38-Uncertainity and Governance

8/8/2019 38-Uncertainity and Governance

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Ref # 124140

Governance Under Uncertainty:

Transactions Costs, Real Options, Learning, and Property Rights

Jay B. Barney&

Woonghee Lee

Fisher College of BusinessThe Ohio State University

310 Hagerty Hall1775 College Rd.

Columbus, OH 43210-1399Tel: 614-688-3161Fax: 614-292-3172

Email (Jay Barney): [email protected] (Woonghee Lee): [email protected]

Submission to:

Business Policy and Strategy Division


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ABSTRACT (50 words)

Governance Under Uncertainty:Transactions Costs, Real Options, Learning, and Property Rights

Transactions Cost explanations of governance emphasize opportunism. RealOptions explanations emphasize flexibility. These objectives should beaugmented by recognizing the impact that learning and securing the right to investin an opportunity have on governance. Together, these four objectives can beused to explain a diverse set of governance phenomena.

Key Words; Real Option; Transaction Cost; Learning


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Consider the following decision situation. 1 A bio-technology firm has developed a

product prototype. While this prototype has shown some potential for treating certain physical

conditions, it has yet to receive regulatory approval for commercial development. To receive this

approval, it must first be tested in clinical trials. These clinical trials and subsequent government

evaluations can last from 10 to 12 years. Thus, this firm will not know, with any degree of

certainty, whether or not its product prototype is economically viable for at least 10 to 12 years.

Despite this uncertainty, this firm must make some critical decisions about how to

manufacture this product. First, it needs to decide how it will obtain sufficient quantities of this

product for clinical trials, and second, it needs to decide how it will obtain sufficient quantities

for the commercialization of this product, if in fact it turns out to be economically viable. This

manufacturing decision is complicated by the fact that manufacturing this type of product is very

complex. It usually takes a firm several years to develop the equipment, procedures, and skills it

needs to reliably manufacture this type of product. However, it is generally the case that much of

the equipment and many of the procedures and skills needed to manufacture this type of product

in quantities sufficient for clinical trials are at least partly transferable to the manufacture of this

type of product in quantities sufficient for commercialization.

This bio-technology firm has at least four options in thinking about how to manufacture

its product prototype first for clinical trials and then for possible commercialization. First, it

could vertically integrate into manufacturing for both clinical trials and commercial production.

Second, it could out-source the manufacture of its product prototype for clinical trials, and then

1 The decision situation described here is not uncommon among bio-technology firms. A more detailed version of this situation is described by Pisano (1990).


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vertically integrate into manufacturing for commercial production. 2 Third, it could vertically

integrate into manufacturing for clinical trials, and then outsource manufacturing for commercial

production. Finally, it could outsource manufacturing both for clinical trials and commercial

production. Of course, deciding among all these options is complicated because at least some of

these choices must be made before clinical trials can begin, at least 10 to 12 years before the

economic viability of this product can be known.

In one sense, the manufacturing options facing this bio-technology firm are classic

vertical integration governance decisions. And there is, in the field of organizational economics,

a well known, and often applied, theoretical model for helping firms make these kinds of

transaction governance decisions: transactions cost economics (Williamson, 1975, 1985).

However, the decision facing this bio-technology firm is complicated by two factors that are not

generally included in transactions cost economics models of governance to the same degree as

they exist in this situation. First, these governance choices are sequentially linked; because it

takes years to develop the capability to manufacture this type of product, and because at least

some of this learning is partly transferable from manufacturing for clinical trials to

manufacturing for commercialization, decisions this firm makes about manufacturing its product

for commercialization are linked to decisions it makes about manufacturing for clinical trials.

Second, these governance choices are made under conditions of very high uncertainty. While

transactions cost economics recognizes the impact that uncertainty about sources of opportunism

in a transaction can have on governance choices (Williamson, 1975, 1985), this bio-technology

2 Outsourcing of manufacturing could take several forms, including licensing arrangements, contract manufacturing,or even forming a joint venture with another firm to manufacture the product.


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firm faces significant uncertainty not only about sources of opportunism, but also significant

uncertainty about whether or not this entire investment opportunity will be economically viable.

The purpose of this paper is to develop a theoretical model for guiding decisions about

governance under these conditions, i.e., where different governance decisions are at least

partially linked sequentially, and where very high levels of uncertainty about the future of a

transaction exist. This model draws on several inter-related literatures, including transactions

cost economics (Williamson, 1975, 1985), real options theory (Myers, 1977; Bowman and Hurry,

1993), theories of organizational learning (Cohen and Levinthal, 1990; Hamel, 1990), and

property rights economics (Grossman and Hart, 1986; Hart and Moore, 1990). Not only does this

model provide practical guidance for firms making governance choices under these conditions, it

also adds a necessary building block in the development of a more complete theory of

governance in the field of organizational economics (Barney and Hesterly, 1996).

The paper begins by reviewing transactions cost economics under conditions of high

uncertainty. Inconclusive and contradictory empirical findings in this area of work suggest that

other theoretical perspectives may also be important. These other perspectives, including real

options theory, learning, and property rights theory, are then discussed and integrated with the

transactions cost perspective to develop a more complete model of governance choices under

uncertainty. Some of the empirical implications of this model are then discussed.


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Transactions Cost Under Conditions of High Uncertainty

Uncertainty about sources of opportunism in economic transactions is an important

variable in transactions cost models of governance. When there is no uncertainty about the

sources of opportunism in a transaction, parties to that transaction will be able to rely on

relatively simple market contracts to manage their exchange. However, as uncertainty about

sources of opportunism increases, it may be necessary for parties to a transaction to adopt more

complicated forms of governance, including intermediate forms of governance like strategic

alliances and joint ventures. In these more hierarchical forms of governance, sources of

opportunism in a transaction can be discovered over time, and appropriate protections and

remedies can be developed. Under conditions of even higher uncertainty about the sources of

opportunism in an exchange, it may be necessary to adopt hierarchical forms of governance. In

general, high levels of ex ante uncertainty about sources of opportunism in a transaction can lead

to high levels of ex post opportunism. Increased levels of threat due to ex post opportunism, in

turn, leads to the adoption of progressively more hierarchical forms of governance (Williamson,

1975, 1985).

A straightforward transactions cost analysis of the governance options facing the bio-

technology firm discussed at the beginning of this paper suggests that this firm should vertically

integrate in manufacturing both for clinical trials and commercial production. Only through

vertical integration would this firm be able to protect itself from the threat of opportunism that

attends this highly uncertain set of transactions. For example, outsourcing manufacturing, either

for clinical trials or commercial production, may force this firm to reveal proprietary information


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about its prototype product, its underlying bio-chemistry, and its ultimate commercial

applications. This information could then have been appropriated by this firms manufacturing

partner for its own purposes. Vertically integrating into manufacturing effectively eliminates

these opportunistic threats.

Of course, this general hypothesis about uncertainty and governance has not gone

untested. Unfortunately, empirical efforts to examine this hypothesis have generated decidedly

mixed results. Some authors report results that are consistent with transactions cost expectations

(e.g., Helfat and Teece, 1987; Anderson and Schmittlein, 1984; John and Weitz, 1988; Masten,

1984), where transactions characterized by high uncertainty are managed through more

hierarchical forms of governance and transactions characterized by low uncertainty are managed

through less hierarchical forms of governance. Other authors report mixed results (Walker and

Weber, 1984, 1987; Masten, Meehan, and Snyder, 1991) (where different kinds of uncertainty

have different effects on governance choices, or the effects are not linear), and still others report

exactly the opposite relationship between uncertainty and governance than what is predicted by

transactions cost logic (Harrigan, 1986). For example, Walker and Weber (1987) show that

certain types of transaction uncertainty actually leads firms to adopt less hierarchical forms of

governance rather than more hierarchical forms of governance. In a similar vein, Balakrishnan

and Werenerfelt (1986) and Kogut (1991) show that the desire to maintain flexibility can lead

firms to adopt less hierarchical forms of governance under conditions of high uncertainty, a result

that directly contradicts transactions cost predictions.


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Real Options Theories of Governance

The mixed empirical results of tests of transactions cost explanations of the impact of

uncertainty on governance choices have lead some authors to begin to examine alternative

theories of this relationship. The most popular of these alternative explanations has come to be

known as real options theory (Myers, 1977; Bowman and Hurry, 1993; Kogut, 1991; Chi and

McGuire, 1996; Folta and Leiblein, 1994). Originally developed as a response to the inability of

traditional net present value methods of valuing an investment to include the option value of that

investment (Myers, 1977), real options theory has more recently been applied as a way to explain

the impact of uncertainty on governance choices.

Real options theories of governance under uncertainty generate predictions that are

precisely the opposite of transactions cost predictions of governance under uncertainty. Real

options logic suggests that the critical objective of firms making governance choices under

conditions of uncertainty is the maintenance of their flexibility. Only by maintaining flexibility

will it be possible for firms to make appropriate decisions in the future, should the uncertainty

facing that firm be resolved one way or another. The maintenance of flexibility under

conditions of high uncertainty becomes a governance issue because some forms of governance

are less flexible than others. In particular, it is generally assumed that it is more costly for firms

to alter hierarchical forms of governance in response to the change of the level of uncertainty in

an exchange than it is to alter less hierarchical forms of governance (Kogut, 1991). Altering

hierarchical forms of governance involves changing numerous explicit and implicit contracts that

constitute this form of governance (Mahoney, 1992). Changing less hierarchical forms of


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governance usually involves altering a smaller number of usually explicit contracts. This

reasoning suggests that, under conditions of very high uncertainty in an exchange, firms will

adopt less hierarchical forms of governance instead of more hierarchical forms of governance.

This real options theory of governance under uncertainty also can be applied to the bio-

technology firm described at the beginning of the paper. An application of this logic suggests

that this firm should out source both its clinical and commercial manufacturing operations. This

is the case since the level of uncertainty about the economic viability of this product prototype is

so high. Outsourcing maximizes the flexibility of this firm as it goes forward. If it turns out that

this product prototype is not economically viable, then this firm will not have invested heavily in

manufacturing capabilities that turn out to not have been valuable. If it turns out that this product

prototype is economically viable, and that the best way to manufacture this product is in-house,

then this firm can shift from outsourcing its manufacturing to in-house manufacturing. It will

still have to develop the manufacturing capabilities it needs to accomplish this in-house

manufacturing, and this will still take some time. However, this capability development can now

occur in a setting where the firm knows, with a high degree of certainty, that it will pay off.

Just like transactions cost theories of governance under conditions of high uncertainty,

real options theories of governance under these conditions have also been subject to empirical

test. Some of this empirical work is consistent with real options: under conditions of high

uncertainty, firms opt for less hierarchical rather than more hierarchical forms of governance

(Balakrishnan and Wernerfelt, 1986; Kogut, 1991; Hurry, Miller, and Bowman, 1992).

However, recall that some of the empirical work testing transactions cost predictions about

uncertainty and governance were consistent with transactions cost logic: under conditions of


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high uncertainty, firms opt for more hierarchical rather than less hierarchical forms of

governance (e.g., Helfat and Teece, 1987; Anderson and Schmittlein, 1984; John and Weitz,

1988; Masten, 1984). Results that are consistent with transactions cost expectations about the

relationship between uncertainty and governance contradict real options expectations about the

relationship between uncertainty and governance.

Limitations of Transactions Cost and Real Options Theories of Governance Under

Uncertainty

Taken as a whole, the empirical literature on the relationship between uncertainty and

governance suggests that it would be inappropriate to conclude that either transactions cost

explanations of governance under uncertainty or real options explanations of governance under

uncertainty have received consistent empirical support. Given this state of contradictory

empirical findings, it seems that additional theoretical refinements are required before definitive

predictions can be made. In particular, we argue that both transactions cost and real options

arguments adopt overly simplistic characterizations of the objectives of firms in making

governance decisions under conditions of uncertainty. Only by recognizing the full range of

these objectives, and how they interact with each other, will it be possible to make definitive

predictions about governance under uncertainty.


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Opportunism and Flexibility

Transactions cost economics has long been criticized for its single minded focus on

making governance choices that minimize the threat of opportunism (Ghoshal and Moran, 1996;

Hill, 1990). The mixed empirical findings in the study of governance under uncertainty suggests

that while minimizing the threat of opportunism may be one of the objectives of firms making

governance choices under uncertainty face, it may not be the only such objective. Indeed, real

options theory suggests that at least one more objective for firms in these settings: maximizing

flexibility.

However, real options theory seemingly replaces a single minded focus on making

governance choices that minimize the threat of opportunism with a single minded focus on

making governance choices that maximize flexibility. It is almost as if real options theorists

believe that opportunism threats do not exist under conditions of very high uncertainty, and that

all firm efforts should focus on maximizing flexibility. It may well be that a single minded focus

on maximizing flexibility in making governance choices under conditions of high uncertainty is

just as naive as a single minded focus on minimizing the threat of opportunism in making these

choices.

Indeed, it has been suggested by some authors (Folta and Leiblen, 1994) that both these

objectives are simultaneously important in making governance decisions under uncertainty, and

that the task firms face is understanding which of these objectives should take precedence and

when. In an empirical test of this assertion, Folta and Leiblen (1994) generated results that

suggest that, under conditions of low and moderate uncertainty, opportunism minimization is the


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primary determinant of governance form. Thus, following transactions cost logic, in conditions

of low uncertainty, firms adopt less hierarchical forms of governance; under conditions of

moderate uncertainty, they adopt more hierarchical forms of governance. Folta and Leiblein

(1994) also found that under conditions of high uncertainty, flexibility maximizing becomes

more important than opportunism minimizing, and thus firms adopt less hierarchical forms of

governance, in a way consistent with real options logic. Later in this paper, we extend this logic

to describe other conditions under which opportunism minimizing and flexibility maximizing

will each be emphasized by a firm in making its governance choices under conditions of

uncertainty.

Learning and Governance

However, even recognizing that both opportunism minimizing and flexibility maximizing

are important in making governance choices under conditions of uncertainty still understates the

complexity of this decision. For example, both of these simple objectives fail to recognize the

sequential nature of some of these governance decisions, a sequential nature that implies lessons

learned from governance decisions made early on can have significant implications for

governance decisions made later. Thus, not only must governance under uncertainty take into

consideration minimizing the threat of opportunism and maximizing firm flexibility, it must also

take into account the impact that governance choices have on the ability of a firm to learn about

the value of its investments in a highly uncertain world.


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Of course, more sophisticated versions of real options theory have long recognized the

importance of sequential investments, and the role that learning plays in making these

investments over time (Bowman and Hurry, 1993; Sharp, 1991). Indeed, in his seminal work on

a real options theory of governance, Kogut (1991) argued that under conditions of high

uncertainty, firms should adopt intermediate forms of governance (e.g., joint ventures) because

they simultaneously allow a firm to remain flexible and to learn about the value of their uncertain

investments. How governance options besides joint ventures affect learning, and the conditions

under which more or less hierarchical forms of governance will be adopted to facilitate learning,

in connection with minimizing the threat of opportunism and maximizing flexibility, are

discussed below.

Securing Property Rights and Governance

Finally, even if governance decisions under uncertainty take into consideration the threat

of opportunism, flexibility, and learning, still another important consideration presents itself:

securing the property right to make an investment once uncertainty about the value of that

investment is resolved. For example, suppose a firm adopts a governance mechanism that

minimizes the threat of opportunism and maximizes flexibility, and through the use of that

mechanism learns that a particular investment opportunity is economically valuable. All this

effort has no positive economic benefit for this firm unless it is able to use the information it has

learned through its governance device to invest in this opportunity. Under some conditions, it


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may be necessary for firms to use a governance device to secure their property rights to make an

investment, once the value of that investment is learned.

Again, Kogut (1991) emphasized the ability of joint ventures to partially secure a firms

property right to invest into a particular market or industry, once the value of that investment

becomes known. As was the case with learning, below we extend Koguts (1991) analysis by

examining the impact of more and less hierarchical forms of governance on the ability of firms to

secure property rights to invest in an opportunity, and discuss the conditions under which these

different forms of governance will need to be implemented to secure these property rights.

Types of Learning, Property Rights, and Governance

In the discussion that follows, it is important to recognize the existence of two types of

learning in an economic exchange: exogenous learning and endogenous learning. Exogenous

learning is learning about the value of an uncertain investment from sources that are external to

the governance mechanisms that are put in place to manage that investment. For example, for

the bio-technology firm described earlier in this paper, exogenous learning could occur if the

value of its prototype product could be estimated based on changes in government policy (e.g.,

the government announces that all biological compounds with the attributes of this prototype will

never receive permission for commercialization) or on the basis of research published in

academic journals (e.g., a published study demonstrates that a very similar compound has shown

commercial potential in a commercial application). Note that the information that enables this

firm to value its uncertain investment does not, in any sense, pass through whatever


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governance devices it has put in place to manage manufacturing or any other transaction. In this

sense, the nature of the governance device put in place to manage a highly uncertain investment

has no impact on exogenous learning.

Endogenous learning, on the other hand, is learning about the value of an uncertain

investment through the governance device that is put in place to manage that investment. For the

bio-technology firm, the ability to learn about how to manufacture this type of bio-technology

product depends critically on the type of governance that is put in place in order to manage its

manufacturing operations. It is extremely unlikely that these manufacturing capabilities can be

learned solely by reading published reports and studies. Rather, they require a great deal of

learning by doing, and the development of a great deal of tacit knowledge about the

manufacturing process. Obviously, the type of governance device that is put in place to manage

this manufacturing process is going to have a substantial impact on the quality of endogenous

learning. Indeed, some governance choices may actually make it virtually impossible for

endogenous learning to take place. Other governance choices may facilitate this type of learning.

Learning and Governance

Suppose that a firm making governance decisions under conditions of high uncertainty

has as its primary objective maximizing its ability to learn about the value of its uncertain

investment, at the lowest cost possible. What type of governance device would it adopt?

In general, if the type of learning that is most likely to enable a firm making an uncertain

investment to estimate the value of that investment is exogenous learning, then this firm will


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prefer less hierarchical forms of governance over more hierarchical forms of governance. The

reasoning behind this assertion is simple: if the most critical learning is likely to be exogenous,

then the ability of a firm to learn about the economic value of its uncertain investment does not

depend upon the nature of the governance devices it uses to manage its learning. In this setting,

the firm should adopt the least costly governance devices possible. Following Williamson (1985,

1991), less hierarchical governance (i.e., market forms of governance) are less costly than more

hierarchical forms of governance. Thus, if the type of learning that is most likely to enable a firm

making an uncertain investment to estimate the value of that investment is exogenous learning,

then less hierarchical forms of governance will be preferred over more hierarchical forms of

governance.

On the other hand, if the type of learning that is most likely to enable a firm making an

uncertain investment to estimate the value of that investment is most likely to be endogenous

learning, then more hierarchical forms of governance will be preferred over less hierarchical

forms of governance. The quality of endogenous learning is significantly effected by governance

choices. Recent work on the knowledge-based theory of the firm suggests that more hierarchical

forms of governance can facilitate the transfer of tacit and subtle knowledge, compared to less

hierarchical forms of governance (Conner and Prahalad, 1996; Spender, 1996). Thus, since

endogenous learning is likely to be tacit, subtle, and involve a great deal of learning by doing,

and since governance choices can have a significant impact on the quality of this type of learning,

if the type of learning that is most likely to enable a firm making an uncertain investment to

estimate the value of that investment is most likely to be endogenous learning, then more

hierarchical forms of governance will be preferred over less hierarchical forms of governance.


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decision about whether or not to vertically integrate into manufacturing during commercial

production (Kester, 1984).

Securing Property Rights and Governance

Suppose that a firm making governance choices under conditions of high uncertainty has

as its primary objective securing the right to invest in an opportunity should it turn out to be

economically viable, but that they would like to be able to secure this right at the lowest cost

possible. What type of governance device would it adopt?

The type of learning that is most likely to enable a firm to learn the value of its uncertain

investment also has an impact on the type of governance that firms will use to secure their

property rights to invest in opportunities once their true value is known. If this type of learning is

most likely to be endogenous, then only those firms that have actually learned endogenously will

be aware of the information needed to value an uncertain investment. This is because

endogenous learning is often of the learning by doing and tacit variety--learning that cannot be

exogenous in character. Because only those firms that have learned endogenously have obtained

this information, this type of learning, per se, secures the right of a firm to exploit this

information by investing in an opportunity if it turns out to be valuable.

Since endogenous learning secures the right of a firm to invest in an opportunity should it

turn out to be valuable, no additional governance is required to secure that right. This means that

firms in this setting should choose the least costly form of governance possible: less hierarchical

(i.e., market forms) of governance. When a firm learns about the value of its uncertain


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investment endogenously, it does not require any other guarantees about its ability to invest in its

opportunities, and thus prefers less hierarchical forms of governance.

On the other hand, when this learning is most likely to be exogenous, then the

information about the value of an opportunity is available to any interested firm. This type of

learning, per se, cannot secure the property rights to invest if it turns out that the investment is

economically valuable. In this setting, firms will opt for more hierarchical forms of governance,

because these more hierarchical forms of governance can provide contractual and other

guarantees that, should an opportunity turn out to be valuable, will enable a firm to invest in

them. When learning, per se, does not secure this property right, more hierarchical governance

is required, even though it is more costly than less hierarchical governance.

This logic, when applied to the example bio-technology firm, suggests that this firm

would decide to out source manufacturing during clinical trials, and then decide upon an

appropriate governance structure for commercial production manufacturing later. This is because

learning about manufacturing in this industry is endogenous. If this firm learns about

manufacturing endogenously, it will not require any other governance devices to secure its right

to exploit this learning, should the product prototype turn out to be valuable. From the point of

view of simply securing this property right, a less hierarchical form of governance (i.e.,

outsourcing) is all that is required, since endogenous learning, per se, secures the right of this

firm to invest in its product prototype if, in fact, it turns out to be economically viable.

Governance Objectives and Governance Choices Under Uncertainty


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Thus far, it has been suggested that firms making governance choices under conditions of

high uncertainty may have at least four objectives: minimizing the threat of opportunism,

maximizing flexibility, learning about the value of an uncertain investment, and securing the

property rights to invest in that opportunity should it turn out to be economically viable.

Moreover, each of these objectives have different, and sometimes contradictory, implications for

the type of governance devices that firms should adopt under conditions of high uncertainty. As

summarized in Figure One, transactions cost economics suggests that the threat of opportunism

under conditions of high uncertainty is minimized through the adoption of more hierarchical

forms of governance. Real options theory suggests that flexibility is maximized under conditions

of high uncertainty by the adoption of less hierarchical governance. Theories about

organizational learning suggest that, if learning is likely to be exogenous, less hierarchical

governance is preferred (because it is less costly then alternatives, and the quality of exogenous

learning is not affected by governance devices). However, if learning is likely to be endogenous,

then more hierarchical governance is preferred (because more hierarchical governance can

facilitate learning about tacit knowledge and learning by doing). Property rights theories suggest

that, if learning is likely to be endogenous, less hierarchical governance is all that is required

(because endogenous learning, per se, secures a firms property rights). However, if learning is

likely to be exogenous, more hierarchical forms of governance will be required to secure a firms

rights to invest in an opportunity should it turn out to be economically viable (because exogenous

learning does not secure a property right, per se, while more hierarchical governance can, through

the use of contracts and other guarantees).


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[Insert Figure One About Here]

Given these multiple conflicting prescriptions about the type of governance that a firm

should adopt under conditions of high uncertainty, an important question becomes: when are

these different objectives more or less important for firms making governance choices under

uncertainty? Once we understand when these different objectives will be more or less important

for firms in making their governance choices, it will be possible to make specific predictions

about what those governance choices will be. Some situations where different of these

governance objectives will be more or less important are described below.

Transaction Specific Investment and Governance Choices

Consider first the threat of opportunism. Following transactions cost logic, the threat of

opportunism in an exchange is due to two factors: the level of uncertainty about sources of

opportunism in that exchange and the level of transaction specific investment in that exchange

(Williamson, 1975, 1985). Indeed, most recent research seems to suggest that the level of

transaction specific investment in an exchange is a more important determinant of the threat of

opportunism in that exchange than the level of uncertainty (Williamson, 1985; Riordan and

Williamson, 1985).

Consider the governance choices of two firms. The first firm (Firm A) must make

governance choices under conditions of both high uncertainty and high transaction specific

investment. The second firm (Firm B) must make governance choices under conditions of high


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uncertainty and low transaction specific investment. It is not hard to see that the threat of

opportunism facing Firm A is considerably greater than the threat of opportunism facing Firm B.

Empirically, this suggests that Firm A is likely to make governance choices that are very

consistent with transactions cost logic, i.e., Firm A is likely to adopt more hierarchical forms of

governance in order to minimize the threat of opportunism. Firm B, on the other hand, faces

some threat from opportunism. However, Firm Bs governance choices will take into

consideration maximizing flexibility, learning, and securing property rights to a greater extent

than Firm As governance choices. Thus, Firm B may make governance choices that are

different then what would be expected if adopted only a transactions cost perspective.

Types of Uncertainty and Governance Choices

Two types of uncertainty have already been identified in this discussion: uncertainty

about sources of opportunism in an exchange, and uncertainty about the economic value of that

exchange. In many circumstances, these two types of uncertainty seem likely to be related. For

example, suppose a firm is investing in a particular type of opportunity for the very first time. It

would not be surprising for this firm to be unsure about the economic viability of this investment.

Moreover, given this firms lack of experience in making this type of investment, it would also

not be surprising for it to be not fully aware of all the different ways that exchange partners could

behave opportunistically over the course of this investment. Indeed, since the economic value of

an investment for a particular firm depends, in part, in how much of that value is appropriated by

exchange partners through their opportunistic actions, uncertainty about sources of opportunism


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in an exchange can be an important cause of uncertainty about the value of an investment

opportunity.

However, in other circumstances, there may be substantial uncertainty about the

economic viability of an investment, but little or no uncertainty about potential sources of

opportunism associated with that investment. For example, suppose a firm has a great deal of

experience in making a particular type of uncertain investment. The economic viability of this

particular investment may depend on the reactions of customers, competitors, suppliers, and so

forth, and thus may be uncertain. However, if this investment turns out to be viable, this firm

may be able to anticipate, with a great deal of accuracy, the potential sources of opportunism

associated with this investment. Their ability to anticipate these sources of opportunism reflects

their substantial experience in making this type of investment; their inability to be certain about

the economic viability of this investment reflects the unique properties of this particular

investment.

When uncertainty about the economic viability of an investment is high, while

uncertainty about sources of opportunism associated with that investment is low, opportunism

minimizing objectives will be less important than other objectives in making governance choices

to manage this investment. This suggests that governance choices will be made in ways that are

more consistent with real options, learning, and property rights objectives. On the other hand,

when both uncertainty about sources of opportunism in an investment and uncertainty about the

economic viability of an investment are high, opportunism minimizing objectives are likely to

increase in importance, and governance choices are likely to be more influenced by transactions


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cost reasoning than would be the case if uncertainty about sources of opportunism in a

transaction was low.

Endogenous Learning Over Time and Governance Choices

One of the fundamental conundrums detailed in this discussion, and summarized in

Figure One, has to do with endogenous learning and its impact on governance to facilitate

learning and governance to secure investment opportunities. A firm that makes governance

choices solely on the basis of facilitating endogenous learning will opt for more hierarchical

governance; a firm that makes governance choices solely on the basis of securing property rights,

given endogenous learning, will opt for less hierarchical governance.

One way to resolve this contradiction is to recognize that the need to learn about the value

of an uncertain investment, and the need to secure property rights to invest in an opportunity, can

vary over the life of an investment. For example, when a firm is first making a highly uncertain

investment, it must learn a great deal about the value of this investment. Moreover, if this

investment in occurring in a highly competitive environment, this firm has a strong incentive to

learn as much as it can about the value of this investment as quickly as it can, in order to obtain

whatever first mover advantages may be associated with this investment (Montgomery and

Lieberman, 1988). If the type of learning that is likely to help this firm learn what it needs to

know to value this investment is endogenous, it will probably invest in more hierarchical forms

of governance, since, as was suggested earlier, more hierarchical forms of governance can

facilitate endogenous learning.


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However, once a firm has used its more hierarchical governance to facilitate its

endogenous learning, it no longer needs that governance to secure the property right to invest in

this opportunity. That right is secured by the endogenous learning, it self. Only those firms that

have experienced this endogenous learning will be able to exploit this information in valuing an

investment opportunity. Thus, more hierarchical governance is no longer required, and will be

replaced, as quickly as possible, by less hierarchical forms of governance.

Thus, for investments where endogenous learning is critical to evaluating the economic

viability of an investment, more hierarchical forms of governance are likely to be adopted during

the early stages of an investment (in order to facilitate endogenous learning), and less hierarchical

forms of governance are likely to be adopted during the later states of an investment (because

hierarchical governance is no longer needed to secure rights to invest in this opportunity).

Indeed, this pattern of governing transactions has already been described in the literature and is

called a learning race (Hamel, 1991).

In a learning race, at least two firms join in a more hierarchical form of governance in

order to learn from each other. This more hierarchical form of governance is typically some type

of joint venture (Hamel, 1991). Since these two firms are learning from each other, learning in

this exchange is, by definition, endogenous. Once at least one of these firms learns all it needed

to learn in this relationship, it abandons the more hierarchical form of governance put in place to

facilitate endogenous learning, and substitutes a less hierarchical form of governance. It can

adopt this less hierarchical form of governance and not fear losing the opportunity to use the

information it has gained to invest in an opportunity, if that opportunity turns out to be valuable,


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because the endogenous learning it has experienced secures that right for it, without the cost of

any additional governance.

Exogenous Learning Over Time and Governance Choices

How does this situation change if the critical type of learning in an investment is likely to

be exogenous? If learning is likely to be exogenous, then learning will not be facilitated by more

hierarchical forms of governance. If a firm making this kind of investment was only interested in

facilitating learning at the lowest cost possible, then it would adopt non-hierarchical (i.e., market

forms) of governance.

However, this firm must also be interested in securing a property right to invest in an

opportunity, should it turn out to be valuable, since exogenous learning, per se, cannot secure this

right for the firm. To do this, this firm must invest in more hierarchical forms of governance

then would be the case otherwise. Thus, in the early stages of this investment, this firm will

adopt a more hierarchical, rather than a less hierarchical approach to governance. With this

governance in place, this firm simply waits until exogenous learning occurs.

Suppose exogenous learning occurs, and it becomes clear that this opportunity is, in fact,

economically valuable. Now, this firms need to secure its property rights are increased. Since

all interested firms have access to exogenous learning, in order to secure this property right, this

firm will need to implement an even more hierarchical form of governance. Thus, unlike the

endogenous learning case, where more hierarchical forms of governance are replaced by less

hierarchical forms of governance once endogenous learning occurs, when learning is exogenous,


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more hierarchical forms of governance are replaced by even more hierarchical forms of

governance, once exogenous learning occurs and the positive value of the investment is

established.

This is the situation described by Kogut (1991). Kogut describes firms adopting more

hierarchical forms of governance (e.g., joint ventures) under conditions of high uncertainty.

These more hierarchical forms of governance may be used to facilitate endogenous learning, or

they may be used to secure the right to invest in an opportunity should it prove to be valuable

through exogenous learning. The purpose of this initial joint venture is revealed by actions that a

firm takes subsequent to learning. If a firm abandons its joint venture subsequent to learning and

replaces it with a less hierarchical form of governance, the purpose of that joint venture was to

facilitate learning, and this investment was most likely characterized by endogenous learning. If,

on the other hand, a firm abandons its joint venture subsequent to learning and replaces it with a

more hierarchical form of governance, the purpose of that joint venture was to secure investment

rights, and this investment was most likely characterized by exogenous learning.

In fact, Kogut (1991) studied the impact of exogenous learning on the structure of

governance. In particular, Kogut (1991) shows that when shipment growth increases in excess of

long term expectations, firms with joint ventures conclude that the uncertain investment they

have made is economically viable. However, because information about shipment growth is

publicly available (i.e., a form of exogenous learning), the ability to exploit this information in

making what is now a more certainly valuable investment requires the use of more hierarchical

forms of governance. Thus, this market signal leads firms that have made this kind of investment


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to acquire their former alliance partners, an action that is consistent with the predictions of

governance choices under conditions of exogenous learning described here.

Governance When Learning is Endogenous and Exogenous

Recognizing the different impacts that endogenous and exogenous learning can have on

governance choices over the lifetime of an investment helps resolve an apparent contradiction in

the literature on joint ventures. Some authors see joint ventures as primarily a learning race,

where joint venture forms of governance are replaced by less hierarchical forms of governance

once the value of an uncertain investment becomes known. Other authors see joint ventures

primarily as a prelude to acquisition, where joint venture forms of governance are replaced by

even more hierarchical forms of governance one the value of an uncertain investment becomes

known. The theory developed here suggests that whether a joint venture should be seen as a

learning race or as a prelude to acquisition depends upon the type of learning that is likely to

have the greatest impact on the ability of a firm to value its uncertain investment. If this type of

learning is endogenous, then the learning race analysis of joint ventures is appropriate; if this

type of learning is exogenous, then the analysis of joint ventures as a prelude to acquisition is

most appropriate.

Of course, this situation is complicated when learning about the value of an uncertain

investment can be either endogenous or exogenous; that is, when firms can learn about the value

of their uncertain investments either through the governance devices they put in place to manage

those investments, or from sources external to that governance. In this setting, governance


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decisions may depend more on the learning capabilities of firms than on the type of learning that

may occur. If a firm has developed endogenous learning capabilities, it is likely to treat this

situation as if endogenous learning was more likely to occur then exogenous learning, and adopt

the learning race approach to governing this investment. If a firm has developed exogenous

learning capabilities, it is likely to treat this situation as if exogenous learning was more likely to

occur than endogenous learning, and adopt the joint venture as a prelude to acquisition approach

to governing this investment.

The concept of absorptive capacity has been proposed as a way to conceptualize the

ability of a firm to learn (Cohen and Levinthal, 1990). The analysis in this paper suggests that

there may be different kinds of absorptive capacity--the ability to learn endogenously and the

ability to learn exogenously--and that these different types of absorptive capacity can have

differential effects on governance choices. It may well be the case that there are other types of

absorptive capacity, and that these two may have differential impacts on governance choices.

That firms may differ in their ability to engage in different types of learning also suggests

that the governance choices described here may be sources of competitive advantage. Suppose,

for example, a firm has developed the capability of learning endogenously, but that the type of

learning that is required in a particular setting is exogenous learning. If this firm attempts to use

it endogenous learning capability in this setting and treats this investment as a learning race, it

might find itself at a competitive disadvantage compared to a firm that is highly capable in

exogenous learning and is seeking to make this investment. In a similar way, a firm skilled at

exogenous learning may find itself at a competitive disadvantage if it engages in a learning race

with a firm skill at endogenous learning. These observations are consistent with what might be


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called a resource-based theory of competitive advantage based on governance choices (Barney,

1986; 1991).

Conclusion

Decisions about governance can occur under conditions of high uncertainty. In these

settings, a simple transactions cost analysis, with its emphasis on making governance choices that

minimize the threat of opportunism, receives only mixed empirical support. A simple real

options analysis, with its emphasis on making governance choices that maximize flexibility, also

receives only mixed empirical support. What is required is an approach to making governance

choices that takes into consideration not only minimizing the threat of opportunism and

maximizing flexibility, but also maximizing the ability of a firm to learn about the value of its

uncertain investment, as well as maximizing the ability of a firm to invest in this opportunity

should it prove to be economically feasible. The theory developed here consider all four of these

objectives for firms making governance choices under conditions of high uncertainty.

Unfortunately, each of these different objectives can lead a firm to make different

governance choices. It has been shown how incorporating information about the type of learning

that is most likely to enable a firm to value its uncertain investment--whether it is endogenous

learning or exogenous learning--can help sort out what kinds of governance decisions firms will

make and when.

Thus, when the level of transaction specific investment is high, along with the level of

uncertainty, opportunism minimizing is a relatively more important determinant of governance


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choices. When the level of transaction specific investment is low, even though the level of

uncertainty is high, opportunism minimizing is a relatively less important determinant of

governance choices. Also, when the level of uncertainty about sources of opportunism is high,

along with uncertainty about the value of an investment, opportunism minimizing is a relatively

more important determinant of governance choices, in comparison to situations where the level

of uncertainty about sources of opportunism is low, even though the level of uncertainty about

the value of an investment is high.

Also, by recognizing that governance choices can vary over the life cycle of an

investment, and that this variance depends at least in part on the type of learning that occurs in

different investments, it is possible to make some predictions about governance choices

overtime. When the critical learning in an uncertain investment is most likely to be endogenous,

firms will treat this investment as a learning race, will opt for more hierarchical governance

before learning occurs, and less hierarchical governance after learning has occurred. On the other

hand, when the critical learning in an uncertain investment is most likely to be exogenous, firms

will treat this investment as a precursor to acquisition, and will opt for more hierarchical

governance before learning occurs, and even more hierarchical governance after learning has

occurred.

Finally, the observation that different firms may have different learning capabilities

suggests that governance choices can lead to competitive advantages for some firms some of the

time. If a firm is highly skilled in endogenous learning, it can obtain competitive advantages in

settings where endogenous learning is likely to be important, compared to firms that are highly

skilled in exogenous learning. On the other hand, if a firm is highly skilled in exogenous


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learning, it can obtain competitive advantages in settings where exogenous learning is likely to

be important, compared to firms that are highly skilled in endogenous learning. This then

becomes a resource-based theory of competitive advantage based on governance choices (Lee,

1998).


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Figure One.

Governance Objectives and Governance Choices Under High Uncertainty

Hierarchical Governance Non-Hierarchical Governance

Facilitate Learning:

When Learning is Exogenous ------------------------------>

38-Uncertainity and Governance

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