Santos, José Fernando Pinto dos

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Repositório Institucional da Universidade Católica Portuguesa

Este texto serviu de base para a minha intervenção no Simpósio ‘Theory of the firmwithin the field of Business Policy and Strategy’, na reunião anual da Academy ofManagement em Cincinnati, em Agosto de 1996. Neste Simpósio intervieram ainda JayBarney, Kathleen Conner, Richard Rumelt, C.K. Prahalad. Estou grato a Jay Barneypelos seus comentários a uma versão anterior deste texto e a Kathleen Conner peloincitamento a publicá-lo, mesmo assim, o que comete para o seu futuro desenvolvimentoALL MANAGERS HAVE A THEORY OF THE FIRM José  Fernando Pinto dos SantosFaculdade de Ciências Económicas e Empresariais,Universidade Católica Portuguesa - Centro Regional do PortoRua Diogo Botelho, 1327 4150 PORTO  PORTUGALAll managers have a theory of the firm, and their theory of the firm has a strong impact intheir decision-making and behavior.My point is not that of showing that there is a ‘right’ theory of the firm, though I will notrefrain from expressing my view. What I hope to leave as a message, is that the Theory ofthe Firm is relevant for management and should be more researched and taught tomanagers. Indeed, managers, even of the more ‘practical’ kind, do know a theory of thefirm.What I mean is that most managers have some implicit explanation of why firms exist,and some idea about their purpose, their appropriate size and scope. These ideas are notneutral. They play a direct and decisive role in matters such as strategy and businesspolicy (e.g., why and what to outsource, how to grow, how to diversify, why and how tostructure an alliance), organizing (e.g., how to coordinate and control, how to contractwith a vendor or a customer), and the management of human resources (e.g., why andwhom to hire or fire).Most managers' theories of the firm consist of non-articulated knowledge, and are anintegral part of a manager's mindset. They are rooted in three dimensions: (1) anempirical dimension consisting of insights and generalizations from a manager’sexperience actively learned in a hands-on and visceral fashion, (2) a theoreticaldimension developed through a managers formal education and professional training, and(3) a cultural dimension reflecting a managers basic assumptions, beliefs, and valuesdirectly and indirectly learned from the environment in a mostly passive fashion.However, even though most managers have an implicit theory of the firm, if you were toask many of them why firms exist, their answer would usually be: "What do you mean?Firms exist, that's it". As with much tacit knowledge, it is easy for those without it (e.g.,in this case, academics) to misconstrue this tacit knowledge, to assume that it isignorance.Another manager may answer the same question differently: “Firms exist because oftransaction costs. You see, people are limited in their rationality and they areopportunistic, too. That is why we have some activities within the firm, under our control.The rest we just buy out there in the market.” In this case, a more articulated theory of thefirm is apparent. The theoretical dimension is stronger, at least in an espoused sense. Itwas acquired, say, when the manager studied the subject of business economics.The three dimensions of the manager’s theory of the firm, the empirical, the theoretical,and the cultural, are not equally present from manager to manager. And they evolve withtime, in each of us. The ‘practical’ manager, not having studied management oreconomics, will not have the theoretical component. The young 'MBA', out from a schoolwith a strong IO group, will have it. In his case, the empirical dimension is yet small,though the cultural one may be largely shaped already. This is, I believe, an interestingand still open area for inquiry, demanding some grounded research and careful inference.That most managers have an implicit theory of the firm does not imply that all thosetheories are the same. Nor does it imply that they are all equally valid. Many managesmay have a "wrong" theory of the firm guiding many of their decisions and behavior.Take, for example, the "make versus buy" decision. Often, I have witnessed this decisionmade solely of the basis of a simple cost comparison: how much does it cost us toproduce the good or service required (usually an estimate of the accounting cost ofproviding the good or service) compared to buying the ‘same’ good or service in themarket. No considerations of transaction costs, opportunity costs, or the long termstrategic implications of this decision are included in the decision making process.Because implicit managerial theories of the firm can vary in their validity, examiningthese theories through research, and sharing the results of this research with managersthrough teaching, is extremely important.I have more than twenty years experience as a manager. I first begun to understand whatthe Theory of the Firm was all about by reading Coase, and his elegant argument of thecost of using price. This was some only some four years ago. Soon thereafter, I readWilliamson's development of transaction cost economics. While impressed, I was notconvinced. In particular, I felt that such transaction costs logic could not explain theexistence of firms I had been associated with. In general, Williamson's transactions costlogic suggests that in a world without opportunism, firms would not exist. I felt that thiscould not be correct. And, moreover, I believed then, and continue to believe, that therole of management cannot be reduced to suspecting, contracting, and economizing.There is an underlying assumption about the nature of humankind in the conventionalformulation of transaction cost economics - and it is not an enlightening one. Add thenotion that organizations exist because markets fail, one that transmits a stigma of lastrecourse. Hierarchies end up being seen as harmful, albeit the least of harms in someunfortunate circumstance. If I was a young MBA, armed with my recently acquired TCEability, I might end up looking for asset specificity, for opportunistic behavior and forways to be ‘cleverer’, for ways of cutting down the cost of transacting in the firm, forcontracts pinning down my suppliers, for controls and sanctions- the more the better.Convinced that the market should be present as much as possible, then surely a way tosucceed in having a performing corporation is to introduce ‘market controls’, such asarms-length deals between divisions inside the corporation. Add similar mechanismseven within divisions. The point is that as TCE ends up being normative, it potentiallyleads to reactive or negative management - and contradictory management, for thatmatter, as illustrated by the ‘market controls inside the firm’ exemplar.More recently, I have become aware of the possibility of a knowledge-based theory of thefirm - as in Conner & Prahalad current work. This theory is based on the assumption thatdifferent people have different portions of knowledge that are private to them. In thisapproach, hierarchy is one alternative that people can use to gain access to each other'sknowledge. Individuals may well decide to become more productive by utilizing therequired portions of knowledge that are private to other individuals. Firms exist because,as the former makes free choices about the organizational mode that is more convenientto them, they may elect to achieve such desideratum by working under the authority ofthe latter. And, concomitantly, the latter may also favor such form of relating. Thisarrangement will also be preferred in some instances of adaptation, say, to a changingenvironment.For this knowledge-based theory of the firm, bounded rationality suffices. The criticalnotion is that we all have different knowledge profiles. Order is a choice of knowledgesubstitution or knowledge flexibility. To order is to substitute knowledge. Hierarchieswill therefore exist in a world fully populated by good human beings, as long as weremain “intendedly rational, but only limitedly so”. To start with, the knowledge-basedview brings in a more positive feeling. Integration will involve more coordination andless control.Hierarchies fail. And, when that happens, markets come in (here I consider only the polarforms of organizing, and will not cover networks nor trust). We will have to understandorganization failure better. However, let me just briefly state my belief on two majorcauses for hierarchy failure - both from a knowledge perspective. Firstly, a perceived or areal misfit of knowledge profiles. For example, a manager does not take into properaccount the knowledge of the employee and his command eventually substitutes all theemployee’s knowledge - with great loss. Secondly, the rigidity of interlocked knowledgeprofiles. The value of the knowledge stock inevitably depreciates, in time and space. Thatrigidity, possibly reinforced by the success of the firm, will induce failure by making newknowledge too costly or impossible.I believe that a manager who uses a knowledge-based theory of the firm will gain anawareness of differences in the knowledge profiles of individuals associated with a firm,and an understanding of how the nature of knowledge may affect the outcome of aneconomic exchange. The more the articulated portion of knowledge prevails, the easier itis to learn, and the more likely that markets will be used to manage an exchange, and thenarrower the scope of operations of a firm - e.g. as in the mold-making industry over thelast twenty years or so.On the other hand, the less articulable and more context dependent the knowledge is, themore difficult it is for others to learn, and the more likely that hierarchies will be used tomanage an exchange. Here is a short example, showing how problematic an implicitmodel and the derived behaviors can be. There are businesses or strategies wherepersonal (or direct) selling is used and which require some specific knowledge about eachand many customers. That is difficult for the manager to have, and that points to a formof contract with the salesperson that is different from the typical employment contract,and much nearer to a market contract. A price (‘salary’) may be set that is fully variable.It is not an issue of motivating the salesperson. It is just a form of relating the managerand the salesperson that clearly establishes boundaries for command and for autonomy.Because of different legal contexts, in the case I know well, there are countries where themore typical employment contract is enforced by law. If I compare the behavior ofmanagers and salespersons in these countries with that of their counterparts in countrieswhere a more market-like contract is used, there are differences. Under the employmentcontract, the salesperson that is hired tends to be of a lesser entrepreneurial nature, and Iobserve a remarkable tendency for managers to dictate more.We should not limit the universe of manager's theories of the firm. I have been exposedto more theories of the firm, coming out from my experience and inquiry on such matters.I will briefly articulate two interesting ones.The first one will show well the relevance of the culture dimension, repeatedly forgotten.In some national cultures, unlike the American one, there are strong collective beliefs andvalues that may well be together with a large acceptance of power differences. This is thecase of many Asian countries and a couple of European countries (e.g., Portugal). Itshould not be a surprise to find that the existence of firms may be explained by asomewhat moral theory: society includes persons with different 'strength'; it is the role ofthe stronger ones to protect the weaker, and they should do so with kindness.In the economic context, managers may share the deep belief that firms exist for thatpurpose - for stronger elements of society to protect the weaker. Big firms are notnecessarily desirable, because humanity will be hard to preserve. The scope of firms isnot an issue, but is dealt with indirectly through size. Once again, this theory of the firmhas managerial implications, and these may be hard to understand from another culturalpoint of view. To start with, employment for life is pervasively implicit. I know ofmanagers that refuse to fire people, or do so only as a last resort - sometimes too late. Foreach individual in the firm, after a certain period, the issue is no longer that of having theright person for the job. What a manager must find is the right job for the person.Another example is what I could name an entrepreneur’s theory of the firm: firms existfor people to realize a dream. This happens when the entrepreneur’s dream can not beattained in the market. He has to build and lead a hierarchy for his dream to come true.There is here a notable link with a knowledge-based theory, in the sense that the dreamcan be interpreted as tacit knowledge that the entrepreneur owns exclusively - somethinghe saw that others can't see. This is where the firm is an opportunity-exploiter, muchmore than a problem-solver. The scope of the firm has to do with its integrity, a keyelement in the eyes of both the consumers and the employees. As far as firm size isconcerned, there seems to be only one direction: to grow, until the dream is fulfilled.Once more, there is an apparent managerial relevance for this theory of the firm - one, bythe way, where the empirical dimension is dominant.Clearly, as managers live, understand and interpret their own experiences, they developan implicit theory of the firm. However, these implicit theories in use would gainconsiderably if they were developed, formalized, and tested. That is a role that can bestbe accomplished by academic researchers, working closely with managers. Thoughwisdom cannot be taught, the process of acquiring wisdom can be informed by theexperience and knowledge of others.REFERENCESCoase, R.H (1937). “The Nature of the Firm”. Economica, 4, 386-405.Conner, K., & C.K. Prahalad (1996). “A Resource-based Theory of the Firm: Knowledgeversus Opportunism”. Organization Science 7 (5) 477-501.Williamson, O.E. (1975). Markets and Hierarchies. Free Press. New York.Williamson, O.E., & S. Winter, editors (1993). The Nature of the Firm: Origins,Evolution, and Development. Oxford University Press. New York..

All managers have a theory of the firm

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All managers have a theory of the firm

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