Traditionally, inter-firm governance decisions about whether a firm
should choose a market contract mode, hierarchical governance mode or
hybrid form of governance (such as joint venture) have been mainly
discussed in the transaction cost theory (Coase, 1937; Williamson, 1975,
1985). According to transaction cost theory, exchange governance choices
are made on the basis of the comparative cost of alternative modes.
Hierarchical governance substitutes market governance when markets fail
due to high transaction cost. This is because hierarchical governance
reduces transaction cost by its ability to control the opportunism
inherent in a market transaction. Since transaction cost theory
postulates that firm organizations exist due to a set of market
failures, this theory is frequently referred to as the theory of the
firm among business and economics scholars.
Indeed, the influence of transaction cost theory on management
literature and related business disciplines is truly impressive. Besides
addressing strategic issues such as make-or-buy decisions (Monteverde
& Teece, 1982; Bigelow & Argyres, 2008), vertical merger
(Spiller, 1985; Weiss, 1992), and diversification (Teece, 1980), the
theory has also been applied to other business and management areas such
as technology and R&D management (Robertson & Gatignon, 1998),
international business (Hennart, 2010; Buckley & Casson, 1976),
finance (Williamson, 1988), and marketing (Dwyer & Oh, 1988).
However, transaction cost theory has been received many criticisms
as it had been adopted in other areas, especially in management (eg.
Donaldson, 1990). Moreover, some scholars in management areas suggested
alternative theories of the firm based on other perspectives such as
capability or knowledge-based theory (Conner & Prahalad, 1996;
Grant, 1996) and real option view (Scherpereel, 2008). It seems that
most of the criticisms on transaction cost theory and central tenets of
so-called new theory of firms center on the fact that transaction cost
is not the only determinant that delineates the boundary of the firm.
Consistent with such trend, this paper explores a rather neglected
aspect in market vs. hierarchy decision.
This paper is organized as follows. First, key concepts of
transaction cost and its critique, along with new theories of firm will
be reviewed. Second, an alliance formation perspective in market vs.
hierarchy decision will be presented. Finally, concluding discussion
2. CRITIQUES ON TRANSACTION COST THEORY AND ALTERNATIVE THEORIES OF
2.1 Criticisms on Transaction Cost Theory
In his seminal article, "The nature of the firm", Coase
(1937) first posed the question: why do firms exist? He asked why there
are organizations when the same production activity could be regulated
by the price mechanism in the market. Central to this question was the
notion that markets and organizations are alternatives for carrying out
the same productive activity. He reasoned that firm organizations exist
when the cost of managing economic exchange across markets is greater
than the cost of managing economic exchange within the boundaries of an
Coase's focus on transaction cost as a foundation of firm
organization was further developed by Williamson (1975, 1985). As
Williamson (1985) put it, the transaction cost logic of economic
organization had its origins in a tautology, which Coase (1988) defines
as "a proposition that is clearly right". In order to avoid
being a tautology, the concept of transaction cost was operationalized
by Williamson according to the attributes of a transaction. It has been
suggested by Williamson that asset specificity, coupled with the human
assumption of opportunism, plays a central role in transaction cost
theory (Riordan & Williamson, 1985).
However, criticism on Williamson's transaction cost theory
came from the same transaction cost theorists. For example, Coase (1988)
stated that he had already thought about the possibility of asset
specificity and opportunism in his original 1937 article, but rejected
it as a general explanation of vertical integration. Consistent with
Coase, many management scholars also criticize the assumption of
opportunism in the market transaction as overemphasized and unnecessary
(Granovetter, 1985; Donaldson, 1990; Hill, 1990; Ghoshal & Moran,
1996). For example, Donaldson (1990) argued that the assumption of
opportunism is too narrow in modeling human motivation and carries a
negative connotation in our society. Also, Granovetter (1985) treated
the assumption of opportunism as 'undersocialized', and
suggested that it can be attenuated depending on the social context in
which economic transactions are embedded. He has argued that since
exchange partners are deeply embedded in social relationships, they are
prevented from behaving opportunistically in order not to put their
social network relationships in danger. Similarly, Hill (1990) argued
that in the long run, the invisible hand of the market deletes actors
and punishes those whose behaviors are habitually opportunistic. As an
illustration, Hill (1995) stated that Japanese firms are believed to
incur lower transaction cost than U.S. firms because they have developed
an institutional environment which fosters relational trust. In
addition, some authors suggest that opportunism can be treated as a
variable instead of a fixed attitude among exchange partners (Ghoshal
& Moran, 1996).
Also, transaction cost theory suffers from the lack of empirical
support. For example, David and Han (2004) recently reviewed 306
statistical tests from 63 empirical papers on transaction cost and found
that overall empirical support for transaction cost theory was 47%. As
for the support for each independent variable, asset specificity
received 64%, which was the highest. On the other hand, the support for
uncertainty was only 24%. Similarly, Carter and Hodgson (2006) closely
examined more prominent and influential empirical tests on transaction
cost theory and concluded that empirical evidence does not decisively
support Williamson's transaction cost theory. Furthermore, they
even suggested that a significant number of the studies can be
reinterpreted in terms of a competence or capability-based approach. In
the next section, some of the representative studies on capability-based
(also called as resource-based, competence-based) theory of firm will be
2.2 Alternative Theories of the Firm and Critique
In the past, alternative theories of the firms were proposed
largely because there had been some dissatisfaction with the
assumptions, logic and predictions of existing transaction cost theory.
For example, based on the evolutionary economics, Kogut and Zander
(1992) emphasized internally accumulated knowledge, capabilities and
organizational routines as a basis for a firm's expansion and
growth. Thus, they proposed that the growth of the firm is built upon
the recombining current capabilities and existing knowledge. This notion
generates a rather tautological proposition such as "what a firm
has done before tends to predict what it can do in the future"
(Kogut and Zander, 1992: 383). The extreme internal focus of this view
is probably due to the fact that while transaction cost theory focuses
on the exchange, evolutionary theory is mainly concerned on the internal
Applied to the firm's make-or-buy decision, these authors
suggest that firms grow by vertical integration (i.e. greenfield
investment) because they are capable of performing a particular activity
better than anybody else (Kogut and Zander, 1992). However, they also
extend their view on the exchange possibility by suggesting that if a
more qualified supplier exists, then outsourcing will be chosen. This
view was frequently called as capability view of outsourcing. Kogut and
Zander (1992), to support this argument, cited empirical tests of the
transaction cost theory conducted by Walker and Weber (1984) and
Monteverde and Teece (1982). Although evidence that support transaction
cost theory was found in both studies, in Walker and Weber (1984), the
most important variable to explain make-or-buy decision was differential
firm capabilities (measured as production cost). Also, in Monteverde and
Teece (1982) study, the most significant variable was the dummy variable
for the firm itself. Additional supporting arguments and empirical
evidence indicating the importance of the capability difference in
governance choices are suggested by other authors as well. For example,
Argyres (1996) examined vertical integration and outsourcing decision in
an in-depth case study and found strong support for the capability
perspective. Consistent with Kogut and Zander (1992), he found that
firms vertically integrated activities for which they possess
capabilities that are superior to potential suppliers', and
outsourced when suppliers possess superior capabilities. These
theoretical arguments and empirical results support the assertion that
the consideration of comparative firm capability is an important factor
in make-or-buy decisions. Similar arguments were made from
resource-based view (Conner and Prahalad, 1996) and knowledge-based view
(Grant, 1996). Real option view on theory of firm can also be
interpreted from the capability perspective because it assumes
capability differences in exchange relationship (Scherpereel, 2008).
However, the competence view suffers from extreme reliance on
organizational capability in predicting the exchange governance choice
just as transaction cost theory exclusively pointed out the problem of
transaction. In addition, both transaction cost theory and capability
theory, although they represent the opposite side, mainly focus on
dyadic transaction between two organizations without equal attention to
other strategic factors that lie beyond the dyadic relationship. In the
next section, alliance building framework which takes into account the
broader strategic influence on the market vs. hierarchy decision will be
3. MARKET VS. HIERARCHY: ALLIANCE BUILDING FRAMEWORK
3.1 Alliance Building to Win Standard War
It is well-known in the technology management literature that firms
deliberately license their technology to competitors to dominate the
technological standard (Shapiro and Varian, 1999). This happened in the
standard war between VHS and Betamax. Although the Beta format of the
VCR had a first-mover advantage of more than a year, and it was
generally believed that the quality of Beta format was superior to VHS,
it lost the standards war to the incompatible VHS format and exited the
consumer market in 1989. This was because Matsushita, which manufactured
VHS format video tape recorder, chose a licensing strategy under which
any consumer electronics company was allowed to manufacture VHS format
players under license. On the other hand, Sony did not pursue this
strategy. Accordingly, many electronics companies including
Philips--Matsushita's competitor--began to produce VHS format. As
sales of VHS players started to grow, movie studios issued more films
for rentals in VHS format. This made the market tip towards VHS players
and eventually VHS became the de facto standard for VCRs, while
Sony's Betamax technology was locked out. The positive feedback
effect between VCR players and VCR tapes is often called indirect
network effect (Katz and Shapiro, 1985). Similar results were observed
in PC industry when Wintel became de facto standard, defeating Apple.
Unlike Apple, Wintel system adopted open strategy and produced many PC
clones by licensing. This in turn increased the number of independent
software vendors, which gave positive feedback to PC manufacturers. More
recent examples include technology dominance battles in modem, high
density DVD format (HD DVD vs. Blu-ray) and etc.
The implication of the standard battle is obvious. When there are
competing standards, aggressive licensing strategy is important in
building an installed based. If Matsushita had followed either
transaction cost or capability logic, it would have not licensed its
technology to its competitor Philips. For example, under the transaction
cost logic, licensing is a feasible alternative only when the level of
transaction cost is minimal. However, Philips is a direct competitor to
Matsushita. For Matsushita, a transaction with a competitor like Philips
will certainly involve high degree of transaction cost, and therefore
should never license the technology. Matsushita's licensing
strategy cannot be explained from capability view either because
Matsushita possess the technological capability that can be exploited by
itself. Therefore, there was no reason for Matsushita to license the
technology in either theories. However, by licensing to competitors like
Philips, Matsushita was able to win the standard war. This means that we
need a different theoretical explanation for such a strategic alliance
to win technology standard war. To summarize, we can propose that a firm
will choose market transaction mode to build strategic alliances in a
standard war, even though the firm possess technological advantage and
the transaction involves high degree of transaction cost.
3.2. Alliance Building to Overcome High Organization Cost
There is also another motivation to use market governance, as
opposed to hierarchy, that does not rely on transaction cost theory or
capability view, but is related to the previously mentioned
'alliance building' motivation. Although this is an extension
of alliance building, it ultimately stems from problems arising from
high organizational cost. It is suggested here that when the cost of
changing organization becomes extremely high, then the firm will rely on
a third party in marketplace as an alliance.
One might argue that problems arising from organization cost had
been already discussed by transaction cost theorist in considering a
market vs. hierarchy decision. However, organization cost problems
suggested by traditional transaction cost theory are rather limited and
have not considered the alliance building incentive that arises from
high organization cost, which is presented in this paper.
For example, Coase (1937) did point out at least three sources of
organization cost. First, as a firm gets larger, there may be decreasing
returns to the entrepreneurial function. Second, as the transactions
which are organized increase, the entrepreneur fails to make the best
use of the factors of production. Third, the supply price of one or more
of the factors of production may rise (for example, Coase suggest that
salary in a larger organization may rise to attract entrepreneurs who
can enjoy freedom in small companies). Coase also noted that "the
costs of organizing and the losses through mistakes will increase with
an increase in the spatial distribution of the transactions organized,
in the dissimilarity of the transactions, and in the probability of
changes in the relevant prices" (Coase, 1937). In other words,
internal organization costs are likely to be higher for transactions
that are differentiated--by either their location or
characteristics--from other activities in which the firm is engaged, and
for which there is a greater degree of uncertainty. Supervision and
management of employees will be more difficult where managers are
unfamiliar with the production process, while more complex or uncertain
transactions demand a greater share of management's limited
attention and would also tend, therefore, to be more expensive to
administer. Masten, Meehan, and Snyder (1991), following Coase (1937),
suggested that organization cost would increase when differentiated task
(or 'low similarity task') is integrated within the firm.
Similarly, Williamson pointed out the problem of internal
production when he suggested that internal production sacrifices the
high-powered incentive advantages of market exchange and, consequently,
demands greater investments in monitoring and administration
(Williamson, 1985). He also noted that the hierarchy not only suffers
from lack of high-powered incentives, it has inherent problem of
internal conflicts when it is hard to attribute performance
responsibilities among divisions. The result is that internal
organization suffers from a different kind of incentive problem, and
therefore bureaucratic costs increases (Williamson, 1985). In the same
context, Hennart (2010) emphasized 'shirking' problem within
organization in the absence of high-powered incentives in multinational
In summary, transaction cost theorist classified organization cost
into two distinct categories. The first type of cost arises from
difficulty of administration as task differentiation and complexity
increases (Coase, 1937; Masten, Meehan, and Snyder, 1991). The second
type of cost is shirking cost that results from the lack of high-powered
incentive system in organization (Williamson, 1985; Hennart, 2010).
However, it will be proposed here that although these are major sources
of organizational cost, another important source of organization cost
has not been considered yet. And as stated earlier, this incentive
creates a need for external alliance building.
Before presenting a formal hypothesis, let us consider the
following market transaction examples that actually happened in a large
manufacturing firm in Korea. Firm A was a successful textile company in
Korea, but was faced with fierce competition and declining
profitability. There was no doubt that this firm desperately needed a
new strategic direction to survive. However, the CEO (and also the
owner) of firm A did not want any new changes in the organization. He
wanted to preserve old management style that worked well in the past,
believing that it could work well in the new environment eventually.
Although most of the senior managers who have deep knowledge of the
industry raised serious doubts on the CEO's judgment, nobody was
successful in persuading the CEO. Numerous internal reports and advices
that stressed the need for strategic change were simply ignored by the
CEO. How could this firm survive from gradual deterioration?
To cope with this problem, some senior managers persuaded the CEO
to hire a prestigious management consulting firm and ask for
professional advice on the future strategic direction. Fortunately, the
CEO finally agreed to this proposal, and a prestigious consulting firm
took this project. And in six months, the consultants produced an
in-depth consulting report that not only emphasized the need for new
strategic change but also contained practical implementation plans to
pursue this goal. In many ways, the consulting firm's report
resembled much of what the senior managers had been suggesting to the
top manager. However, the CEO could not simply ignore the consulting
report this time, because it had more authority. If the CEO dismissed
the report, then he would be ignoring advices from a prestigious
consulting firm and all the money and efforts that were poured into that
project would be of no use. As a result, the CEO decided to change his
mind and firm A was able to change its strategy as most of the senior
In the above example, capability view cannot explain firm A's
outsourcing decision because firm A possesses all the necessary
knowledge and capabilities to formulate and implement the strategy by
itself. Thus, according to capability view, firm A will never outsource
its strategic function. Also, from the transaction cost theory, the
initial outsourcing decision of firm A is not desirable--if not
impossible because such a strategic function is highly firm-specific and
involves high transaction cost. In addition, the threat of opportunism
and thus the need to vertically integrate the consulting firm is not a
matter of consideration here. Therefore, we can suggest that firm
A's outsourcing decision is independent of either capability or
The very reason why firm A outsourced its strategy formulation
function is that the firm is experiencing extremely high organization
cost. The organization cost involved here includes persuading the key
person in the organization so that the key decision maker fully
understands the reality of the market situation and change the strategic
direction of the company. Although all the organization members may try
hard to achieve this objective, sometimes it is virtually impossible to
change top decision maker's philosophy. In such a case,
organization change cost increases almost infinitely. Such an
organization problem has been pointed out in the literature extensively.
For example, some authors suggest that existing organization cannot
change its course of action because of 'organizational
inertia'. One of the reasons why some organizations face such
problems lies on fact that top management (or top management team
members) does not change their management philosophy. This is because
some of them (or all of them) believes that previous core competences
would continue to be of great value in the new environment. On the
contrary to their belief, many authors warns that previous core
competence rapidly becomes 'core rigidity' when the management
(or management team) fails to recognize the changes in environment.
Thus, we can propose that when there exists high level of organization
change cost, a firm may rely on market transaction in order to look for
an ally to backup the organizational change. This will occur even when
the focal firm already possesses high level of capability and there
exist high degree of transaction cost between two transaction parties.
In today's dynamic competitive environment, firms may engage
in thousands of different market transactions every day. However,
existing theories of firm do not seem to catch up with such a rapid
changes and varieties of market transactions that occur in the real
world. The most prominent theory that predicts market vs. hierarchy has
been transaction cost theory. Only recently, capability theory and real
option theory has been applied to this area with limited success. This
paper tried to fill the gap between the theory and reality by extending
the current theoretical argument to accommodate different market
There are at least two important contributions of the alliance
building perspective in the choice of market vs. hierarchy presented in
this paper. First, unlike the traditional transaction cost theory and
the more recent capability-based view of vertical contracting, this view
goes beyond the dyadic relationship between any two transaction parties.
Instead, the alliance building view acknowledges the dynamic interaction
between different participants in the marketplace, especially
competitors. This is especially true for high-tech industry, where de
facto standard setting is important in winning a technology battle.
However, there exists a potential danger in pursuing this strategy. For
example, a firm might succeed in winning the technology war, but fail to
gain significant market share in the industry. This happened in PC
industry when IBM could not obtain substantial market share even though
it won victory over Apple in setting a de facto standard. This is
because there were other competitors which possessed superior
competitive advantage over IBM. Therefore, a firm that chooses to use
market mode to build alliance should protect its core technology in
order to prepare for the next round competition.
Second, the alliance building perspective suggested here not only
looks beyond dyadic relationship, but it also pays detailed attention to
the inner organizational cost. In the past, transaction cost theory
exclusively focused on market failure as the main determinant of
organizational boundary. Likewise, capability view stressed the
importance of organizational advantage as a major influence that shapes
the boundary condition. However, the alliance building perspective
suggested here considers inner organizational cost as a new criterion
for market vs. hierarchy decision.
Third, the alliance building outsourcing will contribute to the
long-term survival of the firm comparing to strategic choice suggested
by other theories. For example, transaction cost theory's
prediction involves increasing transactional efficiency. Similarly,
capability view prediction is mostly concerned with firm specific
capability at a certain point in time. Both previous theories however,
fail to address long term strategic implications of the exchange
governance choice. In the case of technology standard setting alliance,
a firm's licensing decision can contribute to the long term
survival of the firm itself. Also, in the case of high organization
change cost, the firm can get rid of old strategy and set a new
strategic direction by an outside expert. In either case, the alliance
building perspective contributes to the long-term survival of the firm.
However, there are also some limitations in applying the alliance
building perspective in market vs. hierarchy decision. First of all, the
theory presented here does not provide any logic leading to the choice
of M&A. In the case of technology outsourcing, the pending strategic
decision involves whether the firm owns the technology and deploy it by
itself or license it to a third party. The option of M&A is not
considered in alliance building perspective. Second, some alliance
building may result in negative outcome. For example, when technology
standard setting is involved, licensing a technology to a competitor is
a highly dangerous strategy. Perhaps a better strategy would be to have
a cross-licensing agreement in which two or more parties exchange their
licenses. However, since cross-licensing agreement can sometimes work as
a formidable entry barrier, a firm which tries to use this tactic should
be aware of the possible antitrust issues. Finally, although the
alliance building perspective has been compared to both transaction cost
theory and capability view, it has not been compared to real option
theory which recently emerged as an important theory in predicting
market vs. hierarchy decision (Scherpereel, 2008). A possible comparison
between the two may involve examining the similarities and differences.
For example, in case of alliance building for technological dominance,
real option view may treat each licensing agreement as a real option,
whereas the alliance building perspective simultaneously treats all the
licensing agreement in calculating the benefit of pursuing licensing
strategy. It is hoped that future research may focus on this issue to
further strengthen alliance building perspective comparing to other
competing theories of exchange governance.
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Woonghee Lee, Hanyang University, Seoul, Korea
Dr. Woonghee Lee earned his Ph.D. at the Ohio State University,
Columbus in 1998. Currently he is a professor of strategic management at
Hanyang University, Seoul, Korea.