How Firms’ Boundaries and Focus Differ As Agency Hazards and Capability Extendability Vary: Integrating Organizational Economics and Organizational Capabilities Hyoung-Goo Kang Ewha Womans University 1104 International Education Building, 11-1 Daehyun-Dong Seodaemun-Gu, Seoul, Korea 120-750
[email protected] Richard M. Burton The Fuqua School of Business at Duke University 1 Towerview Drive, Durham, NC 27708, U.S.A. Phone: 1.919.660.7847,
[email protected] Will Mitchell The Fuqua School of Business at Duke University 1 Towerview Drive, Durham, NC 27708, U.S.A. Phone: 1.919.660.7994, Fax: 1.919.681.6244,
[email protected] Version: October 29, 2009 Acknowledgements: We have benefited from comments by Vish Viswanathan, Nils Stieglitz, Nicolai Foss, John Daniels, seminar participants at EIASM workshop on information and organization design, the Management Innovation conference at Copenhagen Business School, and students at Ewha Womans University who attended classes about multinational business policy and corporate finance. All errors are ours.
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How Firms’ Boundaries and Focus Differ As Agency Hazards and Capability Extendability Vary: Organizational Economics and Organizational Capabilities Are Both Right, Sometimes
Abstract Firm boundaries and focus are contentious subjects in both research and managerial practice, where boundaries are the number of projects and focus is the variety of projects that a firm undertakes. Organizational economic perspectives such as agency theory advocate using the concepts of moral hazard and information asymmetry to explain how firms select boundaries and focus. By contrast, organizational capabilities perspectives such as resource-based and dynamic capabilities theories argue that the degree of extendibility of a firm’s capabilities determines its boundaries and focus. We link these competing views by constructing a two-stage computational model that endogenizes the ability to mitigate agency hazard and the ability to create flexible capabilities. In doing so, we develop a generalized model that incorporates and extends traditional organizational economics and capabilities arguments of how firms undertake resource allocation activities. Monte Carlo simulation provides evidence that the traditional arguments are correct at particular levels of agency hazard and capability extendibility: both organizational economics and organizational capabilities theories provide valid explanations for (1) low agency and extendible capabilities, and (2) high agency and specialized capabilities. We then complete the model with two other situations: (3) low agency and specialized capabilities and (4) high agency and extendible capabilities. We find that organizational economics explains boundaries in (3) and focus in (4), while organizational capabilities arguments explain boundaries in (4) and focus in (3). By endogenizing the ability to manage agency and flexibility, we then find that firms benefit by turning their attention to decisions about which capabilities to develop, rather than simply focusing on traditional choices about sectors in which to operate. The solutions have two implications. First, a firm's focus and boundaries are substitutes. Second, the value of a multi-project firm is a convex function of its focus, such that choices of intermediate focus are classic sub-optimal “stuck-in-the-middle” situations of generic business strategy applied to corporate strategy. Key words: boundary, focus, simulation, agency hazards, capabilities
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Firms need to choose their boundaries and focus, where boundaries are the number of projects and focus is the variety of projects that a firm undertakes. The organizational economics and the organizational capabilities literatures have different explanations for firms’ choices of boundaries and focus. Organizational economics suggests that agency problems tend to determine both boundaries and focus (e.g., Williamson 1975; Grossman & Hart 1986), arguing that firms should limit their boundaries and focus because agency problems tend to motivate managers to choose projects that may conflict with shareholder interests. In this view, firms should concentrate on a small number of focused projects when agency problems are severe, while firms with less severe agency problems can operate a larger and more diverse set of projects (Arrow 1974). By contrast, the organizational capabilities literature proposes that both boundaries and focus are determined by the firm’s resources and capabilities (Nelson & Winter 1982; Wernerfelt 1984; Kogut & Zander 1992). In particular, a firm can broaden its boundaries and focus if it can extend its existing capabilities towards target subjects, while firms with more specialized capabilities fare better by administering a few projects within a focused target area (Penrose 1959). Thus, while focusing on different mechanisms, both the organizational economics and organizational capabilities perspectives help explain cases in which firms set broad boundaries with broad focus or narrow boundaries with narrow focus. Neither perspective, though, pays enough attention to the more complex mix of boundaries and focus choices in which agency hazards and resource extendibility do not co-vary. This paper develops a model that incorporates both logics to generate a broader explanation of a firm’s choice of its boundaries and focus when agency problems and capability extendibility vary individually, seeking to achieve the goal of integrating across the seemingly conflicting logics of organizational economics and capabilities (Argyres, Felin, Foss & Zenger 2009). At the outset, we will briefly define our key concepts. A firm is subject to high agency problems if it is limited in arranging mechanisms to reduce information asymmetry and align the interests of subgroups (Alchian & Demsetz 1972). The extent of agency problem stems from the 3
innate presence of information asymmetry and moral hazard in a given context, while also reflecting the effectiveness of the organizational governance systems that firms develop to limit the impact of such hazards (Liebeskind 2000). A firm has extendible capabilities if it can redeploy processes and resources toward projects with diverse operational needs (Penrose 1959). The degree of extendibility partly stems from the underlying nature of a set of assets and also reflects a firm’s flexibility to deploy resources across very different projects (Nelson & Winter 1982). Our model is consistent with both organizational economics and organizational capabilities predictions when agency and capabilities co-vary. In turn, the integrated model adds two propositions. First, firms benefit from managing a small number of diverse projects when agency problems are severe and capabilities are extendible to a wide target area. Second, firms benefit from administering a large number of focused projects if agency problems are low and capabilities are specialized. We will demonstrate that both organizational economics and organizational capabilities are jointly relevant to choices of boundaries and focus. The integration of organizational economics and organizational capabilities arguments provides novel insights beyond the separate impact of agency and capabilities on boundaries and focus. A firm can make a joint decision on boundaries and focus by developing organizational systems that address agency problems and exploit the capability of flexibly deploying resources. This condition implies a further generalization in which the extent of agency and capabilities issues are partially endogenous. In this situation, firms should choose either the combination of broad boundaries and broad focus or that of narrow boundaries and narrow focus. Intriguing, moderate levels of focus and boundaries lead to sub-optimal ‘stuck-in-the-middle’ positions. In turn, the boundaries or focus of a firm do not alone determine the efficiency of an organization. Before deciding which projects to choose, a firm should decide whether to develop organizational governance systems that manage agency problems or develop the ability to undertake flexible resource allocation decisions. The choice of emphasizing governance systems leads to the matching of narrow boundaries and narrow focus, while the choice of creating capabilities for achieving 4
flexibility results in broad boundaries and broad focus. Thus, diversification decisions about boundaries or focus should follow decisions about what capabilities to develop (we assume that it typically is too complex for firms to develop deep skill sets in both organizational governance systems and flexibility. Moreover, because we incorporate the behaviors of corporate-level and project-level decision-makers, the model addresses the need to consider the micro-foundations of strategy more seriously (Felin & Foss 2005; Felin & Hesterly 2007). LITERATURE AND THEORY This paper has four core concepts: agency hazards, extendibility of capabilities, firm boundaries, and firm focus. We measure the extent of the agency problem that a firm faces in terms of the maximum efficiency of the organizational governance system to address information asymmetry and moral hazard; the game theory literature refers to such governance systems as mechanism design (e.g., Myerson 1981). We measure the extendibility of capabilities in terms of the benefit in deploying resources widely as a firm gathers information about projects. Firm boundaries are the number of projects that a firm undertakes, while firm focus is the diversity of projects. Table 1 provides a comprehensive list of the concepts and their definitions. ******* Table 1 about here ******* In organizational economic theory, the agency problem determines both the boundaries and focus of a firm. A firm should seek to expand its boundaries and focus only when agency problems are low. Alchian and Demsetz (1972) regard a firm as a team contract that aligns interests. Arrow (1974) maintains that organizations emerge as price systems fail to maximize the benefits of collective actions. Transaction cost economics (Coase 1937; Williamson 1975) argues that the efficiency of internal transactions with respect to market transactions determines firm boundaries, such that asset specificity, which results in the hold-up problem, increases the efficiency of internal transactions compared to market mechanisms based on simple price contracting. Property rights theories view firms as the response to incomplete contracting under agency problems, such that firms are contractual arrangements that fill the incompleteness of standard market contracts 5
(Grossman & Hart 1986; Hart & Moore 1990). Thus, from the perspectives of organizational economic arguments, a firm expands its boundaries and focus according to agency constraints. Most generally, the conventional wisdom in organizational economics is that firm efficiency decreases as a firm’s boundaries become broader and/or its focus becomes increasingly unrelated if there are substantial potential agency problems (Khanna & Yafeh, 2007). Broader boundaries and focus can reflect underlying agency problems such as empire building, tunneling, inefficient internal capital market, and diversification discounts (Stein 1997; Fluck & Lynch 1999; Rottemberg & Saloner 1994; Rajan, Servaes & Zingales 2000; Ross, Westerfield, & Jaffe 2002; Inderst & Muller 2003; Brealey, Myers, & Allen 2005). To illustrate, Rottemberg and Saloner (1994) show that the agency problem under incomplete contracting makes a narrow focus preferable. Scharfstein and Stein (2000) demonstrate that the presence of multiple agency problems compounds the inefficiency of internal capital markets of a multiunit corporation. Rajan, Servaes and Zingales (2000) relate internal power struggles to the diversification discount. Similarly, corporate finance textbooks warn against diversification that does not provide a clear distinction between boundaries and focus (Ross, Westerfield & Jaffe 2002; Brealey, Myers & Allen 2005). The organizational capabilities literature analyzes the boundary and focus problem differently. In this view, a firm expands its boundaries or its focus when it can gain competitive advantages by extending its capabilities towards new target areas. This is the core intuition of capabilities literature from Penrose (1959) to arguments such as core competency (Prahalad & Hamel 1990), resource-based theory (Barney, Wright & Ketchen 2001), evolutionary economics (Nelson & Winter 1982), the knowledge-based view (Kogut & Zander 1992), and dynamic capabilities theory (Teece, Pisano & Shuen1997; Helfat et al. 2007). For instance, resource-based theory suggests that firm boundaries change through the extension of resources to other units’ projects (Barney, Wright & Ketchen 2001). Similarly, the knowledge-based view (Kogut & Zander 1992) proposes that firms arise because they handle tacit knowledge more effectively than markets. This literature agrees with organizational economics arguments that transactional inefficiencies and 6
related agency problems may influence a firm’s choices of boundaries and focus, but the organizational capabilities literature argues that extendibility of capabilities matters more. Table 2 summarizes the base propositions of the traditional organizational economics and organizational capabilities logic. The table is a two-by-two matrix with {agency low, agency high} x {capabilities extendible, capabilities specialized}. ‘Agency low’ means that agency problem is low or reducible. ‘Agency high’ means that agency problem is high and not reducible by the firm. ‘Capabilities extendible’ means that a firm can extend its capabilities outside of its existing boundaries. ‘Capability specialized’ means that a firm’s capabilities are specific to the projects within its current boundaries, so that the capabilities might help growing existing projects but would be unsuitable for boundary spanning. We express the predictions of organizational economics with the agency axis; we express those of organizational capabilities with the capabilities axis. The stylized propositions are: (1) for organizational economics (OE), a firm can expand its boundaries and focus when agency problems are low and (2) for organizational capabilities (OC), a firm expands its boundaries and focus when capabilities are extendible. ‘o’ means ‘expand’, ‘x’ means ‘do not expand’ in the table. ******* Table 2 ******* Table 2 reveals two issues. First, organizational economics and organizational capabilities agree in the diagonal quadrants, but disagree in off-the-diagonal quadrants. Second, the traditional literatures do not provide adequate accounts about firms with many focused projects or those with small numbers of diverse projects. In order to resolve the seemingly conflicting propositions and empirical lacuna, we build a general model from which we can view the traditional organizational economics and organizational capabilities theories as special cases. After logically deriving propositions from the general model, we can then compare the results of a computational simulation with the stylized propositions from OE and OC.
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In order to build the general model, we begin with the two state variables: agency problems and capability extendibility. Rather than regarding these as purely exogenous variables, we model agency and extendibility as partially endogenous, as capabilities that firms can chose to develop. We then consider both gross benefits and marginal benefits of changing boundaries and focus as agency problems and capability extendibility change. We stress the marginal benefits because they allow us to derive boundaries and focus as the optimal solutions that maximize firm value. SETTING Table 3 describes a two-period sequence in which a multi-project firm manages investment decisions. The first period includes process design, signaling, initial investment, and initial cash flow. The second period includes reinvestment, when corporate headquarters invests all money into the best projects, and realization of firm value. Table 3 describes one cycle, without loss of generality to multiple cycles of decision making. The activities during the first period correspond to organizational economics logic because mechanism design occurs in order to address agency problems stemming from information asymmetry and moral hazard. The activities in the second period correspond to organizational capabilities logic because the firm reallocates internal resources as it learns about the types of projects that are available. Thus, by focusing on the first or second stage of the model, we can evaluate the conflicting predictions of organizational economics and organizational capabilities. The operationalization in the first and second parts resemble Burgelman’s (1983, 1991) process of internal variation, selection, and retention mechanisms. ******* Table 3 ******* The settings in Table 1 and Table 3, together with technical operationalizations for the computational model, yield the optimal configuration of the internal resource-allocation process. Table 4 outlines the implications in terms of organizational systems and allocation processes. The optimal process becomes the basis of our computational model. Appendix 1 details the proof and computational process. ******* Table 4 ******* 8
SIMULATION AND RESULTS Figure 1 presents the relationship between expected returns and diversification, measured with both boundaries (number of projects) and focus (correlations among projects). We performed Monte Carlo simulations 10^5 times to compute firm values. Table 5 summarizes propositions that derive from the computational results. The propositions will guide empirical assessment in future research. We will discuss the results and propositions sequentially in this section. ******* Table 5 & Figure 1 ******* In Figure 1, the X-axis denotes the fraction of common factors in the type of a project. The higher the fraction of common factors, the higher the correlation across projects, i.e., the greater the firm’s focus. The Y-axis is the number of projects that headquarters considers investing in, i.e., the boundaries of the firm. The Z-axis is performance, defined as the expected return computed with the ratio between expected firm value and the initial internal resources (performance also signifies average Tobin’s q because it is post-investment market-to-book ratio; we normalize book value of investment as one). Figure 1 demonstrates that the number of projects and the degree of correlation affect expected return in very different ways. This contrast shows the importance of distinguishing conventional diversification in terms of correlation (focus) from the number of projects (boundaries). The view of Figure 1 from the focus axis depicts the relationship between firm value and focus as boundaries change (i.e., for varying numbers of projects). With many projects, increasing correlation among projects (i.e., greater focus) leads to declining returns. With few projects, meanwhile, increasing correlation has a non-monotonic impact on expected returns, first declining, then increasing. Thus, as the number of projects increases, the graph along the focus axis changes from a balanced smile to a smirk. These patterns arise because the number of projects affects firm value more when correlation is small than when it is large. Thus, the correlation and the number of projects are substitutes (∂2V/(∂t∂k)
