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Published online ahead of print October 28, 2011 MANAGEMENT SCIENCE Articles in Advance, pp. 1–14 issn 0025-1909 eissn 1526-5501 http://dx.doi.org/10.1287/mnsc.1110.1444 © 2011 INFORMS be .org. not ms y or On Evaluation Costs in Strategic Factor Markets: ma The Implications for Competition and file Organizational Design The . missions@inf per ibers David Gaddis Ross to Columbia Business School, New York, New York 10027, [email protected] subscr his paper uses a formal model to study how evaluation costs affect competition for resources in strategic fac- policy to Ttor markets. It finds that relative scarcity may not always benefit resource sellers. Rather, when competition le this among resource investors passes a certain threshold intensity, miscoordination among investors increases to the point that sellers’ expected profits decline. This paper extends the model to consider how investors organize to ailab v overcome managerial agency in resource evaluation. Two organizational designs are considered: (a) incentiviza- a tion, wherein a lower-level manager is motivated by an incentive contract to evaluate resources for an investor, and (b) supervision, wherein evaluation is either handled directly or closely monitored by headquarters. The regarding model suggests that competition among investors will be associated with a greater use of supervision and that made investors using supervision will tend to make lower offers. This paper also finds that supervision will be more is common when valuable resources are rare. Key words: strategy; organizational studies; design; motivation–incentives questions which History: Received June 16, 2008; accepted July 22, 2011, by Bruno Cassiman, business strategy. Published y online in Articles in Advance. an ersion, v send 1. Introduction are subject to frictions that interfere with the nor- ance Two central tenets of the resource-based view of mal effects of competition. Examples include imper- fect price discrimination between groups of buyers Please the firm are (1) that implementing product market Adv . strategies requires valuable resources (Penrose 1959, (Rosenthal 1980, Stahl 1989), externalities in fixed and in variable costs when simultaneously competing for site Wernerfelt 1984) and (2) that many valuable strategic s resources are acquired in “strategic factor markets” multiple business opportunities (Lang and Rosenthal ticles (Barney 1986). Given the standard view of markets, 1991), the winner’s curse in bidding (Bulow and Ar Klemperer 2002), externalities in the ownership of author’ in which rents accrue to those sellers and buyers goods (Jehiel et al. 1996), and rent dissipation in this with greater “relative scarcity” (e.g., Williamson 1975, the downstream markets, which may affect bidding for to Pfeffer and Salancik 1978, Porter 1979, Brandenburger and Stuart 1996, Dyer and Singh 1998), the strategy strategic inputs like intellectual property (Anton and ight Yao 2008). These frictions endogenously affect the literature has generally adopted the view that the yr decision of how and even whether a competitor par- profits of resource investors will decline, and the prof- including cop ticipates in a given market. In some circumstances, , its of resource sellers will increase, as the number of competition exacerbates these frictions to the point investors per seller climbs (e.g., Peteraf 1993).1 Indeed, that competitors compete less aggressively and may holds ebsite Adegbesan’s (2009) formal model of a strategic factor w even choose not to enter the market, to the detriment market reached this conclusion. of upstream and downstream market participants. However, within diverse strands of the economics This paper’s first contribution is to construct a for- other literature, authors have observed that some markets y mal model to apply similar reasoning to the workings INFORMS an of strategic factor markets and thereby demonstrate 1 Accordingly, formal work on resource acquisition has studied how that the effect of relative scarcity on the division of on firms can mitigate competition for strategic resources by, for exam- rents between resource sellers and resource investors yright: ple, focusing on resources that best complement the firm’s exisiting is considerably more subtle than the strategy liter- resources (Adegbesan 2009), developing a competence at deploy- ature has appreciated. This paper then goes on to Cop posted ing a particular kind of resource (Makadok 2001, 2002), collect- ing the most useful information about which resources to acquire explore how competition affects how firms organize (Makadok and Barney 2001), or judiciously scheduling resource to evaluate and acquire resources in strategic factor acquisition across time (Pacheco-de-Almeida and Zemsky 2007). markets. 1 Ross: On Evaluation Costs in Strategic Factor Markets 2 Management Science, Articles in Advance, pp. 1–14, © 2011 INFORMS Central to this paper’s argument is that whereas suggests an important role for strategy in shaping the some strategic resources are acquired gradually structure of strategic factor markets. be through firm behavior (Dierickx and Cool 1989) or The importance of resource evaluation costs raises .org. not have values that are widely known, other strategic the question of how firms can best organize to ensure ms y or resources must be obtained through markets and will that managers perform this “entrepreneurial service” ma have values that are not fully apparent. Examples (Penrose 1959) properly in the face of competition include the acquisition of another company (Barney from other firms. In particular, we wish to understand file 1986, p. 1231) as well as technology patented by an the substantial variation that we observe within and independent inventor or a tract of land adjoining a between firms along this organizational dimension in The . missions@inf planned new highway exit (Makadok 2001, p. 391). In a variety of strategic factor markets. Examples include these cases, a responsible investor requires a lengthy the following: per ibers and expensive evaluation to ascertain the value of a 1. Mergers and acquisitions (M&As). While firms to resource before acquiring it. This paper’s model shows often use a centralized corporate development func- subscr formally that when these evaluation costs are consid- tion to vet acquisitions, many firms will, on some policy occasions, delegate responsibility to vet an acquisition to ered, competition among investors increases sellers’ to business development personnel at lower levels le profits and reduces investors’ profits only until a crit- this ical number of investors is reached. As the number of in the hierarchy (Deloitte Financial Advisory Services ailab investors increases beyond that point, investors’ prof- 2010). GE Capital, a very active acquirer, has been v a its do not change and sellers’ profits decrease. cited as a leading example of this practice (Ashkenas Although counterintuitive at first, this result has et al. 1998). In many companies, the chief financial regarding officer (CFO) takes a role in vetting acquisitions (G.A. made an intuitive explanation, which we sketch here and Kraut Company 2008), but the CFO’s role may range is develop at greater length in the body of this paper. As one would expect, the presence of more investors from identification and evaluation (e.g., consumer encourages each investor to make a higher offer to products firm Newell (Collis and Johnson 1998)) to questions which a limited financial vetting of recommendations from y avoid being outbid, to the benefit of sellers. However, an if the number of investors increases beyond a crit- business units, which have primary responsibility for ical number and they all actively participate in the identifying and evaluating targets (e.g., telecommuni- ersion, v market, many investors will incur the cost of eval- cations firm Polycom (Roberto and Carioggia 2005)). send uating a resource but not succeed in acquiring one, 2. Greenfield expansion. Introducing new products, ance driving investors’ expected profits below zero. This opening new plants, and entering new markets require firms to acquire resources such as capital equipment, Please is not sustainable as an equilibrium. Nor is it possi- Adv . ble for a subset of investors to earn positive profits sites for operations, and new managerial personnel. in The autonomy given to business units for organic site and simultaneously block other investors from partic- s ipating in the market. Thus, absent a collusive coor- expansion varies considerably within and among ticles dination device among investors, the only possible firms (Hedlund 1981, Birkinshaw 1997, Birkinshaw Ar equilibria are those where each investor randomizes et al. 1998). For instance, SK Chemical, a part of author’ between (a) incurring the cost of evaluating a resource Korea’s SK chaebol, frequently relies on the chairman’s this the and (b) staying out of the market. This creates the pos- office when deciding to acquire strategic assets, but to sibility of miscoordination that inures to the detriment the head of the petrochemical division was given sig- ight of sellers in two mutually reinforcing ways. First, nificant autonomy in the decision to acquire a site for 2 yr purely by chance, a large number of investors may a large greenfield chemical plant in Poland in 2003. including Likewise, within the same restaurant chain, it is com- cop opt to stay out of the market at the same time with the , result that even a seller with a valuable resource will not mon to observe a chief executive officer (CEO) taking receive any offers for it. Second, the implied ex post an active role in evaluating the acquisition of some holds ebsite potential restaurant sites while delegating evaluation w market power of an investor that does evaluate a given seller’s resource is higher, because the investor of other sites to lower-level managers (Bradach 1998). may correctly guess that it is one of the few—perhaps, 3. Customer acquisition. Acquiring new customers other frequently requires significant expenditures to gener- y the only—investor in a position to make an offer for INFORMS ate leads and subsequent sales.