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Influential economic concepts for strategic management theory

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Four economic concepts are regarded as influential in the field of strategic management: evolutionary theory, transaction cost economics, agency theory and game theoretic concepts (Rumelt et. Al., 1991: 14).

The major influence of the concept of evolutionary economics started to take place in the 1940s.

Schumpeter (1934, 1912), Nelson and Winter (1982, 2002) and Teece (1980, 1986) can be mentioned as representative authors.

These concepts derive from an initial development concern. Principal assumptions are that rationality of the actors is limited and available choices are unknown.

The engine of growth is seen in innovation (technical change) from entrepreneurship in owner operated firms and research and development in developed managed firms.

Price and stable market competition is secondary to change from innovation. The dominant decision rule of this concept is that skills have to be developed for the performance of routine tasks and free resources to develop or imitate revolutionary innovations.

The principal concerns are the processes of economic development, firm growth and performance.

This perspective provides an alternative theoretical perspective to orthodox economics and strategy which focuses on the development of stable prescriptive frameworks and models from the identification of key forces or elements.

The strategic direction of this perspective lies in the recognition of the importance of innovation in processes, products, markets and technology.

Outcomes of this view with regard to explaining competitive advantages are that firm differences are discretionary and that the role importance and limitations of organizational routines and individual skills are investigated.

For Nelson and Winter (1982) such routines play a similar role as the genes in biological evolution theory and cover firm characteristics

that range from well specified technical routines for producing things, through procedures for hiring and firing, ordering new inventory, or stepping up production of items in high demand, to policies regarding investment, research and development (R&D), or advertising, and business strategies about production diversification and overseas investment.
(Nelson and Winter, 1982: 4)

Routines build the basis for organizational capacities “which are not explicitly comprehended, but which are developed and bettered with repetition and practice” (Rumelt et al., 1991: 16).

Competition and selection is seen as instrumental in performance. Further, the centrality of individual competencies and organizational competencies is acknowledged and dynamic capabilities are noted.

From this perspective it is necessary to find ways to develop and maintain capabilities. In addition, the role and importance of tacit knowledge is seen.

Nelson and Winter (1982) combined the concepts of tacit knowledge and routines with the dynamics of Schumpeter’s (1934) competition, Competitive advantages from this view can be realized for a certain time by being the innovator in a particular area.

Nelson and Winter (1982) further outline that long-term effects are possible since innovative firms generate innovations constantly (“success breeds success”).

Linking tacit knowledge, routines and dynamic competition leads to a situation where firms are not simply able to copy best practice, even though they can observe it. Strategies cannot easily be changed from this view.

To sum up, the key idea is that organizational capabilities are based on routines that cannot be explicitly comprehended.

These routines are developed and bettered by repeating and practicing them (Rumelt et al., 1991: 30) to.

Because of this, the historical evolution and firm capabilities best practice cannot be easily intarted.

The major influence of the concept of transaction cost economics started to take place in 1975. Coase (1937, 1984, 1992) and Williamson (1975, 1985, 1991) can be mentioned as representative authors.

Principal assumptions of this concept are that the individual behavior is governed by bounded rationality and opportunistic self-interest.

Transaction economic concepts assume competitive markets which are characterized by complexity and uncertainty and acknowledge unique and specific assets.

Information can be asymmetrical and transactions are not seen as costless. The appropriate unit of analysis here is the, transaction.

The theoretical perspective of transaction costs states that transaction cost-benefit ratios determine governance possibilities.

In addition, it is stated that institutional arrangements and interactional effects of principal assumptions determine the nature of contracting.

Research questions front this theoretical background include: “Why do firms exist?” and “Why do markets fail?”

The focus is on the determination of ‘alternative forms of governance. Transaction costs have an impact on all the explanations in different contexts.

Contributions to the explanation of competitive advantage are that strategy does not only involve knowledge and manipulation of market power forces (characteristic of firms operating in final goods markets) but also the need to be efficient (characteristic of firms in primary and intermediate goods markets).

Williamson (1991) in this context states that in the long run “the best strategy is to organize and operate efficiently” (Williamson, 1991: 75).

He sees it as the core message of the transaction cost perspective that “economy is the best strategy” (Williamson, 1991: 76).

In transaction cost research the appropriateness of different organizational forms and modes of governance is analyzed and efficiency explanations for hierarchy as well as vertical and horizontal integration are given.

Transaction cost economics show the role importance and difficulty of contracting as well as the importance and implications of the uniqueness of assets.

Within the field of, strategic management, transaction cost economics can be seen as “the ground where economic thinking, strategy and organizational theory meet” (Rumelt et al., 1991: 14).

Agency theory and transaction cost economics both deal with transaction employment. However, while transaction cost theory is based on the assumption that it is not possible to write enforceable contracts and thereby cover all contingencies, agency theory seeks the optimal contract form (Rumelt et al., 1994: 28).

The major influence of the concept of agency theory started to take place in the 1970s. Jensen (1983, 1989) and Jensen and Meckling (1976) can be mentioned as main contributors to this field.

Agency theory evolved from combining concepts derived from behavioral and transaction economics on the nature of governance.

Financial incentives to motivate workers (i.e. in terms of various contracting issues) are the center of attention.

In the framework of thoughts of the agency theory a principal i.e. an individual or an organization delegates responsibility to an agent to act on its behalf.

Because of information asymmetries and self-interest the agent does not always act in the interest of the principal.

Resulting problems are analyzed by agency theory approaches. Central concepts are “moral hazard” and “hold up.”

Agency theory is concerned with “the design of incentive agreements and the allocation of decision rights among individuals with conflicting preferences or interests” (Rumelt et al., 1994: 28).

Principal assumptions of this concept are that while economic rationality is bounded, choices are known.

In this framework of thoughts individuals with different interests maximize utility and optimize contracts.

Capital markets are seen as efficient. The focus lies in the identification and calculation of agency costs to determine optimal relationships.

Main research questions are: “How do market forces affect organizational behavior?” and “What are the characteristics of the relationships between principal and agent?”

The problems of corporate control of financial claims and organization structure are investigated.

The objective is to find efficient forms of resource allocation in this context. Rumelt et al. (1991: 15) differentiate agency theory into two branches.

While the principal-agent literature focuses mainly on optimal contract design, the less technical corporate control branch deals with designing financial claims and overall governance structures of the firm (e.g. Shleifer and Vishny, 1991).

Contributions to the explanation of competitive advantage of agency theory are that firms are conceived as a nexus of contracts confronted with different individual interests, moral hazard, hold up and asymmetrical information and the statement that cooperation produces agency problems.

This theoretical perspective also creates awareness that if markets are efficient the market reality cannot be denied, and reactions against market discipline impose costs on firms.

Strategic outcomes of time agency perspective are that it is necessary to monitor the behavior of managers, directors and other organization members.

This approach demands optimal incentive packages on the presumption that effort and performance are related to the reward.

These presumptions are derived from economic assumptions. Jensen’s (1986) “free cash flow” theory of leverage and takeover provides a “valuable framework for strategic management research” (Rumelt et al., 1991: 15).

This perspective is only able to explain certain phenomena with regard to the realization of competitive advantages, and is far from delivering a holistic image of business organizations.

The major influence of the concept of the game theory applied to firm behavior started to take place in the 1980s Spence (1971, 1981), Kreps et al (1982) and Milgrom and Roberts (1990) can be seen as main contributors to this field.

In this concept, traditional assumptions are modified. Strong rationality assumptions are reduced to common knowledge for equilibrium sufficiency.

Choices are known but uncertainty resides in the intentions of others. Actors in this theoretical perspective optimize their individual preferences.

The nature of generated rents is Chamberlinean, i.e. firms thrive for monopoly rents. Firms and products are the fundamental units of analysis.

The role of industrial structure is interpreted as endogenous (Teece et al., 1997). Strategic interactions are the principal concern of game theoretic reasoning.

It is differentiated with regard to the information assumptions (complete or incomplete information) and the time structure (one-shot games, repeated games or dynamic games).

Repeated or dynamic games with incomplete information are seen as especially relevant for strategic management.

These approaches from game theory include the assumption of information incompleteness and imperfection.

However, game theoretic thinking is still based on rationality assumptions to a wide degree, which seems to be problematic for a “realistic” theory of strategic management (Teece, 1990: 48-9).

The rationality assumption of the game theory manifests in the “common knowledge assumption,” i.e. player 1 has rational expectations about the assessment and behavior of player 2, who in turn has rational expectations of how player 1 will act (Schelling, 1960: 87).
The idea that a rational individual is one who maximizes utility in the face of available information is simply not sufficient to generate ‘sensible’ equilibria in many non-cooperative games with asymmetric information.

To obtain ‘sensible’ equilibria, actors must be assigned beliefs about what others’ beliefs will be in the event of irrational acts.

(Rumelt et al., 1991: 15)

Shapiro (1989) developed a theory of business strategy building on this framework of thoughts.

The result of his approach to use game theoretic tools for the analysis of the nature of competitive interaction between rival firms, however, cannot be regarded as a holistic theory of strategy.

Because this approach was not very successful in reaching its main objectives it has only made little contribution to strategic management till now (Teece et al., 1997: 511-1 3).

Even though outlining moves and countermoves of competitors might be useful in situations where competitors have no deep-seated competitive advantages there are many situations where a game theoretic formulation of these interactions is either impossible or not very insightful e.g. when there are major asymmetries between the competitive advantages of the competitors just “playing a good game” cannot ease such asymmetries (Teece et al., 1997: 612).

However, what game theoretic approaches in the field of strategic management have achieved is to provide insights into the consequences of commitment (Ghemawat, 1991), such as asset specificity, access capacity or research and development.”

Ghemawat (1991) sees commitment as crucial for a strategy. Further insights into the consequences of beliefs about reputation (Milgrom and Roberts, 1982) as well as signaling (Spence 1974) are achieved .71)

In games where an actor can have different types and “others must form beliefs about which type is the true one” (Rumelt et al., 1991: 16), reputation arises as a relevant factor.

These single contributions are meanwhile widely accepted in the field of strategic management to yield powerful insights (Rumelt et al., 1994: 30; Teece et al., 1997: 513).”

The contribution of game theory applied to firm behavior to the explanation of competitive advantage realization lies in stating that competitive strategy involves not only determining the likely action of rivals but also signaling intentions (true or false) to rivals.

The relevance of commitment and reputation in strategy design is acknowledged. The outcome of research from this perspective is the finding that multiple equilibria exist that support concepts of strategy as unique and particular.

Finally, more insights into the inventiveness of human behavior are provided by modeling different concepts of mutual action and reaction taking into account interdependencies of past and future behavior of actors.

Contributions from evolutionary, transaction cost, agency and game theory to the explanation of competitive advantages went into the dominant strategic management concepts to be outlined in the following section.


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