Knowledge-based theory: The existence of the firm

The above precepts establish a rationale for the existence of firms. Following Demsetz (1991: 171- 175), the existence of the firm represents a response to a fundamental asymmetry in the economics of knowledge: knowledge acquisition requires greater specialization than is needed for its utilization. Hence, production requires the coordinated efforts of individual specialists who possess many different types of knowledge. Yet markets are unable to undertake this coordinating role because of their failure in the face of (a) the immobility of tacit knowledge and (b) the risk of expropriation of explicit knowledge by the potential buyer. Hence, firms exist as institutions for producing goods and services because they can create conditions under which multiple individuals can integrate their specialist knowledge. These conditions include propinquity and ‘low-powered’ incentives designed to foster coor- dination between individual specialists which avoid the problems of opportunism associated with the ‘high-powered’ incentives directly related to knowledge transactions.

A possible solution to the inability of markets to contract over transfers of tacit knowledge is to contract over units of workers’ time. But even if units of labor time are suitable proxies for the supply of tacit knowledge, so long as production requires the complex integration of multiple types of knowledge within a system of team production, then Rosen (1991) shows that markets must establish an incredibly complex wage structure which sets a separate wage rate for every worker’s interaction with every other worker.3

Note that this view of the role of the firm as a knowledge-integrating institution is somewhat different from that emphasized in the literature. Most research into organizational learning (Levitt and March, 1988; Huber, 1991) and the knowledge-based view of the firm (Spender, 1989; Nonaka, 1991, 1994) focuses upon the acquisition and creation of organizational knowledge. Thus, Spender (1989: 185) defines ‘the organization as, in essence, a body of knowledge about the organization’s circumstances, resources, causal mechanisms, objectives, attitudes, policies, and so forth.’ My approach is distinguished by two assumptions: first, that knowledge creation is an individual activity; second, that the primary role of firms is in the application of existing knowledge to the production of goods and services. This dispensing with the concept of organizational knowledge in favor of emphasizing the role of the individual in creating and storing knowledge is consistent with Simon’s observation that: ‘All learning takes place inside individual human heads; an organization learns in only two ways: (a) by the learning of its members, or (b) by ingesting new members who have knowledge the organization didn’t previously have’ (Simon, 1991: 125). More importantly, however, is the desire to understand the organizational processes through which firms access and utilize the knowledge possessed by their members. The danger inherent in the concept of organizational knowledge is that, by viewing the organization as the entity which creates, stores and deploys knowledge, the organizational processes through which individuals engage in these activities may be obscured. Thus, March views organizations as storing ‘knowledge in their procedures, norms, rules, and forms. They accumulate such knowledge over time learning from their members’ (March, 1991: 73). This learning process involves ‘encoding inferences from history into routines that guide behavior. The generic term routines includes the forms, rules, procedures, conventions, strategies, and technologies around which organizations are constructed and through which they operate’ (Levitt and March, 1988: 320). Taking the organization as the unit of analysis not only runs the risk of reification, but, by defining rules, procedures, conventions, and norms as knowledge fails to direct attention to the mechanisms through which this ‘organizational knowledge’ is created through the interactions of individuals, and offers little guidance as to how managers can influence these processes.

Unlike Spender (1992), who analyzes the dual role of firms in knowledge generation and knowledge application, my emphasis is on the firm as an institution for knowledge application. This is not to deny the importance of organizational context in knowledge creation. If production creation requires the integration of each person’s knowledge with that of others, even if knowledge acquisition is individualistic, the firm provides necessary incentives and direction. If knowledge is specific to a particular team production process, then knowledge creation cannot be separated from knowledge application— both occur within a common organizational context. Thus, if the members of Manchester United soccer team have complementary skills, then they need to be tied together by long-term relationships in order to achieve the investment in team-based skills required to maximize team performance. Market contracts are unlikely to achieve the stability of long-term relationships and are likely to give rise to all the problems of opportunism that transactions cost economics predicts are a consequence of small numbers and transaction-specific investments.

This rationale for the existence of the firm may be criticized as being a special case of the Coase/Williamson transaction cost theory of the firm. Firms exist because they are able to avoid the costs associated with market transactions; the knowledge- based view simply focuses upon the costs associated with a specific type of transaction—those involving knowledge. Certainly, the above analysis draws upon some familiar concepts of market failure. However, the key distinction is emphasis upon the firm as an organization for managing team production rather than an institution for managing transactions. In common with the arguments of Ghoshal and Moran (1996), the central advantage of firms in the production process is not simply an avoidance of the transactions costs associated with market exchange, but their ‘unique advantages for governing certain types of economic activities from a logic that is very different from that of a market (Ghoshal and Moran, 1996: 13). Integrating        the       knowledge       of            many   different individuals in the process of producing goods and services is such a logic. To develop this argument further, these processes for integrating knowledge need to be specified more clearly.

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.

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