Entrepreneurship, Enterprise Design, and the Role of Markets

As implicitly recognized by Penrose, firms need to be viewed as human organizations, not computer-controlled machines. As such, firms must confront challenges in the realm of organizational design including imperfect incentive alignment, imperfect govern- ance, and bureaucratic decision-making. Organizations facilitate decisions because they constrain the set of alternatives as well as the relevant parameters to be considered. Organizations can be rendered more effective and efficient by improving the ways in which those limits are defined and imposed (Simon, 1947; March and Simon, 1958).

While Penrose may have recognized the human element in organizations, she did not really explore issues of organizational design. As noted by Herbert Simon, “[d]esign calls for initiative, focus of attention on major problems, search for alternatives. One cannot choose the best, one cannot even satisfice, until one has alternatives to choose from.” Nowhere is this clearer than in the entrepreneurial activities of organizations. As Simon has observed:

Especially in the case of new or expanding firms, the entrepreneur does not face an abstract capital market. He or she exerts much effort to induce potential investors to share the company’s views (often optimistic) about its prospects. This executive is much closer to Schumpeter’s entrepreneur [and to the Penrosian manager] than to the entrepreneur of current neo- classical theory. Whether the firm expands or contracts is determined not just by how its customers respond to it, but by how insightful, sanguine and energetic its owners and managers are about its opportunities—by how much they possess of the “animal spirits” that Keynes was obliged to introduce into his account of the trade cycle (Nelson/Winter 1982). (1991: 35 ff.)

These factors go beyond the managerial elements highlighted by Penrose. Arguably, they are more important.

One example of the importance of design is in the development of the “architecture” of a business firm. This element of design is embedded in part in management’s choice of (or creation of) a busi- ness model. A business model defines the manner in which a busi- ness enterprise delivers value to customers, entices customers to pay for value, and converts those payments to profit. It reflects the firm-specific assumptions about what customers want and how an enterprise can be profitable as a result of the value delivered. The business model determines: (1) how the revenue and cost structure of business is to be “designed” and then possibly “redesigned” to meet customer needs; (2) the ways in which the resources are to be assembled and the relevant market segments can be identified; (3) the mechanisms through which value can be created and The purpose of a business model is to “articulate” the value proposition, identify targeted market segments, define the structure of the value chain, and estimate the cost structure and profit potential (Chesbrough and Rosenbloom, 2002: 533 ff.). In short, a business model is a plan for the financial and organizational “architecture” of a business that makes valid assumptions about costs, scale, and customer and competitor behavior. It outlines the contours of the solution required to win in the marketplace. Getting the business model right is critical to the success of a new business; adjusting and/or improving the model is likely to be crit- ical for continued success. However, the importance of “business models” has been largely neglected in the management and eco- nomics literature, at least until recently. A firm’s capacity to create, adjust, hone, and replace business models is a critical building block of this firm’s dynamic capabilities.

Design issues are also important when considering the changing nature and dynamics of international business. In recent decades, increased globalization, and in particular outsourcing and off- shoring, appear to have gained momentum. However, while glob- alization has expanded, it is by no means “complete”. Precisely because cross-border integration is incomplete (i.e. the world is characterized by semi-globalization) the study of international business and multinational enterprise remains an important schol- arly activity.20 Otherwise, mainstream strategy and management content would suffice for international business too. Because of incomplete integration and differences in business environments, locational factors and institutional differences must be taken into account. Such differences do not merely indicate the presence of barriers to the internationalization of business; they can also be beneficial to MNEs.

In recent decades, the MNE has been shaped by three key developments critical to its nature and scope: (i) the simultan- eous increase in both the outsourcing and the offshoring of pro- duction, (ii) the emergence of a distributed and open innovation model, that is, not only are production and manufacturing being outsourced, but so is innovation, and (iii) the development of low-cost information and computer technology, which enables small firms to perform transactions, and adopt business mod- els, previously only available to large enterprises. For instance, Internet-based companies such as Amazon, eBay, Google, and Yahoo make it possible for small businesses to reach global mar- kets that were previously inaccessible, except at considerable cost. This has led to the emergence of what might be thought of as “mini”-multinationals, sometimes employing only a handful of workers, and using Internet-based technology to anchor the coor- dination of their global activities. In short, information and com- puter technology has enabled efficient global operations for very small as well as small, medium, and large enterprises. Small enter- prises in particular may be launched from multiple jurisdictions— rendering the home/host country dichotomy irrelevant from the time of organizational founding. Also, these mini-multinationals are often founded by individuals collaborating across boundaries, and they exhibit MNE characteristics from their birth. Designing and orchestrating the business model and organizational structure of such firms has become increasingly complex. In the realm of the external environment, markets for such expanding firms must be “seized” and, sometimes, created.

Although Penrose did recognize the importance of creating mar- kets as a result of entrepreneurship, she did not address the simul- taneous role of entrepreneurs in creating markets and designing organizations.21 An essential characteristic of organizations/firms is that they embody knowledge which can’t easily be bought and sold. Sometimes, the only way to capitalize on knowledge is to start a firm and build the necessary complementary assets (Teece, 1986a).22 Profit flows from innovation, buttressed by the develop- ment of complementary technologies, and the astute deployment of complementary assets.

Penrose’s work differs from Coase’s (1937), in terms of the ratio- nale for the firm’s existence and expansion. She does not assume that “in the beginning there were markets”. Her perspective is more in keeping with Simon’s (1991) perspective that “in the beginning there were firms”; entrepreneurs create new markets by starting entrepreneurial organizations because the relevant external capa- bilities simply aren’t there (cf. Langlois, 1992).23

Penrose emphasized entrepreneurial imagination and the non- market nature of entrepreneurial knowledge. She noted that it is: “evident that such management [entrepreneurship] cannot be hired in the market place” (p. 45). A few decades earlier Frank Knight (1921) perceptively linked the existence of firms to entre- preneurs seizing opportunities for profit in the face of uncertainty: “It is . . . true uncertainty which . . . gives the characteristic form of ‘enterprise’ to economic organization as a whole and accounts for the peculiar income of the entrepreneur” (1921: 232).24

Her vision of entrepreneurship is very close to that of Frank Knight. She emphasized entrepreneurship as explicitly an organi- zational phenomenon: “The productive activities of . . . a firm are governed by what we shall call its ‘productive opportunity’, which comprises all of the productive possibilities that its ‘entrepreneurs’ can see and take advantage of” (p. 31). Entrepreneurs have “inti- mate knowledge of the resources, structure, history, operations and personnel of the firm” (p. 54).

There are other ideas in strategic management that were not directly anticipated by Penrose, perhaps in part because she did not self-consciously endeavor to  provide  normative  frameworks for managers. Hence, her neglect of certain  issues  now  consid- ered important to the field of management today should not be construed as a criticism, but merely as an observation. One such example is the idea that markets need to be developed.  It  is common in economics to assume that markets exist. As Arrow (1974) observed: “Although we are not usually explicit about it, we really postulate that when a market could be created, it would be.” If it is not, this reflects market failure, and such failure can in turn be attributed to “transaction costs” or “adverse selection”. The absence of certain  insurance  markets  is  a  typical  example. As a general rule, economics suggests that markets fail because inputs or outputs are not priced properly. For example, gasoline that pollutes is consumed “too much” because the costs of using it are not fully internalized. Arrow (1962) and Arrow and Debreu (1954) do discuss the absence of fully developed contingent claims markets, but in the main such lacunae are explained by the absence of demand, or just simply transaction costs.

Moreover, in commercializing new technologies, pioneering entrepreneurs often find that formal market research and expert forecasts, however sophisticated from a methodological perspec- tive, fail to predict which new markets will come into existence, and where and when these markets will actually materialize. Christensen (1997), Mintzberg (1994) and others have docu- mented a wide variety of cases that illustrate this unpredictability in business. Human history also attests to this unpredictability in other areas—such as Columbus’s discovery of the New World or the fall of the Berlin Wall.

There is little in economics to suggest that markets can be shaped by the purposeful decisions of managers, that is, by firms. Penrose chose not to develop that point either. For her theory of the growth of the firm, markets were not specifically treated. However, firm behavior shapes markets just as markets shape firm behavior and firm growth. Consistent with this view, Herbert Simon argued that perhaps we should not assume an explanation is needed of why firms actually exist. Simon uses the illustration of a visitor from Mars approaching earth observing economic exchanges, with organizations appearing as green areas, and market transactions as red lines in between. What does the visitor see? Organizations, green areas, would be dominant. We live in an “organization econ- omy” rather than a “market economy”, and organizations are more ubiquitous than market transactions; even more so if we go back in history (Simon, 1991). Simon suggests that the more natural question to ask than the Coasian one, is “why do markets exist?” Instead of focusing on theories to explain the existence of firms, Simon raises questions such as, why do particular organizational forms (such as professional services firms) exist, and how should they be structured? How do these organizational forms relate to broader processes of (technological, cultural, etc.) change in the modern economy? What motivates people in real organizations (authority, rewards, loyalty, identification, coordination)? These are issues to be addressed by strategic management in the future; not all of these are Penrosian themes sensu stricto.

Source: Teece David J. (2009), Dynamic Capabilities and Strategic Management: Organizing for Innovation and Growth, Oxford University Press; 1st edition.

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