Michael Dietrich, Jackie Krafft. To cite this version: HAL Id: halshs

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1 Economics nd Theory of the Firm, Chp. of the Hndbook on Economics nd Theory of the Firm, M. Dietrich nd Jckie Krfft (eds), Edwrd Elgr: Cheltenhm, 0. Michel Dietrich, Jckie Krfft To cite this version: Michel Dietrich, Jckie Krfft. Economics nd Theory of the Firm, Chp. of the Hndbook on Economics nd Theory of the Firm, M. Dietrich nd Jckie Krfft (eds), Edwrd Elgr: Cheltenhm, 0.. Michel Dietrich nd Jckie Krfft. Hndbook on the Economics nd Theory of the Firm, Edwrd Elgr Publishing, pp.588, 0, Edwrd Elgr Hndbook Series. <hlshs > HAL Id: hlshs Submitted on 6 Oct 0 HAL is multi-disciplinry open ccess rchive for the deposit nd dissemintion of scientific reserch documents, whether they re published or not. The documents my come from teching nd reserch institutions in Frnce or brod, or from public or privte reserch centers. L rchive ouverte pluridisciplinire HAL, est destinée u dépôt et à l diffusion de documents scientifiques de niveu recherche, publiés ou non, émnnt des étblissements d enseignement et de recherche frnçis ou étrngers, des lbortoires publics ou privés.

2 PART I INTRODUCTION

3 . Economics nd theory of the firm Michel Dietrich nd Jckie Krfft. INTRODUCTION The title of this Hndbook mkes reference to the economics of the firm nd the theory of the firm. The economics of the firm chrcteristiclly concerns itself with issues of firm internl structure, orgniztion nd boundries. The theory of the firm nlyses behviour nd strtegies in prticulr mrket contexts. Trditionlly within economics these re viewed s seprte spheres of nlysis. Wht hppens inside the firm hs long been studied independently of wht composes the detils of the competitive environment of the firm nd, lterntively, mrket strtegies emerge from firm conceived s blck box. An erly sttement of this seprtion is provided, for exmple, by Penrose (980/959)... we shll not be involved in ny qurrel with the theory of the firm s prt of theory of price nd production, so long s it cultivtes its own grden nd we cultivte ours. (ibid, p. 0) And to reinforce the sme point The economist s min conceptul schem is designed for the theory of price determintion nd resource lloction, nd it is unnecessry nd inpproprite to try to reconcile this theory with orgniztion theory. (ibid, p. 4)

4 In similr vein, but from different trdition, Willimson (985) suggests tht exogenous technologiclly seprble units exist, tht re chrcterized by some degree of sset specificity. Exchnge between these units tkes plce with resulting trnsction costs. The minimistion of these costs then results in firm orgnistion nd more generlly institutionl development. Without wishing to undermine the fundmentl contributions of either Edith Penrose or Oliver Willimson, it is rgued in this chpter tht we must move beyond this seprtion nd, for exmple, exmine how firm behviour, strtegies nd competition ( chrcteristic of the theory of the firm) interct with firm orgnistion. Hence, one guiding principle behind this Hndbook is tht bridges should be creted between these two res of study. Without these bridges potentilly prtil nlysis cn result. Two exmples, developed in more detil below, will be sufficient to illustrte this potentilly prtil nlysis. First, n industry or technologicl life-cycle perspective suggests tht the nture of competition chnges through time. It is rgued below tht different pproches to the economics of the firm similrly evolve through time in mnner linked to the underlying chnges in the competitive environment. Secondly, it is shown below tht when ccount is tken of strtegic interction in oligopoly contexts this hs implictions for bsic trnsction cost ccount of the firm. Both exmples illustrte the potentil importnce of creting bridges between trditionlly seprte res. This potentil interction is not, of course, fundmentlly new ide. For exmple Lnglois (007), Csson (997) or Morroni (99, 006) hve developed work on the firm tht cn be viewed s nlysing this interction. For exmple these uthors suggest tht orgnistionl chrcteristics nd decisions cn be nlysed s ffecting firm scle economies. For the 3

5 current uthors interest in this pproch to the firm goes bck some time. Dietrich (994) suggested tht we cn relly understnd the firm only by tking ccount of governnce structure benefits s well s costs. The benefits encompss wht is clled here the theory of the firm with focus on externl issues nd the costs the economics of the firm with focus on internl issues. More recently Dietrich nd Krfft (0) present frmework to nlyse firm development, nd specificlly verticl integrtion, bsed on creting links between technicl nd orgniztionl spects of the firm. They suggest tht it is truism tht rel firms re both technicl nd institutionl entities. In relity, the firm is obviously technicl unit, nmely unit tht trnsforms fctor inputs into outputs. This is originlly where the theory of the firm strts from nlysing the impct of production nd costs functions with demnd on the mrket. Eqully, the firm is lso n institutionl unit, requiring tht one pys ttention to its bsic definition, its identity, its structure nd boundries which hs become the usul plyground of the economics of the firm. Of course it is lwys possible to ssume one spect exogenous (or in the extreme even ignore it) nd nlyse the other in isoltion. However the outcome is likely to end up with prtil nlysis. For instnce, one cn focus on the issue of sset specificity, n exogenous technicl chrcteristic supposed to generte motivtion problems in context of bounded rtionlity nd opportunism, nd creting the development of institutionl solutions. But n obvious complexity here is tht sset specificities imply non-contestble economic reltionships tht cn impct on the nture of the competitive environment. In turn the competitive environment my feedbck on to motivtion problems. Alterntively, one cn lso focus on given orgnistionl structure tht my constrin the set of productive opportunities, leding to incresing costs in terms of mngeril nd complementry ssets. 4

6 . RONALD COASE AND REAL FIRMS This hndbook develops vision of the economics nd theory of the firm tht echoes work opened up by Ronld Cose with his notion of relism. In his 937 rticle 'The Nture of the Firm', Cose proposes reserch project tht revolves round relistic theory of the firm (Cose, 937/993): it is ll the more necessry not only tht cler definition of the word firm should be given but tht its difference from firm in the rel world, if it exists, should be mde cler. Mrs. Robinson hs sid tht the two questions to be sked of set of ssumptions in economics re : Are they trctble? nd : Do they correspond to the rel world?. Though, s Mrs. Robinson points out, more often one set will be mngeble nd the other relistic, yet there my well be brnches of theory where ssumptions my be both mngeble nd relistic. It is hoped to show ( ) tht definition of firm my be obtined which is not only relistic in tht is corresponds to wht is ment by firm in the rel world, but is trctble ( ) (ibid, p. 8) This ide is reflected throughout his vrious writings, ech time further clrified. In one of his most recent rticle, Cose (998) returns to the notion of relist theory tht the New Institutionl Economics cn offer. According to Cose this theory is quite different from the institutionl economics of Commons nd Mitchell, which does not offer ny robust theory to orgnize the vst collection of fcts. This theory lso differs from trditionl nlysis, which is pure theory, highly bstrct nd little ffected by wht hppens in the rel world (ibid, p. 7). Since Adm Smith, economists hve minly focused on the formliztion of the invisible hnd, i.e. on the nlysis of extreme decentrliztion. However, there re other possibilities to develop economic nlysis. We my be interested on how supply nd demnd determine prices, but we my lso nlyze the fctors tht determine wht goods nd services will be trded on mrkets nd re chrged specific price. Cose believes tht economists hve 5

7 focused only on the first question, s they focused essentilly on the issue of refining the toolbox rther thn the object of study: In sying this I should not be thought to imply tht these nlyticl tools re not extremely vluble. ( ). My point is different. I think we should use these nlyticl tools to study the economic system. I think economists do hve subject mtter : the study of the working of the economic system, system in which we ern nd spend our incomes. (ibid., p. 73). The relist theory of the firm should provide nswers to questions like: wht re the fctors tht determine the reltive costs coordintion within firm or on the mrket? Wht fctors determine the coordintion between firm nd its supplier, client, prtner or competitor? How, ultimtely, is chieved the coordintion of this complex nd interconnected structure of the industry, which is lso subject to the influence of the lws, of the socil system, of technologicl chnges. This distinction between pure theory nd relistic theory of the firm is lso strongly denounced in his speech when he received the Nobel Prize in 99, when he sys tht in the pure theory of minstrem nlysis (Cose, 99): Wht is studied is system which lives in the minds of economists but not on erth. I hve clled the result blckbord economics. The firm nd the mrket pper by nme but they lck ny substnce. (ibid, p. 95). However, in his 993 rticle entitled 'The Nture of the Firm: Mening', Cose explins the methodology of his reserch project. Going bck into the resons tht motivted the 937 rticle, he explins tht the rgument hs to be bsed on hypotheses both usble nd relistic (Cose, 993b): 6

8 My rticle strts by mking methodologicl point : it is desirble tht the ssumptions we mke should be relistic. Most reders will pss over these opening sentences (Puttermn omits them when reprinting my rticle), nd others will excuse wht they red s youthful mistke, believing, s so mny modern economists do, tht we should choose our theories on the bsis of the ccurcy of their predictions, the relism of their ssumptions being utterly irrelevnt. ( ) In effect wht this comes down to is tht when economists find tht they re unble to nlyze wht is hppening in the rel world, they invent n imginry world which they should be cpble of hndling. (ibid, p. 5). This ide is even further reinforced in comment of n rticle by Posner (Cose, 993c): Posner ( ) refers to my dislike of bstrction. This is wrong. It is true tht I sid, in my Wrren Nutter lecture, tht the ssumptions of our theory should be relistic. Relism in ssumptions forces us to nlyse the world tht exists, not some imginry world tht does not (Cose, 988, p. 65). But I go on to sy : it is, of course, true tht our ssumption should not be completely relistic. There re fctors we leve out becuse we do not know how to hndle them. There re others we exclude becuse we do not feel the benefits of more complete theory would be worth the costs involved in including them. Their inclusion might, for exmple, gretly complicte the nlysis without giving us greter understnding bout wht is going on. Agin, ssumptions bout other fctors do not need to be relistic becuse they re completely irrelevnt ( ) There re good resons why the ssumptions of one s theories should not be completely relistic but this does not seem tht we should loose touch with relity (Cose, 988, pp ). As this quottion indictes, I do not dislike bstrction. But the right degree of bstrction depends on the problem tht is being nlysed. Wht I object to is mindless bstrction or the kind of bstrction which does not help to understnd the working of the economic system. My im is to bring existence n economic theory which is solidly bsed (ibid, p. 97). It is therefore cler tht the definition of the firm in the rel world nd in the nlysis is fundmentl issue in Cose s work, leding to possible propositions on wht is theory to understnd how economic systems work. 7

9 In his rticle "Industril Orgniztion: A Proposl for Reserch", published in 97 following conference in honor of the 50th nniversry of the NBER, Cose stresses tht the object of study of the relist theory he developed is the orgniztion of industry, nd not just the firm (Cose, 97): We ll know wht is ment by the orgniztion of industry. It describes the wy in which the ctivities undertken within the economic system re divided up between firms. As we know, some firms embrce mny different ctivities; while for others, the rnge is nrrowly circumscribed. Some firms re lrge ; others, smll. Some re verticlly relted; others re not. This is the orgnistion of industry or s it is used to be clled the structure of industry. Wht one would expect to lern from study of industril orgnistion would be how industry is orgnised now, nd how it differs from wht it ws in erlier periods ; wht forces were opertive in bringing bout this orgnistion of industry nd how these forces hve been chnging over time ; wht the effects would be of proposls to chnge, through legl ction of vrious kinds, the forms of industril orgniztion. (ibid, p. 60). And he dds: But if we re to tckle the problem of industril orgnistion seriously, theory is needed. (ibid, p. 63). The work he considers s importnt in guiding relistic theory of the orgniztion of industry, re those by Willim Thorp, DH Robertson nd Alfred Mrshll. These references hve inspired his 937 theory on the nture of the firm nd fit lso with his rticle of 97 on the orgniztion of industry: The wy in which n industry is orgnized is thus dependent on the reltion between the costs of crrying out trnsctions on the mrket nd the costs of orgnizing the sme opertions within tht firm which cn perform this tsk t the lowest cost. Furthermore, the costs of orgnizing n ctivity within ny given firm 8

10 depends on wht other ctivities it is engged in. A given set of ctivities will fcilitte the crrying out of some ctivities, but hinder the performnce of others. It is these reltionships which determine the ctul orgniztion of industry. ( ). But hving sid this, how fr hed re we? We know very little bout the costs of conducting trnsctions on the mrket or wht they depend on ; we know next to nothing bout the effects on costs of different groupings of ctivities within firms. About ll we know is tht the working out of these interreltionships leds to sitution in which vible orgniztions re smll in reltion to the economic system of which they re prt. (ibid, p. 64). Although the NBER contributions in this re were very few in 97, Cose emphsizes in prticulr three nmes Solomon Mnufcturer The trend of government ctivity in the US since 900 ; Rlph Nelson, Merger movements in Americn industry ; nd Michel Gort, Diversifiction nd integrtion in Americn industry : This proposl for more reserch is founded on my belief tht it is unlikely tht we shll see significnt dvnces in our theory of the orgnistion of industry until we know more bout wht is tht we must explin. An inspired theoreticin might do s well without such n empiricl work, but my own feeling is tht the inspirtion is most likely to come through the stimulus provided by the ptterns, puzzles, nd nomlies reveled by systemtic dt-gthering, prticulrly when the prime need is to brek our existing hbits of thought (ibid, pp. 70-7). Of the three works tht I hve mentionned, tht by Professor Gort comes closest to wht I hve in mind when I spek of the reserch on industril orgniztion tht we need tody. Professor Gort does del with the question of rnge of ctivities orgnized within the firm, nd there cn be few problems of importnce in industril orgniztion on which he does not touch. However, Professor Gort bndoned the more strightforwrd methods of erlier investigtors, such s Willim Thorp. He mkes the centrl theme of his book study of diversifiction. He mesures trends in diversifiction, nd seeks to discover the economic chrcteristics of diversifying firms, nd of the industries entered by diversifying firms. Degrees of diversifiction re not, however, esy to define or to mesure, nd the results which Professor Gort presents re difficult to interpret without knowledge of the underlying industril structure (ibid, pp. 7-73). 9

11 As we shll see lter in this chpter, the reference to Michel Gort by Ronld Cose is of high importnce, since his work together with Steven Klepper on industry life cycles re considered tody s centrl representtion of how the drivers of chnge operte t the level of firms nd industries. This is, ccording to Cose, the premise of relistic theory of industry orgniztion. To develop generl pproch to the firm in the spirit of Cose s rel firms, one hs to recognise tht ny rel firm is mde of two bses: technicl (T) nd institutionl (I). The T bse is the trditionl ren of the theory of the firm nd the I bse is covered by the economics of the firm. To crete linkges between T nd I fctors we cn recognise tht ech cn ct in one of three wys (Dietrich nd Krfft, 0): they cn ct s drivers of chnge, they cn govern chnge processes nd they cn ct s ttrctors of chnge. To understnd the philosophy behind this Hndbook ech of these cn be (briefly) considered in turn. Anlyses of the firm tht emphsise T nd I drivers of chnge re chrcteristiclly Schumpeterin in nture. Although Schumpeter originlly suggested tht innovtion covers both T nd I fctors modern Schumpeterin nlyses of the firm tend to prioritise T drivers with I implictions following from this in mnner tht cn be viewed s governing the detils of chnge processes. Although Schumpeter tends to inspire modern discussions of firm chnge, eqully other erly writers on the firm emphsise T nd I drivers, for exmple Smith nd Mrx. In terms of more modern writing the competence nd cognitive views of the firm emphsise tht chnge drivers re firm specific nd frequently bsed on tcit nd/or system bsed knowledge. 0

12 The nlysis of firm chnge processes cn lso be viewed s being governed by T nd I fctors. For exmple the modern nlysis of modulrity nd network effects emphsises tht firm dpttion is n importnt topic for nlysis. I process fctors re similrly importnt to the nlysis of the firm. For exmple, Glbrith s technostructure cn be viewed in this light or the wy tht cognition nd knowledge chnnel firm development. In ddition Commons nlysis of the firm s n mlgm of rules cn be viewed in this light. Finlly exogenous T nd I chnges cn ct s ttrctors to which firms djust. This is the method chrcteristiclly dopted by Austrin views of entrepreneurship in which firm orienttion is viewed s dpttion to mrket nd technicl chnge. In ddition trnsction cost economics dopts the sme bstrct logic. With regrd to the ltter trdition n importnt impliction follows from the ttrctor logic tht is used. As Willimson (99) himself emphsises, firm dpttion is viewed s economising not strtegising. This point is tken up in lter discussion in this chpter. While different pproches to the firm cn be nlysed in terms of T nd I fctors tht crete chnge drivers, govern chnge processes nd ct s ttrctors, three complexities cn be recognised tht hve influenced the structure nd content of this Hndbook. First the vrious elements of the T-I, drivers, processes nd ttrctors frmework cn be combined. Often this combintion is logiclly necessry. For exmple within trnsction cost economics exogenous technicl innovtion cn chnge sset specificities tht led to institutionl development becuse of the new ttrctor(s). But lso note tht certin combintions crete logicl difficulties. For exmple n emphsis on firm processes tends to downgrde the importnce of chnge ttrctors. In ddition, frequently combining the vrious elements of rel firm nlysis cretes complexities tht need to be mnged. One pproch here is to constrin nlysis to concentrte on prticulr spects of firm ctivity s is done in prts VI nd VII of this

13 Hndbook tht cover wht re clled modern issues nd firm strtegies. The second complexity of rel firm nlysis is tht the vrious possible linkges upon which it is bsed do not crete closed systems. Insted wider institutions nd government policies chnnel the mnner in which vrious linkges cn function. This is reflected in this volume by number of the chpters in prt IV (on the multintionl firm) nd lso in prt VIII on economic policies nd the firm. The finl complexity of rel firm nlysis, is one in which the editors re prticulrly interested. It involves locting the nlysis of the firm in prticulr mrket or similr effects. This is the logic for the inclusion of the chpters in prt VI of this Hndbook tht cover vrious modern issues. Two such specific mrket effects re useful tools to crete bridges between the theory nd the economics of the firm: life cycle theory nd oligopoly theory. In the rest of the min body of this chpter, these two pproches to the nlysis of firms nd mrkets will be used to explore possible interctions between the economics nd theory of the firm. The intention here is tht the two pproches provide complementry insights lthough we will see tht some of these insights re remrkbly consistent. The complementrity here is, of course, fundmentlly methodologicl: on the one hnd n evolutionry perspective nd on the other comprtive sttic nd optimising pproch. The intention is not to provide n exhustive discussion but insted to provide sufficient evidence tht nlysis of the firm should crete bridges chrcteristiclly seprte res of discussion. 3. THE FIRM IN INDUSTRY LIFE CYCLES The growing body of nlysis in the field of industril dynmics since the 980s my led people to think tht new domin of reserch hs emerged. This is of course misperception

14 since some erly contributions provided first steps towrds the elbortion of such n pproch. Schumpeter (9, 94) did significnt work emphsising the role of the entrepreneur in the development of innovtion, s well s the evolution of industry in context of rdicl chnge. Mrshll (890, 90) lso proposed mny lines of inquiry, such s the fct tht the economy is composed of different sectors, the growth nd decline of which is unequl nd intrinsiclly dependent on the orgnistion of knowledge. Over the 980s, however, some uthors built on the neglected work of Schumpeter nd Mrshll, nd focused on mjor chnges tht hve tken plce in industry structure, industril ledership, economic growth nd innovtion. The reserch progrm initited by Nelson nd Winter (98), which focused on evolutionry theory nd economic chnge, opened the door to new interprettions. In one of these new interprettions, Gort nd Klepper (98) tried to understnd the long-term evolution of innovtive industries, nd ssessed tht this long-term evolution is essentilly chrcterized by life cycle in which industries, like bio-orgnisms, rise in their birth phse, grow nd mture in their development time, nd decline in their deth phse. The industry life cycle clerly dded vlue to the explntion of lrge number of regulrities occurring in innovtive industries: production increses in the initil stges nd declines in the finl stges; entry is dominnt in the erly phses of the life cycle nd is progressively dominted by exit ( mssive process of exit - shkeout - occurs in the finl stges of the life cycle); mrket shres re highly voltile in the beginning, nd tend to stbilise over time; product innovtion tends to be replced by process innovtion; first movers generlly hve ledership position which gurntees their long-term vibility; product vriety disppers over time, s dominnt design emerges. One of these regulrities, i.e. the shkeout, progressively becme centrl regulrity to be explored in industril dynmics. Most of the recent debtes ttempted to clrify when nd why shkeout occurs. Given the lrge body of literture it is somewht 3

15 surprising tht linkges hve not been creted with the insights offered by the economics of the firm. This is wht we intend to do here. 3.. Development of technology, development of knowledge: possible sources of shkeout In the 990s, the literture on industril dynmics focused more nd more on the shkeout phenomenon, nd ttempted to clrify wht occurs in pre-shkeout versus post-shkeout periods. This ttention is of course relted to the crucil role of shkeout in the industry life cycle: cycle cnnot be observed without shkeout in mture stges of the industry. But shkeout is lso key to understnding why given industry is declining, nd why mjor ctors of this industry tend to be superseded by new ctors creting new industry. Behind this, there is the ide tht given technology cn crete profit opportunities for some time, but tht new technologies will recurrently be creted nd replce older ones. This Schumpeterin vision of the dynmics of n economic system hs been explored in recent contributions on the shkeout in industry life cycle, with n emphsis on different determinnts from purely externl technologicl shock to more endogenous rguments relted to the development of knowledge t the level of the firm. For Jovnovic nd Mc Donld (994), shkeout is generted by n externl technologicl shock, exogenous to the industry. The first technologicl shock sets in with the development of the new product being lunched on the mrket. Entry is stimulted by the emergence of new profit opportunities relted to this new technology/new product, but subsequently there is progressive reduction in profit mrgins nd the industril structure stbilizes on limited number of firms in the industry. At this stge, which corresponds to the mturity of the industry, new technologicl trjectory emerges nd gin stimultes the process of entry, in 4

16 the mentime, involving n djustment of incumbent firms. The process of djustment is driven by stochstic process nd only few firms survive this externl shock. The shkeout thus elimintes firms which filed to dpt themselves to the new technology. Alterntively, Abernthy nd Surez (978), nd Abernthy nd Clrk (985) hve developed n nlysis of shkeout nd dominnt design. When firm lunches new product in the mrket, it must fce high level of uncertinty ffecting both the conditions of demnd nd supply. On the demnd side, uncertinty comes from the fct tht the firm does not know the detils of customers preferences. On the supply side, the conditions of production re lso highly uncertin nd my evolve over time. Over time, uncertinty decreses nd selection opertes. On the demnd side, uncertinty decreses once customers of the new product hve tested the lterntive chrcteristics, nd cquired experience on wht they expect from the new product, which chrcteristics re more dpted to their personl tste nd usge. On the supply side, rivl producers lern over time nd ccumulte experience on wht customers prefer. In time they lso select series of production techniques which re dpted to low cost production. Since uncertinty decreses, the shkeout ppers s n endogenous phenomenon. Product innovtion diminishes becuse most of the ctors (producers nd customers) re nturlly oriented towrds the production nd consumption of stndrdized good. The progressive emergence of dominnt design involves higher brriers to entry which correspond with investments by incumbents in process innovtion. Entry is thus limited, nd less efficient incumbent firms exit the industry. Finlly, Klepper (996) reltes the shkeout to the timing of entry. The reference is, here gin, the Schumpeterin hypothesis on the reltion between firms size nd R&D cpcity. But the novelty is tht this hypothesis is discussed on the bsis of finer distinction between 5

17 firms which cn eventully be incumbent, new entrnt, or ltecomer. Process innovtion decreses the verge costs of lrge firms, which re the mjor ctors of this type of innovtion. However, some key elements my erode the dvntge of lrger firms. For instnce, lrge firms hve to cover specific costs, such s expnsion costs, which limit their growth. The ctivity of R&D cn lso exhibit decresing returns to scle over time. Becuse of these elements, erly entrnts cn develop process innovtions, sometimes much better thn incumbents or ltecomers. Erly entrnts cn thus enjoy ledership position in process innovtion s, on the one hnd, incumbents hve to del with other problems which re relted to their lrge size nd, on the other hnd, ltecomers hve to concentrte on product innovtion which llows them to grow to minimum size in order to survive. The timing of entry is thus mjor determinnt in the formtion of competitive dvntge over incumbents, s well s in long term survivl over ltecomers. This mechnism provides n lterntive explntion of the shkeout. The ide of shkeout essentilly driven by the evolution of technology over the course of the industry life cycle is thus progressively chllenged by new vision. The development, ccumultion, diffusion nd usge of competencies re thus key elements which drive the industry-life cycle nd, s n outcome, involve sensibly different vision of shkeout which is closer to the Mrshllin trdition. Mueller (990, 997) shows tht the long term vibility of first movers is relted in lrge number of industries to specific fetures of demnd (such s set-up nd switching costs, network externlities of finl users, inerti effects due to the customer s uncertinty on qulity, inerti effects due to the customer s experience of existing products nd services), s well s supply (such s set-up nd network externlities of producers, economies of scle, cost-decresing lerning by using). Finlly, Vn Dijk (998) 6

18 shows tht incresing returns in R&D is not the mjor element in the first movers competitiveness, but tht network effects hve rther decisive effect. Industry life cycle nlyses generlly focus on industries in which competition nd innovtion proceed from the interction between firms (incumbents nd entrnts) within given mrket, delimited by the purchses nd sles of n homogenous product. On some occsions, however, verticl reltionships between firms in the industry nd their direct suppliers or customers hve strong impct on the evolution of industries. Innovtion processes require the ccumultion of complementry competencies, s well s n effective coordintion between firms which generte these competencies. Since the industry is chrcterized by strong coordintion between suppliers nd producers, or producers nd retilers, processes of entry nd exit become industry-specific. Alterntive life cycle ptterns thus pper, eventully with non-shkeout phenomen. In some industries the emergence of specilized suppliers tends to re-dynmize the entry process in the phse of mturity. They develop new production processes, new specilized equipment, new technology t the upstrem level nd sell it to ny downstrem potentil entrnt who cn py the price. They significntly decrese brriers to entry nd fvor competition (Frnsmn, 999; Krfft, 00). In some cses, n industry ws creted by n initil inventor or n cdemic resercher who decided to set up firm to exploit the commercil opportunities of his innovtion. Mny times, however, the production nd distribution of this innovtion required the contribution of other ctors, usully lrger firms. The coordintion of competencies relted to innovtion on the one hnd, nd complementry competencies relted to production nd distribution on the other hnd, strongly shped the profile of evolution of the industry, nd stimulted new entries (Bresnhn nd Rff, 99; Mitchell, 995; Klepper, 997). 7

19 The coordintion of similr competencies is lso n importnt topic for reserchers interested in how innovtions occur nd their implictions for firms nd economic chnge. In some industries there is somewht prdoxicl phenomenon tht both smll, specilized firms nd lrge, diversified firms co-exist in the long run. Specific firms my come nd go, nd there re certinly mergers, llinces, nd bnkruptcies, but the two types of firms seem to n extent mutully dependent on ech. This sitution my led to non-shkeout profiles of evolution, with smll firms nd lrge firms surviving over the long run. It seems importnt to combine such llinces with in-house R&D nd competencies, becuse otherwise the firm hs difficulties in evluting the potentil of new ides nd techniques tht re developed outside the firm. In mny cses, the intrinsic chrcteristics of knowledge in terms of codifiction nd ppropribility requires extended interction, nd explins why collbortion occurs mongst firms with similr competencies in order to stimulte innovtion. But in the mentime, ownership nd control rights re importnt to understnd who hs llinces with whom nd re bsolutely crucil in the evolution of the industry (Mc Kelvey, 996; Sviotti, 998). Finlly, the coherence tht firms tend to develop in the coordintion of similr nd complementry competences tend to pper s mjor issue in industril dynmics. About some 0 yers go, Foss (993) nd Teece et l. (994) climed tht coherence becomes cognitive concept incorporting elements such s orgniztionl lerning within the firm, pth-dependency chrcteristics, the depth nd scope of technologicl opportunities in the neighbourhood of the firm s own technology nd R&D ctivities, nd the influence of the selection environment. Tody, the notion of coherence tends to get n opertionl content in the industril dynmics literture with the development of metrics on reltedness, proximity, similrity nd interconnectedness nd how they tend to evolve over time (Nooteboom, 004; Krfft, Qutrro, Sviotti, 0). 8

20 3.. Industry dynmics nd the nture of the firm Wht conclusions cn be drwn from this discussion of industry dynmics nd life cycles with regrd to the nture of the firm? As preliminry comment, we cn first think tht technology essentilly drives the life cycle of n industry, nd is responsible for the shkeout. This clls to mind Schumpeter s vision of cretive destruction in industril dynmics. An entrepreneur sets up firm to introduce n invention. This firm grows nd holds monopoly position for some time. But in time this firm is imitted by new entrnts tht eventully outperform the initil firm. This sitution cn continue until nother entrepreneur develops new project involving the exit of older nd lrger firms nd the entry of new ones. But we cn lso think bout the shkeout in different mnner. We cn consider tht knowledge nd competencies drive the life cycle of the industry. In tht cse, closer to Mrshll s vision, the growth of knowledge is linked to the bility of firms to ensure coherence between internl economies (orgniztion nd direction of the resources of the firm) nd externl economies (generl development of the economy, including the role of firms in the neighborhood). In this perspective, the shkeout ffects firms differently, since some firms might hve the opportunity to ccumulte specific knowledge nd competencies, nd survive. In some cses non-shkeout ptterns my thus emerge. Beyond these bckground points bout the relevnce of erlier nlysis to orgnistionl s well s technicl fctors we cn suggest tht the diversity of the empiricl evidence, nd interprettions of this evidence, suggests tht no single pproch to the firm is relevnt in ll circumstnces. Consider, first, Schumpeter inspired nlysis tht life cycles re technologiclly driven with key role plyed by the mngement of demnd nd supply side 9

21 uncertinties. To lrge extent this cn be mpped into, for exmple, trnsction cost nlysis of the firm. The technologicl driver is essentilly exogenous to orgnistionl dpttion. The key role of uncertinty, nd its link with lrge firm size, is lso consistent with this perspective on the firm (Willimson, 985). But now consider Mrshllin inspired nlysis tht emphsises the cretion nd mngement of knowledge. Here we cn echo, for exmple, Brnrd (938) nd suggest tht the cretion of new knowledge is endogenous to firm decisions nd in terms of the economics of the firm we must ccount for chnge processes not just dpttion to exogenous technologicl chnges. In ddition Brnrd is useful becuse he emphsises tht firms re not long-lived. In terms of modern writing we cn incorporte competence perspectives on the firm, s suggested bove. We re not suggesting here tht one pproch (Schumpeter or Mrshll) is universlly relevnt insted we prefer to suggest tht the pproches re relevnt in different circumstnces. Consider now wht might be considered the key insight of empiriclly bsed studies of industry dynmic: the role of shkeout. Two key issues would pper to be pproprite here. First, the nture nd type of competition chnges pre- nd post- ny shkeout. Pre-shkeout intense competitive pressures result from firm entry nd exit. Post-shkeout incresed firm size nd reduced entry/exit implies the emergence of oligopolistic structures with the complexity of strtegic interdependence this implies. Argubly the economic-institutionl spects of this post-shkeout world hve been under-nlysed. Hence n oligopoly model tht incorportes trnsction costs is suggested below. The second issue we cn tke from the erlier shkeout discussion is tht we cnnot utomticlly link shkeout with technicl progress becuse of the observed continution of old technologies is some res. This continuing relevnce of old technologies suggests non-dpttion to technologicl ttrctors 0

22 becuse of the dominnce of process considertions. In n orgnistionl context, this observtion (once gin) echoes Brnrd s work. Finlly, in this section, we cn consider the issue of the boundries of the firm. If we ccept the logic of n orgnistionl life-cycle nlysis firm boundries cn be nlysed in terms of the dominnce of driver, process or ttrctor effects, nd so (once gin) no single pproch is likely to be relevnt. In erly life-cycle stges, with the dominnce of technicl nd orgnistionl drivers we cn suggest tht firm boundries re bsed on the restructuring of institutionl nd technicl knowledge linkges. In this context we cn recognise the erlier discussion of the restructuring of verticl reltions nd hence the relevnce of Richrdson (97) bsed nlysis of the firm nd industry. When process considertions dominte firm ctivity we cn suggest tht firm boundries re bsed on ttempts to estblish orgniztionl nd institutionl rules. This estblishment of rules will involve scle nd scope effects long the lines suggested by Chndler (977, 990) nd hence incresing firm size. Using erlier discussion we cn suggest tht this dominnce of process, nd the emergence of estblished rules, requires shkeout of firm ctivity nd hence limittion on entry nd exit. But t the sme time we should not over simplify the emergence of lrge firms, nd expnding firm boundries, becuse of the possible complementrity between smll nd lrge firms. Hence the estblished rules tht govern orgnistionl processes cover inter-firm s well s intr-firm ctivity. Finlly, when ttrctors dominte firm development this will be response to diffusing knowledge nd rule stbility in post-shkeout world. In this context firm boundries cn be understood in the context of efficiency seeking behviour.

23 4. A FORMAL MODEL OF REAL FIRMS In the previous sections links hve been creted between the theory nd the economics of the firm. The bsic conclusion hs been tht no pproch to the firm is uniquely dominnt. In this section different pproch to creting theoreticl linkges is developed in terms of simple model of the firm. The bsis of this modelling is the introduction of trnsction cost fetures into n otherwise stndrd model of the firm. This would pper to be n pproprite mode of nlysis for two resons. First, there is methodologicl consistency in the use of comprtive sttics (Dietrich, 994). Secondly the ssumption of economising on trnsction costs is the dul of optimising behviour. 4.. A single firm The simplicity of the modelling here is tht ll bsic reltionships re ssumed liner, feture tht is commented on s the discussion proceeds. The discussion is presented in two stges. In this section bsic model for single firm is developed. It is shown tht predictions pprently consistent with some observtions in the life-cycle literture re forthcoming. Following this Cournot bsed duopoly nlysis is presented. The objective here is to explore the ide suggested bove tht trnsction cost economics my gin prticulr relevnce in lter life cycle stges tht re chrcterised by reltive knowledge stbility nd strtegic interction. But, once gin, linkges re creted to the life-cycle nd other litertures. The bsic model involves stndrd nd simple, single product firm but introduces possible trnsction cost effects into this. Obviously ny firm undertkes mny specific orgnistionl tsks tht cover the mngement of output mrkets, intr-firm ctivity nd input mrkets. Following stndrd nlysis we cn think of these tsks in generl terms s mnging serch,

24 negotition nd policing ctivities. To simplify technicl detil we ssume tht these vrious mngeril tsks re undertken in fixed proportions with no substitution between orgnistionl humn nd non-humn inputs being possible. This simplifiction llows us to crete n ggregte mesure of trnsction costs (C T ) tht is simply the sum of the vrious specific orgnistionl costs. We therefore hve single mesure of mngeril ctivity tht cn be pplied in the different contexts. In ddition this mesure will be used s n indictor of orgnistion size rther thn using rel output s mesure of firm size. In terms of firm s demnd for rel output we ssume the following liner form: X = ( 0 / ) (/ )p + ( / )C T [] In [] X is output sold per period nd p is selling price. The role of C T here involves, for exmple, greter serch nd negotition ctivity incresing output sold for ny selling price. The linerity ssumptions in [] re clerly not relistic for lrge chnges in the vribles but significntly simplify technicl detil. It is more useful to re-write [] s n inverse demnd function: p = 0 X + C T [b] In turn [b] llows us to define firm s totl revenue: TR = px = 0 X X + C T (X) [c] A firm s verge production costs (AC P ) re modelled s follows: AC P = b 0 b C T > 0 [] With given C T formultion [] defines, of course, constnt returns technology. The C T effect cn be thought of s either more effective mngement of intr-firm ctivity ffecting productivity nd costs nd/or more effective serch, negotition nd policing in input mrkets. In [] it is clerly inpproprite to extrpolte beyond resonble bounds, hence the 3

25 requirement tht AC P is positive. This requirement suggests n orgnistionl cpcity constrint: C T < b 0 /b [b] Using [] we cn define firm s totl production costs (TC P ): TC P = b 0 X b C T (X) [c] In turn we use [c] to define firm s totl costs (TC): TC = b 0 X b C T (X) + C T [d] Using [c] nd [d] firm s profit function is: π = 0 X X + C T (X) [b 0 X b C T (X) + C T ] [3] We cn nlyse [3] in terms of short-run nd long-run solutions. The short-run solution involves profit mximising with two choice vribles X nd C T. Differentiting [3] with respect to these vribles nd setting the derivtives equl to zero: b C b 0 X [3b] 0 X T 0 b X 0 [3c] C T Using [3b] we cn define profit mximising output in terms of C T : X 0 b0 b C T [4] In [4] the first element on the right hnd side is trditionl short-run vibility condition for firm ctivity. In the bsence of trnsction costs, the mximum price tht cn be chrged ( 0 ) must be greter thn exogenous unit costs (b 0 ) to generte positive output. But by introducing trnsction costs this vibility condition is mended. In the short-run (but not the long-run s considered below) positive output cn be generted with 0 < b 0 s long s C T is sufficiently 4

26 lrge, n observtion tht llows us to crete links, suggested below, between this model nd life-cycle nlysis. To solve the system defined by [3b] nd [3c] we substitute [4] into [3c] nd hence define optiml C T : C T 0 0 [4b] b b b The system defined by [4] nd [4b] presents unique solution. Substituting [4b] into [4]: X b [4c] The short-run solution implied by [4]-[4c] cn be nlysed in the context of the life-cycle literture introduced bove. Erly in life-cycle smll firm entry nd exit tends to be high. For successful firms profitbility is high. Firm success, in terms of the current model, requires lrge 0 b 0 i.e. lrge difference between mximum price nd exogenous unit cost. From [4b], lrge 0 b 0 implies smll C T (ceteris pribus). So, erly in life-cycle, when profit opportunities re lrge, we cn expect smll orgnistionl size. Another wy of interpreting this result is tht with 0 > b 0 firm is vible in the trditionl economic sense nd this reduces the requirement for orgnistionl effort. But s life-cycle proceeds mrket growth slows down. In terms of the current model this slowing cn be interpreted s flling 0 b 0. In turn from [4b] this mturing life-cycle implies lrger C T (ceteris pribus) nd so lrger orgnistionl size. Furthermore, eqution [4b] sys more thn this. Mrkets tht re unvible in the trditionl sense, i.e. with 0 < b 0, re short-run vible in our model s they generte lrge orgnistionl effort nd size. Short-run non-vibility in our model is exogenous nd produced by the orgnistionl cpcity constrint [b]. If the lrge C T predicted in [4b], becuse of possibly negtive 0 b 0, is greter thn the constrint defined in [4b] firm my 5

27 experience short-run non-vibility. In short the simple model developed here cn predict n evolution of orgnistionl size tht is pprently consistent with life-cycle nlysis. One peculirity of this model cn be identified. While orgnistionl size (C T ) vries with 0 b 0 in wy tht is understndble, from [4c] it is cler tht physicl output (X) does not vry with 0 b 0. Actul output is determined by the interction between C T nd revenue nd cost determintion, i.e. nd b, but not directly by C T. To some extent this is n interesting property of the model: physicl output is determined by the interction terms in the model nd so indirectly by trnsction cost rther thn simply by profit potentil. Intuitively, ny profit potentil requires pproprite orgnistionl effort. But eqully, one reson for this result is the linerity of the bsic reltionships in the model. With incresing orgnistionl effectiveness s C T increses, or with incresing physicl returns to scle, we would not expect this result to hold. The long-run solution to the model presented here to some extent, but not completely, qulifies the conclusions just drwn. Long-run firm vibility requires non-negtive profits. Re-writing [3] nd imposing this constrint: π = ( 0 b 0 )X X + [( + b )X ]C T > 0 [3 ] Using [4c], i.e. the condition for profit mximising output, it is cler tht [ + b ]X is lwys unity if we impose profit mximistion. Hence the non-negtivity of profit in [3 ] depends on ( 0 b 0 )X X. It follows tht long-run firm vibility requires 0 > b 0, s we would expect in non trnsction cost model. An impliction here is tht in our simple model trnsction costs hve short-run but not long-run impct on firm vibility nd ctivity. But once non-negtive profits re erned the orgnistionl size effects discussed bove re relevnt. 6

28 One finl point is pproprite in this discussion. We hve interpreted the single firm model in terms of possible life-cycle effects. But n lterntive, nd perhps more stndrd, interprettion is possible. Competitive mrket nlysis suggests tht firm entry occurs with positive profitbility, in the bsence of entry nd exit brriers. In this context our model cn be viewed s developed monopolisticlly competitive firm. Successful firm entry will reduce the mrket shres of existing firms. In terms of our simple model successful firm entry reduces 0. Firm entry will therefore eventully impose non-negtive profit constrint s in [3 ]. The possible effects here re illustrted in Tble. tht shows the impct of chnging 0 for prticulr prmeter vlues. Tble. here Impct of chnging 0 As we move from left to right cross the columns of Tble. we see the impct of declining 0 interpreted s either mturing life cycle or greter competition from firm entry. We cn see the unchnged physicl output, feture lredy discussed. More importntly we see incresing orgnistionl size (C T ) nd declining profitbility. If we interpret chnging 0 s response to firm entry the chnge in C T wrrnts discussion. With trditionl monopolistic competition movement to long-run equilibrium resulting from firm entry produces excess cpcity. The ltter, in turn, my introduce n incentive for lrger firm size, perhps vi merger, to eliminte the excess cpcity. In the model developed here we see lrger orgnistionl size emerging with greter competition but this is not becuse of excess cpcity. It is due to the interction between trnsction costs nd firm revenue nd costs. Intuitively, greter competition genertes greter profit seeking incentives tht require lrger 7

29 trnsction costs nd hence orgnistionl size. In the comprtive sttic model developed here this process hs long-run equilibrium with zero profits being erned. This long-run solution is cler in Tble.. This long-run constrint on firm size occurs even though we hve exogenous constnt returns to scle. Hence the constrint is produced by the interction between the economics nd theory of the firm. 4.. A duopoly model of rel firms In this section the discussion of the firm just presented is further developed in terms of Cournot bsed duopoly nlysis. The objectives here re twofold. First we further explore linkges between the economics nd theory of the firm. Secondly we develop the ide tht trnsction cost economics my gin prticulr relevnce in lter life cycle stges tht re chrcterised by reltive knowledge stbility nd strtegic interction. The bsic structure of the nlysis is the sme s tht used bove except tht we hve two firms. The inverse demnd functions re: p = 0 X X + 3 C T p = 0 X X + 3 C T [5] [5b] Note the following fetures here. The two demnd functions hve identicl prmeters. In principle this is unnecessry but simplifies technicl detil. The two firms hve individul prices becuse of individul orgnistionl efforts (C T nd C T ) nd becuse of potentil product differentition when nd re not equl. The issue of potentil product differentition is importnt in this model nd will be discussed further below. But even though there re individul prices in [5] nd [5b] in Cournot equilibrium prices will be the sme becuse of identicl prmeters nd cost functions (s detiled below). X hs n impct on p, in turn C T impcts on X hence there is n indirect effect of C T on p but in [5] there 8

30 is no direct effect. Similrly there is n indirect impct of C T on p but no direct impct. Using [5] nd [5b] we cn define firm totl revenues: TR = p X = 0 X X X X + 3 C T X TR = p X = 0 X X X X + 3 C T X [5c] [5c] Firm costs re structured in the sme wy s in the previous section. Averge production costs re: AC P = b 0 b C T > 0 AC P = b 0 b C T > 0 [6] [6b] There is the sme requirement for orgnistionl cpcity constrints: C T, C T < b 0 /b [6c] Totl costs re: TC = b 0 X b C T X + C T TC = b 0 X b C T X + C T [6d] [6e] Firm profits re: π = 0 X X X X + 3 C T X [b 0 X b C T X + C T ] π = 0 X X X X + 3 C T X [b 0 X b C T X + C T ] [7] [7b] As bove we hve two choice vribles for ech firm (output nd trnsction costs) but in ddition we hve the dded complexity of the strtegic interction of the firms. The relevnt first order conditions re: X X X C b b C 0 [8] 0 3 T 0 T b X 0 [8b] C T 3 X X X C b b C 0 [8c] 0 3 T 0 T b X 0 [8d] C T 3 9