knowledge based theory

Strategic Management Journal, Vol. 17(Winter Special Issue), 109-122 (1996)

TOWARD A KNOWLEDGE-BASED THEORY OF THEFIRMROBERT M. GRANTSchool of Business, Georgetown University, Washington, DC, U.S.A.

Given assumptions about the characteristics of knowledge and the knowledge requirements ofproduction, the firm is conceptualized as an institution for integrating knowledge. The primarycontribution of the paper is in exploring the coordination mechanisms through which firmsintegrate the specialist knowledge of their members. In contrast to earlier literature, knowledgeis viewed as residing within the individual, and the primary role of the organization isknowledge application rather than knowledge creation. The resulting theory has implicationsfor the basis of organizational capability, the principles of organization design (in particular,the analysis of hierarchy and the distribution of decision-making authority), and the determinantsof the horizontal and vertical boundaries of the firm. More generally, the knowledge-basedapproach sheds new light upon current organizational innovations and trends and has far-reaching implications for management practice.

Theories of the firm are conceptualizations andmodels of business enterprises which explain andpredict their structure and behaviors. Althougheconomists use the term 'theory of the firm' inits singular form, there is no single, multipurposetheory of the firm. Every theory of the firm isan abstraction of the real-world businessenterprise which is designed to address a parti-cular set of its characteristics and behaviors(Machlup, 1967). As a result, there are manytheories of the firm which both compete in offer-ing rival explanations of the same phenomena,and complement one another in explaining differ-ent phenomena.

Economic theories of the firm are concernedprimarily with predicting the behavior of firms inexternal markets. In particular, the neoclassicaltheory of the firm uses partial equilibrium analysisto predict the firm's purchase decisions in inputmarkets and supply decisions in output markets.Organizational theory addresses aspects of the

Key words:nation

knowledge; theory of the firm; coordi-

firm ignored by neoclassical economics. Dispos-ing of the notion of the firm as a singular decisiontaker and recognizing the firm as a complexorganization encompassing multiple individuals,organization theory analyzes the internal structureof the firm and the relationships between itsconstituent units and departments.

Interest by social scientists in the firm as aninstitution has been stimulated by the question ofwhy firms exist at all. Dissatisfaction withKnight's explanation of the firm in terms ofoptimal risk allocation in the face of individuals'differential risk preferences (Knight, 1921)encouraged the emergence of the transaction costtheory of the firm which focused upon the relativeefficiency of authority-based organization('hierarchies') with contract-based organization('markets') (Coase, 1937; Williamson, 1975).Attempts at integrating economics and organiza-tional approaches to the theory of the firm haveincluded the behavioral theory of the firm (Cyertand March, 1963) and the evolutionary theory ofthe firm (Nelson and Winter, 1982).

Although strategic management has drawn itstheories of the firm from both economics and

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organization theory, its area of interest is differentfrom both. Its primary goals are to explain firmperformance and the determinants of strategicchoice. The result has been new contributions tothe theory of the firm. The resource-based viewof the firm is less a theory of firm structure andbehavior as an attempt to explain and predictwhy some firms are able to establish positions ofsustainable competitive advantage and, in sodoing, earn superior returns. The resource-basedview perceives the firm as a unique bundle ofidiosyncratic resources and capabilities where theprimary task of management is to maximize valuethrough the optimal deployment of existingresources and capabilities, while developing thefirm's resource base for the future.

The emerging 'knowledge-based view' is not,as yet, a theory of the firm. There is insufficientconsensus as to its precepts or purpose, let aloneits analysis and predictions, for it to be recognizedas a 'theory.' It represents a confiuence of long-established interests in uncertainty and infor-mation with several streams of newer thinkingabout the firm. To the extent that it focuses uponknowledge as the most strategically important ofthe firm's resources, it is an outgrowth of theresource-based view. At the same time, knowl-edge is central to several quite distinct researchtraditions, notably organizational learning, themanagement of technology, and managerial cog-nition. The issues with which the knowledge-based view concerns itself extend beyond thetraditional concerns of strategic management—strategic choice and competitive advantage—andaddress some other fundamental concerns of thetheory of the firm, notably the nature of coordi-nation within the firm, organizational structure,the role of management and the allocation ofdecision-making rights, determinants of firmboundaries, and the theory of innovation. Thepurpose of this article is to make progress indeveloping some key elements of a knowledge-based theory of the firm by synthesizing some ofthe principal contributions to this emerging field.The paper develops and extends some of the ideasoutlined in Grant (1996) into a more generalknowledge-based approach to the firm whichseeks to:

• explain the existence of the firm as an insitutionfor the organization of production (thirdsection);

• explore the nature of coordination within thefirm (fourth section);

• analyze organizational structure, focusing uponthe implications of the knowledge-based viewfor hierarchy and the location of decision-mak-ing authority (fifth section);

• determine the boundaries of the firm (sixthsection).

I begin by identifying some characteristics ofknowledge and establishing some fundamentalassumptions concerning its role within the firm.

FOUNDATIONS

The foundation for any theory of the firm is aset of initial premises which form the basis forthe logical development of propositions concern-ing the structure, behavior, performance and,indeed, the very existence of firms. Developinga knowledge-based theory of the firm raises theissue: What is knowledge? Since this questionhas intrigued some of the world's greatest think-ers from Plato to Popper without the emergenceof a clear consensus, this is not an arena inwhich I choose to compete. In terms of definingknowledge, all I offer beyond the simpletautology of 'that which is known' is the recog-nition that there are many types of knowledgerelevant to the firm.' For the purposes ofdeveloping a theory of the firm, my primary taskis to establish those characteristics of knowledgewhich have critical implications for management.The literature on the analysis and managementof knowledge points to the following character-istics as pertinent to the utilization of knowledgewithin the firm to create value.^

' Machlup (1980) identifies 13 different 'elements of knowing'including: being acquainted with, being familiar with, beingaware of, remembering, recollecting, recognizing, dis-tinguishing, understanding, interpreting, being able to explain,being able to demonstrate, being able to talk about, and beingable to perform. Machlup also identifies five 'classes ofknowledge' including: practical knowledge, intellectual knowl-edge (embracing scientific, humanistic, and culturalknowledge), pastime knowledge (news, gossip, stories, andthe like), spiritual knowledge, and unwanted knowledge.^ A firm can create value in two ways. By production inputsare physically transformed into outputs where the outputshave greater value than the inputs. By arbitrage, either acrossplace (trade) or time (speculation), firms create value bymoving a product from one market to another, but withoutphysically transforming it. In this paper, my focus is uponthe role of knowledge among firms which engage in pro-

Knowledge-based Theory of the Firm 111

Transferability

The resource-based view of the firm recognizesthe transferability of a firm's resources and capa-bilities as a critical determinant of their capacityto confer sustainable competitive advantage(Barney, 1986). With regard to knowledge, theissue of transferability is important, not onlybetween firms, but even more critically, withinthe firm. The management literature has clearlyrecognized the epistemological distinctionbetween knowing how and knowing about whichis captured by distinctions between subjective vs.objective knowledge, implicit or tacit vs. explicitknowledge, personal vs. prepositional knowledge,and procedural vs. declarative knowledge. Mypurpose here is not to make fine distinctionsbetween different types of knowledge. I identifyknowing how with tacit knowledge, and knowingabout facts and theories with explicit knowledge.The critical distinction between the two lies intransferability and the mechanisms for transferacross individuals, across space, and across time.Explicit knowledge is revealed by its communi-cation. This ease of communication is its funda-mental property. Indeed information has tradition-ally been viewed by economists as being a publicgood—once created it can be consumed byadditional users at close to zero marginal cost.Tacit knowledge is revealed through its appli-cation. If tacit knowledge cannot be codified andcan only be observed through its application andacquired through practice, its transfer betweenpeople is slow, costly, and uncertain (Kogut andZander, 1992).

Capacity for aggregation

The efficiency with which knowledge can betransferred depends, in part, upon knowledge'spotential for aggregation. Knowledge transferinvolves both transmission and receipt. Knowl-edge receipt has been analyzed in terms of theabsorptive capacity of the recipient (Cohen andLevinthal, 1990). At both individual and organi-zational levels, knowledge absorption dependsupon the recipient's ability to add new knowledgeto existing knowledge. This requires additivitybetween different elements of knowledge.

duction, mainly because this is the most important and com-plex means of value creation.

Efficiency of knowledge aggregation is greatlyenhanced when knowledge can be expressed interms of common language. Statistics is a parti-cularly useful language for aggregating (andtransferring) certain types of explicitknowledge—its efficiency in this role is greatlyenhanced through advances in information tech-nology. Thus, information on Ford Motor Com-pany's cash balances, its foreign currencyexposure, its inventories of spark plugs and crank-shafts is readily transferred from multiplelocations within the company and aggregated ata single location. Conversely information aboutthe capabilities of Ford managers, or the quirksof individual machine tools, is idiosyncraticknowledge which cannot be aggregated at a singlelocation. Hayek (1945: 521) refers to this as'knowledge of the particular circumstances oftime and place,' and Jensen and Meckling (1992)as 'specific knowledge.' As these authors haveshown, and as we shall explore later in the paper,the ability to transfer and aggregate knowledgeis a key determinant of the optimal location ofdecision-making authority within the firm.

Appropriabiiity

Appropriability refers to the ability of the ownerof a resource to receive a return equal to the valuecreated by that resource (Teece, 1987; Levin etal., 1987). Knowledge is a resource which issubject to uniquely complex problems of approp-riability. Tacit knowledge is not directly appropri-able because it cannot be directly transferred: itcan be appropriated only through its applicationto productive activity. Explicit knowledge suffersfrom two key problems of appropriability: first,as a public or nonrivalrous good, any one whoacquires it can resell without losing it (Arrow,1984); second, the mere act of marketing knowl-edge makes it available to potential buyers(Arrow, 1971: 152). Thus, except for patents andcopyrights where knowledge owners are protectedby legally established property rights, knowledgeis generally inappropriable by means of markettransactions. Lack of clear property rights resultsin ambiguity over the ownership of knowledge.While most explicit knowledge and all tacitknowledge is stored within individuals, much ofthis knowledge is created within the firm and isfirm specific. This creates difficulties over theallocation of the returns to knowledge and achiev-

112 R. M. Grant

ing optimal investment in new knowledge(Rosen, 1991).

Specialization in knowledge acquisition

Fundamental to Simon's principle of boundedrationality is recognition that the human brainhas limited capacity to acquire, store and processknowledge. The result is that efficiency in know-ledge production (by which I mean the creationof new knowledge, the acquisition of existingknowledge, and storage of knowledge) requiresthat individuals specialize in particular areas ofknowledge. This implies that experts are (almost)invariably specialists, while jacks-of-all-trades aremasters-of-none.

The knowledge requirements of production

Production involves the transformation of inputsinto outputs. Fundamental to a knowledge-basedtheory of the firm is the assumption that thecritical input in production and primary sourceof value is knowledge. Indeed, if we were toresurrect a single-factor theory of value in thetradition of the classical economists' labor theoryof value or the French Physiocrats land-basedtheory of value, then the only defensible approachwould be a knowledge-based theory of value,on the grounds that all human productivity isknowledge dependent, and machines are simplyembodiments of knowledge.

THE EXISTENCE OF THE FIRM

The above precepts establish a rationale for theexistence of firms. Following Demsetz (1991:171-175), the existence of the firm representsa response to a fundamental asymmetry in theeconomics of knowledge: knowledge acquisitionrequires greater specialization than is needed forits utilization. Hence, production requires thecoordinated efforts of individual specialists whopossess many different types of knowledge. Yetmarkets are unable to undertake this coordinatingrole because of their failure in the face of (a)the immobility of tacit knowledge and (b) therisk of expropriation of explicit knowledge bythe potential buyer. Hence, firms exist as insti-tutions for producing goods and services becausethey can create conditions under which multiple

individuals can integrate their specialist knowl-edge. These conditions include propinquity and'low-powered' incentives designed to foster coor-dination between individual specialists whichavoid the problems of opportunism associatedwith the 'high-powered' incentives directly relatedto knowledge transactions.

A possible solution to the inability of marketsto contract over transfers of tacit knowledge isto contract over units of workers' time. But evenif units of labor time are suitable proxies for thesupply of tacit knowledge, so long as productionrequires the complex integration of multiple typesof knowledge within a system of team production,then Rosen (1991) shows that markets mustestablish an incredibly complex wage structurewhich sets a separate wage rate for every work-er's interaction with every other worker.-'

Note that this view of the role of the firm asa knowledge-integrating institution is somewhatdifferent from that emphasized in the literature.Most research into organizational learning (Levittand March, 1988; Huber, 1991) and the know-ledge-based view of the firm (Spender, 1989;Nonaka, 1991, 1994) focuses upon the acquisitionand creation of organizational knowledge. Thus,Spender (1989: 185) defines 'the organizationas, in essence, a body of knowledge about theorganization's circumstances, resources, causalmechanisms, objectives, attitudes, policies, andso forth.' My approach is distinguished by twoassumptions: first, that knowledge creation is anindividual activity; second, that the primary roleof firms is in the application of existing know-ledge to the production of goods and services.This dispensing with the concept of organiza-tional knowledge in favor of emphasizing the roleof the individual in creating and storing knowl-edge is consistent with Simon's observation that:'All learning takes place inside individual humanheads; an organization learns in only two ways:(a) by the learning of its members, or (b) byingesting new members who have knowledge theorganization didn't previously have' (Simon,1991: 125). More importantly, however, is thedesire to understand the organizational processesthrough which firms access and utilize the knowl-

' On a simple production process involving n workers, whereeach worker interacts separately with each other worker, atotal of {n^-n)/2 wage rates must be established (Rosen,1991: 78-81).


edge possessed by their members. The dangerinherent in the concept of organizational knowl-edge is that, by viewing the organization as theentity which creates, stores and deploys knowl-edge, the organizational processes through whichindividuals engage in these activities may beobscured. Thus, March views organizations asstoring 'knowledge in their procedures, norms,rules, and forms. They accumulate such knowl-edge over time learning from their members'(March, 1991: 73). This learning process involves'encoding inferences from history into routinesthat guide behavior. The generic term routinesincludes the forms, rules, procedures, conventions,strategies, and technologies around which organi-zations are constructed and through which theyoperate' (Levitt and March, 1988: 320). Takingthe organization as the unit of analysis not onlyruns the risk of reification, but, by defining rules,procedures, conventions, and norms as knowledgefails to direct attention to the mechanisms throughwhich this 'organizational knowledge' is createdthrough the interactions of individuals, and offerslittle guidance as to how managers can influencethese processes.

Unlike Spender (1992), who analyzes the dualrole of firms in knowledge generation and knowl-edge application, my emphasis is on the firm asan institution for knowledge application. This isnot to deny the importance of organizational con-text in knowledge creation. If production creationrequires the integration of each person's knowl-edge with that of others, even if knowledge acqui-sition is individualistic, the firm provides neces-sary incentives and direction. If knowledge isspecific to a particular team production process,then knowledge creation cannot be separated fromknowledge application—both occur within a com-mon organizational context. Thus, if the membersof Manchester United soccer team have com-plementary skills, then they need to be tiedtogether by long-term relationships in order toachieve the investment in team-based skillsrequired to maximize team performance. Marketcontracts are unlikely to achieve the stability oflong-term relationships and are likely to give riseto all the problems of opportunism that trans-actions cost economics predicts are a consequenceof small numbers and transaction-specific invest-ments.

This rationale for the existence of the firmmay be criticized as being a special case of the

Coase/Williamson transaction cost theory of thefirm. Firms exist because they are able to avoidthe costs associated with market transactions; theknowledge-based view simply focuses upon thecosts associated with a specific type oftransaction—those involving knowledge. Cer-tainly, the above analysis draws upon some fa-miliar concepts of market failure. However, thekey distinction is emphasis upon the firm as anorganization for managing team production ratherthan an institution for managing transactions. Incommon with the arguments of Ghoshal andMoran (1996), the central advantage of firms inthe production process is not simply an avoidanceof the transactions costs associated with marketexchange, but their 'unique advantages for gov-erning certain types of economic activities froma logic that is very different from that of a market(Ghoshal and Moran, 1996: 13). Integrating theknowledge of many different individuals in theprocess of producing goods and services is sucha logic. To develop this argument further, theseprocesses for integrating knowledge need to bespecified more clearly.

COORDINATION WITHIN THE FIRM

The assumptions that there are gains from special-ization in knowledge acquisition and storage, andthat production requires the input of a wide rangeof specialized knowledge, restates a premisewhich, either explicitly or implicitly, is funda-mental to all theories of the firm. Without benefitsfrom specialization there is no need for organiza-tions comprising multiple individuals. Given theefficiency gains of specialization, the fundamentaltask of organization is to coordinate the effortsof many specialists. Although widely addressed,organization theory lacks a rigorous integrated,well-developed and widely agreed theory of coor-dination.

Comparative neglect of the mechanismsthrough which individuals integrate their pro-ductive activities refiects organization theory'spreoccupation, not with coordination per se, butwith the problems of cooperation which arisefrom reconciling and subordinating the disparategoals of organizational members. Thus, Lawrenceand Lorsch (1967), building upon the ideas ofMarch and Simon (1958) and Selznick (1948),viewed coordination as the resolution of intraor-

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ganizational goal conflict, while the institutionaleconomics literature has been dominated by theproblems of the divergence of employee andowner goals causing problems of agency (Jensenand Meckling, 1976), shirking (Leibenstein, 1966;Alchian and Demsetz, 1972) and opportunism(Williamson, 1975).

Consistent with this emphasis, organizationtheory's focus upon hierarchy as the basic struc-ture for organizing complex social activity hasconcentrated upon authority relations wherecooperation is achieved through verticallyimposed bureaucratic processes. Later writersidentified multiple mechanisms for coordinationwithin organizations. Ouchi (1979) identifiedthree types of coordination mechanism: marketmechanisms, bureaucratic mechanisms, and clanmechanisms.

The knowledge-based literature has, so far, hadonly limited impact on the analysis of coordi-nation. Research into organizational learning andmanagement of technology has explored the trans-fer and diffusion of knowledge within organiza-tions (e.g., Kay, 1979; Levitt and March, 1988;Boisot, 1995), but has made only limited progressin addressing the fact that, if most of the knowl-edge relevant to production is tacit, then transferof knowledge between organizational members isexceptionally difficult. Nonaka (1994) emphasizesthe conversion of tacit into explicit knowledge(and vice versa), while Brown and Duguid (1991)stress the role of communities-of-practice in pro-viding common structure and meaning for thetransfer of experience.

But transferring knowledge is not an efficientapproach to integrating knowledge. If productionrequires the integration of many people's special-ist knowledge, the key to efficiency is to achieveeffective integration while minimizing knowledgetransfer through cross-learning by organizationalmembers. If Grant and Spender wish to write ajoint paper together, efficiency is maximized notby Grant learning everything that Spender knows(and vice versa), but by establishing a modeof interaction such that Grant's knowledge ofeconomics is integrated with Spender's knowl-edge of philosophy, psychology and technology,while minimizing the time spent transferringknowledge between them.

Viewing the firm's primary task as integratingthe specialized knowledge of multiple individualssuggests that, even with goal congruence, achiev-

ing effective coordination is problematic fororganizations. The literature addressing inte-gration across specialized organizational units hasviewed coordination as dependent upon thecharacteristics of the process technologydeployed. Thus, Thompson identified three typesof interdependence, pooled, sequential, andreciprocal, to which Van de Ven, Delbecq, andKoenig (1976) added a fourth, team interdepen-dence. The type of interdependence within a taskdetermines the mode of coordination deployed.Pooled interdependence calls for coordination byrules, sequential interdependence can be effec-tively coordinated by plans, reciprocal interdepen-dence is associated with mutual adjustment, whileteam interdependence requires group coordi-nation, through scheduled and unscheduled meet-ings (Thompson, 1967; Van de Ven et al, 1976).

A knowledge-based view of the firm encour-ages us to perceive interdependence as an elementof organizational design and the subject of mana-gerial choice rather than exogenously driven bythe prevailing production technology. The generalissue is devising mechanisms for integrating indi-viduals' specialized knowledge. While processtechnology defines the technical aspects of pro-duction and the types of specialized knowledgerequired for the process, the division of tasksbetween individuals and departments and thespecification of the interfaces between them lieswithin the domain of organizational design.

Integrating the literature on formal and explicitcoordination mechanisms with that on informaland implicit coordination processes, and relatingthis to characteristics and role of knowledge,points to four mechanisms for integrating special-ized knowledge:

1. Rules and directives. 'Impersonal': approachesto coordination involve 'plans, schedules, fore-casts, rules, policies and procedures, and stan-dardized information and communication sys-tems' (Van de Ven et al., 1976: 323). Rulesmay be viewed as standards which regulatethe interactions between individuals. Thus, insociety at large, rules in the form of etiquette,politeness and social norms are essential tofacilitating human interaction. The efficiencyof these mechanisms in achieving coordinationextends beyond their ability to minimize com-munication (Galbraith, 1973). As recognizedby Demsetz (1991) direction is a 'low cost


method of communicating between specialistsand the large number of persons who eitherare non-specialists or who are specialists inother fields' (Demsetz, 1991: 172). Such rulesare directives provide a means by which tacitknowledge can be converted into readily com-prehensible explicit knowledge. Thus, it ishighly inefficient for a quality engineer toteach every production worker all that heknows about quality control. A more efficientmeans of integrating his knowledge into theproduction process is for him to establish aset of procedures and rules for quality control.

2. Sequencing. Probably the simplest means bywhich individuals can integrate their specialistknowledge while minimizing communicationand continuous coordination is to organize pro-duction activities in a time-pattemed sequencesuch that each specialist's input occurs inde-pendently through being assigned a separatetime slot. Thompson viewed sequential inter-dependence as technologically determined.Certainly, the characteristics of the product, itsphysical inputs, and its production technologystrongly influence the potential for sequencing:a product comprised of multiple componentsfacilitates sequencing much more than a com-modity produced by continuous processes.However, in most production activities thereis discretion over the extent of sequencing.For example, new product design can be fullysequential, overlapping sequences, or concur-rent (Nonaka, 1990; Clark and Fujimoto,1992).

3. Routines. An organizational routine is a 'rela-tively complex pattern of behavior ... triggeredby a relatively small number of initiating sig-nals or choices and functioning as recognizableunit in a relatively automatic fashion' (Winter,1986: 165). While routines may be simplesequences, their interesting feature is theirability to support complex patterns of interac-tions between individuals in the absence ofrules, directives, or even significant verbalcommunication. To this extent, routinesembody Thompson's notion of coordinationby mutual adjustment. There are two maindimensions to this complexity. First, routinesare capable of supporting a high level ofsimultaneity of individuals' performance oftheir particular tasks—examples include navi-gation of a ship (Hutchins, 1991), surgical

operating teams and auto racing pit crews(Grant, 1996), and the operations of fast foodrestaurants (Leidner, 1993). Second, routinescan permit highly varied sequences of interac-tion. While Nelson and Winter (1982) andGersick and Hackman (1990) have emphasizedthe automatic nature of routines, Pentland andRueter (1994) have shown that a routine canbe a varied repertoire of responses in whichindividuals' moves are patterned as 'grammarsof action.'

4. Group problem solving and decision making.While all the above mechanisms seekefficiency of integration through avoiding thecosts of communication and learning, sometasks may require more personal and com-munication-intensive forms of integration. Gal-braith (1973) points to the need for 'imper-sonal' coordination through rules and plans tobe supplemented by 'personal' and 'group'coordination modes, the last taking the formof meetings. Reliance upon high-interaction,nonstandardized coordination mechanismsincreases with task complexity (Perrow, 1967)and task uncertainty (Galbraith, 1973: Van deVen et al., 1976). Hutchins (1991) documentsthe switch from routine-mode to group prob-lem-solving mode in a crisis. The main contri-bution of the knowledge-based view to thisdiscussion is recognition of the high costs ofconsensus decision making given the difficul-ties of communicating tacit knowledge. Hence,efficiency in organizations tends to be associa-ted with maximizing the use of rules, routinesand other integration mechanisms that econom-ize on communication and knowledge transfer,and reserve problem solving and decision mak-ing by teams to unusual, complex, andimportant tasks.

The role of common knowledge

While these mechanisms for knowledge inte-gration are necessitated by the differentiation ofindividuals' stocks of knowledge, all depend uponthe existence of common knowledge for theiroperation. At its most simple, common knowledgecomprises those elements of knowledge commonto all organizational members: the intersection oftheir individual knowledge sets. The importanceof common knowledge is that it permits individ-uals to share and integrate aspects of knowledge

16 R. M. Grant

which are not common between them. Commonknowledge has some similarities with Nonaka andTakeuchi's redundancy: 'information that goesbeyond the operational requirements of organiza-tional members,' which permits 'individuals toinvade one another's functional boundaries' andprovides 'individuals ... loosely coupled with eachother ... a self-control mechanism' (Nonaka andTakeuchi, 1995: 80-81). Different types of com-mon knowledge fulfill different roles in knowl-edge integration:

• Language. The existence of a common languageis fundamental to integration mechanisms whichrely upon verbal communication between indi-viduals, namely, integration through rules anddirectives, and integration through group prob-lem solving and decision making. The lack ofa common language among workers in manyU.S. plants and other polyglot organizationsis a significant barrier to the introduction ofintegration-intensive manufacturing techniques.

• Other forms of symbolic communication. A sin-gle tongue is but one aspect of commonalityof language. If language is defined to embodyall forms of symbolic communication then liter-acy, numeracy, and familiarity with the samecomputer software are all aspects of commonlanguage which enhance the efficiency andintensity of communication. Companies suchas Motorola and Texas Instruments show thatinvestments in literacy, numeracy and basicstatistics which raise the level of employees'common knowledge increase the effectivenessof rules, directives, and meetings inimplementing sophisticated levels of TQM.

• Commonality of specialized knowledge. Whilelanguage provides a common platform for com-munication-based modes of knowledge, thelevel of sophistication which communication-based modes of knowledge integration achievedepends upon the extent of commonality intheir specialized knowledge. There is somethingof a paradox in this. The benefit of knowledgeintegration is in meshing the different special-ized knowledge of different individuals—if twopeople have identical knowledge there is nogain from integration—yet, if the individualshave entirely separate knowledge bases, thenintegration cannot occur beyond the most primi-tive level.

• Shared meaning. The problem of communi-cation-based modes of knowledge integration is

that they require the conversion of tacit knowl-edge into explicit form. Such conversion typi-cally involves substantial knowledge loss. How-ever, tacit knowledge can be communicatedthrough the establishment of shared understand-ing between individuals. Polanyi (1966: 61)notes that 'a teaching which appears meaning-less to start with has in fact a meaning whichcan be discovered by hitting on the same kindof indwelling as the teacher is practicing'(emphasis added). The organizational learningliterature points to the role of common cogni-tive schema and frameworks (Weick, 1979;Spender, 1989), metaphor and analogy (Nonakaand Takeuchi, 1995: 64-67), and stories(Brown and Duguid, 1991) as vehicles formolding, integrating and reconciling differentindividual experiences and understandings.More generally, Leudar (1992) explores therole of mutual cognitions in coordinatingsocial actions.

I Recognition of individual knowledge domains.Shared understanding facilitates coordinatedactivity, but effective knowledge integrationalso requires that each individual is aware ofeveryone else's knowledge repertoire. 'Recipro-cal' or 'group' interdependence, such as thatoccurring within a soccer or debating team,necessitates coordination by mutual adjustment(Thompson, 1967: 56). Achieving this withoutexplicit communication requires that each teammember recognizes the abilities of other teammembers. Such mutual recognition permits suc-cessful coordination even in novel situations.

Organizational capability

This analysis of the firm as an integrator isespecially helpful to the analysis of organizationalcapabilities. Grant (1996) views organizationalcapability as the outcome of knowledge inte-gration: complex, team-based productive activitiessuch as American Express's customer billing sys-tem, Chrysler's automobile design process, andShell's deep-sea oil exploration, are dependentupon these firms' ability to harness and integratethe knowledge of many individual specialists.

This analysis of organizational capability offersinsight into the linkage between organizationalcapability and competitive advantage. The extentto which a capability is 'distinctive' depends upon


the firm accessing and integrating the specializedknowledge of its employees. If employees aremobile, organizational capability depends moreupon the firm's mechanisms of integration ratherthan the extent of specialist knowledge whichemployees possess. The higher the level andsophistication of common knowledge among theteam, whether in the form of language, sharedmeaning, or mutual recognition of knowledgedomains, the more efficient is integration likelyto be. The shift in employee training from deep-ening of specialist skills towards increased cross-training and job rotation is based on the beliefthat trading off increased common knowledgeagainst decreased specialist knowledge willenhance organizational capabilities.

Longevity of competitive advantage dependsupon the inimitability of the capabilities whichunderlie that advantage. The broader the scopeof the knowledge integrated within a capability,then the more difficult limitation becomes. Thecomplexity of 'broad-scale' integration createsgreater causal ambiguity and greater barriers toreplication. The dilemma for managers is thatorganizational capabilities which require greaterbreadth of knowledge will show lower levelsof common knowledge between team members.Current interest in cross-functional capabilitiessuch as new product development (Clark andFujimoto, 1992), fast response capability (Stalk,1988), 'architectural innovation' (Henderson andClark, 1990) reflects the strategic importance andmanagerial challenge of capabilities which requireeffective integration of many disparate specialists.

ORGANIZATIONAL STRUCTURE

The above assumptions about knowledge and theconceptualization of the firm as a knowledge-integrating institution have two main implicationsfor the intemal structure of the firm: first, therole of hierarchy; second, the location ofdecision making.

Implications for hierarchy

The fundamental organizational problem isachieving purposeful, coordinated action fromorganizations comprising many individuals. Asnoted above, there are two dimensions to thisproblem: first, the pure coordination problem;

second, the cooperation problem. Even if thetechnical problem of coordination can be solved,how are the divergent goals of individualsresolved? Hierarchy has emerged as an efficientsolution to both. Aoki (1990) observes that oneof the differences between U.S. and Japanesecorporations is that, while the hierarchies ofWestern firms combine the roles of cooperationand coordination, Japanese hierarchies exist pri-marily to provide the incentive structures to sup-port cooperation, but coordination occurs outsidethe formal hierarchy.

As observed earlier, within organization theory,analysis of hierarchy has concentrated upon theproblem of cooperation. The preoccupation withorganizations as hierarchies of authority reflectsthe organizational antecedents of business cor-porations: churches existed to impose the auth-ority of God, government departments to imposethe authority of the monarch or (in democracies)the people, while the effectiveness of armies andnavies required the authority to send men totheir deaths.

The analysis of hierarchy as a coordinationmechanism has been associated with cyberneticsand systems theory. Simon (1981) argues thathierarchy is a general feature of complex systemsemerging because of its evolutionary and prob-lem-solving advantages. Hierarchy is an efficientmechanism for coordinating a complex systemcomprising multiple specialized units. Businessfirms are examples of hierarchies since they are'composed of interrelated sub-systems, each ofthe latter being in turn hierarchic in structureuntil we reach some lowest level of elementarysubsystem' (Simon, 1981: 196). Using simplemodels of information processing, Radner (1992)derives principles and algorithms for the optimaldesign of hierarchies.

Simon (1981) identifies intensity of interactionas the basis for organizing hierarchy: at everylevel, interaction within the substructure is moreintense than between the substructures. This prop-erty permits near decomposability—for mostaspects of their functioning each unit may beviewed as operating autonomously. Thompson(1967: 57-61) uses this principle of grouping byintensity of interaction to propose that organiza-tions should structure their hierarchies by groupin, first, those individuals who are reciprocallyinterdependent, and subsequently individuals sub-ject to sequential and pooled interdependence.

118 R. M. Grant

These approaches to hierarchical coordinationinvolve assumptions about the forms of knowl-edge being utilized within organization: typicallythat hierarchies are involved in the processing ofinformation. Once firms are viewed as institutionsfor integrating knowledge, a major part of whichis tacit and can be exercised only by those whopossess it, then hierarchical coordination fails.Consider the design of a new range of cosmetics.Within the marketing department different marketresearchers, brand managers, advertising execu-tives, and sales representatives each have valuableinsights into the market opportunity for a newcosmetic range, the desirable characteristics ofsuch a range, the profiles of potential purchasers,and the appropriate marketing of such a range.Within R&D expertise about the technical opport-unities for using new materials and developinginnovative characteristics in cosmetics is distrib-uted among specialists in botany, fatty acids,emulsification, perfumes, and polymer science. Ifnew product design requires integrating marketingknow-how and technical know-how, how canmeetings between the marketing VP and tech-nology VP achieve this if the required knowledgeis distributed among their subordinates? Whenmanagers know only a fraction of what theirsubordinates know and tacit knowledge cannot betransferred upwards, then coordination by hier-archy is inefficient.

Only one of the integration mechanisms iden-tified in the previous section is compatible withhierarchy: integration through rules and directives.Indeed, the bureaucratic systems typically associa-ted with organizational hierarchies rely heavilyupon rules and directives. However, their basisis different in the knowledge-based model fromthe traditional bureaucratic model. In a bureau-cracy rules and directives are vehicles for theexercise of authority. They emanate from thesource of authority in the organization and applytop down. In the knowledge-based firm, rules anddirectives exist to facilitate knowledge inte-gration; their source is specialist expertise whichis distributed throughout the organization.

Many current trends in organizational designcan be interpreted as attempts to access andintegrate the tacit knowledge of organizationalmembers while recognizing the barriers to thetransfer of such knowledge. While analysis ofdelayering has concentrated upon cost reductionand increasing the speed of decision making, the

knowledge-based view suggests that, to the extentthat 'higher-level decisions' are dependent uponimmobile 'lower-level' knowledge, hierarchyimpoverishes the quality of higher-level decisions.The dilemma is this: if production (and decisionsabout production) require many types of knowl-edge, if that knowledge is resident in many indi-viduals, and if integration mechanisms caninvolve only relatively small numbers ofindividuals—what organizational structures arepossible?

The recent vogue for team-based structureswhere team membership is fluid, depending uponthe knowledge requirements of the task at hand,is one response to the deficiencies of hierarchy.The essence of a team-based organization is rec-ognition that coordination is best achievedthrough the direct involvement of individualspecialists and that specialist coordinators('managers') cannot effectively coordinate if theycannot access the requisite specialist knowledge.The spread of team organization throughout pro-duction activities recognizes that critical know-how is located among individual operatives—specialists. The displacement of scientific man-agement by various forms of participative,employee-empowering management approachespartly reflects the motivational benefits of thesesystems, but is also a result of the greaterefficiency of these systems in accessing and inte-grating the relevant knowledge. Wruck and Jensen(1994) identify total quality management as anonhierarchical, team-based organizing tech-nology that permits an organization to access andutilize individuals' knowledge located at low lev-els of the organization.

In 'higher-level' integration—cross-functionalcoordination for example—barriers to verticalknowledge transfer imply that integration requiresthe direct participation of specialists. Hence, thetrend in new product development has been awayfrom sequential processes coordinated by theheads of functional departments towards cross-functional teams. The key problem with suchteams is, given coordination restricts their size,teams are unable to directly access the full rangeof specialist knowledge relevant to their activities.This can be partially addressed by making theirmembership fluid so that relevant expertise canbe tapped when needed.

More generally, if movement of knowledgewithin the organization requires the movement


of the specialists who possess it, then effectiveknowledge utilization will tend to require thatindividuals occupy multiple organizational rolesinvolving membership of multiple teams.

Implications for the distribution of decision-making authority in the firm

Implications for the allocation of decision-makingauthority in the firm follow directly from theabove discussion of the problems of hierarchicalstructures in integrating knowledge. The conven-tional basis for the analysis of decision makingis delegation. Decision-making rights reside inthe owners of the firm. As representatives ofowners, the board of directors confers decision-making powers on senior management, which intum delegates authority down the hierarchy.Agency theory provides a rigorous analysis ofthe problems of divergent individual goals andthe creation of incentive structures to achievegoal alignment (Jensen and Meckling, 1976).

The knowledge-based view of the firm hastwo principal implications for the distribution ofdecision making. The first issue concerns thelinkage between decision rights and ownership.If the primary productive resource of the firm isknowledge, and if knowledge resides in individualemployees, then it is employees who own thebulk of the firm's resources. The firm contractswith employees for the use of these knowledgeresources. However, unlike physical and financialassets, employment contracts confer upon the firmonly partial and ill-defined ownership rights overemployees' knowledge assets. Moreover, thedecision rights of the firm in relation toemployees' knowledge are severely constrained.Knowledge assets remain resident within individ-ual employees and cannot be readily transferred.If decision rights are conferred by ownershipand if the firm's resources are jointly owned bystockholders and employees—then management'sdecision rights are delegated downwards by thestockholders and board of directors, and upwardsby employees. Thus, the knowledge-based firmcorresponds more closely to Aoki's (1990) analy-sis of the Japanese corporation as a system ofdual control jointly exercised by stockholders andemployees, than it does to the conventional share-holder-owned and controlled corporation whichdominates the Anglo-Saxon capitalist tradition.

The second issue concerns co-location of

decision making and knowledge. The quality ofdecisions depends upon their being based uponrelevant knowledge. If the knowledge relevant toa particular decision can be concentrated at asingle point in the organization, then centralizeddecision making is feasible. But the ability totransfer and aggregate knowledge varies betweendifferent types of knowledge. Explicit knowledgeis transferable, but cannot necessarily be aggre-gated at a single point. Jensen and Meckling'sspecific knowledge is knowledge which is costlyto transfer; this would comprise both tacit knowl-edge and explicit knowledge which cannot beaggregated and analyzed in statistical form. Theprinciple of co-location requires that decisionsbased upon such tacit and idiosyncratic knowl-edge are decentralized, while decisions requiringstatistical knowledge are centralized.

Recent organizational changes in the oil andgas industry illustrate these tendencies (Grant andCibin, 1996). Decisions which require accessingand processing quantifiable information havebecome increasingly centralized—treasury andfinancial risk management functions for example.Decisions requiring tacit and idiosyncraticknowledge—strategic planning, investmentappraisal, and operational decisions concerningindividual oil and gas fields—have becomeincreasingly decentralized.

BOUNDARIES OF THE FIRM

If firms exist to integrate the specialized knowl-edge possessed by a number of individualsbecause such integration cannot be performedefficiently across markets, what determines theboundaries of the firm? In the light of the initialassumptions about knowledge, the vertical andhorizontal boundaries may be analyzed in termsof relative efficiency of knowledge utilization.

The analysis of vertical boundaries followsDemsetz (1991). If markets transfer productsefficiently but transfer knowledge inefficiently(for the reasons outlined earlier), vertically adjac-ent stages of production A and B will be inte-grated within the same firm if production at stageB requires access to the knowledge utilized instage A. If, on the other hand, the output of stageA can be processed at stage B without the needto access the knowledge utilized at stage A, thenstages A and B are efficiently conducted by

120 R. M. Grant

separate firms linked by a market interface. Thedependence of the design of mainframe computersupon the characteristics of integrated circuits(ICs) meant that during the 1960 and 1970s mostcomputer manufacturers were backward integratedinto ICs. Within ICs, vertical integration betweendesign and manufacture depends upon the extentto which intense technical dialogue is requiredbetween design and fabrication stages. 'Fab-lessness' occurs mainly in digital logic ICs whereknowledge separation between design and manu-facture is feasible (Monteverde, 1995).

The horizontal boundaries between firms arealso likely to occur at gaps occurring betweenconstellations of products and knowledge. Thebenefits of specialization in knowledge acqui-sition, the many types of knowledge required toproduce a product, and the difficulty of integra-ting these knowledge inputs across markets, sug-gest that single-product firms will tend to pre-dominate. The problem is that much knowledgeis not product specific and is subject to economiesof scope. Hence efficient knowledge utilizationrequires multiproduct firms. As Grant and Baden-Fuller (1995) argue, firms may be characterizedboth as product domains and knowledge domains.Efficient knowledge utilization requires congru-ence between the knowledge domain of the firmand its product domain. Typically, perfect congru-ence does not exist: the firm's knowledge is notfully deployed by the products it supplies, andthe knowledge required by the products suppliedis not entirely available from within the firm.Firms tend to form around product-knowledgeconstellations. Thus, an input-output matrix ofknowledge inputs and product outputs for theeconomy would display broad product-knowledge clusters which correspond to industrieswithin which smaller clusters correspond to indi-vidual firms. Imperfect congruence between firms'product and knowledge domains creates oppor-tunities for knowledge trading to achieve fullerutilization of knowledge. Such knowledge tradingtends to take place through strategic alliances.

CONCLUSION

Starting from assumptions about the character-istics of knowledge and the requirements of pro-duction, this paper identifies the primary role ofthe firm as integrating the specialist knowledge

resident in individuals into goods and services.The primary task of management is establishingthe coordination necessary for this knowledgeintegration. The main implications of the paperstem from this analysis of coordination. Whileorganization theory has tended to concentrateupon the problems of achieving cooperation, thecomplexities of knowledge integration, especiallywhen tacit knowledge is involved, point to thefact that, even in the absence of goal conflict,coordination is not a trivial issue. When differenttypes of knowledge vary considerably in theirpotential for transfer and aggregation, the impli-cations for organizational structure and thelocation of decision-making authority are pro-found. The principles of organization design sug-gested by the knowledge-based approach conflictwith those of other organizational models, parti-cularly the bureaucratic and information-pro-cessing approaches. An interesting feature of theknowledge-based approach is that it offers atheoretical basis for understanding a number ofrecent organizational innovations and trends.These include the renovation of traditional organi-zational structures through delayering andempowerment and the development of neworganizational forms including horizontal andteam-based structures and interfirm alliances. Theknowledge-based approach also calls into ques-tion other contemporary trends in corporate man-agement. The primary driving force behind cor-porate restructuring and strategic change has beenthe quest for shareholder value maximization andenhanced shareholder power. If the primaryresource of the firm is knowledge, if knowledgeis owned by employees, if most of this knowledgecan only be exercised by the individuals whopossess it—then the theoretical foundations ofthe shareholder value approach are challenged.

An important difference between this knowl-edge-based analysis and other organizationaltheories (including organizational economics) isthe emphasis which the knowledge-based viewgives to the firm as an institution for the pro-duction of goods and services. Sociology-basedtheories of organizations tend to analyze organiza-tion as institutions for collective social actionwithout distinguishing economic organizations,from those which exist for social, political, andreligious ends. It is the task of production throughthe transformation of inputs into outputs wherethe issues of creating, acquiring, storing and


deploying knowledge are the fundamental organi-zational activities. By contrast, the organizationalproblem common to all forms of social organiza-tion is that of cooperation: reconciling the con-flicting goals of organizational members. This toohas been the emphasis of most economic theoriesof organization. Both transaction cost economicsand agency theory regard the primary organiza-tional problem as the incompatibility of individualgoals. It is in the analysis of coordination withinthe firm that the knowledge-based view promisesto make its biggest contribution.

The emphasis on 'promise' rather than achieve-ment points towards the limited progress madeso far in building the knowledge-based theory ofthe firm. This paper has attempted to counterbal-ance the emphasis of the earlier literature onknowledge creation and organizational knowledgeby placing emphasis upon knowledge applicationand the role of the individual. The emphasis uponthe role of the individual as the primary actor inknowledge creation and the principal repositoryof knowledge, I believe, is essential to piercingthe veil of organizational knowledge and clarify-ing the role of organizations in the creation andapplication of knowledge. The focus upon knowl-edge application and disregard for knowledge cre-ation is a more serious limitation. Clearly, a morecomprehensive knowledge-based theory of thefirm will embrace knowledge creation and appli-cation.

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