How Do Firm Specificity and Asset Specificity Differ? Implications for the Choice of Firm Boundaries

Transcription

1 How Do Firm Specificity and Asset Specificity Differ? Implications for the Choice of Firm Boundaries By Christoph Zott INSEAD Boulevard de Constance Fontainebleau Cedex FRANCE Telephone: Fax: christoph.zott@insead.edu and Raphael Amit The Wharton School University of Pennsylvania 3620 Locust Walk Philadelphia, PA Telephone: (215) Fax: (215) amit@wharton.upenn.edu 5 October 2006 We are grateful to Nick Argyres, Quy Huy, Michael Leiblein, Jeff Macher, Joe Mahoney, Laura Poppo, Filipe Santos, Nicolaj Siggelkow, and Brian Silverman for very helpful comments and suggestions on earlier drafts. We would also like to thank seminar participants at the University of British Columbia, and participants at the Atlanta Competitive Advantage Conference (ACAC) and Academy of Management Meetings 2006 in Atlanta for their comments. Christoph Zott has received research support from the Rudolf and Valieria Maag Fellowship in Entrepreneurship at INSEAD, and as Visiting Scholar from the Sauder School of Business at the University of British Columbia. Raphael Amit acknowledges the generous research support of the Robert B. Goergen Chair. Both authors gratefully acknowledge the financial support of the INSEAD-Wharton Alliance Center for Global Research and Development.

2 How Do Firm Specificity and Asset Specificity Differ? Implications for the Choice of Firm Boundaries Abstract We develop a theory of firm boundaries that considers (i) the asset specificity of the resources that enable an activity, (ii) their firm specificity, and (iii) the firm's endowment with these resources. Our theoretical framework, which draws on transaction-cost and resource-based perspectives, leads to new predictions about activities that should be outsourced (market governance) as opposed to those that should be undertaken within firm boundaries (hierarchical governance). For example, in the case where a firm is endowed with firm-specific resources and asset specificity is low, our theory suggests that a hierarchal form of governance is more likely. In another case, where the firm is not endowed with activity-enabling resources, and asset specificity is high and firm specificity low, our theory suggests that a market form of governance is more likely when the ex-ante opportunity costs of the resources are high. 2

3 How Do Firm Specificity and Asset Specificity Differ? Implications for the Choice of Firm Boundaries Boundary decisions of firms continue to receive substantial attention in organization and management theory (e.g., Santos and Eisenhardt 2005; Schilling and Steensma 2002). Scholars consider transaction attributes, such as asset specificity, among the constructs most relevant for boundary choice (Gulati et al. 2005; Williamson 1985). Asset specificity refers to the extent to which the assets deployed in an activity lose value in another activity and with another exchange partner (Klein et al. 1978). Although recent reviews of the empirical literature on firm boundaries (Carter and Hodgson 2006, David and Han 2004) provide support for the importance of measures of asset specificity, they also show that these measures are consistent with competing (or possibly complementary) theoretical underpinnings of firms boundary decisions, in particular, with transaction cost economics and resource-based explanations. How can the mechanisms that drive firms boundary choice be disentangled? In this paper, we surmise that theoretical predictions and associated empirical tests can be clarified by distinguishing between the concepts of asset specificity, which is anchored in the transaction costs perspective (Silverman 2002), and firm specificity, which is anchored in the resource-based view (Barney 1991). Building on Conner (1991), we define firm specificity as the condition where resources are worth more when deployed in activities in a focal firm than in other firms. Assuming that a firm s resource endowment is exogenously given, our question is, what is the independent and joint impact of asset and firm specificity on a firm s choice of boundaries? The literature generally views asset specificity and firm specificity as interchangeable, yielding similar implications for a firm s boundary choice. Scholars argue that firm-specific resources are characterized by, or give rise to, high asset specificity and are therefore associated with high transaction costs. The commonly held assumption, identified by Silverman (1999, p. 1110), is that rent-generating resources are necessarily too asset specific to allow contracting. The gist of this argument is that the circumstances that render resources difficult to imitate also create the conditions for asset specificity. 3

4 The failure to distinguish between firm and asset specificity can cause problems. First, it constrains theory development by excluding cases that could be theoretically interesting. By assuming that firm specificity necessarily translates into asset specificity, a case of high firm specificity and low asset specificity is precluded from consideration. In this paper we show that this case exists and is theoretically relevant, because the transaction cost and resource-based perspectives on boundary choice are at odds with each other. Second, it may also give rise to measurement issues in empirical research. Measures of firm specificity could be taken as measures of asset specificity (or vice versa), and this, in turn, may lead researchers to draw imprecise or incomplete conclusions about the validity of resourcebased or transaction cost explanations of boundary choice (Carter and Hodgson 2006). Third, the failure to distinguish between firm and asset specificity may entail misguided decision-making. Given the increasing importance of boundary choice for managers and entrepreneurs (Business Week 2006), this could involve businesses in significant monetary costs. In this paper, we address these problems by relaxing the assumption that firm specificity translates into asset specificity. We suggest that there are important differences between asset and firm specificity that can affect a firm s boundary decisions. Although both constructs can be viewed as resource attributes, asset specificity denotes the specialization of resources to an exchange partner, whereas firm specificity denotes the specialization of resources in the context of a particular firm. We show that this distinction matters theoretically by developing propositions on the impact of asset and firm specificity on firm boundaries. Using the Activity Concept as a Lens to Study Firm Boundaries Firm Activities In this paper we take the activity as the unit of analysis, defining hierarchical activity governance as the conduct of the activity within firm boundaries and market activity governance as the conduct of the 4

5 activity outside firm boundaries. In between these extremes lie other activity governance modes, such as joint ventures or strategic alliances. Figure 1 illustrates our approach Insert Figure 1 about here In the academic literature on firm boundaries, little distinction is made between the questions of how best to govern a transaction and how best to govern an activity. When managers make decisions on firm boundaries, however, they are usually asking: How should our firm, which has pre-existing strengths and weaknesses (core competencies and disabilities), organize X? (Williamson 1999, p. 1103). Managers are concerned with the governance of an activity: Should activity X be governed within or outside their firm s boundaries? This is evident from the managerial literature on outsourcing (e.g., Burdon and Bhalla 2005, Quinn and Hilmer 1994). Focusing on the activity has two main advantages. First, it allows for asymmetric treatment of potential exchange partners and the dyad of activities that are linked in an exchange; it does not assume homogeneous firms. 1 Instead, it shifts the focus to a focal firm that must make the decision about how to govern a specific activity, i.e., how to link that activity to its current activity system. This is interesting since in practice there may be just one focal firm which has to make a decision whether to outsource an 1 The transaction cost perspective, which takes the transaction as the unit of analysis, usually assumes firm homogeneity (Demsetz, 1988). Given the same transaction attributes and governance mode, the same asset should be equally productive in different firms. In equilibrium, all firms facing a given set of transactional attributes will reach similar conclusions regarding which activities to execute internally and which activities to outsource. 5

6 activity or not. Its counterpart may be a specialized provider of outsourcing processes for whom this question is irrelevant: in other words, there is asymmetry and heterogeneity. 2 Second, and flowing as a direct implication from that first premise, focusing on activity stresses the need to include an analysis of firm-level attributes in the focal firm s governance decision (in addition to transaction-cost arguments). Consequently, in addition to considering those resources that may influence the level of transaction costs, an activity perspective suggests the consideration of all the resources that enable the activity, as well as their relation to the firm s existing resource endowment. What is an activity? Stigler (1951, p.187) conceptualizes the firm as engaging in a series of distinct operations: purchasing and storing materials; transforming materials into semifinished products and semifinished products into finished products; storing and selling the output; extending credit to buyers; etc. Similarly, Porter (1985) defines activities as the building blocks by which a firm creates a product. He contends that every firm is a collection of activities that are performed to design, produce, market, deliver, and support its product (1985, p.36). Since potentially valuable differentiation arises from the choice of activities and how they are performed, and cost is generated by performing activities, they can be viewed as the basic units of competitive advantage (Porter 1996), and organizations can be conceptualized as systems of activities (Siggelkow 2002). Building on these early ideas, we define an activity as a cluster of interlinked workflows and tasks that are performed and enabled by resources. Activities could be based on routines (Nelson and Winter 1982), but they could also involve creative tasks and improvisation (Miner, Bassoff and Moorman 2001). They could be performed within the boundaries of a focal firm, or they could be linked to the activity system of the focal firm through an exchange with another organization that performs the activity within its own boundaries. 2 Consider, for example, firm A s purchase of consulting services from firm B. In this case firm A is the focal firm that has to make a boundary decision. From consulting firm B s perspective, there is no boundary decision to be made about whether to conduct the activity in the market or within its own boundaries. 6

7 Identifying activities that are technologically and/or strategically distinct can be conceptually challenging because the number of potential activities is often quite large (Porter 1985). Many seemingly inseparable activities can be broken down further (Santos 2006). One way to deal with this issue is to define activities at different levels of aggregation. 3 We accept the level of aggregation at which an activity is described as a given. We do not ask where to draw the boundary around an activity (i.e., which level of aggregation to adopt). We ask instead which organizational boundary to draw, given the activity. 4 This emphasis is different from the property-rights approach of Grossman and Hart (1986) and Hart and Moore (1990), which focuses on the question of who should own the assets, taking who conducts the activity as a given. Organizational Resources and Activities Resources are needed to enable and perform activities (Penrose 1959). Resources include (a) all factors that can be owned or controlled by a firm, for example, physical assets, know-how (e.g., in the form of patents and licenses), financial assets, and human capital, and (b) information-based organizational processes (the way information is developed, carried, and exchanged through the firm s human capital) (Amit and Schoemaker 1993, p. 35). These processes are sometimes also referred to as capabilities. For example, the activities of a call-center may be facilitated by resources such as human capital, a database 3 Davenport (2005), for example, mentions the supply chain operations reference model, which lays out top level activities (plan, source, make, deliver, and return), but also specifies sub-activities that can be delineated at second, third, and fourth levels. At high levels of aggregation, activities could comprise whole business functions, such as accounting, or human resource management. At low levels of aggregation (i.e., high levels of decomposition), activities could be as specific as the processing of customer s based on their content, or the translation of product manuals into a foreign language. 4 We also assume that managers can articulate and measure the key performance parameters of the activity. Activities can be exchangeable, in the sense that similar outcomes (e.g., activity performance metrics) could be achieved with different (sub-) clusters of workflows and tasks. 7

8 of existing and potential customers, service processes, IT and telecommunications hardware and software, call center facilities, training programs for employees, and financial capital. A focal firm is said to be endowed with resources when it controls them either through direct ownership or through exclusive access to them (i.e., operational control), for example, through long-term contracts (Conner 1991; Montgomery and Wernerfelt 1988). Indeed, the rationale for the decision to conduct an activity within or outside firm boundaries can be largely resource-driven, as in the case of a firm that wants to tap into the resources of an exchange partner that enjoys lower production costs (e.g., Argyres 1996). In other cases, a firm simply may not be endowed with the resources it needs and also may find it too difficult and costly to acquire or build them (Barney 1999). A fabless semiconductor firm, for example, may exploit the low transaction costs of market-based activity governance by outsourcing the manufacturing function to a dedicated foundry. Resource-based interpretations of that outsourcing decision, however, might be that the company wanted access to the unique production skills that the foundry had amassed; or that it wanted to avoid the high capital costs of acquiring the manufacturing skills and assembling the required assets; or, again, that it relied strongly on unstructured technical dialogue between product designers and fabrication engineers (Monteverde, 1995). Activity-enabling resources constitute the core of the resource bundle deployed in an activity. They are necessary for conducting the activity, and removing any of them from the bundle could crucially affect the focal firm s ability to conduct it. For example, answering customer calls in a call center needs phone operators, but not a fleet of company cars the employees are activity-enabling, the cars are not. Activity-enabling resources can be conceptualized as input factors to the production function that captures the output from the activity; they have more than marginal impact on the output level, quality or cost of the activity. The value creation potential of the activity (i.e., its associated quality, cost, and time) is determined both through the selection of resources combined to enable the activity and through the properties of these resources, in particular, their endowment, their asset specificity and their firm specificity. 8

9 Asset Specificity and Firm Specificity of Resources Asset Specificity In transaction cost theory, assets are durable resources that include sites, physical assets, and human assets (Williamson 1985, pp. 95 6). Asset specificity refers to the degree to which such resources are specialized to an exchange. In this way, asset specificity can be viewed as an exchange attribute as well as a resource property, one that explains the resource s potential for affecting transaction costs. Transaction cost theory asserts that asset specificity is important in conjunction with bounded rationality, opportunism, and uncertainty. When asset specificity increases, under these conditions the redeployability of the assets decreases, and the contracting hazards (notably, the hazard of opportunism) as well as the bilateral dependency (notably, the risk of hold-up) between the parties involved in an exchange, increase (Williamson 1985). Consequently, the likelihood of hierarchical forms of transaction governance increases (Williamson 1991). Asset specificity can not only cause hold-ups, with their associated monitoring and contractenforcement costs, but it also affects the transaction costs engendered by other exchange attributes, such as uncertainty and frequency (Williamson 1975, 1985; David and Han 2004). Indeed, Williamson asserts (1999, p. 1089) that much of the explanatory power of the transaction cost perspective turns on transaction-specific assets. A precise understanding of the concept of asset specificity is important in order to assess its role in a firm s decision on how to govern an activity (Carter and Hodgson 2006). Asset specificity captures the degree of specialization of a resource to a bilateral exchange. More precisely, it refers to the extent to which the value of pre-activity investments is reduced if deployed in another use and with another user (Klein et al. 1978). This definition sets up two conditions that must be met to establish a high degree of asset specificity, i.e., a high risk of hold-up. The first condition (assets worth less if deployed in another use) stipulates that the value of the resource when deployed in a different activity is smaller than its value when deployed in the activity in question within the focal firm; 9

10 in other words, there is a positive quasi (Klein et al. 1978). 5 If the quasi rent were zero, the resource could be deployed in a different activity without loss of value, none of the exchange partners would be subject to hold-up, and asset specificity would be low. The second condition (assets worth less if deployed with another user) refers to the existence of an alternative exchange partner who offers a lower willingness-to-pay (at the extreme, zero) than the original exchange partner. 6 It does not suggest, however, that the resource is controlled and operated by another firm (which would be another, yet in this case incorrect interpretation of the term deployed with another user ). This subtle yet important point can be illustrated by the example of a printer who owns and operates a printing press, and a publisher who buys printing services from the printer (Klein et al. 1978). The printing press is asset specific if (first condition) there is no other value-preserving activity for the printer, and if (second condition) there is no other publisher who has the same willingness-to-pay for printing services as the original publisher (assuming also that the printing press is still owned and operated by the same printer). Firm Specificity Although firm specificity is often meant to denote resource idiosyncrasies among firms, so far researchers have not agreed on a formal definition of the term. Different researchers emphasize different aspects, such as the specificity of resources with respect to fields of application (e.g., Collis and Montgomery 1997, p. 37), specificity with respect to a firm s needs (e.g., Chi 1994, p. 273), or specificity with respect to the 5 Klein et al. (1978) define the value of an asset deployed in an activity as the difference between revenues and operating costs, and denote its value in another use as the salvage value. The quasi rent from the asset is obtained when subtracting operating cost and salvage value from revenues. 6 According to Klein et al. (1978) this condition is also needed for the presence of non-negligible asset specificity, because only then can part of a positive quasi rent be appropriated by an exchange partner. If an alternative exchange partner existed with the same willingness to pay as the original exchange partner, then the scope for ex-post appropriation (and, consequently, asset specificity) would be zero. 10

11 firm s other resources (Conner 1991). In this paper, we build on the idea that firm specificity refers to the value dependence of resources on their use within a particular firm (e.g., Conner 1991). (Note the variance with the definition of asset specificity, which refers to the value dependence of resources on their use in a particular bilateral exchange). We define resources as firm-specific when they yield greater value if they are deployed in activities by one firm than if they are deployed in the same activities by another. The greater that difference in value, the higher the degree of firm specificity. Our definition holds whether or not the firm is already endowed with the resources. A firm s resources could still be firm-specific, even if the firm was not endowed with them, in the sense that their potential to generate value would be greater for that firm than for another. Firm specificity of activity-enabling resources is also often associated with the difficulties involved in imitating and substituting this resource bundle (Rumelt 1984), as well as with the value-enhancing linkages (complementarities) among these resources and the firm s overall resource position (Conner 1991). 7 Firm-specificity is one of the resource properties that define strategic assets (Amit and Schoemaker 1993).The greater a resource s specificity to a firm, the greater its rent potential to that firm, given favorable conditions of demand, public policy and competitor action. Firm-specific resources are often associated with increased efficiency (e.g., Jacobides, 2004). In particular, resources that cannot be purchased, such as organizational culture are, on average, likely to be more specific to the firm than purchasable inputs and hence have the potential to be more significant rent-generators (Conner 1991, p. 137). Isolating mechanisms (Rumelt 1984) can enhance the longevity of these rents. 8 7 Firm-specific resources are user-specific; however, they may or may not be usage-specific (Ghemawat and del Sol 1998). Usage-specific resources are specialized to an application (however narrowly that is defined), and they lose value when the domain of their application changes (see also Montgomery and Wernerfelt 1988). 8 Some activities could be enabled by firm-specific resources or by generic resources, and a focal firm s managers need to determine whether they both can and want to deploy firm-specific resources in the 11

12 Distinctions between Asset and Firm Specificity It follows from this that there is a subtle yet profound difference between the firm-specificity of resources and their asset-specificity. Simply put, to determine the degree of firm-specificity of a resource one needs to consider who controls and operates the resource; in other words, what matters is the value of its use within a firm s boundaries. For asset specificity, one needs to consider whether the resource is specialized to an exchange relationship (i.e., to an exchange partner). Figure 2 illustrates this. Case 1 shows asset specificity when compared to a baseline case (exchange between A and B, A controls and operates the resource). The resource is specialized to the exchange between A and B. Its value decreases if a new exchange partner, C, replaces B. Like B, C does not control or operate the resource but sources the activity that A supplies and which is enabled by the resource. The value derived from the activity that the resource enables declines because the exchange partner (not the resource holder) changes. If, in addition, A (the resource holder) does not have the opportunity to redeploy the resource in another valuepreserving activity, then asset specificity is present. Case 2, when compared to the baseline case, illustrates firm specificity. The resource is still used in conjunction with the same exchange partner, B, but now it is controlled and operated by another firm, C, which replaces A. The value derived from the activity enabled by the resource declines, because the resource holder (not the exchange partner) changes. Firm specificity is present Insert Figure 2 about here Firm specificity of resources does not automatically translate into asset specificity. Firm specificity refers to resources that lose value when deployed in the same activity within another firm, but activity in question. Consider, for example, operating a call center that requires the use of human resource (HR) management processes. The activity could be facilitated by leveraging the firm-specific HR management resources of the focal firm, or it could be enabled by its standard HR resources. 12

13 that may have multiple uses (i.e., could be deployed in multiple activities) of equal value within the focal firm, in which case their asset specificity would be low. Asset specificity, by contrast, arises when there are no other value-preserving uses of the asset for the focal firm, and when there are no other valuepreserving exchange partners. Moreover, asset specificity does not automatically translate into firm specificity. Consider, once again, the example of a printing press (resource) that a printer tailors to a publisher s specifications. Klein et al. (1978) have shown that its asset specificity is high: the value of the press in other activities is smaller than its value in printing for the publisher (perhaps because the press can only be used for printing a format that is unique to the publisher), and other publishers are willing to pay less for the printer s services than the first publisher (perhaps because the printer has tailored his operation to that one publisher s specifications). Therefore, the printing press can give rise to serious transaction hazards. However, while the press may be specialized to the exchange between the printer and the publisher, it is not necessarily firm-specific. Consider, for example, the publisher as the focal firm needing to decide whether to print a certain product (for which the printing press is needed) within or outside its own boundaries. The resource in question (printing press) could be deployed by any other firm (supplier) for the same activity, delivering the same service to the publisher without any loss in value compared with the publisher s choice to do printing within its own boundaries. The Joint Implications of Asset and Firm Specificity on Firm Boundaries We posit that firms seeking to set their boundaries analyze asset specificity, firm specificity, and their endowment with activity-enabling resources. To demonstrate the theoretical usefulness of distinguishing clearly between these concepts in order to determine the desirable form of activity governance (i.e., what maximizes value for the focal firm), we apply it to several situations where these variables take on different extreme values (i.e., are either high or low). In each case, we ask, given the focal firm s resource endowment: (1) how does the degree of asset specificity, which determines the costs engendered by the hazards of opportunism, affect the focal firm s choice of boundary? (2) How does the firm specificity of 13

14 the activity-enabling resources, which determine the rent-creation potential of the activity, affect the focal firm s choice of boundary? And (3), what is the joint effect of asset specificity and firm specificity on the focal firm s choice of boundary? Although, for the sake of parsimony, we focus our exposition on whether an activity should be linked through a market transaction or performed within the boundaries of the focal firm, our analysis does not preclude other forms of activity governance such as joint ventures or alliances. These additional choices can be viewed as permutations of the polar cases we consider. Conner and Prahalad (1996) argue that the study of the polar cases can inform an understanding of all permutations. The Case of Low Asset Specificity and High Firm Specificity We begin by examining the case where asset specificity is low, the focal firm is endowed with the required resources for the activity, and the resources are firm-specific. This is an interesting case, because it represents a departure from the common assumption that firm-specific resources imply asset specificity. It is also a situation in which the transaction cost and resource-based perspectives, as we explain, yield different predictions about the desired boundary choice. How plausible is it? Consider the case of Wal-Mart. Its core business is discount retailing but an important activity supporting the core business is logistics. Over time, Wal-Mart has developed highly sophisticated processes (e.g., cross-docking) that are unrivalled in the industry and which help the company to keep its costs lower than competitors, giving Wal-Mart an important (value-creating) competitive advantage (Bradley and Ghemawat, 2002). Wal-Mart s deep, tacit retailing expertise helped the firm create unique logistics processes, and maintain and improve these processes over time, until they became highly firm-specific. Yet Wal-Mart s logistic processes are also characterized by relatively low (though perhaps not zero) asset specificity, as the firm could apply these processes to other exchange partners, e.g., other discount retailers who might benefit from Wal-Mart s services in a similar (costreducing and profit-increasing) way. Given low asset specificity, the transaction cost perspective points towards market governance of the activity (Williamson, 1975, 1985). The resource-based perspective, however, suggests that ownership 14

15 of firm-specific resources, or exclusive access to such resources, can bestow a firm with a competitive advantage, i.e., create positive economic rents (Collis and Montgomery 1997; Conner 1991; Peteraf 1993). Scholars have also suggested that firms should focus on their core strengths and pursue relevant activities in-house only when they have greater experience or skills than potential suppliers (Argyres, 1996; Quinn and Hilmer, 1994). Several distinct arguments support these assertions. First, ownership or control of firm-specific resources used for in-house activities can help the focal firm generate and appropriate rent (Conner 1991; Peteraf 1993; Zajac and Olsen 1993). These factors are often associated with lower production costs, i.e., higher efficiency and productivity (e.g., Argyres 1996; Jacobides 2004). If they are rare, they can generate Ricardian rents (Montgomery and Wernerfelt 1988). Meanwhile, the focal firm might find it difficult to identify an exchange partner that can perform the activities enabled by these resources with similar quality and/or at similar cost. When these activities are internalized, a focal firm can exert more direct influence over how the activityenabling resources are managed and used, limiting their dissipation in the market and making imitation and substitution more difficult. Second, many firm-specific resources are knowledge-based, and hierarchical governance of the activities that they enable can provide efficient and effective coordination of knowledge and information flows. A firm can use its common language and routines (Langlois and Foss 1999; Monteverde 1995; Silverman 2002) as well as its managerial authority and organizational learning (Conner and Prahalad 1996; Gulati et al. 2005) to its advantage. These factors may also increase opportunities for innovation and facilitate more rapid, flexible recombination of resources (Santos and Eisenhardt 2005). The rentcreation potential achieved through recombination of firm-specific resources may be higher than the rentcreation potential resulting from recombination of generic resources, because such (firm-specific) bundles are difficult to imitate, presumably even more than their component (firm-specific) resources. Third, hierarchical governance ensures direction and control for the future development of an organization s firm-specific resources (Leonard-Barton 1995). The activities that resources enable provide timely feedback about how a firm s resources could be improved. 15

16 Collectively, these arguments suggest that firm-specific resources can be an important source of competitive advantage and of economic rents, and that the benefits of hierarchical governance might more than offset the disadvantages (Leiblein 2003). Indeed, they also suggest important disadvantages of market governance in these cases, because a firm already endowed with activity-enabling firm-specific resources would have to maintain these resources as slack, redeploy them in other activities, or sell them to another firm, potentially realizing less than full value (e.g., Quinn and Hilmer 1994). All of these alternatives can destroy value. These resource-based arguments suggest that an activity enabled by firm-specific resources is usually best conducted within firm boundaries, a conclusion at odds with the prediction from the transaction-cost perspective. Thus, when considered independently, the transaction costs and the resource based perspectives point to different forms of governance for the same activity. To resolve this tension between the two perspectives, we need to consider the potential interaction between low asset specificity and high firm specificity of the activity-enabling resource bundle. In other words, how does low asset specificity affect the hypothesized positive association between high firm specificity and the likelihood that the activity will be governed within firm boundaries? Low asset specificity results either from a violation of condition one (assets worth less if deployed in another use), or condition two (assets worth less if deployed with another user), or both. If the first condition is violated, this implies that the ex-ante investments made to enable the activity can be redeployed without loss of value to another activity within the same firm. Ease of redeployment of firmspecific resources within the firm s boundaries points toward relatively low coordination costs of hierarchical activity governance. It can also be expected to interact positively with the extent to which the firm-specific resources create value for the focal firm: the investment by the firm in activity-enabling resources may be deployed, and/or bundled with other resources in other (potentially new) value-added activities. Hence, when considering concurrently the value creation potential of deploying firm-specific resources in activities within firm boundaries, and the ability to redeploy the resources in other uses (i.e., 16

17 activities) within the firm without loss of value, the joint effect of low asset specificity and high firm specificity points towards hierarchical activity governance. If low asset specificity results from violation of condition two, the implication is that activityenabling resources can be deployed with multiple exchange partners without loss of value. Consider the Wal-Mart example again (see Bradley and Ghemawat, 2002). Assuming low asset specificity, if there were another firm that controlled its own firm-specific, logistics-enabling resources, it could link its logistics activity to several retailers, including Wal-Mart, without much difference in value among exchange partners. Would Wal-Mart have an incentive to outsource its logistics? Since Wal-Mart s logistics are assumed in this case to be highly firm-specific, keeping logistics in-house is likely to create more value than the outsourced logistics. On balance, therefore, these arguments on the independent as well as joint effects of low asset specificity and high firm specificity point towards hierarchical rather than a market form of governance. Proposition 1a If activity-enabling resources are characterized by low asset specificity, high firm specificity, and if the focal firm is endowed with them, then the focal firm is more likely to conduct the activities within its boundaries. But now consider the case where the focal firm is not endowed with the firm-specific resource bundle needed to enable the activity. Let s take Snapple, an independent unit of Cadbury-Schweppes, as a focal firm. Snapple had to make a boundary decision on whether to perform its logistics operations in house, and turn them into one of the firm s core competencies, or outsource them to a firm that specializes in logistics, such as Ryder System Inc, a Fortune 500 provider of transportation, logistics and supply chain management solutions. Snapple s logistics are complex: it purchases 1000 raw materials from 100 suppliers that are fed into 30 production facilities in North America; it ships product to 20 distribution centers owned by third parties; 400 finished products are shipped to several hundred suppliers which in turn resell to retailers. Ryder s activity-enabling resources are highly firm-specific. They derive much of their value from the deep logistics expertise and tacit logistics know-how that the firm has assembled over 17

18 time, and which are reflected in the products (e.g., IT solution) that are constantly improved as a result of feedback and learning processes within the firm. Yet the asset specificity of the activity-enabling resources is low: the resources are tailored to Ryder, not to use with Snapple. The focal firm (Snapple) was not endowed with the resources needed to perform the logistics operations. In this case, Snapple s management decided to outsource to Ryder. In general, a focal firm has three alternatives: (1) acquire the necessary resources from another firm (e.g., through the purchase of another firm see Chi 1994) so that it can internally perform the activities; (2) develop the resources internally and subsequently internalize the activities; or (3) find an exchange partner already endowed with the resources and have that firm conduct the activity. Barney (1999) points out that the acquisition of resources (in particular, firm-specific ones) through the purchase of another firm (option 1) or the development of said resources within the focal firm (option 2) can be prohibitively costly. Any acquisition process can result in inefficiencies, since, by their very nature, firmspecific resources can be difficult to copy and/or substitute. Resource development and/or acquisition costs are likely to be high for firm-specific resources. The costs of establishing a bundle of firm-specific resources can be close or equal to their full value creation potential. Barney (1986) argues that firms can obtain rents from acquired resources only when they have superior information about the value of the resources, or when they are lucky. Otherwise, buyers will not be able to extract superior economic performance from any resource. Reflecting on this argument, Dierickx and Cool (1989) point out that it applies to resources that can be traded, but different criteria must be considered for resources that need to be accumulated internally, notably time compression diseconomies that denote a firm s difficulty (i.e., cost) in speeding up the development of firm-specific resources. In time compression diseconomies, the greater the gap between actual and desired resources, the higher the cost of development, and thus the lower the chances of extracting rent from the resources (Pacheco-de-Almeida and Zemsky 2006). This point of view is echoed by Silverman (2002, p. 476), who argues that decisions on the desired form of governance are sometimes taken not in response to [certain] 18

19 levels of asset specificity, but in response to (1) the gap between existing capabilities and desired capabilities, and (2) the time frame over which the gap must be closed. Argyres (1996, p. 135ff) interprets a case analysis in a similar way. When the costs of establishing a bundle of firm-specific resources are close or equal to their full value-creation potential (e.g., because the focal firm has no information advantages in acquiring external resources or faces serious time compression diseconomies in accumulating them internally), then the firm is less likely to realize a competitive advantage by establishing a resource endowment and undertaking the activities that the resources enable within its boundaries. Under these circumstances, a resource-based perspective predicts a market form of activity governance, just as the transaction-cost perspective predicts, given a situation of low asset specificity. As far as their independent effects are concerned, then, the apparent tension between these perspectives is resolved through the need to establish a resource endowment. But, as before, the interaction of low asset and high firm specificity has to be considered. When low asset specificity arises from the fact that there are multiple uses for the resources, there remains the possibility of redeploying the firm-specific resources, once they are acquired or developed, in any of the alternative activities within the focal firm s boundaries. For the reasons mentioned earlier, this would normally present favorable conditions for the creation of rents. But if the focal firm is faced with time compression diseconomies, or a lack of information advantages in the development of the activityenabling resources, their potential for rent-creation is diminished, and the focal firm s managers have a reduced incentive to acquire or develop them. Hence, the activity for which the resources are required is more likely to be conducted outside firm boundaries. Under these conditions, the juxtaposition of lack of resource endowment, low asset specificity and high firm specificity i.e., their joint effect points toward market governance of the activity. Time compression diseconomies and a lack of information advantages play a similarly important role in determining the desired form of activity governance in a case where low asset specificity arises from the fact that there would be multiple exchange partners if the activity were governed in the market. In the endowment case, this presents the focal firm with an incentive to conduct the activity within its 19

20 own boundaries. Yet, in the case where the focal firm is not yet endowed with the firm-specific resources, if there are time compression diseconomies or the managers of the focal firm do not have special insights into the value creation potential of the activity-enabling resources, then, once again, they would have little incentive to buy or otherwise accumulate the resources themselves. Acquiring the resources and conducting the activity in house would be unlikely to give the focal firm a competitive advantage. Proposition 1b If activity-enabling resources are characterized by low asset specificity, high firm specificity, and if the focal firm is not endowed with them, then the focal firm is more likely to conduct the activity outside its boundaries when (a) the managers of the focal firm do not possess superior information about the rent creation potential of the resources, or (b) there are time compression diseconomies in establishing a resource endowment. High Asset Specificity, And Low Firm Specificity To illustrate the situation where asset specificity is high but the activity-enabling resources are generic, consider a publisher who owns a printing press that provides tailored printing services for the publisher (implying asset specificity), but which is a fairly standard resource (i.e., it is not firm-specific another firm could buy or build the same printing press and operate it for the publisher without loss in value). In this case, a transaction-cost analysis looking at asset specificity alone would recommend hierarchical activity governance to minimize the costs of opportunism. However, from a resource-based view (RBV), the benefits of hierarchical governance could be doubtful. Internalizing the activity does not protect or enhance the firm s resource-based competitive advantage because of the low firm specificity of the activity-enabling resources. Moreover, if the resources deployed in the activity can be freed up by outsourcing, they might be redeployed to other activities with higher strategic value for the focal firm (Santos and Eisenhardt 2005). Additionally, because of the low firm-specificity of the resources, the focal firm is less likely to need to alter the duties and responsibilities of the parties involved in the activity which would be done more effectively and efficiently within the firm s boundaries (Conner and Prahalad 1996). The resource-based perspective points toward market governance of the activity. 20

21 When viewed independently, the transaction cost and resource-based perspectives point in different directions. Once again, in order to resolve the resulting tradeoff, we consider the joint effects of high asset and low firm specificity on the governance of the enabled activity. High asset specificity implies that the opportunity costs of the activity-enabling resources are low. This observation, in turn, decreases the desirability of conducting the activity in the market and redeploying the resources to other activities, because their value-creation potential in these alternative uses will be lower than if they are used to enable the activity in question. When considered jointly, high asset specificity and low firm specificity suggest that, on aggregate, there is little advantage of conducting the activity outside firm boundaries. Proposition 2a If activity-enabling resources are characterized by high asset specificity, low firm specificity, and the focal firm is endowed with them, then the focal firm is more likely to conduct the activity within its boundaries. A lack of endowment with activity-enabling resources can affect the trade-off between transaction costs and the limited rent creation potential of generic resources. Consider the case of TiVo, a startup that in 1999 launched a personal video recorder a new concept that allows users to record up to 80 hours of television and replay it at their convenience (Linder 2004). Because the concept was so new, TiVo had to help its prospective customers understand, install, and use the technology it promoted. The firm needed distinctive customer support; it could not rely on ordinary call-center scripts and routine approaches. TiVo decided to outsource the customer support activity and work with partners to tailor their generic call-center resources (suggesting low firm specificity) to TiVo s needs (suggesting the presence of asset specificity). The partners established tailored call-center processes using open-ended dialogues and investigative problem-solving; developed innovative training materials tailored to TiVo; gave callcenter agents TiVo s product to use in their own homes so that they would think like a TiVo customer; and used TiVo s CRM application so that call center employees could feed rich descriptions of customer 21

22 problems back to TiVo. The focal firm, TiVo, was not endowed with resources that enabled customer support. Although in this case the independent effects of high asset specificity and low firm specificity on activity governance (as discussed above) remain intact, their interaction is different under the condition of low resource endowment. In order to analyze that interaction, we look at the opportunity cost of resources. Lack of endowment implies that necessary investments to support the activity have not yet been made, and the high asset specificity of these investments suggests lower ex-post than ex-ante opportunity costs, which is consistent with Williamson s notion of a fundamental transformation (1985). Once the activity-enabling resources are obtained, either through internal development or through acquisition, they must be dedicated to the particular activity, which will limit their ability to be redeployed without loss of value. If the focal firm is faced with resource constraints (as is the case with a new venture), then it must take into account the costs and the time needed to acquire or develop the nonspecific resources. The higher these costs, and the more resource-constrained the firm is, the less likely it is that the firm will conduct the related activity within its own boundaries. These arguments are particularly important for rapidly growing entrepreneurial firms that need to preserve precious resources and use them strategically and selectively. Such firms might embrace a scalability rationale (Santos 2006) for transacting through the market despite high asset specificity. In the absence of an endowment with activity-enabling resources, the juxtaposition of high asset specificity and low firm specificity points toward conducting the activity outside the focal firm s boundaries when the (ex-ante) opportunity costs of the resources are high. Proposition 2b If activity-enabling resources are characterized by high asset specificity, low firm specificity, and the focal firm is not endowed with them, then the higher the ex-ante opportunity costs of these resources, the more likely the focal firm will be to govern the activity outside its boundaries. 22

23 (See the Appendix for a brief discussion of the more straightforward cases of high [low] asset specificity and high [low] firm specificity.) Discussion and Conclusion While disentangling explanations of the choice of firm boundaries can be challenging (Carter and Hodgson 2006; Conner and Prahalad 1996; Schilling and Steensma 2002), distinguishing between the asset specificity and firm specificity of activity-enabling resources can help in the process. In this paper, we explain the differences between these concepts, and show that they are significant for firms boundary decisions. Focusing on these resource attributes allows us to develop a theoretical framework that considers both transaction-cost economics (TCE) and resource-based perspectives, and that enables us to draw inferences about the governance of an activity. Our theory also takes into account the focal firm s endowment with activity-enabling resources, which we assume to be exogenous. We argue that considering the aggregate implications of resource attributes (i.e., asset specificity, firm specificity, and endowment) independently as well as jointly allows more accurate predictions of when activities will take place within firm boundaries (i.e., a hierarchical form of activity governance) and when those activities will be undertaken outside firm boundaries (i.e., a market form of activity governance). This leads to predictions about activity governance that differ from those made by any of these main organizational perspectives on boundary choice alone. For example, in the case where a firm is endowed with firm-specific resources and asset specificity is low, while TCE alone predicts market governance, our theory suggests a hierarchal form of governance to be more likely. In another case, when the firm is not endowed with the activity-enabling resources, asset specificity is high, and firm specificity is low, although TCE predicts hierarchical governance, our theory suggests that a market form of governance may be more likely, especially when the opportunity costs of the resources are high. This study contributes to the literature by addressing an important gap in research on firm boundaries drawing on and synthesizing transaction cost and resource-based perspectives. The existing 23