Moving to the Resourced Based Approach

Reading Demsetz

The Theory of the Firm Revisited

Where have we been?

Michael Porter’s approach emphasizes market structure and promotes strategies aimed at avoiding direct competition.

Firm should produce differentiated products.

And yet…

He getting to the detail of providing sustainable superior performance, he moves to the value chain idea.

The value chain focus directs managers to examine every aspect of the firms production and marketing with the intention of finding things that can increase the consumer’s willingness to pay or reduce the firms cost of serving the customer.

Which moves us in the direction of the Resource Base View

• The resource based view also notes the necessity to either provide better products or to lower cost.

• However, the degree to which the firm will achieve those objectives will be constrained by the resources available to the firm.

HOWEVER

The resources present in a firm are not merely an assembly of personnel and capital assets that can be expanded, reduced, reconfigured or redeployed in a short amount of time.

Resources?

Engineers, Accountants, representatives, public relations staff, buildings, expertise, teams, reputation, brand names, designs, image, consumer confidence, writers, translators, procurers, sales people, packaging, buildings, trucks, parking lots, congressmen, senators, doctors lawyers, agency contacts, friendly journalists, a look and feel, fanboys, fangirls, a history.

Edit Penrose, The Theory of the Growth of the Firm, 1959

“The resources with which a particular firm is accustomed to working will shape the productive services its management is capable of rendering, but the development of the capacities of men is partly shaped by the resources men deal with.” (78-9 as cited in Kor and Mahoney, “Edit Penrose’s Contributions to the Resource Based View of Strategic Management.”)

Edith Penrose

Firms grow

Edith Penrose

Firms grow

(of that one might say, Duh…)

But consider our standard model.

Max (K,L) p(q)q(K,L) – (rK+wL)

This is done instantaneously

Of course

• It is a common criticism to say a model is static and a dynamic model would be better.

• If there is an equilibrium firm size, most of the firm that we see will be at or near their equilibrium, unless growth is very slow.

• While this may be good economics, it may be unhelpful as a guide to management

In a sense…

Penrose’s contribution is a bit like Coase’s 1937 paper.

We step inside the black box of the firm, as it is modeled in ecnomics.

Reading DemsetzThe Theory of the Firm

RevisitedWe start with a homey example.

Installing and repairing hardwood floors.

4 people. One very experienced craftsman who represented the firm, a younger craftsman, a skilled helper, a helper.

We saw this in several crafts.

• The roofers

• The exterior painters: Six of them, but the full range of experience.

• The drywall hangers

• The kitchen installers

And again

• HVAC (just two, the expert and his helper)

There was one important exception

The dry-stack mason. He wasn’t training anyone. He was in no big hurry. He was…

So, except for the stone(d) mason

All of these crews had a hierarchy of skilled workers.

In most cases, it was clear that the skilled workers were, among other things, training the less skilled workers.

How do these firms grow?

By training workers and splitting off independent crews

Look at the trucks.

But it is not just these crafts trades

Most big firms, in normal times, have personnel policies that include training of new workers and opportunities for employees to grow in their careers

Smithian Good Intentions?

A bit of a reader’s guide:

• Alchian and Demsetz.

The firm as a solution to shirking.

Demsetz is repudiating this line of argument, at least in part in order to focus elsewhere

Also, reading Demsetz

• References to Frank Knight: Role of uncertainty.

• The firm as an institution for sharing risk

• Not central to what is coming.

As before, Demsetz credits the standard model of the firm…

…with all its abstractions, but observes its unsuitability for the problem of understanding the firm.

For this purpose, he criticizes the unsuitability of the models assumption of…”full and free knowledge of production possibilities and prices.”

The standard model of the firm

is based on our model of the price system.

That model is intended to explain how the economy is coordinated in the absence of actively managed coordination.

But the essential distinction of the firm is

actively managed coordination

Management cost vs. Transactions cost

• That’s Coase, though the terminology is due to Demsetz.

• But now consider the firm buying an input, rather than producing it internally. We say that it does so because the transactions costs are less than management costs. But notice, the selling firm had to do the management necessary to produce those goods.

.

***So the real issue is

• Management divided up among many small firms

• Or Management divided up among a fewer, larger firms

• Which poses the issue, are there economies of scale in management?

…or economies of scope.

• Experience with some product creates an advantage in producing some other product. – This is found in Wernerfelt, our next reading.

Does selling backpacks give you an advantage in selling strollers?

Does providing long distance service present an advantage in providing local service?

Not Demsetz

There are more things in heaven and earth, Horatio, Than are dreamt of in your philosophy.

Demsetz

There is much more to the problem of economic organization than is plausibly subsumed under transaction and monitoring cost.

Perhaps the transactions cost and monitoring cost approaches to the firm have confined our search too much.

Importantly, for our purposes,

The issue then becomes, which management activities belong together.

With that, what are the economies to scale in management.

A key observation

“The utilization of the services of a direction giver may demand the presence of several ‘direction receivers’ if these services are to be used efficiently”

Gather around, I have something to say.

Back to our floor technicians

• Scale economies of instruction

• Building crews

• Training programs

• Find a technique and teach it to many people.

Unprotected but valuable

• Much of what we would call technique is not protectable by IP law.

• Why not?

– Not novel, or not demonstrably novel– Innovation is gradual and shared– Tacit versus explicit knowledge*

For example?

• Recipes • Taste (Ok, after recipes, your thinking food,

but I mean more than that.)• Corporate culture• Knowledge of people, places, trading partners

• Hayek’s specific knowledge of time and place

Fine, so those are advantages of the firm…

But what is it about the firm

that is essential?

What characteristics of the firm facilitate these purposes?

Demsetz asks, what makes an organization firm-like?

He looks to corporate charters and finds these common characteristics:

• A statement of the business of the firm

• Expected duration

• Conscious direction (Employees)

What makes organization firm-like?

• A statement of the business of the firm– An agreement to specialize: We will produce

goods to sell.

• Expected duration– We expect a continuing re-association of

people.

• Conscious direction– Individuals are given specific authority.

And why do those things matter? (1)

• Specialization means that the firm will not be a collection of any-old-thing, reassembling itself from time to time like a task force.

• Those who specialize to fit the firm are likely to have a long-term basis for their affiliation.

• Central to the concept of “having a job.”

And why do those things matter? (2)

• Duration means that jobs have continuity and investment in skills will be of value to the employer.

• A reason for the firm to invest in employees, and vice versa

And why do those things matter? (3)

• Conscious direction, rather than contracting allows the firm to bring about a result while keeping unprotectable but valuable knowledge inside the firm.

Compare direction with contracting: Contracting requires fully specifying the technique and outcomes desired.

The heart of the matter

Each firm is a bundle of commitments to technology, personnel, and methods, all contained and constrained by an insulating layer of information that is specific to the firm, and this bundle cannot be altered or imitated easily or quickly. Demsetz, p. 148

Continuing, and divorcing…

• The components of this bundle that are emphasized by transactions cost theory are important, but not exclusively so. (p. 148)