Knowledge, Scale and Transactions in the Theory of the Firm

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A rendering along the lines of the modern economics of organization may be : as firms move increasingly away from their core businesses, they confront increasing adverse selection and moral hazard, since management becomes increasingly unable to monitor efficiently employees or to evaluate their human capital. The ranking of activities seems to suggest the need for the firm to define at least two distinct governance priorities :. Source : Amesse and Cohendet, Within this 'core 'structure, some contractual schemes may naturally be implemented e. Within this second structure of governance, classical contractual schemes are dominant to ensure the information processing that is central to the functioning of the periphery.

In short, there are many issues and reconsiderations of the theory of the firm to be analysed through the perspective of the dual firm. In the following sections of this article, we propose to focus on empirical issues. This supposes in a first stage to specify the meaning of the notion of competence which is central to the analysis of the dual firm. The dual firm : empirical issues. When dealing with empirical measures in the vision of the firm as a processor of knowledge, one faces severe difficulties.

One of the reasons is that the statistical tools have been conceived and adapted to investigate the firm in its classical context of information processing. However another difficulty is due to the rather imprecise and fuzzy concept of competence itself. In the following we propose first to discuss this issue on the way to deal empirically with the key notion of competence, before investigating more complete studies on the dual firm.

Conceptual and empirical approaches of competences. In our view the reason of the difficulty to capture the notion of competence is that this concept comes from very different streams of literature on the knowledge-based vision of the firm. The main alternative approaches are the following : a the resource-based view of the firm, b the strategic competence-based approach, c the evolutionary theory, d the social anthropology of learning approach.

A firm's resource at a given moment in time can be defined as those assets tangible and intangible which are tied semi-permanently to the firm Caves, The claim that resources that are difficult to imitate and only imperfectly substi- tutable create sustainable advantages challenges the standard microeconomic argument that firm differences should erode over time due to imitative mechanisms.

For empirical studies, the resource-based view approach clearly suggests to identify competences of firms through classical static intellectual assets such as patents or trademarks. Indeed such measures are indispensable to situate the specialised domain of competences on which firms have decided to accumulate knowledge. However, they are only very partial measures that say nothing on the dynamics and collective building of competences.

The firm is viewed as a social institution, the main characteristic of which is to know well how to do certain things. Competences are coherent sets of capabilities used in an efficient way. They are the products of a selection process both internal and external to the firm. How these competences are constructed, combined, protected and managed is critical for understanding the boundaries of the firm as well as the co-ordination and incentive structure of the firm.

For Prahalad and Hamel as well as for most of the authors of this stream of research, top managers play a key role in identifying, developing and reinforcing core competences. For empirical works, the strategic competence approach supposes to a large extent to identify competences as the cognitive representation of managers. This can be done through direct interviews, through analysis of activity reports of firms or of official websites of companies some of them explicitly mention the nature of the core competences targeted by the company , through the analysis of presentations made by managers in conferences or colloquiums.

Of course, such an investigation takes time and may be rather imprecise. It may also lead to the false impression that the delineation of the competence domain is the sole responsibility of top managers and when one changes managers, so the competence of a given company may change as well. Knowledge is stored in routines, seen as the regular and predictable behavioural pattern of the firm which not only determines what an organization can do well but also conditions how the organization will interpret messages.

For this approach, innovation is an inherently unpredictable mutation of routines that cannot be guided by the vision of a sole manager. However, distinctive organisational capabilities. For empirical works, the evolutionary theory clearly pinpoints routine as the central element to understand the formation of competences. The possibility for empirical studies to analyse competences through the functioning of routines depends on the extent to which companies have been codifying, replicating and storing their repository of routines.

The routine approach, when feasible, is a rich one that leads to a dynamic understanding of what firms do. This approach centres its interest in the actual process of how knowledge is formed and made explicit through social interaction. The emphasis is on the working community as an active entity of knowing, which reveals specific forms of knowledge through its daily practices. Knowing is harnessed to the sociology of interpersonal and collective relations in firms, influenced by factors such as trust and reciprocity, corporate narratives, languages of communication, and socialization strategies.

What matters is thus the architecture and distribution of the learning processes within the firm. In particular, on-going learning processes between and within communities on which the knowledge-creating process of the firm relies bridge different types of rationality in separate domains. The firm is thus viewed as a set of overlapping learning practices and searching activities, involving recursive interchange between the domains and solutions emerging from these activities 8.

For empirical studies the observation of communities could usefully complement the analysis of routines. Routines experienced. In this perspective, the role of communities is a key one since communities offer a framework with high intensity of knowledge replication due to a day to day practice.

This is certainly beyond the scope of this contribution, but it can be argued in this respect that communities could play a key role in the evolutionary vision of the firm. To sum up, we are confronted with different streams of the knowledge-based approaches of the firm that suggest different ways to measure competence. A logical question that follows is whether there is a fruitful way of putting these different theoretical pieces together 9.

In this perspective, we propose to use a recent typology proposed by Kusonoki, Nonaka and Nagata , that offers a complementary way of looking at the interactions between the different theoretical positions on the formation and use of competences.

According to these authors, the organisational schemes of the firms related to knowledge creation can be categorised in three types :. Based on the previous discussion, our view is that the resource-based theory deals with the first category knowledge base , the strategic competence approach deals with the second category knowledge frames , while the evolutionary dynamic capability approach and the community approach deal with the third category knowledge dynamics. Thus, each approach brings a specific insight into the organisation of knowledge in the competence-based approaches of the firm.

It follows that all these challenging approaches should be essentially considered as complementary ways of dealing strategically with knowledge within the firm. As an example of the need for integrating the different approaches, one may consider the decision of a big firm to acquire a small start-up company for reinforcing its core competence.

Why small firms exist

The interpretation of the decision as essentially motivated by the reinforcement of the strategic cognitive base of the firm has certainly to do with the representation of top managers of the big firm, and belongs to the strategic competence approach. However, on a practical ground, the target of the decision to acquire could be the fact that the start-up company owns a specific patent in the core domain of the big company. It that case, the resource-based approach is activated.

But, it may happen that once the acquisition is made, the absorption of knowledge from the small start-up is more than difficult and that the patent may not be operating because the active communities that constituted the nucleus of the start-up have decided to left and not to join the big company. In that case, the need to think in terms of communities and routines to understand the formation of competences in a dynamic context is critical.

The different approaches are thus essentially complementary. An empirical investigation of the dual firm : the case of Nortel. To support our theoretical analysis, we use as an illustration the case of Nortel Networks in the s. During this decade, Nortel, a strong contender in the s in the digital switch market, became a dominant firm in the new Internet and optical network market. However, since the beginning of the new century what seemed to be a success story has been mitigated by Nortel's severe losses on the financial markets.

Our interpretation is that while in the 80s the evolution of Nortel obeyed a classical transactional approach of an information processing firm that managed its dominant market share in digital switches, from the beginning of the 90s it turned into a firm processing knowledge and accumulating competences in the new optical network market related to the expansion of the Internet. When Jean Monty became President in , he adopted a long-term vision of Nortel focused on building selected core competences, which included a major new focus on opto-elec- tronics.

This core domain determined which companies should be acquired to reinforce the company's core knowledge, and explained the nature of the strategic alliances and technological networks in which Nortel was involved. This is naturally in line with the strategic competence approach of the firm.

The following main aspects stand out about Nortel's strategy after :. Since this technology was becoming mature, it was inevitable that Nortel's competitive gap with followers would be sharply redu-. At the same time as he implemented a severe programme of cost reduction involving plant closures and layoffs, he drew on the company's experience mainly by capitalizing on Nortel's Fiberworld experience to build a new core competence in opto-electronics.

Meanwhile, to afford this new strategy, Nortel started selling peripheral units, such as STC Submarine Systems, in The whole value-added chain began to be reshuffled from a knowledge-based perspective. It is remarkable to see how this strategy began with Nortel's involvement in loose networks with other companies that had expertise in that field. Then in Monty's successor, John Roth, extended the core competence in the Internet protocol network end-to-end broadband solutions. These acquisitions were conceived as a means of absorbing outside technologies and research capabilities to enhance Nortel's lead in opto-electronics.

Theory of the firm

It should be emphasized that the process of acquisitions and alliances implemented by Nortel obeys specific conditions, in order for Nortel to maintain and reinforce its internal core knowledge: when a new company is acquired, Nortel assigns carefully trained employees to the newly acquired unit to facilitate integration. Integration teams were created, which got groups of Bay and Nortel employees focused on solving the adjustment problems. And these practices were closer to the mark than what we had been doing.

Research centres were reorganized along. Each business line has considerable autonomy, to absorb as quickly as possible the knowledge possessed by a new unit entering the group. It is clear that such a strategy developed by Nortel was based on the willingness to integrate into the Nortel's culture the active communities of knowledge of the acquired companies.

In its move toward a new vision, Nortel is experiencing a major shift in the way it organizes production. Initially, Nortel was an equipment manufacturer, producing high-quality, reliable components and systems. Nortel is selling plants and operations to selected suppliers linked to Nortel under long-term contracts.

Here again, the need to absorb, circulate, and diffuse as quickly as possible the new knowledge acquired and produced has been the main trigger of change. The heavy losses of Nortel on financial markets since the beginning of the s illustrate another facet of the vision of the firm as a processor of knowledge.

He forgot one cannot buy knowledge as one buys a well identified product on the market.

Knowledge, scale and transactions in the theory of the firm

Most of the acquisitions failed to contribute to the building of a new core competence. These events underline that building competences is a risky business that takes time, and that acquisitions of firms on financial markets do not lead automatically to acquisition of new knowledge held by the acquired companies. The evolution of Nortel's strategy after to manage core competences is illustrated in the following figure. Concluding remarks We have argued thus far that a competence perspective on the firm - as opposed to a contract or transaction-based perspective - opens up considerably the scope for exploring how firms learn and adapt in complex and changing business environments.

The acquisition and renewal of knowledge - tacit and formal - is crucial for survival, it cannot be taken as pre-given, and it occurs at a variety of levels through a variety of means. For these reasons, the. Source : Amesse and Cohendet : It is primarily a generator of resources, defined as distinctive knowledge and organisational routines, locked in core and non-core competences. We have also argued that the cognitive set up of firms - more specifically their organisational rationality - is crucial for framing expectations and outcomes.

In contrast, a procedural rationality favours learning through continual adjustment as agents modify their behaviours to external circumstances, but is ill-equipped for strategic action in the context of radical change. In practice, individual firms tend to draw on these rationalities selectively depending on the nature of the task in hand, but often routines settle around one dominant cognitive set-up, which is precisely why firms vary in their learning potential. The dual nature of the firm also clearly suggests introducing a managerial dimension in the competence-based theory. More precisely, beside the external selection mechanisms that operate on routines, there is a need to clearly introduce internal selection mechanisms of routines relying on managerial decisions.

When considering the coherence between coordination and incentive. It makes explicit who, in a given context, sets the incentive schemes and for which reasons ; and to what extent the firm is centralised or decentralised. While in the evolutionary approach, the role of hierarchy is generally hidden by the emphasis put on routines and the influence of shareholders is not even mentioned.

This emphasis constitutes a priori a strong obstacle to the integration of incentive mechanisms in the framework of the evolutionary approach. We strongly argue at this point that, on the contrary, there is room in the evolutionary approach for a hierarchy and a managerial component Share Give access Share full text access. Share full text access. Please review our Terms and Conditions of Use and check box below to share full-text version of article. Abstract Firms boundary choices have undergone careful examination in recent years, particularly in information services.

Citing Literature. Volume 19 , Issue 9 September Pages Related Information. Close Figure Viewer. Browse All Figures Return to Figure. Previous Figure Next Figure. Email or Customer ID. Forgot password? Property structures, power and control 2. Aims of the firm 2. Incentives and motivations 2. Ability-based rationality Key concepts 90 97 3. Organisational coordination 3. Capabilities 3. Transactions 3. Scale and scope 6 vii viii Contents 3. Links between the three aspects of organisational coordination Key concepts 4.

Wrestling with uncertainty 4. Key Market contracts Organisations regulating markets Hybrid forms concepts 5. Uncertainty-decreasing strategies within firms 5. Key Reserves and relational agreements The employment relationship Routines Division of labour Sequential aiming and memory of the future Learning concepts 6. Conclusion: growth of the firm as the interplay between the three aspects of organisational coordination 6.

Key The growth of the firm Diversification and flexible production Cross-linked effects in the growth of the firm Strengths and weaknesses concepts Glossary References Author index Subject index Figures I. I continued in the subsequent months at Clare Hall, Cambridge University, where I was a visiting fellow. I am grateful to both these institutions for providing an ideal research setting during my sabbatical leave in and to Oliver Williamson and Elizabeth Garnsey for interesting discussions on the early project of the book.

I have greatly benefited from the reactions of students who used my materials in class. Colleagues who read the work in progress or participated in seminars and conferences where I presented some parts of the book have furnished useful criticisms and suggestions. This has led me to radically revise the original structure of the book, to reformulate many of my ideas and to introduce numerous substantial improvements. I would also like to thank Chris Harrison, Lynn Dunlop and Barbara Docherty for editorial assistance xi xii Acknowledgements and the anonymous reviewers of Cambridge University Press for thoughtful comments.

Finally, my thanks to Rachel Costa for her skilful language revision that has made the text both fluent and accurate. Introduction and summary I. I do not propose here to provide a survey of this fast-growing literature. The present study pursues the avenue of research started with my Production Process and Technical Change Morroni, , moving from analysis of the temporal, organisational and qualitative dimension of production toward a 1 2 On the ubiquity of organisations, see Simon , p.

This makes it possible to overcome the traditional disjunction between the capabilities, transaction costs and scale—scope analyses which so far have generally been treated within separate theoretical approaches.

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Although scrutiny of the interaction between the foregoing three aspects highlights the fact that some explanations provided by the different lines of research will appear complementary rather than rival accounts, I do not set myself the task here of either outlining a synthesis of some features of the existing approaches on capabilities, transactions and scale of processes, or suggesting a joint application of these approaches. I do not dispute that further empirical work is needed, but I judge it to be essential first to make constructive efforts toward a more integrated theory of the firm on which to build additional evidence.

Consequently, an application of the conceptual framework presented here is left as a possible future direction for empirical research, though in the following pages illustrative examples will be drawn from historical investigations, case studies, evidence from experimental results or surveys of applied literature. Business history and applied research on cognitive mechanisms, learning processes and innovative activity provide a vast number of case reports, giving empirical results that are consistent with the arguments developed in the present book.

Obviously, no single model or theory will capture all elements of the puzzle. Trying to organise these fragments of a theory into a coherent economic framework is difficult. Introduction and summary 3 and growth occurs whenever learning processes, complementarities and uncertainty matter. In particular, this interaction is intense if technical and transactional knowledge are costly, some inputs and processes are indivisible and complementary and some relevant knowledge is tacit, non-transmittable and characterised by set-up processes with high fixed costs.

I would like to emphasise that these conditions, which are increasingly important with the spread of the knowledgebased economy, cause interplay among the three aspects of the organisational coordination of the firm even in the presence of perfect rational agents who make decisions under costly information and weak uncertainty.

On the other hand, the impact of the foregoing basic conditions on both the relevance of the three aspects of organisational coordination, and also on the interaction among them, is strongly amplified in all circumstances where the assumption of perfect rationality has to be abandoned because of the presence of radical uncertainty, which prevents individuals from estimating the probability distribution of future contingencies and pay-offs.

Chapters 4, 5 and 6 will show that business organisations provide efficacious instruments to cope with this kind of uncertainty. This book traces its roots backs to several pioneering works. In particular, it rests on the seminal contributions by Frank Knight and John Maynard Keynes on uncertainty; Ronald Coase on transaction costs and flexibility of the employment relationship within firms; Joseph Schumpeter, Nathan Rosenberg, Richard Nelson and Sidney Winter on the innovation activity and evolution of business organisations; Edith Penrose and Robin Marris on managerial resources and the growth of the firm; Nicholas Georgescu-Roegen and Alfred Chandler on the time profile of production and on the relationship between organisation and efficiency; and, finally, Friedrich von Hayek, Herbert Simon, George Shackle, Kenneth Arrow, Richard Cyert, James March, Brian Loasby, Daniel Kahneman and Amos Tversky on knowledge and decision-making.

Whenever the analysis appears too concise in relation to the complexity of the subject, I shall suggest surveys and collections of writings that provide the reader with further and more detailed discussion and exhaustive bibliographical references. Sadly, for numerous key concepts utilised in the present conceptual framework there is not yet a common vocabulary. This may cause ambiguities and misunderstandings.

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  5. In the following pages, an effort is made to relate different taxonomies and clarify the definitions used in this study. At the end of the book, a Glossary gathers together the main definitions adopted. Alfred Chandler showed in his historical investigation on industrial enterprises that firms have evolved by implementing new management ideas and by inventing new organisational and incentive systems, as well as by introducing new strategies and new business initiatives in the attempt to pursue economies of scale and scope.

    In market economies, distinct organisational structures can live side by side. Suffice it to reflect on the dimensional and organisational structure of American high-tech sectors, such as microelectronics, computers, medical technologies and biotechnologies. The presence of different technical and organisational structures and the coexistence 5 Simon , ; March and Simon ; Shackle , , , ; Arrow , , a ; Cyert and March ; Cyert ; Loasby ; Tversky and Kahneman ; Kahneman and Tversky Chandler , The multiplicity of possible organisational configurations is stressed and analysed in depth by Grandori Introduction and summary 5 of firms of noticeably different size and function are common features of many industries even in mature sectors of activity.

    The huge distinctions in the size of firms yield remarkable disparities in market power among them. Production processes may be organised in series, in parallel and in line according to the sector of activity, the technology and the different types of equipment used. These various arrangements result in a dissimilar distribution of idle times among inputs and different forms of division of knowledge and labour.

    The s saw the emergence of contrasting tendencies with regard to integration and concentration processes. The growth of giant firms has been based on horizontal expansion and diversification, and increasing concentration has been balanced by a tendency toward outsourcing and by new entries.

    A centralised enterprise is composed of a functionally 6 7 8 Rosenberg , p. For a historical account of such diversity, see also Rosenberg and Birdzell , pp. A production unit, or a business unit, consists of one or more plants situated in one or more departments, within a single establishment or in neighbouring establishments. The production unit is responsible for organising the production of a single commodity or a range of commodities and the corresponding production methods.

    The multidivisional firm is characterised by corporate headquarters whose function is to oversee a number of divisions functioning as independent profit centres organised along product, brand or geographic lines. In the literature on the theory of the firm, many contributions tend to focus on one particular kind of firm — such as a particular ownership form, governance structure, size, production model or organisational form. Alternatively, and more restrictively, they may address only one distinctive aspect or single function of its activity.

    Antecedents and the general framework of firm economics

    This has brought about a proliferation of special-purpose models with analytical results built on ad hoc hypotheses. Rather, this book is offered as a theoretical framework designed to study the multifarious and changing nature of the firm as a result of the complex links between basic conditions, organisational structure, efficiency and efficacy of business organisations. On this, see Chandler , , The continuous evolution of the M-form over time in the paradigmatic case of General Motors has been analysed by Freeland , , who shows that control has been achieved through significant variations on the original organisational and administrative structure.

    A similar position is expressed in Milgrom and Roberts , p. Partial models have recently attracted various criticisms from other lines of research as well; see, for instance, Simon , p. Both efficiency and efficacy depend on the organisational setting which, in turn, is influenced by basic conditions and internal decision-making. Naturally, the causal chain also runs in the opposite direction: the competitiveness of a firm contributes to creating the basic conditions that shape internal decision-making processes see figure I. The causal chain Basic conditions result from the interplay between the environmental conditions that business organisations face and the internal conditions created by business organisations themselves as a result of external constraints and opportunities.

    The left-hand rectangular block in figure I. Among important elements that influence decision-making mechanisms within the firm, property structures, control rights, the aims of the firm, incentive structures and the level of rationality occupy a salient position central square block of figure I. In order to produce and sell goods or services, a firm must: 11 The tables and figures included in this book summarise the main arguments elaborated in the text. They are intended to provide a visual support that may constitute useful material for presentations and lectures.

    Figure I. Basic conditions, decision-making, coordination and competitiveness. First, developing capabilities means finding, interpreting and using knowledge on both how to plan, organise and perform production processes, and how to arrange transactions with suppliers and customers in order to create and maintain a competitive advantage.

    Differential capabilities can help to explain the performance of firms, and therefore their boundaries. Secondly, firms establish the level of internalisation of separable processes and organise transactions with suppliers. The internalisation of external processes eliminates the transaction costs stemming from the costliness of economic exchange. Transaction costs are usually relevant in the presence of measurement and informational problems.

    Transaction costs affect the level of vertical integration and the extension of organisational coordination among firms. Cooperative agreements with suppliers aim to reduce transaction costs, favour specialisation and enhance learning processes. Overall, organisational coordination within or among firms encourages the transmission of information and knowledge, the strengthening of enforcement power as well as flexibility in facing unexpected contingencies.

    Thirdly, in designing the operational scale of each process the firm has to balance the productive capacities of different indivisible and complementary inputs and intermediate stages. Usually, this balancing is obtained by increasing the scale dimension of individual firms or 12 The financial dimension might be fruitfully added as a fourth aspect of the organisational coordination of the firm.

    However, the analysis of the financial dimension goes beyond the aims of this book. The integration of this aspect into the present framework could be a subject of future research. Moreover, processes based on information and knowledge have a cost that is completely independent of the scale of the process in which such information and knowledge is used.

    This involves super-fixed costs and therefore favours remarkable economies of scale and economies of scope. Finally, in facing unpredictable contingencies, an expansion of the boundaries of organisational coordination allows economies of diversification of activities and of holding reserves that are linked to statistical factors.

    These advantages help to explain the existence and the growth of the firm. Each of the three aspects of organisational coordination is endowed with a different degree of importance in the growth of all social organisations. In figure I. Nonetheless, it must be stressed that it is quite rare, even though conceivable in some circumstances, for the growth of the firm to be based on advantages deriving exclusively from one aspect.

    A firm can expand by hiring new resources and by allocating managerial and administrative tasks to specialist employees. However, while possibly limiting the rate of growth at any moment, this need does not represent a limit on the expansion of its size beyond a certain point Penrose, , p. Even so, there are numerous weaknesses that may result in organisational costs, to the point of hampering the growth of the firm and even precipitating its failure. The weaknesses and internal inefficiencies of firms derive from an Introduction and summary 11 inability to seize potential opportunities.

    If a firm is incapable of anticipating and adapting to environmental changes or countering the negative consequences of morally hazardous behaviour, or does not succeed in developing knowledge or cannot advantageously arrange transactions and exploit economies of scale, then this may compromise its efficiency and efficacy, hamper its growth and even cause its failure. Many counteracting forces stem from asymmetric information and heterogeneous knowledge, such as the action of moral hazard, or influence activities, or in some cases parochial interests and burdens of bureaucracy. But the underlying cause of these weaknesses is to be sought in the lack of managerial ability to create the necessary knowledge, incentive structure and conditions.

    Several routes to overcome these flaws can be undertaken: i vertical communication within the organisation can be enhanced; ii organisational loyalties can be enlisted and incentives devised that attenuate the hazards of internal opportunistic behaviour, as well as mitigating internal influence activities and conflicts of interest; iii the organisational set-up and power structure can be modified in order to strengthen the competitive advantage. In the presence of limited transmittability or tradability of some bits of information and units of knowledge, the evolutionary path takes shape by means of adjustments that occur day by day and which are cumulative, partially irreversible and specific to one business organisation.

    Interaction of the three aspects of organisational coordination With weak uncertainty, costly knowledge and perfectly rational agents, the interaction among competence, transaction and scale considerations may be significant. However, this interaction is significantly reinforced 12 Knowledge, Scale and Transactions in the Theory of the Firm in the presence of cognitive limitations that prevent individuals from computing all possible pay-offs of their actions, thus obliging them to operate under radical uncertainty.

    Radical uncertainty is attributable to the incompleteness of the information set substantive radical uncertainty or to cognitive limitations in processing information procedural radical uncertainty. If individuals have to face unforeseeable contingencies at the time when the contract is drawn up, enforcement difficulties and high transaction costs arise. The second type of radical uncertainty — procedural uncertainty — depends on personal capacities to process information in relation to the complexity of the situation that individuals find themselves facing.

    Farsightedness, uncertainty and multiple decision strategies Arguably, in many circumstances when the problem at hand is well specified and when individuals possess the relevant information and knowledge as well as sufficient information-processing ability, the hypothesis that they are able to foresee all possible pay-offs is plausible and useful for an analysis of the interaction among the various 13 14 15 These two types of uncertainties have been analysed in depth in an insightful paper by Dosi and Egidi , pp.

    The analytical consequences of the transmutable and unknowable nature of the future have been discussed by Davidson , pp. Introduction and summary 13 aspects of organisational coordination and functioning. As a consequence, they are unable to predict all possible pay-offs and operate in conditions of radical uncertainty.

    Within a comprehensive theory of the firm both the perspective which assumes farsightedness and that encompassing radical uncertainty must be considered, according to the particular problem under consideration. These two perspectives can coexist because they address diverse decision strategies. Wrestling with uncertainty If not all information and knowledge is fully transmittable and tradable and radical uncertainty is present, then market failures may occur or markets may be missing as a consequence of informational problems.

    Possible responses to these problems may be found by reducing informational asymmetries and knowledge heterogeneities and restraining conflicts of interest and opportunistic behaviour through: i special contracts 16 17 On how perfectly rational and self-interested organisation members might produce sub-optimal results due to inefficient, informal and institutionalised organisational behaviour, see Gibbons , pp.

    Market failure means that markets fail to achieve efficient allocation. Markets for certain commodities are missing when these markets do not exist and therefore trade does not take place even if some agents would be willing to buy or to sell these commodities. On these definitions, see Newbery , pp. Whenever information and enforcement are not costless, organisations have a crucial role. These organisations, in turn, require expressly designed institutions that regulate contracts. Organisational coordination may operate within firms, through management direction, and among firms, through the creation of interfirm networks.

    The substitution of market coordination by organisational coordination limits uncertainty, curtails opportunistic behaviour, assures protection for specific investment, provides incentives and increases flexibility. In so doing, organisations transform the cost of radical uncertainty into a source of superior efficiency and efficacy. Organisational coordination within and among firms is a tool to cope with uncertainty because it rests on long-term relational agreements and usually implies the existence of some reserves constituted by the asset of the firms.

    As far as individual firms are concerned, their assets — such as equipment, warehouses, capabilities and competencies — represent reserves in case of unanticipated events. Moreover, firms establish relational agreements over time that involve adaptive decision-making in facing unanticipated changes. With dispersed knowledge and interdependence, as is unavoidable under division of labour, trust 18 See Penrose , pp. Introduction and summary 15 becomes essential because work cannot proceed without recourse to knowledge possessed by others Loasby, , p. Simplification and learning mitigate uncertainty because they diminish the gap between the abilities required and the abilities possessed.

    In fact, simplification — which is achieved mainly by routinised operating procedures, technical division of labour and adaptive behaviour — decreases the abilities required, while learning processes increase the abilities possessed. Simplification and learning are closely related because simplification facilitates learning by making limited cognitive resources available.

    In complex and uncertain situations, cognitive and behavioural routinisation save on the abilities required and enhance coordination and predictability. Division of labour requires intentional coordination, which is characterised by increasing returns because division of labour and knowledge allows managerial economies of scale — and, even more significantly, saves on the selection and transmission of information.

    Such a saving appears to be of overwhelming importance today, in the wake of the emergence of the new knowledge-based economy. On this, see also the discussion in Davidson a, p. Early important contributions on the role of power and coordination in the employment relationship come from Coase , p. It also involves the ability to plan and form mental images of possible future events.

    Last but not least, firms facilitate internal learning by virtue of their ability to select useful information and develop communication codes, trust and knowledge based on experience. The coordination of individual learning and production activities within teams makes it possible to cope with the complexity of routines required in many processes and to mitigate the problem of the incompleteness of individual abilities deriving from dispersed personal knowledge and limited information-processing ability.

    The entrepreneur—manager may be an individual or collective agent. These include discovering or creating opportunities, devising markets, formulating conjectures about the future, developing interaction between the environment and the internal organisation, ensuring coordination, creating corporate culture, managing informal relational agreements with suppliers and employees, evaluating techniques and products, mediating between multiple conflicting interests, identifying the necessary capabilities to maintain the competitive advantage and balancing the productive capacities of different processes.

    The complementary relationship between markets and organisations This description of the different ways of coping with uncertainty shows that the traditional dichotomy between business organisations and markets may be misleading. This dichotomy has frequently been seen as a reflection of the long-lasting traditional contraposition between centralisation, through planning and intentional organisation, 20 On the collective nature of the entrepreneur, see Schumpeter , pp. However, as rightly argued by Demsetz , p.

    Prices do not coordinate; they supply information. Both need the agency of organisations that ensure enforcement. Firms defend themselves against external opportunistic behaviour by direct monitoring activity and by means of other organisations which offer information and control services, such as business organisations operating within markets, or organisations that operate outside of the market and can ensure enforcement of contracts courts or state organisations. Both the market and organisations are knowledge generators: they channel learning processes but also provide a setting for the development and selection of new ideas.

    Innovative activity and creative learning are favoured by the presence within the market of a myriad 21 22 23 For an intriguing critical reconstruction of the debate begun in the early decades of the twentieth century on the dichotomy between planning and market equilibrium, see Egidi and Rizzello , pp.

    Loasby , pp. On market making, see Casson , pp. Coase , p. On this, Coase cites the example of the transition toward a market economy in Eastern European countries. The negative microeconomic and macroeconomic effects of recent cases of fiddling accounts in the United States and Europe, and the consequent revision of rules that regulate auditing and set book-keeping standards, are further evident examples of the paramount importance of institutional conditions for the growth of firms and the economic system as a whole.

    However, selection processes cannot operate in perfectly competitive markets because they require a certain degree of variety on which to work. In many sectors of activity, business organisations have increasingly superseded the market. This has made the executives of giant firms the most influential group of economic decision-makers. In this context, organisational coordination can carry out a mediation activity that involves management of the conflict of interests between parties, with the aim of achieving mutual benefits.

    Searching for mutual advantage is itself a process of learning, one that can provide opposing parties operating within firms and markets with new opportunities for growth. Introduction and summary 19 I. The emergence of a knowledge-based economy provides increasing scope for firms, and organisations of firms, that favour learning within markets. Since the s, the transformation of basic conditions has led to two interconnected phenomena: an increasing need for knowledge and rising uncertainty. On the one hand, learning processes lead to innovations that change the environment in which firms operate and augment the degree of radical uncertainty.

    On the other, growing radical uncertainty and mounting pressure for innovation in processes and products call for an increase in knowledge. The expansion of the knowledge-based economy has resulted in an increase in the abilities required in all economic processes. Technical innovations have called for the acquisition, on the part of the consumer, of learning capacities in order to execute a sometimes complex sequence of operations.

    Increasing knowledge is also required for exchange activities due to the growing difficulty of evaluating the technical and service characteristics of similar commodities. Learning processes are linked to the possibility of discovering unexploited opportunities Kirzner, , p. Firms not only seek to identify existing opportunities as yet unperceived by others, but they also attempt to broaden the set of available alternatives and to create new opportunities.

    Learning is seen in this study as a process 20 Knowledge, Scale and Transactions in the Theory of the Firm of expansion of the set of possible of choices. Rather, unexploited opportunities are potentially open to all individuals operating in market processes under radical uncertainty, including consumers, traders, employees and, more generally, members of organisations. When all possible alternatives are known, the decision-making process consists in considering the cost of alternative courses of action under specific constraints.

    With a given and perfectly known set of alternatives, constraints appear to be the major analytical element in decision-making. On the other hand, in a learning framework characterised by the creation of real options, constraints still play an important role, but the ability to look for and create opportunities then becomes a crucial factor. This is due to the existence of inescapable trade-offs and the centrality of the opportunity cost concept in economics. This increase in knowledge not only causes the productive opportunity of a firm to change.

    On sources of new entrepreneurial opportunities, see Shane chapter 2. New knowledge and technical change shift the frontier of technical possibilities. The potential gains derived from diffusion of the knowledge-based economy are enormous, as the use of a bit of information or a unit of knowledge does not in general preclude its utilisation by others.

    For example, in contrast to hard assets, the number of people who can use a given piece of software is potentially infinite and knowledge is characterised by strongly increasing returns due to the insignificant marginal cost. As has been noticed, this is very different from the economics of the oil barrel and opens up a much more optimistic perspective on economic growth Romer, , pp.

    Arrow, a, pp. Transferability of knowledge across time and space requires learning processes and absorptive abilities that take place in communities, markets and organisations, and which may be developed only if some specific favourable conditions are present. Within business organisations, learning processes imply effective communication and active participation.

    Participation by the members of the firm means that they are considered as effective agents in the process of knowledge growth and not as mere inputs that passively adjust to external parameters.

    Mario Morroni: Knowledge, scale and transactions in the theory of the firm

    The focus on learning and opportunities enriches the theory of the firm and also provides a crucial insight into other important related issues such as industrial relations, labour economics, market structures, technical change, and development. The focus on learning implies consideration of the temporal dimension since this dimension becomes essential whenever knowledge changes Loasby, , p.

    In other words, taking into account learning processes entails a shift 22 Knowledge, Scale and Transactions in the Theory of the Firm from an analysis of the properties of states of equilibrium toward a study of the processes by which firms acquire or lose their competitive strength. The intrinsic nature of firms is closely linked to the temporal dimension of production and market processes. In this book, we shall be concerned with processes rather than states of equilibrium.

    Entrepreneurship is about processes. Chapter 1 discusses basic conditions. Chapter 2 addresses decision-making mechanisms within the firm. Chapter 3 analyses the organisational coordination of the firm. In this chapter, the interaction between capability, transaction and scale—scope aspects is moved centre-stage. Chapter 4 seeks to elucidate in which contexts and by what means uncertainty and its costs can be mitigated.

    Special market contracts, organisations regulating markets, organisations of firms and firms are seen in this chapter as responses to uncertainty in a world characterised by privately held information and heterogeneous knowledge. In general, organisational coordination through relational agreements, both within firms and among firms, is more likely to be preferred, the more uncertain are the conditions in which firms operate.

    This is mainly because organisational coordination fosters flexibility, the management of conflicting interests, routinised operating procedures and division of labour, as well as sequential aiming and learning. Chapter 5 examines in detail how control rights deriving from the employment contract allow firms to shape the organisational setting in such a manner as to cope with uncertainty.

    Chapter 6 focuses on the growth of the firm as the interplay between capabilities, transaction and scale—scope under uncertainty and some particular characteristics of the production elements, information and knowledge e. Here, particular attention is dedicated to diversification and flexibility. Section 6. Each chapter ends with a list of key concepts so that the reader may recap the main topics covered in the chapter.

    All key concepts are included in the Glossary p. Introduction and summary Key concepts conglomerate firm corporation entrepreneurship firm H-form holding form holdings market M-form multidivisional form opportunities opportunity cost organisation U-form unitary form 23 1 T Basic conditions h i s chapter is about the external and internal basic conditions that affect the decision-making mechanisms, organisational coordination and competitiveness of the firm. The basic conditions are listed in the left-hand rectangular box in figure 1. Basic conditions are mainly composed of the following interrelated features: i attributes of information and knowledge, ii techniques and equipment available, iii individual motivations and aims, iv individual abilities, v degree of uncertainty, vi structural change and vii institutional and market conditions.

    The basic conditions are two-fold: they have an external face given by the characteristics of the environment and an internal face which emerges from the organisational setting of the firm. For instance, a given enterprise may acquire external knowledge characterised by specific features e.

    The former is an external environmental condition while the latter is an internal condition. Analogously, firms mainly rest on the labour supply characteristics of the local market. The abilities of the members of firms largely derive from the abilities of labour forces available on the market. However, firms have the option of training their employees. This changes the abilities possessed by their employees and moulds the characteristics of the labour force actually utilised by the firm.

    Hence, internal training and the development of experiences by the employees tends to influence the level and kind of abilities available on the market. The same may be said for the equipment in use, the characteristics of technological change and the market conditions. Secondly, 24 Basic conditions 25 Figure 1.

    Basic conditions. The ways in which information and knowledge are created, transmitted and exchanged outside and inside the firms greatly affect their decision-making mechanisms and their organisational structure. These processes of creation, transmission and exchange are, in turn, shaped by the characteristics of information and knowledge that clearly set them apart from other commodities.

    Data, information and knowledge First and foremost it is useful for the purpose of our analysis to distinguish between data, information and knowledge. Information is an organised set of data. A flow of information from one individual to another consists in the one-way transmission of organised data.

    By definition, a bit of information is an indivisible set of data. Information is not self-interpreting; rather, its interpretation is mediated by individual knowledge. Knowledge is acquired by elaborating bits of information, and derives from the ability to search, select, memorise, store, retrieve, structure, compute, embody and use bits of relevant information within a cognitive system.