Moving Opportunism to the Back Seat Bounded Rationality. Costly Conflict, and Hierarchical Forms Foss, Nicolai Juul; Weber, Libby Document Version Final published version Published in: Academy of Management Review DOI: 10.5465/amr.2014.0105 Publication date: 2016 License Unspecified Citation for published version (APA): Foss, N. J., & Weber, L. (2016). Moving Opportunism to the Back Seat: Bounded Rationality. Costly Conflict, and Hierarchical Forms. Academy of Management Review, 41(1), 61-79. https://doi.org/10.5465/amr.2014.0105 Link to publication in CBS Research Portal General rights Copyright and moral rights for the publications made accessible in the public portal are retained by the authors and/or other copyright owners and it is a condition of accessing publications that users recognise and abide by the legal requirements associated with these rights. Take down policy If you believe that this document breaches copyright please contact us ([email protected]) providing details, and we will remove access to the work immediately and investigate your claim. Download date: 28. Sep. 2021 Moving Opportunism to the Back Seat: Bounded Rationality. Costly Conflict, and Hierarchical Forms Nicolai Juul Foss and Libby Weber Journal article (Final published version) CITE: Moving Opportunism to the Back Seat : Bounded Rationality. Costly Conflict, and Hierarchical Forms. / Foss, Nicolai Juul; Weber, Libby. In: Academy of Management Review, Vol. 41, No. 1, 2016, p. 61-79. DOI: 10.5465/amr.2014.0105 Uploaded to Research@CBS: January 2018 Q Academy of Management Review 2016, Vol. 41, No. 1, 61–79. http://dx.doi.org/10.5465/amr.2014.0105 MOVING OPPORTUNISM TO THE BACK SEAT: BOUNDED RATIONALITY, COSTLY CONFLICT, AND HIERARCHICAL FORMS NICOLAI J. FOSS Copenhagen Business School and Norwegian School of Economics LIBBY WEBER University of California, Irvine We augment transaction cost economics’ bounded rationality assumption with heuris- tics (framing) and cognitive biases to expand the understanding of hierarchical gover- nance in the theory. In transaction cost economics opportunism traditionally takes the front seat, while bounded rationality is primarily relegated to the support role of in- voking incomplete contracts. The theory also suggests that hierarchical governance effectively mitigates opportunism-based transaction costs, making it difficult to explain why hierarchies are not always used. However, when an augmented bounded ratio- nality assumption is incorporated into transaction cost economics, we argue, first, that bounded rationality is a separate source of transaction costs and, second, that these costs are not equally mitigated by all forms of hierarchy. Instead, different hierarchical forms are associated with particular frames and social referents that naturally enhance specific bounded rationality–based conflicts, allowing certain hierarchical forms to mitigate bounded rationality–based transaction costs better than others. As a result, bounded rationality takes a front seat in the theory, addressing prior critiques of the theory, expanding the governance questions addressed by the theory, and creating a new moderating role for asset specificity in internal exchanges. In transaction cost economics (TCE), contracting processing capacity limits, which lead to incom- issues only arise when both bounded rationality plete contracts (Foss, 2003). By augmenting the and opportunism are present. Although both be- bounded rationality assumption with heuristics havioral assumptions are considered essential in (specifically frames) and cognitive biases, we move TCE, we suggest that the focus is primarily on miti- bounded rationality to the front seat, allowing us to gating opportunism-based transaction costs, while address a long-standing critique of hierarchy in those that arise from bounded rationality are largely TCE, to extend the theory to choices between in- ignored. As a result, opportunism takes a front seat ternal governance forms, and to uncover a new role in the theory, with bounded rationality relegated to for asset specificity in internal exchanges. the explanatory backseat. We argue the imbalance Critics have challenged that TCE does not ade- occurs because the bounded rationality assump- quately explain when hierarchies may fail (why all tion is underdeveloped in TCE, focusing only on transactions are not organized in firms as opposed to other governance forms) and, therefore, the limits of hierarchy (e.g., Gibbons, 2010; Grossman & Hart, We thank participants of the 2013 Academy of Management 1986; Nickerson & Zenger, 2008; Zenger, Lazzarini, & annual meeting, the 2013 Atlanta Competitive Advantage Con- Poppo, 2002). Instead, TCE scholars consider hierar- ference, the 2013 Strategic Management Society Conference, and the 2014 INFORMS Conference in the Organization Science Track chy to be an effective governance mechanism to for their constructive comments that helped us develop the paper. mitigate opportunism-based transaction costs. Ad- Additionally, we thank participants of the Emory University Col- ditionally, the theory considers all forms of hierarchy loquia Series and the Syracuse University Colloquia Series and equally efficient at mitigating these costs, despite ı attendees at the internal seminars at Bocconi University, Sa¨d the fact there are many different types of hierarchy.1 Business School, and University of California, Irvine for their in- sightful comments. We are especially grateful to our anonymous reviewers and former associate editor Cindy Devers for their 1 The exception is the insight that the multidivisional form guidance, which we feel improved the article significantly. We (M-form) more effectively mitigates managers’ bounded ratio- also particularly thank Phil Bromiley and Margarethe Wiersema nality arising from “communication overload” (Williamson, for their feedback on the manuscript during its development. 1985: 281). 61 Copyright of the Academy of Management, all rights reserved. Contents may not be copied, emailed, posted to a listserv, or otherwise transmitted without the copyright holder’s express written permission. Users may print, download, or email articles for individual use only. 62 Academy of Management Review January We argue that an underdeveloped bounded ratio- inherent intergroup conflict and unintentional nality assumption leads to this simplistic view of misunderstandings can be just as costly. Second, hierarchy, since bounded rationality–based trans- we argue that different hierarchical forms facili- action costs are not considered in governance tate specific cognitive frames and biases, linking decisions. them to particular bounded rationality–based Although TCE has been augmented in various conflicts. Third, we posit that some hierarchical ways over the last decades (e.g., Bromiley & Harris, forms mitigate bounded rationality–based trans- 2006; Mayer & Argyres, 2004; Nickerson & Zenger, action costs better than others. 2004; Weigelt & Miller, 2013; Williamson, 2000), cognitive influences informed by advances in psy- chology and neuroscience have largely been ig- BOUNDED RATIONALITY IN TRADITIONAL TCE nored (for an exception see Weber & Mayer, 2014), TCE rests on two behavioral assumptions: op- even though Simon (1997: 80) himself viewed sys- portunism and bounded rationality (Williamson, tematic information distortions as part of bounded 1985). Bounded rationality prevents parties from in- rationality. Augmenting TCE’s bounded rationality cluding all relevant contingencies in their contracts, assumption with heuristics (simplified models of while opportunism suggests that the exchange reality, such as frames, that help individuals and partner may take advantage of the incomplete con- groups make sense of a complex world) and cog- tract. Without bounded rationality, market con- nitive biases allows us to expand beyond its current tracting can coordinate all economic activity and ex ante function of explaining why contracts are handle all problems of misaligned incentives, elim- incomplete to an important ex post role as a source inating the need for discriminant analysis of differ- of “maladaptation costs,” amajorfocusinTCE ent governance structures (the main interest of TCE; (Williamson, 2000). The key idea is that frames and Williamson, 1996: 36). biases, which are linked to different hierarchal Given its purported centrality in the theory, one forms,maygiverisetocostlyconflictsthatareen- may expect bounded rationality to be precisely tirely rooted in bounded rationality, as opposed to defined in the TCE literature (cf. Suddaby, 2010). opportunism. Specific hierarchical forms—notably, Williamson usually quotes Simon’s statement the unitary, multidivisional, and project matrix that man is “intendedly rational, but limitedly so” forms—exacerbate or attenuate such conflicts to (Simon, 1947: xxiv). However, this is not a precise different degrees, which implies that the choice of definition but simply an acknowledgment that hierarchical form becomes important for minimiz- rationality is not maximized.2 We suggest that ing bounded rationality–based transaction costs. the vague definition results in a one-dimensional Augmenting the bounded rationality assump- bounded rationality assumption in TCE that takes tion moves it to the front seat in TCE, since it plays a back seat to opportunism. That is, once bounded a much more substantial role in the theory. Note rationality (defined as processing capacity limi- that we do not seek to eliminate opportunism from tations)