Business Organization as a Coordination Problem: Toward a Dynamic Theory of the Boundaries of the Firm

Richand N. Langlois The Universityode Connecticut

Paul L. Robertson Universityof New South Wales,ADFA

Introduction

Many writershave noted that, since 1873, the main thrustof mainstream theoryhas shifted away from the concernsof Adam Smithand the classicals [12]. This "marginalist"or neoclassicaltheory was designed not to understand the springsof economicgrowth and the sourcesof wealthbut ratherto analyze the allocationof known and given resources. In his Theory of Political Economy,William StanleyJevons [11, p. 267] put the matterthis way. "The problemof economics,"he wrote, "may,as it seemsto me, be statedthus: -- Given, a certainpopulation, with variousneeds and powersof production,in possessionof certainlands and other sourcesof material:required, the mode of employingtheir labourwhich will maximize the utility of the produce." Even at the start,however, marginalist theory was far from homogeneousin its concerns[10], and both the Austrian and Marshallian streamsretained, albeit in slightlydifferent ways, many of the classicalpreoccupations. In any case,neoclassical economics grew to encompassa numberof distinctvariations, each arguably pointing at a differentset of concerns.The Walrasian system poses an answer to an abstractlogical problem whose generalrelevance one may question.But "MarshallJan"comparative statics -- itself only one aspectof Marshall's opus-- was designedto answersome quite importantquestions: how in the short run do exogenouschanges in boundaryconditions affect the directionof changein price and quantity (suppliedand demanded)in relativelyisolated markets [26]? Is this the set of questionsthat interestbusiness historians? Arguably, business historians are at least as interested in the sorts of issues that animated Smith: what are the sources of economic growth and industrial competitiveness?How do the organizationof productionand the institutions of societyaffect economicgrowth and competitiveness?To the extentthat businesshistorians have been interestedin suchquestions, then, mainstream

BUSINESS AND ECONOMIC HISTORY, VolumeTwenty-two, no. 1, Fall 1993. Copyright¸ 1993 by the BusinessHistory Conference. ISSN 0849-6825.

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theory has been of limited usefulness. Indeed, in the areas in which the concernsof businesshistorians and economictheorists have overlapped-- namely so-calledIndustrial Organization theory --neoclassical modelshave beenstrained well beyondtheir limits, leading to inappropriateapplications of theoryand, as in the areaof antitrustpolicy, often absurd and harmful policy conclusions. Attackson mainstreamtheory are in abundantsupply these days, and sucha blanketcriticism is not our goalhere. Rather,we wantto suggestthat the appropriatetheory for businesshistorians ought to be animatedby the questionswith whichbusiness historians concern themselves. These are surely historicalquestions. More abstractly,however, they arequestions, not onlyof allocationand welfare, but alsovery importantlyof growthand development: how is new value created? They are, moreover,institutional questions: how do socialinstitutions and forms of businessorganization lead to growth and competitiveness?And how arethese institutions shaped in turnby growthand competition? Confronting such questionsanalytically may not mean abandoningmainstream ideas so much as abandoningthose assumptions that were designedfor other purposesand are inappropriatefor the historian's questions.

The "why" of Organizations.

The formal neoclassicaltheory of the firm takes "the firm" as a fundamentalbuilding block in the constructionof a theory of the industry. This building block is a simplifiedand anthropomorphizedideal type -- a "monobrain,"as Fritz Machlup [30] put it. Especiallyin its true Marshallian formulation,such an approachhas proven extremely valuable for the questions of partial-equilibriumcomparative statics for which it was intended. But, not surprisingly,that theory has not proven very usefulin analyzingwhat goeson insidethe firm or, more importantly,how productionis actually organized within the economy.In Axel Leijonhufvud'sirreverent image [29, p. 203], the formal neoclassicalconception of the firm "is more like a recipe for bouillabaissewhere all the ingredientsare dumpedin a pot, (K, L), heatedup, f(o), and the output,X, is ready." It providesno insightinto organizational structureor the sequencingof tasks. More generally,economists tend to centertheir theoriesaround the premisethat firms existto provideprofits for their owners. This assumption holdsboth for the relationshipof the firm to its externalenvironment -- what the firm choosesto do itself and what it purchasesand sells to others-- and for the internal organizationof the firm -- how it goes about producing whatever goodsor servicesit has decidedbelong within its proper sphereof activity. From the perspectiveof businesshistory, this approachbegs some of the most importantquestions. It essentiallyrelegates to secondplace, or even assumesaway altogether,the activitiesthat the peopleworking for the firm are actually engagedin. These include decidingwhat to produceand how to produceit and then actuallyproducing it in the way that best rewardsthe firm's owners. Hence, successderives from the firm providing goodsand 33

servicesthat meet the needsof potentialcustomers in a way that generatesthe highestpossible returns to its owners. In short,firms, and thosewho would understandthem, must keep an eye on bothblades of the Marshallianscissors [27]. If this is true (and we think it is), then we should conceiveof firms as organizationsthat need to tackle a variety of goals. These goals are interdependentin the sensethat, while all of them are important,many may be in conflict if they are not coordinatedor "managed."This holdseven if we leave asidequestions of opportunismand shirking. If the firm is to survive, let aloneprosper, it mustmake surethat it producessomething that customers desire,which meansthat it must acquireand accuratelyuse information,or knowledge,about products and productionprocesses. In fact, a firm mustbe organizedto undertakeone, several, or all of the following activitiesassociated with the profitableproduction of a good or service: conception,design and development,manufacturing, provision of inputs, marketing and distribution,and many others. A design that is outstandingin the sensethat it meetsthe performanceattributes [15] that potentialpurchasers desire, however, may for that very reasoncost more to producethan those same purchasers are willing to pay; or it may be impossible to produceat all. Thus,one reason for organizingsuch diverse activities is to providecoordination between aspects of productionso that a plausibleoutcome resultsin the form of a goodor servicethat can be produced(a) with non-cost attributesattractive to potentialbuyers; (b) at a price that is also acceptableto those buyers;and (c) that allows for an acceptablereturn on the productive resources involved. Whetherthe proper vehicle for generatingsuch a plausibleoutcome is a verticallyintegrated firm, or severalfirms specializingin differentlinks in the productivetrain, or a groupof independentand unattachedworkers is a separatequestion. The answerdepends, inter alia, on levels of transaction costsand the relativestrengths and relevanceof the capabilitiesof the possible participantsin the productionprocess.

Transaction-cost Approaches

Recently, of course,a new set of theorieshas emergedto focus more clearly on issuesof organization.In one way or another,these strands have takentheir inspirationfrom the work of RonaldCoase [6]. Here the firm is by no meansthe sort of black box it is in traditionalIO theory. Moreover, these approachesdo not "take the firm as a unit of analysis."In Oliver Williamson'formulation of transaction-costanalysis [44], for example,it is the "transaction"-- which may occur within the firm or acrossmarkets -- that becomesthe fundamentalunit of analysis. This approachis able to ask questionsthat are somewhatdifferent from those of traditionalIO theory. Principalamong these is the matterof the boundaryof the firm: why are some activitiesorganized across markets and someorganized within firms. As a consequence,the transaction-costapproach has also proven able to provide 34

someanswers that are not only differentfrom but arguablyricher and more sensible than those of traditional IO. 1 Salutaryas theseinnovations have been, it nonethelessremains the case thattransaction-cost analysis retains fundamentally the neoclassical conceptual apparatus.This is so in a coupleof respects.First, transaction-cost analysis in all its principalforms is concernedwith the allocationof knownand given resources.Now, it is certainlytrue that imperfectionsin informationfigure prominentlyin this tradition. We might even say that the assumptionof imperfectionsin informationlie at the very heart of all transaction-cost approaches.But it remainsthe casethat the "imperfections"allowed are of a ratherparticular and limited sort. Imperfectinformation or knowledgein these approachesis alwaysof a "parametric"or purely quantitativekind [16]. For example,it may be costlyto monitorlevels of effort, or it may be costlyfor one party to know whethera productis a "lemon." But there is never any "structural"or qualitativeuncertainty. There is never any disagreement betweenparties aboutthe fundamentalcategories of action:all know what it would mean to providea certainlevel of effort; all know what it meansfor a productto be a "lemon";all know and agreeon the gamethey are playing. To put it anotherway, there is never in these models any possibilityfor surprise,genuine innovation, or differingperceptions of reality.2 Another respectin which the Coaseantraditions remain neoclassicalis their near-exclusivefocus on exchangeto the neglectof production.Almost by definition,problems of transactionabound; but there is seldomin these models any fundamentaldifferences in or ignoranceabout productive information.3 As Demsetz[7, p. 148;see also p. 144]complains, "although informationis treatedas being costly for transactionor managementpurposes, it is implicitlypresumed to be free for productionpurposes." Transaction-cost economicsfollows neoclassical theory in repressing,as RichardNelson [32] putsit, the differencesamong firms in productiveability. But businesshistory is vitallyconcerned with bothstructural uncertainty and differencesin productionknowledge (and in the sourcesof production knowledge). The transaction-costtheories emanatingfrom Coase ask useful

1Aprominent example of thiswould be the area of whatWilliamson [44] calls "non-standard contracting,"including especially vertical arrangementslike resaleprice maintenanceor tying contracts.

21tis the case,however, that a numberof writershave pointed in thisdirection, albeit unconsciouslyin many cases. The most explicit was Frank Knight, who was nonetheless misunderstoodon the matter [25]. Onecan also see glimmers in Coase'sdiscussion of incomplete contracts[6]. Somepresent-day writers may alsobe seenas edgingtoward something like this view: Hart [8] from formal modeling,Barzel [3] from moral-hazardtheory, and perhapseven Klein [14]. All takeproductive capabilities as given, but they do appealin the endto fundamental kindsof uncertaintythat make complete contracts costly, requiring unified ownership by a residual claimant.

30nthis point see also Winter [45]. 35

and important questions,but without some substantialmodifications in orientationand perspective,they cannotproperly frame, and thereforecannot reliably answer, the questionsof uncertaintythat are central to business history. What we need,to put it simply,is a dynamicor entrepreneurialtheory that allowsfiner distinctionsbetween the properspheres of firm and market.

The Theory of Economic Capabilities

There doesexist a currentof thoughttoday that addressesclearly the issue of the creationof productionknowledge. The fountainheadof this approachis arguablyEdith Penrose's 1959 book, The Theoryof the Growthof the Firm [35]. Penrose saw the firm as possessingvarious productive resources,including intangible managerial resources, that are often lumpy and indivisible. As a result,the firm tendsto find itself with excesscapacity in someresource, which leadsit to grow and to diversifyinto areasin which the excessresources might be put to good use. Althoughher terminologydiffers, Penrose anticipated many of the most importantideas later elaboratedby other writers. Among these is G. B. Richardson,who introducedthe usefulterm capabilitiesto refer to the skills, experience,and knowledgethat a firm possesses.He concludesthat firms "would find it expedient,for the most part, to concentrateon similar activities,"that is, on thoseactivities that require common capabilities [37, p. 895]. More recently,David Teece [41, 42] has developeda similar account of the scopeof the firm. Teeceexplicitly draws on the evolutionarytheory of Nelson and Winter, who have formulateda more microanalyticaccount of the nature of capabilities:namely, the habits and routinesthat individualsand organizationsacquire through practice. "Routines," as theyput it [34, p. 124], "arethe skillsof an organization."In the courseof its development,a firm acquiresa repertoireof routinesthat derivesfrom its activitiesover the years. Note that routines refer to what an organizationactually does, while capabilitiesalso include what it may do if its resourcesare reallocated.Thus a firm's routinesare a subsetof its capabilitiesthat influencebut do not fully determinewhat the.firm is competentto achieve. In essence,capabilities and routinesare forms of knowledgeabout how to carry out productivetasks. Some of this knowledgemay be tacit [36] and not easily articulatedor transferredto others,but othercapabilities may be generallyavailable to those willing to make the investmentnecessary to acquirethem. Unlike neoclassicaltheory in most of its forms, this capabilities approach-- as we may call it -- sharesthe concernsof Smith and the classicals:the natureand sourcesof productiveknowledge. But, alsolike the economicsof the classicals,this approachdoes not by itselftell us everything we needto know abouthow productiveknowledge is allocatedbetween firm and market [22]. When connectedwith transaction-costtheory, however,the capabilitiesapproach can provide dynamic or entrepreneurialtheory of the firm -- or, more correctly,of businessinstitutions. The result is a theory of the boundariesof the firm that is quite differentfrom what one finds in the mainstream literature of transaction costs. 36

Dynamic Transaction-costTheory of Firm Boundaries

As Alchian and Woodward[2] suggest,present-day transaction-cost economicscomes in two basic flavors: assetspecificity [13, 44] or moral hazard[1, 3]. What bothof theseapproaches have in commonis thatthey see businessinstitutions -- and the firm in particular-- as optimalresponses to incentiveproblems. In termsof the new institutionaleconomics [17, 24], we might say that mainstreamtransaction-cost theory explainsthe firm as the solutionof a prisoners'-dilemma-likegame. 4 In a prisoner'sdilemma, informationis certainlyimperfect. But the fundamentalproblem the players face is less one of information than one of incentives. And the measure of a governancestructure (to use Williamson'sterminology) lies in its ability to align incentivesand overcome "opportunism" (another term from Williamson). In this formulation,the raison d'dtre of the firm doesnot lie in coordination. Most economistsunderstand that marketsare importantinstitutions of coordination,even if the Walrasian apparatusseverely handicapstheir understandingof the natureof thatcoordination. s What few havenoticed, however, is that other kinds of economicinstitutions -- firms prominently amongthem -- can alsoserve a coordinationfunction as well as (or perhaps rather than) merely an incentive-alignmentfunction. To put it anotherway, businessinstitutions may also arise as solutionsto coordinationgames. In a world of fundamentaluncertainty, in which capabilitiesand knowledgediffer amongactors, this, ratherthan incentivequestions, may be the centralrole of such institutions. To seewhy this may be so, let us returnto the notion of capabilities. The capabilitiesthat exist in an economyare, as we saw, the evolvedrules, habits, conventionsthat constituteproductive abilities. Those business institutionstend to do betterthat can createand utilize superiorcapabilities. As Schumpeter[39] maintained,this process in whichnew capabilitiesemerge and are testedis the competitiveprocess. 6 Sucha processis necessarily complex and historically contingent. But there are a few theoretical generalizationsone can make aboutwhich types of businessinstitutions will likely be most successfulunder various circumstances. As we havealready suggested, one of the principalfactors that business institutionsmust deal with is structuraluncertainty. Thus, one of the principal determinantsof the appropriateform of businessinstitution will be the nature of the uncertainty--or, if you prefer,the innovation--involved. The second critical factoris the existingstructure of relevantcapabilities, including both the substantivecontent of those capabilitiesand the organizationalstructure underwhich they are deployedin the economy.

4Onthe functionalist character ofthis kind of explanation, seeLanglois [16, 18].

SButsee Hayek [9].

6Foran argument that Schumpeter wasattacking theneoclassical conception ofcompetition rather than defending"monopoly" in the neoclassicalsense, see Langlois [19]. 37

One patterntypical in the historyof businessinstitutions emerges when a systemicinnovation would yield significantgains in one or moreof the three areaswe listed above:an improvementin the non-pricecharacteristics of a product(which may sometimesmean a "new"product); a reductionin price; or an increasein the returnto the input suppliers.To be successful,a systemic innovationrequires simultaneous change in severalstages of production.7 This would likely renderobsolete some existing assets and, at the sametime, call for the use of capabilitiesnot previouslyapplied in the productionof the product. If, in addition,the existingcapabilities are underseparate ownership -- or, to put it looselyand somewhatinaccurately, the existingproduction systemis coordinatedthrough market mechanisms -- thenwe arrive at one importantrationale for the institutionof the businessfirm. Under this scenario,the businessfirm arises becauseit can more cheaply redirect, coordinate,and where necessary create the capabilitiesnecessary to make the innovationwork. Becausecontrol of the necessarycapabilities in the firm would be relativelymore concentratedthan in the existingorganizational structure,such a firm could overcomenot only the recalcitranceof asset- holderswhose capital would have creativelyto be destroyedbut also the "dynamic"transaction costs a of informingand persuading new input-holders with necessarycapabilities [40, 20, 22]. Thisscenario accurately describes the situationsurrounding the creation and growth of many of the enterprisesAlfred Chandlerchronicled in The VisibleHand [4]. With the loweringof transportationand communications costsin the Americaof the nineteenthcentury, there arose profit opportunities for thosewho couldcreate mass markets and take advantageof economiesof scalein massproduction. Examples range from steeland farm machineryto cigarettesand brandedgoods. In all thesecases, profitable improvements in productattributes and costs9 required the creativedestruction of existing decentralizedsystems of productionand distributionin favor of systems involvingsignificantly different capabilities. Gustavus Swift's creationof the system of refrigerated meat-packing [4, pp. 299-302] was a systemic innovation that rendered obsolete the older network of live-animal distribution. Swift wasforced to integrateinto both refrigerated railroad cars and wholesale distributionin order to overcomethe oppositionof vestedinterests and to persuadeothers in the chainof productionof the value of his innovation[40, pp. 28-29].

7Thisusage follows Teece [43]. The opposite ofa systemicinnovation isan autonomous one,in which changecan proceedin onestage of productionwithout requiring coordination with other stages. amoregenerally, dynamic transaction costs -- or,more generally still, dynamic governance costs -- are the costsof not havingthe capabilitiesyou needwhen you needthem [22].

91nmany of these cases, the non-price attributes ofthe products may initially have deteriorated in consumereyes as mass-produceditems substituted for particularizedor hand-madeones. But any suchdisadvantage was, of course,rapidly outweighed by reductionsin productprice. 38

This pictureof the rationalefor the firm is what we might legitimately call a strategic,entrepreneurial, or Schumpeteriantheory of verticalintegration. The superiorityof centralizedcontrol of capabilitieslies in the ability to redeploythose capabilities in the serviceof an entrepreneurialopportunity whensuch redeployment would otherwisebe costly[28]. The firm overcomes the "dynamic"transaction costs of economicchange. It is in this sensethat we may say the firm solvesa coordinationproblem: it enablescomplementary input-holdersto agreeon the basicnature of the systemof productionand distributionof the product. It providesthe structurein a situationof structural uncertainty.

On Firms and Markets

A numberof writers,with Schumpeterhimself in the lead, have taken this pictureof the firm to imply the superiorityof the firm -- especiallythe largevertically integrated firm -- in mostif not all timesand places. In fact, however,the scenariowe just depictedis by no meansthe only importantone, let alonethe onlypossible one. The superiorityof the firm restedon its ability cheaplyto redeploy,coordinate, and create necessary capabilities in a situation in which(1) the entrepreneurialopportunity involved required systemic change and (2) the necessarynew capabilitieswere not cheaplyavailable from an existingdecentralized or marketnetwork. In situations,however, in whichone or both of theseconditions is missing,the benefitsof the firm are attenuated, and its rationaleslips away. In manycircumstances, for example,change -- evensometimes rapid change-- may proceedin autonomousfashion. A prime exampleof this occurswhen the attributesbuyers desire can be providedin the form not of a preset packagebut of a modular system[27]. Stereo systemsand IBM- compatiblepersonal computers are prominentexamples, but there are many othersas well, includingcases in the realm of processtechnology [23]. For presentpurposes, the key featureof a modularsystem is that the connections or "interfaces"among components of an otherwisesystemic product are fixed andpublicly known. Suchstandardization creates what we mightcall external economiesof scope [23] that substitutein large part for centralized coordinationamong the wieldersof complementarycapabilities. This allows themakers of componentsto concentratetheir capabilities narrowly and deeply and thusto improvetheir piece of the systemindependently of others. Moreover,in highlydeveloped economies, a widevariety of capabilities may be availablefor purchaseon ordinarymarkets, in the form either of contractinputs or finishedproducts. At the sametime, it may alsobe the case that the existingnetwork of capabilitiesthat mustbe creativelydestroyed (at least in part) by entrepreneurialchange is not in the handsof decentralized input suppliersbut is in fact concentratedin existing large firms. The unavoidableflip-side of seeingfirms as possessedof capabilities-- and thereforeas accretionsof habitsand routines-- is that suchfirms are quite as susceptibleto institutionalinertia as is a systemof decentralizedeconomic capabilities. Even though firms may have a strategicdecision-making function,they may yet be unableto reorientthemselves in the face of rapid 39

change[27]. Economicchange has in many circumstancescome from small innovativefirms relying on the capabilitiesavailable in the marketrather than existingfirms with ill-adaptedinternal capabilities. Sometimes,of course,large firms are able to catchand overtakethe innovators-- or the innovatorsthemselves become large firms, as in many of the nineteenth-centurycases Chandler chronicles. But when the innovation involved is not systemic, innovation may actually proceed faster in a decentralizedsystem because of its ability to utilize a more diverseset of information[33]. A casein point is the present-daymicrocomputer industry. Here technologicalchange, volume production,and unit-costreductions are proceedingat a paceto rival any Chandlerianindustry in history. But these gains have come in the virtual absenceof large firms integratedacross the stagesof microcomputerproduction. Although some of this advanceis surely the result of internal economiesin firms like Intel and Microsoft, even those firms are relativelynarrowly focused. Large establishedfirms, which have been able in other industriesto overtake innovative first movers, have a record of dismalfailure in this industry[21]. •ø Theyhave missed opportunities at every turn, and have shown themselvesunable to compete with the more nimble independentmarketer-assemblers. The Japanesehave made few inroads.And IBM's recordhas been that of a technologicalfollower living off its brand-namecapital. Indeed,IBM's successwith the original standard- settingPC in 1981 was basedon a strategyof buying inputson the market ratherthan accordingits internaldivisions their accustomedprivileged access to resources-- a strategythe firm subsequentlyabandoned to its detriment.

Conclusions

What we are suggesting,once again, is the following. We oughtto see marketsnot as merely allocatingknown and given resourcesbut as providing the framework for the coordinationof productivecapabilities. Business institutions -- including but not limited to firms -- arise within that frameworkto take advantageof entrepreneurialopportunities. And we can study those institutions analytically by examining the nature of the coordinationproblem the entrepreneurialopportunity implies, both in the abstractand relative to the existinginstitutional configuration of capabilities in the economy.

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