Testing Alternative Theories of the Firm,
Transaction Cost, Knowledge-Based, and
Measurement Explanations for Make-orBuy Decisions in Information Services
Authors: Laura Poppo and Todd Zenger
Strategic Management Journal (1998), 19: 853-877
Presented by: Bradley Skousen
Purpose:
• The purpose of this article is to develop and test competing
hypotheses from the transaction cost, knowledge-based,
agency, and measurement literature regarding boundary
choice and governance performance.
• Each theory provides a different explanation for the
boundary of the firm or governance choice.
• Examples
• TCE = Higher asset specificity triggers higher threats of
opportunistic behavior that leads to higher transaction costs
to safeguard against such threats.
• Knowledge-based Theory = Increasing asset specificity
enhances efficiencies within internal governance (not a result
of market failure or opportunistic behavior).
• Property Rights and Agency Theory = Have argued that
boundary choice is reflective of measurement issues.
Purpose, Cont.
• Model to explicitly test the relationship between exchange
attributes and performance of the firm and market:
• Critical assumption is that the firm will choose the governance
mode with the highest performance through the minimization of
transaction and production costs.
• The authors argue that past research has largely assumed the
relationship between exchange attributes and performance but not
tested it.
Data
• Authors performed a survey of top computer executives in
regard to the performance, governance, and exchange
characteristics of internally and externally sourced information
services.
• Information services included: data entry, software application
development, software applications maintenance, support for
end users, and the design of data networks.
• Note: Exchange performance was measured as the degree of
satisfaction with 1) the overall cost, 2) the quality of the
output or service; and 3) responsiveness to problems or
inquiries.
• Note: Boundary choice was measured by the percentage of
outsourcing for each service (greater than 75% signified that it
was wholly outsourced).
Hypothesis 1a
• Hypothesis 1a: Increases in the specificity of an activity may
negatively affect the performance of governance through the
market (Based on Transaction Cost) .
• Exchange Attribute: Asset Specificity
• Supported: Managers become less satisfied with the cost,
quality, and responsiveness of outsourced activities as
information service activities become more firm specific.
Hypothesis 1b
• Hypothesis 1b: Increases in the specificity of an activity will
positively affect the performance of governance through firm
organization (Based on Knowledge-based Theory).
• Exchange Attribute: Asset Specificity
• Not Supported: Based on results, managers do not become
more satisfied with performance as internal information
service activities become more firm-specific.
Hypothesis 1c
• Hypothesis 1c: Increases in the specificity of an activity will
have stronger positive effects on firm governance than market
governance. Consequently, increases in the specificity of an
activity encourage vertical integration (Based on Knowledgebased theory).
• Exchange Attribute: Asset Specificity
Logic: TCE suggests that the effects of asset specificity may be
negative and the knowledge-based view suggests that the effect
of asset specificity on firm performance is positive.
• Supported: Results indicate that firm specificity has a strong
negative effect on market performance and no clear effect on
firm performance. Consistent results among all models.
Hypothesis 1d
• Hypothesis 1d: Increases in the specificity of an activity will
have similar effects on firm and market governance.
Consequently, increases in the specificity of an activity will be
unrelated to the choice of boundary.
• Exchange Attribute: Asset Specificity
• Not Supported. Results indicate that hierarchies more
effectively cope with asset specificity compared to markets. In
sum, the governance choice matters.
Hypothesis 2a
• Hypothesis 2a: Increased difficulty in measuring the
performance of an activity will negatively affect the
performance of exchanges governed through the market
(Based on Agency Theory & Property Rights).
• Logic: Ability to measure accurately is what defines the
effectiveness of markets.
• Exchange Attribute: Measurement Difficulty
• Partially Supported. When information service managers
could not easily measure the performance of an outsourced
activity, they were less satisfied with the cost. No other
support was found for quality and responsiveness to
problems.
Hypothesis 2b
• Hypothesis 2b: Increased difficulty in measuring the
performance of an activity will negatively affect the
performance of exchanges governed through firm organization
(Based on Agency Theory).
• Exchange Attribute: Measurement Difficulty
• Supported: Managers were less satisfied with cost, quality,
and responsiveness of internal activities when performance
was not easily measured.
Hypothesis 2c
• Hypothesis 2c: Increased difficulty in measuring the
performance of an activity will have similar effects on market
and firm performance. Consequently, changes in
measurement accuracy will be unrelated to the choice of
boundary (Based on Agency Theory).
• Exchange Attribute: Measurement Difficulty
• Not Supported. Results were unclear and the authors suggest
that it may depend on the which performance dimensions
managers place the most emphasis on.
Hypothesis 2d
• Hypothesis 2d: Increases in the difficulty of measuring an activity
will have a weaker negative effect on the performance of internally
governed exchanges than on market-governed exchanges.
Consequently, increases in measurement difficulty increase the
likelihood of vertical integration (Based on Institutional Agency
Theory).
• Logic: Firms have the ability to substitute authority and behavioral
monitoring whereas markets do not.
• Exchange Attribute: Measurement Difficulty
• Not Supported. Results were mixed. For example: Measurement
difficulty has a greater negative effect on cost performance in
markets than firms but a stronger negative effect on quality and
responsiveness performance within firms than within markets.
Hypothesis 3a
• Hypothesis 3a: Increased technological uncertainty will
negatively affect market performance (Based on Transaction
Cost).
• Logic: Greater uncertainty will increase contracting costs.
• Exchange Attribute: Technology Uncertainty
• Not Supported. No support indicated that managers were less
satisfied with performance when activities had higher levels of
technological change for outsourced activities.
Hypothesis 3b
• Hypothesis 3b: Increased technological uncertainty will
negatively affect firm performance (Based on Technological
Obsolescence).
• Logic: Technological uncertainty increases the probability of
internal capabilities and routines becoming obsolete.
• Exchange Attribute: Technology Uncertainty
• Not Supported. No support indicated that managers were less
satisfied with performance when activities had higher levels of
technological change for internal activities.
Hypothesis 4
• Hypothesis 4: Increases in the scale of demand for an
internally sourced activity will positively affect firm
performance, but have no sizable effect on the performance of
externally sourced activities. Consequently, an increase in the
scale of internal demand for an activity increases the likelihood
of vertical integration (Based on Production Cost).
• Logic: Firms produce internally that which they produce
efficiently.
• Exchange Attribute: Economies of Scale
• Supported. A strong positive affect on satisfaction with the
performance of internalized activities was identified and
internal demand had no effect on the level of satisfaction with
the performance of outsourced activities.
Hypothesis 5
• Hypothesis 5: Increases in the magnitude of the skill set
required to perform an activity will damage internal
performance and positively affect market performance.
Consequently, increases in the magnitude of skill sets increase
the likelihood of outsourcing (Based on Production Cost).
• Exchange Attribute: Magnitude of Skill Set
• Supported. Results, however depend upon the model
specifications. The relevant variance in skill sets appears to
occur across, not within, information service functions.
Key Points
• TCE = Results strongly support TCE’s argument that higher
asset specificity leads to diminishing effectiveness of market
governance.
• In sum, markets are less efficient than firms in resolving
coordination problems and opportunism that arise as
exchanges become increasingly specialized.
• Knowledge-based Theory = Results did not support the
Knowledge-based theory of the firm.
• Agency Theory and Property Rights = Results confirm the role
of measurement difficulty as a determinant of governance
performance in both markets and hierarchies.
Conclusion:
• The study suggests that boundary choice matters as each
governance mode has different advantages.
• Results support TCE and agency theory and
measurement explanations; however, measurement
explanations are inconsistent in the direction of effect.
• The results are not informative on the role of
technological uncertainty on governance performance
and optimal boundaries.