If firms exist to integrate the specialized knowledge possessed by a number of individuals because such integration cannot be performed efficiently across markets, what determines the boundaries of the firm? In the light of the initial assumptions about knowledge, the vertical and horizontal boundaries may be analyzed in terms of relative efficiency of knowledge utilization.
The analysis of vertical boundaries follows Demsetz (1991). If markets transfer products efficiently but transfer knowledge inefficiently (for the reasons outlined earlier), vertically adjacent stages of production A and B will be integrated within the same firm if production at stage B requires access to the knowledge utilized in stage A. If, on the other hand, the output of stage A can be processed at stage B without the need to access the knowledge utilized at stage A, then stages A and B are efficiently conducted by separate firms linked by a market interface. The dependence of the design of mainframe computers upon the characteristics of integrated circuits (ICs) meant that during the 1960 and 1970s most computer manufacturers were backward integrated into ICs. Within ICs, vertical integration between design and manufacture depends upon the extent to which intense technical dialogue is required between design and fabrication stages. ‘Fab- lessness’ occurs mainly in digital logic ICs where knowledge separation between design and manufacture is feasible (Monteverde, 1995).
The horizontal boundaries between firms are also likely to occur at gaps occurring between constellations of products and knowledge. The benefits of specialization in knowledge acquisition, the many types of knowledge required to produce a product, and the difficulty of integrating these knowledge inputs across markets, suggest that single- product firms will tend to predominate. The problem is that much knowledge is not product specific and is subject to economies of scope. Hence efficient knowledge utilization requires multiproduct firms. As Grant and Baden- Fuller (1995) argue, firms may be characterized both as product domains and knowledge domains. Efficient knowledge utilization requires congruence between the knowledge domain of the firm and its product domain. Typically, perfect congruence does not exist: the firm’s knowledge is not fully deployed by the products it supplies, and the knowledge required by the products supplied is not entirely available from within the firm. Firms tend to form around product-knowledge constellations. Thus, an input-output matrix of knowledge inputs and product outputs for the economy would display broad product- knowledge clusters which correspond to industries within which smaller clusters correspond to individual firms. Imperfect congruence between firms’ product and knowledge domains creates opportunities for knowledge trading to achieve fuller utilization of knowledge. Such knowledge trading tends to take place through strategic alliances.
Source: Grant Robert M. (1996), “Toward a Knowledge-Based Theory of the Firm”, Strategic Management Journal,
Vol. 17, Special Issue: Knowledge and the Firm (Winter, 1996), pp. 109-122. https://www.jstor.org/stable/2486994