THEORY OF THE FIRM

AND

THE STRATEGIC UNBOUND DECISION.

Working Paper Series

2010

RICARDO ROJAS MONTERO

e-mail: rrmmex@netscape.net
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About the Author

Ricardo Rojas is a Management Consultant who have experience in Strategy, Supply Chain and
Public Policy through more than 20 consulting projects at national and international level. His
professional objective has been to help organisations to design its business strategy to maximise
value in a cost effective manner and implement such strategy in their operations and supply chain.
Ricardo studied a Bachelor Degree in Political Sciences and a Master of Business Administration
(MBA) at ITAM followed by a Master in Operations and Supply Chain Management at Manchester
Business School.

Contact details:

Ricardo Rojas Montero

e-mail: rrmmex@netscape.net
The limits of the firm

Theory of the firm is the framework that helps to design and explain the business strategy and
determine the make or buy decision. In this sense, the Theory of the firms, not only explains the
firm boundary determines which activities are performed within and outside of the firm, but
determine the areas in which the organizations compete in the business arena.

Resources Dependence Theory (RDT): Considers the firm as a coalition of participants that
depends on each other and this interdependence explains the firm behaviour and its outcomes.
Central proposition is that organizational survival hinges on the ability to procure critical resources
from the external environment. In order to survive, the organizations have set their main objectives
as managing their criticality of resources and restructuring their dependency. The limits of the firm
are determined by the resource importance, the discretion over resource allocation and use, and the
alternatives or extend of control over the resource(Pfeffer and Salancik, 1978, Casciaro and
Piskorski, 2005, Dyer et al., 2004).

Resources Based View and the Knowledge Based View of the firm (RBV/KBV): Firm is
considered as historical and social entity which has the ability to acquire or exploit resources
depending on their place in time and space The objective of the firm is to procure resources that are
not easily imitable by competitors to sustain a competitive advantage. The boundary of the firm
depends on the capacity to develop the capabilities internally and the cost of acquiring them in the
market. (Hart, 1995, Barney, 1991)

Transaction Cost Economics (TCE): Defines firms as a bundle of contracts. Companies exist as
there is a cost to use the price mechanism and this cost could be avoided if a firm becomes
vertically integrated and coordinate the transactions internally. The firm’s objective is to minimize
cost. When the economic exchange transaction cost is high it is more efficient to coordinate
activities within the boundaries of the firm (Hobbs, 1996).

The frameworks had been used to explain two limits of the firm, limit of the production or buy
activity and the geographic boundary. Both limits explain four outcomes, Domestic Outsourcing,
Offshore Outsourcing, Captive Offshoring and In-House production disintegration (Sako, 2006).
The term Domestic Outsourcing means the delegation of internal activities to a third entity in the
same country and Offshore Outsourcing in a foreign country (Domberger, 1998, Javalgi et al.,
2009). The outsourcing is not a result of consideration whether to purchase or not, but it represents
the fundamental choice to reject the internalization of an activity, which makes it a highly strategic
decision (Gilley and Rasheed, 2000) .

Offshoring occurs when companies transfer activities abroad that have been done in their home
(Domberger, 1998). In this sense, when the activities are located outside of the home country and
sourcing is undertaken from a foreign subsidiary it is called Captive Offshoring. When the activities
are developed domestically it is called In-House.

Figure 1. Boundaries of the firm (Based on: Sharma and Loh, 2009, Sako, 2005).
Resources Dependence Theory

The central proposition of Resources Dependence Theory is that organizational survival hinges on
the ability to procure critical resources from the external environment. In order to survive, the
organizations set their objectives as managing criticality of resources and restructuring their
dependency. The firm is considered as a coalition of participants that depends on each other and this
interdependence explains the firm behaviour and its outcomes. (Pfeffer and Salancik, 1978,
Casciaro and Piskorski, 2005, Dyer et al., 2004).

Criticality is related with the ability to continue operating without the resources. In this sense,
organizational survival will be determined, first of all, by the resource importance, and then by the
discretion over resource allocation, use, and the alternatives or extend of control over the resources.
The importance of a resource is determined by the relative magnitude of the exchange and its
criticality. Discretion over a resource means the right or ability to have access or use of a resource.

Restructuring their dependencies and managing criticality help in decreasing uncertainty.

Uncertainty or instability derives from the possibility that the resource is not available. Managers
could use certain unilateral tactics to reduce the importance of a resource, or restructure their
dependencies through supplier development and coalitions. Also, they can obtain the right over a
resource by absorbing constraints through Merges and acquisitions or absorb partially using long
term contracts (Casciaro and Piskorski, 2005).

The company interdependence derives from the concentration of resource control, or the number of
suppliers in the market (Pfeffer and Salancik, 1978).The greater the mutual dependence of
organizations is better to expand the limits of the firm by Merge and Acquisition (Casciaro and
Piskorski, 2005). Absorb constraints is not recommended in the presence of modular and sequential
synergies. In the first case, when firms manage their resource independently and collaborate only
for a specific project, alliance has shown to be the best strategy. In the latter case, when there are
many suppliers and the output of one firm is the input of another, the best tactic is partnership with
long time contract or a cooperative alliance (Dyer et al., 2004).

From a unbound capabilities point of view, Caniëls and Roeleveld (2009) studied the factors that
influence the Outsourcing decision-making process. The authors argue that interdependence,
specific technological expertise and existence of alternative suppliers are the important factors in
the unbound decision. Firms experiencing a power advantage for the suppliers without
interdependence asymmetry tend to keep the core activities in house. Only in the case that firm has
the dependence domain, it will be more likely to outsource core activities.

Resources Based View and the Knowledge Based View

The central proposition of RBV/KBV is that differential firm performance is a consequence of its
internal factor rather than industry structure (Barney, 1991). Competitive advantages can be
sustained only if the capabilities are supported by resources that are not easily imitable by
competitors (Hart, 1995). The firm is considered as historical and social entity with the ability to
acquire or exploit resources depending on their place in time and space (Barney, 1991, p. 213).

RBV/KBV, as exposed, are internally based views developed to examine the link between firm’s
internal resources, capabilities and its sustained competitive advantage (Barney, 1991, Hart, 1995).
RBV/KBV have adopted two assumptions: resource heterogeneity and immobility. The former,
assumes that firms within an industry that possess exactly the same strategic resources are not able
to enjoy a sustained competitive advantage. The latter, establishes that, when barriers to entry or
mobility do not exist, competitors are able to acquire any resource that support firm competitive
advantage (Shook et al., 2009, Barney, 1991).

Figure 2 The Resources Based View (Source: Author based on literature review)

Resources are strengths that firms can use to conceive and implement their strategies (Barney,
1991). Capabilities are a group of resources used on a particular value-added activity (Hart, 1995).
It is widely recognised that there are three groups of resources: physical (physical technology,
firm’s plant and equipment, geographic location and access to raw material), human capital
(training, experience, judgment, intelligence, relationships, managers and workers) and
organizational capital (reporting structure, planning, controlling and coordinating system and
informal relationships).

Although, Knowledge Based View argues that intangible assets are the only resources unique across
firms over time (Shook et al., 2009), RBV identify four essential resources characteristics so as to
generate a sustainable competitive advantage, those are (Barney, 1991):

• Valuable. Helps to exploit opportunities or neutralize threats.

• Rare. A particular mix of resources to implement the strategy.
• Inimitable: ability of other firms to obtain such as resources. This can be because of:
◦ Unique historical reason (path dependence). Firm’s performance depends on the path a
firm followed to acquire resources.
◦ Causally ambiguous. The link between sustained competitive strategy and resources is
not understood at all.
◦ Socially complex. Ability to systematically influence and manage.
• No strategically equivalent valuable. There is no other resource to implement the strategy.

Under RBV/KBV perspective the limits of the firms are determined by the resources required to
perform in the market. In order to identify a firm’s resource, managers have to define the activity of
the company and the minimum successful factors in a specific markets and then identify the
resources aimed at strengthening main capabilities to compete in the market place (Wernerfelt,
1984). The acquisition strategy should be based on the resource’s interconnectedness, that means
(Wernerfelt, 1984, Hart, 1995):

1. Acquiring a resource depending on having already developed other resource first (related
supplementary / path dependence) or
2. Acquire a capability depending on the simultaneous presence of other resources acquired
(related complementary / embeddedness).

Lutz and Ritter (2009) support this observation empirically. Focus on supply chain upgrading and
the interconnectedness of firm’s competencies they remark that the partition of connected
competencies may generate an adverse cost structure. As well, they found that all the outsourced
activities analyzed were interconnected and the employability of core capabilities may depend on
the access to the outsourced competencies.
As a consequence, the make or buy decision depends on the capacity to develop the capabilities
internally and the cost of acquiring them in the market. This theory suggests, in the first instance, to
develop the capability or acquire the specific capability and considering it as the last option to buy it
in the market. The choice between these decisions is based on the cost to develop or acquire such
capability (Cousins et al., 2008). The acquisition strategy could be the use of a single resource in
several business, i.e. sequential entry strategy; exploitation of existing resource and developing a
new one based on it, i.e. exploit and develop strategy; and acquire and develop related skills to
produce into a specific industry, i.e. stepping stones.(Wernerfelt, 1984)

Companies should outsource only attributes and not resources in order to develop a Sustainable
Competitive Advantage. Only if the cost to acquire the resource is prohibitively high then the firm
has to acquire in the market (Cousins et al., 2008). However, acquire the resource with sourcing
partners possessing complementary resources and capabilities in the market has to be a means of
transferring knowledge to internal control (Prahalad and Hamel, 1990, Domberger, 1998, Shook et
al., 2009). Tate et al. (2009) remarks this theoretical conclusion to support empirical research from
a Resources Based View. They found that the companies which engaged in Offshore Outsourcing
began to see supplier capabilities as a part of their own organizational competitive capability.

Finally, two other factors determine the location of the firm (Aron and Singh, 2005), operational
risk and structural risk. Operational risk refers to the capacity of the supplier to execute the activity
as well as their employees’ performance in house. Operational risk is higher when the tacit
knowledge in the product or service is lower. Structural risk refers to potential opportunistic
behaviour. Both types of risk determine the process potential to offshore and determine the
organisational structure to realize the expected benefits of the operation.

In this sense, to decrease operational risk, companies use location, such as onshore, nearshore or
offshore; and organizational structure (governance) to react to the structural risk. When both,
operational and structural risks are low, firms outsource this process to overseas suppliers. Firms
have to be characterized by high levels of operational risk to nearby countries. When both
operational and structural risk are very high companies must keep the processes onshore and in-
house (Aron and Singh, 2005).
Transaction Cost Economics

Transaction Cost Economics (TCE) is based on the Theory of Firm of Coase (1937). One of the
main advantages of this approach is that it only requires the comparison of the cost of market versus
hierarchy associated with the individual sourcing transaction in order to decide whether to make or
buy (Barney, 1999, Shook et al., 2009). According to TCE, firms are a bundle of contracts and
exists as there is a cost to use the price mechanism and this cost could be avoided if a firm becomes
vertically integrated and coordinate the transactions internally (Hobbs, 1996, Demsetz, 1988). In
this sense, when the economic exchange transaction cost is high, it is more efficient to coordinate
activities within the boundaries of the firm. This cost to use the market is affected by (Hobbs,
1996): behavioural characteristics (bounded rationality and opportunism) and the transaction
characteristics (frequency, asset specificity and information asymmetry).

Behavioural characteristics include two assumptions: Bounded rationality and opportunism.

Bounded rationality is related with the lack of capacity of people to make a fully rational decision
or evaluate all possible alternatives (Hobbs, 1996). Opportunism has been defined by Cousins
(2008, p.31) as achieving one’s goal through calculated efforts of guile, lying, stealing, cheating,
passing false information, distorting or disguising information, and generally misleading the other
party. In other words, opportunism recognizes that individuals are selfish and will try to take
advantage of a situation to their own interest.

Transactions characteristics suppose that the frequency of the transaction, information asymmetry
and asset specificity affect the cost of use the market. Frequent transactions provides buyers and
seller with information about one another, as a rule, the less frequent is the transaction, the higher
the tendency to exhibit opportunistic behaviour. Less frequent transactions increase the “haggling”
costs of negotiating a contract for each exchange transaction (Hart, 2008). It implies a learning
curve effect, driving a fall in the unit costs resulting from experience or learning by doing (Gilbert
and Harris, 1981, Weigelt, 2009, Cabral and Riordan, 1994).

Information asymmetry refers to situations where all parties face the same but incomplete level of
information. Information asymmetry can lead to opportunistic behaviour (and uncertainty) when
one of the parties hide relevant information before the transaction or the behaviour is not directly
observable after the transaction (Hobbs, 1996).
Asset specificity is “an asset tangible or intangible that has little value outside of a particular
relationship” (Lohtia et al., 1994). High asset specificity increases the risk of opportunistic
behaviour by partners trying to appropriate some rents of the transaction. Asset specificity includes
six dimensions (Lamminmaki, 2005):
• Human. Any unique knowledge or skill transferred to a particular employer/employee
relationship.
• Physical. Investment related to a particular trading relationship (could be in a short term).
• Site. Investment made in a site that is in close proximity to a buyer or seller.
• Dedicated. Asset purchased for a long-term trading relationship.
• Brand capital. Related to reputation, one party has control over activities that can damage
the reputation of the other.
• Temporal asset specificity. Investment where timing and coordination activities are critical.

The make or buy decision searches for the most efficient governance structure (Madhok, 2002).
“The basic understanding of TCE is that firms must make investment to transact with each other”
(Cousins et al., 2008). This transaction specific investment could incentive opportunist behaviour
and firms use governance as a mechanism to manage its economic exchanges (Barney, 1999). So,
the decision to make or buy is based on efficiency, i.e. the optimal choice that minimize the cost of
the transaction (Cousins et al., 2008).

Uncertainty in the external environment determines the location of the firm (2008). This
environment uncertainty is related with the degree of volatility in the market place due to
disruptions to the market. High levels of uncertainty increase the risk of service contracts in the
market due to the improbability to comply fully with the agreement.
Conclusion

Based on the literature review on Resource Dependence Theory, Resources Based View and
Transaction Cost Economics, the next table summarizes the main characteristics related to each
theory. Although, the geography boundary is not discussed in a broad way in any of these theories,
it provides interesting drivers that helps to understand how firm outline its limits.

Table 1. Comparisons of firm and geographic boundaries across three theories (Source:
Author based on literature review)
Drivers of Drivers of
Central Objectives of
Theory Main factors Firm Geographic
proposition the firm
boundary boundary
Firm survival Manage - Importance of resources - Criticality of - Discretion
depends on critical - Discretion over the resource over the
Resource
ability to resources and resources - Ability to resources
Dependence
procure critical restructure - Inter-dependence restructure - Inter-
Theory
resources dependencies their dependency
dependency,
Firms’ Acquire or - Acquire “strength” - Keep core - Gain access to
supernormal develop resources. competencies critical
economic resources that - Characteristics: - Outsource to resources.
Resources
return is are Valuable capitalize
Based View
explained by heterogeneous Rare supplier
its resources. and immobile. Inimitable capabilities
No equivalent
Firms exist due Minimize cost - Behavioural - Minimize risk - Cost
to the cost to through an characteristics: - Minimize minimization
use price appropriate Bounded rationality Transaction - Uncertainty in
Transaction mechanism governance Opportunism Cost the external
Cost structure - Transaction environment
Economics characteristics:
Frequency
Asset specificity
Information asymmetry.

Theories are complementary and contradictory in the prescription about the limits of the firm. The
prescription offered by Resources Based View (RBV) and RDT are theoretically complementary.

The complementary nature of both theories is based on the resource criticality and specificity. TCE,
RBV and RDT share a complementary theoretical standpoint that specific assets, critical resources
and distinctive capabilities are difficult to imitate or trade. However, TCE diverge form RBV and
RDT in the optimization decision, while TCE is focus on cost minimization, RBV and RDT focus
on resources accumulation. In this sense, TCE first option is to buy in the market while in the case
of RBV and RDT is to absorb constraints.
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