firm theory of

Coase's theory of the firm (Coase, 1937) --
Coase examined the question of why business organizations exist in a specialized exchange economy in which the distribution of resources is ""organized"" by the price mechanism

• He theorized that the reasons business organizations form, as opposed to a network of freelance contractors, is to minimize transaction costs.
• A firm consists of a system of relationships where the direction of resources is dependent upon an entrepreneur.
• Outside the firm production is coordinated through a series of exchange transactions in the market. Inside the firm, these complicated market transactions are eliminated, and instead the entrepreneur-coordinator directs production.
• The firm eliminates at least two costs it would have using the price mechanism to ""organize"" production: (1) discovering what relevant prices are, and (2) the costs of negotiating and concluding a separate contract for each exchange transaction
• At the margin, the costs of organizing within the firm will be equal either to the costs of organizing in another firm or to the costs involved in leaving the transaction to be ""organized"" by the price mechanism.

Penrose's definition of the firm --
Economic function and definition of the firm (Penrose, 1995, xi) --
The economic function of the firm was assumed simply to be that of acquiring and organizing human and other resources in order to profitably supply goods and services to the market. A collection of resources bound together in an administrative framework, the boundaries of which are determined by the 'area of administrative coordination' and 'authoritative' communication.

Environment of the firm (Penrose, 1995, xiii) --
The relevant environment is the set of opportunities for investment and growth that the entrepreneurs and managers perceive is different for every firm and depends on its specific collection of human and other resources. Moreover, the environment is not something 'out there', fixed and immutable, but can itself be manipulated by the firm to serve its own purposes.

Growth of the firm (Penrose, 1995, xii-xiii) --
Managerial resources with experience within the firm are necessary for the efficient absorption of managers from outside the firm. The availability of 'inherited managers' with such experience limits the amount of expansion that can be planned or undertaken in any period of time. Once expansion is completed, managerial resources are freed up for further expansion. The factor of managerial resources may limit the growth rate, but do not limit the theoretical overall size of the firm.

There is no reason why a firm should see its prospects of growth, its productive opportunities, in terms of its existing products only, while there are many reasons why it should see them in terms of its productive resources and its knowledge and should search for opportunities for using its resources and knowledge more efficiently. This process will drive the diversification of the firm as it searches for growth.

Evolution of the firm (Penrose, 1995, xiii-xiv) --
One of the primary assumptions of the theory of growth of firms is that 'history matters'; growth is essentially an evolutionary process and based on the cumulative growth of collective knowledge, in the context of a purposive firm. The administrative structure of the firm provides an equilibrium structure of theory and policy within which individual knowledge can evolve without threatening organizational coherence; but that equilibrium itself is the consequence of an evolutionary process during which managers learn to operate effectively together within a particular environment. It is the evolutionary process which generates the growth of managerial services, or reduces governance costs, shaping the content and scope of those services.

Evolution and the theory for a firm (Penrose, 1995, xiii-xiv) --
Knowledge grows within a framework consisting of a managerial administrative 'theory and policy' acting as a sort of research programme, itself representing a kind of temporary evolutionary equilibrium of the firm having little to do with the equilibrium of the economy as whole.

Rumelt's strategic theory of the firm (Rumelt, 1981)
""By viewing strategy as entrepreneurship that both depends upon and creates interfirm heterogeneity, I have generated a number of propositions concerning the behavior of populations of firms. I have also drawn implications for normative theory."" (Rummelt, 1981, 570)

Rumelt has a Schumpeterian view of business economics. He empirically identifies those aspects of general management that have material effects on the survival and success of business enterprises based on field studies of business firms and the historical analysis of the evolution of business enterprises. With his theory of uncertain imitability and causal ambiguity, he finds entrepreneurship generates firm heterogeneity as an outcome rather than as a given. There are several implications of this. One is related to the size of the firm, as entrepreneurs seek to enter and create new markets, rather than diversifying to reduce the risk of bankruptcy. (Korn - firms that play to win win-out over firms that play to not lose). Rumelt identifies sources of potential rents and the mechanisms that isolate those sources from potential competitors. Lastly, he identifies the normative implications of his theory.

General management business policy concerns --
The concept of a firm's competitive position is defined by a bundle of unique resources and relationships and the task of general management is to adjust and renew these resources and relationships as time, competition, and change erode their value. This way of looking at the firm is not a theory; it is a set of constructs that have proved useful in describing and summarizing the empirical studies of firm behavior that form the core of business policy literature. These broad empirical observations are:

1. The general managers of firms make choices, and some of these choices are considerably more important (having more impact on performance) than others.
2. Strategic choices are not necessarily explicit but may be characterized by infrequency, uncertainty, the irreversibility of commitments, and multi- functional scope, and they are usually nonrecurring.
3. The most critical strategic choices exhibited by a firm are those concerned with the selection of the product-market areas or segments in which the firm will compete and the basic approach to those businesses.
4. Similar firms facing similar strategic problems may respond differently
5. Firms in the same industry compete with substantially different bundles of resources using disparate approaches. These firms differ because of differing histories of strategic choice and performance and because managements appear to seek asymmetric competitive positions.

Uncertain imitability and causal ambiguity --
With his theory of uncertain imitability and causal ambiguity, he finds entrepreneurship generates firm heterogeneity as an outcome rather than as a given. There are several implications of this. One is related to the size of the firm, as entrepreneurs seek to enter and create new markets, rather than diversifying to reduce the risk of bankruptcy.

Selection, adaptation, and isolating mechanisms --
Rumelt identifies sources of potential rents and the mechanisms that isolate those sources from potential competitors. Given uncertain imitability, in equilibrium the average firm earns positive economic profit and is more efficient at what it is doing than a new entrant should expect to be. Were this not true, entry would proceed until it was true. If the equilibrium is permeated by heterogeneous firms with evolved local advantages, there are a number of immediate implications. Among the most straightforward are these:

1. New entry activity will essentially be a function of market growth rather than industry profitability. High levels of profitability in stable markets may well signal incumbents possessing difficult-to-imitate skills and deter entry.
2. Firms that are successful in one endeavor will tend to seek out related activities in which their revealed special competences are useful."" Hence profitability and growth will be correlated even when the effects of demand pull are controlled.
3. If the basis for success in a market shifts to a new function, firms that have been successful in the past may now be at a disadvantage relative to outside firms possessing demonstrated skills related to the new required competence.

In industrial organization theory a barrier to entry exists when a prospective entrant is at a disadvantage relative to an incumbent."" In an important paper, Caves and Porter extend the entry barrier concept by defining mobility barriers as asymmetries among firms within industries that act to limit differential expansion and the equalization of profit rates."" Their emphasis on heterogeneity deserves special attention:

Limits on entry and limits on mobility remain stubbornly immiscible as long as we stick to conventional thinking about cost functions and intra-industry differences among firms. The conventional approach takes firms within an industry as identical in all economically important respects except for their size. Then cost conditions either define an optimal scale for the firm, leaving no explanation why size should change, or render scale indeterminate, providing no clue as to what could deter infinitesimal changes in a firm's scale. . . . The key to conjoining barriers to entry to a more general theory of interscale mobility of firms is the hypothesis that sellers within an industry are likely to differs systematically in traits other than size.""

In Caves and Porter's view, industries can be broken into groups of firms that exhibit distinct characteristics (e.g., broad-line vs. specialist). Mobility barriers both define these groups and are reinforced by the strategic activities of group members. The group concept is frequently all that is needed, but there is no theoretical reason to limit mobility barriers to groups of firms. I shall therefore use the term isolating mechanism to refer to phenomena that limit the ex post equilibration of rents among individual firms.

In the pure theory of uncertain imitability, the isolating mechanism is causal ambiguity. The inability of economic agents to fully understand the causes of efficiency differences limits competition by entry or imitation. However, many other isolating mechanisms exist. For example, mineral rights laws convert the results of risky exploration investments into ex ante uncertain but ex post persistent streams of rent. Similarly, patents, trademarks, reputation, and brand image serve to limit second-mover imitation of first-mover success. These and other important isolating mechanisms are listed below, the Elements of strategic position.

The importance of isolating mechanisms in business strategy is that they are the phenomena that make competitive positions stable and defensible. Many of them appear as first-mover advantages. For example, the first firm to commit idiosyncratic capital to serving a small market segment may gain a stable position serving that segment. From an equilibrium perspective, such events are inherently uncertain. That is, the existence of the market may have been problematic, the technology may have been uncertain, the information necessary to make the early move may have been unpredictably distributed, or by first-mover we may simply mean the first successful mover.

Although isolating mechanisms provide (ex post) stable streams of rent, the opportunities to create, ""jump behind,"" or otherwise exploit them must arise from unexpected changes. Without uncertainty there is no wedge between the ex ante price of an asset or market position and its ex post value. It is the juxtaposition of isolating mechanisms with uncertainty that permits the modeling of heterogeneity in an equilibrium framework.

The elements of strategic position emphasizes this point by also showing the important sources of potential rents. They are essentially unexpected changes in the environment. These elements present a simple theory of strategy: a firm's strategy may be explained in terms of the unexpected events that created (or will create) potential rents together with the isolating mechanisms that (will) act to preserve them. If either element of the explanation is missing, the analysis is inadequate.

Elements of strategic position --

• Sources of potential rents --
• Changes in technology
• Changes in relative prices
• Changes in consumer tastes
• Changes in law, tax, and regulation
• Discoveries and inventions
• Isolating mechanisms
• Causal ambiguity
• Specialized assets
• Switching and search costs
• Consumer and producer learning
• Team-embodied skills
• Unique resources
• Special information
• Patents and trademarks
• Reputation and image
• Legal restrictions on entry

Normative implications --
Are there normative implications of this view of strategy or does it place the fortunes of the firm in the hands of exogenous events and impersonal isolating mechanisms? My view is that there are very real normative implications and they can be based on much sounder theory than much of the currently popular prescription.

First, it should be clear that a firm's stability and profitability fundamentally depend upon entrepreneurial activity. There cannot be a simple algorithm for creating wealth. Still, it is true that some ways of approaching the problem of strategy will be more fruitful than others. In particular, these points deserve emphasis:

1. The opportunities for strategic change occur infrequently, and their timing is largely beyond the control of management. The chance toimprove one's competitive position does not arise out of pricing or advertising tactics, but the recognition of change in some underlying factor.
2. Unexpected events may change the distribution of sales and profits within an industry, acting as windfall gains and losses to incumbents. It is vital that management recognize and take full advantage of these events. The routine component of strategy formulation is the constant search for ways in which the firm's unique resources can be redeployed in changing circumstances.
3. More fundamental shocks act to change the very structure of the industry, altering the nature and magnitudes of the isolating mechanisms at work. Examples of such events are airline deregulation, the advent of small computers, and the impact of oil prices on the world automobile market. In such situations it is usually unclear what the eventual structure of the industry will be. Firms that are lucky or insightful enough to make early commitments to what turn out to be defensible positions can be stunningly successful. The implication is that a developmental theory of industry structure would be of significant value.
4. A critical strategic question in a growth industry is the shape of the final equilibrium. When industry growth is rapid, profits rates are normally quite high, but reinvestment rates that are even higher work to produce net negative cash flows. If firms misjudged the strength of isolating mechanisms in the final equilibrium, the slowing of growth will bring profit rates to below-normal rates; the industry will have functioned as a cash trap. Theory and empirical work on this issue would have obvious normative value.
5. If opportunities for significant shifts in strategic position are infrequent, and if isolating mechanisms create defensible positions, it follows that many firms can ignore strategy for long periods of time and still appeear profitable. As a corollary, high levels of profitability are not necessarily an indicator of good management. If a strategic position is strong enough, even fools can churn out good results (for a while).
6. Because strategic opportunities are by definition uncertain and connected to the possession of unique information or resources, strategy analysis must be situational. Just as there is no algorithm for creating wealth, strategic prescriptions that apply to broad classes of firms can only aid in avoiding mistakes, not in attaining advantage.
Because isolating mechanisms act to protect the first successful mover, speed is critical despite (and, in fact, because of) high levels of ambiguity. Good strategy is not necessarily enacted with a high level of initial confidence, although general management may appear confident in order to spur action. If firms wait until the proper method entering a market or producing a product is fully understood it will normally be too late to take advantage of the information.