web viewnotes on industry and firm ... governance is practice of authority, direction and control....

Diego Zunino circa Numero [email protected]

NOTES ON INDUSTRY AND FIRM ANALYSIS MODULE 2

Diego Zunino, EMIT MSc Student

Diego Zunino – Notes on INDUSTRY AND FIRM ANALYSIS MODULE 2

Corporate Governance (Zingales, 1997)

Governance is practice of authority, direction and controlNo need of authority in standard microeconomic theory due to the existence of only standardized transactions. Real life transactions imply customized interactions which depart from perfect competition towards a bilateral monopoly.Authority is crucial in such a kind of transactions to allocate the revenues (quasi-rent)Governance System is a set of constraints which shape bargaining over the allocation of quasi rents.The incompleteness of a contract leaves room for bargaining between the parties.Bargaining is affected by several factors: Ownership of the subject of the contract; Availability of alternatives; Institutional Environment, e.g. law enforcement, professional norms.

There are two conditions over the governance: (i) relationship must generate quasi-rents (ii) quasi.rents must not be allocated perfectly ex ante.Corporate Governance is a set of constraints that shape the bargaining over the allocation of quasi rents generated by firms.Corporate Governance depends by the firm definition:If firm is defined as a nexus of contracts, CG is nothing more than an extension of contractual governanceIf firm is defined as a collection of assets, CG is more relevant as embodies assets not captured by the contractIf firm is defined as a nexus of specific investments, CG does not coincide with the legal definition of firm and CG is mainly relevant.With “neoclassical” contracts there is no room for CG: Contracts are complete There is perfect information The renegotiation is costless

The allocation happens ex ante Decisions taken ex ante are executed ex

postIf contracts were optimal, the public policy would only preserve from inefficiency, but not awarding damages for inefficiency, jurisprudence does not support this assumption. Therefore, CG emerges whenever there are incomplete contracts.There are three channels through which economic efficiency is influenced by CG: 1) Ex ante incentive effects.

a) Agents do not spend optimal value-enhancing resources if not rewarded (e.g. a car supplier would not locate nearby its main customer in order not to lose its bargaining power).

b) Rational agents perform inefficient activities in order to increase their power at ex post bargaining stage (e.g. a worker who wastes time to capture benevolence of her superior).


c) Governance system is able to promote or prevent such behaviors by altering their marginal effects (e.g. supplier merges with the customer and finds optimal to be allocated nearby).

2) Ex post inefficiency. There are different degrees of information between the parties (e.g. too fragmented control-rights

distribution, free riding may undermine the efficient solution).A compensating transfer cannot be efficiently agreed as one of the parties is liquidity constrained

(no resources, cfr. Aghyon and Tirole,1994) or has better opportunities to invest (too high opportunity cost).

Divergence of interest of control rights holders leads to ex post bargaining inefficiency. Even without any formal model or theory the evidence is sufficiently convincing.3) Risk aversion.

Governance system can affect the ex ante value of surplus by allocation of risk by effectively distributing it to more risk tolerant parties. Different governance systems can generate different amounts of risk.The objectives of corporate governance should be: 1) Maximizing the incentives for investments and minimizing power seeking.2) Minimizing ex post inefficiencies.3) Minimizing risk of governance by allocating risk to more risk tolerant parties.

Who should control the firm? If firm is intended as a nexus of contracts the control power should be left to shareholders, which are not covered by contracts.This holds only if contracts are complete. If this holds, no room of manoeuvre is left to shareholders. Other parties which are not covered by the contract should need the same protection granted by control. If firm is intended as a collection of assets the control is allocated to shareholders in order to maximize the incentives to provide specific investments in human capital. This applies only to entrepreneurial firms, otherwise the three counterarguments are provided:a) Shareholders Investment is more valuable. No evidence for treating human capital lower valuable

than physical capital.b) Other stakeholders may have better forms of protection through contracts. No evidence of more

ease of contracting in human rather than in physical capital.c) Other stakeholders have sources of ex post power to protect their investments. Even if financial

supplier is espoused to more risk in case of failure it is not clear why one should assign them control powers.

To establish residual rights to shareholders it is necessary a theory able to account the difference among stakeholders and between contractual and non-contractual relations.The owner of the assets increases its share of surplus captured by the assets but has no incentive to specialize, then a decrease of outside opportunities happens and less quasi rent is generated.If firm is viewed à la Rajan and Zingales, control rights:Should not be allocated to human capital holders as decrease their incentive to specialize.


Should not be allocated to physical capital holders and fund providers, as they could be too prudent.Should be allocated to a third party able to work in the interest of the firm and not only to protect investments the Board of Directors.By a normative analysis, the private optimal corporate governance cannot be socially efficient as entrepreneurs may delay their bargaining power into the future in order to appropriate future rents. The legal system affects welfare distribution only in incomplete contracts theories, while the government intervention which solves the ex post inefficiency can lead to welfare improving ex ante distribution choices. Limitation to this approach: too sensitivity to what contracts can be written; relies on agents ability to forecast future contingencies. This theory is suitable more in case of entrepreneurial firms.

Committees, Hierarchies, Polyarchies (Sah and Stiglitz, 1988)

People is generally reluctant to delegate decisional power, but there is an implicit general belief that the wisdom of a group is greater than the wisdom of a single.Trade-offs in organizational decision-making:(i) Not approval of good projects (Type I error) vs. (ii) approval of bad projects (Type II error).(a) Cost of evaluation vis-à-vis (b) quality of evaluation.Three types of decision bodies:Committee. Each member evaluates every project. Approval happens only if consensus reaches a given threshold.Hierarchy. A project is evaluated by progressively higher-level individuals and only if approved by lower-level individuals up to the highest level. Different kind of evaluation costs.Polyarchy. A project is approved if it is approved by anyone of the members of the board. The paper aims to find the optimal level of consensus and the optimal size of the decision body.The cost of evaluation is assumed to depend by the number of people who evaluate the project. Moreover, only binary signals can be communicated. There is no difference of approval errors among different kinds of organizations. There are two references in the literature: (i) agents have the same values but different judgments different preferences different organizations; (ii) reliability theory and analysis of the jury.The Model.The number of members in the decision body is given by n. The minimum consensus required is k. (1-p1) is probability of Type I error. The probability of Type II error is given by p2.Given n, the higher k implies a lower probability of approval; given k the higher n implies a higher probability of approval. A higher probability of approval by a single member implies the higher probability of approval by the decision body.

Analysis of the Committee. The model introduces β=(1−α ) z2α z1

where β is the quality of the portfolio; α

is the proportion of good projects in the portfolio; zi i=1,2 is the output produced by the i-th project. Whenever β<1 the portfolio is high quality; β>1 the portfolio is low quality.


A sufficient condition for k to be smaller than majority rule is that the quality of projects needs to be high. When p2=1-p1 and β=1 the majority rule is optimal.Comparative Statics. A larger committee has a larger optimal consensus: the scrutiny becomes slacker and tightness needs to be restored. However the optimal consensus increases less than proportionally than the committee size. When two types of error are equal, the optimal k gets closer to the majority rule as n increases. The optimal k increases as the quality of portfolio decreases.When the two types of error are equal the optimal k gets closer to the majority rule as p1 increases (effect of increase of managerial quality. Optimal Size of a Committee. A larger marginal cost of committee members leads to a smaller committee size as well as a lower k. Hierarchy. A smaller β or a larger evaluation cost implies a smaller number of levels in a hierarchy.Polyarchy. A smaller β or a smaller evaluation cost implies a higher number of members n in a polyarchy. Comparison of committee, hierarchy and polyarchy. The relative performance of a hierarchy or a polyarchy improves with respect to a committee when evaluation costs are higher.The relative performance of a polyarchy with respect to a committee, and the relative performance of a committee with respect to a hierarchy is better when portfolio quality is better (lower β).A smaller Type I error improves the relative performance of either a committee or a polyarchy with respect to a hierarchy if p1<.5.Extensions.Strategic Considerations. Even with strategic consideration of Nash Equilibrium the model holds. Delays in Decision Making. Sequential evaluation leads to delays, which reduce the project’s NPV. Where n is large polyarchies may have a competitive advantage. Complex Organizations. The archetypes can be combined but only they perform better when shocks happen. Complex organizations are perfect only when n ∞ , when unfortunately the costs are unfeasible.

The Vertical Boundaries of the Firms (Bresanko, Branove and Shanley , 2000)

The vertical boundaries of a firm: activities that a firm performs by itself as opposed to recurring to the market. Market Firms are firms which offer B2B services as a result of their specialization in supporting activities. The make or buy decision is the result of a cost-benefit approach. There are 5 fallacies about M-o-B:1. Firms should make an asset rather than buying it if it is a source of competitive advantage . If a

marketable asset is a source of competitive advantage something is not going so good…2. Firms should generally buy to avoid the costs of making the product. The price faced when the

product/service is bought encompasses the expenses for its realization.


3. Firms should generally make rather than buy to avoid paying a higher margin to market firms. If the price charged by the supplier is high, why there is no competition for the product/service?

4. Firms should generally make to pay the cost and not the price, subject to fluctuation. What about futures and long-term contracts to avoid such a risk?

5. Firms should make to tie up their distribution channel. Number of cases where foreclosure did not lead to success.

Choosing to Buy.Tangible benefits from using the market. Proprietary information to perform the activity (e.g. IPRs); Economies of scale and lower costs; Economies of experience.Intangible benefits from using the market. Ignoring agency costs may be better than trying to avoid them. (e.g. Cost centers where firms have no incentives to be efficient); influence costs may be saved (see supra Zingales, 2000)

The costs of recurring to the market are linked to limitations of contracts: (i) A complete contract eliminates the opportunistic behavior: no possibility to exploit the other party’s difficulties. (ii)The complete contract needs to have all the contingencies mapped, together with measurable performances and enforceability. These features are impossible due to bounded rationality. Contract law can make transactions with incomplete contracts feasible but do not overcome completely the problem. It is in fact difficult to interpret ex ante the wording of a law without any uncertainty. The cost of litigation is monetary and non monetary.Moreover a contract system can undermine coordination and may lead to risk of bottlenecks.Still, leakage of information and transaction costs may lead the firm away from the decision of recurring to the market.Relation-specific assets. They are investments made in order to bind the party to a trading partner, they are: 1. Site Specificity. Colocation of assets.2. Physical asset specificity. Assets tailored to partner’s requests.3. Dedicated assets. Assets made to fulfill the partner’s requirements. 4. Human Asset Specificity. Workers tailored around the firm’s routines.After a relation specific investment the market becomes a bilateral bargaining. Rent: profit expected from an investment assuming first best option.Quasi Rent: difference in profits from an investment between first and second best options. Holdup problem. A firm may attempt to renegotiate the terms of a deal in order to get the quasi rent. This happens when contracts are incomplete (need of Governance system). When holdup exists it can lead to: increased difficulty in negotiation and increased frequency of renegotiation; inefficiency in investing in relation specific assets; distrust; inefficiency in investing to retain more ex post bargaining power.


Hierarchies (Garicano, 2000)

Production is made of physical resources and knowledge, i.e. who must learn what.Knowledge needs to be classified: if it is cheap and codified the solution is straightforward. If it is tacit and embodied the solution is far less easy. The knowledge needs to be organized according to a knowledge-based hierarchy: Easiest problems at the production floor. Gradually more difficult problems by climbing the hierarchy.Still, there is a trade-off between communication (h) and knowledge acquisition costs (c).The organization is characterized by task designing and structure of the hierarchy. A cheaper acquisition cost of knowledge implies higher discretion of production workers and problem solvers, and higher speed of control by problem solvers.Cheaper transmission of knowledge decreases the scope of knowledge of production workers and increases the span of control of problem solvers.Knowledge of higher levels is not needed to encompass knowledge of lower levels. (assumption of the model)Beggs(2000) queuing theory to allocate workers with exogenously given skills to different layers of hierarchy.Bolton, Dewatripont(1994) tradeoff between specialization and coordination costs.The Model. Workers decide to learn how to solve problems which are common enough to satisfy the cost c. Moreover a communication cost (h) is suffered to the “receiver” of a problem, independently if the same it is solved or not.

The organization is partitioned into L classes of size βI such that ∑i=1

L

β i=1.

A knowledge set Ai⊂Ω is associated to each class, possibly overlapping. There are li classes whom may be asked by workers for solutions.Time is allocated for helping other classes (t i

H) or producing (t iP) with t i

H+t iP≤1.

Organization is large enough such that time can be traded as a non-stochastic variable. Everyone in li can be asked.The model aims to allocate to each class: (i) a number of workers, (ii) a list, (iii) a set of knowledge, (iv) the time needed to produce or help.The equilibrium is: Only one class of workers Workers solve common problems; Problem

solvers solve exceptions

No knowledge overlapping βL < βL-1<…< β1

When difficulty of the problem is introduced the same results hold but in the third proposition workers specialize in easiest problems while problem solvers specialize in gradually more difficult ones.


When technological change is introduced, the model takes into account the desity of the problems

λ : f ( λ )=eλ. The number of layers is assumed to tend to infinite L∞.At the equilibrium the marginal value of more knowledge at lowest level is equal to the decrease in the cost of higher learning workers and the increase in the production time. The marginal cost and the marginal benefit of knowledge are independent of the level of workers. Comparative statics. A decrease in the cost of acquiring knowledge ( c ):-Increases the expertise of problem solvers (zS) and workers (zw).-Increases the span of control of problem solvers.

-Reduces the time delay for finding the solution. -Does not increase, but may reduce the number of layers needed.

An increase in the complexity of the problem:-May increase or decrease the expertise of both problem solvers and workers.-Reduces the span of control of problem solvers.

-Increases the time delay.-Increases, but not reduce the number of layers needed.

The model argues that complexity needs more layers, assuming no difference in intrinsic value of workers and managers.Extensions. 1. Case of knowledge overlapping.Similarities: specialization of workers, pyramidal structure.Differences: diminishing returns for extra layers and small number of equilibrium layers.2. ICT introduction.ICT lowers both the costs of communication and learning. There has not been yet a clear and homogeneous empirical evidence. 3. Make or buy decisions. A decrease of communication costs makes layers too small to be kept in house outsourcing.A decrease of knowledge accumulation costs decreases the outsourcing.A decrease of complexity implies a decrease in outsourcing. A market for technology would find an obstacle in the fixed fee needed for learning. The equilibrium price will be equal to the average cost of learning and the communication: pM4T=acc+ahh. Where ac+ah=1.

Technological Change and the Nature of the Firm (Teece, 1988)

Even if there are different kinds of R&D activities, in the U.S. prevails the integrated structure. Historically the inventions sold by market came at the end of XIX century and left the room for vertically integrated R&D in the Twenties, to come back into the Nineties. However market-mediated and in-house R&D are complements rather than substitutes. Simplest research should be outsourced while the most complex problems are performed in house. According to the specialization of labor, the contracted R&D should provide higher quality outcomes, still contractual difficulties arise from issues of: (i) specification; (ii) disclosure; (iii) lock-in.


Fixed fee contracts show difficulties in disclosure of pre-contract information, protection of IP and lock-in effect. The difficulties can be mitigated only whenever a Dominant Design emerges.Cost plus contracts may be superior to integration only in one-shot transactions. It is in fact needed to set up administrative structures which replicate the firm feature to guarantee the feasibility. The more tacit is the knowledge, higher are the transaction costs.Integration between user and research. Innovative success depends on three gatekeepers: Market Gatekeeper: bridge between R&D and competitors, regulators and customers. Technical Gatekeeper: bridge between R&D and the scientific community. Manufacturing Gatekeeper: bridge between R&D and the suppliers. They are enhanced by integration as it makes boundaries more permeable and defines clearer procedures. Tacit knowledge is a further incentive to integration.Regardless to technological change core business shows a certain stability due to routines and boundaries in the different departments. Even after strong technological discontinuities, competences downstream should link the firm to reposition herself nearby. If needed, issue of a technological en masse purchasing.Opportunity of expansion in new markets. By market (M&A) or ex novo? 4 factors: Ease of technological transfer to an

unaffiliated entity. Degree of protection of the ideas.

Quality of the contracts. Complementary competences of the

counterpart.The contract by these conditions is less satisfactory than in house development. At the time of the paper there were no clear links between vertical structure and technical change. Innovation can be autonomous or systemic. Where systemic innovation(interdependencies arise) happens, there is the need of cost-benefit allocation along the vertical structure and there is an increase in the lack of coordination.

There is need to license when the technological shift implies: a locus of innovation outside the corporation and the knowledge is proprietary and hard to imitate.Conclusion. In-house development as the ‘natural’ solution, especially for large firms.Diversification economies comes from technological shifts.Vertical integration may lead to the delay of new technologies in order not to cannibalize the firm’s incumbent products.Research collaboration does not happen only among firms by contracts but also with universities.

The Management of Innovation (Aghyon and Tirole, 1994)

The model. There is a research unit (RU) which perform research for a customer (C) which leads to an innovation of value V>0. The discovery happens with probability p such that it depends from a non-contractible effort by the RU e and an investment by C E. The function of probability p(e,E) is increasing and strictly concave. It is also assumed to be separable, i.e. p(e,E)=q(e)+r(E).


The min e is normalized to zero. E may be either monetary and contractible or non-monetary and non-contractible but the results are similar. The socially optimum values of effort and investment e*(V), E*(V) are derived from:maxe ,E

[ p (e , E )V−e−E ]i.e q ' (e∗(V ) )V=1and r ' (E∗(V ) )V=1

However contracts are incomplete, specifying only the property right of the innovation and the sharing rule of the revenues. When C holds the property rights, RU receives no reward and we refer to the integrated case.When RU holds the property rights, agents bargain over the licensing fee for the innovation. It is referred to non-integrated case. V is equally split between RU and C such that C pays to RU a fee equal to V/2.Ownership of Innovation. Assumption of C owning no shares of RU. Ex ante bargaining power of the parties.1) Integrated case. No reward to RU leads to e(0)=0.C has therefore to maximize p(0,E)V-E which leads to E*(V).URU=0 and Uc=p(0,E*(V))V-E*(V)2) Non-integrated case. RU receives V/2 and spends the effort e=e*(V/2): max p(e,E)V/2-e.C maximizes p(e*(V/2),E)V/2 –E which leads to E*(V/2).U^RU=p(e*(V/2),E*(V/2))V/2 –e*(V/2) and U^c= p(e*(V/2),E*(V/2))V/2-E*(V/2).If e*(V/2): U^c>Uc, the property rights are assigned to RU.If U^c<Uc results are dependent from the bargaining power. If RU has bargaining power she will allocate to herself the rights if and only if U^RU+U^C>URU+UC.If C has the bargaining power she will always retain the rights because of the impossibility for RU to cash compensate towards the (socially) optimal solution. Shareholding. When C owns 0<α<1 shares of RU co-financing issue allows C to transfer to RU a smaller V(α)є[0,1/2]. α=0 is never optimal, while α=1 may be optimal if effort is sensitive to dilution.Schumpeterian hypotheses. Assuming exogenously given organizational form α, the Schumpeterian hypotheses of scale and market power effect (Sch. Mk II) and scope effect (Sch. Mk I) boil into V change: ∂e∂V

>0 ; ∂ E∂V

>0; ∂ p (e , E)∂V

>0.

A shift from integrated to non-integrated structure has opposite effects on e and E with ambiguous effects.Financial Constraints. They shape the optimal choice of the organizational form. If C is financial constrained the ownership may shift from C to RU as the investment is smaller.Split Property Rights. When more than one customer exist, innovation can be consumed by the user or purchased by another customer at price Vt. When this situation occurs, property rights are split according to the party which will have the competitive advantage. Size of innovation. It is measured by γ where γ=1 is the status quo. In case of a potential entrant with respect to an incumbent:

In case of an integrated structure the size of innovation γC will be optimal for the industry.


In case of a non-integrated structure the RU will focus progressively on more radical innovations as the willingness to pay of the entrant increases.Conclusions. R&D will be performed into a vertically integrated structure when: (i) the relevance of physical input is substantial with respect to intellectual input; (ii) customer has more bargaining power ex ante due to RU competition; (iii) customer can deep pocket. Otherwise rights go to RU.The size of innovation is affected by the organizational structure of research.Critiques. Static management of innovation; no consideration of government; no consideration of infra-team competition.

Markets for Technology (Arora, Fosfuri and Gambardella, 2001)

Organizational changes are enhanced by rapid growth in the arrangements for the exchange of knowledge and technology, i.e. a decrease of transaction costs (Teece,1988)The possibility for markets for technology (M4T) is limited by tacitness and context specificity of technology. They affect the firm’s corporate strategy both as technological users or suppliers. They increase the strategy space by creating the option for licensing. M4T open the possibility of entry for more specialized start ups, undermine the dominant position of incumbents by alternative strategies.The “alternative” is a departure from the traditional concept of in house appropriability of innovation.M4T are markets for: (i) Intellectual Property (ii) intangible assets (iii) technology embodied in a product (iv) technical services. The technology transaction may take the form of Joint Venture or Licensing.The definition is similar to what is given by the Antitrust guide from the Department of Justice. The successful of the firm has always been told by the literature to lie in non tradable assets leading to in-house exploitation and technology sold at higher prices (quasi-rents). Some technology may have resulted to be underexploited, wasting some value (cfr Teece, 1988 the conclusions).Big firms have incentive to invest in technology to access to complementary assets: by realizing co-specialized asset firms can maximize their return from a development of a new technology. When the assets get tradable, the complementary assets lose their crucial role. Still, transaction costs may make in-house development comparatively advantageous due to incompleteness of contracts, cognitive factors and market imperfections. M4T do not imply conversion to market mediated knowledge development nor a unique business model but they: lower entry barriers, increase competition, suggest alternative strategies.If the innovation is not extremely huge, firms may choose the market even if the invention is general. Codified knowledge is easier to get traded due to the protection conferred by IPRs. M4T provide a valuation tool for the value of a technology disembodied from other assets. If more competition is downstream rather than upstream, the firm will engage in licensing.Tradeoff in licensing between revenue effect and profit dissipation effect (loss of market share). Multiproduct firms overcome this problem licensing only where their market is smaller.M4T: lower transaction costs, increase competition, push management to focus on IPRs, push for venture capital financing as more ‘patient’ form of capital.


For small firms more difficulty due to the efficiency issues of both M4T and market for complementary assets due to their small bargaining power. However, integration may harm and hurt the culture of the firm, as they have comparatively larger incentive to exploration rather than larger firms. M4T increase the effects of the ‘NIH’ (Not invented here) syndrome as increases the probability of duplication of invention. Monitoring the M4T may lead the firm to develop new innovations specific to local markets. Specialization leads to production where it is more efficient. At industry level, M4T lowers the barriers to entry giving the possibility to buy the assets and gives birth to industry specific suppliers. M4T shortens the Product Life Cycle and makes technology a less effective leverage of competitive advantages. M4T encourages the exit of the inefficient firms. Dynamic capabilities rather than stock of technology should be sought to get the competitive advantage.

Do Scientists Pay to Be Scientists? (Stern, 2004)

Properties of abstract knowledge production are non rivalry, expropriability and cost to monitor. That leads to inefficient levels of R&D. On the other hand, science has a discretion in choosing the projects and has a particular reward structure based on intellectual priority.There are two explanations for science oriented approach: researcher likes to interact in their community, the firms adopting science may gain in productivity.There are no conflicts between participation versus spillovers prospective, but they have different effects on scientists’ wages. Economics of science. Science leads to theories which bring technological applications unrelated to scientist’s aim (ec. Spillovers). A strategy which differentiates from IPRs and Trade Secrecy as Science is involves the complete disclosure of the knowledge produced. Dasgupta and David (1994) and David (1998) focalize on the scientists’ inefficient behavior because a priority based system of incentives on one hand discourages shirking, but on the other hand creates too much knowledge diffusion.Rosenberg (1990), Cohen and Levinthal (1990) and Arora and Gambardella (1993) treat knowledge spillovers as a tool to improve productivity as science orientation is repaid by higher rates of technological innovation. The two perspectives are not conflicting even if the literature confounds preference and productivity effect. The model. The model is an empirical one based on 164 job offers to 66 postgraduate scientists. The results are negative effects of science incentives on wages. i.e. scientists ‘pay’ to be scientists. The ordinal data from the analysis reinforces the outcomes. They are the only professional community where ‘ethics’ influence so much their behaviors.


Policy suggestion is to subsidize science as it spurs long term technological change. One critic point is that providing too high explicit rewards ($$$) to applied research may undermine the peer review reward system, raising the average costs of knowledge production.

Breakthroughs and Long Tail of Innovation (Fleming, 2007)

The large majority of inventions are useless, only a few bunch in the so-called ‘long tail’ (of a Log-normal distribution) are breakthroughs. The statement holds for any kind of measure of quality of the innovation.Three factors help us to understand the arise of breakthroughs: 1) shots on goal; 2) average scores(μ); 3) Maximum scores (σ).Lone inventors. They generate fewer inventions (as it is the result of creative recombination of knowledge) which are less likely to be used or further developed but they have greater variance of output. To have a lone inventor in a lab, the firm needs to be aware of the frequency of failures.Influence of Collaboration. Brokered collaboration is made of individuals who interact with an individual called ‘hub’ who has first access and control of the information. He has more inventions but they are less likely to be used and developed. The organization is dependent on the ‘hub’ guy when technology transfers need to be performed.Cohesive collaboration is made of separate and independent relationships.The management needs to be able to ‘fine tune’ the trade off in order to catch the advantages and avoid the disadvantages of the two collaboration approaches. None of the approaches is per se superior but it depends on the culture and the organizational environment.Role of Gatekeepers. Gatekeepers span the boundaries of the firm among different groups. They increase the firm’s inventive capacity by adoption of other’s inventions. Such a network may facilitate the diffusion of knowledge but can be a disadvantage for firms which want to retain their knowledge and can magnify the effects of ‘NIH’ syndrome.Diversity. Diversity within teams may increase the average number of efforts but not their average rate of success. On the other hand can increase the variance and therefore, the probability of breakthroughs. Science. Scientific procedures reduce the variance leading teams to produce less attempts but with higher expected value.

A Knowledge-Based Theory of the Firm (Nickerson, Zenger, 2004)

The aim of management is not how to exploit the existing knowledge but how to create new one. This is a knowledge based theory of the firm. This kind of literature seeks a theory without transaction costs nor assumption of opportunism: firms exist to economize on knowledge rather than to attenuate opportunism. A critique received is that the literature succeeds to explain knowledge exchange rather than knowledge production. There are contradictory claims on relation between hierarchies and knowledge production.


The critical question of the paper is how to organize people to generate knowledge. The value of the knowledge gets identical to the value of the problem. The latter depends on two factors: value in the array of the solution and cost of discovering it. Solution to complex problems depends on unique combinations. The solution to a problem may be depicted as a landscape and the search may be represented as heuristics on the landscape’s topography. The management has to choose on how to organize the search, whether to make or buy the required knowledge. The choice of the problem happens by expected value of their solution and the capabilities of the firm. Simon (1962) conceptualized a complex system as the “number of parts interacting in a nonsimple way”. The recombination of existing knowledge represents the solution to complex problems.The degree of interaction influences the topography of the landscape: Low interaction implies smooth and predictable landscapes with low height of the peaks and

maximum reached by incremental innovation. High interaction implies valleys and peaks, peaks are higher and no correlation of similar solutions.Taxonomy of the problems. Decomposable problems. They can be divided into many independent sub-problems. Each of them adds value to the system. Non-decomposable problems. Interaction among choices, any actor with only a specific set of knowledge can’t add value to the system. Nearly decomposable problems: degree of decomposability is influenced by some trade-offs.Taxonomy of the search.Local of directional: incremental, guided by feedbacks, one element altered at each time. Cognitive or Heuristic: movement due to heuristics, theory driven structures, different elements involved.Knowledge Formation Hazards. Knowledge appropriation. Moves from Arrow’s Paradox on knowledge, agents have incentives to extract the other party’s knowledge. Cognitive limits make difficult to protect it by contracts. Strategic Knowledge Accumulation. Actors strategically retain knowledge in order to maximize their own (partial) value rather than the system’s value.Both hazards are irrelevant when the problem is nearly decomposable. Governance alternatives for mitigating hazards. Governance is characterized by: i) decision rights; ii) communication channels; iii) incentives to search .

Market. Organized dispersed knowledge and creates new one. Markey induces people to do desirable things without telling the to do. Control is decentralized to knowledge holders: search is an aggregation of many different independent searches. There are incentives to expand one’s knowledge but weak support to knowledge sharing. Markets perform much worse when complex problems arise due to the costly and overwhelming system of contacts and law enforcement. When contracts are adopted, hazard is easy to happen.Authority Based Hierarchy. Authority in this governance system is established in order to reach efficiency in the knowledge transmission. A central agent is looking for knowledge interaction and


composes heuristics. By this way the solution landscape is narrowed. Whenever the manager is overconfident problems may arise. It is suitable to nearly decomposable problems.Consensus Based Hierarchy. It is a knowledge-based form of governance, where there is knowledge sharing and common search heuristics. A ‘social community’ that creates and transfers knowledge in a quicker and more efficient way than markets . Boundaries of the firm coincide with the scope of social knowledge available. Low powered incentives are crucial to obtain consensus and foster knowledge sharing. This solution is optimal only if problems are highly complex, whenever they are nearly decomposable, authority based hierarchies over perform the consensus based one.Conclusions. The paper provide why and when firms exist, and how they solve problems. Sill, the theory does not take into account interdependences of problems on choice of governance. The theory provides a problem life cycle where problems start from being complex to be decomposable (cfr. Chesbrough and Kusunoki) with a consequent shift from CBH to Markets.The management needs to practice very much a self evaluation and recognize their limits in order not to fall into the fallacies of ABH.

Landscape Design (Levinthal and Warglien, 1999)

The theory moves from Kauffman (1993) for NK models, Simon (1952) about the adaptive behavior of agents. In the search process surface is more important than the peaks. Interdependencies are the key issues of the paper. Fitness landscape can be employed from individual to organizational level.Fitness. It is influenced by several elements such as business strategy, human resource policy and manufacturing. Can be represented by profits or a set of variables related to a goal. Peaks are representing the best strategic answer, they are Nash Equilibria. Intelligence of the agent is local (otherwise no difference between smooth or rugged landscapes) and incremental search leads to ‘hill climbing’ according to a certain basin of attraction towards a local (or global) optimum.Single Peaked Landscapes. Whenever a landscape is smooth or robust (K/N is near to zero) independently from the starting point the search will lead to an improvement. Such a design may be useful when it is not clear where the solution is but the designer is confident that such a solution would be found or approached. In this way experimentation costs are avoided. A way to design a robust landscape is to implement ‘baka yoke’ procedures which induce only one behavior.Rugged Landscapes. Whenever a landscape is rugged, local search may lead to an ‘imprinting effect’ that binds the agent toward a local peak. Rugged landscapes may be sought whenever exploration is needed. A way to obtain such landscapes is to develop cross functional teams which are able to highlight the interdependencies of the problem. A variety of alternative designs is likely to emerge: matrix structures encourages the finding of interdependencies. This kind of search is more likely to lead to breakthrough or platform innovations. Once such inventions are discovered, some independences may be restored to foster incremental research (see Problem Life Cycle in Nickerson an Zenger, supra). Multiple starting points are needed in order to fully explore the landscape.


Coupled Landscapes. Cooperation may lead to coupling of landscapes which may deform the landscape and induce the need of change. Coupling leads to conflicts: social dilemmas are overestimated by the theory: even if the level is far from optimum, pure free riding does not occur. However incentives need to be realigned: when common pool resources are deployed, agents face illusory hill climbing given by the benefit of cooperation, despite the individual peak is getting further. The number of players may harm the cooperation benefit as increases the likelihood of opportunistic behaviors.Rigidity to organizational change (no collaboration) stems from reluctance to recognize the flaws in the incumbent business strategy need of consultants to induce the change. Landscape Communication and Representation.Communication has a particular value for rugged landscapes: without it, agents are more likely to choose the less risky but less valuable alternative, when communication exists they coordinate towards more ambitious alternatives.Strategy guide may be given by ‘Postcard Landscapes’ i.e. simplified and maybe wrong representation may lead actors to go towards a direction believed as a gradient.

Exploration and Exploitation in Organizational Learning (March, 1991)

Model. External reality as an m-vector where each element can assume the values 1 or -1 with probability .5. Beliefs about reality are held by individuals from an organization and by an organizational code. The elements of such m-dimensional vectors may have as values -1, 1 or 0 (they are neutral). Individuals may change their beliefs within the organization: If the element of organizational code is 0 it has no effect on the individual perceptions. If elements differ, individual may learn from the code with probability p1. If elements differ, dominant beliefs may influence the code with probability p2.The process begins with an organizational code with neutral beliefs on all dimensions. The beliefs among individuals are affected through the code.Outcomes.Simulations are made. The highest output comes from a scenario where p 1 is low (small socialization) and p2 is high (permeability of the code). Slower learning of individuals lets the possibility of more exploration. A superior performance occurs with an heterogeneous population of workers. Slow learners do not benefit from fast learners while it is true for the opposite. Turnover may help when the socialization rate is high. Otherwise it shows only monotonous decreasing. When turnover happens, less socialized people come in and increase the exploration (benefit from diversity). The work of old-timers is more knowledge intensive but redundant with respect to the organizational code. Turnover makes possible to the organizational code to be updated and adapted to the shifts of the real world vector. The probabilities of turnover are depicted by p3 and the probability of shift in the real world is p4.


The model wants to stress the relevance of exploration with respect to exploitation which tends too easily to inhibit it. Sometimes socialization and fast learning do not imply positive outcomes. The development of knowledge needs to maintain an influx of naïve and ignorant, not automatically leaving the victory to whom is properly educated.

Neuroscientific Foundations of Exporation-Exploitation Dilemma (Laureiro Martinez et al., 2010)

4 gaps in exploration-exploitation dilemma literature : 1) No analysis of environmental effect in changing behavior2) No analysis of how exploration and exploitation occur and which level is interested3) Different definitions of exploration and exploitation4) Microfoundation focus on team’s ambidexterity and not individual’s.Group building: cognitively specialized groups lead to political battles and their decision has to face a cognitively oriented manager. Flexible managers would reduce the issue of political fights and suboptimal decisions. Microfoundation of the exploration-exploitation dilemma. Exploration/exploitation as defined by neuroscience. Attention is regulated by Locus Coeruleus which interact with Anterior Cingulate Cortex and Orbito-Frontal Cortex. LC phasic activation leads to exploitation, while LC tonic activation leads to exploration. There is evidence from LC activity using pupil movement as a proxy. Higher the uncertainty, the more explorative will be the behavior, this happens bat the low expected utility experienced by the individual. The higher the Expected utility, the more exploitative the behavior will be. Risk tolerance may alter the expected utility perceived and leads to different outcomes. Relevance also of expected and unexpected uncertainty. At individual level exploration and exploitation are orthogonal while at group level they lie in a continuum.Case of Menlo Park. Edison was able to turn properly to exploration or exploitation according to the stages of development of his inventions: issue of the cognitive flexibility. Conclusions. Decision making depends on: (i) level of uncertainty, (ii) utility assessment, (iii) arousal of attention mode, (iv) behavior manifestation. Trade off solving: at micro level what matters to balance the trade off is not specialization but cognitive flexibility of the decision makers. Aggregation of individuals choice remains the limit of neuroeconomics. Perils of extreme outsourcing to pursue extreme specialization.At macro level the theory opposes to March’s issue of turnover to introduce novelty the issue of neurological characteristics as the way to induce slower socializationThe paper can be a teaching tool to develop cognitive flexibility.

Organizational Routines as a Source of Flexibility and Change (Feldman and Pentland, 1996)

Routines are the primary means by which a firm accomplishes her task. They are thought to be source of inertia but also as source of accountability. They are efficient in organizing the enterprise and exercising the power. Meta-routines are the procedures to be follower to change routines; they may be source of


change and flexibility. The paper states that the routines by themselves can be source of change and flexibility. In the previous literature they are thought to change in cases of: early stage, ambiguity and crisis by means of adaption and mutation. A routine is defined by the literature as a repetitive and recognizable pattern of interdependent actions performed by multiple actors. They have a dualism embedded: structure as the abstract idea, agency the action performed by a specific person in a specific place at a specific time. The presence of agency in the routine definition makes them as more oriented towards the possibility of change by adaption and learning. An example of routine brought by the paper is academic hiring.There are three metaphors in theorizing routines: (1) organization as a human body, (2) routines as a computer program, (3) routines as genetic material.Origin. Routines come from the need of complexity reduction , cognitive efficiency, response to managerial goals and environmental pressures. They legitimate organization as an institution which reduces conflicts by exercising of the power. Routines emerge when individuals take easer actions avoiding other harder and they have these effects: Stability, deskilling, mindlessness, demotivation, inertia; Organizational memory; Tools for learning;The paper focuses on structure rather than agency part. Approaches from genetic definition of routines as genealogical entities passing information largely intact by successive replications. There are problems with mainstream theory as it lacks of the consideration of human interaction treated as exogenous, while data from empirical work is controversial. A new Ontology of Organizational Routines. Stems from the analysis of power in principle and in practice. Both aspects are present also in routines.Routine is composed by: a) ostensive part. Ideal or schematic form. b) performative part. Ostensive aspect is codified as a standard operative procedure or a taken-for-granted norm. Tacitness embedded, it is not a single even but it is subjective and unevenly distributed. Its definition cannot encompass any specific performance or contextual detail.Performative aspect is each action which comes from common background and rules, it is somehow unique as it encompasses at least a reflexive self monitoring. It is possible to interpret the code and sometimes make variations. The improvisational behaviors set precedents and establish altered expectations. Performative aspect is a constant stream of variations and exceptions. Such definition is still consistent with the first dualism structure/agency and to the first definition of repetition, recognizable by multiple agents and interdependent actions.A new understanding. Repetition: routines are performed over time as sum of performances.Recognizable pattern of actions: only a core pattern of actions is always performed.Multiple Agents: Knowledge is unevenly distributed (see Garicano, 2000) .Interdependent Actions:

web viewnotes on industry and firm ... governance is practice of authority, direction and control....

Documents