A Strategic Theory of the
Firm as a Nexus of
Incomplete Contracts: A
Property Rights Approach
JONGWOOK KIM, JOSEPH T. MAHONEY, JULY 2010
AS PRESENTED BY JOSHUA DOWNS, 9/23/2014
Overview
Discussion of nascent and under-defined field of Dynamic Capabilities
using a blend of Property Rights and Austrian Economics
Compares and contrasts this approach with aspects of transaction costs
& resource theory
Defines the firm as a Nexus of Incomplete Contracts that represent an
allocation of alienable property rights which can be strategically
realigned with inalienable resources as contractual learning takes place
to generate and capture new economic value
Resources as Bundles of
Property Rights
Resources can be partitioned into aspects of ownership: transfer,
collection of rents, etc.
Economic Transactions are exchanges of bundles of partitioned property
rights to resources
Decision makers are expected to maximize economic efficiency through
partitioning and transacting property rights, and the contracting process
contributes to learning for these decision makers
The organizational processes of maximizing economic efficiency
(integration or coordination, learning, and reconfiguration or
transformation) can be defined as dynamic capabilities
These processes can also be defined in terms of property rights theory…
Internalizing Externalities:
Establishing Economic Value
Dynamic Capabilities are how firms internalize externalities so that
decision makers capture the full extent of economic benefits and incur
the full extent of their economic costs
Resources and Capabilities can be unbundled and reconfigured
internally & in the marketplace
The repetitiveness of these organizational processes allows decision
makers to improve efficiency and identify new opportunities
Firm Boundaries
Transaction costs define the firm through economizing make-or-buy
decisions
Austrian view (Penrose) states that Firm performance can differ in
turbulence
Therefore, firm boundaries are more defined by knowledge, foresight
and co-specialization of human capital to physical assets that allow
firms to expand by fully utilizing resources that are tied to the firm
Entrepreneurs tie resources to the firm through a series of incomplete
contracts
Generating Economic Rents
Transaction Costs rents come from economizing on costs of transacting
across firm boundaries and capturing quasi-rents
Countering, Penrose states rents are derived from the superiority of
certain managers to recognize and capture from the “Subjective
Opportunity Set”, therefore, rents are derived from entrepreneurial
alertness and innovative capacity
Property rights theory brings contractual approach to entrepreneurial
discovery
◦ The search for entrepreneurial rents is a discovery process which uncovers
opportunities previously hidden due to market incompleteness
◦ The establishment of new property rights through shifts in technology or
price is consistent with entrepreneurial approach of Austrian Economics
Systemic View
Entrepreneurial capacity difficult to measure ex ante, but firm processes
provide context
Routines and patterned activities can contextualize capability
development, capabilities can be sustained through subsequent
institutional normalization, while adaptability for rejuvenation is
maintained through flexible informal practices and inherent nature of
incomplete contracts
Property rights systems become conduits for value-creating activities
where resources are channeled to higher yield uses
Processes for establishment of property rights (contracting) are where
information is derived that can reduce instances for opportunism and
thus create value by improving likelihood of resource allocation to
increasingly higher yield use
Nexus of Incomplete Contracts
Firms are viewed as coalitions of resource holders and firm’s goal is to
maximize economic output of resources through coordination with
capabilities through contractual relationships (internal & external)
Contracts are incomplete due to resources and capabilities that are
difficult to contract on like tacit know-how, and co-specialization
The existence of residual property rights control indicates an incomplete
contract
◦ This can be indicative of exchange hazards
◦ However, can represent opportunities for gain to the extent that the contract
is incomplete
The nexus implies that the firm has many different providers of
resources and capabilities contributing to value creation, but with
differing extents of commitments
Descriptive Tables
Conclusions
Because resources are scarce and property rights can be bundled and
unbundled, entrepreneurial insight can be superior to a pure market
mechanism in creating and sustaining competitive advantage.
The contractual process is an avenue through which firms can discover
new opportunities to maximize economic value
◦ Examples can include improving efficiencies within inter-firm transactions
Through the development of entrepreneurial insight sparked by this
learning, new market opportunities can be identified
◦ By bundling and rebundling property rights, resources can be aligned to
capture these opportunities in ways that create competitive advantage
◦ Firms normalize certain processes while leaving flexibility in others to create
sustainability, contractual learning helps entrepreneurs in these decisions.
Example 1: Netflix Streaming
Utilization of Postal Service
◦ Negotiated deal reduces automation rate,¹Free
by-hand sorting²
Utilization of ISPs
◦ Previous experience grants opportunity
recognition and capture
◦ Largest traffic provider
◦ Purchasing channels from Cogent³
◦ Comcast changed policy with Cogent
◦ Netflix traffic became congested
◦ Netflix negotiated directly with Comcast
◦ Since agreeing to pay Comcast, Netflix also has
agreed to pay TWC, AT&T and Verizon for
interconnection.
◦ Testified to block Comcast/TWC Merger
Example 2: Netflix Streaming
Content
Netflix-by-mail negotiates discount rates for bulk purchases
Netflix Streaming requires licensed content
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2008: Contracts with Starz for content (approx. $30M)¹
Streaming boom for Netflix, Starz competitor
Disney expresses displeasure with Starz
2010: Netflix agrees to $200M annual license with studios for content²
2011: Netflix ends negotiations with Starz for $200M³
2012: Netflix agrees to deal with Disney⁴
Netflix gradually acquiring individual series according to consumer
demand
◦ 2014: Netflix agrees to $2M per episode for Blacklist⁵
Discussion
How can the competitive advantage derived from managerial
entrepreneurial insight be maintained given the inevitability of
entrepreneurial ambition? Entrepreneurial board? Entrepreneurial
shareholders?
If a manager’s capacity to learn to recognize and capture opportunities is
paramount, then is hiring them after gaming the media bad if they can
be properly incentivized?