Strategic Management Journal Strat. Mgmt. J. (2008) Published online in Wiley InterScience (www.interscience.wiley.com) DOI: 10.1002/smj.718 Received 22 March 2006; Final revision received 16 May 2008 ENVY, COMPARISON COSTS, AND THE ECONOMIC THEORY OF THE FIRM JACK A. NICKERSON* and TODD R. ZENGER Olin Business School, Washington University, St. Louis, Missouri, U.S.A. An economic theory of the firm must explain both when firms supplant markets and when markets supplant firms. While theories of when markets fail are well developed, the extant literature provides a less than adequate explanation of why and when hierarchies fail and of actions managers take to mitigate such failure. In this article, we seek to develop a more complete theory of the firm by theorizing about the causes and consequences of organizational failure. Our theory focuses on the concept of social comparison costs that arise through social comparison processes and envy. While transaction costs in the market provide an impetus to move activities inside the boundaries of the firm, we argue that envy and resulting social comparison costs motivate moving activities outside the boundary of the firm. More specifically, our theory provides an explanation for ‘managerial’ diseconomies of both scale and scope—arguments that are independent from traditional measurement, rent seeking, and competency arguments—that provides new insights into the theory of the firm. In our theory, hierarchies fail as they expand in scale because social comparison costs imposed on firms escalate and hinder the capacity of managers to optimally structure incentives and production. Further, hierarchy fails as a firm expands in scope for the simple reason that the costs of differentially structuring compensation within the firm to match the increasing diversity of activities also rises with increasing scope. In addition, we explore how social comparison costs influence the design of the firm through selection of production technologies and compensation structures within the firm. Copyright 2008 John Wiley & Sons, Ltd. INTRODUCTION externally managing activities. When market gov- ernance is costly or markets fail, integration is The theory of the firm has primarily focused on likely; when internal governance is costly or orga- the question of firm boundaries, articulating when nizations fail, market governance is likely. Cur- firms supplant markets and when markets sup- rent theory provides well-developed explanations plant firms. Coase (1937) originally articulated the for the failure of markets. Markets commonly fail logic that boundary choices depend on a com- when exchange demands highly specialized assets, parative assessment of the costs of internally and involves measurement difficulty, or requires the transfer of knowledge (Williamson, 1975; Klein, Crawford, and Alchian, 1978; Barzel, 1982). How- Keywords: theory of the firm; envy; comparison costs; ever, as both Coase (1937) and Williamson (1985) diseconomies of scale and scope; firm boundaries note, a theory of market failure alone is not a the- ∗ Correspondence to: Jack A. Nickerson, Olin Business School, ory of the firm, because such theory fails to resolve Washington University, Campus Box 1133, One Brookings Drive, St. Louis, MO 63130-4899, U.S.A. a basic puzzle: If firms are advantaged in manag- E-mail: [email protected] ing these complexities in exchange, ‘why is not all Copyright 2008 John Wiley & Sons, Ltd. J. A. Nickerson and T. R. Zenger production carried on by one big firm?’ (Coase, highly autonomous internal units and then structur- 1937: 394). What precludes the firm from selec- ing market-like incentives within its boundaries. tively using the control features of hierarchy and Similarly, this argument does not explain why a otherwise replicating market incentives within its firm cannot integrate an independent firm or activ- boundaries? If firms can replicate market incen- ity and craft incentives that fully replicate the mar- tives and utilize authority to control exchange only ket incentives that previously existed. when needed, the firm should face no boundary Influence activities within organizations, as dis- limits. Indeed, absent impediments to replicating cussed by Milgrom and Roberts (1988; 1990a; market incentives within the firm, the boundaries 1990b), provide a partial explanation. When an of the firm become rather irrelevant and managers activity is integrated within the boundaries of the enjoy enormous flexibility in the design and struc- firm, it is placed in an arena in which incentives ture of organizations. now exist for both those managing the integrated Existing theory provides little in the way of activity and those positioned elsewhere in the firm explanation for the limits of the firm or the causes to politically influence the distribution of rewards of organizational failure. The prevalent view in allocated to those managing it. They argue that early writings on industrial organization was that such rent-seeking activity is wasteful and fully limits to firm size were due to ‘diminishing returns absent when the activity is autonomously con- to management’ (Sraffa, 1926; Kaldor, 1934). trolled by the market. Absent integration, there is Implicitly, Coase (1937) adopted a similar argu- simply no one to politic and therefore no influ- ment, assuming that at some point, integrating ence activities. While these influence activities additional transactions becomes more costly than undoubtedly play an important role in shaping the managing them externally. However, Coase pro- boundaries of firms, they provide at best a par- vided no clear explanation as to the origin of these tial explanation. The theory does not explain why costs or why so-called management costs should these organizational costs should increase with rise with firm scale and scope. Indeed, Coase has size or scope. Thus, while Milgrom and Roberts commented that the question of why the costs (1988, 1990a, 1990b, 1992) explain why selec- of internal organization increase with firm scale tive intervention is costly within firms, they do and scope remains unanswered (Coase, 1988). Our not explain why the marginal transaction or activ- goal is to develop a theory of organizational fail- ity becomes increasingly costly to integrate, as the ure, more precisely a theory of organizational dis- economies of scale and scope that is rooted in firm increases in scale and scope. Since Milgrom processes of social comparison as discussed in and Roberts’ (1988, 1990a, 1990b, 1992) argument the sociology and social psychology literatures. is invariant to size and scope, the theory fails to These processes of social comparison give rise to explain the limits to firm size and scope. what we label ‘social comparison costs’ (Zenger, In this study, we develop a theory of managerial 1992; 1994). Our theory argues that while transac- diseconomies of scale and scope, which are orga- tion costs in the market prompt access to author- nizational failures that constrain the boundaries of ity through integration, social comparison costs the firm. We begin by assuming that market fail- prompt managers to limit the degree of integration ures of the type commonly described in the trans- and otherwise take costly organizational actions to action cost economics literature provide the impe- restrict and efficiently manage these social com- tus to integrate activities within the boundaries parison costs. of the firm. Cognizant of these transaction costs We are, of course, not the first to explore the in the market that prompt the extension of firm question of organizational failure (see Hennart, boundaries, we develop a theory of countervail- 1994). Some have argued measurement difficul- ing social comparison costs that impel managers ties escalate with firm size and limit the capacity to restrict these boundaries or otherwise control of large firms to offer the high-powered incen- these costs. Thus, while market failures create a tives prevalent in markets (Barzel, 1982; Holm- type of centripetal force for moving activities out strom, 1989; Rasmusen and Zenger, 1990; Zenger, of the market and into a firm, our theory explains 1992; Williamson, 1985). But, this argument alone when and how organizational failures create a cen- does not explain why a large firm can’t replicate trifugal force for moving activities out of the firm the measurement precision of markets by creating andintothemarket. Copyright 2008 John Wiley & Sons, Ltd. Strat. Mgmt. J. (2008) DOI: 10.1002/smj Envy, Comparison Costs, and the Economic Theory of the Firm As a brief preview, our theory begins by examin- costs that arise as managers attempt to selec- ing the behaviors of both individual employees and tively infuse market incentives within the firm. managers in response to the infusion of market-like We then discuss the structure of these costs and incentives within the firm. Consistent with a wide identify and describe three levers, or organiza- range of social science literature, we assert that tional design choices, available to management individual employees invidiously compare their to attenuate them. We use two levels of analy- rewards with others they deem to be within their sis—employee decisions about how to attenuate referent group (for example, see Adams, 1963; envious emotions and managerial policy decisions Festinger, 1954). If perceived inequity arises, the about the structure of the firm—to develop an resulting negative feeling—what we refer to as argument for how social comparison generates dis- envious emotion—drives individuals to expend economies of scale and scope in firms. We then effort to ameliorate these perceptions of inequity. discuss the implications of our theory along with Such behaviors include reduced effort, influence a few caveats and conclude. activities, departure, noncooperativeness, or even outright sabotage. Such behaviors impose substan- tial costs on the firm—costs that we reference as Selective intervention and social comparison social comparison costs. costs Managers, of course, are not passive actors in responding to these comparison costs. Managers Our theory is designed to complement, not replace, anticipate social comparison costs or at least per- the logic of transaction cost economics.