be overcome.’ However, it is one thing
to use a model as an extreme benchmark which, for example, shows the extreme
conditions that must be present for competitive advantage to be non-existent. It
is another thing to build theorizing on that extreme benchmark,2 as has clearly
been the ambition in the RBV (Lippman and Rumelt 1982; Peteraf 1993). While
the former use of an extreme benchmark does not put constraints on theorizing,
the latter does. The underlying theme in this chapter is that this difference may
not have been recognized in the RBV. The basic or ‘pure’ RBV model (Barney
1991; Peteraf 1993) is founded on a patched-up competitive-equilibrium model,
in which a few select information asymmetries represent the spanners in the
works that are just sufficient for producing rents in equilibrium (see the section
‘Main Tenets of the Resource-based View’ below). The origin of this can be
found in the works of Chicago-UCLA industrial-organization economists, not-
ably Harold Demsetz (1973) (see ‘On the Pedigree of the Resource-based View’
below). Observing this goes beyond doctrinal history. The questions that can
meaningfully be raised, framed, and answered in strategic management are
constrained by underlying theories and models. It is the contention here that
because of the theoretical path-dependence in the development of the RBV the
view is still explanatorily constrained by the limitations of the competitive-
equilibrium model (see ‘Competitive Equilibrium and Explanation in the Re-
source-based View’ below. For a discussion with a similar thrust, see Lippman
and Rumelt 2003b).
Main Tenets of the Resource-based View

The main structure of the RBV as it pertains to the analysis of sustained
competitive advantage was built with a handful of contributions that appeared
from the mid 1980s to around the end of that decade (notably Wernerfelt 1984;
Rumelt 1984, 1987; Barney 1986, 1991; Dierickx and Cool 1989). Barney
(1991) is probably the first full development of the RBV; that is, the first
paper that draws together all of those elements that today would be considered
indispensable in the RBV—one of the most heavily cited papers in business
administration in general. Peteraf (1993) provides another canonical summary of
the main tenets of the RBV. The gestation period of the approach would
therefore seem to have been a very short one if compared, for example, to the
almost forty years of transaction cost economics (or almost seventy years, if we go
back to Coase 1937; Williamson 1999).
Rather than providing a comprehensive review of the evolution of the RBV,
the main focus here will be on the ‘pure’ RBV, as represented by two authoritative
papers that elegantly but rather differently pull together in simple frameworks
the diverse theoretical components that enter into the RBV analysis of SCA.
These two papers are Jay B. Barney’s ‘Firm Resources and Sustained Competitive
Advantage’ (1991) and Margaret A. Peteraf ’s ‘The Cornerstones of Competi-
tive Advantage’ (1993).3
the resource-based view 63
Barney’s 1991 Analysis

The RBV is usually distinguished from other approaches to strategy by its taking
the individual resource as the unit of analysis when it comes to understanding the
sources of SCA. Moreover, the RBV is also often characterized as a distinctive
approach by its beginning from the factor-market side rather than from the
product-market side (Barney 1986), again somewhat in contrast to other ap-
proaches to strategy. Thus, attention is focused on various characteristics of
resources, including the price at which their services are acquired, in order to
clarify whether these resources may be sources of SCA. However, Barney begins
by formulating the analysis of SCA in terms of the strategies that firms imple-
ment in product markets:
A firm is said to have a competitive advantage when it is implementing a value creating
strategy not simultaneously being implemented by any current or potential competitors.
A firm is said to have a sustained competitive advantage when it is implementing a value
creating strategy not simultaneously being implemented by any current or potential
competitors and when these other firms are unable to duplicate the benefits of this
strategy. (Barney 1991: 102; emphasis in the original.)
Thus, sustained uniqueness of product-market strategies appears to be a
necessary condition for SCA to obtain.4 Now, it is not immediately clear what
is meant by a (unique) ‘value creating strategy not simultaneously being imple-
mented by any current or potential competitors’ (i.e. CA), the ‘benefits’ of which
cannot be ‘duplicated’ by other firms (i.e. SCA). For example, if a number of
firms in an industry implement cost strategies based on learning curves that are
identical save for the learning curve of the cost leader, which lies just a fraction
below the learning curves of the other firms, can the cost leader be said to have a
competitive advantage? Aren’t they really implementing the same strategy, albeit
with slightly different success? Perhaps all that is meant is that a firm has an SCA
if it is more efficient at some value-creating activity than any current or potential
competitor in a way that cannot be imitated by said competitors. However, in
that case the unit of analysis should have been activities rather than strategies.
Barney does not explicitly address these issues; however, he arguably provides
an implicit answer by turning his attention to the resources underlying strategies.
By examining the implications for SCA if resources are mobile and homoge-
neous, Barney is led to the conclusion that ‘in order to understand sources of
sustained competitive advantage, it is necessary to build a theoretical model
that begins with the assumption that firm resources are heterogeneous and
immobile’ (Barney 1991: 105; emphasis added). However, there is then a jump
in the argument from the two ‘primitives’ of heterogeneity and immobility to
four other conditions of SCA. In order to have the ‘potential’ for SCA, Barney
explains, a resource ‘must have four attributes: (a) it must be valuable [ . . . ] (b) it
must be rare among a firm’s current and potential competition, (c) it must be
imperfectly imitable, and (d) there cannot be strategically equivalent substitutes
for this resource that are valuable but neither rare or imperfectly imitable (ibid.
105–6).
Referring to the SWOT framework, Barney defines resources as being valu-
able when they help in seizing an opportunity in the firm’s environment or when
they help in neutralizing some threat in that environment, or at least in shielding
the firm against the threat. By resources being rare Barney seems to have a simple
counting sense (as distinct from an economic sense) in mind.5 Firms that control
valuable and rare resources possess a competitive advantage and will be able to
obtain a CA. If furthermore the relevant resources are non-imitable and non-
substitutable, a SCA may be obtained. The non-imitability (or more correctly:
‘costly-to-imitate’) condition directs attention to whether (or, at what cost)
competitor firms can acquire or accumulate resources with attributes and levels
of attributes similar to some desired resource (Barzel 1997) which produces a
competitive advantage. The non-substitutability (or, ‘costly-to-substitute’) con-
dition directs attention to whether (or, at what cost) competitor firms can access
(different) resources that will allow them to implement the same strategies as
some successful firm. It is also these two criteria that allow Barney to define SCA
in terms of situations in which all attempts by competitor firms at imitating or
substituting a successful firm have ceased. Thus, SCA is a property of an
equilibrium. Barney’s framework is summarized in Figure 3.1a.6
Before leaving Barney’s (1991) contribution, we note that he defines the
dependent variable in the RBV as unique product-market strategies. This is
different from Barney (1986), which is framed with above-normal profits as
Ex post
Value Rareness Heterogeneity barriers to
competition
Sustained Sustained
competitive competitive
advantage advantage
Ex ante
Inimitability Non-substitutability Immobility barriers to
competition
(a) The Barney 1991 framework (b) The Peteraf 1993 framework
Figure 3.1a/b. Sustained competitive advantage in Barney (1991) and Peteraf (1993).
the dependent variable. In Barney (1991) the key to SCA is inter-firm differences
in efficiencies; however, such efficiencies may have nothing to do with differ-
ences in profit, as we argue later. Barney (ibid.) singles out two necessary
‘primitives’ that must obtain for SCA to exist, namely heterogeneity and immo-
bility. However, the relation between these two ‘primitives’ and the four other
conditions of SCA (i.e. resources being rare, valuable, costly to imitate, and costly
to substitute) is not made clear. The implication of Barney’s discussion is that the
four latter are collectively sufficient for SCA, and if they (all) obtain, heterogen-
eity and immobility also obtain. However, the four conditions are not all
necessary, whereas immobility and heterogeneity are. In other words, possessing
resources that are rare, valuable, costly to imitate, and costly to substitute is not
the only way to gain and sustain competitive advantages, as long as the relevant
ways conform to the criteria of resources being immobile and heterogeneous.
This, however, is not clarified in Barney’s paper.
Peteraf ’s 1993 Analysis

Peteraf ’s analysis of the conditions for SCA, which is summarized in Figure 3.1b,
is quite different from Barney (1991) in terms of its explicit reliance on econom-
ics, unit of analysis, and substantive content. Thus, Peteraf more clearly draws on
price theory (specifically the economics of rent), takes individual resources as the
relevant level of analysis (not strategies), and reaches different conclusions with
respect to the conditions of SCA. According to Peteraf, resources yield an SCA to
the firm that controls them when they meet four conditions:
four conditions underlie competitive advantage, all of which must be met. These include
superior resources (heterogeneity within an industry), ex post limits to competition,
imperfect resource mobility and ex ante limits to competition.
While heterogeneity is not precisely defined in Peteraf (1993), indications of
its meaning are given by arguing that resource bundles differ across firms in terms
of efficiencies and that these different efficiencies give rise to different levels of
value creation. These efficiency differences may translate into differences in rents,
or, if you like, differential profits. In turn, rents are the relevant dependent
variable in Peteraf (ibid.). Thus, her definition of SCA differs from Barney
(1991) in the requirement that firms must earn relatively more on a sustained
basis than other firms in order to possess an SCA. While heterogeneity is the
condition under which a firm may generate a rent/differential profit, the remain-
ing three conditions are sufficient to realize these rents and make them sustain-
able. Thus, ‘ex ante barriers’ means that factor markets do not appropriate all of
the rent; ‘imperfect mobility’ means that not all of the rent differential is
eliminated through factor-market competition; and ‘ex post barriers’ that the
rent differential is not eliminated through product-market competition.7
What is Competitive Advantage?

A comparison of Barney (1991) and Peteraf (1993) leaves us unsure about
whether the RBV is a theory of sustained competitive advantage in the sense of
unique product-market strategies where the uniqueness can be sustained in
equilibrium (Barney), or in the sense of differential rents/profits in equilibrium
(Peteraf ), or perhaps both? Apart from the obvious reason that it is unfortunate
that disagreement exists with respect to something so basic as the definition of
sustained competitive advantage, this is important to clarify because the two
understandings have no necessary relation. Thus, sustained competitive advan-
tage in the sense of sustaining a unique strategy in equilibrium (Barney) does not
necessarily imply the earning of rents in that equilibrium (Peteraf ), and vice
versa. For example, a firm may persistently implement a unique strategy based on
resources acquired in fully competitive and informationally efficient factor
markets, in which case the firm may in principle have a sustained competitive
advantage in the sense of Barney, but only realize ‘normal’ profits (and thus not
have a sustained competitive advantage in the sense of Peteraf ). This is because in
informationally efficient and competitive factor markets the firm would have to
pay the full value of the resources necessary for creating the relevant sustained
competitive advantage.8 Peteraf ’s understanding of sustained competitive advan-
tage as referring to differential profits in excess of opportunity costs avoids this
problem, and in general addresses the issue of appropriability of profit streams
more thoroughly.
The Recent Evolution of the RBV

Peteraf ’s identification of the four ‘cornerstones’ of sustained competitive advan-
tage provides a starting point for putting the strengths and weaknesses of the
RBV into perspective, as well as for describing the recent evolution of the RBV.
Heterogeneity. It has often been argued that the work of Penrose (1959) is the
single most important precursor of the RBV. However, that may be (and it will be
discussed critically later in this chapter), it can at least be argued that Penrose’s
contribution represents the first sustained attempt to argue for the importance to
strategic analysis of resource heterogeneity, and that the RBV is thoroughly
Penrosian in this sense. Given this, the causes of firm heterogeneity have actually
been surprisingly under-researched in the RBV—surprising, that is, given that
the approach is supposed to start out from this condition, and that part of the
marketing effort of RBV scholars has been to argue that the RBV in contrast to
industrial-organization economics places firm heterogeneity center stage. It is
perhaps telling that a recent special issue of the Strategic Management Journal
(Oct. 2003) on the RBV was (sub)titled ‘Towards a Theory of Competitive
Heterogeneity’!
Ex post barriers to competition. Lippman and Rumelt (1982), Rumelt (1984),

and Wernerfelt (1984) added the cornerstone of ‘ex post barriers’ (although their
respective terminologies differed from this). This gave rise to a spate of work, of
which Dierickx and Cool’s short, but extremely influential, discussion (1989)
still stands out, and which was taken up (1) with examining the generic mech-
anisms that may sustain competitive advantage (e.g. Dierickx and Cool 1989;
Reed and DeFilippi 1990; Williams 1992) and (2) with classifying resources
on the basis of their potential contribution to sustainability (e.g. Grant
1991). Notable empirical work has also grown out of this focus, such as
Miller and Shamsie’s discussion (1996) of the sources and sustainability of
competitive advantage in the Hollywood film studios in terms of ‘property-’
and ‘knowledge-based’ resources, or Knott, Bryce, and Posen’s empirical work
(2002) on the characteristics of asset-accumulation processes.
Ex ante barriers to competition. Barney (1986) established the cornerstone of ‘ex

ante barriers’ to competition with his strategic factor-market argument; that is,
the argument that informational asymmetries are needed to produce that diver-
gence between resource price and discounted net present value that is a condition
of competitive advantage. Some of the most innovative recent work in the RBV
has been the refinements and extensions of this argument; notably, in the works
of Richard Makadok (e.g. Makadok and Barney 2001; Makadok 2003). Thus,
Makadok and Barney (2001) develop the Barney (1986) factor-market argument
into a story of information acquisition in which the ultimate determinant of
competitive advantage is the firm’s skill at researching the future value of
resources.
Immobility. Perhaps the least examined cornerstone has, until rather recently,
been that of ‘immobility’. The notion that those input owners whose services are
regularly acquired by the firm (notably employees) have bargaining powers and
that the distribution of these powers determines how surplus is split surfaced
rather late in the RBV (although Wernerfelt (1989) was quite explicit about it).9
Russell Coff ’s work (1997, 1999) in particular has drawn attention to this.
Lippman and Rumelt (2003b) show how game-theoretical bargaining theory
may inform an RBV perspective on how rents are split between resource owners.
Thus, it is apparent that some of the cornerstones have attracted more
attention than others, and that the theoretical evolution of the RBV during the
last twenty years is a matter of (1) gradually expanding the understanding of the
determinants of sustained competitive advantage in the sense of incorporating
more determinants and (2) refining the analysis of each individual determinant
(i.e. each ‘cornerstone’). The RBV has not yet completed this evolution. Thus,
disproportionate attention has been paid to, notably, the ‘ex post barriers to
competition’ condition, usually in the form of trying to clarify which resource
attributes make resources costly to imitate. It is only quite recently that the other
three cornerstones have begun to receive similar attention. Seen in the light of the
underlying theme of this chapter—that the RBV is founded on the competitive-
equilibrium model—this is far from surprising. The divergence from competi-
tive equilibrium is smaller when strategy is modeled in terms of making some
given advantage costly to copy than if one seeks to endogenize heterogeneity,
model factor-market competition with asymmetric information, or model bar-
gaining processes, all of which has been notoriously hard to align with competi-
tive equilibrium. It is time to pursue the theme of the connection between the
RBV and competitive equilibrium in greater detail.
On the Pedigree of the Resource-based View

When the origins of the RBV are pondered, one name unavoidably comes up;
namely, that of Edith Tilton Penrose. In their magisterial study of the research
process that produced Penrose (1959), as well as the impact of this book and the
challenges it still raises for strategic-management research, Kor and Mahoney
(2000) document how numerous Penrosian themes can be found in modern
resource-based writings. However, their interpretation of the RBV is consider-
ably broader than the one adopted in this chapter, encompassing also, for
example, the knowledge-based view of the firm. If a more narrow interpretation
of the RBV is adopted, as in this chapter, Penrose’s status as the matriarch of the
RBV becomes more questionable, and it makes sense to look elsewhere for
precursors of it.10
Edith Penrose on the Theory of the Growth of the Firm

The basic idea in Penrose’s 1959 book, The Theory of the Growth of the Firm, is
well known and will be only briefly summarized. Firms are collections of
productive resources that are organized in an administrative framework that
partly determines the amount and type of services that the resources yield. As
they proceed with their productive operations, firms—in Penrose particularly
management teams—acquire increased knowledge of the services that may be
obtained from resources. The (related) results of such learning processes are, first,
the expansion of the firm’s ‘productive opportunity set’ (the opportunities that
the firm’s management team can see and can take advantage of ) and, second, the
release of managerial excess resources that can be put to use in other, mostly
related, business areas. Since the opportunity costs of excess resources are zero,
there will be a strong internal incentive for such diversification. Because the firm’s
expansion to a large extent builds on its ‘inherited’ resources, and because there ‘is
a close relation between the various kinds of resources with which the firm works
and the development of the ideas, experience and knowledge of its managers and
entrepreneurs’ (ibid. 85), this expansion will tend to take place in areas of
competence that are close to the firm’s existing areas of competence.
The basic skeleton of some of Penrose’s ideas may be cast in the language of
equilibrium and (dynamic) optimization characteristic of mainstream econom-
ics, and this has been tried repeatedly (see Kor and Mahoney 2000 for details).
For example, one may argue that at any given point in time there is a set of
product-market applications (business areas) that maximizes the rents on the
firm’s existing resources and corresponds to an organizational equilibrium (à la
Montgomery and Wernerfelt 1988), and a part of the optimization problem is
the information costs that the firm’s management team confronts (Casson 1997).
However, in Penrose’s own view her theory constituted a powerful critique of
certain aspects of the neoclassical theory of the firm (if not necessarily
of neoclassical economics in general; cf. Rugman and Verbeke 2004). In the
neoclassical theory of the firm there is ‘no notion of an internal process of
development leading to cumulative movements in any one direction’ (Penrose
1959: 1), a notion that in her view is absolutely crucial for understanding firm
development. Rather, growth is simply a matter of adjusting to the equilibrium
size of the firm. However, if services are produced endogenously (and continu-
ously) through various intra-firm learning processes involving increased know-
ledge of resources, ‘new combinations of resources’ (ibid. 85), and an expanding
productive-opportunity set, there is no equilibrium size.
There is clearly what we today would recognize as a Schumpeterian (change
‘from within’) and Veblenian (cumulative causation) flavor to such arguments
(Foss 1998a). Penrose’s basic vision of the competitive process in general, and of
the firm in particular, is disequilibrium-oriented and subjectivist,11 and it stresses
entrepreneurship, flexibility, change, and uncertainty. ‘In the long run’, Penrose
explains,
the profitability, survival and growth of a firm does not depend so much on the efficiency
with which it is able to organize the production of even a widely diversified range of
products as it does on the ability of the firm to establish one or more wide and relatively
impregnable ‘bases’ from which it can adapt and extend its operations in an uncertain,
changing and competitive world (ibid. 137)
Thus, seemingly paradoxically, flexibility is just as much a message of the analysis
as specialization is. The paradox vanishes when it is realized that specialization is
specialization in terms of the underlying resource base (rather than products) and
that such specialization may be fully consistent with reacting to new business
opportunities. In fact, as Penrose makes clear, there may be a considerable option
value associated with a specialized resource base:
A firm is basically a collection of resources. Consequently, if we can assume that
businessmen believe there is more to know about the resources they are working with
than they do know at any given time, and that more knowledge would be likely to
improve the efficiency and profitability of their firm, then unknown and unused pro-
ductive services immediately become of considerable importance, not only because the
belief that they exist acts as an incentive to acquire new knowledge, but also because they
shape the scope and direction of the search for knowledge (ibid. 77).
Thus, firm development is an evolutionary and cumulative process of
‘resource learning’ (Mahoney 1995), in which increased knowledge of the
firm’s resources both helps create options for further expansion and increases
absorptive capacity (Cohen and Levinthal 1990). Therefore, a major focus of The
Theory of the Growth of the Firm lies in the application of resources.
To sum up, while the RBV is Penrosian in its emphasis on firm-level hetero-
geneity, most of Penrose’s basic themes—flexibility in an uncertain world,
organizational learning as an evolutionary discovery process, path-dependency,
the vision of the management team, entrepreneurship, firm differences being
traceable to the efficiency with which resources are applied rather than to
resources themselves, etc.—seem to lie outside the orbit of the RBV, at least as
it has been defined in this chapter. And it is indeed the contention here that the
most important source of inspiration for the RBV is not the work of Penrose, but
rather Chicago-UCLA price theory, notably as represented by the work of
Harold Demsetz.12
Harold Demsetz on Industrial Economics

Harold Demsetz has worked within a number of economic sub-disciplines, such
as the theory of property rights, the theory of the firm, and industrial organiza-
tion. It is primarily Demsetz’s contribution to industrial-organization economics
that is relevant here. Much of Demsetz’s work (see, in particular, Demsetz 1974)
in this area has been concerned with critically discussing doctrines developed by
economists associated with the so-called ‘structure-conduct-performance’ school
in industrial organization (Bain 1959; Scherer and Ross 1990); that is, the main
source of inspiration for Michael Porter’s work (1980, 1981). In particular,
Demsetz has subjected their thinking on entry barriers and on the link between
industry structure and performance to critical scrutiny. Thus, Demsetz was
probably the first economist to develop an understanding of barriers to entry
as essentially informational in nature (e.g. advertising), and to argue that this
understanding should influence antitrust policies. This focus on information
asymmetries and costs as the real entry barriers is clearly related to the overall
resource-based idea that the primary barriers that hinder the equalization of rents
across firms are informational in nature (e.g. Lippman and Rumelt 1982).
However, there are other, even more direct, similarities. In fact, in Demsetz’s
1973 article ‘Industry Structure, Market Rivalry, and Public Policy’ we encounter
very clear anticipations of what would eventually become the RBV. At the
beginning of this paper Demsetz notes that the presence of information costs,
uncertainty, and less-than-fully-mobile factors may imply that ‘a differential
advantage in expanding output develops in some firms’ (Demsetz 1973: 1).
And the returns (rents) that such differential advantages may yield
need not be eliminated soon by competition. It may well be that superior competitive
performance is unique to the firm, viewed as a team, and unobtainable to others except by
purchasing the firm . . . The firm may have established a reputation or goodwill that is
difficult to separate from the firm itself [ . . . ] Or it may be that the members of the
employee team derive their higher productivity from the knowledge they possess about
each other in the environment of the particular firm in which they work, a source of
productivity that may be difficult to transfer piecemeal (p. 2)
Note the emphasis placed on heterogeneity, on different resource bundles as the
sources of heterogeneity and therefore differential efficiencies that in turn are the
basis for differential competitive advantages. In the same article, Demsetz also
clearly anticipates the RBV conditions of ex post barriers to competition and ex
ante barriers to competition that were considered above:
One such enterprise happens to ‘click’ for some time while others do not. It may be very
difficult for these firms to understand the reasons for this difference in performance or to
know [to] which inputs to attribute the performance of the successful firm. It is not easy to
ascertain just why GM and IBM perform better than their competitors. The complexity of
these organizations defies easy analysis, so that the inputs responsible for success may be
undervalued by the market for some time. [ . . . ] inputs are acquired at historic cost, but the
use made of these inputs, including the managerial inputs, yields only uncertain outcomes.
Because the outcomes are surrounded by uncertainty and are specific to a particular firm at
a particular point in its history, the acquisition cost of inputs may fail to reflect their value
to the firm at some subsequent time. By the time their value to the firm is recognized, they
are beyond acquisition by other firms at the same historic costs, and, in the interim,
shareholders of the successful or lucky firm will have enjoyed higher profit rates (ibid.).
Sufficient evidence has now been presented to allow us to infer that Demsetz
should indeed be reckoned as among the important precursors of the RBV,
particularly with respect to the analysis of the conditions of sustained competitive
advantage, the first key research theme within the RBV. In this respect he is more
important than Penrose, for she does not really inquire into these conditions in
her 1959 book. An important issue is whether these ideas were first developed by
Demsetz and then independently discovered by later resource-based strategy
theorists. Or, is there a more direct route through which Demsetz’s ideas may
have spread?
The UCLA Environment

Jay Barney, who is one of the prime movers behind the emergence of the resource-
based approach in the 1980s, as argued that the rational-reconstruction approach
to the history of the RBV—according to which the development of the RBV can
be dated back to Selznick and Penrose and shown to progress rather smoothly
from there—is simply a ‘myth’ (Barney 1995). Instead, Barney argued that the
RBV largely owes its origin to the interaction—mainly at UCLA—between such
economists and strategy scholars as William Ouchi, Michael Porter, Richard
Rumelt, Oliver Williamson, and Barney himself. Only subsequently came the
recognition that much of the early work of Selznick, Penrose, Chandler, and
Andrews anticipated modern resource-based thought.
From the interaction at UCLA emerged two seminal contributions that came
to play a founding role for the emerging RBV in the 1980s. The first was
Lippmann and Rumelt (1982), which models equilibria with firms that earn
different returns (rents) because of differential productive efficiencies, and imi-
tation barriers that hinder the equalization of such rents. The other seminal paper
is Barney (1986), which develops the first RBV account of ex ante barriers to
competition. Both papers extend and (in the case of Lippman and Rumelt)
formalize reasoning that was present much earlier in Demsetz’s work.
Some evidence has been provided that, at least in its purer and explicitly
economics-oriented incarnations (such as Lippman and Rumelt 1982; Barney
1991; Peteraf 1993), the RBV owes much to the Chicago approach to industrial
organization (Brozen 1971; Demsetz 1973, 1974, 1982, 1989; Peltzman 1977).
To resource-based writers, and notably the highly influential Richard Rumelt and
Jay Barney, the Chicago approach represented an appealing way to reconcile the
emphasis on the idiosyncratic and firm-specific that is characteristic of the
strategic-management field with economic-equilibrium theory. In particular,
Barney’s analysis of the conditions of sustained competitive advantage is rather
Chicago-ite in its emphasis on resources being costly to copy, etc. (compare
Brozen 1971; Demsetz 1973, 1974, 1982, 1989; Peltzman 1977). His argument
that all performance differences are explainable in terms of differential efficien-
cies of the resources underlying strategies, and that, therefore, superior returns
are fully compatible with social welfare, is straight out of the Chicago book (e.g.
Demsetz 1974). Barney’s earlier emphasis (1986) on factor-market, rather than
product-market, imperfections as a condition of competitive advantage is, as
already suggested, also vintage Chicago (e.g. Demsetz 1973).
Looking back at the twenty years of evolution of the RBV, it is easy to jump to
the conclusion that the application of economic equilibrium theory (of the
specific Chicago-UCLA variety) in many ways furthered the field by reconciling
strategic management and industrial organization economics in a way entirely
different from Michael Porter’s (1980). It expanded the vocabulary and the
toolbox of the strategy field significantly by introducing efficiency rents, factor-
market imperfections, costly-to-imitate resources, and other Chicago insights.
However, this came at a price. Something unwanted sneaked in through the
back-door.
Competitive Equilibrium and Explanation in the Resource-based View

Competitive Equilibrium in the RBV
What sneaked into the RBV was the competitive equilibrium (or ‘perfect
competition’) model with its many constraining assumptions (Hayek 1948;
Machovec 1995; Makowski and Ostroy 2001; Foss 2003b). Although borrowing
from the Chicago approach in many ways furthered strategic management, it is
also arguable that the set of phenomena relevant to strategic management that can
be framed by relying on this approach is rather limited. Fundamentally, this stems
from the basic Chicago research methodology, which is to cast virtually all social
phenomena in terms of competitive equilibrium—what Chicago School insider
Melvin Reder (1982) characterized as the ‘tight-prior-equilibrium’ assumption.
The competitive equilibrium that is used in RBV core contributions (such as
Lippman and Rumelt 1982; Barney 1991; Peteraf 1993) may not be entirely of the
perfect-competition textbook variety. For example, some superior technology may
be costly to imitate (Demsetz 1973; Lippman and Rumelt 1982) or there may be
some asymmetric information in factor markets (Demsetz 1973; Barney 1986).
Still, the basic model is one of instantaneous market clearing in markets populated
by traders with no bargaining power, and firms that—within a given industry—are
essentially identical. We can see the legacy of the competitive equilibrium model in
a number of the shortcomings or weaknesses of the RBV. I elaborate below.
Excluding Market Power?

Since firms have no bargaining power in product markets—because of the
assumption of price-taking—competitive advantage cannot be a matter of ‘mar-
ket power’ in the sense of raising price above cost through restricting supply (as in
(e.g.) Porter 1980). Thus, there can be no profits from market power, only
scarcity rents. This runs counter to the empirical evidence, which strongly
suggests that firms’ returns are composed of both rents and profits (Montgomery
and Wernerfelt 1988; Demsetz 1989; Sanderson and Winter 2002). This could
be defended by invoking a division of labour in which the RBV addresses the
efficiency rent parts of sustained competitive advantage, leaving the profit parts
to industrial organization approaches (Barney 2001). Moreover, the argument
may also be put forward that it is sensible to begin analysis by assuming the
harshest possible competitive environment, that is competitive conditions.13
Such a procedure would allow the environment to be black-boxed, because it
eliminates the need to bother with complicated oligopolistic interdependence
and with forms of competition other than pure Bertrand competition.
However, such arguments are not entirely unproblematic. For example, note
that under Bertrand competition returns come to a firm through low costs (as in
Peteraf 1993). However, profits come to an industry through cost heterogeneity.
This implies that there is a collective incentive to install an industrial structure
that maximizes cost heterogeneity—even if this does not minimize costs. Thus, it
is not only the form of competition that matters for performance, but also
the organization of industry. For example, Farrell et al. (1998) examine the
vertical organization of complementary activities by analytically separating
whether firms compete in terms of selling an end product (a ‘system’) or whether
firms compete in terms of selling individual components (that together make up
the system). Contrary to intuition, even under Bertrand competition these two
ways of organizing industry are not perfect substitutes (in terms of overall
efficiency and firm performances), provided that firm resources (proxied by
production costs) differ. This means that the organization of industry (here in
terms of systems or component organization) is a choice variable for firms, and
that firms may have an incentive to organize industry in such a way that cost
heterogeneity is maximized (which may not minimize costs). Thus, differential
resources clearly matter (in fact, the whole analysis of Farrell et al. 1998 requires
taking such a starting point), but they matter for reasons that are somewhat
different from those normally identified in the RBV.
This line of reasoning suggests that while it may make sense to begin from
harsh competitive conditions, it is unsatisfactory to let analysis stop here. And if
it does not, that is if non-competitive conditions are admitted, it becomes
problematic to uphold the division of labor between the RBV and industrial-
organization-inspired approaches (Porter 1980; Ghemawat 1997), because non-
competitive conditions invite the consideration of, for example, entry deterrence
as a means of sustaining competitive advantage. Moreover, once non-competitive
conditions are admitted and market power is allowed, some pet RBV themes
seem to break down. Consider the notion that sustained competitive advantage is
a matter of unique, value-creating strategies. This idea may run into problems
when strategies are complementary. An important distinction in recent industrial-
organization economics concerns whether firm strategies are substitutes or com-
plements (Bulow et al. 1985; Tirole 1988). If firm A’s return from implementing
a strategy is increasing in firm B’s return from implementation of its strategy and
vice versa, then the strategies of the two firms are complementary. A special case
of this obtains when A and B implement the same strategy. This can be the case in
oligopoly industries in which firms will benefit from implementing and enfor-
cing the same pricing strategies.14 Product-market strategies are not unique, yet
firms may earn profits in excess of opportunity costs. In fact, in the latter case
homogeneous resources may be a distinct advantage, since such homogeneity
may ease the enforcement of oligopolistic collusion (Tirole 1988). The notion of
heterogeneity as a necessary condition of sustained competitive advantage also
runs into problems if market power is allowed for. As a simple example, consider
an industry where incumbents control homogeneous resources and implement
the same strategies based on these resources, but where competition is Cournot
and high entry barriers exist for whatever reason. Firms will earn returns above
the competitive level, although the resources they control, and the strategies they
implement, are identical.15
Neglect of the Interaction Between Value Creation and Value Appropriation

It is a basic insight of economics that although determining the size of the pie is
something different from dividing the pie, how the pie is divided may influence
the size of the pie. Economists often conceptualize this insight—which, as we
shall see later (Ch. 5), only holds true if (some) transaction costs are positive—in
terms of interaction between allocation (creating value) and distribution (divid-
ing value). It is crucially important for understanding the economic implications
of reward systems and the allocation of property rights. Much of the modern
economic theory of the firm revolves around it, the ‘hold-up problem’ (Hart
1995; Williamson 1996a) being an important manifestation of the expected
sharing of surplus impacting on the creation of that surplus (through the effect
on investment incentives). And yet it is an insight that is conspicuously and
surprisingly absent from the RBV (an exception being Kim and Mahoney 2002).
One reason is that bargaining is abstracted from, so that dissipation of value from
bargaining activities (i.e. the ‘pie’ being reduced as a result of haggling) cannot be
treated. By the same token, creating value by means of reducing such activities (as
in Williamson 1996a) cannot be treated either. This is a manifestation of the
neglect of transaction costs in the RBV.
Transaction Costs Are Absent

Because transaction costs are not explicitly considered in the RBV, the reduction
of transaction costs—for example, through choosing governance structures that
are more efficiently aligned to the relevant transactional dimensions than those
that were previously in place (Williamson 1996a)—cannot be a source of value
creation in such a world. In other words, the sources of competitive advantage
cannot lie in economizing on transaction costs. It is also not clear how the
strategic opportunities implied by transaction costs being positive (Foss 2003b)
may be handled, if the competitive model is the starting point. As Makowski and
Ostroy (2001: 529) note, ‘[w]ith the standard model as the point of departure,
the simplicity of price-taking behavior leaves the perfect competitor unprepared
for the entirely new strategic considerations he confronts when transaction costs
are positive’.
No Theory of the Firm

The view of the firm in the competitive equilibrium model is what Williamson
(1996a) calls the ‘production function view’, which is an important part of the
neoclassical theory of production, as stated in basic economics textbooks. While
this view has been contrasted with the RBV (e.g. Conner 1991), it is not clear
what exactly is the difference between saying that the firm is a production
function and saying that the firm is a bundle of resources. True, ‘resources are
heterogeneous’ in the RBV whereas ‘inputs are (usually) homogeneous’ in the
production-function view. But the latter assumption is simply made for calcula-
tional convenience. The production function describes the relation between
inputs, that is resources, and output, and such a production function may of
course be constructed for any firm (Wernerfelt 2003). It is not logically com-
mitted to an assumption of resource homogeneity. In fact, some of the critical
assumptions of the production function carry over to the RBV.
From a TCE point of view there are two problems with the production-
function view. First, it contains no predictions with respect to the optimum scope
of the firm (Teece 1982; Williamson 1996a).16 Second, it assumes what should
be explained; namely, that input factors (resources) are optimally used inside a
firm. Because its view of productive activities is not essentially different from that
of the production-function view, the RBV similarly contains no implications for
the optimum scope of the firm and similarly works from the assumption that
resources are optimally used inside the firm. Differences in competitive advan-
tages are therefore not a matter of how well resources are organized or managed,
but of the inherent efficiencies of the resources that firms control. This means
that there is little or no attention to the managerial task or to organizational
matters in the RBV. The ‘resource-based view of the firm’ may therefore be a bit
of a misnomer, because the RBV says very little about firm organization and
because it is not clear how the view fundamentally differs from basic economic-
production theory.
Disequilibrium is Not Considered

Since by the basic Chicago methodology all phenomena that relate to strategic
management must be expressed in terms of equilibrium, those aspects of strategic
management that are best understood as disequilibrium phenomena are
hidden from view. Notably, it is hard to make room for entrepreneurship in an
‘equilibrium-always’ approach, because the essence of entrepreneurship is to
either restore or upset equilibrium (Kirzner 1973; Machovec 1995; Lewin and
Phelan 2000). Of course, it is possible to use equilibrium models to examine the
effects of entrepreneurship (e.g. in terms of earning rents in equilibrium), but the
models themselves do not allow for the phenomenon itself, except in the very
stylized form of draws from probability distributions over technologies with
differing costs (as in Lippman and Rumelt 1982). Related to this, dynamics
becomes a matter of performing comparative-static exercises; that is, comparing
equilibria where the variables differ because of changes in underlying data.17
While disequilibrium characterizes the transition from one equilibrium to an-
other, it is not treated in the model. In an alternative interpretation, disequilibria
may indeed be induced by entrepreneurs, but a new equilibrium is very quickly
restored, because transaction costs are zero: ‘When equilibrium is disturbed in a
positive transaction cost world, price adjustment is not expected to be instant-
aneous.’ Of course, this is in contrast to a zero-transaction-cost world, where
‘when equilibrium is disturbed a new equilibrium is instantaneously attained
because, given zero transaction costs, the cost of adjustment is zero’ (Barzel 1997:
101). Thus, the reason why the RBV is an equilibrium approach is not just a
matter of not explicitly addressing entrepreneurship and innovation (Teece
2003), it is also a matter of abstracting from transaction costs.
Summing Up
The implication of the above is that with respect to the key strategic-management
issues of understanding value creation and appropriation, a competitive
equilibrium starting point has quite a number of constraining consequences.
Thus, value creation by means of product innovation or differentiation (Macho-
vec 1995), advertising, improving contractual arrangements and internal organ-
ization (Akerlof 1970; Williamson 1994, 1996a), and other ways of reducing
inefficiencies becomes difficult to represent. This is caused by the suppression of
entrepreneurship, disequilibrium, and transaction costs in the competitive-equi-
librium model. In fact, quite a number of the shortcomings discussed above
derive from the zero-transaction-cost property of the competitive model.
Conclusions
During the last decade and a half the RBV has emerged as perhaps the dominant
approach to strategy-content theory. Indeed, as Kor and Mahoney (2000: 119)
note, a number of recent textbooks ‘situate the resource-based view as the crown
jewel of strategic management’. There can indeed be little doubt that the RBV
has not only been influential but also very useful. However, as noted at the start
of this chapter, the RBV was built in a hurry by a few key contributors, and
although the view is now approaching its twentieth birthday, this is a short life in
a social-science context. It is therefore not surprising that some aspects of the
RBV are less clear and less developed than one might wish them to be. Boundary
conditions may not always be identified (Priem and Butler 2001a; Foss and
Knudsen 2003). And there is a certain path-dependency in the RBV, caused
by the initial reliance of some of the key RBV writers on the competitive-
equilibrium model. Concentrating on the representative and elegant formula-
tions put forward by Barney (1991) and Peteraf (1993), this chapter has argued
that, at least in these pure forms, the RBV is underpinned by a patched-up
version of the competitive equilibrium model (Chicago-UCLA style), and that
this has introduced an explanatory straitjacket that the RBV seems only now to
be breaking out of (Lippman and Rumelt 2003a/b).
Many strategic management writers have noted that the RBV may be limited
in dimensions such as endogenizing resources and allowing for disequlibrium
(e.g. Teece 1993; Teece, Pisano, and Shuen 1997). These writers have generally
embraced knowledge-based (or ‘dynamic capabilities’) approaches. Others have
argued that the RBV can best overcome its limitations by making contact with
organizational theory, including organizational economics (e.g. Mahoney 1992;
Kor and Mahoney 2000; Foss 2003b). The following two chapters relate to these
two strategies, as the next chapter discusses the knowledge-based view of the firm
and Chapter 5 discusses how notions of transaction costs and property rights may
further the RBV.
Notes
1. Note that the focus in this chapter is on what may be called the ‘pure’ RBV,
here exemplified by Barney (1991) and Peteraf (1993), and not on the various
related approaches such as dynamic capabilities, competence, or knowledge-based
approaches. These are dealt with in Chapter 4.
2. Cf. the discussion in Mises (1949) of the ‘evenly rotating economy’ (aka competitive
equilibrium) and the discussion in Coase (1988) of the explanatory role of zero-
transaction-cost settings. See also Coddington (1983), Furubotn and Richter (1997),
and Foss and Foss (2000a) for further methodological reflection on these issues.
3. Foss and Knudsen (2003) raise a number of critiques of these two papers that are not
reproduced here.
4. Barney is not the only one to argue this. Thus, according to Aharoni (1993: 31),
‘[c]ompetitive advantage can be achieved if the firm is able to be different. Success is
based on using a unique strategy. The ability to protect the uniqueness against
imitators ensures continued success.’ The emphasis on uniqueness goes back to the
founding fathers of the strategy field, such as Selznick (1957) and Andrews (1971).
5. Thus, if a million firms control a certain resource it is not likely to be rare (even if a
billion firms badly need the relevant resource). From an economic point of view,
resources cannot be valuable if they are not rare; thus, a rare resource is a valuable
resource (Lewin and Phelan 1999).
6. It should be mentioned that Barney (1997) later added the efficient organization of
resources as an independent necessary condition for SCA.
7. Unfortunately, Peteraf is not entirely forthcoming about whether her conditions
constitute the minimum set of jointly necessary conditions for SCA, or whether they
are individually necessary conditions, or whether they are merely collectively suffi-
cient for SCA. However, she does say that all conditions must be met (Peteraf 1993:
185), that the four conditions are ‘related’ (p. 185), that heterogeneity is ‘necessary
for sustainable advantage but not sufficient’, and that we require ‘ex post limits to
competition as well’. Because the conditions are related, Peteraf spends some time
explaining how the meeting of one condition may mean that another one is also met.
She does not, however, say that the four conditions constitute the bare-minimum
necessary (and sufficient) conditions for SCA, and qualifies her discussion by saying
that the four conditions are ‘distinct’, yet ‘related’.
8. Or to take the inverse case. A firm may adopt the same strategy as a large number of
competitors, but may still exploit informational advantages or bargaining advantages
in factor markets or be favoured by luck, so that, while it does not have a sustained
competitive advantage in the sense of Barney, it does earn higher profits than the
competition and thus realizes a sustained competitive advantage in the sense of
Peteraf (1993).
9. Perhaps this is because immobility is hard to distinguish from factor-market com-
petition, and may be placed under ‘ex ante barriers to competition’. Surprisingly,
while bargaining power has been important in connection with ‘immobility’, it has
played no role in connection with the ‘ex ante barriers to competition’ cornerstone
(leading to the incorrect conclusion that with perfect factor markets the supply side
will always appropriate all rent).
10. The first paper to explicitly make and develop this point seems to be Foss (1999b),
on which the following section draws. Rugman and Verbeke (2002) is the most
extensive argument that in key dimensions Penrose cannot rightly be considered a
precursor of the RBV. This view is amplified in Rugman and Verbeke (2004).
11. Penrose’s subjectivism is particularly apparent in her adoption of Kenneth Boulding’s
concept of ‘the image’: ‘the environment is treated . . . as an ‘‘image’’ in the entrepre-
neur’s mind of the possibilities and restrictions with which he is confronted, for it is,
after all, such an ‘‘image’’ which in fact determines a man’s behaviour’ (1959: 5). In
other words, the environment is basically ‘enacted’—to use Weick’s terminology.
12. Conner (1991) also mentions Chicago-UCLA industrial-organization theory as an
input into the development of the RBV, but not as a particularly important one.
13. In fact, it may be argued that as a matter of general modeling practice it is wise to
begin by assuming the harshest possible kind of competition, since all sorts of
behaviors and performances may be rationalized by assuming less harsh competition.
14. Another example concerns network industries (i.e. industries characterized by net-
work externalities), in which case incumbents, or a subset of the incumbents, may
benefit from adopting identical strategies. The application of the RBV to such
industries is an important unexamined issue.
15. This further suggests that the boundary conditions of RBV analysis may not be
entirely clear. See Foss and Knudsen (2003) for such a critique.
16. Relatedly, it is hard to see what is distinctly resource-based about Conner and
Prahalad’s ‘resource-based theory of the firm’ (1996).
17. Foss (1996b) speculates that the suppression of disequilibrium issues is what explains
the branching of the ‘resource-based view’, broadly conceived, into, first, the
RBV proper, and, second, various ‘competence-based’, ‘capabilities’, ‘dynamic-
capabilities’, etc. approaches which all try to highlight dynamics in various ways
(e.g. Hamel and Prahalad 1994). Priem and Butler (2001a) recently also noted the
lack of dynamics in the RBV.
4
Knowledge-based Views of the Firm
Introduction
As discussed in Chapter 2, knowledge-based views (henceforth ‘KBV’) of the
firm have become very influential in a host of disciplines and sub-disciplines
in business administration, notably in the strategy, organization, and inter-
national-business fields (Kogut and Zander 1993; Grant 1996; Spender 1998).
It has also made some headway into economics (Hodgson 1998) and economic
geography (Maskell et al. 1998). A conclusion in that chapter was that knowledge-
based views of the firm are trying to capture some important, perhaps essential,
aspects of economic organization that have been imperfectly theorized in other
theories, or have not been addressed at all (Holmström and Roberts 1998;
Williamson 1999). A case was made for ‘integrationism’. However, an important
prerequisite for successful integrationism may well be a disciplined dialog between
proponents of governance (organizational economics) perspectives and propon-
ents of knowledge-based views based on shared insights and terminology. How-
ever, so far there has not been much dialog between these, communication being
limited to proponents of knowledge-based views criticizing governance perspec-
tives. It is also questionable to what extent there exists a body of shared insights and
terminology, a ‘pfefferdigm’ (Pfeffer 1993). Partly because of this, not much
concrete integrative work has actually emerged (e.g. Argyres 1996; Silverman
1999; Coff 2002; Heimann and Nickerson 2002).
One reason for the relative lack of dialog is that different disciplinary and
institutional backgrounds (economics and universities vs. business administration
and business schools) are involved. Another one is that the sources of the KBV are
many more and more diverse than the sources of organizational-economics
approaches. Whereas organizational economics is mainly a continuation of main-
stream economics, its theoretical core essentially consisting of game-theoretical
information economics (Williamson’s brand of transaction cost economics being
an exception), the KBV is an amalgam of ideas from evolutionary economics
(Nelson and Winter 1982), Austrian economics (Hayek 1964), organizational-
learning theory (March 1991), the behavioral theory of the firm (Cyert and March
1963), the resource-based view of strategy (Barney 1991), Penrose’s work (1959),
and epistemology (Spender 1996).
Not surprisingly, it is a task of considerable complexity to identify what is the
(knowledge-related) unit of analysis of the KBV, how this unit is dimensiona-
lized, which causal mechanisms it posits with respect to the unit of analysis, and
the outcomes at the level of organization and competitive advantage that the
perspective wishes to address. A fundamental reason why communication and
integrative efforts are bound to be severely handicapped for some time to come is
that the KBV suffers from some fundamental explanatory problems. At the most
fundamental level, its micro-foundations are at best unclear, and perhaps non-
existent. A consequence of this is that the fundamental explanatory notions in
the KBV—notions such as ‘capabilities’, ‘competencies’, ‘dynamic capabilities’,
and even ‘routines’ (depending on which subset of the KBV one focuses on)—
are notions in search of micro-foundation. As they appear in the literature, these
notions are aggregate concepts that may be located in firms, among firms, and
even in industrial districts (Foss and Eriksen 1995). However, we are rather in the
dark about how they relate to individual actions and learning. Because the
fundamental mechanisms, the micro-foundations, are unclear, a number of
explanatory difficulties emerge in knowledge-based views.
Rather than examining the entire body of KBV contributions, this chapter
focuses in on one important early contribution to this stream of research; namely,
Richard Nelson and Sidney Winter’s celebrated 1982 book, An Evolutionary
Theory of Economic Change. A fundamental argument in the previous chapter on
the RBV was that an understanding of the nature and causes of some of the
explanatory weaknesses that beset the RBV could be gained by examining the
pedigree of the RBV. This chapter similarly pursues a theme of intellectual path-
dependence. Specifically, the claim here is that some of the conceptual and
explanatory difficulties that the modern KBV confronts are at least partly
traceable to Nelson and Winter (1982). This is particularly the case with respect
to the problem of missing micro-foundations.
Particular attention is devoted to Nelson and Winter’s much-cited treatment
in chapters 3–5 of their book of bounded rationality and tacit knowledge in the
context of firm organization and behavior—a treatment that Nobel Prize winner
Reinhardt Selten (1990: 649) characterized as having ‘brought new impulses to
the modeling of boundedly rational behavior in economics’. This examination is
primarily undertaken because the Nelson and Winter approach to conceptualiz-
ing the firm and understanding its organization and behavior has been extremely
influential for writers within the KBV.
The KBV is quite often seen as an approach to the theory of the firm that puts
much more of an emphasis on bounded rationality than is the case in, notably,
transaction cost economics (e.g. Fransman 1994; Conner and Prahalad 1996;
Marengo et al. 2000). It is also seen as one that goes beyond information
processing and stresses the tacit and socially embedded aspects of knowledge
(Fransman 1994). Both of these characteristics hark directly back to Nelson and
knowledge-based views of the firm 83
Winter. Below I engage critically with this influential view. Specifically, the
following points are developed. First, the theory of the firm put forward in
Nelson and Winter (1982) is considerably less about bounded rationality than it
is about socially held tacit knowledge. Bounded rationality and tacit knowledge
do not logically imply each other. It may, in fact, be argued that Simonian
bounded rationality and Polanyi’s notion of tacit knowledge are ultimately
founded on very different, and perhaps incompatible, epistemologies (see
Nightingale 2003). Attempts to combine the two are likely to be unsuccessful,
one driving out the other. This is largely the case in Nelson and Winter (1982),
in which tacit knowledge looms much larger than bounded rationality. The
tipping of the balance in favor of tacit knowledge has become even more
pronounced in subsequent work within the organizational capabilities approach.
Second, the emphasis on socially held knowledge in the form of ‘routines’ and
the downplaying of bounded rationality in Nelson and Winter (ibid.) mean that
there is very little attention given to the level of the individual agent. Indeed, the
Nelson and Winter theory (as well as many subsequent contributions to the
KBV) may be criticized for not being consistent with methodological individu-
alism, at least in the sense that it works with aggregate entities (i.e. routines and
capabilities) that are not explicitly reduced to individual behavior. Third, I argue
that the absence of a clear behavioral foundation for the organizational-capabil-
ities approach is the root cause of the difficulties, discussed in Chapter 2, that the
KBV has with respect to illuminating the key organizational economics issues of
the internal organization and boundaries of the firm.
Nelson and Winter (1982): A Foundation of the Knowledge-based View

The Place of An Evolutionary Theory of Economic Change in the Evolution
of the KBV
Nelson and Winter (1982) has arguably appealed more to business administra-
tion and management scholars than to economists. One paper after another,
in such fields as strategy, organizational learning, international business, and
organizational behavior, has generously cited the book, particularly the three
chapters (3–5) that deal with issues pertaining to individual and organizational
behavior and capabilities. These three chapters may well be the single most
important reason why strategy scholars are increasingly converging on organiza-
tional capabilities as a key construct in strategy research (e.g. Cockburn and
Henderson 1994; Teece, Pisano, and Shuen 1997; Eisenhardt and Martin 2000)
(Felin and Foss 2004). In fact, rereading the chapters makes one realize that
perhaps not so much essential has happened in two succeeding decades of
work on capabilities, competence, evolutionary, etc. theories of the firm
that goes beyond Nelson and Winter’s treatment. It is arguable that later
knowledge-based ideas on competence traps, the central importance of tacit and
socially complex ‘resources’ for explaining competitive advantage, knowledge
replication, and dynamic capabilities can be found in at least an embryonic,
and often a quite explicit, form in Nelson and Winter (1982).
Quite appropriately, contributors to the organizational capabilities approach
have therefore often treated Nelson and Winter (1982) not only as a source of
inspiration, but also as a foundation. At first sight this may appear somewhat
surprising, given that building a distinct theory of the firm was never the intention
of Nelson and Winter (1982). However, what may appeal to knowledge-based
theorists of the firm is the attempt in that book to treat in a unified fashion
bounded rationality and tacit knowledge, and at the same time place these in a
social context—all of which converges in a single, intuitively plausible concept,
namely that of ‘routine’. These ideas, as well as the use of them to help explain
revealed competitive advantages, innovation, and limited aspects of economic
organization, cannot really be found in any other of the precursors of the
capabilities approach. While Cyert and March (1963) have much to say about
bounded rationality and standard operating procedures, and touch on competitive
advantage, they have next to nothing to say about socially held tacit knowledge.
And while Penrose does treat the latter theme, she says nothing about bounded
rationality and competitive advantage. The single unifying theme in the diverse
streams of research that make up the KBV, that is ‘capabilities’ (Richardson 1972;
Chandler 1992; Langlois 1992), ‘dynamic capabilities’ (Teece and Pisano 1994),
‘competence approaches’ (Sanchez 2001), and, of course, the ‘evolutionary theory
of the firm’ (e.g. Dosi 2000; Marengo et al. 2000), is indeed an emphasis on the
central explanatory importance of experiential, localized, socially constructed, and
embedded knowledge and learning in understanding firm organization and
behavior. Of all the many precursors of the KBV, only Nelson and Winter
(1982) explicitly feature this theme.1
Skills, Routines, and Organizational Behavior

The KBV literature is often interpreted as an attempt to make more room for
bounded rationality in the theory of the firm than is standard in the economics of
organization (e.g. Fransman 1994; Conner and Prahalad 1996). However, it is
seldom made clear in exactly what sense the KBV may be characterized as starting
from bounded rationality. Because bounded rationality is, unfortunately, a
concept that comes with a legacy of diverse and even conflicting meanings, it
does matter where exactly one starts from, and it is rather uninformative to say
that the organizational capabilities approach builds on bounded rationality,
unless one specifies what kind of bounded rationality. Thus, are we talking
about Newell and Simon’s work on heuristic search, or Selten’s aspiration-
adaptation theory, or Lipman’s or Rubinstein’s axiomatic foundations for
bounded rationality, or regularities established in experimental-psychological
research, or any other of the great number of different—indeed, very
different—variations on Simon’s Grand Theme?
However, such information is virtually never forthcoming. Indeed, it is easy to
become skeptical about the real role played by bounded rationality in the KBV
for the basic reason that out of the many sources that the approach builds
on, notably the works of Philip Selznick, Alfred Chandler, Edith Penrose,
G. B. Richardson, and Nelson and Winter (1982) (see Foss 1997 for a sample),
only Nelson and Winter explicitly address and try to incorporate bounded
rationality. All this raises suspicions that talk of bounded rationality in connec-
tion with the KBV may in actuality be more rhetorical (in the pre-McCloskeyan,
derogatory sense) than substantive. Understanding the extent to which the KBV
builds on a foundation consisting of bounded rationality requires that we take a
look at Nelson and Winter, because, as argued, this contribution has been hugely
influential in the development of the KBV conceptualization of firms.
Quite early in Nelson and Winter (1982), namely when discussing ‘the need for
an evolutionary theory’, the authors observe that their ‘basic critique of orthodoxy
is connected with the bounded rationality problem’ (p. 36), and that, therefore,
they ‘accept and absorb into our analysis many of the ideas of the behavioral
theorists’ (pp. 35–6), notably Cyert, March, and Simon. In particular, they are
attracted to the behavioralist notion that short- and medium-run firm behavior is
determined by relatively simple decision rules (Cyert and March 1963). They also
make use of behavioralist models of satisficing search (Simon 1955). In a later
contribution they note that ‘[t]he view of firm behavior built into evolutionary
economic theory fits well with the theory of firms contained in modern organ-
ization theory, especially the part that shares our own debt to the ‘‘Carnegie
School’’ (March and Simon 1958; Cyert and March 1992)’ (Nelson and Winter
2002: 42). However, in the 1982 book Nelson and Winter go significantly beyond
behavioralism by examining populations of firms with differing decision rules, by
addressing the interplay between changing external environments and changing
decision rules (see also Pierce, Boerner, and Teece 2002), and, the most interesting
theoretical innovation in the context of this paper, by trying to bring bounded
rationality together with tacit knowledge. It is the last aspect of Nelson and
Winter’s ‘updating exercise’ that I shall argue is not entirely successful.
Nelson and Winter’s main problem with ‘orthodox’ theory, and particularly
the neoclassical theory of the firm, does not appear to be that this theory rules out
diversity in terms of productive or organizational capabilities between firms in an
industry per se. Indeed, that theory does allow for variety in these dimensions.
For example, to the extent that differences in how well (‘competently’) a firm is
run reflects owners’ on-the-job consumption, and these owners are able and
willing to bear the consequences of this consumption (Demsetz 1997), the
neoclassical theory of the firm allows for differential competencies to exist in
equilibrium. Moreover, differential initial endowments of some costly-to-copy
resources may simply be postulated (à la Lippman and Rumelt 1982), so that
firms with differential efficiencies may exist in equilibrium. However, the main
point of Nelson and Winter’s critique is that in mainstream economics hetero-
geneity is at best exogeneously determined (as in the cases of differing preferences
for on-the-job consumption or different initial endowments). To paraphrase
their argument, in the setting of the (basic) neoclassical theory of the firm, it
has to be this way, because the production set is assumed not only to be given (or
at best changing through given technological-progress functions or similar con-
structs) but also to be fully transparent (Langlois and Foss 1999). The implica-
tion, as Demsetz (1991) notes, is that if information costs are thus assumed
to be zero, what one firm can do at the level of production another firm can
do equally well.
Unlike Demsetz, Nelson and Winter do not cast their argument in terms of
the information (and other) costs of copying rival firms’ resource endowments.
Instead, they devote a whole chapter (ch. 4) to an analysis of skills. By a ‘skill’ they
mean ‘a capability for a smooth sequence of coordinated behavior that is
ordinarily effective relative to its objectives, given the context in which it
normally occurs’ (1982: 73). The attractions of the notion of skill are apparent.
First, it provides a way of introducing dynamics at the level of production, since
skills need to be nurtured and tend to grow with practice. Second, it provides an
analogy to the behavioralist notion that behavior is strongly guided by relatively
rigid decision rules, and thus serves to underscore Nelson and Winter’s critique
of maximization in the sense of forward-looking, informed deliberate choice.
They put much emphasis on this, noting that ‘the sort of choice that takes place
in the process of exercising a skill is choice without deliberation’ (p. 82), although
they are careful to note that the behavioral ‘programs’ embodied in skills may be
initiated through deliberate, but presumably boundedly rational, choice.
However, this and the notion that routines may be changed through meta-
routines (i.e. search routines) is the only substantive connection that the notion
of bounded rationality makes to skills and the organization-level counterpart to
individual skills, namely routines. Neither concept is directly derived from
bounded-rationality considerations. Third, starting from skills and developing
the organization-level analogy to skills allow Nelson and Winter to bring con-
siderations of tacit knowledge into the picture and to develop a strong critique of
the ‘blueprint’ view of neoclassical production function theory. Fourth, it helps
them to establish a link between individual action and organizational behavior.
That link is initiated in a rather straightforward way by the observation that
‘directly relevant to our development here is the value of individual behavior as a
metaphor for organizational behavior’ (ibid. 72; emphasis in the original).
In turn, ‘organizational behavior’ is addressed in terms of ‘routines’ that serve
as organization-level metaphorical equivalents to individual skills. Like skills,
routines represent stable sequences of actions (i.e. they coordinate actions) that
are triggered by certain stimuli in certain contexts and which, in a sense, serve as
memories for the organizations that embody them. However, because routines
are social phenomena, they go beyond the skill metaphor and raise issues of
motivation and coordination. However, Nelson and Winter sidestep the motiv-
ation issue, arguing that routines represent ‘organizational truces’—an idea going
back to Cyert and March (1963).
Thus, quite a lot—and perhaps too much—is packed into the notion of
routine, including a variety of behaviors (e.g. heuristics and strategies), organ-
izational processes and arrangements, cognitive issues (e.g. ‘organizational mem-
ories’), and incentives (‘truces’). Nelson and Winter defend this by noting that, in
actuality, ‘skills, organization, and ‘‘technology’’ are intimately intertwined in a
functioning routine, and it is difficult to say where one aspect ends and another
begins’ (1982: 104). Although it is true that the boundaries are blurred, it is not
clear why one is not allowed, for purposes of analytical clarity, to look at one
aspect at a time. It is one thing to claim that ontologically things are a mess. It is
another thing to openly admit the mess into analysis. This is perhaps only a
minor problem for Nelson and Winter. Because their level of analysis lies higher
than the firm, they can afford to keep the firm level messy. However, their all-
inclusive notion of routine may have contributed to the thick terminological
soup that characterizes the organizational-capabilities approach, as well as the
difficulties of giving precise content to the notion of routines (cf. Cohen et al.
1996), and derived and related notions, such as capabilities, competencies, etc.
Below, another possible source of conceptual and explanatory problems in the
organizational capabilities approach is considered; namely, the absence of a clear
foundation, rooted in individual, boundedly rational choice behavior, for the
notion of routines.
Micro-foundations, Bounded Rationality, and Tacit Knowledge

At first glance bounded rationality appears to be quite crucial to Nelson and
Winter’s argument (Fransman 1994). Thus, firm members can only learn rou-
tines through practising them; routines are simply repeated until they become
too dysfunctional; learning is myopic, search is satisficing; etc. All of these very
strong assumptions about individual and organizational behavior would seem to
make room for a rationality that is very bounded indeed. Apparently, this is
Williamson’s impression when he argues that Nelson and Winter work with a
version of bounded rationality, ‘organic rationality’, that assumes less intention-
ality, foresight, and calculativeness than his own notion of bounded rationality
(Williamson 1985: 47).2 However, (re)reading chapters 3–5 in Nelson and
Winter suggests that what ultimately interests them is not really bounded
rationality per se, in the sense of a commitment to building specific models of
boundedly rational individual behavior that, in turn, may be fed into models of
organization-level behavior and outcomes. What interests them is rather tacit
knowledge and its embodiment in their firm-level analogy to individual skills,
namely routines, and how these notions assist the understanding of sluggish
organizational change and adaptation. These claims are substantiated below.
The Limited Role of Bounded Rationality in Nelson and Winter

Bounded rationality has a bad reputation for being used as a sort of catch-all
category that can ‘explain’ all observed deviations from maximizing rationality
(Conlisk 1996; Casson and Wadeson 1997). The Simon dictum that man is
‘intendedly rationality, but only limitedly so’ is an example. In itself it is vacuous
and therefore explains or predicts virtually nothing. Explanation and prediction
that begin from a foundation of bounded rationality require that bounded
rationality be focused through specific models of behavior (such as Simon
1955). This is where the link to the skill metaphor of organizational behavior
becomes important, for it is the use of the notion of skill and particularly its
transfer to the organizational level that step in and fill the explanatory and
predictive vacuum left by invoking bounded rationality in general terms. In
other words, it is skills and, particularly, routines that allow Nelson and Winter
(1982) to work out an explanatory and predictive theory of firm behavior.
However, the further assumptions that are added to the basic invocation of
bounded rationality are not drawn from the existing evidence, notably from
psychology, on boundedly rational behavior per se, although Nelson and Winter
(2002: 31) in a later paper argue that ‘[i]n contrast to the usual quest for
microfoundations in economics, seeking consistency with rationality assump-
tions, our quest is for consistency with the available evidence on learning and
behavior at both the individual and organizational levels’.
In fact, it turns out that what they mean by the ‘available evidence’ may be
somewhat idiosyncratic. They go on to argue, in the 2002 paper, that ‘[w]ith
respect to individual learning, the plausibility of our behavioral foundations for
evolutionary economics has received support from an unexpected quarter. Stud-
ies linking cognitive abilities and brain physiology have established the existence
of anatomically distinct memory processes supporting the skilled behaviors of
individuals’ (ibid. 33). Not only is such memory ‘highly durable’, it also ‘func-
tions in some ways that are alien to theories of calculative rationality’ (p. 34).
While this cognitive science support for the notion of skilled behavior seems
compelling, the evidence they present in support of the critical move from
individual skilled behavior to the organizational, routine level is less so. The
only cited evidence is an experimental study of card-playing teams (Cohen and
Bacdayan 1994) that demonstrated that team-level skills (i.e. ‘routines’) acquired
under one specification of the game played made the adaptation to a new
specification of the game sluggish. While this has much to do with skilled and
inertial behavior and problems of adaptability at the level of teams, it is not clear
what exactly all this has to do with bounded rationality (or indeed with firm
behavior). Thus, Nelson and Winter’s recent stocktaking (2002) reinforces the
tendency in Nelson and Winter (1982) to lump together an almost empty
characterization of bounded rationality with a much richer description of skilled
behavior. Bounded rationality is, in effect, suppressed as a result of this exercise.
This raises the question of why bounded rationality is treated as a background
assumption while individual and organizational-level skilled behavior takes
precedence.
Why Tacit Knowledge is More Important than Bounded Rationality

in Nelson and Winter
Nelson and Winter (1982) explicitly compare skilled behavior to the execution of
a computer program. The outcomes of computer programs are predictable, given
knowledge of what is fed into them and knowledge of the program itself. When
triggered in a certain context, skilled behavior is also predictable, and knowledge
of an individual’s skill set, the relevant context, and the relevant stimulus may
also allow for reasonably accurate prediction of his behavior. By implication,
organizational routines, the organization-level counterpart to individual skills,
may also be understood as programs that make aggregate (i.e. organization-level)
behavior predictable and inert. And it is inert organizational behavior that
Nelson and Winter (ibid.) are after, because this is a necessary part of their
evolutionary mode of explanation. Thus, tacit knowledge, as embodied in skills
and routines, can do the job. Can bounded rationality do the job; that is, can it
explain inert organizational behavior?
In Nelson and Winter bounded rationality is mainly treated to the extent that
it provides an underpinning for the behavioralist notion of decision rules,
particularly in connection with search. Such decision rules may be understood
as manifestations of bounded rationality at the individual level (cf. Simon 1955)
and, less obviously, at the organizational level (Cyert and March 1963). One may
expect rule-bound behavior also to provide a strong explanation of inert organ-
izational behavior. However, there are two reasons why bounded rationality and
the decision rules it gives rise to may not be a strong foundation for a theory of
organizational inertia. First, decision rules that are explicit (i.e. Cyert and March’s
1963 ‘standard operating procedures’) may arguably be changed at lower cost
than complex routines that embody huge amounts of tacit knowledge. In this
sense, routines that are rationalized in terms of skills and tacit knowledge offer a
stronger explanation of organizational sluggishness than standard operating
procedures. Tacitness beats bounded rationality with respect to the explanation
of inertia, as it were. Second, it is far from clear that individual bounded
rationality produces inert behavior at the aggregate level. To be sure, such stories
can be told (e.g. Heath, Knez, and Camerer 1993; Egidi 2001), but they require
that bounded rationality and the interaction between boundedly rational agents
be specified in certain ways. To take an almost trivial example, if similar agents all
suffer from status quo biases, their aggregate behavior may indeed manifest
inertia. In contrast, it is not clear that inert aggregate behavior will in general
follow from individual-level rule-following; for example, in the form of some
satisificing model.
Thus, bounded rationality alone cannot do what Nelson and Winter wish
their behavioral assumptions to do for them; hence the invocation of skills, and
the use of the skill metaphor to address aggregate behavior. In the end, bounded
rationality is more a sort of background argument that serves to make plausible
the notion of organizational routine (including search routines), and therefore
the sluggish organizational adaptation that is so crucial to Nelson and Winter’s
evolutionary story. Thus, the whole construct works from an initial argument
about bounded rationality, goes from there to behavioralist decision rules, jumps
via analogy to ideas on tacit knowledge as embodied in skilled behavior, and then
transfers skills to the level of routines and organizational capabilities. Bounded
rationality re-enters the story when changes in routines and capabilities have to
be explained; namely, in the form of dynamic search routines.
This is a complicated exercise that has some unfortunate consequences. In
addition to the various problems identified in the Cohen et al. symposium
(1996) on the meaning of routines, there are at least two further problematic
consequences of this exercise. First, tacit knowledge and bounded rationality tend
to become indiscriminately lumped together, because it is not transparent where
the one ends and the other begins. Of course, tacit knowledge and bounded
rationality are different things and do not necessarily imply each other. Thus,
there can be tacit rules for maximization, as Machlup (1946) argued. Or, agents
can cope with bounded rationality by means of fully explicit operating proced-
ures. While one can certainly construct an argument that boundedly rational
agents make use of experientially produced—and ‘skilled’—decision rules that
are likely to embody a good deal of tacit knowledge (Langlois 1999), there is
simply no necessary connection between bounded rationality and tacit know-
ledge. Second, and perhaps more seriously, bounded rationality at the level of the
individual becomes suppressed. This makes it hard to understand the link
between bounded rationality, on the one hand, and routines and other organ-
izational phenomena, on the other. In other words, what exactly is the nature of
the mechanism that aggregates from individual behavior to routines and organ-
izational behavior? This mechanism is never really identified in Nelson and
Winter (1982). It also means that there is a certain interpretative ambiguity
surrounding the notion of routines to the extent that it is related to bounded
rationality. Is organization-level routinization produced by interaction effects
among the members of a team or is it ultimately founded in aspects of individual
cognition (Egidi 2000: 2). These issues are not resolved in Nelson and Winter
(1982). In fairness, it should be noted that this is perhaps not surprising, since
not much work existed on this issue when Nelson and Winter wrote their book.
Wider Consequences: Explanatory Difficulties and Lack of Micro-foundations

Explanatory Difficulties
Nelson and Winter (1982) is indeed a high point in the development of the KBV,
and their work has been foundational for much subsequent work within this
approach. In Chapter 2 the KBV’s aspiration to become a full-blown theory of
economic organization, a point at which it goes beyond Nelson and Winter
(ibid.), was discussed. The argument that will briefly be developed here is that
certain characteristics of Nelson and Winter (ibid.) were carried over into the
organizational capabilities approach, characteristics that may not be so problem-
atic if the analytical purpose is one of explaining rigidity in firm behavior as part
of a broader evolutionary story, but which are much less appropriate for the
purpose of building a theory of economic organization. The relevant character-
istic is a strong emphasis on aggregate entities, notably routines and organiza-
tional capabilities, an emphasis that comes at the expense of attention to
individual behaviors, and derives from Nelson and Winter’s attempt to establish
a metaphorical solution to the aggregation problem of moving from the level of
the agent to the level of the organization. Because they fully recognize the
metaphorical character of this maneuver, they do not commit the mistake of
conflating an ontological claim with a useful research heuristic. Later contribu-
tors to the knowledge-based view may not have been as careful here as Nelson
and Winter are.
Problems seem unavoidably to emerge as soon as Nelson and Winter’s ideas
on organizational routines and capabilities are transferred from their original
place in the analysis of a changing population of firms to an analysis of the
behavior and, particularly, organization of individual firms. While these notions
have indeed been of value for the understanding of, for example, the sources of
competitive advantage (although much of this literature is also plagued by
conceptual ambiguity), their application to economic organization is more
problematic.
The boundaries of the firm. The problem is apparent in another founding

contribution to the KBV that actually introduced the ‘capabilities’ construct,
namely Richardson (1972). In Richardson the import of capabilities is their
limitations. Because of what are effectively cognitive constraints, all organizations
must specialize; and, since the chain of production in an advanced economy
requires a diversity of very different capabilities, the costs of integrating across
many links in that chain are necessarily high, and firms must rely on various
kinds of market and hybrid arrangements to coordinate their activities even in
the face of contractual hazards. In Richardson’s terminology, production can be
broken down into various stages or activities. Some activities are similar, in that
they draw on the same general capabilities. Activities can also be complementary
(in both a technical and an economic sense) in that they are connected in the
chain of production and therefore need to be coordinated with one another.
Juxtaposing different degrees of similarity against different degrees of comple-
mentarity produces a matrix that maps different types of economic organization.
Notably, Richardson argues, closely complementary activities (which are in need
of substantial coordination) that are, however, dissimilar are organized more
efficiently in inter-firm relations than under unified governance or market
governance.
Richardson’s argument is intriguing and the first systematic attempt to explain
economic organization in terms of the capabilities construct (as well as one of the
few attempts in the literature to dimensionalize capabilities). However, it suffers
from some of the same kind of problems that also characterize later developments
in the KBV. Thus, capabilities are only loosely defined in Richardson (ibid.);
namely, as firm-specific ‘knowledge, experience and skill . . . [that] may depend
upon command of some particular material technology, such as cellulose chem-
istry, electronics or civil engineering, or may derive from skills in marketing or
knowledge of and reputation in a particular market’ (p. 888). Also, what are
‘similar’ or ‘dissimilar’ and ‘complementary’ and ‘closely complementary’ cap-
abilities is mainly explained in terms of examples, and Richardson, like virtually
all writers in the KBV, is not very forthcoming in defining these dimensions of
his unit of analysis.3
In these respects, there are no differences between Richardson (ibid.) and
Kogut and Zander (1992), in spite of the twenty years that separate these two
heavily cited papers. Thus, like Richardson, Kogut and Zander (ibid.) argue
directly from organizational capabilities to the boundaries of the firm; that is,
from an aggregate construct to an aggregate phenomenon. And, like Richardson,
they do not offer an elaborate micro-argument to support this. The supporting
argument is that ‘firms know more than their contracts can tell’. However, there
is no attempt to address this is in terms of comparative contracting, and,
ultimately, individual behavior. What exactly is it that cannot be written in
contracts? Even if writing costs in fact are prohibitive, why cannot relational
contracting, involving highly incomplete contracts, between independent parties
handle the transfer of knowledge? Why is it only vertical integration that
economizes with what are presumably writing and communication costs? No
compelling answers are given to such questions. This is the case for most of this
literature as it is applied to economic organization. A partial exception is the
work of Langlois (1992). Langlois attempts to supply the missing mechanism
from organizational capabilities to the boundaries of the firm by means of the
concept of ‘dynamic transaction costs’, which are essentially communication
costs that arise because of ‘dissimilar’ (Richardson 1972) capabilities in a vertical
structure of firms. Presumably, efficient economic organization minimizes such
costs (as well as other more ‘traditional’ transaction costs—allowance being made
for possible trade-offs between these).
Internal organization. However, this idea may imply another difficulty, one that
is also present in Nelson and Winter (1982) and in virtually all of the KBV. This
difficulty is that knowledge inside firms is very often assumed to be homoge-
neous (or, less strongly, not very costly to communicate), while knowledge
between firms (‘differential capabilities’) is taken to be (very) heterogeneous
(and therefore costly to communicate) (notably Kogut and Zander 1992).4
Thus, Winter (1986: 175) assumes that ‘the search for information from external
sources does not proceed with the same ease as for internal sources’. Knott (2003:
691) argues that the firm’s ‘knowledge stock’ is a ‘public good inside the firm that
can be redeployed on other projects. What makes the knowledge stock a public
good are the facts that it is non-rival—once the firm has acquired the knowledge
it can be used by multiple departments at zero cost—and nonexcludable—the
department which developed the knowledge can’t (or would have no reason to)
keep other departments from using it.’ It is easy to see why such assumptions are
made in the KBV. It makes it plausible that communication costs could carry
implications for the boundaries of the firm, as in the Kogut and Zander (1992)
argument that the boundaries of firms are strongly influenced by firms knowing
‘more than their contracts can tell’.
However, although there may be some intuitive appeal in the assumption, it is
hard to accept as true in general. There are many examples of firms where the
bandwidth of the communication channels between some business unit of the
firm and an external firm (e.g. buyer or seller) is much higher than the bandwidth
between the unit and, say, corporate headquarters. Moreover, the implicit as-
sumption that knowledge in hierarchies can be taken, at least as a first approxi-
mation, to be communicable at zero cost makes it hard to understand hierarchical
organization, since with zero cost communication the managerial task has no
economic rationale (Demsetz 1991; Casson 1994).
Methodological Individualism
It seems fairly obvious that the essentially ad hoc assumptions that knowledge
inside firms can be communicated at low cost while knowledge between firms
can only be communicated at high cost slip into the analysis when the units of
analysis are routines or organizational capabilities. It is then easy to postulate that
‘firms know more than their contracts can tell’ and that all organizational aspects
are ‘intertwined in a functioning routine’. If instead the analysis had started in an
explicit individualist methodological mode, that is from individual choice be-
havior, the argument that communication costs within, for example, certain
business units may be lower than the communication costs between people in
the unit and people in a supplier firm might have been derived as an outcome of a
properly specified model instead of being postulated. The problem is that there is
no theory of individual choice behavior in KBV, so that KBV writers have to treat
economic organization in a collectivist methodological way; namely, in terms of
postulating crude causal relations between capabilities and economic organiza-
tion, little attention being paid to the microanalytic issues involved. Not sur-
prisingly, these stories are vulnerable to critiques from more microanalytic
perspectives (Foss 1996; Williamson 2000).
Ironically, therefore, it turns out that much of the KBV is vulnerable to the
same critique that Winter (1991) forcefully (and justifiably) launched against the
neoclassical theory of the firm. Specifically, and borrowing directly from Winter,
it is in potential ‘conflict with methodological individualism’ (p. 181) (because of
the emphasis on routines and organizational capabilities), ‘provides no basis for
explaining economic organization’ (p. 183) (because transaction costs and com-
parative contracting are not considered), lacks ‘realism’ (because of its ‘unrealis-
tic’ treatment of decision-making as entirely guided by routines), and provides a
‘simplistic treatment of its focal concern’ (e.g. because it is simply assumed that it
is easier to gather, combine, source, etc. knowledge inside firms than between
firms). The main underlying problem, it has been argued here, is that too little
attention is devoted to individual decision-making, and that much of the KBV de
facto subscribes to methodological collectivism (Felin and Foss 2004).5 To see
this, consider the following diagram, which is an adaptation of the familiar
‘bathtub diagram’ from Coleman (1990).
The KBV relies heavily on mode (4) explanation; that is, aggregate-level
explanation where aggregate ‘social facts’ directly cause aggregate social outcomes.
(4) Competitive advantage,

Capabilities
economic organization
(‘social facts’)
(‘social outcomes’)
(1) (3)
(2)
Individual Individual
conditions actions
Figure 4.1. Explanation in the organizational-capabilities approach.

Source: Adapted from Coleman (1990).
For example, ‘capabilities’ are argued to cause the boundaries of the firm as well
as overall firm performance. This is methodological collectivism, whereas meth-
odological individualism would dictate substituting for mode-(4) explanation,
an explanation that involved at least mode (3) and possibly also modes (1) and
(2). The fundamental problems with such methodological collectivism are that
it (1) ascribes independent causal powers to collective entities; (2) suppresses
more ‘micro’-explanatory mechanisms that are located at the level of individual
action; and therefore also (3) neglects the complicated processes of interaction
between individuals (Hayek 1952; Ullman-Margalitt 1977). Not surprisingly,
there is a strong tendency in methodological collectivism to treat individuals as
homogeneous.
We can see all these characteristics in the KBV. The problems at least partly go
back to Nelson and Winter and their sidestepping of individual behavior in favor
of aggregate notions (i.e. routines and capabilities). Although Nelson and Winter
were aware of the limitations and problems of sidestepping individual behavior
in favor of collective entities as the explanatory ‘primitives’, and Winter certainly
seems committed to methodological individualism (Winter 1991), later KBV
writers seem more at variance with individualistic explanation, and some expli-
citly abandon it (Spender 1996).6 In fact, Howard Aldrich argues for a potential
shift completely away from individuals, conjecturing that ‘if we truly focused on
routines, competencies, practices and so on, we would not follow people anymore
in our research’ (Murmann, Aldrich, Levinthal, and Winter 2003: 25–7; em-
phasis in the original). Recent work has also argued for the existence and
importance of aggregates or collections of routines and nth level capabilities
(Nelson 1994; Eisenhardt and Martin 2000; Zollo and Winter 2002; Helfat and
Peteraf 2003; Winter 2003; Zott 2003). This seems somewhat problematic,
given that clarity on the basic constructs has not yet been achieved (Felin and
Foss 2004).
Conclusion
In conclusion it is appropriate to set the argument in this chapter in a somewhat
broader context. In an excellent recent paper (2003) Paul Nightingale’s argument
parallels the one developed here. He argues that Nelson and Winter (1982) seek
to ‘bring together two very different ways of thinking about knowledge’; namely,
the more appreciative ‘tacit knowledge tradition that derives, in part, from
Polanyi’s phenomenology’ and the more formal ‘objectivist information process-
ing, problem-solving approach that derives, in part, from Simon’ (2003: 1). This
is visible in their attempt to conceptualize firms both in terms of information
processing and in terms of tacit and socially embedded knowledge. Nightingale
argues that a number of tensions in the science-and-technology policy literature
are traceable to this problematic attempt in Nelson and Winter to fuse two
epistemologies, the tensions between which have fuelled other recent debates,
notably in artificial-intelligence research.
Much of the argument in this chapter may be cast in similar terms.
The attempt in Nelson and Winter to combine ideas on routines and skilled
behavior derived from Polanyi with ideas on bounded rationality and satisficing
search derived from Simon has not been entirely satisfactory, and may be an
important source of some of the explanatory difficulties that confront the
modern KBV. An indication that Nelson and Winter’s reconciliation exercise
was not entirely successful is that tacit knowledge and bounded rationality simply
are not equal partners in the 1982 book; the three central chapters on firm-
behavior and organization are to a much larger extent about tacit knowledge than
about bounded rationality. Thus, contrary to a commonly held view, the role of
bounded rationality in the knowledge-based view is very much a background
one. Its precise relation, if any, to the notion of the central concepts of routine
and capability is unclear. Its role seems more rhetorical than substantive. At any
rate, boundedly rational behavior at the level of the individual agent is not
modeled either in Nelson and Winter’s seminal 1982 book or in the many
contributions to the KBV that are so heavily indebted to this contribution.
Finally, lest this chapter be taken as a general attack on the KBV, it is
important to stress that its real message is a methodogical one. In the spirit of
what was called ‘integrationism’ in Chapter 2, the position here is that the KBV
embraces interesting issues, but that KBV theorists should devote more analytical
energies to getting the micro-foundations right. It will not do in the long run to
continue working with concepts whose micro-foundations are unclear. This is
not just a matter of conforming to the conventional methodological individualist
approach of most economics and business administration. It is also, and more
substantively, a matter of the explanatory and predictive capabilities of the KBV
being less impressive than they could be as a result of the lack of micro-
foundations for concepts such as routines, capabilities, etc. Also in the spirit of
integrationism, the central argument in the following chapter is that various ideas
that belong to the broad theoretical body of ‘new institutional economics’
(including organizational economics) have the potential to further the KBV as
well as the RBV.
Notes
1. Penrose (1959) does treat localized, tacit knowledge, but only at the level of the
management team.
2. For discussions of the role of bounded rationality in organizational economics see Foss
(2003a).
3. It is not surprising that the balance between theoretical and empirical work in the
capabilities perspective seems weighted towards the theoretical side, and that most
empirical work is qualitative.
4. While this is the most common assumption in the KBV, Nickerson and Zenger (2003)
point out that some KBV make exactly the opposite assumption. For example, Conner
and Prahalad (1996) invoke the Demsetz (1991) argument that the main advantage of
authority (i.e. order giving) is that it allows use to be made of knowledge without
communicating this knowledge.
5. For an excellent extended critique of the KBV along these lines see Felin and Hesterly
(2004).
6. Although a few knowledge-based writers explicitly try to eschew the dangers of
methodological collectivism (notably Grant 1996).
5
Strategy, Resources, and Transaction Costs
Introduction
Transaction cost economics (henceforth ‘TCE’) has for a long time been a
favorite whipping boy of sociologists and heterodox economists of various
colours (e.g. Hodgson 1998). TCE bashing continues to be a thriving industry
in these fields, but new entrants are increasingly recruited from the ranks of
management scholars, particularly from the strategic management field. As noted
in Chapter 2, work in economics on transaction costs and their role in structur-
ing economic organization attracted a great deal of sympathetic attention and
influence at the beginning of the 1980s in the strategic-management field (e.g.
Dundas and Richardson 1980; Rumelt 1984) following the seminal work of
Williamson (1975). However, during the 1990s transaction cost economics
became increasingly subject to critical discussion and even opposition, as know-
ledge-based approaches swept across business administration. In the strategy
field, resource-based and knowledge-based theorists have been particularly
vocal critics, and have explicitly used the critique of TCE as a starting point
for developing their own approaches to the firm (Kogut and Zander 1992;
Conner and Prahalad 1996; Ghoshal and Moran 1996; Madhok 1996). At
much the same time similar critiques were put forward in economics (e.g.
Langlois 1992; Foss 1993; Hodgson 1998; Witt 1999), drawing on somewhat
similar sources (notably Penrose 1959 and Richardson 1972).
While Chapter 2 was essentially an essay comparing the respective merits and
drawbacks of existing theory of the firm-based approaches in strategy, this chapter
is an attempt to go beyond existing positions. It does so in two ways. First, in the
spirit of the ‘integrationism’ promoted in Chapter 2, it will be argued that TCE
can further the resource-based view. More fundamentally, it will be argued that
rather than supplying non-negligible, but still second-order, arguments about
optimum sourcing and sales arrangements, internal organization, and the like
(Seth and Thomas 1994), TCE arguments have the potential to add to the very
core of strategic-management research; that is, value creation and appropriation.
Second, the chapter does not build on Williamsonian foundations. As it is
understood here, TCE is not limited to Williamson’s work (Eggertson 1990;
Barzel 1997; Furubotn and Richter 1997), and TCE is not committed with any
strategy, resources, and transaction costs 99
logical necessity to the specific behavioral assumption of opportunism (Hart
1995) or the assumption of asset specificity (Barzel 1997).
Thus, the chapter will sketch an approach that is perhaps more dependent on
the property rights branch of transaction cost economics (Barzel 1982, 1997)
than on the Williamsonian branch. While entirely consistent with what follows,
asset specificity and opportunism are not central characters. Instead, below
we frame the fundamental questions of strategic management directly in a
transaction cost context by asking questions such as: Is competitive advantage
possible in a zero-transaction-cost world? How does the presence of transaction
costs influence strategic opportunities? Does an explicit recognition of transac-
tion costs direct attention to resource types that have been overlooked in previous
strategic-management research? And so on. These questions go right to the heart
of the matter of the central issues of strategic management in their concern with
the creation and appropriation of value. What is added is a fundamental concern
with the role that transaction costs play in such processes.
In addition to unfolding some of the relations between transaction costs and
value creation and appropriation, the chapter links the discussion to the resource-
based view (the ‘RBV’) (Barney 1991; Peteraf 1993) and the knowledge-based view
(the ‘KBV’) (Kogut and Zander 1992; Grant 1996). It does so by drawing on the
economics of property rights (the ‘EPR’) (e.g. Coase 1960; Alchian 1965; Demsetz
1967; Cheung 1969; Barzel 1997). Property rights over resource attributes consist
of the rights to use, consume, obtain income from, and alienate these attributes.
Property rights matter to strategy because a resource owner’s ability to create,
appropriate, and sustain value from resources partly depends on the property rights
that she holds to those resources and how well protected these rights are. In turn,
transaction costs—the costs of exchanging, protecting and capturing property
rights—matter to strategy, because they influence the value that a resource owner
can appropriate. This conceptualization unifies the theoretical constructs of prop-
erty rights, transaction costs, and value creation and appropriation with the notion
that resources are fundamental to strategic management.
The Strategic-management Debate on Transaction-cost Economics:

Are the Right Questions Being Asked?
The debate—or, set of connected debates—in the strategic-management field on
the role of TCE with respect to furthering insights in firm strategy that was
surveyed in Chapter 2 has usually centered on Williamson’s version of TCE
(Williamson 1975, 1985, 1996a). This is arguably not surprising, because the
link between transaction costs economics and firm strategy was first made explicit
in Williamson’s demonstration (1975) of the capacity of transaction cost reason-
ing to throw light on fundamental corporate strategy issues (i.e. the issue of
efficient firm boundaries), as well as functional and organizational strategy issues
(i.e. the issue of efficient internal organization). Also, Williamson and his students
and co-authors have continued to be influential voices in the strategic-manage-
ment field. The Chandler-Williamson M-form hypothesis quickly became a key
insight in the strategic management field, particularly after being supported in a
number of influential empirical studies (e.g. Armour and Teece 1978). The classic
transaction cost papers on such issues as the multinational firm, vertical supply
arrangements, joint ventures, franchising, sales force organization, etc.—most of
which has been built on Williamsonian foundations—have become standard
references in the strategic management field.
Given all this, it is not surprising that Rumelt, Schendel, and Teece (1994: 27)
could introduce the proceedings from the 1990 Napa conference on ‘Funda-
mental Issues in Strategy: A Research Agenda for the 1990s’ with the observation
that ‘[o]f all the new subfields of economics, the transaction cost branch of
organizational economics has the greatest affinity with strategic management’,
and then go on to observe that within strategic management TCE ‘is the ground
where economic thinking, strategy and organizational theory meet’ (Rumelt et al.
1994: 27). Their views echoed Rumelt’s earlier argument (1984) that William-
sonian TCE should serve as the foundation for firm strategy research and,
ultimately, managerial practice. Only TCE supplied an understanding of such
foundational issues as the existence, boundaries, and, to a smaller extent, the
internal organization of the firm, and a number of derived issues (e.g. the
structuring of joint ventures, franchise contracting, diversification, etc.). How-
ever, the relevance of TCE seemed to be limited to corporate strategy issues;
implicitly, it was acknowledged that TCE had very little to say about competitive
strategy; that is, issues relating to positioning in an industry and defending such a
position.
TCE was first openly challenged by attempts to frame the then relatively
recent RBV as a theory of the firm (in particular, Conner 1991; Kogut and
Zander 1992). These attempts were launched against a general background of
critique of TCE, particularly Williamson’s version of TCE. Critics of William-
sonian TCE attacked the theory on a broad front. Thus, it was argued that TCE
(1) put too much emphasis on opportunism and too little on trust (Ghoshal and
Moran 1996); (2) neglected ‘transaction benefits’ and focused solely on transac-
tion costs (Zajac and Olsen 1993); (3) only considerd ‘exchange’ and excluded
‘production’ (Winter 1991); (4) could not explain firm heterogeneity (Conner
1991); and (5) was static (Langlois 1992). In contrast, it was argued that a new
‘strategic theory of the firm’ could be built from insights into such neglected
phenomena as transaction benefits, firm heterogeneity, etc., the obvious impli-
cation being that Williamsonian TCE was not necessary for developing a
strategic theory of the firm. As shown in Chapter 2, the debate has attracted
numerous contributors and has sometimes provoked heated arguments and
strong opinions. Important issues appear to be at stake. However, while the
debate may have clarified positions, both substantive and meta-theoretical, it is
questionable whether it has actually provided essential new insights.
One possible reason why the debates may not have been fruitful is that right
from the start they implicitly assumed that the specific Williamsonian formula-
tion of TCE contained the entire set of TCE assumptions and propositions
relevant to strategic management. Thus, virtually all contributors to the debates
on the role of TCE in strategic management research have tended to focus on
theory-of-the-firm issues, and most have adopted different takes on the ‘know-
ledge or opportunism in the theory of the firm’ theme originally introduced by
Conner (1991), Kogut and Zander (1992), Langlois (1992), and Foss (1993).
This reflects the heuristic ideas that, first, the theory of the firm is very important
to strategic management research, and, second, there is a choice to be made
between knowledge and incentive issues in the explanation of economic organ-
ization.
Both ideas may be contested. Although I think that the first idea is ultimately
sound (cf. also Chapter 2), while the second isn’t, even the first idea and its
various implications—notably, that strategic management research should expli-
citly begin from a theory of the firm—is open to some debate. Strategic
management research has typically had a firm focus, and its fundamental concern
has been to explain how firms can create and appropriate more value than the
competition (e.g. Hofer and Schendel 1978; Porter 1980; Peteraf 1993). Eco-
nomic theories of the firm fit neatly into this overall conceptualization. Their
level of analysis is the firm (albeit units of analysis may differ) and they are
fundamentally concerned with value creation and appropriation. To illustrate, in
a recent paper Mahoney (2001; emphasis in the original) provides what he
considers a fundamental reason why the Williamsonian transaction cost ap-
proach to the firm is important to strategic management:
asset specificity (sunk cost commitment) is a necessary condition for isolating mechan-
isms that sustain rents [ . . . ] Often the firm achieves sustainable competitive advantage
(i.e., sustains rents) because it reduces opportunistic behavior and allows for firm-specific
investment. In the absence of opportunism the rent-generating firm need not exist. In the
absence of opportunism, contracting would be sufficient to support investments that are
strategic commitments.
A number of things are noteworthy about such reasoning.1 First, sustained
competitive advantage, which is taken to be the central explanandum of strategy
research, is unambiguously located at the firm level. However, it is strictly
speaking not firms that appropriate value, but the numerous stakeholders that
supply inputs to the legal fiction known as the firm. Second, this suggests that
there is more to the TCE/strategic management nexus than asset specificity;
for example, the role of TCE arguments would seem to be a general matter
of exploring how well alternative contracting practices constrain the strategic
behavior of the firm’s stakeholders. Third, it is assumed that the TCE/strategic-
management nexus is indirect in the sense that establishing it requires taking a
route over the theory of the firm. Such a view is potentially constraining, because
it seems to imply that a TCE approach to strategic management must necessarily
involve Williamsonian notions of asset specificity and opportunism. However,
this route is not the only possible one. While applications of the Williamsonian
approach in strategic management continue to produce outstanding research
(e.g. Oxley 1999; Silverman 1999; Nickerson and Zenger 2002; Nickerson and
Silverman forthcoming), it is possible, and, it will be argued, worthwhile, to
explore the strategic-management/TCE nexus along different routes.
The Argument: An Example

According to Coase (1992: 716), ‘[b]usinessmen in deciding on their ways of
doing business and on what to produce have to take into account transaction
costs [ . . . ] In fact, a large part of what we think of as economic activity is
designed to accomplish what high transaction costs would otherwise prevent’. To
illustrate Coase’s idea, consider the strategy that a major player in the world’s
diamond industry, the DeBeers cartel, has adopted for organizing sales to its
customers. The customer informs DeBeers of her wishes with respect to the
number and quality of stones. DeBeers then offers the customer a packet of
stones, a ‘sight’, that roughly corresponds to the customer’s wishes, and that sight
is offered on a ‘take-it-or-leave-us-permanently’ basis. The price is calculated on
the basis of the gross characteristics of the stones, and no negotiation over the
price is possible.
Does this strategy reflect the raw exercise of market power on the part of a
player that controls 80 per cent of the world’s market for raw diamonds?
Economists (Barzel 1982; Kenney and Klein 1983) writing from the perspective
of property-rights economics have argued that it does not. Rather, it is a practice
that maximizes the created value in firm–customer relations by reducing the costs
customers would otherwise have expended on sorting and negotiating, and exists
for this reason (it would be superfluous in a zero-transaction-cost world). With
this practice DeBeers sorts, but only in a coarse manner. The ‘take-it-or-leave-us-
permanently’ practice and the posted price mean that costs of negotiation are
effectively eliminated. Because only minimum resources (i.e. transaction costs)
are spent on sorting and negotiating, DeBeers’s practice maximizes the total
created value that the parties to the transaction can split between them.2
Although strategic-management research has paid virtually no attention to
such practices and how they can be explained, their theoretical explanation has
important implications for strategic management, not least the RBV. First,
transaction costs and value creation appear to be linked. Thus, sorting costs (an
instance of transaction costs) reduce the value that is created through exchange.
However, certain practices (that would be irrelevant in the absence of transaction
costs) may reduce transaction costs, increasing created value. In other words, they
‘accomplish what high transaction costs would otherwise prevent’. Second,
transaction costs and value appropriation appear to be linked. Suppose DeBeers
posts prices that reflect the mean quality of the diamonds in a given sight. If
DeBeers then allows customers to sort between the diamonds in a sight, cus-
tomers will only pick high-quality stones. DeBeers’s actual sales strategy raises
customers’ (transaction) costs of sorting to infinity, allowing DeBeers to maxi-
mize the share of created value that it can appropriate. Ideas on property rights in
economics provide a convenient way of focusing these insights and at the same
time relating them to the RBV and the KBV.
Relating Property Rights and Transaction Costs to Resources3

Although notions of property rights abound in the analysis of the strategic
implications of intellectual-property issues (e.g. Liebeskind 1996; Teece 1987;
Argyres and Liebeskind 1998), the EPR is a very unusual visitor to the pages of
the strategic-management journals (Foss and Foss 2000a; Kim and Mahoney
2002; Foss 2003b). There are many reasons for this. First, while the property-
rights approach was quite influential at the end of the 1960s and in the 1970s
(Furubotn and Pejovich 1972), in the 1980s—the decade where strategic man-
agement was established as an academic field—micro-economists directed their
interest to game-theoretical information economics. Ironically, however, ideas on
property rights were reintroduced into the economics profession through the
medium of game theory (Grossman and Hart 1986; Hart and Moore 1990),
and the older, non-formal tradition in the EPR was given a new lease of life in
the work of, particularly, Yoram Barzel (1994, 1997).4 Second, much of the
property-rights program was directed to understanding the allocational conse-
quences of social institutions (e.g. Alchian 1965; Demsetz 1967); that is, the
program primarily worked at a level of analysis that was substantially higher than
those levels that strategic management is concerned with. Third, strategic
management scholars tend to associate the EPR with intellectual property rights
issues alone. However, the EPR goes far beyond issues of intellectual property. It
is therefore appropriate to state the fundamentals of the EPR, especially as these
relate to firm strategy issues, particularly the RBV.
Property Rights and Resources

The pioneering paper on the economics of property rights is conventionally and
justifiably taken to be Coase (1960). In this paper Coase examines the economic
implications of the allocation of legally delineated rights (liability rights) to a
subset of the total uses of an asset; namely, those that have external effects on the
value of other agents’ abilities to exercise their use rights over assets. As part of his
critique of the Pigovian tradition in welfare economics, Coase (ibid. 155) notes
that a reason for the failure of this tradition fully to come to grips with the
externality issue lies in its ‘faulty concept of a factor of production’, which—
according to Coase—should be thought of not as a physical entity but as a right
to perform certain actions. This right is a property right.
Following Coase, economists writing within the EPR stress that transactions
involve the exchange of property rights rather than the exchange of goods per se.
Hence, the unit of analysis is the individual property right. Clearly, this is a unit
of analysis that is more microanalytic than those that are applied in the RBV and
the KBV.5 While the units of analysis of the EPR and the RBV thus differ, the
EPR view is not at variance with the RBV position that for the analysis of
sustained competitive advantage resources are what matters. Rather, the EPR
refines the RBV understanding of resources and how resources create and
appropriate value.
Different definitions of ‘resources’ are put forward in the RBV literature. For
example, Wernerfelt (1984) thinks of resources as assets that are tied ‘semi-
permanently’ to the firm, and Barney (1991) defines resources as anything that
may be of potential value to a firm. Elaborate taxonomies of resources have been
constructed, partly on the basis of the supposed contribution to sustained
competitive advantage of different kinds of resources (physical, human, organ-
izational, relational, financial, etc.). Because the standard definitions of resources
are so broad (cf. Barney’s definition, ibid.), confusion has occasionally surfaced in
the literature with respect to the levels at which resources are located, and many
writers have developed elaborate resource hierarchies (e.g. hierarchical structures
that relate ‘competencies’, ‘capabilities’, and ‘resources’, such as in Sanchez 2001)
to address what they see as a need to distinguish between mundane resources that
can—through the application of ‘higher-level’ resources—be assembled into less
mundane resources with the potential to bring sustained competitive advantage.
Many contributions to the KBV take this perspective. One reason why such
exercises may be warranted is that simply defining resources as ‘anything that
may be of value to a firm’ risks obscuring the ways in which those resources that
indeed create value to the firm (e.g. in the sense of helping it to obtain sustained
competitive advantage) are built from other, more mundane, resources. High-
lighting resource hieararchies may bring attention to mechanisms that are
otherwise in danger of being black-boxed.
The EPR suggests a different way of refining the understanding of resources.
From this perspective resources can be thought of as being composed of different
functionalities and services (Penrose 1959); that is, different attributes. Property
rights may be held to such attributes (Barzel 1997)—property rights over
attributes consisting of the rights to consume, obtain income from, and alienate
these attributes (Alchian 1965). A car is composed of numerous attributes, such
as the ability to carry passengers and goods, the ability to drive fast or slow, etc.
However, the set of property rights that a person may hold to the attributes is
usually smaller than the set of attributes. For example, the use right to the
attribute of delivering speed at 250 km per hour is constrained in most countries.
Similarly, firm resources, such as a brand name, may also have attributes to which
use rights are constrained. An owner of a brand name can decide in which
contexts she wishes to deploy the brand name in the non-virtual world; that is,
she holds property rights to the relevant uses (attributes) of the brand name and
appropriates the value from the services it yields by allowing customers and
suppliers to identify the firm that owns the brand name in various contexts (i.e.
social, geographical). Her use rights may still be constrained, for she may not be
allowed to use the brand name as a domain name on the Internet.
Resources, Property Rights, and Attributes

These examples suggest that it is useful to think of resources as bundles of property
rights to attributes. The resource is an important aggregation of the unit of
analysis (the individual property right), because often resources rather than
individual property rights over attributes are traded or created. Trading bundles
of property rights of which only some are specified is efficient because it is often
too costly to specify and trade each individual attribute (Foss and Foss 2001).
The implication is that how attributes are bundled to constitute a ‘resource’ is
dependent on transaction costs. In other words, resources are outcomes of pro-
cesses of economizing with such transaction costs. For example, the extent to
which copying machines and servicing agreements are sold as a combined good
(i.e. a ‘tying arrangement’) may depend on the costs to the seller or lessor of
monitoring the impact of non-standard servicing on the machine (Elzinga and
Mills 2001). Transaction costs often hinder resource owners from realizing their
income rights to all of the attributes of a resource by selling individual attributes.
For example, the transaction costs of trading production time mean that the
practice of leasing such attributes to other firms is rather unusual.
The value that an owner of a resource potentially can create from a resource
depends on the bundle of property rights (specified as well as unspecified) that he
holds to the attributes of the resource.6 For example, the value to the owner of the
brand name mentioned earlier may be increased if she also has the right to use it
(use rights) as a domain name on the Internet.
The value that an owner of a resource can appropriate from her resource
depends on her right and ability to exclude non-owners from the attributes of the
resource; for example, various uses of the resource. Thus, the value that a firm can
appropriate from its brand name by selling it or by deploying it in-house depends
on its legal rights to exclude non-owners (other firms) from using the name, as
well as its ability to enforce this right. While the resource owner has the legal and
moral right to exclude non-owners from using and obtaining value from his
resources, he may still find it too costly to exclude non-owners from all possible
uses of the resource. Relatedly, given the costs of protecting property rights over
attributes, owners often choose to control the relevant property rights to varying
degrees, and the value that a resource can appropriate will reflect this. For
example, in a franchise chain the value of a brand name to the franchisor will
be eroded (Dierickx and Cool 1989) when it is too costly to the franchisor to
control franchisees’ use of the brand name for selling products that are below the
quality standards of the chain. The implication is that the value that a resource
can appropriate depends on the costs of controlling the property rights to the
attributes that make up the resource. These costs are transaction costs. Attempts
to maximize resource value must take these costs into account.
The Capture and Protection of Property Rights

An important part of transaction costs are the costs of using legal and/or private
means of protection. The existence of transaction costs means that most property
rights are not fully protected and can be subject to capture attempts; that is,
resource-consuming activities of appropriating value from other players without
compensating them. Thus, capture is the source of negative externalities. Moral
hazard, adverse selection, and hold-up are familiar examples of capture. While
capture is different from exchange, it may take place in exchange relations. For
example, two parties to a transaction agree on a price for a resource with certain
attributes (e.g. a certain quality level); however, the supplier may deliver a resource
of a lower quality. Such post-contractual opportunism on the part of the supplier
amounts to capturing (some) valued resource attributes from the buyer.7
Given this definition of capture, ‘protection’ can be defined as the resource-
consuming activities that players undertake in order to reduce others players’
possibilities of capturing value. Since capture takes many forms, the notion of
protection that is present in the EPR goes significantly beyond making and
keeping resources costly to imitate or substitute (Teece 1986; Barney 1991).
Protection includes such activities as using the legal system, establishing private
orderings (Williamson 1996), deterring entry (Tirole 1988), establishing isolat-
ing mechanisms (Wernerfelt 1984; Rumelt 1987), writing contracts, and adopt-
ing sales strategies to avoid adverse sorting, as in the DeBeers example (Barzel
1982; Kenney and Klein 1983). The RBV and the KBV mainly consider a subset
of these protection activities; namely, protecting against competitive imitation.
However, there are many other relevant kinds of capture and corresponding
protection activities, and there is no inherent reason why the RBV should not
consider a much broader set.
To see why this is so, consider a hypothetical insurance company that is the
first to market a particular kind of accident-insurance concept that is in heavy
demand, and can be fully protected from imitation by legal means. Moreover,
assume that factor markets can only bargain for a small part of the value created
by the new concept, and that customers also have weak bargaining powers. Given
all this, the insurance company would seem to implement ‘a value creating
strategy not simultaneously being implemented by any current or potential
competitors and [ . . . ] these other firms are unable to duplicate the benefits of
this strategy’ (Barney 1991: 102); that is, to realize a sustained competitive
advantage. However, this may not be the case. Because of transaction costs, the
price of insurance contracts cannot perfectly reflect the true accident risks of each
individual who takes out insurance. Given variation in risks, some customers,
namely those with high accident risks, capture value in excess of what they pay for
(i.e. ‘adverse selection’, Akerlof 1970). At the limit, all of the rents from the new
strategies will be eroded through the value capture/adverse selection of cus-
tomers. As this example suggests, resources are not fully protected from value
erosion unless they are protected from all kinds of capture. And it suggests that
protection of resource value goes beyond keeping resources inimitable. In the
example, the proper way to protect value is to segment the customer base.
This suggests that the EPR contains implications for value creation and
appropriation, and therefore sustained competitive advantage, that add to the
RBV and the KBV. In order to spell this out more clearly, it is useful first to
examine value creation and appropriation in a setting where transaction costs are
zero; that is, the setting underlying the Coase theorem (Coase 1960, 1988), and
then add transaction costs and trace the implications for value creation and
appropriation. Thus, essentially the same strategy that Coase (1937, 1960)
followed is followed here. Examine an extreme setting (i.e. the Coase theorem
setting) to see what this tells us about the phenomenon that we are interested in
understanding (i.e. the firm (Coase 1937), the law (Coase 1960)—and strategic
management (this chapter))—and then demonstrate that this understanding is
furthered by the introduction of transaction costs.
A Coasian Benchmark
Value Creation and Appropriation when Transaction Costs Are Zero
A compact way of stating the Coase theorem is that in the absence of transaction
costs all the value that can conceivably be created from the exchange and use in
production of the available resources in the economy will, in fact, be created. An
underlying assumption is that in such a surplus-maximizing equilibrium players
have full information.8 Therefore, there are no costs of bargaining and of
measuring the attributes of resources, and property rights to (all attributes of )
all resources are defined and protected at zero cost. Because the costs of exchan-
ging property rights are zero, all property rights to all attributes will be tradable.9
All rights will therefore move to their highest valued uses, so that in this
benchmark situation the total value that resources can create, and which there-
fore will be imputed to them, will be at its maximum.
Another way of stating that the costs of exchanging property rights are zero is
that prices for all relevant resource uses (attributes), namely those that are realized
in the surplus-maximizing equilibrium, emerge immediately from costless bar-
gaining processes. As an example, consider a car park that is located adjacent to a
supermarket. Since information and bargaining costs are zero, the owner will
bargain with users of the car park so that all attributes will be priced. Relevant
attributes may be the time and date and how close one can park to the
supermarket entrance. Different prices for different attributes will probably
emerge. Because prices are perfect signals of scarcities, all attributes will be
perfectly rationed; that is, no queues emerge and reallocating the use rights to
the parking spaces cannot increase created value. The division of the created
value between the owner of the car park and each of the customers depends only
on bargaining powers. Moreover, for any resource the bundle of attributes will be
well defined and will be the one that maximizes resource value.
This reasoning suggests a further remarkable implication of the zero-
transaction-cost assumption; namely, that the value created by the use of re-
sources is always independent of the value that each individual resource appro-
priates, because in such a world resources will always get at least their opportunity
costs, and resource investments will always be covered (Hart 1995). One may
think of parties to transactions (i.e. resource owners) as first agreeing to maximize
the value that can be created from their resources, and afterwards splitting this
value through bargaining that defines each party’s share of the created value
(Milgrom and Roberts 1992). In other words, value creation is independent of
value appropriation when transaction costs are zero.
However, while the zero-transaction-cost notion informs us that total resource
value will be maximum for the coalitions chosen by maximizing players, it does
not directly speak to the issue of value appropriation. Game-theoretic reasoning
shows that there is an upper limit to what a player can appropriate; namely, no
more than his contribution to overall value creation (Hart 1989). Making this
more determinate requires that more assumptions be added; for example, that
agents can join and leave ‘coalitions’ as they please, that there are ‘many’ agents,
etc. Taking this to the extreme brings us to the competitive equilibrium model,
where agents receive their marginal product value. In other settings it is usually
not possible to say exactly how cooperating agents will split the value they create,
in the absence of rather detailed knowledge about the size of the transfer
payments that will normally be required to sustain an efficient outcome, bargain-
ing powers, the structure of interaction, etc.10 It may be split in any possible way
within the bounds given by opportunity costs and reservation prices. However,
the Coase theorem implies that bargaining processes are instantaneous, consume
no resources, and that there is no feedback effect from the splitting of value to the
creation of value.
The Coase Theorem and Strategic Choice

As Coase (1960) notes, rents may be earned when the supply of input resources is
not perfectly elastic, independently of whether transaction costs exist or not.
Because property rights are perfectly protected, these rents are sustainable. Thus,
the rudiments of the resource-based view of sustainable competitive advantage
(Barney 1991; Peteraf 1993) are consistent with the zero-transaction-cost as-
sumption; firms may implement strategies based on resources that are valuable,
rare, and (infinitely) costly to imitate and substitute, even if transaction costs are
zero. However, maximum value would be created instantaneously in each time
period, all rent streams would be perfectly protected, bargaining over the division
of these streams would take place instantaneously and costlessly, there would
be no problems of implementing a strategy (since organizational costs would be
zero), etc. In sum, value creation and appropriation would pose no problems
whatsoever.
Arguably, a significant part of the content of strategic management seems to
lie in all these processes not being instantaneous, costless, and unproblematic.
Extreme settings, such as the one underlying the Coase theorem or its cousin the
competitive-equilibrium model, leave little room for strategic choices. To see
this, observe that the Coase theorem implies that all possible uses of assets are
fully known, all returns from all uses of all assets are perfectly known, all
legitimate and illegitimate uses of assets are perfectly specified, and all this is
perfectly enforceable (Barzel 1997). If all rights are completely defined in this
way, by definition no conflicts can arise over the use of scarce resources or the
returns from assets, because individuals do not have any discretion in the use of
resources. Somewhat paradoxically, because there are no impediments to effi-
ciency, there is also no genuine discretion, including no room for strategic choice.
In order to find a role for strategic choice, ‘imperfections’ have to be thrown
into this perfect world, as has been argued. This has, of course, been known ever
since strategy became established as an academic field, as various kinds of ‘market
failures’ (e.g. Dundas and Richardson 1980; Porter 1980, 1981) have been
invoked to make sense of strategic opportunities. However, such failures have
seldom been explicitly related to transaction. Market failures arise as transaction
costs are introduced into the perfect world of the Coase theorem.11 One
consequence is that the choice of, for example, organizational arrangements
now matters, because—in contrast to the perfect world underlying the Coase
theorem—different arrangements have different consequences in terms of cre-
ated value. For example, contractual arrangements with suppliers, internal or-
ganization, quality systems, sorting of customers, etc. may all be sources of value
creation, notably because organizational arrangements influence value appropri-
ation (Milgrom and Roberts 1990a, 1992; Williamson 1996a; Barzel 1997).12
There are, however, many other ways in which transaction costs influence value
creation and appropriation. Some of these are discussed below.
Putting Transaction Costs into the Resource-based View

Like other economic approaches to strategy, the RBV is concerned with value
creation and value appropriation. What needs to be given fuller attention in the
RBV is the way in which these two processes interact. When transaction costs are
zero, there is no such interaction. Accordingly, the RBV should embrace trans-
action costs. A manifestation of the interaction of value creation and value
appropriation in a world of positive transaction costs is dissipation of value;
that is, costly capture and protection. Dissipation results from players seeking
to maximize the value that they can appropriate by means of engaging in costly
capture and protection activities (Barzel 1997). This reduces created value. The
presence of capture introduces a second feedback loop from value appropriation
to value creation that is absent in the zero-transaction-cost world. Notably, the
threat of hold-up, and imitation in relations may induce inefficient investments
and thus reduce potential value creation (Hart 1995; Williamson 1996a; Kim
and Mahoney 2002). The feedback loop from value appropriation to value
creation suggests two ways of creating value that are absent in a zero-transac-
tion-cost world. First, in a positive-transaction-costs world an important source
of value creation stems from the reduction of dissipation. Second, a resource
owner can devise means of protecting (in a low-cost manner) against capture
attempts by other players and can thereby realize value from transactions that
otherwise would not take place. This is exemplified below.
Creating Value through Reducing Dissipation: An Example

In a positive-transaction-costs world it will never be possible to realize the full
potential of all resources with respect to value creation, because with scarce
resources (so that competition over resource uses arise, Alchian 1965), some
dissipation is unavoidable. Dissipation of value results from players’ attempts
to maximize the value that they can appropriate by means of engaging in costly
capture-and-protection activities (Barzel 1997). Increasing protection of prop-
erty rights in order to reduce capture reduces one kind of dissipation but
increases another. Similarly, reducing protection in order to save on protection
costs increases capture. This trade-off means that there is an optimal amount of
dissipation (i.e. that amount which maximizes created value). An implication is
that value creation requires that resource owners consider not only their own
costs of protection, but also the costs to other players of engaging in capture
(Skaperdas 1994). Below, I exemplify how reducing dissipation increases created
value. I then link the example to the RBV.
Consider a uniquely located (hence, inimitable) car park that is placed
adjacent to and owned by a supermarket. Customers value a combined good;
namely, the combination of what the supermarket offers and parking spaces. This
will be reflected in both the demand the supermarket faces and the prices it can
charge. The supermarket will earn a profit from being located next to the car
park. The source of the profit is the positive externality in consumption. Thus,
use rights to the parking spaces are unprotected in the sense that non-owners can
use these attributes without directly compensating the owner, but it will still be
rational for the owner to make available the car-park resource to non-owners
when he can appropriate the value it produces through its complementarity to
the supermarket.
Assume now that the supermarket’s pricing decisions can be represented in
terms of the monopoly diagram familiar from economics textbooks (see Fig. 5.1).
D1 is the demand curve for its goods that the supermarket would face in the
absence of the car park. Created value is represented by the area IJHC. However,
if the supermarket constructs a car park but does not police its use, D2 is the
combined demand curve for the goods offered by the supermarket and the free
services of the car park. The price is lower in the absence of the car park (P1 ),
because consumers value having access to a car park. Total created value increases
by BFHC to IJFB. The supermarket can capture EFHG (¼ BFHC) by charging
the higher price (P2 ). However, when the car park of a limited size is offered for
B
P3 C D
P2 E F
P1 G H
D3
I J MC
D2
Sales
MR D1
Figure 5.1. Pricing and value creation.

free, customers queue for the unpriced parking spaces. This results in dissipation
of value in the form of waiting time. (In Fig. 5.1 it is assumed that not all value is
dissipated in this way.) Dissipation can be reduced if the supermarket extends the
car park or if it protects its property rights and charges patrons for parking. The
demand curve will shift outwards, because customers no longer have to expend
resources on queuing. Total created value increases by ADFB to IJDA. If the
supermarket charges the equilibrium price that fully rations parking space (i.e.
P3 P1 ), and prices supermarket goods at P1 , it can capture the extra value
CDFE that pricing the car park generates.13 The cost of pricing the car park has
to be subtracted from CDFE; in other words, as long as these costs are less than
CDFE it will pay to price the parking services.
So far it has been assumed that the value of each parking space to customers is
independent of location and time. However, it is much more realistic to assume
that customers value a parking space adjacent to the entry of the super-
market higher than other spaces and that they value parking at peak shopping
hours higher than at other hours of the day. A single price will therefore not
perfectly ration the use of high-valued parking spaces. If the supermarket can
devise means of reducing the cost of pricing and enforcing property rights to
these attributes, it will appropriate a greater part of the value that the resource can
create. In the case of a car park this may require investments in developing
sophisticated ticket systems and control systems. Incentives to invest in such
transaction-costs-reducing technology stem from the ability to reduce dissipation
and to capture a greater share of the value of attributes.
Pricing and Exchange as Sources of Value Creation

The above example runs counter to a recurrent theme in the RBV; namely, that
strategically important resources are often unpriced (Dierickx and Cool 1989;
Reed and DeFilippi 1990; Lippman and Rumelt 2003a: 1070, 2003b; Teece
2003). For example, it is often pointed out that strategically important resources
are accumulated in-house, should also be deployed in-house, and are unpriced.
However, the RBV is not entirely forthcoming about why resources are unpriced.
Perhaps for this reason, it is not recognized that pricing may be a source of value
creation.14
However EPR logic suggests two reasons why resource attributes are unpriced.
First, attributes may be costly to define and measure in ways that are verifiable to
the parties to a potential transaction. For example, defining and measuring the
attributes of a firm-specific technological or organizational capability may be
very costly. Second, it may be prohibitively costly to exclude non-owners from
capturing property rights. For example, while firms may exclude non-owners
(e.g. by means of secrecy and covenants not to compete) from firm know-
how as long as the relevant know-how is deployed internally, firms cannot
enforce their property rights through legal means if they seek to trade their know-
how. When the costs of specifying the relevant attributes and protecting the
property rights to those attributes exceed the benefits of trading the bundle of
attributes the resource will not be priced.15 This may lead to the conclusion that
value creation is always sustained by keeping resources unpriced. However, the
car-park example shows that pricing not only serves to divide the surplus created
by the resource, but also serves to ration the use of the resource in such a way that
dissipating competition over created value is avoided.
As a general matter, exchange is value-creating because it allows resources to
move to better uses. Transaction costs represent one important reason why not all
value-creating trade takes place. The transaction costs that inhibit trade are of
various kinds and the measures that firms can take to reduce these transaction
costs therefore differ. For example, costs caused by adverse selection and moral
hazard may be reduced by the creation of brand name and reputations (Barzel
1982), and costs from opportunistic hold-up may be reduced by means of private
orderings (Williamson 1996a). Trade increases as these costs are reduced. Per-
haps because the reasons for such non-tradability (or ‘non-transferability’) are not
clearly framed in the RBV, the opportunities for exchanging such resources have
been neglected. To be sure, certain kinds of technological knowledge may be
easily imitable, and this speaks in favour of in-house deployment. However,
technological knowledge may also yield substantial returns if traded. This sug-
gests that there is a trade-off between keeping resources in-house (which may
contribute to making the resource costly to imitate: Reed and DeFilippi 1990),
and trading it (which may contribute to value creation). However, firms may
influence the trade-off in a manner favorable to themselves. For example,
technology trading has emerged among firms in closely knit networks (Hippel
1988). The trading is supported by reciprocity norms and the ability to exclude
free riders from the network. In-house deployment is substituted by within-
network deployment.
In the EPR resources are perceived as bundles of property rights to attributes.
In the zero-transaction-cost setting property rights to attributes can be traded
separately; in actuality, transaction costs often inhibit such trade. However, value
can be created if transaction costs can be reduced so that individual attributes can
be employed in better alternative uses. For example, value can be created when
use rights to production equipment or labor service that would otherwise be idle
can be traded in rental arrangements. Trade can also create value when resources
have attributes that are non-exclusive in use. Brand names used by several sales
outlets at the same time are examples of this. Contractual innovations such as
franchise contracts have allowed for substantial trade in such attributes. Lippman
and Rumelt (2003b: 1082) note that the RBV predicts that firms will focus their
energies on developing ‘complex ‘‘homegrown’’ resources [ . . . ] Yet a glance at
corporate reality reveals that much more effort is devoted to combinations, deals,
mergers, acquisition, joint venture and the like’. They therefore suggest that more
attention be devoted to such resource assembly. What is missing in their per-
spective, but supplied by the EPR, is the recognition that created value is
constrained not only by knowledge about resource complementarities but also
by the transaction costs that attend the exchange aspects of ‘combinations, deals,
mergers, acquisition, joint venture and the like’.
Sustained Competitive Advantage

The centerpiece of the RBV is the analysis of the conditions of sustained
competitive advantage (cf. Ch. 3) (Barney 1991; Peteraf 1993). Below, the
contribution of the EPR to this analysis is outlined, using Peteraf ’s identification
(1993) of the ‘cornerstones of competitive advantage’ in terms of heterogeneity,
barriers to ex ante and ex post competition, and immobility.
Heterogeneity. By stressing that resources are composed of property rights to

attributes, the EPR contributes a further dimension to the RBV analysis of
heterogeneity which stresses the inherent efficiencies of resources (Peteraf
1993) and resource complementarities (Dierickx and Cool 1989; Denrell,
Fang, and Winter 2003). Property rights are typically bundled together in
resources because of the costs of exchanging individual property rights, including
the costs of protecting these rights. Thus, resources are outcomes of processes of
economizing with such transaction costs, and vary in their efficiencies and
potential for being combined in a complementary manner because they encom-
pass different attributes. By implication, resource heterogeneity changes under
the impact of innovations in sales practices, contracting practices, and other
transaction-cost-reducing technologies.
Ex ante competition. The RBV stresses informational barriers to ex ante compe-

tition as a necessary condition of the existence of rents (Barney 1986). The EPR
adds a different mechanism by which discrepancies between value and price may
be established on strategic factor markets. In the EPR resource heterogeneity is
caused by variation in the types and levels of valued attributes that resources
embody. Such variation causes costly measurement (Barzel 1997). Costly meas-
urement implies that (1) not all attributes are priced and (2) some actors may be
able to capture value from unpriced attributes (Barzel 1982). Actors on strategic
factor markets that have low costs of capture because of superior efficiencies in
searching and/or in low opportunity costs of search will be able to purchase
resources—that is, bundles of property rights over attributes, including the highly
valued one—at prices below their value to the seller. This suggests that rent
capture is connected to transaction costs, and that variation in the attributes of
resources is a resource dimension that is important to understanding rent capture.
Ex post competition. In the RBV ex post competition is mainly a matter of

competitive imitation and of resource substitution. A condition of sustained
competitive advantage is that there are barriers to imitation and substitution
(Barney 1991). The EPR adds to this by pointing to ex post dissipation of value
and to other kinds of capture than imitative competition and substitution. For
example, moral hazard and adverse selection are instances of capture and cause ex
post dissipation of value as victims of capture seek to protect themselves. The EPR
also expands the avenue of research pursued in the RBV with respect to identi-
fying characteristics of resources that may contribute to sustained competitive
advantage. For example, causal ambiguity is often seen as a characteristic that
supports sustainability (Lippman and Rumelt 1982). However, from an EPR
perspective causal ambiguity may make it costly to write contracts and enforce
performance norms. Causal ambiguity may therefore reduce value creation and
appropriation. The general lesson from the EPR is that barriers to ex post capture
as well as dissipation are a necessary condition for the sustainability of competi-
tive advantage.
Immobility. While the RBV suggest that from the firm’s point of view resource
immobility is preferable, transaction costs may imply that immobility leads to
underinvestment. Granting resources outside options, such as giving patent
rights to research scientists, may increase their bargaining power (make them
more ‘mobile’) and improve their investment incentives (Hart 1995). This points
to a trade-off in certain situations between immobility and value creation, and
therefore refines the analysis of immobility as a condition of sustained competi-
tive advantage.
Conclusion
The aim of this chapter has been to sketch in more precisely one specific route
through which the integrationism that was endorsed in Chapter 2 could be
developed. Specifically, the argument has been that the economics of property
rights—a theoretical input into organizational economics—may complement
and further the RBV (and therefore also the KBV where this overlaps with the
RBV) by refining the notion of resource, adding insight into resource value, and
suggesting new, transaction cost-based sources of value creation.
An implication of the discussion is that the contribution to competitive
advantage of a resource depends not only on its use and its scarcity and the
amount of capture in the form of competitive imitation and substitution (Barney
1991), but also on the costs of controlling capture in the form of, for example,
moral hazard, adverse selection, and hold-up. Estimating the sustainability of
competitive advantages must involve taking such costs into account. Another
implication is that resources are not given, but are outcomes of processes of
economizing with transaction costs. Therefore, what are physically the same
resources may to different firms be economically different resources; for example
because the relevant firms are not equally capable of protecting the relevant
attributes. Finally, the discussion directs attention to those resources that may be
advantages to firms by increasing created (and appropriated) value by means of
reducing transaction costs; for example, specific ways of sorting goods (e.g. in the
retailing industry and industries such as fruit and vegetables) or customers (e.g.
credit classes in banking), contracting, the use of private orderings, etc. (William-
son 1996a; Barzel 1997). The conjecture here is that these resources are import-
ant sources of heterogeneity and competitive advantages in a number of
industries. However, they have been largely neglected in the RBV. One may
speculate that this is because these resources are only visible if a positive-
transaction-cost world is assumed, and the RBV has not yet explicitly endorsed
transaction-cost perspectives.
The RBV has proved to be an influential and useful analytical structure for the
analysis of many strategic issues. However, it is also like a ten-to-fifteen-year old
building built by a few key contractors on a tight completion deadline and on the
basis of somewhat different inputs (Foss and Knudsen 2003). Some of the
limitations are beginning to show up. First, as argued in Chapter 3, the RBV
building was constructed on a foundation—the competitive-equilibrium
model—that makes it hard to extend the building. Second, some essential
materials—namely transaction costs—were not used to a sufficient degree.
A number of deficiencies have resulted. Accordingly, the repair attempt
should be a fundamental one, and will have to be directed at building a better
foundation and adding the essential material of transaction costs. The first kind
of repair attempt has been initiated by Lippman and Rumelt (2003a/b); the
second one is that sketched out in this chapter. However, much more work is
required to flesh out a satisfactory synthesis between resource-based and trans-
action cost ideas.
Among the important problems that must be addressed in such an undertak-
ing are these. While notions of transaction costs and property rights may
illuminate the notion of resource heterogeneity (and therefore firm heterogen-
eity), do they go far enough? Or do these arguments merely set the problem at a
higher level, so that the question becomes: Why are firms different in recognizing
and managing property rights and transaction costs? Admittedly, TCE, including
the EPR, has devoted little effort to developing insights into issues such as
tacitness of knowledge, social complexity, path-dependence, and the like and
how these explain firm heterogeneity. Thus, the RBV and the KBV contain a
number of ideas that are not present in TCE. Also, TCE directs primary
attention to reducing inefficiencies associated with exchange as an important
source of value creation. Evidently, there are numerous sources of value creation
that do not fall within this perspective. For example, in many cases creating value
through product and process innovations does not. Thus, TCE is not an all-
encompassing strategic perspective. No perspective is. However, it directs atten-
tion to phenomena that, although important, have hitherto been comparatively
neglected in strategic-management research.
Notes
1. I leave out the claim that asset specificity is a necessary condition for isolating
mechanisms.
2. Similar practices can be observed in many industries, such as pre-packaging of fruit
and vegetables in grocery stores or block booking in the movie industry; arguments
about their existence similar to the explanation of the DeBeers sales practice can be
advanced (Barzel 1982, 1997; Kenney and Klein 1983).
3. This section draws on Foss and Foss (2004).
4. Note that I here primarily rely on the Alchian-Barzel-Cheung-Coase-Demsetz brand
of property-rights economics, rather than on the formal approach associated with
Hart. For a comparison of the two property-rights approaches see Foss and Foss
(2002).
5. Of course, it could be argued that the notion of resource is sufficiently flexible also to
include the individual property right.
6. This adds a property-rights dimension to Penrose’s distinction (1959) between re-
sources and the services they yield. The services that a firm can derive from its
resources (i.e. the fungibility of the resources) are not just constrained by path
dependencies, the functionalities of the resources, and managerial imagination (Pen-
rose 1959), but also by property rights.
7. Note that there is also a dimension of capture to competition, to the extent that
competitive activities aim at capturing value without compensating the current holder.
This is perhaps most conspicuous in the case of resource imitation, reverse engineer-
ing, and the like; however, competition in terms of investing in bargaining power,
quality improvements, and technology may also be analyzed in terms of capture,
because such activities reduce the value that a resource can appropriate without
compensating the resource owner (Barzel 1994; Foss 2003a).
8. A strong version of the Coase theorem (as in Coase 1988 and Barzel 1997) is adopted
here. Readers who recall the critique in Chapter 3 of founding strategy research on the
competitive equilibrium model may wonder why the Coase theorem is any less
constraining. However, there are some subtle, yet important, differences between
the Coase theorem setting and the standard competitive-equilibrium model that are
of relevance to their utility as benchmarks in strategy research. Thus, the Coase-
theorem setting directs attention to individual agents bargaining with each other,
rather than interacting anonymously through a price system as in the competitive-
equilibrium model. And the Coase-theorem setting does not make any assumptions
with respect to market structure (see also Makowski and Ostroy 2001).
9. For this reason, the very notion of a ‘resource’, strictly speaking, dissolves in this
extreme world. Exchanges will only involve attributes.
10. Economists have come up with a number of more or less plausible concepts to resolve
to bargaining problems. See Muthoo (1999) and Lippman and Rumelt (2003a) for
an application to strategy.
11. Relating market failures to fundamental strategic issues takes the form of arguments
such as ‘asymmetric information is a necessary condition for internal capital markets
to be superior to external capital markets’; ‘the public goods nature of knowledge
may make it more efficient to exploit excess knowledge through diversification rather
than contracting’; ‘because of asymmetric information, knowledge transfer may
more efficiently take place inside firms than across firms’; etc. These are the
arguments underlying the Alchian-Williamson argument in favor of internal capital
markets (Williamson 1975), the economies of scope-cum-transaction-costs story of
diversification (Teece 1982), and the theory of the multinational enterprise (Teece
1986) respectively; that is, theories that have been highly influential in the evolution
of strategic management.
12. Williamson (1994) thinks that these choices are so fundamental that ‘economizing is
the best strategy’. Presumably this is because governance and contractual choices are
ubiquitous, must be made by all firms, and can have an important impact on
performance, whereas strategizing, which appeals to a market-power perspective, is
only open to major players.
13. Here I have assumed that extending the car park is more costly than pricing parking
services. In the example, although customers are never worse off, the monopolist
supermarket captures all created value from the car park and from pricing parking
spaces. In other words, customers have no bargaining power. Also, we have assumed
that customers have similar queuing costs and valuations of parking spaces. Relaxing
the assumptions does not compromise the overall conclusion.
14. Only Lippman and Rumelt (2003b: 1085) note that ‘intuition suggests that a
resource bundle will be more valuable if it can be accurately priced’.
15. Resources may also be unpriced because they are extremely firm-specific (Lippman
and Rumelt 1982). Such resources are necessarily best used in-house, and the fact
that there are no prices on such resources is not a sign of a potential for value
creation. However, it may be doubted that such resources are common.
Part II
Organization: Critical Perspectives

6
Economic Organization in the Knowledge Economy
Introduction
During the last decade management academics have firmly stressed the role of
organizational factors in the process of building knowledge-based strategies that
will bring sustained competitive advantage (Nonaka and Takeuchi 1995; Grant
1996; Myers 1996; Brown and Eisenhardt 1998; Day and Wendler 1998).1
Arguably, this emphasis is also reflected in managerial practice. Thus, firms are
said to adopt ‘network organization’ (Miles and Snow 1992) and engage in
‘corporate disaggregation’ (Zenger and Hesterly 1997), so as to become ‘informa-
tion age organizations’ (Mendelsson and Pillai 1999) that can build the ‘dynamic
capabilities’ required for competing in the knowledge economy. These changes
with respect to the organization of economic activities take place in tandem with
changes in the composition of inputs toward knowledge inputs, an increase of the
‘knowledge-content’ in outputs, a stepping up of innovative activity, an increasing
differentiation of demand, increasing globalization, and increasingly inexpensive
networked computing—changes that are taken to indicate the emergence of the
‘knowledge economy’ (cf. Ch. 1 and Halal and Taylor 1998; Prusac 1998;
Tapscott 1999; Munro 2000).
This chapter attempts to address economic organization in the context of the
emerging knowledge economy. Thus, it asks what are the implications for our
understanding of issues relating to the scope and organization of alternative
governance structures of some of the key tendencies that we may take as charac-
terizing the knowledge economy. As discussed in Chapter 1, these include such
tendencies as that many industries become increasingly ‘knowledge-intensive’, an
increasing share of the workforce is constituted by ‘knowledge workers’, commer-
cially useful knowledge becomes increasingly distributed and needs to be accessed
from several sources, many lying outside the boundaries of firms, etc.
Admittedly, significant analytical complexity is involved here. Moreover, any
discussion of economic organization in the context of the emerging knowledge
economy is unavoidably somewhat harmed by the lack of robust and clear
definitions of, as well as a solid empirical knowledge base about, the ‘knowledge
economy’. However, understanding economic organization in the context of the
emerging knowledge economy is an important challenge—for three reasons.
122 organization: critical perspectives
First, it arguably concerns important real tendencies and phenomena with respect
to economic organization—which so far have only received sporadic attention
from economists of organization.2 Second, it goes right to the heart of the crucial
and perennial issues in the theory of economic organization, challenging us to
rethink issues such as: What are the limits to resource allocation by means of
authority? What do we mean by authority? What defines the boundaries of firms?
How do we distinguish an independent contractor from an employee? These
‘classic’ questions are pertinent ones, because it is an underlying theme in much
recent work on economic organization in the knowledge economy that authority
relations, the boundaries of firms, and the way in which mechanisms for
coordinating economic activities are designed and combined will undergo sig-
nificant change under the impact of knowledge that is complex, controlled by
specialists, and distributed. Third, and closely related to the previous point, some
writers on the knowledge economy (e.g. Boisot 1998; Helper, MacDuffie, and
Sabel 2000) argue that existing approaches to the economics of organization,
such as transaction cost economics, are not capable of providing an adequate
explanation of economic organization in the knowledge economy. To illustrate:
firms are increasingly engaging in collaborations with their suppliers, even as they are
reducing the extent to which they are vertically integrated with those suppliers. This fact
seems incompatible with traditional theories of the firm which argue that integration is
necessary to avoid the potentials for hold-ups created when non-contractible investments
are made (Helper, MacDuffie, and Sabel 2000: 443)
The following arguments and positions are developed in this chapter. Admit-
tedly, it is a justified complaint that post-Coasian organizational economics so far
has not comprehensively addressed economic organization in the context of the
knowledge economy. However, the insights developed in this body of thought are
actually quite useful for framing the issues. Moreover, they help to temper—by
making clear the limits of—more extreme claims about organization in the
knowledge economy. Among such claims are that authority relations will strongly
diminish in importance or at least change significantly in character (Zucker
1991); that ownership-based and legal definitions of the boundaries of firms
will become increasingly irrelevant for understanding the organization of eco-
nomic activities (Helper, MacDuffie, and Sabel 2000); and that constraints on
the space of feasible combinations of coordination mechanisms will be very
significantly relaxed (Miles et al. 1991). Below, such claims are all addressed
and framed in the context of organizational economics, so as to examine their
reach.
However, this does not mean that organizational economics can survive in a
completely unchanged form confrontation with the knowledge economy. On the
contrary, much work needs to be done with respect to understanding the
importance of knowledge assets (cf. also Holmström and Roberts 1998), distrib-
economic organization 123
uted knowledge (Foss 1999a), and environmental complexity (Athey et al. 1994)
for organizational design.3 Still, many of the basic insights and ideas survive and
are very useful for the understanding of economic organization in a knowledge
economy, including new organizational forms. Thus, the basic aim of this
chapter is not theory building per se. It is rather to engage in a dialog with
those management academics who have written on organization in the emerging
knowledge economy, and in this context to examine the reach of organizational
economics with respect to framing organizational issues characteristic of the
knowledge economy.
Economic Organization in the Knowledge Economy: Framing

Recent Debate
In this section some recent claims about how the advent of the knowledge
economy will change economic organization are reviewed. In order to focus
the discussion, six ‘interpretive propositions’ are identified. These are intended to
summarize influential recent ideas on (1) the changing role of knowledge in
production, (2) economic organization in the knowledge economy, and (3) how
(1) and (2) are connected.
Some Recent Claims about Economic Organization in a Knowledge Economy

Many disciplines, fields, and sub-fields are involved in the ongoing discussion of
efficient organization in the context of the emerging knowledge economy.
Nevertheless, a number of distinct themes are discernible in much of the debate.
Overall, a consensus seems to be emerging that tasks and activities in the
knowledge economy need to be coordinated in a manner that is very different
from the management of traditional manufacturing activities, with profound
transforming implications for the authority relation and the internal organization
and boundaries of firms. There are several reasons for this.
Because of the increasing importance in knowledge-intensive industries of
combining knowledge inputs, sourcing knowledge for this purpose, and keeping
sourcing options open, knowledge-based networks (Harryson 2000) increasingly
become the relevant dimension for understanding the organization of economic
activities. Such networks typically cut across the legal boundaries of the firm; for
example, in the sense that inter-firm communication channels may have much
greater bandwidth than intra-firm channels or that coordination requirements
are more severe between firms than within firms.4 Networks are particularly
useful organizational arrangements for sourcing and transferring knowledge
because of the costs of pricing knowledge (in a market) or transferring it (in
a hierarchy) (Powell 1990: 304; Liebeskind et al. 1995: 7). The increased
reliance on knowledge networks tends to erode authority-based definitions of
the boundaries of the firm, because authority increasingly shifts to expert
individuals who control crucial information resources and may not be employees
of the firm. As Zucker (1991: 164) argues:
While bureaucratic authority is by definition located within the firm’s boundaries, expert
authority depends on the information resources available to an individual, and not on the
authority of office. Thus, authority may be located within the organization [ . . . ] but
when an external authority market can provide information that leads to greater effect-
iveness, then authority tends to migrate into the market.
To the extent that important knowledge assets are increasingly controlled by
employees (‘knowledge workers’) themselves, traditional authority relations are
fading into insignificance. This is partly a result of increased bargaining power on
the part of knowledge workers (stemming from the control over critical know-
ledge assets) (Coff 1999), and partly a result of the increasingly specialist nature
of knowledge work (Hodgson 1998). The specialist nature of knowledge work
implies that principals/employers become ignorant about (some of ) the actions
that are open to specialist agents/employees, thus making the exercise of author-
ity through direction increasingly inefficient. The combined effect of the in-
creased importance of knowledge assets that are controlled by knowledge workers
themselves and the increasingly specialist nature of knowledge work is to wreck
the traditional economist’s criterion of what distinguishes market transactions
from hierarchical transactions (Zingales 2000). Thus, direction by means of
order giving (Coase 1937; Simon 1951; Williamson 1985; Demsetz 1991) and
backed up by the ownership of alienable assets (Hart and Moore 1990) is
increasingly irrelevant for understanding the organization of economic activities
in a knowledge economy (Grandori 2000).
Not only does the emerging knowledge economy profoundly change the
authority relation, and the boundaries of firms, it also influences the design of
firms’ internal organization; that is, their allocation of decision rights. As Miles
et al. (1997: 7) argue:
Each major era in business history has featured a particular form of organization. Early
hierarchical, vertically integrated organizations have largely given way to network organ-
izations that link the assets and know-how of numerous upstream and downstream
industry partners. A number of leading companies today are experimenting with a new
way of organizing—the cellular form. Cellular organizations are built on the principles of
entrepreneurship, self-organization, and member ownership. In the future, cellular or-
ganizations will be used in situations requiring continuous learning and innovation.
By suggesting that radical internal hybrids, ‘built on the principles of entrepre-
neurship, self-organization, and member ownership’, are emerging as stable
organizational modes, this quotation (and others like it) suggests that mechan-
isms for coordinating economic activities are more malleable, and that the set of
stable discrete governance structures is larger than is conventionally assumed in
much organization theory and in the economics of organization (e.g. Coase
1937; Williamson 1996a).5 These new governance structures are increasingly
often referred to as ‘new organizational forms’ (Daft and Lewin 1993; Zenger
and Hesterly 1997). To the extent that new organizational forms represent new
ways of combining mechanisms that have traditionally been seen as characteristic
of governance structures that are polar opposites, they also exemplify the fading
boundaries between markets and firms (Helper, MacDuffie, and Sabel 2000).
What is Going on Here? Six Interpretative Propositions

In order meaningfully to discuss economic organization in a knowledge economy
there is a need for some conceptual clarification and some focusing of the issues.
Most fundamentally, it is necessary to define the aspects of the knowledge
economy that are most obviously relevant for an understanding of economic
organization. Existing treatments emphasize such dimensions as increased know-
ledge content of outputs and the composition of inputs, hyper-competition and
therefore the paramount importance of learning, decreasing corporate size, the
importance of IT innovations, increasing differentiation of demand, increased
general-environmental complexity, increasing importance of networks for the
transfer and production of knowledge, etc. (e.g. D’Aveni 1994; Nonaka and
Takeuchi 1995; Grant 1996; Miles et al. 1997; Boisot 1998; Matusik and Hill
1998; Leadbetter 1999; Coombs and Metcalfe 2000; Zingales 2000).
Needless to say, dealing with all of this as it impacts on economic organization
is a task of forbidding complexity. A narrowing of the issues is required. In order to
do so, I submit that for the purposes of understanding economic organization, recent
claims about the impact of the knowledge economy on organization may usefully
be narrowed down to two basic propositions about knowledge in production and
four basic propositions about economic organization.6 The first two assertions
both turn on the increased importance of specialist knowledge:
Proposition 1: Because of the increased need for diverse, specialized know-
ledge in production, commercially relevant knowledge is becoming increas-
ingly distributed in the Hayekian sense (e.g. Hayek 1945; Coombs and
Metcalfe 2000).7
Proposition 2: Because of the increased importance of sourcing specialist
knowledge, knowledge assets controlled by individual agents (‘knowledge
workers’) are becoming increasingly important in production (e.g. Boisot
1998).
For convenience, settings in which Propositions 1 and 2 hold true are character-
ized as ‘Hayekian’. Further narrowing of the issues is produced by the three
following (related) propositions about economic organization in a knowledge
economy—all of which may be found in recent writings:
Proposition 3: In the emerging knowledge economy, authority relations will
become increasingly inefficient and insignificant means of allocating resources
(e.g. Semler, 1989; Hodgson 1998).
Proposition 4: The boundaries of firms blur because of the increasing im-
portance of knowledge networks that transcend those boundaries. Thus,
while legal and ownership-based definitions of the boundaries of the firm
may formally be made, they will be increasingly irrelevant from an eco-
nomic (and strategic) perspective (e.g. Zucker 1991; Helper, MacDuffie,
and Sabel 2000).
Proposition 5: Coordination mechanisms will be combined in new, innova-
tive ways, suggesting that these mechanisms are inherently combinable and
not limited to being necessarily clustered in specific discrete governance
structures (e.g. Grandori 1997; Helper, MacDuffie, and Sabel 2000).8
Although these propositions are rather open-ended, they are susceptable of
theoretical treatment (and in principle of empirical test as well). Moreover, so
is the final proposition:
Proposition 6: The effects described in Propositions 3–5 are driven by
changes in the way in which knowledge enters into the productive process,
as described in Propositions 1–2.
The strategy that I follow in the ensuing pages is that of critically discussing
Proposition 3–6, taking Propositions 1 and 2 as given (i.e. accepted). In other
words, I discuss the typically Coasian themes of authority, the boundaries of the
firm, and the combinability of coordination mechanisms in the context of the
typically Hayekian setting in which knowledge is distributed and subjectively
held. The strategy is to discuss the role (if any) of authority in Hayekian settings,
examine the connections between authority and ownership, and finally discuss
how authority and ownership constrain the malleability and combinability of
coordination mechanisms. Thus, as will become clear, the themes of authority,
ownership, and the malleability of coordination mechanisms are connected.
These themes are addressed seriatim below.
Authority in the Economics of Organization

The following is a discussion of the notion of authority as it appears in a few,
crucial organizational-economics contributions. The reason for focusing on what
economists of organization have said about authority is that these scholars offer
clear and stark interpretations of authority and that this chapter is based on
organizational economics. This is not to deny that much insight may be gained
from the more encompassing classic discussions of Barnard (1938), Weber
(1947), etc., and that economists of organization should pay more attention to
these (cf. Aghion and Tirole 1997). However, at this stage a narrower and more
focused approach is appropriate, particularly as the above propositions primarily
relate to the relatively narrow notions of authority typically found in the works of
organizational economists.
Coase and Simon

It is conventional to date the birth of organizational economics to Ronald Coase’s
1937 paper ‘The Nature of the Firm’. This is justified by Coase’s stress on market
failure caused by transaction costs as the starting point for any explanation of
firms, and by his contractual approach, comparative institutionalism, and clear
identification of the main explanatory requirements of a theory of the firm (i.e.
explaining the existence, boundaries, and internal organization of firms).9 Coase
also founded the widespread practice of identifying the firm with the employ-
ment contract; indeed, he puts much emphasis on the flexibility afforded by
incomplete employment contracts and the authority relation as the ultimate
reason for the existence of firms.10 Thus, as Langlois and Foss (1999) have
argued, Coase’s explanation for the emergence of the firm is ultimately
a coordination one: The firm is an institution that lowers the costs of qualitative
coordination in a world of uncertainty.11 The employment contract is explained
in related terms, as ‘one whereby the factor, for a certain remuneration (which
may be fixed or fluctuating) agrees to obey the directions of an entrepreneur
within certain limits. The essence of the contract is that it should only state the
limits to the powers of the entrepreneur. Within these limits, he can therefore
direct the other factors of production’ (ibid. 242).12
A later paper, by Herbert Simon (1951), provides a formalization of Coase’s
notion of the employment relationship and a clarification of the notion of
authority. The latter is defined as obtaining when a ‘boss’ is permitted by a
‘worker’ to select actions A 0 A, where A is the set of the worker’s possible
behaviors. More or less authority is then simply defined as making the set A 0
larger or smaller. The model is basically a multi-stages game in the context
of an incomplete contract with ex post governance. In the first period the
prospective worker decides whether to accept employment or not. Then nature
intervenes, uncertainty is resolved, and the costs and benefits associated with the
various possible tasks are revealed. To the extent that the boss cares about his
reputation, he will not direct the worker to undertake tasks that lie outside the
latter’s ‘zone of acceptance’, and there may thus be an equilibrium in the three-
stages game.13
To sum up, in the Coase/Simon view of authority the action space is well-
defined and known both to the ‘boss’ and the ‘worker’, the boss observes those
states of nature to which it is necessary to react (e.g. a realization of demand on
the firm’s product markets), he possesses the right to direct the worker, and the
worker obeys the boss’s instructions ‘within limits’.
The Puzzling Notion of Authority

The Coase/Simon view of authority raises several questions. In the present
context four such questions are particularly relevant:
1. What is ultimately the source of the employer’s authority? In other words,
why exactly is it that the employee accepts being directed? These are pertinent
questions, given that slavery is prohibited (i.e. human assets are inalienable).
2. What happens to the Coase/Simon view if the employer does not possess full
knowledge of the employee’s action set (i.e. the actions that he can take when
uncertainty is resolved), so that the employee can take actions about which the
employer has no knowledge (in other words, the employer suffers from ‘sheer
ignorance’ in the sense of Kirzner 1997)?
3. What happens to the Coase/Simon view of authority if the employee is better
informed than the employer with respect to how certain tasks should (opti-
mally) be carried out? In the Coase/Simon view there is an implicit assump-
tion that the employer is at least as well informed, and presumably better,
about the efficiency implications of alternative actions.14
4. What happens to the Coase/Simon view if employees control knowledge
assets that they cannot, or will not, alienate (sell, transfer), and which may
give them substantial bargaining power, so that they cannot automatically be
depended on to obey instructions?
The last three questions relate to the issue of the limits of authority in Hayekian
settings, while the first question asks about the sources of the employer’s bargain-
ing power over the employee.15 Only the first question has been given extensive
treatment in the economics of organization. In fact, it has been one of the
classic points of contention in a long-standing debate in economics initiated
by Alchian and Demsetz (1972). They argue that it is not meaningful to assume
that an employer can force an employee to do what the employer wants in the
absence of coercion.16 An implication of this view is that the distinction between
the authority-based and the price-based modes of allocation emphasized by
Coase (1937) is superficial. One may perhaps talk about a nexus of contracts
being more ‘firm-like’ when continuity of association among input owners
increases and/or residual claimancy becomes more concentrated, but it is not
in general useful to talk about ‘firms’ as distinctive entities. In reality, they argue,
there is no economic difference between ‘firing’ one’s grocer and firing one’s
secretary.17
Authority and Ownership

One response to the nexus-of-contracts view is that there are in fact fundamental
economic differences between firms and markets, because the law makes an
explicit distinction between market transactions and employment transactions—
a distinction that makes the incentives faced by the parties to the relevant
transactions differ (Masten 1991), and provides an economic role for authority
(Vandenberghe and Siegers 2000). However, the work of Oliver Hart and others
(Grossman and Hart 1986; Hart and Moore 1990; Hart 1995, 1996)—called
the incomplete contracts literature—provides an approach to the understanding
of authority that is not dependent on legal considerations of this kind. In
one important respect this approach differs from all earlier treatments of author-
ity. Whereas Weber, Coase, Barnard, Simon, etc. focus on direct authority over
(non-alienable) human assets, the incomplete-contracts literature, rather, ex-
plains authority over human assets as something that is indirectly acquired
through authority (ownership) over alienable assets. Since reference will be
made to this kind of reasoning later, it is worth examining it briefly.
Contributors to the incomplete-contracts literature distinguish two basic
types of decision rights (‘property rights’): residual rights and specific rights.
The former are generic rights to make decisions in circumstances not spelled out
in the contract, and imply the ability to exclude other agents from deciding on
the use of certain assets. Residual control rights are conferred by legal owner-
ship.18 In contrast, specific rights are allocated through contract terms. If
contracts were complete, all rights would be specific, and there would be no
residual rights. Two kinds of assets are distinguished; namely, alienable (i.e. non-
human) and non-alienable (i.e. human) assets. Given this, the distinction be-
tween an independent contractor and an employee (i.e. between an inter-firm
and an intra-firm transaction) now turns on who owns the non-alienable assets
that an agent (whether independent or employee) utilizes in his work. An
independent contractor owns his tools etc., while an employee does not. The
importance of asset ownership derives from the fact that the willingness of an
agent to undertake a non-contractible investment (say, exertion of effort or
investment in human capital) which is specific to the asset depends on who
owns the asset.
As in Alchian and Demsetz (1972) the parties to a relation—whether cus-
tomer and grocer, or employer and employee—are seen as being in a bargaining
situation, each having an outside option. Although the parties in the specific
models that are analyzed always reach an efficient agreement, the division of the
surplus from the relation will nevertheless depend on who owns the alienable
assets in the relation, since the pattern of ownership will influence the parties’
outside options. For example, if the employer owns all the alienable assets, the
employee can still quit if he dislikes the employer’s orders (as in Alchian and
Demsetz 1972), but he cannot take the assets with him, and the employer can
ensure that if the employee leaves, somebody else can take over the job. Thus, as
Hart (1996: 379) explains, ‘an employer’s authority is represented not by the
ability to force an employee to do what s/he wants, but rather by the ability to
obtain a substantial share of the ex post surplus from the relationship through the
control of non-human assets’. Efficiency considerations then suggest that author-
ity (i.e. ownership of the alienable assets) should be allocated to the agent who
makes the most important (non-contractible) relation-specific investment. Thus,
in an elegant manner, Hart (and his colleagues) link together the issues of the
boundaries of the firm (which are defined in terms of ownership of alienable
assets) and authority.19 However, this only provides an answer to the first of the
four puzzles above. The remaining three are discussed in the next section.
The Knowledge Economy as a Challenge to Authority: Distributed Knowledge

So far, the debate in organizational economics has almost exclusively centered on
the problem of providing explanations of what it is that makes the employer able
to direct the employee and whether this differs fundamentally from market
exchange. In contrast, the knowledge-related questions, made increasingly rele-
vant by the emergence of the knowledge economy, have not been given much
attention. The problem of what happens to the Coase/Simon notion of authority
when agents are better informed than principals about how certain tasks should
be carried out, the principal is ignorant about certain actions that the agent may
take, or agents have considerable bargaining power because of their control over
knowledge assets, is not necessarily one of ‘asymmetric information’, as this is
understood in information economics. In a typical asymmetric-information
problem an uninformed agent knows what he is uninformed about (e.g. the
precise quality of a car). However, this excludes ignorance and how ignorance
may be overcome through processes of discovery (Kirzner 1997; Foss 1999a).
A possible interpretation of the claim that authority relations will be trans-
formed, and perhaps vanish, in the emerging knowledge economy is that these
relations will break down under the impact of principals becoming increasingly
uninformed about the actions open to agents and at the same time becoming
increasingly reliant on the knowledge controlled by agents. These are the char-
acteristics of Hayekian settings.
Hayekian Origins of ‘Distributed Knowledge’

Examining the relation between economic organization and distributed know-
ledge brings us into distinctly Austrian territory. Thus, it is no coincidence that so
many of those who write on economic organization in the emerging knowledge
economy approvingly cite Hayek’s work (e.g. Ghoshal, Moran, and Almeida
1995; Nonaka and Takeuchi 1995; Grant 1996; Cowen and Parker 1997). The
first systematic argument that distributed knowledge represents a challenge to
central planning and direction was in fact developed by Hayek (1935, 1937,
1945) in the context of the inter-war debate on the economic efficiency of
socialism (see Lavoie 1985). In these early works Hayek does not directly criticize
the use of authority as a mechanism of coordination; rather, his critical target is
the notion that benevolent planners can draft complete contingent plans for the
allocation of resources at a societal level, based on all relevant knowledge being
concentrated in the hands of a central planner. Still, it is easy to see that Hayek’s
argument represents a challenge to authority in the sense of Simon and Coase.
Consider his famous characterization of the economic problem (1945: 77–8):
The economic problem of society is [ . . . ] not merely a problem of how to allocate ‘given’
resources—if ‘given’ is taken to mean given to a single mind which deliberately solves the
problem set by these ‘data’. It is rather a problem of how to secure the best use of resources
known to any of the members of society, for ends whose relative importance only these
individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge
which is not given to anyone in its totality.
As the dating of the Hayek paper suggests, the problem of making optimal use of
distributed (or ‘dispersed’) knowledge is, of course, not a novel one, only brought
about by the emergence of the knowledge economy; rather, any complex social
system confronts it (Hayek 1964). As Hayek later observes, it is only in the ‘most
simple kind of organization [that] it is conceivable that all the details of all
activities are governed by a single mind’ (Hayek 1973: 49).
Along these lines, what proponents of the position that economic organiza-
tion is undergoing a radical transformation as a result of the emergence of the
knowledge economy implicitly assert is that problems posed by Hayekian dis-
tributed knowledge have become increasingly pressing for firms (cf. Cowen and
Parker 1997). Thus, because of the increased importance of specialist workers,
the increased knowledge-intensity of production, and the increasing need to
combine knowledge from multiple, diverse sources (Coombs and Metcalfe
2000), coping with the issue raised by Hayekian distributed knowledge has
moved from being a problem for socialist planners to also being a problem
confronted by managers of firms in capitalist economies. However, before the
nature of this argument can be assessed, a more accurate characterization of
distributed knowledge is required.
Distributed Knowledge
During the last decade the notion of distributed knowledge has been used with
increasing frequency as an apt description of the knowledge conditions in which
modern firms, the argument goes, increasingly find themselves.20 Thus, in
the strategy field Tsoukas (1996) conceptualized the firm as a distributed know-
ledge system, and Granstrand, Patel, and Pavitt (1997) documented the increas-
ing extent to which the knowledge bases controlled by major technology-
intensive corporations are distributed. Lessard and Zaheer (1996) discussed the
implications of distributed knowledge for decision-making, Hutchins (1995)
and Gherardi (1999) discussed its implications for organizational learning, while
Cohen and Regan (1996) applied the notion to technology management, Foss
(1999a) discussed its implications for the modern economics of organization,
and Larsen (2001) applied it to knowledge-intensive service firms.
Apparently, the notion rings a bell in a number of diverse contexts. But what
does it mean to say that knowledge is distributed? Unfortunately, the above
contributions are not entirely forthcoming with respect to precise definitions
of this concept. The same critique may actually be directed against the
Austrian literature. While suggestive, the famous passages from Hayek (1945)
hardly qualify as definitions of the notion of distributed knowledge. Moreover,
it is not clear whether Austrian dispersed knowledge is identical to distributed
knowledge. Below, I attempt to go somewhat further in the direction of
definition.
Distributed knowledge is a member of a set of concepts that relate to the
different ways in which knowledge may ‘belong’ to a group of agents. Two other
examples of this kind of concept are the game-theory notions of ‘common
knowledge’ and ‘shared knowledge’. An event is common knowledge among a
group of players if each player knows it, each one knows that the other players
know it, each player knows that other players know that the other players know
it, and so on (Aumann 1976).21 Shared knowledge differs from common
knowledge by not requiring that each agent knows that the other agents know,
etc. Thus, there is shared knowledge of a fact if each agent knows this fact, but
does not know that the other agents know it.
If common knowledge lies at one end of the spectrum, distributed knowledge
lies at the other end. Loosely, knowledge is distributed when a set of agents knows
something no single agent (completely) knows. Thus, the notions that firms
(Tsoukas 1996) or whole economies (Hayek 1945, 1973) are distributed
knowledge systems mean that the set of agents comprising these entities collect-
ively possesses knowledge that no single agent possesses. In this sense, distributed
knowledge has the same characteristics as dispersed ‘knowledge in society’ as
discussed by Hayek (1945). Note that this does not amount to asserting the
existence of mysterious supra-individual ‘collective minds’. Knowledge still
ultimately resides in the heads of individuals; however, when this knowledge is
combined and ‘aggregated’ in certain ways it means that, considered as a system,
a set of agents possesses knowledge that they do not possess if separated. On the
basis of epistemic logic (Hintikka 1962) distributed knowledge may be defined
as follows:
Definition—Distributed Knowledge: If Ki pi means that agent i knows prop-
osition i, a set of n agents has distributed knowledge of a proposition q (i.e. Dq)
when: K1 p1 ^ K2 p2 ^ . . . ^ Kn pn ) Dq, q 6¼ pi , 8i.22
For example, Jack knows that p is the case and Jill knows that p implies y, but
neither know that y is the case. However, if Jack and Jill’s information states are
‘added’ there is a sense, which is more than metaphorical, in which they may
know that y is the case (Gerbrandy 1998: 53). The information that y is the case
is present in the system comprising Jack and Jill, but in a distributed form.
The above definition is open to some interpretation. At one extreme, Jack and
Jill may both be completely ignorant about the knowledge controlled by the
other party. Sometimes such an interpretation consists of the ‘competitive-
equilibrium’ model in economics: Although knowledge of technologies and
preferences is private, all this knowledge is utilized in the best possible way, so
that the knowledge of how to bring about an allocation of resources with superior
welfare properties is distributed in the economy. At the other extreme there is
considerable, but not complete,23 knowledge overlap (pi may be close in some
sense to pj ), but it is still the case that no single agent knows q. Between the
extremes are different degrees of overlap between individual knowledge elements.
Changing Distributed Knowledge

Many writers argue that distributed-knowledge conditions have become increas-
ingly important in modern competitive conditions, as firms to a greater extent
need to access an expanding set of external knowledge sources (Arora and
Gambardella 1994; Coombs and Metcalfe 2000; Smith 2000), and increasingly
need to rely on specialist knowledge controlled and accumulated by specialist
employees (Miles et al. 1997). There is nothing new per se in the notion that
knowledge for productive purposes may be distributed; indeed, it is a necessary
consequence of the division of labor and bounded rationality (Hayek 1945, 1973;
March and Simon 1958; Arora and Gambardella 1994). Rather, what is being
asserted by a number of authors seems to be that there are significant discontinu-
ities in the evolution of distributed knowledge, so that the distributed character of
knowledge has strongly increased during the last decades. Thus, Granstrand, Patel,
and Pavitt (1997) document the significantly increasing extent to which firms
organize in-house distributed technological knowledge, drawn from a growing
number of underlying technological disciplines. Wang and Tunzelman (2000)
emphasize that not only is the number of disciplines that firms draw on expand-
ing, it is also the case that these disciplines themselves evolve in terms of their
depth and specialization; firms’ sourcing of technological knowledge reflects this.
These observations and the above definition help us better to understand what
it means to argue that ‘knowledge is becoming more distributed’. Thus, we may
say that knowledge becomes more distributed when
1. n (i.e. the number of agents and propositions/knowledge elements) increases
(cf. Granstrand, Patel, and Pavitt 1997); and/or
2. The overlap between individual knowledge elements is reduced. Knowledge
overlap may be reduced for two principal reasons:
(a) One (or more) knowledge element that was known by j (# n) agents is
now only known by h (< j) agents. Thus, forgetfulness in this sense makes
knowledge more distributed. Changing from a state with less division of
labor to one with more may exemplify this, because each agent needs to
control less different knowledge under more division of labor; and/or
(b) Knowledge elements/propositions become more heterogeneous (cf. Wang
and Tunzelman 2000). For example, whereas in an initial period a firm
draws all its production-knowledge elements from the engineering dis-
cipline, in a later period it adds knowledge elements drawn from the
discipline of organic chemistry.
Handling Distributed Knowledge

A well-known Hayekian point is that a market system (but not a socialist one)
promotes a tendency towards allocating property rights to those who can make
best use of them; a system with alienable property rights solves simultaneously
both the assignment and the moral-hazard problem. However, firms solve these
problems differently. Thus, within firms resources are directed (to a larger extent
than in markets), and motivation of employees is engineered (to a larger
extent than in markets). From a Hayekian perspective, firms would seem to be
inherently disadvantaged relative to markets, for firms encounter a fundamental
problem that markets do not; namely, ‘the problem which any attempt to bring
order into complex human activities meets: the organizer must wish the individ-
uals who are to cooperate to make use of knowledge that he himself does not
possess’ (Hayek 1973: 49). In order to cope with the problem, designed orders,
such as firms, must adopt some of the organizing principles of spontaneous
orders; notably, the reliance on rules:
every organization must rely also on rules and not only on specific commands. The reason
here is the same as that which makes it necessary for a spontaneous order to rely solely on
rules: namely that by guiding the actions of individuals by rules rather than specific
commands it is possible to make use of knowledge which nobody possesses as a whole
(ibid. 48–9).
Such rules are ‘rules for the performance of assigned tasks’. They are therefore
‘necessarily subsidiary to commands’ (ibid. 49).
Thus, Hayek does not deny that in practice the problem of making use of
distributed knowledge can be solved by firms, and that authority, the central
characteristic of firm organization, is consistent with distributed knowledge.
However, observe also that Hayek does not explain how the problem is solved:
If knowledge inside the firm is indeed distributed, how can management choose
good ‘rules for the performance of assigned tasks’? How are employees assigned
to tasks and how are standards for performance chosen when these actions are
partly dependent on knowledge that management does not itself hold?
An obvious way to handle the problem is to suppress distributed knowledge as
far as possible by discouraging local initiative, indoctrinating employees harshly,
and operating with rigid routines and operating procedures. The archetypal
‘machine bureaucracy’ fits this overall characterization. However, to the extent
that competition is increasingly knowledge-based, this is a self-defeating strategy,
because suppressing distributed knowledge in this way also implies that beneficial
explorative and innovative efforts are suppressed. Therefore, an often more
attractive way to handle the presence of distributed knowledge inside is to
delegate decision rights (cf. Hayek 1945: 83–4; Galbraith 1974: 31–4; Jensen
and Meckling 1992), balancing the resulting agency costs against the benefits
from improved use of distributed knowledge. An interpretation of internal
hybrids, such as team organization, ‘molecular forms’, and the like, is that
these manifest attempts to delegate decision rights and structure reward schemes
so that such optimal trade-offs are reached (Jensen and Wruck 1994; Zenger and
Hesterly 1997; Foss and Foss 2002; Zenger 2002). However, this still does not
resolve the issue of how management can rationally decide on delegation, install
rules, etc. in the face of distributed knowledge. Such decisions, too, are acts of
authority, and would therefore seem to be challenged by distributed knowledge.
This is discussed further below.
Narrow and Broad Notions of Authority

Although there is mounting evidence that the employment relation is undergo-
ing significant changes, we do not observe anything amounting to a complete
breakdown of authority relations. One reason is the possibility of benefits of firm
organization that offset the knowledge-related inefficiencies of authority. An-
other reason is the simple one that there is a large distance between the real
phenomenon of authority and the usual way in which economists think of
authority. In fact, both those who have criticized authority for being an increas-
ingly inefficient coordination mechanism in the emerging knowledge economy
and organizational economists may be criticized for working with a too narrow
understanding of what authority is and can accomplish. For example, a repre-
sentative of the first group, Grandori (1997: 35), argues that
whatever its basis, authority is a feasible governance mechanism only if information and
competence relevant to solving economic action problems can be transferred to and
handled by a single actor, a positive ‘zone of acceptance’ exists, the actions of other
supervised actors are observable, and if the system is not as large as to incur an over-
whelming communication channel overload and control losses
This critique seems to be directed at the Coase-Simon view of authority, and is, as
such, a valid criticism. The Coase-Simon view is too narrow, because it implies
that the boss performs a detailed direction of the worker’s actions, based on a
complete knowledge of the worker’s action set, and because it implicitly asserts
that the boss is always at least as, or more, knowledgeable about what actions
should optimally be carried out. To the extent that authority is understood only
in this narrow sense, it is not difficult to argue that indeed authority will become
increasingly inefficient and therefore increasingly less prevalent as a coordination
mechanism (i.e. Proposition 1).
However, as Simon (1991: 31) himself pointed out four decades after his initial
paper on authority, ‘[a]uthority in organizations is not used exclusively, or even
mainly, to command specific actions’. Instead, he explains, it is a command that
takes the form of a result to be produced, a principle to be applied, or goal
constraints, so that ‘[o]nly the end goal has been supplied by the command, and
not the method of reaching it’. This notion of authority as commanding some-
body to work towards a specified goal, for example backed up by some superior
bargaining power, is entirely consistent with Assumptions 1 and 2. Although an
employer may be ignorant of the efficient action, and perhaps of most of the
employee’s possible action, he can always tell him to ‘Do something to fix it!’
This suggests the more general implication that some overlap of knowledge
may be sufficient to make coordination by means of authority work in the
presence of distributed knowledge. In particular, note that it is not in conflict
with the notion of distributed knowledge (at least as defined earlier) that some
agent possesses the knowledge that—in terms of the earlier example—if Jack and
Jill’s knowledge sets are somehow aggregated, this will result in their having, as a
‘system’, a knowledge that none of them possesses individually. This agent does
not need to know that Jack knows that p is the case and Jill knows that p implies
y. However, she does need to know that there is a set P of which p is a member
and that these elements map to certain outcomes Y of which y is a member. Thus,
though she may still be ignorant in an important sense about the knowledge
controlled by Jack and Jill, she does not suffer from complete ignorance;24 there
is some, possibly rather modest, knowledge overlap. She may therefore be able to
pass judgment on the overall abilities of Jack and Jill, and, in particular, on how
actions based on Jack and Jill’s knowledge may be coordinated. In other words, it
is possible to have knowledge of interdependencies between actions based on
different knowledge elements without possessing much knowledge of these
elements themselves.
In his pioneer contribution Frank Knight (1921) made it clear that the
effective exercise of authority does not require full knowledge of an employee’s
action set and precise knowledge of exactly which action should be picked in
response to contingencies: ‘What we call ‘‘control’’ consists mainly of selecting
someone else to do the ‘‘controlling.’’ Business judgment is chiefly judgment of
men. We know things by knowledge of men who know them and control things
in the same indirect way’ (ibid. 291).25 These principles also apply to hierarchical
organization, which Knight conceptualizes as layers of agents exercising judg-
ment of subordinates’ judgment and other capabilities (particularly ibid. 291–7).
Delegation, Knight argues, rests on judgment. Such judgment does not require
that that the principal know the agent’s entire action set.26 Thus, when Hayek
(1973) argues that authority in the sense of the delegation of decision rights, the
imposition of rules on the organization, the checking of whether actions are in
conformity with the rules, etc. is consistent with distributed knowledge condi-
tions, this can be explained by invoking management judgment of subordinates.
This suggests that authority in the sense of direction and centralized decision-
making—which does not necessarily require detailed knowledge about a subor-
dinate’s knowledge or available actions—may persist in Hayekian settings, in-
cluding the emerging knowledge economy. Thus, authority may be based on
judgment rather than perfect knowledge. Below, I discuss this further. To make it
more concrete, situations involving distributed knowledge are approximated by
‘hidden knowledge’ (Minkler 1993) in principal–agent relations. That is, it will
be assumed that the problem facing a principal is not just that she is uninformed
about what state of nature has been revealed or of the realization of the agent’s
effort (i.e. hidden information), as in the standard agency paradigm. Rather, the
agent’s knowledge is superior to that of the principal with respect to certain
production possibilities (i.e. hidden knowledge). The principal may be ignorant
about some members of the set of possible actions open to the agent, or the agent
may be better informed than the employer with respect to how certain tasks
should (optimally) be carried out, or both. Given this, the issue is whether in
these situations it is possible, under hidden knowledge, to make sense of this
notion of authority on grounds of efficiency. It turns out that it is indeed possible
to explain the presence of authority in such a setting. The key factors that will be
considered in the following are (1) the urgency of decisions, (2) decisive know-
ledge, and (3) monitoring, incentives, and externalities. However, coping with
distributed knowledge inevitably seems to lead in the direction of decentraliza-
tion, as Hayek (1945: 83–4) forcefully argued:
If we can agree that the economic problem of society is mainly one of rapid adaptation
to changes in the particular circumstances of time and place, it would seem to follow that
the ultimate decisions must be left to the people who are familiar with these circumstan-
ces, who know directly of the relevant changes and of the resources immediately available
to meet them. We cannot expect that this problem will be solved by first communicating
all this knowledge to a central board which, after integrating all knowledge, issues its
orders.
Coping with distributed knowledge would thus seem to require extensive dele-
gation of rights. In fact, there is an argument that under Hayekian distributed
knowledge de facto delegation of rights already obtains. Therefore, the formal
right to decide need not confer effective control over decisions, as Aghion and
Tirole (1997) point out, with a bow to Max Weber. Thus, real authority is
already largely determined by the structure of information in the organization,
including the distribution of Hayekian dispersed knowledge. Of course, agents
who possess local knowledge may be subject to the exercise of authority by
uninformed hierarchical superiors, but this is likely to harm incentives.27 Thus,
in Aghion and Tirole (1997) an increase in the agent’s real authority is assumed
to lead to control losses from the point of view of the principal but also to
promote initiative; efficient organization produces value-maximizing trade-off. It
is apparent that Hayekian distributed knowledge has important implications for
understanding internal organization, such as the adoption of internal hybrids in
the form of project- or team-based organization, ‘molecular forms’, ‘cellular
organizations’, etc.28
However, while a Hayekian perspective is informative for understanding
internal hybrids, it does not answer the question of why such hybrids are at all
organized inside firms. Because they are organized inside firms, they are subject to
the exercise of, at least formal, authority. Being overruled by formal hierarchical
superiors may harm motivation. Thus, moving teams out of firms would seem to
yield net benefits, since incentives would be strengthened.29 In fact, spin-offs,
carve-outs, and the like may be explained in these terms, so we should ask why
not all internal hybrids are spun off.
A further issue is that the ownership-based notion of authority developed by
Hart also seems to play only a limited role under Hayekian distributed know-
ledge. There are several reasons for this. First, in Hart’s framework all residual
decision-making power is concentrated in the hands of the owner/manager,
whereas in actuality delegation often amounts to delegating at least some residual
decision rights to hierarchical subordinates (e.g. division managers). Implicitly,
the notion that, on the one hand, there are rights that may be clearly specified in
a contract and allocated to another party, and that, on the other hand, there are
rights that cannot be specified at all in a contract but can only be allocated to a
single party through asset ownership means that the only room left for delegation
is that agents receive well-specified rights to carry out well-specified actions.
However, this implies that if agents can take actions about which principals have
no knowledge, or are better informed about how certain actions should be carried
out, the superior knowledge of agents cannot be utilized.
A second reason why Hartian ownership-based authority may be increasingly
irrelevant under Hayekian distributed knowledge is that the assets that in Hart’s
scheme confer authority are primarily physical assets (Hart 1995). However, as
many writers have emphasized, an important aspect of the knowledge economy is
exactly that physical assets are of fast-waning importance (Myers 1996; Boisot
1998; Neef 1998). Of course, the implication is that ownership over such assets is
an increasingly ineffective source of bargaining power and that, therefore, au-
thority must wane as bargaining power increasingly becomes more symmetrically
distributed over the owners of knowledge assets. The following section discusses
this in greater detail.
Authority When Knowledge is Distributed

Authority in the Presence of Hidden Knowledge
This section further examines the role of authority, understood in the broad sense
of direction, in a Hayekian setting of distributed knowledge. Distributed know-
ledge is here approximated by ‘hidden knowledge’ (Minkler 1993) in principal–
agent relations. That is, it will be assumed that the problem facing a principal is
not just that she is uninformed about what state of nature has been revealed or of
the realization of the agent’s effort (i.e. hidden information), as in the standard
agency paradigm. Rather, the agent’s knowledge is superior to that of the
principal with respect to certain production possibilities (i.e. hidden knowledge).
The principal may be ignorant about some members of the set of possible actions
open to the agent, or the agent may be better informed than the employer with
respect to how certain tasks should (optimally) be carried out, or both. The
setting is one of incomplete contracts, so authority refers to the giving of
direction in situations about which contracts are silent. Given this, the issue is
whether it is possible, under hidden knowledge, to make sense of authority in the
sense of direction on grounds of efficiency. It turns out that it is indeed possible
to explain the presence of authority in such a setting. The key variables are (1) the
urgency of decisions and, what is often the other side of the coin, the wish to
avoid duplicative effort (Bolton and Farrell 1990), (2) decisive information
(Casson 1994), (3) economies of scale in decision-making (Demsetz 1991;
Hermalin 1998), and (4) the setting of incentives and the curbing of externalities
(Holmström 1999). These are discussed below.
Urgency and Duplication Avoidance

While Hayek (1945) did much to identify the benefits of the price with respect to
coping with the problems introduced by distributed knowledge and unexpected
disturbances, he arguably neglected those situations where efficiency requires that
adaptation be ‘coordinated’ rather than ‘autonomous’ (Williamson 1996a).
Coordinated adaptation or action may be required when actions or activities
are complementary (Milgrom and Roberts 1992; Foss 2001). Coordination
problems are examples of this. In game theoretic parlance, these problems obtain
when there is more than one equilibrium in pure strategies. Examples are
Schelling’s famous where-to-meet problems (Schelling 1960) or the choice of
standards, such as which side of the road to drive on. Game theory demonstrates
that even in extremely stylized and simple, but still decentralized, settings with
players possessing perfect reasoning capabilities and common knowledge, they
may still be unable to coordinate their independently taken actions or only
coordinate these after costly trials and errors. Authority may be a least-cost
response to such problems (cf. Ch.9).
In order to determine the costs and benefits of centralized and decentralized
decision-making in a specific context, Bolton and Farrell (1990) study a coord-
ination problem with private information in the setting of a natural-monopoly
market. The coordination problem concerns who should enter the market
when costs are sunk and are private information. Under decentralization,
which is represented as a two-period incomplete-information game of timing
(sink costs/enter or wait another period), each firm is uncertain about whether
the other firm will enter. However, the incentive to enter depends on the height
of a given firm’s cost—low-cost firms being less worried that their rival will
enter (and vice versa). If costs are sufficiently dispersed, the optimal outcome
prevails; that is, the lowest-cost producer enters and preempts the rival(s).
However, if costs are equal or are high for both, inefficiencies may obtain,
since firms will then enter simultaneously (inefficient duplication) or will wait
(inefficient delay).
Enter a central authority whose job is to nominate a firm for entry. In the
spirit of Hayek, Bolton and Farrell assume that this central authority cannot
possess knowledge about costs. In their model, s/he nominates the high-
cost producer half of the times, which is clearly inefficient. However, this
cost of centralization should be compared with the costs of decentralization
(delay and duplication). Bolton and Farrell show that ‘the less important
the private information that the planner lacks and the more essential coordin-
ation is, the more attractive the central planning solution is’ (1990: 805).
Moreover, the decentralized solution performs poorly if urgency is important.
Centralization is assumed not to involve delay and therefore is a good mechanism
for dealing with emergencies, a conclusion they argue is consistent with
the observed tendencies of firms to rely on centralized authority in cases of
emergency.30
The inefficiencies under decentralization (duplication, delay) that Bolton and
Farrell point to may arguably be particularly relevant for much ‘knowledge-
intensive’ production. This is because much of this production is ‘pooled’ rather
than ‘sequential’ or ‘reciprocal’, in the terminology of Thompson (1967); that is,
involves relatively decentralized efforts aimed at a common end. Research-based
organizations where much production takes place in decentralized project groups
may be an example. A centralized authority may be necessary to give priority to
certain projects rather than others, even though that authority is basically very ill
informed about the projects.
Decisive Information
Even under distributed knowledge, where the centralized decision-maker by
definition does not possess (at least some) local information, s/he may in many
cases still hold the information that is decisive. Intuitively, information is decisive
when actions taken on the basis of such knowledge impact strongly on the firm’s
pay-offs. According to Casson (1994), the extent to which a productive task
involving the knowledge of several individuals has decisiveness features and the
cost at which knowledge can be communicated help to explain the allocation of
decision rights. For example, if supply conditions (changing technologies and/or
input prices) are more volatile than demand conditions (changing sales and/or
tastes), it may pay to investigate supply before investigating demand. In fact, if
supply volatility is considerably higher, it may be evident what the firm should do
in terms of its output and pricing decisions without checking demand condi-
tions. In both cases, information about supply is decisive (and more so in the
latter case). Note that decisiveness in the examples suggests that decision rights
should be allocated towards the production side of the firm. The more general
principle is that decision rights will tend to be concentrated in the hands of the
individual who has access to the decisive information, and particularly so the
more costly it is to communicate this information.
This means that there may be a role for authority under hidden knowledge;
namely, when the latter is not decisive, it is costly to communicate the knowledge
that is decisive, and the consequences of an incorrect decision are expected to be
small relative to the costs of communicating the knowledge. In contrast, exten-
sive information-sharing is only necessary if each party holds information which
is highly likely to be decisive or if the costs of not making the correct decision if
lacking some of the tacit information are high. In that case, knowledge transfer
and delegation of decision rights are likely to characterize the organization.
Economies of Scale
Demsetz (1991) argues that economies of scale in managing are a neglected
factor in the explanation of the existence of firms and the understanding of
authority, but doesn’t spell out the underlying reasoning. However, the relevant
economies may relate both to managing the relations between agents inside the
firm and managing relations to outside agents (customers, suppliers, government
agencies) (Hermalin 1998). Not only may there be scale economies in such
activities; there may also be substantial learning economies. Other agents may be
happy to let a central agent incur the effort costs of negotiating, learning about
potential suppliers, etc., and compensate him accordingly. At first glance, this
only explains why a team may hire a ‘consultant’; it does not explain why this
consultant should have any authority (Foss 1996). However, as will be argued
later, it may pay to give the consultant authority to the extent that he risks being
held up by the other agents to whom he specializes his human capital. Giving the
‘consultant’ authority is tantamount to giving him ownership of the firm’s
alienable assets.
Setting Incentives and Curbing Externalities

As pointed out earlier, Hayekian distributed knowledge poses special problems
for the use of monitoring mechanisms and incentive pay, as these are discussed
in the mainstream agency literature (e.g. Holmström 1979) (Minkler 1993;
Aghion and Tirole 1997; Foss 1999a; Foss and Foss 2000b). Minkler (1993:
23) argues that ‘if the worker knows more than the entrepreneur, it is pointless
for the entrepreneur to monitor the worker’, which implies that to the extent that
monitoring is a precondition for the exercise of direction, using the authority
mechanism also seems to become ‘pointless’. In the extreme case both the agent’s
type and actions may be fully observable by the principal but the latter may still
not understand the full set of production possibilities open to the agent (all in
contrast to the standard agency paradigm). Clearly, in that extreme case the
problem is to design a contract that (1) allows the agent to use his superior
knowledge ex post, and (2) gives him the incentive to do so efficiently. This will
typically amount to allocating decision rights as well as rights to residual income
streams to the agent, which indeed are key features of many new organizational
forms.31
However, even under hidden knowledge there may still be a role for authority
(as suggested in connection with the discussion of distributed knowledge
earlier in this chapter). For example, Foss and Foss (2002b) construct a hid-
den-knowledge model in which the principal can, nonetheless, form conjectures
of the pay-offs that result from the agent’s activities (even though the principal
cannot observe and fully understand these activities). The pay-offs are assumed to
be related in a simple manner to the amount of discretion that is left to the agent.
It can then be shown that the surplus from the relation may be maximized by
choosing degrees of discretion that differ from those the agent would have
preferred if he were completely on his own. The power to choose these levels
of discretion (i.e. the exact delegation of decision rights) stems from the princi-
pal’s ownership of the assets in the relation.
More broadly, the ability of a principal to form conjectures with respect to an
agent’s output even under hidden knowledge—what was earlier by Knight
(1921) called ‘judgment’—and enter into formal or informal contracts over
this, implies that limited notions of monitoring and incentive pay may still
have a role to play. For example, so-called ‘forcing contracts’, in which, for
example, a bonus is paid only if a certain threshold of output is reached, may
work under hidden knowledge. Subjective forms of performance assessment may
be workable to the extent that the principal can form estimates of the level of
output that can ‘reasonably’ be expected of the agent.32 Even softer forms of
incentive instruments—such as norms and the provision of intrinsic motiv-
ation—are arguably particularly important under hidden knowledge (see Jensen
and Wruck 1994; Osterloh and Frey 2000).
In a somewhat speculative vein, it may be argued that the greater the departure
from very simple settings where employees, undertaking routinized tasks, are
very easily monitored, and the harder we make it to find out what the employee
can deliver and actually delivers, the more likely it is that an employer will
choose to rely on multiple-incentive instruments to influence employee behavior
(Henderson 2000). Under these circumstances, a key managerial task is to
‘balance’ incentive instruments (Holmström 1999); that is, design and maintain
coherence between the various ways in which an employee may be motivated so
that negative spillover effects between these ways are minimized.33 In a dynamic
economy, maintaining coherence between such instruments may be a recurrent
task. Economies of scale in this task may dictate that this activity is centralized.
Moreover, centralization is required to the extent that externalities arise when the
instruments are controlled by separate firms and transaction costs hinder the
internalization of these externalities. Both arguments point towards the central-
ization of decision rights.
Summing Up
It has been argued that it is possible to give efficiency explanations of authority in
the sense of direction and centralized decision-making in the context of Hay-
ekian settings.34 Thus, a response has been provided to Proposition 3 (‘In the
emerging knowledge economy, authority relations will become increasingly
inefficient and insignificant means of allocating resources’). This is not to say
that authority relations, and the allocation of decision rights in firms in general,
will be unaffected by the increased reliance on specialist knowledge (i.e. by
Propositions 1 and 2 becoming increasingly descriptively correct). The growing
prevalence of internal hybrids that go beyond traditional hierarchies (Zenger
and Hesterly 1997) may very well be caused by the increased importance
of Hayekian distributed knowledge. Still, internal hybrids are organized inside
the firm and are thus subject to the exercise of authority. Therefore, even if
the hierarchy becomes flatter because of the existence of cellular organizations,
authority persists.35 A reason for this is that even in knowledge-based firms
there may be a need for centralized coordination, as we have seen. When there
is such a need, it is often efficient to centralize ownership to alienable assets,
as the following section demonstrates. In turn, this suggests that centralized
coordination is a feature of firms rather than markets. In other words, it will be
argued that the presence of Hayekian settings does not invalidate the notion of
the boundaries of the firm, even when these are conceptualized in legal and
ownership-based terms.
Ownership and Firm Boundaries in Hayekian Settings

Ownership and Assets in the Knowledge Economy
The previous section did not say much about what backs up authority. However,
we know from Hart (1995) and other economists of organization that ownership
may play a key role in this respect; the purpose of this section is to go further into
ownership issues—particularly the ownership of knowledge assets—and there-
fore the issue of the boundaries of the firm. One of the key characteristics of the
knowledge economy is usually taken to be the increased importance in produc-
tion of knowledge assets and the decreasing importance of physical assets (Boisot
1998). A further argument is that this transformation will also transform eco-
nomic organization, because knowledge assets have different implications for the
boundaries of firms than physical assets (e.g. Powell 1990; Zucker 1991; Kogut
and Zander 1992; Boisot 1998).36
The category of ‘knowledge assets’ is a broad one—encompassing individually
held tacit knowledge, firm-level capabilities (‘organizational knowledge’), pa-
tents, client lists, etc.—and difficult to frame analytically.37 Perhaps for this
reason, there are different—albeit all somewhat underdeveloped—modeling
strategies available. One such strategy is to stress problems of appropriability as
a key determinant of the boundaries of the firm (Teece 1987; Liebeskind 1997).
In this scheme the boundaries of the firm reflect attempts to maximize the rent
streams from the firm’s valuable knowledge assets (rather than the hold-up
problem). A second one is to stress that many knowledge assets are collective
or public goods (e.g. capabilities or reputational assets) and that this creates free-
rider problems, bringing about a need to delimit access to such goods (Holm-
ström and Roberts 1998). A third strategy is to argue that knowledge assets in the
form of differential capabilities give rise to communication costs, and attempts to
economize with such costs help determine the boundaries of the firm (Langlois
1992; Monteverde 1995). A fourth possibility is to rely on more standard
transaction cost economics and incomplete contracts theory arguments about
the need to protect specialized assets and investments specific to such assets from
rent-capture attempts (Rabin 1993; Brynjolfsson et al. 1994; Putterman 1995).
Since the latter strategy is the one that most obviously connects to the theme of
authority that has been pursued in so much of this chapter, I briefly discuss this
approach.
An Incomplete Contracts Approach to Knowledge Assets and the Boundaries

of the Firm
Following Brynjolfsson et al. (1994), use will be made of the incomplete
contracts modeling methodology of Hart and Moore (1990) to get an under-
standing of the implications of knowledge assets for the boundaries of the firm.
This is a key issue, because asset ownership may provide the bargaining lever that
backs up authority, and the concentration of decision rights that we call authority
may have important efficiency implications, as already argued. Thus, this section
connects the discussion of authority in a knowledge economy with the issue of
the boundaries of the firm in such an economy. The emphasis is on supporting
the claim made earlier that when there is a need for centralized coordination,
efficiency considerations often suggest a need also to concentrate asset ownership
(Hermalin 1999; Holmström 1999).
The primary required change in the basic Hart and Moore framework is a
more explicit introduction of knowledge assets (which may be alienable or non-
alienable). In fact, we can dispense entirely with physical assets, and discuss a
purely knowledge-based firm.38 It is assumed that agents enter into productive
relations with other agents but that synergies between agents occur only through
the assets that they control (and not through the actions they take). Furthermore,
although assets may influence the value of actions, the reverse is not true
(Brynjolfsson et al. 1994: 433). This means that we can write the cost of agent
i’s action as c(xi ) and the marginal value of i’s actions when he is in a productive
relation with other agents simply as vi (A), where A is the set of all assets owned by
agents (and their actions can be suppressed).39
For simplicity, assume that two agents interact and that one of these, the
‘entrepreneur’, owns a knowledge asset, K, that is ‘inside his head’ (e.g. an
entrepreneurial idea) and the other agent, the ‘scientist’, owns the only other
asset in the relation, P, which we may assume to be a ‘patent’. Both assets are
necessary to create value in the relation, and K and P are (strictly) complemen-
tary, so that the one is of zero value without the other. It is prohibitively costly to
communicate the knowledge embodied in K from the entrepreneur to the
scientist, so K is effectively non-alienable, although the services of K may of
course be traded. Moreover, it is not possible to write a comprehensive contract
governing the use of the assets in all contingencies. Given this, we may ask who
should own the alienable asset P; which—in terms of the Hart and Moore (1990)
analysis—is tantamount to asking who should own the firm.
In this setting, if the entrepreneur makes an effort investment, xe , that is
elaborates on his idea and creates extra value, the scientist can effect a hold-up on
the entrepreneur, since the latter needs access to the patent to create value (and
the contract is incomplete). Of course, the reverse also holds, so that if the
scientist makes an effort investment, xs , (e.g. makes a spin-off patent), the
entrepreneur can hold up the scientist by threatening to withdraw from the
relation. Under the standard assumption of Nash bargaining, the entrepreneur
and the scientist each realizes half of the extra value created as a result of their
efforts. Because of the externality problem, each underinvests; specifically, each
party invests to the point where the marginal cost of effort investment equals half
of the marginal value.40 Suppose instead that the entrepreneur owns both the
patent and the entrepreneurial idea. This will strengthen the entrepreneur’s
incentives (the scientist cannot hold him up any more) and it will leave the
scientist’s incentives unaffected.41 Obviously, this ownership arrangement should
be chosen.42
A conclusion at this stage is that it is possible to speak of the boundaries of
the firm in terms of ownership (and therefore also in legal terms)—even in
a situation where all assets are knowledge assets.43 However, this does not
yet demonstrate the point made earlier; namely, that concentration of coordin-
ation tasks produces a need for concentration of ownership. We can address
this issue, however, by assuming that one of the agents has decisive information
(in the sense of Casson 1994). While efficiency may require that this
agent should have decision rights amounting to authority, should he also be an
owner?
Consider a ‘knowledge-based’ group of scientists in which each scientist owns
a patent, Pi . One of the scientists possesses decisive knowledge, C, and the other
scientists communicate directly with him rather than with each other.44 For
example, this agent aggregates information from the messages of the other agents
and issues directives. His knowledge is decisive in the sense that without it all
actions of the other agents produce zero value. The coordinator may improve on
this decisive knowledge. Each agent needs access to his own patent and to C in
order to be productive. Given this assumption (which means that we need only
consider relations between any agent and the coordinator), we have the by now
familiar underinvestment problem for both the coordinator and the scientists.45
If the coordinator is given ownership to all patents things change. While the
incentives of the scientists are not affected,46 the incentives of the coordinator to
invest in augmenting his decisive coordination knowledge are strengthened.
Thus, this ownership arrangement should be chosen.
Summing Up
Although the framework that has been applied in this section is extremely stylized
and in many ways quite limited (Holmström 1999; Foss and Foss 2001), it does
succeed in providing an answer to Proposition 4 in Section II that ‘[t]he
boundaries of firms blur because of the increasing importance of knowledge
networks that transcend those boundaries. Thus, while legal and ownership-
based definitions of the boundaries of the firm may formally be made, they will
be increasingly irrelevant from an economic (and strategic) perspective’. The
analysis shows, first, that it makes perfect sense to address ownership issues in
terms of knowledge assets, and, second, that ownership of such assets may be
important in situations where agents need to be provided with incentives (and
where contracts are incomplete). Therefore, ownership-based (and therefore
also legal) definitions of the boundaries of the firm will continue to be
crucially important. The discussion ties together the notions of authority and
ownership in the context of knowledge-based production. As will be argued
in the following section, this has implications for the malleability of coordination
mechanisms; for example, the extent to which market mechanisms can be
introduced in firms.
Coordination Mechanisms in Hayekian Settings

The Malleability and Combinability of Coordination Mechanisms
The dominant perspective in much of organization theory and organizational
economics has been that there are stable, discrete governance structures that
combine various coordination mechanisms in predictable ways. The specific
combinations are typically seen as dependent upon the underlying technology,
characteristics of the environment, such as exchange conditions, and the strategy
of the firm (Thompson 1967; Williamson 1985, 1996a; Holmström and
Milgrom 1994; Nickerson and Zenger 2002).
In contrast to this, it has been argued that there are no compelling reasons why
specific coordination mechanisms should necessarily cluster in a few ideal-typical
governance structures of the ‘firm-hybrid-market’ variety (see Grandori
1997, 2000). In particular, advances in networked computing, management-
information systems, and methods of measuring performance have made pos-
sible a richer set of combinations of coordination mechanisms. ‘Cellular’ or
‘molecular’ forms are examples. The fact that these forms—which operate on
very market-like principles—are still organized inside firms serves to illustrate the
flexibility with which coordination mechanisms may be combined. This raises
the issue of whether there are constraints on the ways in which coordination
mechanisms may be combined.
There is a substantial literature on these points. For example, in economics
much emphasis has been placed on the need to design organizational structures
so that their constituent elements are complementary (Holmström and Milgrom
1994; Zenger and Hesterly 1997). Organization theory has long highlighted
‘consistency’ among constituent elements (Burns and Stalker 1961; Thompson
1967). The following section briefly discusses this. Later chapters (7 and 8)
exemplify and undertake further analysis.
Incentive Limits to the Use of Market Mechanisms

The problem of combining market and hierarchy has been much discussed
in economics. In an early contribution the Austrian economist Ludwig von
Mises (1949: 709) argued that there are inherent contradictions involved
in ‘playing market’; that is, trying to simulate a market in the context of
hierarchy. With reference to various socialist schemes of his day that tried to
preserve some market relations while eliminating capital and financial markets,
Mises argued that these schemes would be unworkable. The concentration of
ultimate decision-making rights and responsibilities, and therefore ownership, in
the hands of a central planning board would dilute the incentives of managers.
Thus, while planning authorities could delegate rights to make production and
investment decisions to managers, these rights were likely to be used inefficiently.
First, since managers could not be sure that they would not be overruled by the
planning authorities, they were not likely to take a long view, notably in their
investment decisions. Moreover, since managers were not the ultimate owners,
they were not the full residual claimants of their decisions and, hence, would not
make efficient decisions. Therefore, Mises declared, the attempt to ‘play market’
under socialism would lead to inefficiencies. In modern parlance, Mises argued
that the economic institutions of capitalism are strongly complementary, so that
(unhampered) capitalism is a stable system, consisting of interlocking elements,
where changes away from pure capitalism will result in serious allocational
inefficiencies.
In a related vein, the attempt to simulate markets in a firm hierarchy may lead
to inefficiencies. Later research has clarified that (1) handling the problem
requires that the planning authorities can credibly commit to a non-interference
policy, and (2) the problem goes beyond the comparative systems context. It is
latent in all relations between ‘rulers’ and ‘ruled’ (North 1990; Miller 1992;
Williamson 1996a). The problem arises from the fact that it is hard for the ruler
to commit to a non-interference policy, because reneging on a promise to
delegate will in many cases be extremely tempting and those to whom rights
are delegated will anticipate this. Loss of motivation results. The problem is not
unknown in organizational studies (e.g. Vancil and Buddrus 1979: 65). In
particular, Williamson’s concept (1985, 1993, 1996a) of the ‘impossibility
of selective intervention’ is highly relevant, and will be discussed further in
Chapter 7.
Suffice it here to note that it is, in fact, conceivable that the ruler may credibly
commit to not intervene in such a way that his sub-goals are promoted.
The logic may be stated in the following way (cf. Baker, Gibbons, and Murphy
1999). Assume that a subordinate initiates a project.47 Assume further that
the manager has information that is necessary to perform an assessment of
the project, but that he decides up front to ratify any project that the subor-
dinate proposes. Effectively, this amounts to full informal delegation of the
rights to initiate and ratify projects—‘informal’, because the formal right
to ratify is still in the hands of the manager and because that right cannot
be allocated to the subordinate through a court-enforceable contract (cf.
Williamson 1996a). Because the subordinate values being given freedom—she
is partly a residual claimant on the outcomes of his activities—this will induce
more effort in searching for new projects (Aghion and Tirole 1997). To the
organization the expected benefits of these increased efforts may be larger than
the expected costs from the bad projects that the manager has to ratify. However,
a problem arises when the manager has information about the state of a project
(‘bad’ or ‘good’), because he may then be tempted to renege on a promise to
delegate decision authority; that is, intervene in a ‘selective’ manner. If he
overrules the subordinate, the latter will lose trust in him, holding back on effort.
Clearly, in such a game a number of equilibria, each one characterized by
different combinations of employee trust and managerial intervention, are feas-
ible. What determines the particular equilibrium that will emerge is the discount
rate of the manager, the specific trigger strategy followed by the subordinate (e.g.
Will he lose trust in the manager for all future periods if he is overruled, or will he
be more forbearing?), and how much the manager values his reputation for not
reneging relative to the benefits of reneging on a bad project (Baker, Gibbons,
and Murphy 1999).
The implication of this reasoning is that mixing very different coordination
mechanisms may lead to efficiency losses, and may not be sustainable for this
reason. The basic problem is that emulating market organization inside firms
amounts to ‘playing market’. Unlike independent agents in markets, corporate
employees never possess ultimate decision rights. They are not full owners. This
means that those who possess ultimate decision rights can always overrule
employees. Thus, there are fundamental incentive limits to the extent to which
market principles can be applied inside firms.
These insights imply that coordination mechanisms are not combinable in an
arbitrary fashion. In other words, using the case of internal hybrids, an argument
has been made that Proposition 5 (i.e. ‘Coordination mechanisms will
be combined in new, innovative ways, suggesting that these mechanisms
are inherently combinable and not limited to being necessarily clustered in
specific discrete governance structures’) needs substantial qualification. There
are inherent (incentive) limits to the extent to which such mechanisms can be
combined. It is the tension between authority (backed up by ownership) and
delegated rights that creates limits to the combinability of coordination mech-
anisms. To the extent that authority persists in the knowledge economy, so will
these limits.
Conclusion
Addressing economic organization in the context of the emerging knowledge
economy is a task of almost forbidding complexity. It is also inherently specula-
tive, suggesting to some that the use of scenario techniques is appropriate
(Hodgson 1998) or that a multidisciplinary approach is justified (Daft and
Lewin 1993). However, this chapter has taken a narrower approach, by trying
to distill some key assumptions and propositions that characterize much of this
literature, and examine these in the light of organizational economics. This has
the advantage of making explicit what may be the issues of contention and the
terms of the debate, thus contributing a possible starting point for further
empirical and theoretical work. Thus, it has been argued that the recent literature
on economic organization in the knowledge economy may be summarized in a
handy way by means of two basic assumptions about knowledge conditions,
three propositions about economic organization, and one proposition that relates
the former to the latter. Admittedly, this is a much too crude way to say much
that is definite; however, it serves to identify what needs to be explained and to
examine the reach of some popular arguments. Thus, using this framework, it
was argued that what matters to economic organization is not so much the
prevalence of knowledge assets per se as it is the growing importance of inalien-
able assets. Moreover, it was argued that it is possible to give efficiency explan-
ations of authority under distributed-knowledge conditions. One import of this
argument is that most economists work with a notion of authority (called above
the ‘Coase-Simon view’) that is perhaps too far removed from the real phenom-
enon (cf. also Grandori 2001).
However, the discussion also implies a further challenge to the knowledge-
based view (the KBV) of the firm in addition to those discussed in Chapter 4.
The KBV argues that economic organization is explainable in knowledge terms
rather than in terms of efficiently allocating property rights and incentives to
maximize joint surplus. For example, the boundaries of the firm reflect partly
differential capabilities (Richardson 1972; Kogut and Zander 1992). However,
in their present manifestation these arguments may not be sufficiently worked
out fully to convince. Thus, the above discussion has exemplified how difficult it
is to relate certain knowledge conditions (i.e. distributed knowledge) to organ-
izational outcomes (i.e. the use of authority). Problems introduced by distributed
knowledge can be overcome by means of delegation and judgment. It may not
matter (or matter much) for allocative outcomes if a manager does not know how
exactly an agent produces an output, but can pass precise judgment on the levels
and quality of that output. The right to choose the means to produce this output
may be delegated to the agent, possibly backed up by some incentive mechanism
that mitigates the attendant moral-hazard problem (Jensen and Meckling 1992).
If this is the case, it is hard to see how distributed knowledge constrains firms. It
may well do so, but before this issue can be clarified, it is necessary to look into
underlying issues such as: How exactly does increased ignorance on the part of
employers/principals influence the quality of the decisions they make? Exactly
what do we mean, in an economic context, by more or less ignorance? Which
factors limit the efficacy of managerial judgment? Heterogeneity of the relevant
knowledge inputs (e.g. delegating decision-making rights to employees with
widely different disciplinary backgrounds)? If so, what does it mean that know-
ledge is more or less ‘heterogeneous’? And so on.
Notes
1. However, the pedigree of this goes back a long time, including, for example, Burns and
Stalker (1961).
2. By the ‘economics of organization’ reference is made to principal–agent theory,
incomplete-contract theory, and transaction-cost economics. Thus, on this definition
proponents of resource-based, knowledge-based, capabilities, or evolutionary theories
of the firm are not economists of organization.
3. It is also true that organizational economics needs to develop a better understanding of
external and (particularly) internal hybrids (Zenger 1997).
4. From such a position the legal boundaries of the firm will only coincide with the
boundaries of knowledge-based networks if considerations of appropriability, impos-
ing a strong need for protecting knowledge, completely dominate considerations of
sourcing knowledge from networks. More probably, however, the boundaries between
markets and firms are fading into insignificance as generalized, reciprocal knowledge
exchange in communities of practice and other network forms, as well as hyper-
competitive conditions, make knowledge-protection issues less relevant. What will
matter for long-run competitive advantage will not be the extent to which, for
example, technical capabilities can be protected from imitation, but the dynamic
capability continuously to source, integrate, and recombine diverse knowledge inputs
(D’Aveni and Gunther 1994; Grant 1996).
5. See Grandori (2000) for a sophisticated argument that because both organization
theory and organizational economics have put too much emphasis on discrete, stable,
‘consistent’ governance structures, and too little on more microanalytic coordination
mechanisms (e.g. price, norms, authority, teams, etc.), the number of ways in which
such mechanisms may be combined has been strongly underestimated.
6. The assumptions and propositions are extremely crude, so there is clearly a straw-
man issue here. Although it may be possible to find authors who present Propositions
(3)–(6) in an extreme form, it may also be argued that one can always dig up
unimportant extremists, smash their arguments, and obtain an easy victory. Two
responses are pertinent here. First, the proponents of Propositions (3)–(6) who have
been cited are not unimportant extremists, but established and respected academics.
Second, even if the statements contained in Propositions (3)–(6) were the brainchil-
dren of intellectual extremists, investigating them would still be a worthwhile task.
This is because such an activity helps establish the boundaries of the discussion. For
example, although it may be argued that nobody truly believes that all authority
relations will disappear completely in the knowledge economy, we still need to know
why authority relations will persist and how they will change. Answering this
question makes us better understand the limits and potentials of authority in
Hayekian settings. For example, as I have argued, it furthers understanding of the
extent to which coordination mechanisms that are characteristic of market allocation
can be introduced in firms’ internal organization.
7. ‘Distributed knowledge’ is knowledge that is not possessed by any single mind and
which may be private and tacit, but which it may nevertheless be necessary somehow
to mobilize for the carrying out of a productive task (Hayek 1945). Many writers
have argued that such distributed knowledge is of increasing importance in an
innovation-rich, knowledge-based economy (e.g. Ghoshal, Moran, and Almeida-
Costa 1995; Hodgson 1998; Coombs and Metcalfe 2000). Grant (1996: 378)
argues that Hayekian distributed knowledge is crucial to the understanding of
organizational capabilities: ‘Although higher-level capabilities involve the integration
of lower-level capabilities, such integration can only be achieved through integrating
individual knowledge. This is precisely why higher-level capabilities are so difficult to
perform.’
8. By ‘coordination mechanisms’ reference is made to a wide set of mechanisms for
allocating resources, such as authority, norms, teams, prices, contracts, voting, etc.
For an innovative overview see Grandori (2001).
9. In other respects, however, Coase is not so obvious a precursor. For example, the
emphasis in the modern economics of organization on incentive conflicts, including
the hold-up problem (Williamson 1985; Hart 1995), as a main explanatory principle
cannot be found in Coase’s paper, as he himself has stressed (Coase 1988).
10. ‘It may be desired to make a long-term contract for the supply of some article or
service’, Coase writes. ‘Now, owing to the difficulty of forecasting, the longer the
period of the contract is for the supply of the commodity or service, the less possible,
and indeed, the less desirable it is for the person purchasing to specify what the other
contracting party is expected to do. It may well be a matter of indifference to the
person supplying the service or commodity which of several courses of action is
taken, but not to the purchaser of that commodity or service. But the purchaser will
not know which of these several courses he will want the supplier to take. Therefore,
the service which is being provided is expressed in general terms, the exact details
being left until a later date. [ . . . ] The details of what the supplier is expected to do is
not stated in the contract but is decided later by the purchaser. When the direction of
resources (within the limits of the contract) becomes dependent on the buyer in this
way, that relationship which I term a ‘‘firm’’ may be obtained’ (Coase 1937: 242–3).
11. Apparently, some organization scholars disagree with this. Thus, Grandori (1997:
37) notes that it has been ‘well-documented’ in organization studies that ‘authority is
not very effective in managing uncertainty’. It will later be argued that this depends
to a large extent on the context; for example, if strong interdependencies (‘comple-
mentarities’) between activities are involved, authority may be extremely effective for
‘managing uncertainty’.
12. See Hodgson (1998b) for an interesting critical discussion of Coase’s notions of
authority and the employment contract.
13. A problem with Simon’s paper is that he does not really address the issues in the
manner of comparative contracting. Thus, the worker only has the choice of accept-
ing or not accepting to work for the boss; the parties are not seen as choosing between
an employment relation and alternative contractual arrangements for regulating a
relation. In an interesting contribution, Wernerfelt (1997) begins from Coasian and
Simonian premises. By portraying governance mechanisms as game forms (spot
contracting, price lists, hierarchy) chosen to regulate trade, Wernerfelt makes precise
Coase’s idea that the choice of a governance mechanism is partly determined by the
flexibility afforded by that mechanism, and he extends Simon’s analysis by explicitly
comparing alternative mechanisms. Specifically, game forms determine how players
adapt to changes in the environment and communicate about these changes. Wer-
nerfelt’s conjecture is that these different game forms will be systematically charac-
terized by different levels of costs of making adaptations. For example, in the case of
the hierarchy, the employer and the employee avoid the costs of negotiating either a
very complex agreement or a series of short-term contracts. Instead, the parties
negotiate a once-and-for-all wage contract. In this context, authority is simply an
implicit contract which states that one of the parties should have the authority to tell
the other what to do (as in Coase 1937). This game form requires less bargaining
over prices than the market game form, and is selected to save too on communication
(adaptation) costs. The agreement to play by the least costly adaptation mechanism is
upheld by the parties’ concern for reputation in a repeated game.
14. This is explicitly argued in Demsetz (1991) and Conner and Prahalad (1996).
15. However, as will become apparent later, the four questions are closely related.
16. Relatedly, Barnard (1938) argued that for authority to be effective it has to be
accepted.
17. Note that this ‘nexus-of-contracts’ position is remarkably close to the position that in
a knowledge-based economy the firm/market boundary is unclear and the notion of
authority elusive at best, although its conceptual basis is rather different.
18. For a critique of these aspects of the incomplete-contracts literature see Foss and Foss
(2001).
19. Although the property-rights approach of Hart and Moore succeeds in adding an
important component to the understanding of authority, and provides a strong
answer to the Alchian and Demsetz denial that authority is a useful concept, arguably
it doesn’t succeed in giving a full explanation of the employment contract, or the
firm. For example, the bargaining power possessed by a principal who owns the
complementary physical assets in a relation may be exercised over an employee or it
may be exercised over a legally independent party who just happens to have given up
ownership of alienable assets to strengthen incentives (i.e. vertical quasi-integration)
(Foss and Foss 2001). In other words, there is no one-to-one correspondence
between the firm and the Hart understanding of the exercise of authority. In fact,
as Bengt Holmström (1999: 87) has recently argued, the incomplete-contracts
literature ‘is a theory about asset ownership by individuals rather than by firms’.
20. The term seems to originate with Halpern and Moses (1990).
21. Common knowledge is a core assumption in much contemporary game-theory-
based micro-economics, such as agency theory (Salanié 1997). It is discussed in
greater detail in Chapter 9.
22. pi could be interpreted as a vector of propositions. Thus, it is not asserted here that
each agent only knows one thing.
23. If knowledge overlap is complete, the agents will also know or be able to infer q (if
they have perfect rationality/perfect reasoning assumptions and/or the knowledge
elements, and how they connect is easy to comprehend).
24. On the other hand, it may not be entirely correct to say that she is ‘asymmetrically
informed’. In asymmetric information models, such as agency models, an agent
knows precisely what she is ignorant about (e.g. the probability distribution associ-
ated with quality levels of a good). No such strong knowledge requirements are
assumed here; only that the coordinator can pass judgment on the capacities of
individual agents and on how their efforts may be aggregated into some coherent
outcome.
25. Relatedly, Minkler (1993: 18) in parts of his modeling attempts assumes that the
‘entrepreneur can form a conjecture about the worker’s possible output without
contemplating how that output can be produced’.
26. Note that the ownership-based notion of authority developed by Hart (1996) is
somewhat problematized under distributed knowledge. In Hart’s framework all
residual decision-making power is concentrated in the hands of the owner/manager,
whereas in actuality delegation often amounts to delegating at least some residual
decision rights to hierarchical subordinates (e.g. division managers). Implicitly, the
notion that, on the one hand, there are rights that may be clearly specified in a
contract and allocated to another party, and, on the other, there are rights that cannot
be specified at all in a contract but can only be allocated to a single party through
asset ownership, means that the only room left for delegation is that agents receive
well-specified rights to carry out well-specified actions. However, this implies that if
agents can take actions about which principals have no knowledge, or are better
informed about how certain actions should be carried out, the superior knowledge of
agents cannot be utilized.
27. Here is a further limitation to the use of authority. As Frey (1997) argues, both the
use of incentive instruments and authoritative direction may harm intrinsic motiv-
ation. Osterloh and Frey (2000) and Osterloh, Frost, and Frey (2002) explore some
of the organizational implications of this.
28. The basic conclusion in such a perspective is that decision rights should be delegated
in such a way that the benefits of delegation in terms of better utilizing local
knowledge are balanced against the costs of delegation in terms of agency losses
(Jensen and Meckling 1992; Jensen and Wruck 1994; Aghion and Tirole 1997;
Foss and Foss 2002). An interpretation of much of the contemporary emphasis
on internal hybrids, such as team organization, ‘molecular forms’, and other mani-
festations of organizational delegation and decentralization, is that these are
prompted by a pressure to delegate decision rights and structure reward schemes
in such a way that optimal trade-offs are reached (Zenger 2002; Zenger and Hesterly
1997).
29. In fact, some writers draw what appears to be the logical consequence of a Hayekian
starting point, and flatly argue that only firms that explicitly emulate market
organization to the largest possible extent can survive and prosper in the knowledge
economy (Cowen and Parker 1997).
30. Although Bolton and Farrell don’t note this, the example is vulnerable to the critique
that the two firms may enter a court-enforceable contract that lets entry depend on
the flipping of a coin. However, in many realistic situations, particularly when
urgency is involved, contracts may not be court-enforceable, or the potential delay
introduced by using the court system may be intolerable.
31. The problem and its solution are of course subtler than this suggests. The precise
arrangements may also involve the payment of a lump sum from the agent to the
principal (as in franchising relationships), and it will be shaped by the risk prefer-
ences of the parties and whether liquidity constraints are present or not.
32. See Prendergast (1999) for an argument that higher environmental uncertainty may
lead to more performance pay (contrary to mainstream agency theory) because it
complicates input monitoring.
33. For example, if motivation is mainly secured by pecuniary means, this may harm
other instruments, such as trying to motivate by fostering a culture that emphasizes
trust and sharing.
34. These reasons also seem broadly consistent with organization theory work on
authority in the context of flat hierarchies (where Hayekian distributed knowledge
is particularly prevalent). In a study of authority in newspaper publishing companies
Brass (1984) identified the determinants of authority as ‘criticality’ (i.e. decisive
knowledge), ‘centrality’ (i.e. centralized decision rights because of economies of scale
in certain tasks), and ‘the friendship network’.
35. For a discussion of the differences between authority and hierarchy see Ménard
(1994).
36. In fact, two of the flag bearers of modern formal-contract economics, Bengt Holm-
ström and John Roberts (1998: 90), recently observed that ‘[i]nformation and
knowledge are at the heart of organizational design, because they result in contractual
and incentive problems that challenge both markets and firms [ . . . ] In light of this, it
is surprising that leading economic theories [ . . . ] have paid almost no attention to
the role of organizational knowledge.’
37. For example, it is not clear whether it makes sense to speak of ownership of firm-level
capabilities. For a discussion of this and related issues see Zingales (2000).
38. This is because the key issue is not whether assets are physical or immaterial, but
whether they are alienable or non-alienable.
39. One may wonder what has happened to Hayekian distributed knowledge in this
setting. Although it is a necessary assumption that the agents can observe each others’
marginal product values, they don’t need to observe each others’ specific actions or
know the underlying knowledge. Thus, Hayekian distributed knowledge is consist-
ent with the assumptions being made here.
40. The first-order conditions are given by (1) 1⁄2 ve (K, P) þ 1⁄2 ve (K) ¼ c0 (xe ) and
(2) 1⁄2 vs (K, P) þ 1⁄2 vs (P) ¼ c0 (xs ). Since it has been assumed that the value of the
assets outside the relation is zero, the second term in (1) and (2) equals zero.
41. This may be seen from inspecting the first-order conditions when the entre-
preneur owns both K and P: (3) 1⁄2 ve (K, P) þ 1⁄2 ve (K, P) ¼ c0 (xe ) and (4) 1⁄2 vs
(K, P) ¼ c0 (xs ).
42. This shows somewhat more formally the argument made earlier that incentives are
likely to be strengthened by spinning off employees who come up with idiosyncratic
entrepreneurial ideas that are costly to communicate to the rest of the firm.
43. For applications of the basic model, for example with respect to what happens if
knowledge (K) is made alienable, see Brynjolfsson et al. (1994).
44. Clearly, this is a strong assumption, but one that is made for analytical convenience.
The main point is simply that there is a central agent whose centrality in the
information network is crucial to the value-creating efforts of other agents.
45. For example, the first-order condition for any individual scientist is: (5) 1⁄2 vi (P, C) þ
⁄2 v (P) ¼ c0 (xi ), where the second term is zero.
1 i
46. The first-order condition for any individual scientist is now: (6) 1⁄2 vi (P, C) ¼ c0 (xi ),
which is the same as (5).
47. This should be understood in a broad sense. A ‘project’ may refer to many different
types of decisions or clusters of decisions.
7
Internal Organization in the Knowledge Economy: The
Rise and Fall of the Oticon Spaghetti Organization
Introduction
In academic research, as well as in managerial practice, the search for the sources
of competitive advantage has increasingly centered on organization-related fac-
tors (e.g. Barney 1986; Kogut and Zander 1992; Mosakowski 1998a; Nahapiet
and Ghoshal 1999). Thus, many firms are said radically to have changed the way
in which they structure their boundaries (e.g. Helper, MacDuffie, and Sabel
2000) as well as their internal organization (e.g. Miles et al. 1997). They have
arguably done this in an attempt to foster the dynamic capabilities that are
necessary for competing in the emerging knowledge economy. Fundamental
advances in IT and measurement technologies have facilitated these changes
(Zenger and Hesterly 1997), while equally fundamental developments in the
organization and motives of capital markets as well as increasing internalization
are said to have made them necessary (Halal and Taylor 1998).
From an organizational economics perspective these experiments with eco-
nomic organization fall into the categories of either external hybrids (Williamson
1996a), that is market exchanges infused with elements of hierarchical control, or
internal hybrids (Zenger 2002), that is hierarchical forms infused with elements
of market control. The aims of the experimental efforts are to reduce coordin-
ation costs, improve incentives, and help to clarify the nature of the businesses
the firm is in, thereby improving entrepreneurial capabilities and the ability to
produce, share, and reproduce knowledge (Grant 1996; Miles et al. 1997; Day
and Wendler 1998; Mosakowski 1998a). Although both internal and external
hybrids are means to reach these aims, they would seem to be highly imperfect
substitutes. For example, adopting an internal-hybrid form has the benefit of
involving fewer lay-offs relative to adopting external hybrids. Also, spin-offs,
carve-outs, and the like are often legally complex operations, whereas adopting
an internal hybrid may simply be a matter of managerial fiat. Further, manage-
ment may fear that leaving too many activities in the hands of other firms will
hollow out the corporation (Teece et al. 1994), or make it difficult to protect
valuable knowledge (Liebeskind 1996). Given this, one may wonder why firms
should ever make governance choices in favor of external hybrids. However, a
main point of this chapter is that internal hybrids are beset by distinct incentive
costs that external hybrids (and markets) tend to avoid, and that this may explain
why external hybrids are chosen over internal hybrids.
Research on new organizational forms is an emerging field (Daft and Lewin
1993; Zenger and Hesterly 1997), and rather little is known about the costs and
benefits of these organizational forms. This chapter mixes empirical observation
with theoretical reasoning, mostly drawn from organizational economics, in
order to gain a better understanding of the organizational design problems of
internal hybrids. The theoretical emphasis is on the (neglected) costs of internal
hybrids, and in particular on motivational and commitment problems that derive
from the delegation of decision rights. The root of such problems is that in firms,
(delegated) decision rights are not owned; they are always loaned from the
holder(s) of ultimate decision-making rights; namely, the top management
and/or the shareholders. Given this, a fundamental problem for top manage-
ment/owners is to commit to real delegation and refrain from selective interven-
tion (Williamson 1996a) that harms motivation, and may reduce effort and
investments in firm-specific human capital.
These ideas are developed and discussed empirically with reference to organ-
izational changes that took place in the Danish electronics (primarily hearing-
aid) producer Oticon A/S from 1991 onwards. Oticon became world-famous for
its radical delegation experiment. The ‘spaghetti organization’, as it came to be
called, was explicitly conceived by its designers as an attempt to infuse the Oticon
organization with strong elements of market control (Kolind 1990; Lyregaard
1993), and was seen as a hard-to-replicate source of knowledge-based competi-
tive advantage (e.g. Gould 1994). In fact, a recent cottage industry has treated the
Oticon experience as an outstanding example of the sustained benefits that
radical project-based organization may provide (e.g. Verona and Ravasi 1999;
Lovas and Ghoshal 2000; Ravasi and Verona 2000). However, this literature fails
to note that the spaghetti organization in its initial radical form does not exist any
more—since about 1996 it has been superseded by more structured administra-
tive systems. Below, these organizational changes will be discussed from an
organizational-economics starting point. The approach followed with respect
to understanding the nature of organizational changes in Oticon is a historical
one that relies heavily on the large number of thick descriptions of Oticon that
have been produced by a number of mainly Danish academics, journalists, and
Oticon insiders throughout the 1990s (in particular, Lyregaard 1993; Poulsen
1993; Morsing 1995; Eskerod 1997, 1998; Jensen 1998; Morsing and Eiberg
1998). However, these sources have been supplemented with semi-structured
interviews with the prime mover behind the spaghetti experiment, the then CEO
Lars Kolind, as well as the current Oticon HRM officer (both June 2000).
The chapter begins by developing an organizational economics interpretation
of the spaghetti organization (‘The Spaghetti Organization: A Radical Internal
internal organization 159
Hybrid’). The spaghetti organization appears to have been a particularly well-
crafted internal hybrid. Still, it gave way to a more traditional matrix structure. It
is not plausible to ascribe this organizational change to outside contingencies, or
to dramatic changes in strategic intent. This suggests that the spaghetti organ-
ization may have been beset by organizational costs that came to dominate the
benefit aspects, necessitating a change of administrative systems (‘Spaghetti and
Beyond’). The Oticon spaghetti experiment carries lessons for the design of
internal hybrids. In particular, it directs attention to the incentive problems
of delegating rights within a firm when top management keeps ultimate decision
rights. Refutable propositions for the design of internal hybrids are derived
(‘Discussion: Implications for Internal Hybrids’).1
It should be clear already at this stage that the following is an attempt to
pursue a specific interpretation of the Oticon spaghetti organization. Organiza-
tional economics per se is hardly in an early stage of theory development any
more, given that early work goes back almost seven decades (Coase 1937) and the
last three decades have witnessed a flurry of work in this field. There is therefore
little need to follow a logic of grounded theory per se (Glaser and Strauss 1967).
Moreover, organizational economics is a particularly appropriate tool of inter-
pretation in the present context, because only this body of theory simultaneously
frames internal hybrids theoretically, casts the analysis in the relevant compara-
tive-institutional terms (e.g. allows external and internal hybrids to be com-
pared), and frames the kind of incentive problems that will be central in the
analysis below. For example, information processing or motivation theory cannot
accomplish all this.2
In sum, the contributions of this chapter are to (1) present a novel and in key
respects more encompassing account and interpretation of a well-known organ-
izational-change case, exemplifying the interpretative usefulness of organizational
economics in the process; (2) analyze the (neglected) costs of internal hybrids in
terms of the problem of selective intervention, thus contributing to understand-
ing the efficient design of such hybrids; and (3) argue that the analysis under (2) is
also helpful for understanding broader issues of economic organization, such as
the governance choice between internal and external hybrids.
The Spaghetti Organization: A Radical Internal Hybrid

Recent work has used the Oticon spaghetti experiment for the purpose of
developing notions of strategy making as ‘guided evolution’ (Lovas and Ghoshal
2000), and to discuss how the deliberate introduction of ‘structural ambiguity’
through the choice of loosely coupled administrative systems (Ravasi and Verona
2000) may help to build ‘organizational capabilities for continuous innovation’
(Verona and Ravasi 1999). This literature places all the emphasis on the benefit
side (mostly innovation performance) of the spaghetti experiment and fails to
note that (and explain why) the spaghetti organization has been largely aban-
doned. In contrast, this chapter accounts for the costs of this particular internal
hybrid in terms of organizational economics, and uses this account to explain the
change from the spaghetti organization.
Oticon: Background
Founded in 1904 and based mainly in Denmark, Oticon (now William Demant
Holding A/S) is a world leader in the hearing-aid industry. In the early 1990s
Oticon became a famous and admired instance of radical organizational change.
CEO Lars Kolind and his new organizational design became favorites of the
press, consultants, and academics alike. The new organization was cleverly
marketed as the very embodiment of empowering project- and team-based
organization. Moreover, it quickly demonstrated its innovative potential by
revitalizing important, but ‘forgotten’, development projects that, when imple-
mented in the production of new hearing aids, produced significant financial
results, essentially saving the firm from a threatening bankruptcy, as well as
turning out a number of new strong spin-off products. The background to the
introduction of the spaghetti organization was the loss of competitive advantage
that Oticon increasingly suffered during the 1980s as a result of increasingly
strong competition (mainly from the USA), and a change in the technological
paradigm (Dosi 1982) in the hearing-aids industry, which was gradually moving
through the 1980s from ‘behind-the-ear’ to ‘in-the-ear’ hearing aids (Lotz 1998).
Oticon’s success in the 1970s was founded on miniaturization capabilities. While
these had been critical for competitive advantage in the ‘behind-the-ear’ hearing-
aid paradigm, new technological capabilities in electronics, which were not under
in-house control by Oticon, were becoming crucially important in the emerging
in-the-ear paradigm.
There is evidence (e.g. Poulsen 1993; Gould 1994; Morsing 1995) that at the
end of the 1980s Oticon was locked into a competence trap that was reinforced
by strong groupthink characterizing both the management team and the em-
ployees. A symptom of this was that the dominant opinion among managers and
development personnel at Oticon was that the in-the-ear hearing aid would turn
out to be a commercial fiasco. Moreover, in-the-ear hearing aids were not
perceived to be Oticon turf, in terms of both technological and marketing
capabilities (Poulsen 1993). The self-image of the company clearly was one of
being a traditional industrial company with its strongest technological capabil-
ities in miniaturization, and specializing in mass-producing behind-the-ear hear-
ing aids, developing the underlying technology incrementally. Administrative
systems were organized traditionally into functional departments, the managers
of which together constituted the senior executive group. When problems began
to accumulate, various attempts were made to change the situation, which,
however, were either too insignificant or did not survive political jockeying inside
Oticon. In 1988 Lars Kolind assumed the position of new CEO, concentrated all
decision-making power in his own hands, and implemented drastic cost-cutting
measures. However, he also quickly realized that something else had to be done
to cope with the decisive changes that were under way with respect to products
and processes in the industry. More radical measures were needed regarding the
strategic orientation of the firm, the administrative systems that could back this
up, and the technology that the firm sourced, leveraged, and developed.
Trying Spaghetti
The new, radical measures were first sketched in a six-page memo (Kolind 1990),
which described a fundamental change of corporate vision and mission: The
company should be defined broadly as a first-class service firm with products
developed and fitted individually for customers, rather than narrowly as a
manufacturing company producing standard behind-the-ear hearing aids.
A new organizational form, namely the ‘spaghetti organization’ (so called in
order to emphasize the point that it should be able to change rapidly, yet still
possess coherence), would support this strategic reorientation. The new form
should be explicitly ‘knowledge-based’; that is, consisting of ‘knowledge cen-
tres . . . connected by a multitude of links in a non-hierarchical structure’ (Kolind
1994: 28–9). Making the organization ‘anthropocentric’, that is designing jobs so
that these would ‘fit the individual person’s capabilities and needs’ (ibid. 31), was
argued to provide the motivational support for this knowledge network. Fur-
thermore, basing the network on ‘free-market forces’ (Lyregaard 1993) would
make it capable of actually combining and recombining skills in a flexible
manner, whereby skills and other resources would move to those (new) uses
where they were most highly valued. Clearly, the aim was to construct a
spontaneously functioning internal network that would work with only minimal
intervention on the part of Kolind and other managers; that is, ‘essentially, a free
market at work’ (LaBarre 1996).
The new organizational form was primarily implemented at the Oticon
headquarters (i.e. administration, research and development, and marketing).
In order symbolically to underscore the fundamental transformation of Oticon,
headquarters moved, at 8 a.m. on 8 August 1991, to a completely new location
north of Copenhagen. In the new building all the desks were placed in huge,
open office spaces, and employees did not have permanent desks, but would
move depending on which projects they were working on. The number of formal
titles was drastically reduced, resulting in a two-layered structure, with Kolind
and ten managers representing the managerial team and the remaining part of
the organization being organized into projects (Kolind 1994). Thus, the new
organization represented a breakdown of the old functional department-based
organization into an almost completely flat, project-based organization. Depart-
ments gave way to ‘competence centers’ (e.g. in mechanical engineering, audi-
ology, etc.) that broke with the boundaries imposed by the old departments. The
‘multi-job’ concept represented a notable break with the traditional division of
labor in organizations. It was based on two key features. First, there were no
restrictions on the number of projects that employees could voluntarily join, and,
second, employees were actively encouraged (and in the beginning actually
required) to develop and include skills outside their existing skill portfolio.
The underlying notion was that this would increase the likelihood that project
teams would consist of the right mix of complementary skills and knowledge,
because of the increase in the scope of the knowledge controlled by each team
member. Moreover, the multi-job concept would ease knowledge transfer,
because of the increase in the overlap of knowledge domains that it would
produce, as employees familiarized themselves with other employees’ specialized
fields.
These changes were accompanied by an extensive delegation of the rights to
make decisions on resource allocation. Notably, employees would in essence
themselves decide on which projects they would join rather than being assigned
to tasks and projects from above. Project managers were free to manage projects
in their preferred ways. Wage negotiations were decentralized, project managers
being given the right to negotiate salaries. Finally, although project teams were
self-organizing and basically left to mind their own business once their projects
were ratified, they were still to meet with a ‘Products and Projects Committee’
once every three months for ongoing project evaluation.
To meet the two, potentially conflicting, aims of making it possible for project
teams rapidly and flexibly to combine the right skills, and achieving overall
coherence between rather independently taken decisions, the new organization
was founded on four fundamental ideas (Kolind 1994). First, as noted, the
traditional, functional department structure was eliminated in favor of a project
organization that went considerably beyond the traditional matrix structure.
While this served to increase flexibility, other measures were directed towards
achieving organizational coherence. Thus, second, new information-technology
systems were designed and implemented to make it possible to coordinate plans
and actions in this decentralized organization. Everybody was supposed to have
full access to the same information. Third, the traditional concept of the office
was abandoned, as already mentioned. Finally, Kolind worked hard to increase
intrinsic motivation by developing a corporate value base that strongly stressed
responsibility, personal development, and freedom. These fundamental organiz-
ing principles were backed up by other measures. For example, in order to
increase motivation Kolind introduced an employee stock program, in which
shop-floor employees were invited to invest up to 6,000 Dkr (roughly $US800)
and managers could invest up to 50,000 Dkr (roughly $US7500). Although
these investments may seem relatively small, in Kolind’s view they were suffi-
ciently large significantly to matter to the financial affairs of individual employ-
ees; therefore, they would have beneficial incentive effects. More than half of the
employees made these investments.
The implementation of the spaghetti organization had quick and strong
performance effects (Peters 1992; Poulsen 1993). Improved performance in
terms of the use and production of knowledge was almost immediate, resulting
in a string of remarkable innovations during the 1990s (Verona and Ravasi 1999;
Ravasi and Verona 2000). Improved growth and financial performance followed
somewhat later (see Table 7.1).
With respect to improvements in the use of knowledge, the spaghetti organ-
ization allowed significant shelved projects to be revitalized. For example, it was
realized that Oticon had already embarked upon development projects for in-
the-ear hearing aids as far back as 1979. These projects provided essential inputs
into many of the product innovations that Oticon launched during the 1990s.
Another effect of the spaghetti organization was that product-development time
was reduced by 50 per cent. In 1993 half of Oticon’s sales stemmed from
products introduced in 1993, 1992, and 1991. A total of fifteen new products
had been introduced since the implementation of the new organization, whereas
none had been introduced in the last five years of the earlier organization.
A recurring theme in academic treatments of the Oticon spaghetti organiza-
tion (Morsing 1995; Verona and Ravasi 1999; Ravasi and Verona 2000) is that
an important cause of the observed increase in Oticon’s innovativeness was the
introduction of ‘structural ambiguity’; that is, the deliberate engineering of
freedom and ambiguity in the role system and in the authority structure by
means of the introduction of a radical project organization. This condition
facilitated the efficient and speedy integration and production of knowledge,
resulting in the observed improvement in Oticon’s innovativeness in the 1990s.
This interpretation fails, however, to explain why the spaghetti organization
was gradually abandoned from about 1996 in favor of a more traditional
matrix organization. It also fails to account for the possible costs of the spaghetti
organization. The following section presents a complementary interpretation,
based mainly on organizational economics.
The Spaghetti Organization as an Internal Hybrid

A striking aspect of the spaghetti organization is the prevalence of the market
metaphor in the commentaries on the new form by both insiders and outsiders
(Peters 1992; Lyregaard 1993; LaBarre 1996). The spaghetti organization
may indeed be interpreted as a radical internal hybrid, because the organization
was strongly infused with elements characteristic of market exchange (see
Table 7.2).
Table 7.1. Oticon financial and technological performance
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Net revenue 423,8 449,6 455,4 476,5 538,8 661,3 750,3 940,2 1.087,3 1.413,4 1.613,1 1.884,3
(million Dkr)
Profit margin (%) 1,6 8 3,7 1,8 5,8 13,1 17,9 12,4 12,8 13,8 15,4 17,9
RoE (%) 8,5 11,6 9,4 1,5 7,2 37 37,9 25,9 24,3 30,6 35,7 53,8
Product – – – Multi- Personic Oticon Noah Micro- Digi- Spin-off Spin-off Ergo Swift
innovation Focus 4 Kids Focus Focus innovations innovations Digi-Focus II
of Digi-focus of Digi-Focus
Sources: Ravasi and Verona (2000); annual reports of Oticon A/S and William Demant Holding A/S.
Table 7.2. Market organization and the spaghetti simulation
Market organization The spaghetti organization
Allocation by means of pricing Transfer prices not used

Legal independence between parties Employment contracts (employment law)
(contract law)
Freedom of contract Freedom of contract approximated by
delegating rights to suggest and join projects
High-powered incentives Variable pay; initially based on objective
input and output measures
Dispersed residual claimancy Employee stock schemes
Dispersed decision rights Very widespread delegation of rights
Dispersed ultimate decision rights (dispersed Concentrated ultimate decision rights
formal authority) (concentrated formal authority)
Resource allocation decentralized, and Local entrepreneurship very strongly
strongly influenced by local entrepreneurship encouraged
Project approval easily obtained
Strong autonomous adaptation properties Secured through extensive delegation of
decision rights
Although there was no attempt to price internal services in the spaghetti

organization and Oticon employees did not become legally independent sup-
pliers of labor services, in many other relevant dimensions Oticon was more like
a market than a traditional hierarchical firm. Thus, employees (particularly
project leaders) were given many and quite far-reaching decision-making rights.
Development projects could be initiated by, in principle, any employee, just like
entrepreneurs in a market setting, although these projects had to pass not the
market test but the test of receiving approval from the Products and Projects
Committee. Project groups were self-organizing in much the same way that, for
example, partnerships are self-organizing. The setting of salaries was decentral-
ized to project leaders, acting like independent entrepreneurs (Business Intelli-
gence 1993). Incentives became more high-powered (i.e. efforts and rewards
were more closely tied together), as performance pay was increasingly used and as
the employee-stock-ownership program was introduced, thus mimicking the
superior incentive properties of the market. Most hierarchical levels were elim-
inated and formal titles done away with, etc., mimicking the non-hierarchical
nature of the market. In sum, market organization was indeed emulated in a
number of dimensions.
As a general matter, the attraction of infusing hierarchical forms with elements
of market control is that some of the basic advantages of the hierarchy, such as the
superior ability to perform coordinated adaptation to disturbances (Williamson
1996a), build specialized social capital (Nahapiet and Ghoshal 1999), and share
knowledge (Osterloh and Frey 2000), can be combined with the superior
incentive properties of the market (Williamson 1996a) and its superior flexibility
with respect to autonomous adaptation (Hayek 1945; Williamson 1996a). Along
similar lines, Kolind explicitly saw the spaghetti organization as combining the
superior abilities of a hierarchy to build knowledge-sharing environments and
foster a cooperative spirit with the flexibility and creativity of a market-like
project organization (Kolind 1994).
The Structure of Rights in the Spaghetti Organization

Organizational economics suggests that understanding the costs and benefits of
any organizational form requires examining the structure of decision and income
rights in the relevant form (Fama and Jensen 1983; Jensen and Meckling 1992;
Hart 1995; Williamson 1996a; Barzel 1997; Baker et al. 1999, 2002; Holm-
ström 1999). The benefits and the costs of the spaghetti organization can be
comprehended through this lens. The remaining part of this section concentrates
on the benefit side.
Centralized decision-making systems, particularly large ones, have well-
known difficulties with respect to mobilizing and efficiently utilizing important
‘sticky’ knowledge (Hippel 1994), such as the precise characteristics of specific
processes, employees, machines, or customer preferences (Jensen and Wruck
1994). They therefore often also have difficulties combining such knowledge
into new products and processes. As Hayek (1945) explained, the main problem
is that much of this knowledge is transitory, fleeting, and/or tacit, and therefore
costly to articulate and transfer to a (corporate) center. Markets have advantages
relative to pure hierarchies with respect to utilizing such knowledge, particularly
when it is not required to utilize the relevant knowledge in conjunction with
other knowledge sets (where a hierarchy may have comparative advantages).3
Thus, markets economize on the costs of transferring knowledge by allocating
decision rights to those who possess the relevant knowledge, rather than the other
way around (Hayek 1945; Jensen and Meckling 1992). Rights will move towards
the agents who place the highest valuation on those rights. Since these agents
become residual claimants, effective use will be made of the rights they acquire.
From this perspective, internal hybrids are fundamentally attempts to mimic,
inside the hierarchy, the decentralization of decision and income rights that
characterizes the market, in an attempt to improve the efficiency of processes
of discovering, creating, and using knowledge.
The spaghetti organization may be understood through this lens; that is, as a
hybrid organizational design that aimed at improving the co-location of know-
ledge and rights through extensive delegation, and backed this delegation of
decision rights up by giving employees more income rights. By giving project
teams extensive decision rights, requiring that ideas for projects be made public,
and ensuring that project teams possessed the necessary complementary skills for
a particular marketing, research, or development task, the spaghetti organization
stimulated a co-location of decision rights with knowledge. High-powered
incentives were provided in an attempt to make sure that efficient use was
made of those rights. This improved the use of existing knowledge (cf. the
revitalization of ‘forgotten’ projects) and eased the combination of knowledge
in the production of new knowledge.
However, Oticon’s use of ‘free-market forces’ (Lyregaard 1993) was funda-
mentally a simulation, because the allocation of decision rights in that organiza-
tion (as in any firm) remained in important respects different from the allocation
that characterizes market organization. In contrast to markets, firms cannot
concentrate to the same extent income rights (i.e. residual claimancy) and
decision rights in the same hands. An agency problem results from this separ-
ation. Many of the elements of the spaghetti organization may be seen as
responses to this fundamental agency problem, most obviously the increased
use of high-powered incentives. Consider also the rights to allocate resources to a
particular project. These may be broken down into groups of decision-making
rights; namely, rights to (1) initiate projects, (2) ratify projects, (3) implement
projects, and (4) monitor and evaluate projects (cf. Fama and Jensen 1983). The
efficiency of decision-making processes in project-based firms rests on the
allocation and exercise of such rights. For reasons of efficiency, firms usually do
not concentrate these rights in the same hands; rather, initiation and implemen-
tation rights may be controlled by one person (or team), while ratification and
monitoring rights are controlled by other persons, usually hierarchical superiors.5
This allocation of decision rights was characteristic of the spaghetti organiza-
tion. Whereas anybody could initiate a project, projects had to be evaluated by
the Products and Projects Committee that was staffed by Kolind, the develop-
ment manager, the marketing manager, and the support manager. The Commit-
tee either rejected or approved the project. The only formal criteria for getting a
project accepted were that the relevant project relate to the business areas of
Oticon and yield a positive return over a three-year period and with a discount
rate of 30 per cent. Apparently, the Products and Projects Committee did not
control the use of corporate resources by means of controlling the budgets of
individual projects at the project-ratification stage. In particular, the use of
human resources, the main input category, across projects was not monitored.
The rights to implement a project following approval included the right to hire
employees in open competition with other projects (Eskerod 1998). Operating
projects would meet every third month with the Products and Projects Com-
mittee, or a representative thereof, for project evaluation (i.e. monitoring).
The fact that the Products and Projects Committee could veto a project ex
ante suggests that it was the real holder of power in Oticon. Frequent interven-
tion on the part of the Committee ex post project approval confirms this (ibid.).
Thus, it became increasingly clear that the Committee could at any time halt,
change, or even close projects. This kind of intervention took place frequently.
The Products and Projects Committee’s exercise of its ultimate decision rights
may be seen as simply reflecting the separation discussed above between decision
management (i.e. initiation, implementation and daily project management) and
decision control (i.e. project evaluation and monitoring).5 However, this separ-
ation does not logically imply the kind of ex post intervention that the Committee
engaged in. For example, one may imagine that the relevant rights might be
allocated so precisely and with so much foresight that there are no incentives to
intervene ex post, as in the case of a very detailed contract between two legally
independent firms. However, the way in which the Products and Projects
Committee exercised their ultimate decision rights is more akin to reneging on
a contract, perhaps even to performing a ‘hold-up’ (Williamson 1996a). Thus,
the Committee effectively reneged on implicit contracts with the projects as the
efforts of projects became, in the eyes of the Committee, superfluous (e.g.
because of new technological developments), moved in unforeseen directions,
or were revealed to have been founded on ill-conceived ideas. In turn, this
exercise of ultimate control rights caused unforeseen incentive problems, as will
be discussed later.
Organizational Complementarities
An interesting aspect of the spaghetti organization is that an explicit logic of
complementarity was present in the reasoning of its main designer. Observed
Kolind: ‘It was not strictly necessary to do all these things at the same time, but
we opined that with a simultaneous implementation of the changes [in organ-
izational elements] . . . they would reinforce each other’ (in Mandag Morgen
1993: 17; my translation). Complementarities between elements of an organiza-
tional form exist when increasing the level of one element increases the marginal
return from increasing the level of all the remaining elements (Milgrom and
Roberts 1990b; Hemmer 1995; Zenger 2002). Loosely, when complementarity
obtains, the dynamics of organizational elements imply that they move together.
Changing one element in an isolated way is likely to set in motion (possibly
unforeseen) processes of change in other elements, because the system will grope
towards an equilibrium where all the elements have changed (Zenger 2002). The
process of groping may be associated with serious inefficiencies. Therefore,
organizational change initiatives should ‘get the complementarities right’.
Apparently, the spaghetti organization did exactly this. Thus, the alteration in
the rights structure of Oticon was such that decision rights changed in a way that
was complementary to the change in income rights; specifically, widespread
delegation of decision rights was accompanied by making incentives more
high-powered through performance pay and employee ownership. In turn, the
change in incentives was backed up by complementary changes in measurement
systems. Thus, a performance evaluation system was implemented in which
employee performance was measured in 3–8 different dimensions (depending
on the type of employee) and pay was made dependent on these measures
(Poulsen 1993).
Other initiatives may also be seen to be complementary to the increase in the
delegation of rights in the spaghetti organization. For example, the open-office
landscape and the strategically placed coffee bars and staircases were comple-
mentary to rights delegation in terms of utilizing and building knowledge,
because they helped foster the knowledge exchange that gave rise to new ideas
for project teams. With respect to the moral hazard problem introduced by
delegating rights, the new, much more information-rich environment was also
complementary to this delegation, because it helped to build reputational effects
(cf. Eskerod 1997, 1998) and eased mutual monitoring among employees,
keeping agency problems at bay. Kolind’s strong emphasis (1990) on building
culture in the new organization may be seen in a similar light. Influencing
preferences through the building of shared values became an important activity
in the spaghetti organization, because its strong delegation of rights introduced
both problems of coordinating independently made decisions (Miller 1992) and
agency problems—problems that are reduced as preferences become more
homogeneous. The complementary nature of these organizational elements
also explains the speed and toughness with which Kolind managed the transition
from the old organization. This is because it is usually inefficient to change
systems of complementary elements in an incremental manner; transition
between such systems should normally be accomplished in a ‘big-bang’ manner
(cf. Dewatripont and Roland 1995).
Spaghetti and Beyond

Retreating from Spaghetti
In his account of the spaghetti organization Gould (1994: 470) noted that ‘Lars
Kolind’s vision was the right one for Oticon. In any case, one thing was certain:
there could be no turning back’. However, from 1996 a considerable ‘turning back’
actually began: Oticon embarked upon a partial abandonment of the spaghetti
organization and gradually adopted a more traditional matrix structure. In 1996
Oticon headquarters was divided into three ‘business teams’that are essentially new
administratives layers. In addition to the business teams, a ‘Competence Center’
has been set up. This unit is in charge of all projects and their financing and of an
operational group that controls administration, IT, logistics, sales, and exports. It
is one of the successors to the now abandoned Products and Project Committee.
However, its style of managing projects is very different. In particular, care is taken
to avoid the kind of intervention in already approved projects that characterized
the Products and Projects Committee. The team leaders and the head of the
Competence Center comprise, together with the CEO, the ‘Development Group’,
which may be seen as a second successor to the Products and Projects Committee of
the original spaghetti organization. The Development Group, which is essentially
the senior executive group, is in charge of overall strategy making. It is also the unit
from which most of the initiative with respect to starting new projects comes.
Many of the decision-making rights earlier held by project leaders have now been
concentrated in the hands of the Competence Center, or the managers of the
business teams. For example, project leaders’ rights to negotiate salaries have been
constrained. Project leaders are appointed by the Competence Center, so that the
right to be a project leader is not something that one grabs, as under the spaghetti
organization. Although the multi-job concept is still present, the extreme forms
that characterized the spaghetti organization are not.
To sum up, recent changes of administrative systems at Oticon have
amounted to a break with the radical bottom-up approach that characterized
the original spaghetti structure. Thus, although Oticon is still characterized by
considerable decentralization and delegation of rights, many of the crucial
elements of the spaghetti organization have been abandoned.
Searching for Possible Causes of the Partial Failure of the Spaghetti Experiment
Although the spaghetti organization at first glance seems to have been a particu-
larly well-crafted internal hybrid, closer inspection may reveal design mistakes
that led to its abandonment. A number of candidates for design mistakes are
discussed below. They may be grouped into problems of allocating competence,
eliminating tournaments, sacrificing specialization advantages, coordination,
knowledge sharing, and influence activities.6
Allocating competence. Demsetz (1991) and Casson (1994) argue that firms are
hierarchical because this is an efficient way of utilizing different, yet comple-
mentary, knowledge; direction may be less costly than instruction or joint
decision-making. When this is the case, those with more decisive knowledge
should direct those with less decisive knowledge. Thus, the hierarchy is an
efficient method of allocating competence. The spaghetti organization elimin-
ated most hierarchical levels. Thus, the extent to which hierarchy could be used as
a sorting mechanism for allocating skills was much smaller in the spaghetti
organization. For example, the delegation of project-initiation rights implied
that competent and less competent employees had the same rights to initiate
projects and get a hearing before the Products and Projects Committee. Know-
ledge-based inefficiencies may have resulted that could have been avoided in a
traditional hierarchy.
However, this explanation implicitly asserts that managers are, on average,
more knowledgeable with respect to what actions subordinate employees should
optimally take than these employees are themselves. If this is not the case,
bottom-up selection processes may sort better than hierarchical processes. In
fact, the spaghetti organization was (at least in the official rhetoric) very much
founded on the notion that bottom-up processes would select more efficiently
than hierarchical processes. Hierarchical superiors may be more knowledgeable
about which actions should optimally be taken by subordinates when there are
strong complementarities between the actions of subordinates, hierarchical su-
periors possess superior information about these complementarities, and/or they
possess private information about which states of the world have been realized
(Foss and Foss 2002). To be sure, complementarities between subordinates’
actions and knowledge sets obtained in the spaghetti organization. However,
the purpose of the spontaneous, market-like, bottom-up processes was exactly to
discover and utilize such complementarities—something that the earlier hier-
archical organization had not been capable of. Thus, it seems unlikely that
abolishing the hierarchy in Oticon led to serious inefficiencies related to the
allocation of competence.
Eliminating tournaments. From an incentive perspective, the extremely flat

spaghetti organization implied that one particular incentive instrument was no
longer available to the organization: Hierarchical job ladders could no longer
function as incentive mechanisms in their own right, since the spaghetti organ-
ization essentially abolished what agency theorists call ‘tournaments’ between
managers (Lazear 1995). Promotion was no longer a ‘prize’ that could be
obtained through expending effort. However, while the spaghetti organization
may have eliminated this particular incentive instrument, it introduced a number
of new incentive instruments, such as performance pay. From the point of view of
individual employees, these new instruments may have been stronger with
respect to motivation than tournaments, because they were less open to political
manipulation. Thus, the sacrifice of tournaments as an incentive instrument may
not have been a major problem.
Sacrificing specialization advantages. A key component of the spaghetti organ-

ization was the multi-job concept, which implied that each employee was
(1) encouraged to develop skills outside her present skill portfolio, and (2) free
to join projects as she saw fit. Much work on Oticon has treated the multi-job
concept as a strong stimulus to knowledge exchange and integration (e.g. Verona
and Ravasi 1999; Ravasi and Verona 2000), presumably quite rightly so. How-
ever, the concept may also have introduced distinct costs, most obviously the
sacrifice of specialization advantages that it would seem to imply. However, there
are indications that this was actually not the case. For example, an Oticon
engineer might have been encouraged to develop English writing skills, which
would place him in a better position to undertake technical translation relevant
to his project, and do so in a more informed way than a professional translator
would be capable of. Thus, this aspect of the multi-job concept may have led to
beneficial exploitation of complementarities between different skills.
Problems of coordination. However, there is strong evidence that the second part
of the multi-job concept, the freedom to join projects, had significant costs.7
Nobody kept track of the total time that employees spent on projects.8 Moreover,
project leaders were free to try to attract those who worked on competing
projects, and in many cases they succeeded in doing so. This was a consequence
of the explicit aim to emulate the market, but the effect was that it was hard to
commit employees to projects and to ensure an efficient allocation of attention to
projects (Gifford 1992). This led to severe coordination problems, because
project leaders had no guarantee that they could actually carry a project to its
end. Moreover, many employees joined more projects than their time resources
could possibly allow for, creating problems of coordinating schedules and work
hours. The Products and Projects Committee had no routines for dealing with
these problems. Apparently, reputation mechanisms were not sufficient for
coping with them either. It would seem perhaps that these problems could
have been reduced by simply prohibiting employees from working on more
than, say, two projects, that could not add up to more than 100 per cent of the
employee’s total work hours.9 Establishing such controls in the original spaghetti
organization would, however, have run counter to the official rhetoric of auton-
omy, empowerment, and delegation. Alternatively, monitoring systems might
have been refined to control dimensions of employee behavior that related to
their attention and work allocation across the projects they participated in, so as
to reduce coordination problems. However, the very elaborate monitoring sys-
tem that was implemented alongside the spaghetti organization and involved the
construction of objective measures on half a dozen aspects of employee behavior
(Poulsen 1993) appears to have been quickly and tacitly shelved and substituted
with a simpler system that relied much more on subjective performance assess-
ment (Business Intelligence 1993). This suggests that the problem with mon-
itoring systems under the original spaghetti organization was rather that they
were already too complex and costly to administer in practice.
Problems of knowledge sharing. The multi-job concept promoted knowledge

sharing and, in turn, knowledge creation. However, there is evidence (Eskerod
1997, 1998) that knowledge sharing was not always spontaneous and uninhib-
ited. In fact, in some cases knowledge tended to be held back within projects,
because of the widespread, and correct, perception that projects were essentially
in competition over corporate resources. Thus, by stressing so strongly a market-
like competitive ethos and by making incentive systems more ‘high-powered’
(Williamson 1996a) than they had been under the old organization, the spaghetti
organization to some extent worked against its stated purposes. The organiza-
tion’s measurement and reward systems apparently could not fully cope with
these problems. It may be questioned how significant this problem was. The
impressive innovation record of Oticon in the 1990s indicates that the firm’s
creation of knowledge may not have been significantly harmed by the competi-
tive relations existing within the spaghetti organization. Still, the relevant ques-
tion is whether the knowledge-sharing environment could have been better
designed. Knowledge sharing is not necessarily best stimulated by a kind of
project organization that simulates competitive markets. To the extent that
knowledge sharing is a hard-to-measure performance variable, employees are
likely to put less of an emphasis on it (Holmström and Milgrom 1991). Upon
realizing this, resort to lower-powered incentives is likely (Holmström 1999).
This corresponds to what has happened in Oticon. Although the performance-
measurement systems in Oticon now include attempts to measure employees’
contribution to knowledge sharing, it is also the case that the strong competitive
ethos which characterized the spaghetti organization has been significantly
dampened in the successor form.
Influence activities. Influence activities are activities that subordinates engage in

when they influence hierarchical superiors to make decisions that are in their own
interests, rather than in the organization’s (Milgrom 1988; Argyres and Mui
2000). Resources expended on influence activities are, from the point of view of
the organization, waste. It is arguable that it is relatively more difficult under an
organization such as the spaghetti organization to protect against influence
activities. This is because everybody has, in principle, direct access to the
management team. A comparative advantage of the traditional, hierarchical,
and rule-governed organization is exactly that it may be better at protecting itself
against influence activities, because access to those who hold ultimate decision
rights is more difficult. In fact, the spaghetti organization, which actively stimu-
lated competition between project groups for the approval of the only relevant
‘hierarchical superior’ left, namely the Products and Projects Committee, did
produce such influence activities (Eskerod 1998). In contrast, under the hier-
archical form existing prior to the spaghetti organization such activities had been
much less prevalent, because of the aloof management style of the old manage-
ment (Poulsen 1993). Personal relations to those who staffed the Committee
became paramount for having a project ratified by the Committee. As Eskerod
(1998: 80) observed:
Part of being a project group may be lobbying in the PPC trying to obtain a high priority
status by influencing the PPC members. The reason for doing this is that a high
priority project is regarded as a very attractive place for the employees, because the
management sees this project as important.
It is, however, not clear from the existing empirical studies of the spaghetti
organization that this was perceived as a serious problem in the organization,
for example, whether it resulted in obviously unimportant projects being ap-
proved by the Committee. Rather, it was taken as an unavoidable, and relatively
small, cost of the spaghetti organization.10
To sum up, the search for the causes of the partial abandonment of the
spaghetti organization so far seems to lead only to inefficiencies stemming
from the lack of well-functioning project management routines on the part of
Products and Projects Committee being a serious problem. However, handling
this problem did not necessarily require a major organizational change. Still, the
many possible small liabilities of the spaghetti organization (problems of know-
ledge being held back in projects, influence activities, etc.) may together have
added up to significant costs that could be reduced by adopting a more struc-
tured organizational form (Børsens Nyhedsmagasin 1999; interview with Henrik
Holck, June 2000). Moreover, there is one fundamental problem left that was
clearly present in the spaghetti organization, and which is a strong candidate for
explaining the abandonment of that organizational form.
The Problem of Selective Intervention

Although infusing hierarchical forms with elements of market control seems
attractive, crafting and implementing such internal hybrids is a highly compli-
cated problem. One reason is a fundamental incentive problem that plagues all
hierarchies, but is arguably particularly prevalent in the very flat kind of organ-
ization of which the Oticon spaghetti organization is an example. An early
statement of the nature of this problem can be found in the comparative-systems
literature in economics; that is, the literature taken up with the economic
differences between capitalist and socialist systems. Thus, Mises (1949: 709)
argued that there are fundamental problems involved in ‘playing market’ inside
hierarchies.11 Specifically, schemes for a socialist market economy would not
work, because the concentration of ultimate decision-making rights and respon-
sibilities (i.e. ownership) in the hands of a central planning board would dilute
the incentives of managers. Thus, while planning authorities could delegate
rights to make production and investment decisions to managers, these rights
would be inefficiently used. First, because managers could always be overruled by
the planning authorities, they were not likely to take a long view, notably in their
investment decisions. Second, because managers were not the ultimate owners,
they were not the full residual claimants of their decisions and, hence, would not
make efficient decisions.
Later research has clarified that (1) handling the problem requires that the
planning authorities can credibly commit to a non-interference policy, and (2)
the problem goes beyond the comparative-systems context. It is latent in all
relations between ‘rulers’ and ‘ruled’ (North 1990; Miller 1992; Williamson
1996a; Foss and Foss 2002). The problem arises from the fact that it is hard for
the ruler to commit to a non-interference policy, because reneging on a promise
to delegate will in many cases be extremely tempting and those to whom rights
are delegated will anticipate this. Loss of motivation results. The problem is not
unknown in organizational studies, (e.g. Vancil and Buddrus 1979: 65). In
particular, Williamson’s concept (1996a) of the ‘impossibility of selective inter-
vention’ is highly relevant. He describes it as
a variant on the theme, ‘Why aren’t more degrees of freedom always better than less?’ In
the context of firm and market organization, the puzzle is, ‘Why can’t a large firm do
everything that a collection of small firms can and more.’ By merely replicating the
market the firm can do no worse than the market. And if the firm can intervene selectively
(namely, intervene always but only when expected net gains can be projected), then the
firm will sometimes do better. Taken together, the firm will do at least as well as, and will
sometimes do better than, the market (1996a: 150).
Williamson directly argues that (efficient) selective intervention of this kind is
‘impossible’. Incentives are diluted, because the option to intervene ‘can be
exercised both for good cause (to support expected net gains) and for bad (to
support the subgoals of the intervenor)’ (ibid. 150–1). Promises only to intervene
‘for good cause’ can never be credible, Williamson argues, because they are not
enforceable in a court of law. The wider implication of this reasoning is that since
decision rights cannot be delegated in a court-enforceable manner inside firms
(i.e. are not contractible), authority can only reside at the top. Authority cannot
be delegated, even informally, since any attempt to do this will run into the
problem of the impossibility of selective intervention. One would therefore
expect to see little use of delegation. Given that delegation is clearly a viable
and widespread organizational practice, this suggests that this implication is
going too far.
In fact, it is conceivable that the ‘intervenor’ may credibly commit to not
intervene in such a way that the ‘subgoals of the intervenor’ are promoted. The
logic may be stated in the following way (cf. Baker, Gibbons, and Murphy 1999).
Assume that a subordinate initiates a project.12 Assume further that the manager
has information that is necessary to perform an assessment of the project, but that
he decides up front to ratify any project that the subordinate proposes. Effect-
ively, this amounts to full informal delegation of the rights to initiate and ratify
projects—‘informal’, because the formal right to ratify is still in the hands of the
manager and because that right cannot be allocated to the subordinate through a
court-enforceable contract (cf. Williamson 1996a). Because the subordinate
values being given freedom—she is partly a residual claimant on the outcomes
of his activities—this will induce more effort in searching for new projects
(Aghion and Tirole 1997; Foss and Foss 2002). To the organization the expected
benefits of these increased efforts may be larger than the expected costs from the
bad projects that the manager has to ratify. However, a problem arises when the
manager has information about the state of a project (‘bad’ or ‘good’), because he
may then be tempted to renege on a promise to delegate decision authority, that
is, intervene in a ‘selective’ manner. If he overrules the subordinate, the latter will
lose trust in him, holding back on effort. Clearly, in such a game a number of
equilibria, each one characterized by different combinations of employee trust
and managerial intervention, are feasible. What determines the particular equi-
librium that will emerge is the discount rate of the manager, the specific trigger
strategy followed by the subordinate (e.g. Will he lose trust in the manager for all
future periods if he is overruled, or will he be more forbearing?), and how much
the manager values his reputation for not reneging relative to the benefits of
reneging on a bad project (Baker, Gibbons, and Murphy 1999).
All of the above builds on standard-economics assumptions on motivation
and cognition. Employees are motivated solely by being able to share in the
outcomes of their activities, and managerial intervention decreases motivation
because it means that the expected gain from putting effort into a project
diminishes. Including richer motivational and cognitive concerns aggravates
the problem of selective intervention. As argued in an extensive literature in
psychology (summarized in Frey 1997), people are also likely to be intrinsically
motivated. Such motivation may be sustained by psychological contracts
that involve loyalties and emotional ties (Brockner et al. 1992; Robinson and
Morrison 1995; Osterloh and Frey 2000: 541). Managerial intervention, par-
ticularly when it is perceived to be essentially arbitrary, may break such contracts
and harms intrinsic motivation (Robinson and Rousseau 1994). Other aspects of
psychological research (summarized in Bazerman 1994) suggest other ways in
which the problem of selective intervention may be aggravated in practice. Thus,
robust findings in experimental psychology show the presence of a systematic
overconfidence bias in judgment; that is, people tend to trust their own judg-
ments more than is ‘objectively’ warranted. Managers are not exceptions to this
bias; perhaps quite the contrary. The presence of the overconfidence bias in the
judgments that underlie managerial decision-making is likely to aggravate the
problem of selective intervention, because it produces additional meddling in
subordinates’ decisions.
Selective Intervention in Oticon

It is arguable that the main reason why the spaghetti organization was changed
into a more hierarchical organization has to do with the kind of incentive and
motivational problems described above. The official Oticon rhetoric, stressing
bottom-up processes in a flexible, market-like, and essentially self-organizing
system, with substantial autonomy and a management team (i.e. the Products
and Projects Committee) that acted as little more than a facilitator (Kolind 1990;
Lyregaard 1993), became increasingly at odds with the frequent selective inter-
vention that was undertaken by the Products and Projects Committee.13 The
need for selective intervention was rationalized by an external observer in the
following terms:
PPC [the Products and Projects Committee] does not make general written plans, which
are accessible to the rest of the organization . . . if this were done, plans would have to be
adjusted or remade in an ever-continuing process, because the old plans had become
outdated (Eskerod 1998: 80)
This entirely ad hoc approach was taken by the Products and Projects Committee
to be an unavoidable feature of a flexible, project-oriented organization (ibid.:
89). However, it was also a direct signal to employees that the ‘contract’ between
any project and the Products and Projects Committee was very incomplete
(Williamson 1996a), and that the Committee might at any time exercise its
ultimate control rights for the purpose of intervening in projects. This produced
diluted incentives and badly harmed motivation (as documented at length by
Eskerod 1997, 1998). Accumulating frustration finally resulted in a major
meeting in 1995, which marks the beginning of the retreat from the spaghetti
organization. At the meeting employees vociferously expressed their concerns
about the contrast between, on the one hand, the Oticon value base, including
the strong rhetoric of delegation, and, on the other hand, the way in which the
company was actually managed. Frustration that projects were interrupted in
seemingly arbitrary ways and that the organization was far better at generating
projects than at completing them was explicitly voiced.
The preceding discussion suggests that a fundamental problem in the spa-
ghetti organization was that Kolind and the Products and Projects Committee
never committed to a policy of not intervening selectively; neither, apparently,
did they intend to do so, or even see any rationale in it. Kolind’s view appears to
have been that in important respects and in many situations he and the Products
and Projects Committee would possess accurate knowledge about the true
commercial and technical possibilities of a given project, and that efficient
utilization of corporate resources dictated intervening in, and sometimes closing
down, projects. However, that view clashed at a basic level with the rhetoric
of widespread delegation of decision rights, leading to the demise of the
spaghetti organization, and the adoption of the current more structured matrix
organization.
In principle, Kolind and the Products and Projects Committee could have
committed to a policy of non-interference from the beginning, rather than acting
on the belief that organizational flexibility required that they selectively intervene
in projects. Conceivably, this might have made this radical internal hybrid
viable. However, even if Kolind and the Products and Projects Committee had
announced initially that they would refrain from selective intervention, there are
reasons why this commitment might not have been sustainable in the longer run.
Thus, it was increasingly realized that the elaborate system of measures that was
initially installed was inadequate. It did not capture important dimensions of
behavior (e.g. employees’ contribution to knowledge sharing) and it may have
caused some projects to hold back knowledge. Rather than trying to refine the
system further, it was abandoned.14 However, the implication was that manage-
ment could no longer take place solely through incentives (following initial
ratification of projects). The employee-stock-ownership program was arguably
not sufficiently high-powered to truly motivate, and did not confer sufficient
decision rights to halt the practice of selective intervention in employees’ terri-
tory. The implication was that Kolind and the Products and Projects Committee
had to engage in much more monitoring of the projects. Being able to do this
without compromising team autonomy and harming motivation was unlikely.
The New Organization

A notable feature of the current Oticon organization lies in its much more
consistent approach towards projects. Organizational expectations are that pri-
orities do not change in the rapid and erratic manner that characterized the
original spaghetti organization, and that employees can be much more sure that
the projects they are working on will be seen through to the end. In the new
organization projects are rarely stopped or abandoned, and there is an explicitly
stated policy of sticking to ratified projects. Two reasons are given for this. First,
projects are more carefully examined with respect to technical feasibility and
commercial implications. An aspect of this is that the Competence Center now
puts forward project ideas much more actively, and contacts potential project
leaders, rather than relying on the bottom-up approach that characterized the
original spaghetti organization. Thus, hierarchical selection has to some extent
substituted for selection performed by bottom-up processes. Second, the wish to
avoid harming motivation (i.e. diluting incentives) by overruling existing pro-
jects is firmly stressed. The management team has openly announced this policy,
and has made it credible by (1) consistently sticking to it and (2) researching
project ideas carefully ex ante so that employees’ perception of the probability
that intervention will occur is low. Some reasons why a more traditional hier-
archy may be better at making such commitment credible are discussed in the
following section.
Discussion: Implications for Internal Hybrids

Proponents of internal hybrids argue that their advantage lies in the ability to
integrate the virtues of more conventional organizational forms (Miles et al.
1997). Specifically, internal hybrids combine the ability to achieve efficiencies
through specialization that characterizes the functional form with the relative
independence that can be granted in a divisional form and the ability to transfer
resources and capabilities across division and business-unit boundaries that
characterize the matrix organization (e.g. Miles and Snow 1992). Strikingly
similar arguments were invoked by the designers of the Oticon spaghetti organ-
ization (Kolind 1990, 1994; Lyregaard 1993). This suggests that broader lessons
with respect to the efficient design of internal hybrids may emerge from the
Oticon experience.
Getting Complementarities Right

A basic proposition in much organization theory is that for reasons of efficiency
organizational forms are aligned with environmental conditions, strategies, and
exchange conditions in a systematic and discriminating manner (Thompson
1967; Meyer, Tsui, and Hinings 1993; Williamson 1996a; Nickerson and
Zenger 2002). Thus, Zenger (2002: 80) argues that many attempts to infuse
hierarchies with elements of market control break with this basic proposition and
often ‘violate patterns of complementarity that support traditional hierarchy as
an organizational form’. For example, managers implement new structures
without new performance measures and new pay systems, or they implement
new pay systems without developing new performance measures. This results in
unstable, possibly inefficient, hybrid forms. In contrast, viable internal hybrids
are characterized by organizational elements clustering in certain characteristic,
complementary combinations, just as in the case of markets and hierarchies
(Williamson 1996a).
Did the spaghetti organization get the complementarities between organiza-
tional elements right? On first inspection, it did, as has been argued. However,
closer inspection reveals a somewhat different picture. Thus, it may be argued
that Oticon did not get the organizational complementarities exactly right,
because the kind of radical internal hybrid that was adopted requires that projects
be managed almost exclusively through the provision of incentives and owner-
ship (Miles et al. 1997; Zenger 2002). The performance measurement systems in
the spaghetti organization were not adequate to support precise performance
evaluation. Some relevant performance dimensions (e.g. contribution to know-
ledge sharing) were not measured at all. Also, the incentive effects of the
employee-stock-ownership program appear to have been limited. Thus, remu-
neration schemes may not have rested on sufficiently precise and encompassing
measures and were not sufficiently high-powered to complement the widespread
delegation of decision rights in the organization. This fostered a need for selective
intervention on the part of Kolind and the Products and Projects Committee that
went beyond what would have been necessary with better measures of employee
performance, and which had the unintended effect that motivation was seriously
harmed. This reasoning suggests the following proposition:
Proposition 1: Internal hybrids that violate patterns of complementarity
characteristic of this organizational form will be subject to more problems
of selective intervention than hybrid forms that get the complementarities
right.
A corollary to this proposition is that advances in measurement methods will
result in less selective intervention, because the measurement of performance is
improved so that the moral hazard stemming from the delegation of rights is
reduced.
Problems of Intervention and Organizational Form

The motivational and incentive problems that may emerge from selective
managerial intervention are not independent of organizational structure;
notably, the number of hierarchical layers in the organization, and therefore
the distribution of information and authority in a firm. Arguably, organizations
that adopt internal hybrids that amount to drastically reducing the number of
hierarchical layers, such as Oticon’s spaghetti experiment, are more prone to the
problem than more traditional hierarchical firms. There are (at least) three
reasons for this.
First, decision rights are more solidly established in a traditional hierarchy,
being associated with well-defined, distinct positions, than in a flat, project-based
organization, where decision rights are more fleeting. Organizational expect-
ations that certain positions come with certain decision rights are very well
established, and potentially costly for a top manager to break with through
selective intervention. The same kind of organizational expectations are not
likely to be established in a flat, project-based organization. Second, a top
manager who selectively intervenes in a hierarchical organization risks overruling
the whole managerial hierarchy (all those below him), whereas this may be a
smaller concern in a flat organization, where the CEO may only harm motiv-
ation in a specific project team if he overrules that team. Third, information
processing perspectives (Thompson 1967; Galbraith 1974) suggest that the
hierarchy is not just a structure of authority, but also one of information. The
informational distance between projects and top manager may be enlarged by
having a multi-layered hierarchy. This implies that the top manager knows that
he is in key dimensions ignorant about the project (Aghion and Tirole 1997). In
this case, his incentives selectively to intervene will be small. The preceding
arguments suggest the following proposition:
Proposition 2: An internal hybrid form that is organized within a firm with
few hierarchical layers will be associated with larger efficiency losses caused by
problems of selective intervention than an internal-hybrid form that is organ-
ized within a firm with more hierarchical layers.
Problems of Intervention and the External Environment

A key reasons why the Products and Projects Committee considered that fre-
quent selective intervention was necessary had to do with the impossibility of
making detailed plans for future business development in an industry where
unforeseen contingencies (e.g. new technologies) often occurred. This suggests a
third proposition:
Proposition 3: There will be more selective intervention in internal hybrid
forms that operate in turbulent industries than in internal hybrid forms that
operate in tranquil industries.
This proposition may be taken to be the other side of the coin of the transaction-
cost argument that external hybrids are unstable in ‘dynamic’ industries
(Williamson 1996a) because in such industries unexpected contingencies that
may give rise to hold-ups are more likely. Along similar lines, the argument
underlying Proposition 3 is that in dynamic industries the implicit contract
between teams/projects and management in internal hybrids is likely to be
relatively more incomplete than in more tranquil industries. Therefore, manage-
ment is likely to engage in more selective intervention in an attempt to influence
how projects react to unexpected contingencies.
Internal and External Hybrids and Internal and External Markets

The problem of selective intervention casts a novel light over governance choices
between internal and external hybrids and internal and external markets. These
organizational forms may be seen as rather close substitutes. For example, they
may be adopted in order better to exploit local knowledge (Cowen and Parker
1997), or to strengthen incentives because they make agents residual claimants to
a higher degree than is the case in traditional hierarchies. However whereas
internal hybrids/internal markets may suffer from problems stemming from
selective intervention, external hybrids/external markets do not suffer from
these. Of course, external hybrids and markets may suffer from inefficiencies
caused by hold-up problems when specific assets are deployed. However, creating
competition between suppliers, investing in hostages, having some tapered
integration, etc. may strongly reduce problems related to hold-up. The legal
system also constrains the hold-up possibility, however imperfectly. In contrast, a
solution to the problem of avoiding harmful selective intervention cannot rely on
market forces or court-enforceable contracts. The implication is that, on average,
external markets and external hybrids are likely to have incentive properties that
are superior to those of internal markets and internal hybrids, so that there will be
(transaction and production) cost penalties associated with the use of the latter.
This results in the following proposition:
Proposition 4: Firms that choose external hybrids (markets) over internal
hybrids (markets) will have a cost performance that is superior to those that
choose internal hybrids (markets) over external hybrids (markets).
This reasoning may be seen as a variation of a familiar theme of transaction cost
economics (Williamson 1996a); namely, that vertical integration be considered
the option of last resort.
Managing Commitment to Not Selectively Intervene

While theory suggests that the problem of committing to not selectively inter-
vene is a tough one, we do seem to observe a substantial amount of delegation in
real-world firms. This indicates that it is possible credibly to commit to non-
intervention. There are two fundamental methods that managers may use for this
purpose. Both essentially tie the hands of a would-be intervenor.
The first one is to commit oneself to being (rationally) ignorant. Thus, a
manager may choose not to be informed about a number of critical dimensions
in projects. In very hierarchical organizations this may be easy to accomplish
because of the large informational distance between top management and
projects. A second approach proceeds by managers making it harmful to them-
selves selectively to intervene. Open announcement of a non-intervention policy,
ensuring such a policy is recorded in company documents, working to install it in
corporate culture, etc. all go some way to meet this aim, since they make the
possible clash between the communicated values and interventionist managerial
practice extremely sharp, and make very obvious the breaking of the explicitly
stated psychological contract (Brockner et al. 1992).
The Spaghetti Organization as a Modulation between Stable Organizational Forms

Although organizational forms that break with a logic of complementarity may
incur penalties in terms of static efficiency (i.e. economizing with transaction
costs and costs of production), they may still conceivably yield benefits in terms
of dynamic efficiency (i.e. innovativeness). Calls for ‘chaotic’ organization (Peters
1992) often implicitly make such arguments. Organization design needs to
consider both types of efficiencies (Ghemawat and Ricart i Costa 1993). An
implication is that in an inter-temporal perspective, choosing ‘consistent’ con-
figurations of organizational elements may not necessarily maximize the value of
the firm. An ingenious argument of this kind has been developed by Nickerson
and Zenger (2002). They suggest that considerations of efficiency may require
modulating between discrete organizational forms—such as the old hierarchical
Oticon organization and the post-spaghetti matrix structure—even in response
to a stable set of environmental conditions. This is because the steady-
state functionality delivered by a discrete organizational form may itself be
discrete, and the desired functionality may lie in-between those delivered by the
discrete organizational forms. Efficiency gains may then be obtained by modu-
lating between the forms.
If indeed the Oticon spaghetti organization did incur inefficiencies with
respect to the organization of its administrative systems, it is hard to dispute
that it was also quite an innovative organization (cf. Table 7.1). These benefits
may have overwhelmed the organizational costs. Although the spaghetti organ-
ization was not stable in the presence of the problem of selective intervention, it
would still have made sense to choose this form, even if the designers had known
it to be inherently unstable. In fact, much of the early discussion of the spaghetti
organization made reference to the need to try something entirely new and
admittedly chaotic, for the purpose of drastically shaking up the original,
bureaucratic organization (Kolind 1990; Peters 1992; Poulsen 1993). This is
consistent with Nickerson and Zenger’s theory. The spaghetti organization may
indeed be an example of modulating between the stable organizational form of
the traditional, pre-spaghetti hierarchy and the stable matrix organization post
spaghetti. What lends credence to this interpretation is that although the hearing-
aid industry was technologically quite dynamic in the relevant period (Lotz
1998), it is not possible to identify environmental changes that might have
caused the organizational change away from the spaghetti organization.
Firms and Markets

This discussion casts light over the classic question of the fundamental differ-
ences between firms and markets, and supports the original Coasian position that
the key difference is that markets do not rely on resource allocation by means of
authority whereas firms do (Coase 1937). ‘Authority’ is a problematic word,
because it is often invested with too narrow a meaning; for example, detailed
direction and supervision (Foss and Foss 2002). Ultimately, the meaning of
having authority is that one can restrict the decisions of one’s subordinate,
overrule him, and perhaps fire him. This means that although decision rights
may be delegated, we can still trace the chain of authority in a firm, and we will
always realize that ultimate decision-making power resides at the top. As this
chapter has illustrated, all subordinates’ decision rights ‘are loaned, not owned’
(Baker, Gibbons, and Murphy 1999: 56). Fundamentally, it can never be
otherwise. This is because ultimate decision-making rights can only be trans-
ferred from bosses to subordinates in one way; namely, by transferring ownership
(Hart 1995). However, transferring ownership amounts to spinning off the
person to whom ownership is given. It means creating a new firm. It is
this fundamental difference in how ownership is allocated that underlies
the problem of selective intervention. The analysis in this chapter thus makes
direct contact with important modern theories of economic organization (Hart
1995; Williamson 1996a; Baker, Gibbons, and Murphy 2002) that stress the
importance of ownership for the understanding of the nature of firms and firm
boundaries.
Conclusion
To many firms the adoption of new, hybrid organizational forms is increasingly
seen as imperative. However, rather little theoretical and empirical research has
treated, particularly, internal hybrids. This chapter has examined a specific
experiment with adopting and later strongly modifying a radical internal hybrid,
in an attempt to identify some possible liabilities of the adoption of such
organizational forms. In particular, the focus has been on motivational problems
that may be caused by problems of committing to refraining from harmful
selective intervention. A main argument was that problems of selective interven-
tion are particularly prevalent in organizations that adopt radical internal hy-
brids. In contrast, firms with more traditional hierarchical structures better shield
themselves from these problems. Managers may commit to non-intervention by
means of rationally choosing to be ignorant or by making it harmful to them-
selves selectively to intervene. Finally, the problem of selective intervention is a
prime candidate for understanding the incentive liabilities of hierarchies and
internal hybrids vis-à-vis markets or external hybrids.
Although this chapter has thus exemplified the interpretative power of organ-
izational economics, it must be admitted that organizational economics only tells
part of the story. From an organizational economics perspective the spaghetti
organization represented a matrix of rights and incentives that are helpful for
understanding its liabilities, and how these liabilities gave rise to certain organ-
izational dynamics (i.e. the partial abandonment of the spaghetti organization).
However, it may indeed also be understood in terms of an attempt to, for
example, foster dynamic capabilities (Ravasi and Verona 2000), a perspective
that lies outside organizational economics. Thus, the full story of the Oticon
spaghetti experiment requires that more than one perspective be considered.
Relatedly, the chapter has suggested that organizational economics should con-
sider to a fuller extent psychological insights into motivation and cognition.
While it is possible to tell stories of managerial commitment, selective interven-
tion, and stifled incentives based only on organizational economics, there is little
reason to be so narrow. A vast literature on procedural justice in organization,
psychological contracts, and (biased) cognition exists, the insights of which may
be combined with organizational-economics insights in order to further the
understanding of problems of managerial commitment, including problems of
selective intervention (cf. also Miller 1992; Lindenberg 2000).
Notes
1. See Teece (2003) for a study that is complementary to this chapter. Teece studies
an internal hybrid (the organization of the Law and Economics Consulting Group)
that is organized on very different principles from those of the Oticon spaghetti
organization.
2. However, a main purpose of conducting analysis of single cases is often to be able to
pose competing explanations for the same set of events (and perhaps to indicate
how these explanations may be applied to other situations) (Yin 1989). Moreover,
basic considerations of internal validity dictate that alternative explanations be con-
sidered. However, while I shall indeed make reference to and discuss other possible
explanations of some of the relevant events (e.g. ideas from motivation theory and
information processing theory), the main emphasis is on developing one specific
interpretation. While an eclectic, multiple-perspective approach may be superior in
the abstract, more insight may arguably be provided in the concrete by pursuing, in a
relatively narrow fashion, one specific interpretation and exploring the limits of this
interpretation.
3. The possibility that external hybrids or market contracting may be alternatives to
internal hybrids never seems to have been considered in Oticon. Thus, that incentives
may be strengthened by relying on the real market (rather than the simulated internal
one) by spinning off functions and departments (Aron 1991) does not appear to have
been seen as a serious alternative to internal disaggregation.
4. Exceptions may occur when giving subordinates more extensive rights (e.g. a package
of initiation, ratification, and implementation rights) strengthens employee incentives
(see Aghion and Tirole 1997; Baker, Gibbons, and Murphy 1999; and Foss and Foss
2002 for analyses of this).
5. For example, it could reflect attempts to curb moral hazard in project teams. However,
the increased use of high-powered incentives and more widespread employee owner-
ship were designed to remedy problems of moral hazard.
6. In addition, a motivation theory perspective would suggest that while employees’
lower-level needs were not sufficiently satisfied (low income, uncertainty because of
the reorganization and lay-offs), management already tried to address their higher-
level needs (more comprehensive tasks, more responsibility). Thanks to an anonym-
ous reviewer for this point.
7. Eskerod (1997, 1998) in particular documents this. My later interview with the chief
HRM officer strongly confirmed Eskerod’s finding that the multi-job concept had
severe costs in terms of problems of coordination and frustrating employees.
8. Nor would this have been possible, as nobody in Oticon, not even the Products and
Projects Committee, kept track of the total number of development projects. Records
were only kept of the ten-to-twenty major projects. An estimate is that under the
spaghetti organization an average of seventy projects were continously running
(Eskerod 1998: 80).
9. In fact, the more structured project organization gradually implemented from 1996
has established controls that ensure that the coordination and time-allocation prob-
lems that beset the original spaghetti organization are kept at bay.
10. Interview with HRM manager Henrik Holck.
11. Somewhat later the literature on internal-transfer prices revealed the existence of
various incentive problems that may beset this organizational practice (e.g. Holm-
ström and Tirole 1991).
12. This should be understood in a broad sense. A ‘project’ may refer to many different
types of decisions or clusters of decisions.
13. See Simons (2002) for a highly pertinent discussion of employees’ perception of the
fit between managers’ words and actions, and the motivational consequences of this
perception.
14. Since behavior was apparently difficult to measure, a more output-based system
could have been tried (Prendergast 1999); for example, contracts that specified
rewards for specific accomplishments (e.g. a system that rewarded according to
milestones in a development project). However, it is doubtful whether such a
contract could actually be made court-enforceable. A managerial-commitment prob-
lem would again result.
8
Performance and Organization in the Knowledge
Economy: Innovation and New Human Resource
Management Practices
Introduction
The ongoing restructuring of management and organization practices designed to
cope with an increasingly complex and rapidly changing knowledge-based econ-
omy has received increasing attention from scholars from a diversity of disciplines
and fields (Bowman and Singh 1993; Huselid 1995; Guest 1997; Zenger and
Hesterly 1997). In particular, much attention has been given to the restructuring of
the employment relation in the form of changed human resource management
(henceforth ‘HRM’) practices that has accompanied the emergence of firms
specialized to compete in dynamic, information-rich environments (Ichniowski
et al. 1996). These practices encompass various types of team-based organization,
continuous (often internal and team-based) learning, decentralization of decision
rights and incentives, systems for mobilizing employee proposals for improve-
ments, quality circles, emphasis on internal knowledge dissemination, etc. (Lado
and Wilson 1994; Zenger and Hesterly 1997; Mendelson and Pillai 1999).
While many of these new practices may not, strictly speaking, be entirely
novel, some of the broad generalizations about new HRM practices refer to
trends that appear to be truly recent (Osterman 2000). Thus, new HRM
practices appear to follow a steep diffusion curve (ibid.), and they tend to be
adopted in a system-like manner rather than as individual components
(Ichniowski, Shaw, and Prennushi 1997; Laursen and Mahnke 2001). Moreover,
there are some indications that they tend to be associated with high innovation
performance (Mendelson and Pillai 1999; Michie and Sheehan 1999). It is these
emerging ‘stylized facts’, and particularly the latter two, that we try theoretically
and empirically to address and substantiate in this chapter.
The increased attention paid to new HRM practice has been particularly
prevalent in the fields of strategic management, human resource management,
and, increasingly, the economics of organization. For example, strategy scholars
have argued that human resources are particularly likely to be sources of
This chapter is co-authored with Keld Laursen.
sustained competitive advantage and that HRM practices should therefore be
central to strategy (Barney 1991; Lado and Wilson 1994; Barney 1995). One
reason for this is the system-like—or, in the terminology that we shall make use
of, ‘(Edgeworth) complementary’—way in which HRM practices may connect:
complex interaction between many complementary practices is arguably harder
for would-be imitators to copy than stand-alone practices (Barney 1991; Porter
and Rivkin 1997). The complementary nature of many of the elements of
(formal and informal) organizational structure has been examined in an emer-
ging important literature in organizational economics (notably Milgrom and
Roberts 1990a; Aoki and Dore 1994; Milgrom and Roberts 1995; Holmström
and Roberts 1998). Insights from this literature have made some impact in the
human resource management field (Baron and Kreps 1999ab).
The connection between firms’ internal organization and their innovativeness
has certainly never been neglected in the innovation and evolutionary-economics
literature. After all, the increasing bureaucratization of the R&D function was a
key theme in Schumpeter’s later work. However, it is also fair to say that these
literatures are characterized by relatively scant attention being paid to new
(complementary) HRM practices and how they influence innovation perform-
ance.1 Something similar may be said of the HRM literature; here, too, is a lack
of theoretical and empirical treatment of how new HRM practices impact on
innovation performance.2 In sum, there is clearly in a number of fields and
disciplines an emerging theoretical and empirical understanding of how HRM
practices and complementarities between these impact on productivity and, in
turn, on financial performance, but that understanding needs to be extended to
also encompass innovation performance. Accordingly, the purpose of this chapter
is to add to the theoretical and empirical understanding of how HRM practices
and complementarities assist in explaining innovation performance. Thus, we
shall argue and empirically demonstrate that new HRM practices, and comple-
mentarities between these, impact on innovation performance; that is, on future
competitive advantages.
This chapter is one of the first major empirical examinations of the link
between innovation performance and complementary new HRM practices.
Only a few other chapters are available on this topic, including Michie and
Sheehan (1999). Thus, for example, while Gjerding (1997) and Mendelson and
Pillai (1999) do examine the HRM/performance link, they do not incorporate
considerations of complementarity. Lorenz (1998) presents an analysis of com-
plementarities between the use of new HRM practices and so-called new pay
policies, but he does not include a measure of performance in the analysis.
And Ichniowski, Shaw, and Prennushi (1997) discuss the complementarity/
performance (productive efficiency) link, but they do not deal with innovation
performance. In contrast, we link together complementarity and innov-
ation performance. Furthermore, in our analysis the HRM ‘systems’ (i.e. par-
performance and organization 189
ticular combinations of HRM practices) emerge out of the empirical analysis
(namely, from our principal-component analysis), while Ichniowski, Shaw, and
Prennushi (1997) and Michie and Sheehan (1999) assume their different systems
from the outset. Arguably, Ichniowski, Shaw, and Prennushi (1997) are able to
define fine-grained controls, since they focus on HRM complementarities found
in steel-finishing lines only. However, the drawback is that the conclusions drawn
do not concern the entire economy as such. In contrast, we test hypotheses that
articulate the HRM/innovation link on a large Danish data set—the DISKO
database—which contains cross-sectional information on the HRM practices
and innovation performances of 1,900 privately owned Danish firms in both
manufacturing and non-manufacturing industries.
We contribute to several literatures. For instance, our finding that comple-
mentarity obtains in HRM practices provides further empirical support for
theoretical work on complementarity in organizational economics and elsewhere.
Our investigation of the links between complementary HRM practices and
innovation performance contributes to the firm-strategy literature as well as to
the innovation literature. However, we see this chapter as most directly linking
up with work in evolutionary economics and innovation studies. Much of this
work has had an aggregate focus in which the internal organization of the firm
has been given less attention, and where the main interest has centered on issues
such as appropriability, firm size, market structure, complementary assets, etc. as
determinants of innovation performance. The findings in this chapter may be
taken as an indication of the importance of internal factors for the understanding
of innovation (while not denying the importance of other factors).
The design of the chapter is as follows. In the section, ‘Complementarity, New
HRM Practices, and Innovation Performance: Theoretical Considerations’ we
begin by reviewing recent work on complementarities in organizational econom-
ics. The notion of complementarities allows us better to understand the ‘sys-
temic’ quality which may characterize not only technologies but also the
organizational elements that constitute the internal organization of firms.
Thus, we argue that complementarities allow us better to understand the cluster-
ing of HRM practices in firms. Moreover, the notion of complementarity is
helpful for understanding how performance is influenced by such systemicness.
Thus, complementarities between HRM practices influence not only the firm’s
profits but also, as we argue, its innovation performance. In the section, ‘Empir-
ical Analysis’ we specify an empirical model that allows us to test these ideas on
the data set represented by the DISKO database. We apply an ordered probit
model as the relevant means of estimation. Using principal-component analysis,
we identify two HRM systems which are both conducive to innovation. The
first is one in which seven of nine HRM variables matter (almost) equally
for the ability to innovate. The second system is dominated by firm-internal
and -external training. Hence, we conclude that application of HRM practices
does matter for the likelihood of a firm being an innovator. Furthermore, since
the two HRM systems are strongly significant in explaining innovation perform-
ance, while only two individual practices (out of the total of nine) are found to be
strongly significant, we find support for the hypothesis stating the importance of
complementarities between certain HRM practices (within each of the two
HRM systems) for explaining innovation performance.
Complementarity, New HRM Practices, and Innovation Performance:

Theoretical Considerations
The HRM–Innovativeness Link: A Black Box?
Contributions that not only mention but actually theoretically and empirically
address the link between HRM practices and innovation performance are surpris-
ingly few in number. To be sure, there is a large, somewhat heterogeneous, literature
on the management of innovation and technology. However, much of this litera-
ture is largely taken up with strategy issues connected to the exogenous dynamics of
technology (e.g. technology life cycles), large-scale organizational issues, and
questions relating to appropriability (e.g. Tushman and Moore 1988). Of course,
beginning with Burns and Stalker (1961), the organizational-behavior field has
stressed the link between ‘organic’ organizational structures and innovation per-
formance. A recent stream of pertinent organizational-behavior research has been
prompted by March’s distinction (1991) between ‘exploration’ and ‘exploitation’.
However, it is not too unfair to say that more precise theoretical identifica-
tions of the mechanisms underlying the hypothesized links between HRM
practices and innovativeness are virtually non-existent. This is true of both the
technology-management and the organizational-behavior literatures. To offer
further illustrative examples, Baron and Kreps’s economics-inspired treatise
on human-resource management (1999) does not treat innovativeness as a
relevant performance variable. Michie and Sheehan (1999), while empirically
finding a link between HRM practices and innovation performance, do not offer
a theory of this link. Virtually all of the economics literature on the firm-level
determinants of innovation has dealt with issues such as the famous debates on
the relation between firm size and innovation performance (Acs and Audretsch
1988; Cohen and Klepper 1996). The organizational factors which may mediate
any such relations have largely been black-boxed. Finally, while the emerging
evolutionary economics literature on the firm (e.g. Kogut and Zander 1992;
Dosi and Marengo 1994; Henderson 1994; Granstrand, Patel, and Pavitt 1997;
Pavitt 1998; Laamanen and Autio 2000) has stressed complementarities between
diverse technologies, and the learning that such complementarities may give rise
to, the organizational requirements for coordinating and reaping benefits from
these complementarities have not been investigated in any detail.
In sum, therefore, while a number of contributors have noted a link between
new HRM practices and innovation performance, and while some contributions
have stressed the link between complementary-knowledge stocks and innovation
performance, no contributions appear (as far as we know) to have put forward
theoretical arguments asserting a link between complementary new HRM prac-
tices and innovation performance. However, as indicated, various literatures do
contain ideas that are pertinent to the understanding of the link between HRM
practices, complementarities between these, and innovation performance. We
briefly discuss such ideas below.
Complementarities
One of the most important strides forward in the economics of organization
during the last decade is the increasing use that has been made of the notion of
Edgeworth complementarities (Milgrom and Roberts 1990a; Milgrom, Qian,
and Roberts 1991; Aoki and Dore 1994; Holmström and Milgrom 1994;
Milgrom and Roberts 1995; Ichniowski, Shaw, and Prennushi 1997; Holmström
and Roberts 1998; Baron and Kreps 1999). Without doubt, the pioneers in this
application have been Paul Milgrom and John Roberts. As they define it,
complementarity between activities obtains if ‘doing more of one thing increases
the returns to doing (more of ) the others’ (Milgrom and Roberts 1995: 181).
Formally, this will be seen closely to correspond to mixed partial derivatives of a
pay-off function with standard assumptions about smoothness of this function.
However, as Milgrom and Roberts argue, drawing on the mathematical field of
lattice theory, the notion of complementarity is not wedded to the conventional
differentiable framework.3 Mathematically, complementarity between a set of
variables obtains when a function containing the relevant variables as arguments
is super-modular.4
There are a number of reasons why scholars in a diverse set of fields, including
evolutionary economics, technology studies, and organizational behavior,
should take an interest in the notion of complementarities (and the associated
formalisms). At the most fundamental level, it provides an understanding of
those systemic features of technologies that have traditionally interested such
scholars (e.g. national systems of innovation, technology systems).5 The other
side of the coin is that complementarity is an important source of path-depend-
ence: successful change has to involve many, perhaps all, relevant variables of a
system and involve them in specific ways.6 This also helps to explain why
complementarities are an important source of self-propelled change (cf.
Milgrom, Qian, and Roberts 1991); that is, ‘cumulative change’.7 Thus, the
notion of complementarity is helpful for understanding, for example, techno-
logical paradigms and national systems of innovation. At the level of the firm, the
notion of complementarity may assist in the understanding of diversification
patterns (Granstrand, Patel, and Pavitt 1997)—for example, it implies that firms
will find most profitable new activities (or technologies) in areas that are
complementary to newly increased activities (technologies). As we shall argue
further, the notion of complementarity is also helpful for understanding the links
between organizational variables—specifically, what is here called ‘new human
resource management practices’—and innovation performance.
Innovation, Complementarities, and New HRM Practices

To repeat, ‘new HRM practices’ is the overall label put on a host of contemporary
changes in the organization of the employment relation, referring to team-based
organization, continuous (often team-based) learning, decentralization of deci-
sion rights and incentives, emphasis on internal-knowledge dissemination, etc.
While there may be strong financial-performance effects, productivity effects,
and flexibility advantages of such new HRM practices—as documented by
Huselid (1995), Ichniowski, Shaw, and Prennushi (1997), and Mendelsson and
Pillai (1999) respectively—our main emphasis is on the impact on innovation
performance; in particular, on product innovation.
New HRM practices can be conducive to innovative activity for a number of
reasons. With respect to process innovations/improvements, one notable feature
of many new HRM practices is that they increase decentralization, in the sense
that problem-solving rights are delegated to the shop floor. Accomplished in the
right way, this amounts to delegating rights in such a way that they are co-located
with relevant knowledge, much of which may be inherently tacit (and thus
require decentralization for its efficient use). In other words, increased delegation
may better allow for the discovery and utilization of local knowledge in the
organization, particularly when there are incentives in place that foster such
discovery (Hayek 1948; Jensen and Meckling 1992). Indeed, much of the ability
of Japanese firms to engage in ongoing, incremental process innovation turns on
a successful co-location of problem-solving rights and localized knowledge
combined with appropriate pecuniary and non-pecuniary incentives (Aoki and
Dore 1994).
Relatedly, the increased use of teams that is an important component in the
package of new HRM practices also means that better use can be made of local
knowledge, leading to improvements in processes and perhaps also to minor
product improvements. However, teams can do something more, since they are
often composed of different human-resource inputs. This may imply that teams
bring together knowledge that hitherto existed separately, potentially resulting in
non-trivial process improvements (when teams are on the shop floor) or ‘new
combinations’ that lead to novel products (Schumpeter 1912/34)(when teams are
in product-development departments). Training of the workforce may be
expected to be a force pulling in the direction of a higher rate of process
improvements and may possibly also lead to product innovations, depending on
the type, amount, and quality of the relevant training. Generally, increased
knowledge diffusion, for example through job rotation, and increased informa-
tion dissemination, for example through IT, may also be expected to provide a
positive contribution to the firm’s innovation performance, for rather obvious
reasons.
Thus, there are grounds for expecting that among the benefits from adopting
new HRM practices will be increased innovation performance. Arguably, the
adoption of a single such practice may sometimes provide a contribution
to innovative performance. For example, the increasingly widespread practice
of rewarding shop-floor employees for putting forward suggestions for process
improvements (e.g. by giving them a share of the cost savings) is likely to increase
such incremental innovation activity (Bohnet and Oberholzer-Gee 2001)
more or less regardless of the specific firm in which the reward system
is implemented. However, other practices may not be expected to have a
significant impact on innovation performance if merely implemented in isol-
ation. At least to the extent that implementing new HRM practices is associated
with extra effort or with disutility of changing to new routines, etc., employees
will have somehow to be compensated. Thus, we would expect many
new HRM practices to work well (in terms of both profits and innovation
performance) only if accompanied by new, typically more incentive-based,
remuneration schemes. Evidence appears to support this (Ichniowski, Shaw,
and Prennushi 1997).
In general, we should on a priori grounds expect new HRM practices to be
most conducive to innovation performance when adopted not in isolation but as
a system of mutually reinforcing practices. The arguments in favor of this are
relatively straightforward. For example, the benefits from giving shop floor
employees more problem-solving rights will probably depend positively on the
level of training of such employees. The converse is also likely to hold: employees
may invest more in upgrading their skills if they are also given extensive problem-
solving rights (i.e. actually utilize those skills), particularly if they are given the
right (intrinsic or extrinsic) motivation. Relatedly, rotation and job-related
training may be complements in terms of their impact on innovative activity.
All such practices are likely to be complements to various incentive-
based remuneration schemes (whether based on individual, team, or firm per-
formance), profit-sharing arrangements, and promotion schemes (Zenger and
Hesterly 1997).
In sum, while individual new HRM practices may be expected have some
positive impact on innovation performance, theory would lead us to expect that
because of complementarities between these practices systems of HRM practices
will be significantly more conducive to innovation than individual practices.
Below we examine these ideas empirically.
Empirical Analysis
The Empirical Model
Based on the discussion above, the probability of introducing an innovation may
be specified as follows:
a ¼ f (b1 z,b2 x): (1)
Here, a is the probability of introducing an innovation associated with a certain
degree of novelty, b1 and b2 are parameter vectors, and z is a set of (exogenous)
determinants of innovation, related to the application of human-resource-
management practices, while x is a set of other variables explaining innovative
performance across business firms. The variables included in the vector x are
arguably standard variables in the literature aiming at explaining innovation
performance (Geroski 1990; Kleinknecht 1996). The model may be made
operational in the following way:
Prob(Ai ¼ 0 : : j) ¼ aSIZEi þ xSECTi þ dLINKi þ fEXRELi
j
þ wSUBSIDi þ hj HRMP i þ : : þ hn HRMPin þ ei , (2)
where Prob(Ai ¼ 0 : : j) expresses the firm’s probability of introducing an innov-
ation associated with a certain degree of novelty on the market. If the firm in
question is a non-innovator, the variable takes the value of 0; if the firm has
introduced (in the period 1993–5) a product or service new to the firm the value
is 1; if the firm has introduced a product that is new in a Danish context over the
period the value is 2; while the value for this variable is 3 if the firm has
introduced a product (or service) that is new to the world.8 Our sample includes
928 non-innovators, 728 firms that produced products/services which were new
only to the firm itself and 125 firms that produced products/services that were
new to the national market, while 103 firms introduced products/services that
were new to the world. Since our dependent variable is a discrete variable we
apply an ordered-probit model as the means of estimation.9
As is common in studies aimed at explaining innovative performance
(e.g. Geroski 1990; Michie and Sheehan 1999), we control for firm size (SIZE)
and for sectoral affiliation (SECT). We include nine sector categories. For what
concerns the sectoral classification, we apply the taxonomy developed by Pavitt
(1984) and the four corresponding sectors for manufacturing firms. For the
service firms in our sample we construct five additional sectors. Explanations of
the sectoral classification that we apply may be found in Appendices 1 and 2 to
this chapter (on pp. 207–9 below). As argued by Geroski (1990), such sectoral
controls can be interpreted as capturing the differences in technological oppor-
tunities which face firms located in different sectors.
Other control variables include whether or not the firm in question has
increased its vertical interaction with other firms, whether upstream or down-
stream (LINK). This variable is supposed to pick up the effect of interactions
with suppliers and users for innovation performance as stressed by, for example,
Lundvall (1988) and Hippel (1988).
EXREL expresses whether the firm has increased its interaction with know-
ledge institutions, including technical-support institutions, consultancies, or
universities. In this context it may be noted that Brouwer and Kleinknecht
(1996) found that firms which had consulted an innovation center were more
likely to innovate than other firms. Although both LINK and EXREL concern
whether firms have increased their external linkages, we interpret these variables
more broadly as measuring the strength of the respective linkages. Thus, we argue
that respondents who have strong linkages with external partners are very likely
to answer that they have increased interaction with partners. Finally, we control
for whether or not the firm is a subsidiary of a larger firm. The effect of this
variable is, however, ambiguous. On the one hand, firms with centralized R&D
departments might not wish their subsidiaries to be innovative, as this might
hamper economies of scale in R&D. On the other hand, as argued by Harris and
Trainor (1995), subsidiary firms might benefit from the larger resource base and
experience of the parent firm. Some early empirical studies (e.g. Howells 1984)
found a negative effect of this variable on innovation performance, while more
recent studies have detected a positive effect (Harris and Trainor 1995; Love,
Ashcroft, and Dunlop 1996).
j
The variables HRMP i : : HRMPin are our new HRM variables; that is, those
variables that are key to the analysis. We include nine discrete variables pertaining
to new HRM practices. They express the degree to which firms apply (i)
interdisciplinary work groups, (ii) quality circles, (iii) systems for collection of
employee proposals, (iv) planned job rotation, (v) delegation of responsibility
(i.e. decision rights), (vi) integration of functions, (vii) performance-related pay,
(viii) firm-internal training, and finally (ix) firm-external training. For the first
seven variables the possible values are 0, 1, 2, and 3, which corresponds to the fact
that 0 < 25 per cent, 25–50 per cent and >50 percent of the employees are
involved in a given practice respectively. For the last two variables the possible
values are 0, 1, and 2, which corresponds to the fact that 0 <50 per cent and >50
per cent of the employees are involved in a given practice, respectively.
However, as argued earlier, the literature on complementarities suggests that
HRM practices are more effective when they are applied in systems than on a
stand-alone basis. Hence, we will estimate models where HRM practices enter
the equation to be estimated in specific configurations or systems:
Prob(Ai ¼ 0 : : j) ¼ aSIZEi þ xSECTi þ dLINKi þ fEXRELi
j
þ wSUBSIDi þ ˆj HRMSi þ : : þ ˆn HRMSin þ ei , (3)
j
where the notation is the same as in Equation (3). HRMS i : : HRMSin denote
HRM systems, made up by configurations of our nine HRM practices.10
Subsequently, we shall estimate both Equations (2) and (3) separately and
compare the significance of the estimations made when applying the HRMPs
individually and when they appear in an HRM system.11
Concerning the signs of the parameters for each variable, we expect all signs to
be positive, except for the SECT variable. In this case the interpretation has to be
made relative to the other sector categories. For what concerns SIZE, we expect
larger firms to be more likely to innovate, while we expect the likelihood of
innovation at the level of the sector to correspond to what is normally thought of
as a high-tech/low-tech typology.
The Data
The main source of data for this chapter is the DISKO database. The database is
compiled from a questionnaire which aims at tracing the relationship between
technical and organizational innovation in a way that permits an analysis of new
principles for work organization and their implications for the use and develop-
ment of the employee’s qualifications in firms in the Danish private-business sector.
The survey was carried out by the DISKO project at Aalborg University in 1996.
The questionnaire was submitted to a national sample of 4,000 firms selected
among manufacturing firms with at least twenty full-time employees and non-
manufacturing firms with at least ten full-time employees.12 Furthermore, all
Danish firms with at least a hundred employees were included in the sample; that
is, a total of 913 firms. The resulting numbers of respondents was 684 manufac-
turing and 1,216 non-manufacturing firms, corresponding to response rates of,
respectively, 52 per cent and 45 per cent.13 The first descriptive analysis of the
survey can be found in Gjerding (1997). The database is held by Statistics Den-
mark, and the data on the firms in the database can be linked to regular register data
(which are also held by Statistics Denmark). For the purposes of this chapter we
have obtained data on the size of the firms in the sample from regular register data.
Table 8.1a–c displays descriptive statistics for our explanatory variables.14 It
can be seen from the table that the most widely dispersed HRM practice is
‘delegation of responsibility’, since only 15.9 per cent of the firms do not apply
this practice at all. A percentage of 39.1 of the firms use this practice while
involving more than 50 per cent of their employees. The least diffused practice is
‘planned job rotation’, where 64.3 per cent of the firms do not use this practice at
all. A percentage of 94.5 of the firms apply at least one of the HRMPs, while
66.7 per cent apply at least three such practices. For what concerns the distribu-
tion on sectors and across size categories, it may be seen that none of the groups
is either extremely large, or extremely small. Since the analysis contains
many different variables, each reflecting different aspects of HRMPs, we use
Table 8.1. Descriptive statistics for a set of DISKO variables (n ¼ 1,884)
Percentage of firms using an HRMP
Variable 0 <25 25–50 >50
Percentage of employees involved for each firm
Interdisciplinary work groups 51.0 27.0 12.9 9.1

Quality circles 62.5 18.7 9.0 9.8
Systems for collection of 56.1 18.0 7.2 18.7
employee proposals
Planned job rotation 64.3 22.0 7.1 6.6
Delegation of responsibility 15.9 22.0 23.0 39.1
Integration of functions 43.7 28.9 14.3 13.1
Performance-related pay 61.0 16.6 6.9 15.5
Percentage of firms using an HRMP
Variable 0 <50 >50
Percentage of employees involved for each firm
Firm-internal training 48.2 23.0 28.8

Firm-external training 30.7 38.7 30.6
Variable Percentage of total sample
Applies at least two HRMPs 94.5

(HRMPONE)
Applies at least three HRMPs 66.7
(HRMPTHREE)
Scale-intensive 13.5
Supplier-dominated 11.9
Science-based 3.6
Specialized suppliers 7.3
Crafts 14.5
Wholesale trade 17.7
Specialized traditional services 19.6
Scale-intensive services 5.0
ICT-intensive services 6.9
1–10 employees 11.7
101 þ employees 25.4
principal-component analysis in order to reduce the amount of variables in the

regression analysis to be carried out subsequently. The principal-component
technique—which is a form of factor analysis—estimates linear combinations
of the underlying variables; in this case, the indices of various work practices that
‘explain’ the highest possible fraction of the remaining variance in the data set.
Thus, the first principal component is estimated to explain the highest possible
fraction of the total variance, the second principal component the highest
possible fraction of the variance which is not explained by the first principal
component, etc. By maximizing the ‘explained residual variance’ in each round,
the first m (< n) principal component will explain a relatively large proportion of
the total variance. Since our variables are discrete, we have followed the normal
procedure by transforming (or ‘smoothing’) the variables using the method of
alternating least squares, before conducting the principal-component analysis.
An economic interpretation of the sets of factor loadings15 (‘factors’) from the
factor analysis is that the ‘typical’ pattern is one in which some of the above-
mentioned work practices play a major role. Accordingly, we interpret each of the
factors as ‘HRM systems’. The sets of factor loadings for each factor are reported in
Table 8.2. It can be seen from this table that we include two factors in the analysis.
The reason for retaining two factors is that Factor 2 is the last factor (of the potential
nine factors), where the Eigenvalue exceeds 1. In other words, Factor 2 explains
more of the total variance than each of the nine individual HRMP variables does,
whereas Factor 3 explains less than one of the nine original variables. The factors
have been rotated using orthogonal Varimax rotation. This operation ‘amplifies’the
initial (non-rotated) factors, so that the factors become more distinct.16
Factor 1 in Table 8.2 is the first of our HRM systems. In this case the factor
loadings are all positive and all have approximately the same size (factor loadings
of about 0.5–0.7), except for firm-internal and firm-external training, cases in
which the values of the factor loadings are rather low. Nevertheless, Factor 1
expresses an HRM system in which seven of our nine HRMPs are equally
important. Note that each individual firm which scores high on Factor 1 is not
necessarily applying all seven HRMPs simultaneously.17 However, it does imply
that a firm which scores high on Factor 1 applies several of the seven HRMPs.
Table 8.2. Factor loadings for nine organizational variables (Varimax rotation, n ¼ 1,884)
Variable Factor 1 Factor 2
HRMP1: Interdisciplinary work groups 0.71 0.14

HRMP2: Quality circles 0.66 0.15
HRMP3: Systems for collection of employee proposals 0.65 0.04
HRMP4: Planned job rotation 0.62 0.08
HRMP5: Delegation of responsibility 0.57 0.03
HRMP6: Integration of functions 0.65 0.05
HRMP7: Performance-related pay 0.55 0.05
HRMP8: Firm-internal training 0.14 0.90
HRMP9: Firm-external training 0.02 0.92
Cumulative % 0.33 0.50
Hence this system (Factor 1) is one in which all seven practices are applied in just
about equal proportions. In the same manner Factor 2 is dominated by firm-
internal and firm-external training (factor loadings of 0.9).
Estimation
The estimations of our models can be found in Table 8.3. First, it may be noted
that the null hypothesis that the slopes of the explanatory variables are zero is
strongly rejected by the likelihood ratio test for all of our three specifications.
Furthermore, it may be seen from the table that large firms are more likely to
innovate than small firms (e.g., in model i), although the effect is not particularly
strong. Given that our dependent variable is not a measure of the frequency of
innovation this finding is not surprising, but should be controlled for.18
It can be seen from Table 8.3 that the likelihood of firms being innovators,
given their sectoral affiliation, can be ranked as follows: (1) specialized suppliers,
(2) ICT-intensive services, (3) science-based, (4) wholesale trade, (5) scale-
intensive, (6) supplier-dominated, (7) scale-intensive services, (8) specialized
traditional services, and (9) crafts. Such a ranking may be said to be in agreement
with what one would expect on more intuitive grounds, since it is so clearly
related to whether sectors are ‘high-tech’ or ‘low-tech’ (OECD 1996).
The results also confirm that the external linkages of firms are important to
innovation, since the parameters for both vertical linkages (LINK) and for other
knowledge linkages (EXREL) are significantly different from zero. It may be
noted, however, that upstream or downstream linkages are particularly import-
ant, given the high parameter for this variable. The latter finding is in line with
the predictions of Lundvall (1988) and Hippel (1988), and with the empirical
findings of Rothwell et al. (1974) and Malerba (1992). The variable for being a
subsidiary has a positive sign, and is significant in models (i) and (iii).
By inserting the two retained factors from the principal-component analysis
described above into the regression, we find that both HRM systems are condu-
cive to innovation.19 The first is Factor 1 from Table 8.2, in which seven of our
nine HRM variables (namely, ‘interdisciplinary workgroups’, ‘quality circles’,
‘systems for collection of employee proposals’, ‘planned job rotation’, ‘delegation
of responsibility’, ‘integration of functions’, and ‘performance-related pay’) mat-
ter (almost) equally for firm’s ability to innovate. The second system which is
found to be conducive to innovation (Factor 2 from Table 8.2) is dominated by
‘firm-internal’ and ‘firm-external training’. Nevertheless, based on the principal-
component regression we can—as a first step—conclude that HRMPs matter for
the ability of firms to innovate. It should be noted that while the significant
estimates for the HRMP variables are consistent with the view that the applica-
tion of ‘new’ HRM practices is conducive to innovation performance, it is
equally clear that—given the cross-sectional nature of the present data—strong
Table 8.3. Ordered-probit regressions, explaining innovative performance across 1,884
Danish firms
Model (i) Model (ii) Model (iii)
Variable Estimate p-value Estimate p-value Estimate p-value
Sector controls
Scale-intensive 0.242 0.061 0.182 0.172 0.247 0.063
Supplier-dominated 0.275 0.037 0.190 0.162 0.301 0.026
Science-based 0.143 0.418 0.111 0.536 0.132 0.469
Specialized suppliers 0.082 0.567 0.181 0.215 0.079 0.590
Crafts 0.948 0.000 0.877 0.000 0.964 0.000
Wholesale trade 0.203 0.098 0.176 0.161 0.210 0.098
Specialized 0.722 0.000 0.654 0.000 0.725 0.000
traditional services
Scale-intensive 0.694 0.000 0.631 0.000 0.748 0.000
services
ICT-intensive Benchmark Benchmark Benchmark
services
SIZE 0.016 0.043 0.015 0.064 0.018 0.029
LINK 0.614 0.000 0.598 0.000 0.595 0.000
EXREL 0.267 0.000 0.247 0.000 0.270 0.000
SUBSID 0.127 0.042 0.098 0.123 0.130 0.043
Factor 1 0.192 0.000 – – –
Factor 2 0.063 0.027 – – –
HRMP1 – – 0.025 0.466 – –
HRMP2 – – 0.010 0.744 –
HRMP3 – – 0.042 0.114 – –
HRMP4 – – 0.041 0.246 – –
HRMP5 – – 0.055 0.066
HRMP6 0.067 0.024
HRMP7 0.051 0.059
HRMP8 0.154 0.000
HRMP9 0.004 0.924
HRMPONE – – – 0.423 0.027
HRMPTHREE – – – 0.378 0.000
Log-likelihood
1757.5 1742.0 1755.8
Restricted
log-likelihood
1987.8 1987.8 1987.8
Log-likelihood test 460.4 491.6 464.0
inferences about causality cannot be made. In fact, Capelli and Neumark (2001)
use panel data and find only weak evidence for the effect of ‘high-performance’
work practices on labour productivity.
Concerning our hypothesis on the complementarity of HRMP, it may be
seen from Table 8.3 (model (ii)) that only four of the HRMPs are individually
significant, and moreover, that only ‘integration of functions’ (HRMP6) and ‘firm-
internal training’ (HRMP8) are significant at the 5-per-cent level. However, when
seven HRMPs (all but firm-external and -internal training) of the HRMPs are
combined into a single variable (a ‘system’), this ‘synthetic’ variable (Factor 1) is
strongly significant. Seven out of the nine HRMPs appear to be complementary,
since they jointly (as expressed by Factor 1) give rise to better innovation perform-
ance. This pattern applies to one group of firms, while for another group of firms
complementarity between firm-internal training and firm-external training
(as expressed by Factor 2) appears to be the important factor with respect to explain-
ing firms’ ability to innovate. Factor 2 is significant at the 5-per-cent level. We take
the two positive and significant results for the system variables as evidence of the
existence of Edgeworth complementarities between the HRMPs in our analysis.
However, it is not evident why the HRMPs cluster in exactly these ways, and
we can only speculate on the reasons for the above pattern, since the data set does
not allow us to resolve the issue. In this context one can argue that it is surprising
that as many as seven of the total of nine practices turn out to be complementary
(as expressed by Factor 1). However, it should be noted that we have not selected
at random the work practices examined. Rather, we have chosen some of the
practices already identified in the literature as being relevant candidates for
obtaining complementarities (with other practices). The majority of the variables
underlying Factor 1 are intuitively complementary. For instance—and as argued
in the theoretical section of this chapter—‘performance-related pay’ appears to
go hand in hand with team-based practices such as ‘interdisciplinary work
groups’ and ‘quality circles’. Moreover, it appears that the team practices can
successfully be used jointly with ‘delegation of responsibility’, since the use of
such team-based practices does not make much sense without at the same time
allocating the appropriate decision rights down to the team level. However, some
of the work practices underlying Factor 1 could be seen to be substitutes, rather
than complements. For instance, ‘planned job rotation’ and ‘integration of
functions’ could, at a first glance, be seen to be substitutes. However, on closer
inspection—and as pointed out by Aoki (1990) in the context of product
development—the use of teamwork involving job rotation increases the inter-
action between the different key actors in various successive stages (basic con-
ceptualization, successive phases of detailed design, prototype fabrication,
testing, redesign, mass production, and marketing) of product development.
Since processes of product development are characterized by various feedback
loops between the ‘phases’ (Kline and Rosenberg 1986), job rotation among
different engineering offices, as well as between engineering jobs and supervisory
jobs at the factory, facilitates the knowledge sharing needed for horizontal
coordination among the different phases of development.
With respect to the two training variables, captured by Factor 2, it is surpris-
ing that these practices were found not to be complementary to other HRM
practices. However, note that while these may conceivably be expected on a priori
grounds to be complementary to other HRM practices (e.g. ‘performance-related
pay’ or ‘delegation of responsibility’) captured by Factor 1, one may also point
out that these practices are arguably the most traditional of the nine HRMPs that
we consider; for example, even very traditional, hierarchical industrial firms are
likely to make use of some internal training. Thus, one can expect firms that
otherwise will not apply HRMPs to make use of some training. Moreover, there
may be a significant size bias here, since small firms that (because of their
smallness) need not make use of HRMPs to any great degree may still make
considerable use of external training. Taken together these effects may help
explain the pattern in the application of HRMPs.
Another way of gauging HRMP complementarities is to look at whether it is
sufficient to apply at least one HRMP, rather than it being necessary to apply
several practices together. In Table 8.3, model (iii) we test the hypothesis of the
positive effect of having at least one HRMP against the alternative hypothesis
stating the positive effect of applying three or more HRMPs at the same time.
Both variables, HRMPONE and HRMPTHREE, are binary variables, taking into
account only whether or not a certain practice is used, and not the degree to
which the practice is used within each firm (in contrast to the previous analysis).
Although having at least one practice (HRMPONE) is positive and significant
when entered in the regression alone (not shown for reasons of space),
HRMPONE is significant only at the 5-per-cent level when taken together with
the variable expressing whether or not each firm applies three or more
HRM practices (HRMPTHREE). In contrast HRMPTHREE is highly significant
(p < 0.0001). We take this as further evidence of the importance of comple-
mentarities between new HRM practices with respect to determining innovation
performance.20
The final part of our analysis is devoted to the assessment of whether sectoral
regularities in the application of the two (successful) HRM systems can be
detected. Despite the fact that the correlation coefficients are not very high in
Table 8.4, we find that of our total of nine sectors the four manufacturing sectors
correlate positively with the first system. Firms belonging to wholesale trade and
to the ICT-intensive service sectors tend to be associated with the second system
(firms in the scale-intensive sector tend to be associated with the second system as
well, although the association is rather weak). Hence, it seems fair to conclude
that, generally speaking, sectoral regularities in the effect of HRMP complemen-
tarities on innovation performance exist.
Conclusion
We began by noting a number of stylized facts that relate to the ongoing changes
in the nature of the employment relation—often conceptualized by the term
Table 8.4. Correlations among HRM systems and the firm’s sectoral affiliation
Factor 1 p-value Factor 2 p-value
Scale-intensive 0.16 0.000 0.05 0.031

Supplier-dominated 0.08 0.001 0.09 0.000
Science-based 0.12 0.000 0.02 0.490
Specialized suppliers 0.15 0.000 0.07 0.002
Crafts 0.20 0.000 0.11 0.000
Wholesale trade 0.00 0.936 0.08 0.001
Specialized traditional services 0.17 0.000 0.06 0.006
Scale-intensive services 0.05 0.041 0.09 0.000
ICT-intensive services 0.03 0.178 0.12 0.000
‘new HRM practices’—to the apparently systemic nature of these practices, and
to their adoption by innovative firms. We argued that the notion of comple-
mentarities (and the associated theorizing and formalisms) is helpful for allowing
us to construct explanations of these stylized facts. In particular, we argued that
while the adoption of individual HRM practices may be expected positively to
influence innovation performance, adopting a package of complementary HRM
practices could be expected to impact much more strongly on innovation
performance. However, we have not offered a finely honed theory about why
this should be so. In general, there is very clearly a theoretical deficit in this area.
Future work will be devoted to more comprehensively theorizing the links
between complementary HRM practices and innovation performance. However,
the main emphasis of this chapter is empirical.
In our empirical analysis of these overall ideas and hypotheses we began by
finding that strong linkes to users or suppliers are conducive to innovation (while
controlling for size and sectoral affiliation). Moreover, strong links to knowledge
institutions, including technical-support institutions, consultancies, or univer-
sities, were similarly found to be conducive to innovation. With respect to the
application of new HRM practices, we applied principal-component analysis in
order to compress the information from the survey and in order to identify
possible patterns of HRM practices. Hence, in our analysis the HRM ‘systems’
emerged out of the principal-component analysis, while previous contributions
in the field have assumed different systems from the outset. Using the principal-
component tool we identified two HRM systems that are conducive to innov-
ation. The first is one in which seven of our nine HRM variables matter (almost)
equally for the ability to innovate. The second system which was found to be
conducive to innovation is dominated by firm-internal training in addition to
firm-external training. Hence, we conclude that the application of HRM prac-
tices does matter for the likelihood of a firm being an innovator. Furthermore,
since the two HRM systems were strongly significant in explaining innovation
performance, while only two individual practices (out of nine) were found to be
strongly significant, we found support for the hypothesis of the importance of
Edgeworth complementarities between certain HRM practices within each of the
two HRM systems.
The final part of our analysis was devoted to assessing whether sectoral
regularities in the application of the two (successful) HRM systems could be
detected. Of our total of nine sectors we found that the four manufacturing
sectors correlate with the first system. Firms belonging to the wholesale-trade
sector and to the ICT-intensive service sector tend to be associated with the
second system. Theoretical analysis has focused almost exclusively on identifying
organizational practices and complementarities between such practices, disre-
garding the type of activity in question (e.g. Milgrom and Roberts 1995). Hence,
in order to inform future theoretical research in the field, further empirical
research should be devoted to the more detailed unfolding of sectoral regularities
in the effect of HRM-practice complementarities on innovation performance.21
Notes
1. The clear exception is some scholars’ interest in Japanese economic organization and
how this connects to innovativeness. Thus, Freeman (1988: 335) explicitly notes how
in ‘Japanese management, engineers and workers grew accustomed to thinking of the
entire production process as a system and of thinking in an integrated way about
product design and process design’, and he makes systematic reference to quality
management, horizontal information flows, and other features of new HRM practices.
One could also construct an argument that already the concern with horizontal
information flows in the late 1960s Project SAPPHO demonstrates a long-standing
awareness of the relation between HRM practices and innovation performance.
However, exceptions can always be found, and we think it is a fair judgment that
other determinants of innovation performance, such as appropriability, market struc-
ture, control of complementary assets, etc. have played bigger roles in the literatures.
2. For example, Guest’s programmatic discussion (1997) does not mention innovation as
a relevant performance variable.
3. In terms of the intuition of the notion of complementarity, the notion represents a
strong possible conceptualization of such concepts as ‘synergy’, ‘(organizational) fit’,
and ‘consistency’ (Porter 1996; Baron and Kreps 1999ab).
4. Given a real-valued function f on a lattice X, f is supermodular and its arguments are
complements if for any x and y in X, f (x) f (x ^ y) # f (x _ y) f (y) (Milgrom and
Roberts 1995: 183). A lattice (X, $) is a set (X) with a partial order ($) with the
property that for any x and y in X there is a smallest element (x _ y) that is larger than x
and y and largest element (x ^ y) that is smaller than both.
5. At the method level it is attractive that complementarities (and the underlying
mathematical lattice theory) do not involve the drastic divisibility and concavity
assumptions that have often been criticized by evolutionary economists (e.g. Nelson
1980).
6. Not surprisingly, the notion has been extensively used in recent research in com-
parative systems (e.g. Dewatripont and Roland 1997).
7. As Milgrom and Roberts (1995: 187) point out, a ‘movement of a whole system of
complementary variables, once begun, tends to continue’, thus providing an aspect of
the understanding of co-evolution.
8. Hence, only the final category qualifies for being an innovation in the strict(est) sense
of the word.
9. Hence, the method is maximum-likelihood estimation (MLE), which provides a
means of choosing an asymptotically efficient estimator for a set of parameters. (For
an exposition of the properties of ML estimators see Greene 1997: 129.) Although
MLE has been criticized for having less than optimal small-sample properties (may
be biased, since the MLE of the variance in sampling from a normal distribution is
biased downwards), this is unlikely to be a major problem, given the fact that our
sample contains about 1,900 firms.
10. The way in which the HRM practices are transformed into ‘systems’ will be explained
in the section below.
11. If the effect of individual practices as well as the systems of practices were estimated
in the same model this would result in perfect collinearity.
12. In the stratification of the sample, firms with less than ten employees were excluded
from the analysis. However, in our analysis we have a size category containing firms
with less than ten employees. The reason for this is that when the sample was
stratified, size was measured at a given point in time. However, in this chapter we
measure size as the number of full-time employees over a full year.
13. The full questionnaire is available in English as appendix 1 to Lund and Gjerding
(1996).
14. Of the total of 1,900 responding firms, data are not available for size or for sectoral
affiliation for 16 of those firms. Hence, we conduct our analysis using information
on 1,884 firms.
15. The factor loadings are the parameters relating the original variables to the principal
components.
16. We have experimented with oblique rotation methods as well, but the choice of
oblique rather than orthogonal methods does not change the results in any important
way.
17. Admittedly, it is a weakness of the principal-component methodology that the size of
each factor loading chosen, for one to conclude that an underlying variable is
‘important’, is somewhat arbitrary.
18. The marginal effects from the probit analysis (corresponding to the coefficients
shown in Table 8.3), are reported in the Appendix Table 8.5. They show that the
probability of introducing an innovation increases with firm size, since the marginal
effect for the size variable is negative only in the case of no innovation (A ¼ 0), while
the marginal effect is positive in the case of innovation at all levels of novelty (A ¼ 1,
2, 3). Indeed, this is the interpretation which can be put on all of the significant
coefficients (including the parameters for the HRM variables), since the marginal
effects are negative only in the case of no innovation (A ¼ 0) for all significant
coefficients. However, it can also be noted that the marginal effects are larger for
A ¼ 1 (than for A ¼ 2 and A ¼ 3); that is, the explanatory variables have the
strongest effect on introducing a product ‘new to the firm’.
19. Other examples of principal-component regression include Arvanitis and Hollen-
stein (1996), in which the effects on innovation performance of various sources of
innovation are examined. In the field of international economics Dalum, Laursen,
and Verspagen (1999) analyzed the effect of international patterns of specialization
on economic growth, while applying the methodology.
20. It can be noted that we have tested our models not only by using an ordered-probit
model, as documented in Table 8.3, but also by making standard binary probit
estimations (collapsing our discrete dependent variable into a binary variable which
takes the value of 0 if the firm does not innovate and takes the value of 1 if the firm
innovates). This change of estimation method does not change our results in any
important way.
21. For a preliminary empirical analysis in this direction see Laursen (2002).
Appendix 1: The Sectoral Classification

Applied in this Chapter
Pavitt (1984) identifies differences in the importance of different sources of innovation

according to which broad sector the individual firm belongs to. The Pavitt taxonomy—
which is based on grouping firms according to their principal activity—emerged out of a
statistical analysis of more than 2,000 post-war innovations in Britain. The underlying
explanatory variables are the sources of technology; the nature of users’ needs; and firms’
means of appropriation. Based on this, four overall types of firms were identified; namely,
supplier-dominated firms, scale-intensive firms, specialized suppliers, and science-based
firms. Supplier-dominated firms are typically small. Most technology comes from sup-
pliers of equipment and material. Scale-intensive firms are found in bulk materials and
assembly. Their internal sources of technology are production engineering and R&D
departments. External sources of technology include mainly interactive learning with
specialized suppliers, but inputs from science-based firms are also of some importance.
Specialized suppliers are small firms which are producers of production equipment and
control instrumentation. Their internal sources of technology are design and develop-
ment. External sources are users (science-based and scale-intensive firms). Science-based
firms are found in the chemical and electronic sectors. Their main internal sources of
technology are internal R&D and production engineering. Important external sources of
technology include universities, but also specialized suppliers.
Because the Pavitt taxonomy was created mainly with the manufacturing sector in
mind (although our crafts sector (see below) could be included in the supplier-dominated
sector, if one were to follow the original Pavitt taxonomy), and since we are conducting an
analysis of firms in both manufacturing as well as in services, we have added five
additional service sectors. ICT-intensive services are firms providing business services and
financial services. Wholesale trade consists of firms selling bulk materials or machines.
Scale-intensive services consist typically of large firms in the transport industries, cleaning
services, as well as of supermarkets and warehouses. Specialized services is made up of
smaller firms, including miscellaneous shops, hotels and restaurants, taxi companies etc.
Crafts consists of firms in construction industries, as well as of automobile repair shops.
For a detailed assignment of all industries into our nine sectors see Appendix 2 to this
chapter.
Appendix 2: The Assignment of Industries into

Nine Sectoral Categories
No. Industry Sector No. Industry Sector
1 Production etc. of meat and SCAI 43 Sale of motor vehicles, SSER

meat products motorcycles, etc.
2 Manufacture of dairy products SCAI 44 Maintenance and repair of CRAF
motor vehicles
3 Manufacture of other food SCAI 45 Service stations SSER
products
4 Manufacture of beverages SCAI 46 Wholesale of agricultural raw WTRA
materials, live animals
5 Manufacture of tobacco SCAI 47 Wholesale of food, beverages, WTRA
products and tobacco
6 Manufacture of textiles and SDOM 48 Wholesale of household goods WTRA
textile products
7 Manufacture of clothes; SDOM 49 Wholesale of wood and WTRA
dressing etc. of fur construction materials
8 Manufacture of leather and SDOM 50 Wholesale of other raw WTRA
leather products materials and semi-
manufactures
9 Manufacture of wood and SDOM 51 Wholesale of machinery, WTRA
wood products equipment, and supplies
10 Manufacture of pulp, paper, SDOM 52 Commission trade and other WTRA
and paper products wholesale trade
11 Publishing of newspapers SDOM 53 Retail sale of food in non- SCIS
specialized stores
12 Publishing activities, excluding SDOM 54 Retail sale of food in SSER
newspapers specialized stores
13 Printing activities, etc. SDOM 55 Department stores SCIS
14 Manufacture of refined SCAI 56 Retail sale of pharmaceutical SSER
petroleum products, etc. goods, cosmetic art. etc.
15 Manufacture of chemical raw SCIB 57 Retail sale of clothing, SSER
materials footwear, etc.
16 Manufacture of paints, soap, SCAI 58 Retail sale of furniture, SSER
cosmetics, etc. household appliances
17 Manufacture of SCIB 59 Retail sale in other specialized SSER
pharmaceuticals, etc. stores
18 Manufacture of plastics and SCAI 60 Repair of personal and SSER
synthetic rubber household goods
No. Industry Sector No. Industry Sector
19 Manufacture of glass and SDOM 61 Hotels, etc. SSER

ceramic goods, etc.
20 Manufacture of cement, bricks, SCAI 62 Restaurants, etc. SSER
concrete industry etc.
21 Manufacture of basic metals SCAI 63 Transport via railways and SCIS
buses
22 Manufacture of metal SCAI 64 Taxi operation and coach SSER
construction materials, etc. services
23 Manufacture of hand tools, SDOM 65 Freight transport by road and SSER
metal packaging, etc. via pipelines
24 Manufacture of marine SPEC 66 Water transport SCIS
engines, compressors, etc.
25 Manufacture of other general- SPEC 67 Air transport SCIS
purpose machinery
26 Manufacture of agricultural SPEC 68 Cargo handling, harbours, etc., SCIS
and forestry machinery travel agencies
27 Manufacture of machinery for SPEC 69 Monetary intermediation ITIS
industries, etc.
28 Manufacture of domestic SCAI 70 Other financial intermediation ITIS
appliances n.e.c.
29 Manufacture of office SCIB 71 Insurance and pension funding ITIS
machinery and computers
30 Manufacture of radio and SCIB 72 Activities auxiliary to financial ITIS
communication equipment, intermediates
etc.
31 Manufacture of medical and SPEC 73 Letting of own property SSER
optical instruments, etc.
32 Building and repairing of ships SCAI 74 Real-estate agents, etc. SSER
and boats
33 Manufacture of transport SCAI 75 Renting of machinery and SSER
equipment excluding ships, equipment, etc.
etc.
34 Manufacture of furniture SDOM 76 Computer and related activity ITIS
35 Manufacture of toys, gold and SDOM 77 Research and development ITIS
silver articles, etc.
36 General contractors CRAF 78 Legal activities ITIS
37 Bricklaying CRAF 79 Accounting, bookkeeping, and ITIS
auditing activities
38 Installation of electrical wiring CRAF 80 Consulting engineers, ITIS
and fittings architects, etc.
39 Plumbing CRAF 81 Advertising ITIS
40 Joinery installation CRAF 82 Building-cleaning activities SCIS
41 Painting and glazing CRAF 83 Other business services ITIS
42 Other construction work CRAF
Note: CRAF ¼ Crafts; ITIS ¼ ICT-intensive services; SCAI ¼ Scale-intensive firms; SDOM ¼ Supplier-dominated
firms; SCIB ¼ Science-based firms; SCIS ¼ Scale-intensive services; SPEC ¼ Specialized suppliers; SSER ¼ Specialized
services; WTRA ¼ Wholesale trade
Appendix 3
Table 8.5. Marginal effects from the ordered-probit analysis (Table 8.3)
Variable A¼0 A¼1 A¼2 A¼3
Model (i)
SIZE 0.0059 0.0037 0.0012 0.0010
LINK 0.2387 0.1493 0.0483 0.0412
EXREL 0.0986 0.0617 0.0199 0.0170
SUBSID 0.0390 0.0244 0.0079 0.0067
HRMP1: Interdisciplinary workgroups 0.0099 0.0062 0.0020 0.0017
HRMP2: Quality circles 0.0042 0.0026 0.0008 0.0007
HRMP3: Systems for collection of employee proposals 0.0167 0.0104 0.0034 0.0029
HRMP4: Planned job rotation 0.0162 0.0101 0.0033 0.0028
HRMP5: Delegation of responsibility 0.0219 0.0137 0.0044 0.0038
HRMP6: Integration of functions 0.0268 0.0168 0.0054 0.0046
HRMP7: Performance-related pay 0.0202 0.0126 0.0041 0.0035
HRMP8: Firm-internal training 0.0615 0.0385 0.0124 0.0106
HRMP9: Firm-external training 0.0015 0.0010 0.0003 0.0003
Model (ii)
SIZE 0.0063 0.0039 0.0013 0.0011
LINK 0.2451 0.1510 0.0503 0.0438
EXREL 0.1066 0.0657 0.0219 0.0191
SUBSID 0.0507 0.0312 0.0104 0.0091
Factor 1 0.0766 0.0472 0.0157 0.0137
Factor 2 0.0253 0.0156 0.0052 0.0045
Model (iii)
SIZE 0.0070 0.0043 0.0014 0.0012
LINK 0.2372 0.1469 0.0482 0.0421
EXREL 0.1076 0.0666 0.0219 0.0191
SUBSID 0.0520 0.0322 0.0106 0.0092
NWPONE 0.1689 0.1046 0.0343 0.0300
NWPTHREE 0.1509 0.0934 0.0307 0.0268
9
Cognitive Leadership and Coordination
in the Knowledge Economy
Introduction
Why are major organizational restructurings often communicated through large-
scale gatherings where top management addresses employees through face-to-
face contact instead of relying on, for example, electronic mail? Why do many
corporations spend substantial amounts of money on flying in managers from
foreign subsidiaries to tell them things in personal meetings with top manage-
ment that they could easily be told over the telephone, by fax or by e-mail? More
generally, why are executives so fond of face-to-face, verbal communication,
when in many situations written communication or other means of communi-
cation would appear to be appropriate substitutes?
The phenomena described may seem to be ritualistic and ceremonial, perhaps
only susceptible of explanation in terms of group psychology or the desire to
achieve legitimacy through conforming to institutional requirements, etc. For
such reasons, it may be argued that they lie outside the orbit of ‘rational’ social
science. However, it will be argued in this chapter that simple ideas from (mostly)
game theory suggest a rational explanation. More specifically, the hypothesis here
is that the above phenomena are manifestations of the exercise of cognitive
leadership designed to coordinate the complementary actions of many people
through the creation of belief conditions that (at least) approximate common
knowledge. Indeed, the overall argument is that leadership, coordination, and
common beliefs/knowledge are closely related phenomena, and that cognitive
leadership is a prominent member of the set of ‘alternative institutions for
resolving coordination problems’ (Cooper, DeJong, Forsythe, and Ross 1994).
The argument is developed using simple ideas from non-cooperative game
theory on coordination games, and on exploring these ideas from a decision-
theoretic point of view in a non-formal manner; hence the emphasis on the
epistemic states of players.
To get an intuitive idea of the argument, consider the following story as told
by Kevin Kelly, the Executive Editor of Wired. Kelly (1999: 17) recounts
participating in 1995 in a computer-graphics conference organized by Loren
Carpenter where one of the events consisted in having all 5,000 attendees
simultaneously operate a submarine simulator. Thus, the challenge for the 5,000
co-pilots, each one equipped with their own joystick
was to steer a submarine through a 3D undersea world to capture some sea monster eggs.
[ . . . ] The sub could go up/down, open claws, close claws, and so on [ . . . ] when the
audience first took command of the submarine, nothing happened. Audience members
wiggled this control and that, shouted and counter-shouted instructions to one another,
but nothing moved. Each person’s instructions were being canceled by another person’s
orders. There was no cohesion. The sub didn’t budge.
Finally Loren Carpenter’s voice boomed from a loudspeaker at the back of the
room. ‘Why don’t you guys go to the right?’, he hollered. Click! Instantly the sub
zipped off to the right. With emergent coordination the audience adjusted the
steering details and smoothly set off in search of sea-monster eggs. In the terms of
the argument of this chapter, Mr Carpenter was exercising cognitive leadership
aimed at coordinating the complementary actions of many people through the
creation of common knowledge. An underlying theme in the chapter is that this
kind of leadership will become increasingly important in the knowledge econ-
omy to the extent that this economy is characterized by the need to coordinate
distributed knowledge in networked systems.
As an academic subject leadership is characterized by huge differences with
respect to the basic conceptualization of the phenomenon. No doubt this is
because many disciplines have contributed to the study of leadership and because
leadership behavior is manifest in many diverse social settings. It is therefore
advisable to be explicit about what is meant by leadership. And the literature on
leadership has in general heeded such advice. Even a casual reading of the
literature reveals that it is very rich indeed with respect to providing conceptu-
alizations. In fact, it is much richer in this respect than with respect to providing
explanations of the phenomenon.
In this chapter I define cognitive leadership as the ability to resolve coordin-
ation problems by influencing beliefs. This is both a conceptualization and a stab
at an explanation. For some reason, the leader is able to spot and resolve
coordination problems by influencing beliefs more effectively than other people.
For example, the leader may have privileged information about some state of
nature that perturbs the underlying game. Because, as will often be the case in
practice, the leader’s own pay-offs are somehow tied to the pay-offs of his
followers (and they know this), they are actually prepared to believe and follow
him. The leader’s announcement of what strategy should be followed is effective
in resolving the underlying coordination problem because it creates a belief
structure that at least approximates common knowledge. It is well known from
the literatures on conventions, focal points, the robustness of game-theoretical
equilibria, etc. that whether common knowledge obtains or not, the extent to
which it is approximated by beliefs, etc. may make crucial differences for
cognitive leadership and coordination 213
outcomes (e.g. Monderer and Samet 1989; Rubinstein 1989; Crawford and
Haller 1990).
This overall explanation arguably grasps much—if certainly not all—of what
is meant by leadership, both in common parlance and in the scholarly literature.
Because the emphasis is on the coordination of beliefs (e.g. of people in an
organization), it is appropriate to make use of a particular class of games, namely
coordination games. Indeed, this chapter may be read as a contribution to a small
but growing literature that tries to cast organizational phenomena in terms of
resolving interaction problems that can be represented by various types of
coordination games (notably Camerer and Knez 1994, 1996, 1997; Greenan
and Guellec 1994; Weber 1998). However, this literature has not dealt with
leadership. Another important source of inspiration is political-science contri-
butions on leadership (notably Frohlich, Oppenheimer, and Young 1971;
Hardin 1982; Calvert 1992, 1995) that clearly identify a link between leadership
and coordination problems (particularly Calvert 1992), but without using the
epistemic arguments presented in this chapter.
The design of the chapter is as follows. First comes a rather selective literature
review. Instead of reviewing the enormous and diverse literature on leadership, I
concentrate briefly on the few economics approaches to leadership. I then argue
that a different approach to leadership may be developed—one that both retains
a rational-choice orientation and links up with those contributions to the
leadership literature that have stressed the cognitive aspects of leadership; that
is, how leaders influence what people believe. I then go on to present some basic
game-theory ideas. Even at an elementary level we can make the basic point that
coordination games aren’t trivial, somewhat contrary to common perception, and
that they are likely to capture the essence of a large number of real-world
situations. Notably, they are likely to help us gain an improved understanding
of important aspects of leadership. What is offered in the following pages is not a
finely honed theory about leadership behavior (as in Hermalin 1998). Rather, it
is an explorative discussion (somewhat in the style of Kreps 1990a and Langlois
1998), aimed at convincing organizational scholars of the value of basic game-
theoretic ideas, and economists of organization of the possibility of alternative
routes of research.
Leadership: A Highly Partial Literature Review

Leadership has been defined as ‘leading others along a way, guiding’. There are
clearly two distinct aspects involved in the exercise of leadership; namely, first,
selecting a goal, and, second, making others follow that goal (Gardner 1990: 11).
From the perspective of the economics of organization, ‘the problem of motiv-
ating employees to follow a vision is the standard agency problem’ (Brickley,
Smith, and Zimmerman 1996: 309). Below, I shall briefly discuss a few
contributions that work from a similar logic, and then suggest the possibility of
an alternative view that, while it is consistent with a rational choice approach,
puts more stress on cognition and belief formation than on motivation per se.
Some Recent Economics Contributions

That social-interaction problems and leadership are somehow connected is not a
new recognition in social-science research. At least, political scientists have often
made the link explicit (Frohlich, Oppenheimer, and Young 1971; Hardin 1982;
Calvert 1992, 1995). In contrast, economists have had relatively little to say
about leadership, and when they have addressed the issue it is fair to say that one
specific modeling heuristic has been dominant. To see this, consider three
important economics contributions to the leadership literature; namely Kreps
(1990), Rotemberg and Saloner (1993), and Hermalin (1998). All three work
out of contract-economics approaches. Thus, Kreps and Rotemberg and Saloner
begin from an incomplete-contract setting, whereas Hermalin takes his starting
point in the Holmström (1982) (complete contracts) team-model. Consider each
of these in turn.
Strictly speaking, Kreps’s paper is not about leadership per se, but rather about
corporate culture, and how the reputation that a corporate culture may help
build provides an important part of the explanation of firm organization.
Nevertheless, it certainly makes provision for leadership. Beginning from the
property rights/incomplete-contracts theory (Grossman and Hart 1986; Hart
1995), Kreps argues that incompleteness of contracts may produce a need for
implicit contracts. However, in the face of unforeseen contingencies it is not clear
how implicit contracts should be administered; in particular, it is not clear how
well standard reputation arguments work with unforeseen contingencies.
The possible role of leadership in this setting is to provide general principles
(i.e. focal points) that instruct employees and suppliers about how unforeseen
contingencies will be handled in the future by management (see also Shleifer and
Summers 1990).
Rotemberg and Saloner are more taken up with how leadership styles are
influenced by environmental contingencies. However, the same basic insight as
in Kreps—namely, that the provision of incentives is not straightforward under
incomplete contracting—plays a key role in their paper. Specifically, they con-
sider the problem of compensating middle managers who develop project ideas,
when compensation cannot be based on the manager’s unobservable effort but
has to be based on whether the project is implemented, and where the CEO may
have difficulties committing to implementation; hence, contracting is incom-
plete and commitment is imperfect. Leadership style affects employees’ beliefs
about how they will be compensated in various circumstances. Assuming that
shareholders will select the firm’s leadership style to maximize profits, they will
appoint ‘empathic’ leaders (whose utility functions include the utility of their
manager) if the firm operates in an opportunity-rich environment, whereas
‘selfish’ leaders (whose utility functions do not include the utility of their
managers) will be appointed in stable environments.
Finally, Hermalin studies incentive problems in the context of the team model
of Holmström (1982). The problem here is that the leader for some reason has
privileged information about what the team should do, but—because she shares
in team output—has an incentive to exaggerate the value of effort devoted to the
common activity. In Hermalin’s main case the problem may be solved if the
leader acts as a Stackelberg leader and expends effort earlier than the other team
members. Based on their observation of effort, the other team members form
beliefs about the leader’s information. Interestingly, this produces the conclusion
that the leader works harder than she would do under symmetric information.
The leader indeed ‘leads by example’.
To be sure, these modeling efforts are neat, logical, and produce interesting,
sometimes counter-intuitive, conclusions. However, they are limited in various
ways that are typical of recent contract economics. The basic thrust of this
literature is to conceptualize virtually any issue related to economic organization
in terms of solving incentive conflicts. The motivation for this presumably is an
underlying argument that in the absence of such conflicts the first-best can be
reached without major obstacles (e.g. Hart 1995). Thus, the essence of the above
contributions is that (business) leaders exist because they resolve incentive
conflicts, albeit sophisticated and non-standard ones. However, other perspec-
tives on leadership are certainly possible, and insights from related disciplines are
likely to enrich economic approaches to leadership.
Towards a Different View

The view that all, or most, organizational phenomena are reducible to problems
of aligning incentives is one that is implicitly (and sometimes explicitly) contra-
dicted by contributions to organization studies (Thompson 1967), the executive
and leadership literature (Barnard 1948; Carlsson 1951; Selznick 1957; Kotter
1996), political science (Calvert 1992, 1995), (rational-choice) sociology (Cole-
man 1990), and in some quarters of the economics of organization (Milgrom
and Roberts 1992: ch. 4; Camerer and Knez 1994, 1996, 1997; Langlois 1998;
Weber 1998; Langlois and Foss 1999). Many of these contributions are directly
relevant to the issue of leadership.
For example, Coleman (1990) observes that charismatic authority may be a
response to coordination problems that don’t necessarily turn on misaligned
incentives (see also Langlois 1998). In fact, Coleman’s discussion suggests
that he has an assurance game in mind. Calvert (1992, 1995) and Camerer
and Knez (1994, 1996, 1997) argue that attention should be shifted to
coordination games (rather than cooperation games) in seeking a foundation for
the understanding of organizational phenomena. Although he has placed pri-
mary emphasis on problems of ex post opportunism, Williamson (1991: 278) has
not been blind to the possibility of coordination problems, noting that failures of
coordination ‘may arise because autonomous parties read and react to signals
differently, even though their purpose is to achieve a timely and compatible
combined response’. While making much room for the role of incentives in
organization, Chester Barnard also emphasized the importance of ‘the inculca-
tion of belief in the real existence of a common purpose’, which he considered to
be ‘an essential executive function’ (Barnard 1948: 87). Indeed, he very clearly
argued that ‘an organization can secure the efforts necessary to its exist-
ence . . . either by the objective inducements it provides or by changing states of
mind’ (ibid. 141).
The aim of the following pages is to develop some of these suggestions. Thus,
in line with Calvert (1992, 1995), Camerer and Knez (1994, 1996, 1997) and
Weber (1998), the focus is on coordination games rather than on cooperation
games. And in line with Barnard, and others who have stressed the cognitive
aspects of leadership (e.g. Selznick 1957), the emphasis will be on ‘the inculca-
tion of belief ’ and on ‘changing states of mind’; for example, through (credible)
communication. In contrast, all incentive problems will be suppressed. Basic
game-theory ideas will be used to explicate the reasoning.
Coordination Problems and Coordination Games

Cooperation and Coordination Games
Criticism of the predominant incentive-alignment heuristic in the economics of
organization has often been cast in terms of basic game theory (e.g. Camerer and
Knez 1994, 1996, 1997; Foss 1996). Thus, the critics have argued that all the
emphasis has been on cooperation games; that is, games where the pay-off space
of the game is such that the efficient outcomes are not supportable as equilibria
(at least in one-shot play). The key problem that such a game leads one to ponder
is how to avoid the Pareto-inferior outcome. Indeed, the basic hold-up situation
has a prisoners’ dilemma structure (Milgrom and Roberts 1992: 128), and this is
also the case with the team-production problem and other problems with
information externalities and moral hazard (Holmström 1982, 1999). Accord-
ingly, the literature is taken up with how reallocating incentives and property
rights may improve on outcomes. In contrast, the economics-of-organization
literature is characterized by a corresponding lack of interest in the interaction
problems that may be represented by coordination games—a somewhat surpris-
ing neglect given the the increasing emphasis on such problems in other areas of
economics, such as standards (Farrell and Saloner 1985; Witt 1997), conventions
(Young 1996), learning behavior (Crawford and Haller 1990), and macro-
economics (Cooper 1999) (Friedman 1994).
There is a distinction between shared-interest (or ‘pure’) coordination games
and coordination games with mixed interests. In the former category players’
preferences over equilibria coincide. In symmetric, shared-interest coordination
games all equilibria are efficient and pay-off equivalent, so that players are
indifferent about which equilibrium is chosen, so long as one is in fact chosen.
The coordination problem in question concerns actually choosing an equilib-
rium (Bicchieri 1993). In contrast, non-symmetric, shared-interest coordination
games exhibit multiple Pareto-ranked equilibria. This (sub-)category encom-
passes assurance games where the coordination problem is caused by the riskiness
of coordination on the Pareto optimal equilibrium (Cooper 1999). While
coordination games with mixed interests will also exhibit multiple equilibria,
these equilibria are ranked differently by the players (cf. the battle of the sexes or
the chicken games), so that the problem again is choosing one of the equilibria.
In this chapter reference will mostly be to shared-interest coordination games.
Coordination Problems and Approaches to Organizational Phenomena

Much recent work in game theory has consisted in refining a number of equilib-
rium concepts, most of them variations on the basic notion of Nash equilibrium.
In general, the refinement literature analyzes alternative equilibrium concepts in
terms of the epistemic states of players; that is, what they know or believe about
other players’s beliefs, knowledge, rationality, etc., and about the game (Aumann
and Brandenburger 1995). Thus, the literature has a strong decision-theoretic,
even ‘subjectivist’, orientation. Complicated interactive epistemics is involved,
and impressive reasoning skills are imputed to players. Critics may easily gain the
impression that classical game theory solves the coordination problem by defining
it away; that is to say, by assuming that agents by means of pure ratiocination can
reason their way to equilibrium. And such critics may argue that the literature
begins from what is basically an existence claim; namely, that if rational players
have commonly known and identical beliefs about all other players’strategies, then
those beliefs are consistent with some equilibrium in the game. A problem with
this is that nothing is said about the origin and formation of beliefs, and it is in
principle possible that although there is an equilibrium in players’ strategies, they
may never be able to realize that equilibrium.
Along the lines of classical game theory, most of today’s formal economics of
organization proceeds on the assumption that players can choose the efficient
game form for regulating their trade and can also choose any desired equilibrium
thereof. It is a story of unproblematic coordination, given the constraints.
Although information asymmetries and conflicting incentives may hinder reach-
ing the first-best outcome, there is no problem picking the equilibrium that is
induced by these constraints (and the rationality of the players, etc.). In this
literature, one does not encounter, say, two pay-off-equivalent second-best out-
comes, with players confronting the coordination problem of choosing between
the two. Such problems are defined away. Of course, this is a short cut to
conceptualizing various contractual arrangements as equilibria of some properly
specified underlying games, involving conflicting incentives, and it may be
argued that suppressing coordination problems is justified because it allows
one to concentrate on the essentials (but see Foss and Foss 2000a). Moreover,
it may be claimed that coordination problems are in fact not suppressed in the
formal economics of organization, since the whole point of these exercises is to
show how agents may coordinate to avoid inefficiency, or at least reach the
second best. However, something different is involved here. More specifically,
the argument is that organizations, and leaders, do more than make agents avoid
inefficiencies in prisoners’ dilemma-like interaction situations. For example, a
proponent of institutional organization theory may argue that a function of
organization is to define what strategies are available, in the sense of being
‘legitimate’ relative to some environment (Powell and DiMaggio 1991). An
entrepreneurship scholar may point out that the function of leadership is to
alert to new business opportunities. Although placing primary emphasis on the
hold-up problem, Williamson (1985, 1996a, 1998) has long argued—following
a time-honoured tradition in organization theory (March and Simon 1958)—
that an organization also serves the purpose of alleviating bounds on rationality.
To be sure, it is hard to make game-theoretic sense of such functions of
organization and leadership. For example, if the leader’s function lies in his
‘defining new strategies’, this amounts to introducing a new game, and it is not
at all clear what is gained by comparing a string of different games. However,
more unconventional ideas (relative to economics) on ‘symbolic leadership’, the
leader’s ‘inculcation of belief ’ among those being led, etc. can in fact be treated in
relatively simple game-theoretic terms. Camerer and Knez (1994, 1996, 1997)
and Weber (1998) have already demonstrated the usefulness of a coordination-
game perspective for understanding a host of organizational phenomena. The
following may be taken as an extension of the basic thrust of their arguments to
the phenomenon of leadership in organizations. To understand the argument it
is, however, necessary to spend some time arguing that, somewhat contrary to
common perception, coordination games are non-trivial and quite fundamental.
Coordination Games are Non-trivial and Fundamental

The dominant implicit attitude among social scientists appears, at least until
recently, to have been that coordination games, particularly of the shared-
interests type, are basically trivial. The sources of this attitude are hard to trace,
but the verdict issued in R. Duncan Luce and Howard Raiffa’s very influential
book Games and Decisions (1957: 59), that at least in pure coordination games
‘everything is trivial’, seems to be a possible—and likely—source. In contrast to
what may be called ‘the Luce and Raiffa legacy’, a growing literature asserts that
coordination games, even pure ones, are not so trivial as they may appear at first
glance. Moreover, they are fundamental in the sense that they help identify
fundamental interaction problems (e.g. interactive belief formation) and how
such problems are resolved (e.g. through conventions). Finally, coordination
games are fundamental not only in the sense that a host of everyday situations
conform to their structure(s) (Schelling 1960, 1978) but also in the sense that
from a theoretical perspective problems of equilibrium selection, which may
often be seen as coordination problems, are very common.
Fundamentally, coordination games are (very often) non-trivial because their
multiplicity of equilibria serves to highlight the importance for outcomes of
agents’ beliefs about each others’ beliefs. And such interactive epistemology can
be quite a complicated business, as both the philosophical (Lewis 1969; Dupuy
1989; Gilbert 1992; Bicchieri 1993), theoretical (Rubinstein 1989; Bacharach
1993; Aumann and Brandenburger 1995; Sugden 1995; Colman 1997; Colman
and Bacharach 1997), and experimental (Cooper et al. 1992, 1994; Bacharach
and Bernasconi 1997; Colman and Stirk 1998) literatures confirm. Thus,
equilibrium-selection theories have been devised for rationalizing certain out-
comes rather than others in asymmetric coordination games (Harsanyi and
Selten 1988); there is a body of work on how repeated play may lead to
convergence to an equilibrium (Crawford and Haller 1990); work has been
done on how players’ labeling of their strategies influences their beliefs (Sugden
1995); and there is a literature on communication in coordination games (Farrell
1987; Rabin 1990)—all of which is far from trivial.
Moreover, coordination games are fundamental in a number of ways—first of
all, in the basic phenomenological sense of being pervasive in social life (Schelling
1960, 1978). Second, they provide a useful conceptualization of one class of
interaction situations that may lead to the emergence of social institutions
(Calvert 1995; Young 1996) or organizational phenomena (Camerer and Knez
1994, 1996, 1997). Moreover, they are fundamental in a theoretical sense, too,
since recent work in game theory has revealed that coordination problems (that
may be represented in terms of coordination games) emerge in a multiplicity of
game situations. In particular, this is the case as dynamics is introduced, the
number of players is increased, and less knowledge is ascribed to players.
Types of Coordination Problem

A possible categorization of coordination problems that may be illustrated by
means of coordination games lies in the following distinction between three
broad classes of coordination problems:
(1) the problem of coordinating on an equilibrium when agents are initially
outside equilibrium (i.e. have inconsistent beliefs, lack of common know-
ledge), and don’t know, for example, how strategies are labeled;
(2) the problem of coordinating on one equilibrium out of a multitude, when
strategies, pay-offs, and rationality are common knowledge (e.g. the
battle-of-the-sexes game); and
(3) the problem of moving from an inferior equilibrium to the efficient
equilibrium, when strategies, pay-offs, and rationality are common know-
ledge (e.g. the assurance game).
What is common to all three problems is that belief dynamics is essential to
them. They are briefly considered seriatim.
Coordinating on an equilibrium. This is the problem of rationalizing the

formation of those beliefs that will make it possible for agents to realize some
equilibrium. To be sure, there has been an increasing interest in defining
equilibria in terms of the beliefs and conjectures of agents, for example in
connection with interpreting the notion of mixed strategies (where the relevant
probabilities are interpreted as subjectively held probabilities) (Aumann and
Brandenburger 1995). However, the problem of actually rationalizing the emer-
gence of equilibrium beliefs—rather than ‘simply’ providing conditions for
these—has attracted less general interest, at least until recently.
Thus, in a much cited paper, Crawford and Haller (1990) study how fully
strategic agents may learn to coordinate in the context of a repeated coordination
game where they initially have no shared information about how the strategies
are labeled or how the game is presented (e.g. the normal form of the game),
where strategies are symmetric (i.e. yield the same pay-offs), and where the
players are also symmetric in the sense that they are in identical strategic positions
in the game. Although they are playing the same game, they may (and probably
will) perceive it differently. This effectively excludes any focal points based on the
description of the game. However, after some play the players will develop
distinctions between strategies and players, and when these distinctions
become common knowledge, coordination may take place very quickly. The
assumption that sets in motion, as it were, the right belief dynamics that
establishes common knowledge is that players follow the meta-strategy of repeat-
ing successful strategies.
Of course, one should be extremely cautious in drawing inferences from the
very simplified setting of Crawford and Haller (ibid.) to more complicated (and
realistic) settings, where the problem of reaching an equilibrium may be com-
plicated by, for example, the imperfection as guides to future behavior of
precedents generated in earlier play when players play against different players
(Knez 1998). However, one important feature of the Crawford and Haller
analysis lies in their demonstration that in the situations they analyze ‘it is
sometimes optimal to forsake an efficient strategy forever in favor of an ineffi-
cient one that is less costly to locate’ (1990: 584). In other words, although
coordination sometimes takes place quickly, there is no guarantee that agents
coordinate in an efficient manner.
Selecting among multiple equilibria. It is well known that prisoners’-dilemma

games with many players or hidden information imply many different ways of
motivating cooperation, and that a key problem is making players choose beliefs
that will pick out one of these solutions (Calvert 1995: 242). However, somewhat
in contrast to the situation analyzed in Crawford and Haller (1990), there may be
a coordination problem even in the presence of common knowledge. The
conventional illustration of this is the symmetric pure coordination game, such
as game (a) in Figure 9.1.
The problem is that classical game theory is not terribly helpful with respect to
telling us how players will avoid coordination failure in such situations. Of
course, when a (one-shot) game has multiple Nash equilibria in pure strategies
it often has a unique mixed-strategy equilibrium (Nash 1951). But the basic
problem of rationalizing the beliefs that lead players to play mixed strategies, and
choose certain probabilities (and believe that others choose certain probabilities)
rather than other ones, is not really addressed. There is still a fundamental
problem of rationalizing the formation of equilibrating beliefs. In one interpret-
ation of Nash equilibrium—namely, that it is the outcome of non-binding pre-
play communication leading to the selection of a self-enforcing agreement
(Farrell 1987)—the problem can, of course, be handled. It is arguably outside
the conventional interpretation of games in normal form, such as the one in
matrix 9.1(a), where the players make their choices simultaneously and there is
no explicitly modeled stage in which they can communicate. However, in
an exploratory chapter such as the present one, we wish to allow for this
possibility, too.
B B B
1 2 1 2 1 2
1 1,1 0,0 1 1,1 1,0 1 1,1 0,0

A A A
2 0,0 1,1 2 0,1 2,2 2 0,0 2,2
(a) Symmetric (b) Assurance (c) Asymmetric
Figure 9.1. Coordination games.

Moving away from an inferior equilibrium. The simultaneous-move-assurance

game (matrix 9.1(b)) has become a popular pedagogical device for illustrating
coordination failures, and it is one of the work horses of the experimental game
theorist (e.g. Cooper et al. 1988, 1992; Van Huyck et al. 1990). Of course, this is
motivated by the game’s ability to portray risky coordination and strategic
complementarity. Relatedly, the game connects to the theoretical issue of equi-
librium selection in situations in which the existing refinement procedures do
not work. For example, Harsanyi and Selten (1988) forcefully argue that the pay-
off-dominant outcome ((2, 2) in matrix 9.1(b)) is a natural focal point. However,
there is experimental evidence that coordination failure ‘almost always’ occurs
(in the absence of pre-play communication) (Van Huyck et al. 1990; Cooper
et al. 1992).
Perhaps less obviously, rationalizing the pay-off-dominant outcome as the
focal point in the apparently less risky asymmetric pure coordination game
(matrix 9.1(c)) is far from trivial (Farrell 1988; Colman 1997; Colman and
Bacharach 1997). The basic problem is that A appears to have no rational
grounds for choosing strategy 2 unless he has grounds for believing that B will
choose strategy 2, because if A went to choose the strategy 1, B would do better
also to choose strategy 1. Of course, B is in the same epistemic situation, and the
reasoning process winds up in infinite regress. Pre-play communication does not
necessarily help, for how can one player be sure that the other player has
understood him? There still seems to be a problem of justifying beliefs. So how
can we justify everybody’s strong intuition—that the pay-off-dominant outcome
will in fact be chosen?
Colman and Bacharach (ibid.) suggest that players may solve the problem by
using something they call the ‘Stackelberg heuristic’. Essentially, this heuristic
works by letting agents mentally transform a normal-form game to an extensive-
form game. Thus, they know that they will choose simultaneously but think as if
they will choose sequentially. Specifically, player A will simulate the game by
thinking of himself as moving first. Then B has to move with knowledge of A’s
choice, choosing a best-reply meta-strategy; namely strategy 1 if A also chooses 1
and strategy 2 if A also chooses 2. Of course, the latter choice is best for A.
Having performed this simulation, A, returning to the real game, chooses what is
(in the mental simulation) the utility-maximizing strategy provided that B
responds with a best reply (namely strategy 2). Player B, performing the same
simulation, makes the same choice. However, the requirement for the Stackel-
berg heuristic to do its work is that these simulations are common knowledge; in
other words, that the heuristic itself is common knowledge.
Summing Up and Looking Ahead

The preceding pages have established that coordination games are non-trivial and
fundamental. They are extremely helpful mental laboratories that assist in
exploring the boundaries of game theory (e.g. Harsanyi and Selten 1988; Young
1996; Colman and Bacharach 1997), and in providing indirect rationales for
phenomena, such as conventions (Lewis 1969; Young 1996) and other social
phenomena that somehow turn on the issue of belief dynamics. The suggestion
that will be developed in the following pages is that coordination games are also
helpful for understanding the cognitive aspects of leadership; that is, what Barnard
(1938) referred to as ‘the inculcation of belief in the real existence of a common
purpose’. The argument is not different in kind from other arguments pertaining
to how coordination problems are solved in reality; namely, through the effect on
the beliefs that players hold of communication, the formation of conventions, etc.
Thus, leadership is an important member of the set of ‘alternative institutions for
resolving coordination problems’ (Cooper, DeJong, Forsythe, and Ross 1994).
However, the argument is, if one likes, ‘comparative-institutional’, in the sense
that it is claimed that leadership may, in certain situations, be a low-cost alternative
to these other methods of coordination.
Leadership
Conceptualizing Leadership
In much of the organization-theory literature it is held that the essence of
organization is coordinated response to volatility; for example, in technologies
or preferences (Thompson 1967; Galbraith 1973). Obviously, management and
leadership have key roles here, for some volatility cannot be handled by organ-
izational routine but requires judgment and decision. As we have seen, the
economics of organization, to the extent that it relates to leadership and man-
agement issues, is not taken up with managers’ and leaders’ concrete actions and
the judgments that inform such actions. However, it surely is informative with
respect to leaders’ and managers’ roles in the design of explicit and implicit
contracts (Kreps 1990a; Miller 1992; Rotemberg and Saloner 1993; Hermalin
1998), and much of the nature of leadership and managerial work may be
conceptualized in this way. Thus, a classic contribution on the nature of man-
agerial work (Mintzberg 1973: 5) lists six basic reasons why organizations need
managers:
1. The prime purpose of the manager is to ensure that his organization serves its basic
purpose [ . . . ] 2. The manager must design and maintain the stability of his organization’s
operations [ . . . ] 3. The manager must take charge of his organization’s strategy-making
system, and therein adapt his organization in a controlled way to its changing environ-
ment [ . . . ] 4. The manager must ensure that his organization serves the ends of those
persons who control it [ . . . ] 5. The manager must serve as the key informational link
between his organization and its environment [ . . . ] 6. As formal authority, the manager is
responsible for the operating of his organization’s status system.
On the face of it, much of this sounds largely consistent with the basic thrust
of the economics of organization. It is indeed possible to cast virtually all of
the above six points in terms of monitoring and the design of implicit and
explicit contracts.
However, if one reads Mintzberg’s own further detailing of what the six
points actually mean and imply, it turns out that an economics-of-organization
conceptualization does not do full justice to them. For Mintzberg is clear that
the production of ‘values’ and ‘atmosphere’ through ‘directing’, disseminating
information, and acting as ‘spokesman’, ‘negotiator’, and ‘figurehead’ is
what lies behind the above managerial roles. Such roles and functions have so
far not been treated from the perspective of the mainstream economics of
organization.
The symbolic and cognitive aspects that Mintzberg associates with manage-
ment become even more pronounced if one turns to the large and diverse
literature on leadership in organizations (e.g. Vecchio 1997; Conger and
Canungo 1998). Here, the leader is seen as engaging in numerous activities,
such as planning strategy, changing standard practice, creating vision and mean-
ing for the organization, and inducing changes in values, attitudes, and behavior.
The reason why the economics literature on leadership may look somewhat
meager (if considerably more precise) relative to the richness in the leadership
literature overall arguably turns on the difficulty of providing economic inter-
pretations of the cognitive and entrepreneurial aspects of leadership in particular.
Of course, the aim should not be to present the phenomenon in all its complex-
ity, but it is hard to escape the conclusion that economic approaches to leadership
miss some essential aspects of the phenomenon, particularly those relating to the
cognitive dimensions.
Below, I shall suggest that the basic ideas on coordination games that have
been discussed so far are helpful for understanding precisely those aspects of
leadership. More specifically, I shall develop a notion of leadership as the taking
of actions that coordinate the complementary actions of many people through
the creation of knowledge (or belief ) conditions that at least approximate
common knowledge, and where these actions characteristically consist of some
act of communication directed at those being led.
Beliefs and Coordination Problems

An example of the type of belief dynamics that I am taken up with here involves
the crucial epistemic construction in H. C. Andersen’s well-known fairy tale ‘The
Emperor’s New Clothes’ that knowledge may be held identically (i.e. everybody
knows that x is the case), but not in common. The child’s loud announcement
that the emperor really isn’t wearing any clothes creates the belief dynamics that
transforms the situation from one in which everybody knows that the emperor is
not wearing any clothes to one in which everybody knows this and knows that
everybody else knows it. The transformation essentially works because something
else is common knowledge; namely, that everybody knows that everybody knows
what the child has exclaimed.
One, possibly far-fetched, interpretation of the situation described in the tale
is that a sort of assurance game is involved. Everybody would prefer that the truth
be told, but because pay-offs (and possibly also rationality) are not common
knowledge, telling the truth is risky. (Scorn may be heaped upon you!) Only the
‘mediation’ of the non-calculative child allows for beliefs to be coordinated on the
superior equilibrium. In his classic contribution Schelling (1960) explicitly
linked what he called ‘mediators’ to coordination problems:
a mediator can do more than simply constrain communications—putting limits on the
order of offers, counter-offers, and so forth—since he can invent contextual material of
his own and make potent suggestions. That is, he can influence [ . . . ] expectations on his
own initiative [ . . . ] When there is no apparent point for agreement, he can create one by
his power to make a dramatic suggestion.
In other words, when ‘Schelling competence’—that is, players’ capacity to
coordinate by means of focal points (Bacharach and Bernasconi 1997: 2)—is
low, coordination by means of a ‘dramatic suggestion’ may be required. Although
Schelling doesn’t spell this out, we may suggest that the creation of common-
knowledge conditions is what is involved in his notion of mediation. A first hint,
then, derived from Andersen and Schelling, is that part of the leader’s function
may be the break-up of an epistemic stalemate through acts of communication
that influence ‘in the right way’ the beliefs held by players.
Coordination and Communication

The formalization (Crawford and Sobel 1982; Farrell 1988; Rabin 1990) and
empirical investigation (Cooper et al. 1989, 1992, 1994) of communication is a
relatively recent undertaking in game theoy. Thus, Cooper et al. (1992) experi-
mentally evaluated the effect of ‘cheap talk’ under one-way communication and
under two-way communication in the context of an assurance game. They found
that with no communication, coordination failure was universal (the efficient
equilibrium was never reached), with one-way communication, coordination
substantially improved (the efficient equilibrium was reached about 50 per
cent of the time), and two-way communication almost completely eliminated
any coordination failures.
Intuitively, things are even simpler in pure, symmetric coordination games
(Rabin 1990), where one would expect one-way communication to be more
successful than in the context of assurance games. Thus, one person’s communi-
cative act may create a focal point that becomes common knowledge, such as the
child’s announcement in the H. C. Andersen fairy tale. But there is an apparent
difficulty here (Monderer and Samet 1989). For whereas it was implicitly
assumed in the discussion above that a public announcement automatically
becomes common knowledge, it is not at all obvious that such an assumption
is always warranted, particularly as the group to which a message is directed
grows in size. For example, there may be a probability, however small, that
somebody in the group was inattentive at the time of the announcement,
which effectively means that the announced message will not be common
knowledge.
In a famous note Rubinstein (1989) pointed out that whether or not common
knowledge obtains may matter dramatically for outcomes. In his ‘electronic-
mail-game’ example, nature chooses one of two two-person, risky coordination
games with equal probabilities. If the state of nature is common knowledge,
coordinating on the desired equilibrium is taken by Rubinstein to be straight-
forward. Not so if what Rubinstein calls ‘almost common knowledge’ obtains;
that is, if only a finite (but possibly very large) number of propositions of the sort
‘1 knows that 2 knows that A knows . . . that the state x (a or b) obtains’ are true.
Effectively, this situation implies that the game becomes one of incomplete
information, although the players are allowed to communicate.
In the example the first player knows which one of the two games will be
played and he sends a message to the second player informing him about this.
The second player acknowledges receipt of the message, player 1 acknowledges
receipt of the acknowledgment, and so on. However, there is a small probability
that a message gets lost in the process, in which case the process of communica-
tion is brought to a halt. The problem now is that neither of the players knows
whether it is his message or the other player’s acknowledgment that was lost.
Rubinstein proves that the uncertainty caused by incomplete information implies
that under almost common knowledge there is actually only one Nash equilib-
rium in the game. Thus, there is no ‘convergence’ to the common-knowledge
situation, where the players will play a certain strategy if state ‘a’ obtains and
the other strategy if state ‘b’ obtains. Clearly, the agents would be better off
if some mechanism could somehow throw a condition of common knowledge
into their game.
It is of course easy to construct an argument that because we, strictly speaking,
can never be absolutely certain that something is common knowledge many
potential Pareto improvements are never realized. Some may even argue
that common knowledge is a useless fiction. However, in a stimulating paper
Monderer and Samet (1989) argued that common knowledge can be approxi-
mated (in a way they make precise) by the notion of common belief. Using
Aumann’s (1976) model, in which knowledge is partitions and beliefs are
posterior probabilities, belief may be defined as being ‘common’ in the conven-
tional way; namely, when an infinite hierarchy obtains. The difference is that
beliefs are held with a probability, such that a common r-belief may be defined
for each r in [0,1]. Monderer and Samet then show that when ‘r’ approaches 1,
common r-belief approximates common knowledge. This line of reasoning
further suggests, if only loosely, that not only are agents’ successes at coordinating
their strategies dependent on the beliefs they hold about each others’ beliefs, but
that the more well-founded these beliefs are the better they are able to coordinate
strategies. This brings us directly to leadership; for one role of leadership is to
influence how well founded agents think certain beliefs are.
Leadership and Coordination

For the purposes of this chapter leadership has been defined as the taking of
actions that coordinate the complementary actions of many people through the
creation of belief conditions that (at least) substitute for common knowledge,
and where these actions characteristically consist of some act of communication
directed at those being led. It is time to make something more out of this
tentative definition.
Why may coordination problems cause a need for leadership in the above
sense? In order to get a take on this issue, it is convenient to create a distinction
between coordination problems (represented by means of coordination games) in
which common knowledge (or, at least a common r-belief where r is close to 1)
about pay-offs and strategies obtains initially and those in which it does not.
Moreover, it is convenient to make a distinction between games where agents can
communicate by exchanging cheap talk (at no or low cost) and those in which
they can’t (or communication is very costly). However, the leader will be
privileged by being the only player who can always communicate if he so chooses.
These distinctions produce four cases in which leadership plays different roles
(Table 9.1). They are considered seriatiam.
Case 1 represents the case where leadership is least likely to play a role, since
knowledge is common and agents can communicate at low or no cost. If
communication costs are strictly 0, coordination will be instantaneous. However,
with positive (if small) communication costs, delay is a possibility. For example,
the relevant game may be a pure symmetric coordination game without any focal
points (e.g. matrix 9.1(a)). In this situation agents want to delay decisions
because they first want to communicate with other agents. The incentives for
delay are caused by the complementarity of actions that implies gains from
coordination. These incentives may, however, cause an inefficiency, since there
is no social gain from delay (Gale 1995). In this situation the exercise of
leadership, that is the picking of some strategy, may economize on delay and
communication costs.
Case 2 differs from case 1 by not allowing agents to engage in communica-
tion. However, the common-knowledge assumption is maintained. As we have
seen, there is substantial empirical evidence that agents may not choose
the efficient equilibrium when they cannot communicate, for example in
Table 9.1. The role of leadership under alternative assumptions about common knowledge
and communication
The role of leadership
With Case 1: Leadership may economize on

communication delay and communication costs,
particularly in many-players situations.
With Without Case 2: Leadership may be required when
common communication ‘Schelling competence’ is low and/or
knowledge there is coordination failure because
agents avoid the risky, but efficient,
equilibrium, and/or agents have to go
through complex and costly reasoning
Coordination
processes in order to reach their preferred
games
equilibrium (e.g. leaders may ‘build
assurance’ in assurance-game situations).
Without With Case 3: Leadership economizes on the
common communication communication costs of establishing
knowledge common-knowledge conditions (e.g.
leaders may help convince players that
there are gains from coordination).
Without Case 4: Leadership helps establish
communication common-knowledge conditions by
influencing beliefs, or chooses one
equilibrium out of a multiplicity.
assurance-game situations (e.g. matrix 9.1(b)), although they have full common
knowledge about pay-offs, strategies, and rationality. In this situation the leader
may, by playing the efficient equilibrium and making this common knowledge,
induce the other player to play the efficient equilibrium.
Moreover, agents may have difficulties coordinating on an equilibrium, when
their ‘Schelling competence’ is low (i.e. there are no obvious focal points), or they
have to go through complex and costly reasoning processes à la Stackelberg
heuristic of Colman and Bacharach (1997), or they have to invest in flexibility
(i.e. choose several actions at the same time by incurring some costs—see
Galesloot and Goyal 1997) in order to reach their preferred equilibrium.
Through the signal provided by the leader picking some strategy these coordin-
ation problems may be resolved.
Case 3 refers to the situation where knowledge is not held in common, but
where agents may communicate at no or low cost. If communication costs are
strictly 0, one would expect common-knowledge conditions to be established
instantaneously, and coordination follows in the same split second. However, if
communication costs are positive, but small, there may still be a role for
leadership, particularly with respect to convincing players that there are gains
to be had from coordination.
Case 4 refers to the situation where knowledge is not held in common, and
where agents cannot communicate (at reasonable cost). Although theoretically
extreme, this is also the most realistic of the four cases. The real world of
managers and leaders is not a world of simple two-strategies, two-players coord-
ination games with costless cheap talk and common knowledge, but of rather
large-scale games with imperfect recall, state-contingent uncertainty, etc. In this
situation players are likely to have incomplete information (or none at all) about
other players, available strategies, previous plays, etc., and games will have to be
redefined and played anew (Calvert 1995). In a large-scale game, individual
belief formation may at most proceed from extrapolating the current aggregate
behavior of the population. There is not likely to be an exact (if any) corres-
pondence between players, strategies, and outcomes in various ‘repetitions’ of
‘the game’. There will probably be multiple equilibria. In such a situation,
leadership may be conceptualized as picking one equilibrium out of a multipli-
city (Calvert 1992); for example, by establishing belief conditions that approxi-
mate common knowledge.
To be more specific about how leadership works by influencing beliefs in the
absence of common knowledge, consider Colman and Bacharach’s work on the
‘Stackelberg heuristic’ (1997) mentioned earlier. In their work no player is,
strictly speaking, a leader; the Stackelberg element is introduced by thinking of
oneself as a Stackelberg leader. However, we may find room for more genuine
leadership if we provide a realistic interpretation of the fundamental assumption
in the model that any conclusion about which strategy to play reached by player
A will be perfectly anticipated by player B, and vice versa (i.e. is common
knowledge). This may make sense for small groups characterized by a long
period of interaction (Camerer and Knez 1994). But in larger-scale settings
with less of a history of interaction players may not have such an easy time
performing the Stackelberg heuristic. In such situations it may make sense to
condition one’s strategy choices on the choices of one particular player—who will
be, in a sense, a leader.
Another example relates to the electronic-mail game of Rubinstein (1989).
Organizational phenomena that are akin to the electronic-mail game may be
represented by problems of coordinating in an administrative hierarchy. If senior
management’s strategic plan calls for new initiatives if certain conditions obtain
and these new initiatives require inter-departmental coordination, what should
division managers do (Rumelt 1995)? Moving first may be costly, but commu-
nication regarding concerted action will not lead to common knowledge. Top
management may circumvent these problems simply by ordering all division
managers to show up at a particular place and date, communicating their new
initiatives, and making sure that all division managers publicly and explicitly
agree on coordinating their actions. This may help establish the required condi-
tion of common knowledge (or an approximation in terms of common beliefs).
To sum up on the above, leadership may be thought of in terms of remedying
(1) problems of coordinating on an equilibrium when agents are initially outside
equilibrium; (2) problems of coordinating on one equilibrium out of a multi-
tude; and (3) problems of moving from an inferior equilibrium to the efficient
equilibrium by influencing the beliefs that agents hold. The question then
arises of how the leader accomplishes this and what motivates his followers to
follow him.
Leadership, Knowledge, and Communication

The story that has been sketched in the preceding pages relies heavily on the
notion of common knowledge (or at least common r-belief with a high r).
However, it has already been noted that common knowledge may be an unreal-
istic assumption because we, strictly speaking, can never be absolutely certain that
something is common knowledge. One may conclude that in interaction we will
always suffer from the inefficiencies illustrated by Rubinstein’s electronic-mail
game (1989). However, such a conclusion is premature.
One interpretation of the notion of common knowledge is not actually to
think of it as involving conscious, ever ascending processes of reasoning, but
rather as something that players recognize heuristically, somewhat akin to Mon-
derer and Samet’s notion of common r-belief (1989). For example, if players have
a long history of interaction this may be sufficient to allow them to short-cut the
infinite processes of reasoning involved in the common-knowledge assumption.
For example, from the observed body language of the other players or through
eye contact, etc. they may conclude on the basis of their earlier history of
interaction that common knowledge is being formed (or, r is approaching 1).
They simply know.1 Hence, the importance of face-to-face contact in the
examples with which I began this chapter. Other social practices in firms—
notably various kinds of social gatherings at which management typically insists
that a substantial percentage of employees be present—may play a similar role.
They are mechanisms for installing common knowledge among employees. For
example, they may help to build up the ‘precedents’ (Knez 1998) that Kreps
analyzes (1990) as an important part of corporate culture, and which means that
all employees know that everybody knows that in situations of type x the thing to
do is y.
Judgment, Motivation and Commitment

So far, I have tacitly assumed that the leader is a sort of benevolent deus ex
machina, who spots and resolves coordination problems to the benefit of all
concerned. This raises a number of problems that have been sidestepped so far.
The first problem relates to the informational advantage of leaders, the second
relates to the leader’s motivation for leading, and the third relates to how he
ensures that those he wants to lead actually follow him.
With respect to the first issue Hermalin (1998) begins his analysis by assuming
that the leader already has some informational advantage. The ability to glimpse
or intuitively judge what is the ‘true’structure of a situation (say, an ongoing battle)
and take action on the basis of that judgment is a common interpretation
(perhaps, rather, definition) of successful leadership. It is, however, not clear
that traditional social science has much to contribute to the understanding of
the cognitive and psychological issues of what makes the leader’s judgment
superior to other players’ judgment or, conversely, why leaders sometimes fail in
their judgment of a situation. However, it is certainly possible to address a number
of issues that are connected to the exercise of judgment, such as the consequences
of the exercise of judgment and the motivation of leaders and followers.
With respect to the motivation of the leader we may well make standard
assumptions with respect to his behavior. As portrayed so far, the leader’s
activities create additional utility for the relevant players; by making players
change their strategies, he moves them towards better equilibria. He can be
paid out of this extra value, or, if he is one of the players in the game himself,
he will automatically gain from his activities (supposing the relevant games are
coordination games such as those in matrices 9.1(a)–(c)).
With respect to the issue of how to motivate followers to actually follow,
things are slightly more complicated. As discussed so far, leadership consists in
influencing beliefs so that better equilibria can be reached; for example through
explicit (speech act) and more tacit (body language) communication and through
‘leading by example’ by being the first to pick a certain strategy. That the issues of
communication and commitment are closed linked has often been pointed out.
Thus, Kotter, an expert on leadership, argues that ‘people will not make sacrifices
[ . . . ] unless they think that the potential benefits of change are attractive and
unless they really believe that transformation is possible. Without credible
communication, and a lot of it, employees’ minds and hearts are never captured’
(Kotter 1996: 9). In the way that Kotter uses the concept here, ‘credible
communication’ corresponds closely to the point that leaders may be instrumen-
tal in installing common knowledge conditions among players. Thus, if every-
body believes that everybody else will move to a superior equilibrium when such
a change has been communicated by the leader, and if it is common knowledge
that players condition their behavior on the leader and that the leader himself
gains by the change, then the leader’s communication is very credible indeed. To
put it in simpler terms, in pure coordination games we would clearly expect
‘cheap talk’ to be credible, since it is clearly in the interest of the announcing
player to follow what he himself announces.
Evidence
Existing experimental evidence has a bearing, directly or indirectly, on the issues
under consideration here. For example, it is a rather robust result that coordin-
ation on the efficient equilibrium in weakest-link games is virtually impossible
for groups of ten people or more (Van Huyck, Battalio, and Beil 1990; Camerer
and Knez 1994). Of course, this doesn’t prove the need for leadership, but it does
suggest that various institutions, and among them leadership, exist for the
purpose of building assurance. One device that for a wide class of games
improves coordination—both in theory and in experiments—is communication
(Farrell 1987, 1988; Cooper, DeJong, Forsythe, and Ross 1989, 1992, 1994),
and communication and leadership have indeed been connected in this chapter.
However, there is reason to be cautious here, for communication is not always
helpful. Thus, Weber, Camerer, Rottenstreich, and Knez (1998) conducted
experiments with weakest-link games and found that letting one member of a
large group take the role of a speaker and engage in brief one-way, pre-play
communication did not improve the success with which the group coordinated.
It may of course be objected that weakest-link games are extreme games (they are
very risky) in a broad class of coordination games and that the experimental
subjects that were picked as speaker/leaders were inexperienced students, not real
managers. However, the results of Weber et al. (1998) do indicate that commu-
nication is not necessarily effective across the board and that in some interaction
situations communicative leadership will have to be backed up by other means
that can further build assurance (cf. Kotter 1996).
Moreover, recent experimental work has begun to discern some basic mistakes
that leaders may be prone to commit. Thus, Weber (1998) investigated
the dependence of successful coordination in weakest-link games (generalized-
assurance games) on the size of the group that played the game. His results
indicate that starting with small groups and then ‘growing’ them at a slow
rate (corresponding to ‘controlled growth’ in firms) led to successful coordination
in large groups, whereas successful coordination was impossible if the size of
the group was initially large. Weber then allowed for the possibility that one
of the players may become a ‘leader’ in the sense that he is allowed to determine
the growth path of group size. The experiments suggest that leaders tend
to increase group size too quickly. In other words, they tend not to have
the correct cognition of the situation. Again, the easy objection is the same
as above—that is, weakest-link games are extreme games in the broad class of
coordination games and the experimental subjects are inexperienced students—
but the results certainly do indicate the potential importance of behavioral
aspects for the understanding of leadership (cf. also Heath, Knez, and
Camerer 1993).
Applications
The primary aim of this chapter has been to put forward a conceptualization of
leadership that while based on simple game theoretical ideas can capture much of
what is meant by leadership from a cognitive or symbolic perspective, and goes
some way towards rationalizing such a notion. The ideas here should be judged
relative to how well they make sense out of cognitive and symbolic understand-
ings of leadership, and how they illuminate business practices in an increasingly
networked knowledge economy. The emerging knowledge economy is very often
characterized in terms of increasing information richness. However, the flip side
of this information richness, increasing connectivity, is usually given less atten-
tion, although it is everywhere, from the linking of primitive cash registers into
smart inventory-management systems to the amazing connectivity we can ob-
serve on the internet. Another word for ‘connectivity’ is ‘network’, although
connectivity goes way beyond those industries that have traditionally been
considered ‘network industries’, such as telecommunications, operating systems,
and the like. Networks introduce critical mass through network externalities.
Actions become increasingly interdependent, and coordination problems of the
kind that have just been considered become increasingly important to cope with.
Below I argue that establishing knowledge conditions approximating common
knowledge will be an increasingly important capability in this economy.
Organization
The argument that there may be a connection between common knowledge and
economic organization has occasionally been made. Thus, Camerer and Knez
(1996) suggest that total-quality management may play a role akin to the role
that this chapter has ascribed to leadership; namely, helping to establish focal
points that ease coordination of actions. Kreps (1990a) puts forward a similar
argument with respect to corporate culture. This perspective may be generalized,
drawing on the ideas of this chapter. Thus, the currently highly fashionable
emphasis on ‘knowledge management’ may be interpreted as an attempt to create
knowledge conditions among employees that approximate common knowledge.
In such an interpretation the practice of knowledge management—which may
roughly be interpreted as a practice of disseminating and sharing knowledge that
was hitherto more asymmetrically distributed—is useful, not because it dissem-
inates valuable knowledge per se, but rather because the process of knowledge
management is a vehicle for establishing knowledge conditions that more
closely resemble those of common knowledge (Foss and Mahnke 2003). Thus,
knowledge-intensive organizations engage in knowledge management projects
not (just) because this allows for more efficient use of the knowledge that is
available to the organization, but because these firms typically have a coordin-
ation need (e.g. because employees are hard-to-monitor professionals, organiza-
tion structures are flat) that cannot easily be resolved by means of existing
hierarchical mechanisms. Establishing common knowledge conditions helps
here.
However, much depends on how knowledge management exercises are actu-
ally carried out. Notably, there is a tendency in the knowledge management
movement to think that technology can replace face-to-face contact. This line of
thinking has become influential, because it seemingly helps drastically to cut
travel budgets, reduce the opportunity costs of meeting activity, etc. As Nancy
Dixon (2000: 4) laconically observes, ‘[a]lthough this sounds reasonable, it
unfortunately just doesn’t always work out that way’. She finds that the know-
ledge-management systems she studied unavoidably gravitate towards a mix of
technology and face-to-face meetings. In her story, one of the causes of this is that
much knowledge is tacit, and hence not directly open to transfer through existing
knowledge-management technologies. A common-knowledge perspective sug-
gests a complementary explanation. Thus, if knowledge is placed in a central
‘storehouse’, employee A may know that a particular piece of information is
located there; for example, because he himself supplied it. He also knows that all
other employees may retrieve it. But he doesn’t know whether they have retrieved
it; that is, whether they, in fact, know. And even if he guesses that they know, how
does he know that they know that he knows. Well, he doesn’t. Only more direct
contact, and preferably direct meetings, can guarantee this kind of common
knowledge. The implication is that knowledge that it is crucial that all employees
know and where coordination requirements necessitate that all know that all
know should not be disseminated through conventional knowledge-management
techniques.
The relevance of common knowledge/coordination also applies to corporate
values and what such values can accomplish for firms. As previously discussed, in
many industries traditional ‘Taylorist’ authority in the sense of detailed order-
giving and control is waning in importance, as knowledge workers increasingly
control strategically important assets, have attractive exit options, and are anyway
increasingly difficult to monitor and control, because of their expert knowledge.
Traditional hierarchy and supervision is giving way to empowerment, delegation,
and autonomy and disintegration into molecular team-based units. However,
firms still often need to take concerted action. They also need to share know-
ledge, for example, for the purpose of taking such concerted action. It is not
immediately clear how firms can fulfil these aims at the same time as they are
restructuring their organizations towards much more decentralized structures.
Corporate cohesion would seem to be threatened in the face of the centrifugal
forces of decentralization. As a consequence of this, more and more firms are
working not only on installing shared value bases that are intended to compen-
sate for (and more) those formal communication channels that decentralization
may have swept away. However, they often fail to do it in the right way. Insights
into coordination problems and common knowledge show us why.
Although corporate value bases are currently all the rage, very many firms
communicate these value bases in a surprisingly naive manner. Often the initial
training session is the only time during her career in which an employee is
explicitly exposed to the corporate value base. Such an exercise is, at best, useless.
For corporate value bases to help in internal coordination tasks they have to be in
the nature of what Danish marketing executive turned guru Jesper Kunde (1997)
strikingly calls ‘corporate religion’. Though perhaps a bit tasteless (at least to the
believer), the religion metaphor is nevertheless descriptively highly apposite. This
is because a living religion is not the holy Scriptures per se, but is the lived
practice and the feeling of community implied by and revolving around those
Scriptures. Most religions thus consider active participation in the community,
including participating in services, essential. Common knowledge helps us to
understand why this is so. Thus, common knowledge is best established through
being physically present at the same location and, if possible, through eye
contact. Rituals perform much of this function (Chwe 2001). Corporate value
bases are not something that should only be communicated from a human-
resources manager to a prospective or new employee; they are something that is
meant for large-scale, relatively frequent (perhaps yearly) gatherings, involving as
many of the firm’s employees as possible, allowing for eye contact and other
aspects of bodily language. This is the way to maximize the chances that any
employee knows that any other employee knows that any given action is or is not
in conformity with corporate values, with ‘the way we do it ‘‘round here’’ ’;
something which we have seen is a great assisting force in resolving coordination
problems.
In this connection note that while Taylorist authority may indeed be waning
in the information-rich, networked economy, this is not the case for what Max
Weber called ‘charismatic authority’. The successful charismatic leader is not only
the one who makes each individual believe in the real existence of a common
purpose; he also succeeds in making all those he leads believe that everybody
believes in this common purpose. This kind of authority is certainly a source of
cohesion also in those firms that adopt radical decentralizing exercises. Perhaps it
is the only source left.
Strategy
Arguments on the role of common knowledge in resolving coordination
problems may be applied to strategy, particularly strategy in a networked know-
ledge economy. It goes almost without saying that beliefs must be crucial to
the enterprise of strategy. Thus, beliefs are central to the phenomenon of
entrepreneurship (individual and corporate), clearly an important part of how
competitive advantages are created and maintained. The ambitious notion of
‘vision’—as propagated by Gary Hamel and C. K. Prahalad (1994)—refers to
corporate beliefs and how these may help mold future competitive landscapes.
Shorter-run aspects of strategizing, such as signaling tactics, are also ultimately
rooted in what is believed about competitors, what they believe about you, what
you believe that they believe about you, etc. (Tirole 1988). And the outcomes of
bargaining with, for example, suppliers or employees also depend very much on
the beliefs you and your suppliers or employees hold.
In fact, according to Barney’s argument (1986) considered in Chapter 3, the
very phenomenon of competitive advantage—arguably the fundamental subject
of strategic management—is ultimately a matter of beliefs. The core of the
argument is that buyers and sellers may hold different beliefs with respect to the
value-creating potential of a resource, and that superior insight, or luck, may help
to exploit those differences.2 Because beliefs are so obviously central to strategy,
and underlie its central phenomenon, one would expect the formal study of belief
management to constitute the central core of strategy. This is not the case. Apart
from a few contributions (Barney 1986; Phelan 2000), beliefs have been given
surprisingly little attention in the strategy literature. To be sure game theorists,
psychologists, marketing specialists, etc. are taken up with beliefs, how they are
formed, how they interact, how they may be influenced. Strategic-management
scholars are much less so. Rather, strategists are instructed to utilize the informa-
tion that they, and no (or only a few) others, possess in order to be able to utilize
possible divergences in the beliefs about the true values of resources on factor
markets. This is taking the beliefs of others as given, and hence unchanging.
However, there are reasons to believe that to the extent that the emergence of
the knowledge economy is also the emergence of an increasingly networked
economy, as many argue (e.g. Kelly 1999; Tapscott 1999; Varian and Shapiro
1999; Teece 2000), the ability to influence beliefs will increasingly be a central
strategic capability. It will be one that goes significantly beyond the marketing
function (although it will bring marketing and strategy closer together); it will be
central to managing supply networks, to influencing customers and users; and it
will be the key to managing employees. Firms will increasingly be confronted
with coordination problems that arise for various reasons, primary among which
are network effects. Standards represent an example that is so familiar that it will
not be discussed further here. Instead, implications that relate to consumption
rather than production are discussed below.
Organizing Consumption through Cognitive Leadership

To be able to consume in an intelligent manner one has to be able to rank the
relevant consumption, process available information, understand why and how
various goods and services produce utility, and compute what is the optimal
bundle of goods and services one can afford to buy. The conventional assump-
tion—certainly in economics, but to some extent also in marketing—is that once
given sufficient information in the form of advertising, the consumer can easily
and autonomously choose his most-preferred, ‘utility-maximizing’ bundle of
goods. In a competitive equilibrium the consumer needs to know the menu
of available goods, the prices of these goods, his own preferences (which are of
course ‘given’), and his own wealth. Knowing all of the goods in the economy is
already mind-boggling. But there is one thing this consumer does not have to do;
namely, care at all about the consumption choices of other consumers, since all
interaction effects that are not transmitted through the price system are squeezed
out of this model. Moreover, she knows exactly how the various goods and
services that she may purchase produce utility for her. Her ‘consumption cap-
abilities’ (Langlois and Cosgel 1998) are perfect.
In more realistic settings, such as our increasingly networked economy,
consumers are not likely to come equipped with such perfect consumption
capabilities. Moreover, everything is not somehow mysteriously organized for
the consumer (or user) so that all he must do is pick his preferred bundle. Think
of how beer drinkers now organize to influence the traditional breweries to
produce higher-quality beers; or the role of the hobbyists in the development
of the emerging PC industry, and, in general, how much of innovation activity is
really a matter of interaction between users and producers. Or think of how
much of advertising is really educating you as a consumer not only about prices
and where to get the goods, but also about how products fit with each other, how
you will ‘fit’ with all other buyers once you have purchased the product, or
how—ironically, and ultimately self-defeatingly—you will not fit with the other
consumers if you buy a certain product. In all these cases you are being educated
about how your consumption pattern may fit into the consumption patterns of
other consumers. Sometimes this is done in less than subtle ways (‘fifty million
Americans can’t be wrong’, etc.), but often it is done in very subtle ways indeed.3
A particularly subtle example, discovered and ingeniously interpreted by
Michael Chwe (2001), is Super Bowl advertising. The Super Bowl is the most
popular program that occurs regularly on network television. It is likely to be
seen by a majority of American households. In fact, any American household is
likely to know that a majority of other households have seen it. The Super Bowl,
in other words, is one giant common-knowledge generator. Chwe examined
what kind of products are typically advertised on the Super Bowl transmission,
and noticed that it is products such as the Macintosh, the Discover card,
Chrysler’s Neon automobile, and various Nike and Reebok trainers. Is there
anything special about such goods? Yes, indeed: buying each one of them
constitutes a coordination problem. In fact, Chwe talks about ‘coordination
goods’ as a separate category of products.4
To illustrate, imagine that you are back in 1984. Why does buying a
Macintosh constitute a coordination problem for you? Well, the answer is
of course that when you consider buying a Macintosh you want as many others
to buy a Mac as well, so as to be able to exchange programs, documents, games,
etc. This is the network externality. Your problem is that you don’t know whether
a sufficient number of other buyers will in fact buy a Mac; you don’t know
whether there will be ‘critical mass’. Enter the Super Bowl transmission. As a
potential Mac buyer, at least this will make you know that other potential Mac
buyers have seen the Mac ad. In fact, this goes for any potential Mac buyer who
has seen the Super Bowl transmission. In other words, common knowledge is
established.
Now, coordination goods may possess this quality for various reasons. Thus,
in some cases the potential buyer is interested in connectivity and a large network
for purely technical reasons. In other cases, such as those of Nike or Reebok
trainers, technical complementarity has very little to do with purchasing de-
cisions. Rather, consumers purchase such goods because they are interested in
having others form certain beliefs about them; for example, that they, too, are
members of a certain in-group. Thus, consumption may in itself carry informa-
tion and reduce uncertainty. Or, consumers’ preferences are influenced by the
number and character of other purchasers, quite apart from considerations of
expediency. Purchase may be purely a matter of snobbery. However, in all these
cases consumers face a coordination problem. And in all of these cases establish-
ing common knowledge may be key to consumers solving their coordination
problems—and to firms succeeding. Some firms, if certainly not all, are acutely
aware of this. A striking example was an increasingly squeezed WordPerfect filing
a court complaint against Microsoft to make the court stop the Microsoft claim
that Word was the globally most popular software for word-processing purposes.
Another example is Netscape’s Navigator campaign which revolved around the
slogan, ‘Netscape Everywhere’.
Conclusion
This chapter has had an exploratory, yet ambitious, agenda. At the overall level it
has been suggested—following the lead of Camerer and Knez (1994, 1996,
1997)—that coordination games carry important lessons for the study of organ-
izational phenomena, including leadership in organizations, and that they also
help to illuminate aspects of strategy in a networked knowledge economy. The
innovation of this chapter is to suggest and sketch a notion of leadership that
links up with cognitive notions of leadership—in which the ‘inculcation of
beliefs’ is central—but which is founded on a rational-choice methodology and
draws upon simple ideas in game theory. Thus, the chapter suggests that
leadership is an important member of the set of institutions for resolving
coordination problems; it is closely connected to issues of communication; it
may arise as a response to significant communication costs in large-scale groups;
it functions partly through communication; and it partakes of its coordinative
role by establishing common-knowledge conditions (or, belief conditions ap-
proximating these).
The aim of this chapter has primarily been to take the first step in concep-
tualizing the leadership phenomenon in a way that while linking up
with important strands in the leadership literature is founded on rational-
choice methodology, and to suggest some applications of this conceptu-
alization that may be particularly pertinent to the knowledge economy. To
the extent that the knowledge bases to which firms need access become increas-
ingly distributed whilst economic activity becomes increasingly networked,
the cognitive concept of leadership developed here may become increasingly
relevant.
Notes
1. Chwe (2001) explicitly argues that in everyday interaction we often succeed in short-
cutting the infinite regress involved in common knowledge. In particular, eye contact
helps to establish such epistemic conditions that ‘I don’t have to think through
anything; I can simply infer from past experience that usually when we make eye
contact, common knowledge is formed’ (ibid. 77). Focal-point coordination implies
much the same. When there is a focal point, you don’t have to think through anything;
you can just play the focal-point strategy.
2. A fairly well-known example concerns the initial sources of Microsoft wealth creation,
which was very much based on landing a lucrative contract with IBM for an operating
system (which MS still had to develop) and then discovering a small OS developer
whose product was acquired for the (comparatively) miniscule sum of $50,000 (US),
keeping the IBM contract entirely secret.
3. One important means of trying to establish common knowledge is through empha-
sizing simplicity. A classic example that pertains to a coordination product is
movies, specifically the very different ads for Steven Spielberg’s Jaws and Robert
Altman’s Nashville, both from 1975 (Chwe 2001: 81). While the Jaws poster showed
little more than a swimming (and naked) woman and a shark, the Nashville poster
showed the whole twenty-four character cast emblazoned on the back of a blue denim
jacket. The simpler poster is likely to be noticed and remembered by many more than
the more complicated poster. It is therefore more likely to help create common
knowledge. Karl Weick (1979: 164) argued that as a general matter, managers
engage in processes of ‘enactment’, whereby they ‘construct, rearrange, single out,
and demolish many ‘‘objective’’ features of their surroundings. They unrandomize
variables [and] insert vestiges of orderliness.’ Enactment, in Weick’s description, is
essentially making order by means of simplification that helps agents to construct
shared understandings with which they can interpret reality and act in a cohesive way.
While Weick had organizational action in mind, my argument implies that firms
should try to enact their external environment not only for themselves, but just as
much for their customers.
4. Many goods are actually coordination goods, even if this is seldom realized, such as car
oil or photo copying machine. There isn’t necessarily anything fancy about coordin-
ation goods.
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Index
Adler, Paul 12 Chicago-UCLA approach 72

Agency costs 135 Coase theorem 107, 108
Agency problem 29, 53 Coase, Ronald 16, 23, 26, 42, 52, 99,
Alchian, Armen and Harold Demsetz 128 102, 103, 127, 131, 158
Alchian, Armen 27 Coleman, James 94, 215
Alienable asset 129, 145 Common knowledge 132, 211, 220, 222,
Appropriability 144 229
Appropriation 99 Communication costs 93
Asset specificity 28, 101 Communication 211, 219, 225
Attributes of Assets 104, 105 Competitive advantage 2
Austrian economics 130 Competitive equilibrium model 61,
Authority 36, 122, 126, 128, 149, 183 76–77, 109, 116
Competitive equilibrium in the RBV 73
Balancing of incentive instruments 143 Competitive strategy 100
Bargaining 108, 124 Complementarities 12, 52, 74 168, 171,
Barney, Jay B. 34, 42, 61, 63–65, 72, 81, 179, 182, 188, 191
99, 104, 106, 114–115, 157, 236 Complete contracting theory 29
Barzel, Yoram 98– 99, 102, 106, 114, 116 Conner, Kathleen 37
Beliefs 212, 236 Consumption capabilities 237
Holmström, Bengt 16 Contracts 27
Bertrand competition 74 Cooper, Russell 225
Bolton, Patrick and Joseph Farrell 140 Cooperation games 216
Boundaries of the firm 12, 24, 41, 96, Coordination failure 221
126, 144 Coordination games with mixed
Bounded rationality 23, 29, 47, 83, 84, interests 217
85, 87, 88, 133 Coordination mechanisms 11, 126,
Brand name 105, 106 149
Brusoni, Stefano 10 Coordination on an equilibrium 220
Brynjolfsson, Erik 7 Coordination problem 219
Business judgment 136 Coordination problems 139, 211
Coordination games 216
Camerer, Colin 213, 233 Core competences 41
Capabilities 32, 34, 53, 54, 84, 104, 91, Corporate disaggregation 121
144 Corporate strategy 23, 99
Capture 110 Corporate values 234
Casson, Mark 69, 93 Crawford, Vincent 220
Castells, Manuel 1
Chandler, Alfred 11 DeBeers 102
Changing distributed knowledge 133 Decision rights 135, 142, 149, 158, 166,
Chicago methodology 76 167, 180, 183
278 index
Decisive Information 141, 146 Grandori, Anna 124, 126, 135, 148, 150
Delegate 134 Grant, Robert 24, 34, 37
Delegation of responsibility 199, 201
Delegation of rights 137 Hart, Oliver 27, 31, 42, 49, 115, 138,
Delegation 166 145, 214, 215
Demsetz, Harold 27, 36, 63, 70–72, 86, Hayek, Friedrich 81, 95, 130, 131, 132,
93, 99, 141, 170 134, 166
Discontinuity thesis 3 Heterogeneity 33, 44, 54, 66, 74, 114,
Disequilibrium 77 116
Dissipation of value 110 Hidden knowledge 139
DISKO database 189, 196 High-performance work practices 12
Distributed knowledge 10, 130–132, Hippel, Eric von 37
138, 212 Hodgson, Geoff 98, 124, 150
Domains of application 42 Hold-up 28, 113, 181, 168, 218
Dosi, Giovanni 48, 52 Holmström, Bengt 122, 142, 143, 145,
Dynamic capabilities 2, 121 173, 215
Dynamic industries 181 HRM system 201, 202, 203
Dynamic transaction costs 93 Human assets 129
Human capital 1, 7, 8, 31
Economic organisation 91 Human resources 167
Economies of scale in managing 141 Human resource management 187
Electronic-mail-game 226 Hyper competition 125
Employment contract 35, 127
Entrepreneurship 76 Ignorance 130
Evolutionary economics 88 Immaterial assets 1
Evolutionary 70 Immobility 67, 115
Ex ante barriers to competition 65, 67 Imperfect mobility 65
Ex ante contractual alignment 31 Impossibility of selective intervention
Ex post barriers to competition 65, 67 148
Ex post competition 114 Incentive conflicts 31, 32
Ex post governance mechanisms 31 Incentive alignment 51
Exchange as value-creating 113 Incentive-based remuneration
Existence of the firm 24 schemes 193
Exploitation 190 Incentives 7
Exploration 190 Increased delegation 192
External hybrids 157 Incremental process innovation 192
External linkages of firms 199 Industrial districts 82
Industry boundaries 15
Factor-market competition 65 Influence activities 173
Firm routines 9 Informal delegation 149
Firm-external training 199, 203 Information and communication
Firm-internal training 199, 203 technologies 1
Information processing perspectives 180
Globalization 121 Information/knowledge distinction 7
Governance Structures 126 Innovation performance 190, 191, 193
index 279
Institutional organization theory 218 March, James 81, 190
Integration of functions 199 Market control 165, 179
Integrationism 50, 96 Market failures 109
Intellectual property 103 Matrix structure 162
Intellectual-property-rights 103 Methodological collectivism 94, 95
Interdisciplinary workgroups 199 Methodological individualism 84, 93, 94,
Internal and external hybrids 181 95
Internal hybrids 143, 157, 178, 179 Micro foundations 3, 46, 82, 96
Internal organisation 24, 93 Milgrom, Paul 191
IT 125, 157 Mintzberg, Henry 223, 224
Mises, Ludwig von 148, 174
Job-related training 193 Monitoring 172
Judgment 137, 142 Monopoly 111
Moving away from an inferior
Keynes, John Maynard 3 equilibrium 222
Klein, Benjamin 6, 39 Multinational firm 40, 100
Knight, Frank 136, 142
Knowledge assets 124, 130, 144, 147 Nash equilibrium 217
Knowledge based strategies vii National systems of innovation 3
Knowledge economy vii, 1, 2, 11, 17, Nelson 34, 82
138, 144, 236 Network organization 2
Knowledge inputs 123 Networked economy 236, 237
Knowledge intensive vii New economy 1, 6
Knowledge management 2, 233 New HRM practices 187
Knowledge sharing 166, 172, 173 New organizational forms 11, 158
Knowledge worker vii Nickerson, Jackson 10
Knowledge workers 8, 121 Non-contractability 29
Knowledge-based networks 123 Non-contractible investments 129
Knowledge-based view 23 Non-imitable and non-substitutable 64
Kogut, Bruce 24, 37, 92, 144, 157 Non-tradability 113
Kolind, Lars 161, 162, 169
Kotter, Philip 231 Opportunism 28, 101
Kreps, David 213, 214, 230, 233 Organizational advantage 55
Organizational codes 32
Langlois, Richard N. 13, 15, 23, 34, 90, Organizational form 180
93, 98, 127, 144, 213, 215, 237 Organizational inertia 89
Leadership literature 224 Organizational restructurings 211
Learning economy 3 Oticon A/S 158, 160
Level of analysis 103 Oticon spaghetti experiment 159
Local knowledge 181, 192 Outsourcing 11, 52
Lundvall, Bengt-Åke 1, 3 Overconfidence bias 176
Ownership 148, 183, 184
Machlup, Fritz 40, 90
Macro-economics 3 Path-dependence 32, 63, 116
Mahoney, Joseph 68 Pavitt, Ketih 10
280 index
Pavitt taxonomy 207 Rotemberg, Julio 31
Penrose, Edith 33, 48, 52, 68, 69, 81, 84, Routines 86–87, 89
98 Rubinstein, Ariel 226
Performance-related pay 199 Rumelt, Richard P. 23, 34, 62, 72, 78,
Peteraf, Margaret 61, 65, 95, 99, 114 106, 115
Physical assets 138, 144
Planned job rotation 199 Saloner, Garth 31
Positive-transaction-costs world 110 Schelling, Thomas 219, 225
Prahalad, C.K. 36, 37 Scope of the firm 53
Prencipe, Andrea 10 Schumpeter, Joseph A 14, 188, 192
Pre-play communication 222 Selecting among multiple equilibria 221
Pricing as a source of value creation Selective intervention 158, 159, 174, 176,
112 181
Principal-agent theory 28, 30 Self-enforcing agreement 221
Problems of coordination 172 Simon, Herbert A. 86, 87, 89, 95, 127,
Production function view 33 136
Profit-sharing arrangements 193 Spaghetti organization 161
Project groups 165 Specialization advantages 171
Project-based organization 180 Specialized knowledge 38
Promotion schemes 193 Specific rights 28, 129
Promotion 171 Stackelberg heuristic 228, 229
Property rights approach 29 Stackelberg leader 215
Property rights 99, 103, 104, 134 Stakeholders 102
Protection 110 Strategic factor markets 114
Pure coordination games 217 Strategic opportunities 75
Strategic theory of the firm 24
Quality circles 187, 199 Super Bowl advertising 237
Superior knowledge 142
Rajan, Ramanujan 10 Sustained competitive advantage 61, 66,
Real authority 138 74, 114, 121
Reciprocity 113 Systems for collection of employee
Rents 65, 66 proposals 199
Residual claimant 175
Residual claimants 148 Tacit knowledge 83, 88
Residual rights 28, 29, 129 Team practices 201
Resource-based view of the firm 15 Techno-economic paradigm 3
Resources are unpriced 112 Teece, David J. 15, 100, 106
Resources as bundles of property rights to Tirole, Jean 75, 106, 123, 126, 138, 142,
attributes 105 149
Resources 70 Tournaments 171
Richardson, George B. 31, 35, 39, 91, 92, TQM 7
98 Transaction cost economics 26, 98
Roberts, John 16, 191 Transaction costs are zero 107
Romer, Paul 9 Transaction costs 75
Rotation of jobs 193 Trust 5, 149
index 281
Unpriced resources 112 Williamson, Oliver E. 16, 23, 26, 38, 41,
Urgency 139 42, 49, 75, 81, 99, 100, 106, 147,
148, 168, 175, 179, 182
Value creation 99 Winter, Sidney G: 34, 82, 95, 114
Veblen, Thorstein 14 Witt, Ulrich 48, 98
Vertical linkages 199
Zander, Udo 24, 37, 92, 144, 157
Weakest-link games 232 Zenger, Todd 7, 12, 143, 147, 157, 168
Wernerfelt, Birger 34, 42, 49, 104, 106 Zingales, Luigi 8, 10, 16

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Strategy, Economic Organization, and the Knowledge Economy

The Coordination of Firms and Resources

The Coordination of Firms and Resources

We are regularly told by politicians, high-ranking bureaucrats, CEOs, the busi-

List of Figures xii

1 Strategy and Economic Organization in the Knowledge Economy 1

Part I: Strategy: Critical Perspectives

3 The Resource-based View: Aligning Strategy and

4 Knowledge-based Views of the Firm 81

5 Strategy, Resources, and Transaction Costs 98

Part 2: Organization: Critical Perspectives

7 Internal Organization in the Knowledge Economy:

8 Performance and Organization in the Knowledge Economy:

9 Cognitive Leadership and Coordination in the Knowledge Economy 211

3.1a/b Sustained competitive advantage in Barney (1991)

2.1 A taxonomy of theory relations 43

AT&T American Telephone and Telegraph Company

Introduction: The Knowledge Economy as Context

What Do We Know about the Knowledge Economy?

The Knowledge Economy as Vision

Information and Communication Technologies

The Increasing Importance of Human Capital

Distributed Knowledge and Innovation

Changing Internal Organization

Changing Firm Boundaries

Organization and Strategy

The Need for Foundational Inquiry

About this Book

Strategy: Critical Perspectives

The Strategic Theory of the Firm: Meaning and Relevance

Isolationist Strategy No. 1: Organization Economics as a Foundation for the

Incomplete Contract Theories

Complete Contract Theories

Why Organizational Economics is Not a Strategic

Isolationist Strategy No. 2: The Knowledge-based View as a Foundation

The Knowledge-based View as a Theory of Economic Organization

Weaknesses of the Knowledge-based View

Economic Organization: The Existence of the Firm, Asset Ownership,

Methodological Problems: Lack of Predictive Power and Modeling Heuristics

The Knowledge-based View as a Strategic Theory of the Firm?

Possible Theory Relations

Explanandum Knowledge-based Organizational-economics

Why do firms exist? Conner (1991), Alchian and Demsetz

Finally, there is the possibility of correspondence. In a homogeneous relation of

Translating the Knowledge-based View: Some Examples

Resource heterogeneity. Resource (input) heterogeneity is in fact a key theme

Which Theoretical Relations Obtain?

Knowledge-based Challenges to Organizational Economics?

Bounded rationality and learning. According to KBV writers (e.g. Ghoshal,

Cognition. OE follows virtually all of economics in assuming cognitive homo-

Integrationism in the Strategic Theory of the Firm

Why Do We Need Integrationism?

What Might Integrationism Look Like? Some Entry Points

Agency problems and capabilities. Arguably, cognitive factors are important

Agency problems and learning capabilities. Although the presence of capabilities

Capabilities, clustered transactions, and asset specificity. Winter (1991: 178–9)

Heterogeneity of transactions. To many KBV writers the import of capabilities

Main Tenets of the Resource-based View

Barney’s 1991 Analysis