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Testing Alternative Theories of the Firm: Transaction Cost, Testing Alternative Theories of the Firm: Transaction Cost, Knowledge-Based, and Measurement Explanations for Knowledge-Based, and Measurement Explanations for

Make-or-Buy Decisions in Information SystemsMake-or-Buy Decisions in Information Systems

Laura Poppo Laura Poppo (Virginia Tech)(Virginia Tech) Todd Todd Zenger (Zenger (Washington University)Washington University)

(1998)(1998) Strategic Management JournalStrategic Management Journal

Group 3:

Jason Franken Jason Franken Prasanna Karhade Prasanna Karhade Hsiao-Ching Lee Hsiao-Ching Lee

Jennifer ShenJennifer ShenMarko MadunicMarko Madunic

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GOALS AND OBJECTIVES

Strategic management seeks to explain how and why there are differences in firms’ economic performances

Poppo and Zenger’s paper represents transaction-cost economics explanation of firm boundaries

TCE – not an exhaustive tool for analyzing boundary choices

Compare transaction cost, knowledge-based, and measurement cost explanations of make-or-buy choices

TCE has been a popular framework for analyzing the efficiency of inter-organizational boundary decisions

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Then, why should a firm buy knowledge on a market when it has the capacity to build it internally?

Knowledge is built as coordination and communication mechanisms emerge and become embedded in some shared identity (Kogut and Zander, 1996)

This common identity lowers the cost of communication for future search

“As an activity becomes more specific to the firm, it increasingly accesses and develops a common organizational communication code which both codifies knowledge and facilitates its efficient dissemination and protection ”

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Then, why should a firm buy knowledge on a market when it has the capacity to build it internally?

Knowledge-based reasoning suggests that firms with superior capabilities tend to have more efficient production

Efficiencies are sensitive to scale, firms with greater production volume tend to internalize functions through vertical integration

STRATEGIC IMPORTANCE OF KNOWLEDGE WITHIN FIRM

(RBV and knowledge based view) – firms will control particular knowledge source when strategic importance is highFirms adopt the knowledge acquisition mode of internalization

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Asset specificity

TCE: Assumption that efficient production necessitates investments in physical and human assets that are transaction specific (Williamson, 1979)TCE logic assumes that firm specific assets reduce costs, these assets are also hypothesized to damage the performance of simple market governance as a result of costly contractual safeguards to protect from opportunist behavior (Williamson, 1981, 1985)

Resources and capabilities The resource-based perspective is similar to TCE theory because asset specificity is related to the nature of firm resourcesRBV focuses on the firm’s competencies and capabilities of coordinating productive resources that are not transaction specific

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SAMPLE AND METHODS

Authors study the governance of nine information services at 152 companies, resulting in a sample 1,368 observationsSurvey data were gathered using a key informant technique from chief information service officer or the manager of information technology

DEPENDENT VARIABLE Information technology support services that require specialized skills were used as a dependent variableThe dependent variable has been defined as dichotomous, reflecting a yes/no decision toward outsourcing

Information systems – highly specific functions, involving tacit knowledge were less likely to be outsourced

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Results and findings:

Authors found that contrary to the RBV hypothesis (hypothesis 2) managers do not become more satisfied with performance as internal activities become more firm specific (page 867).

Firm specificity has a strong negative effect on market performance and no clear effect on firm-level performance

TCE view is corroborated as empirical test clearly shows that asset specificity triggers governance choices because hierarchies more effectively cope with asset specificity than markets

Routines, language and embedded forms of knowledge are thus rigid mechanisms that hamper performance

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Decision to vertically integrate when information services are firm specific are more determined by performance dissatisfaction with using market governance (outsourcing) rather than performance satisfaction with using internal governance (internal sourcing)

Therefore, boundary choices should be a function of the possession and composition of rare and inimitable resources that are a source of competitive advantage

Risk of obsolescence is better managed by external suppliers

Results and findings:

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Firm sizeContrary to the scale economies hypothesis, larger firms are inclined to outsource their IT activities more

Increasing management costs, linked to more complex organizational structure, are major determinant of the outsourcing of non-core activities

IT: Information systems are generally viewed as non-core activities, and difficult to manage internally

Firms will outsource IS functions, the more comprehensive the demands for personnel with extensive knowledge and skills

Results and findings:

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TCE LIMITATIONS

The dynamics of rapidly evolving information technology exposed theoretical shortcomings of TCE research

Authors question overemphasis in TCE on asset specificity, without sufficient consideration of the firm’s competencies and capability of coordinating productive resources that are not transaction specific

If competitive advantage emanates from valuable and inimitable resources (Barney, 1991) then boundary choices should be explained by the possession and composition of resources that are a source of competitive advantage