MARKET FRICTIONS AS BUILDING BLOCKS OF AN … · market frictions as building blocks of an organizational economics approach to strategic management joseph t. mahoney1* and lihong

Strategic Management JournalStrat. Mgmt. J., 34: 1019–1041 (2013)

Published online EarlyView 13 March 2013 in Wiley Online Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2056

Received 10 May 2011 ; Final revision received 23 May 2012

MARKET FRICTIONS AS BUILDING BLOCKS OF ANORGANIZATIONAL ECONOMICS APPROACH TOSTRATEGIC MANAGEMENT

JOSEPH T. MAHONEY1* and LIHONG QIAN2

1 Department of Business Administration, College of Business, University of Illinoisat Urbana-Champaign, Champaign, Illinois, U.S.A.2 School of Business Administration, Portland State University, Portland, Oregon,U.S.A.

This paper shows that market frictions are fundamental building blocks for an organizationaleconomics approach to strategic management. Various organizational economic approaches(transaction costs, property rights, real options, and resource-based) have distinctive focalproblems and emphasize different combinations of market frictions. A wider recognition of therole of market frictions is useful for three main objectives. First, it helps identify an evolvingmarket-frictions paradigm in strategic management. Second, it shows how two primary questionsin strategy of why firms exist and why some firms outperform others and the three primarystrategic goals of cost minimization, value creation, and value capture can be better joined andevaluated. Third, different combinations of market frictions can generate new research questionsand advance theory development in the strategic management field. Copyright 2013 JohnWiley & Sons, Ltd.

INTRODUCTION

The purpose of this paper is to take stock andto look ahead concerning the role of market fric-tions as key building blocks of an organizationaleconomics approach to strategic management. Interms of taking stock, this paper shows the logicalcohesiveness, for at least the past quarter century,of the strategic management field’s use and devel-opment of an organizational economics approach(Barney and Ouchi, 1986; Hesterly, Liebeskind,and Zenger, 1990; Rumelt, Schendel, and Teece,1991) for addressing two primary questions: why

Keywords: market frictions; organizational economics;cost minimization; value creation; value capture*Correspondence to: Joseph T. Mahoney, Caterpillar Chair ofBusiness and Director of Graduate Studies, Department ofBusiness Administration, College of Business, University ofIllinois at Urbana-Champaign, 140C Wohlers Hall, 1206 SouthSixth Street, Champaign, IL 61820, U.S.A.E-mail: [email protected]

Copyright 2013 John Wiley & Sons, Ltd.

firms exist (the organizational boundary question1)and why some firms outperform others (as mea-sured by economic rents2). Towards this objective,we develop a market-frictions logic that considersevolving paradigmatic contributions from transac-tion costs, property rights, real options, and theresource-based approach3 (Mahoney, 2005).

1 The organizational boundary decision (Mosakowski, 1991;Parmigiani, 2007) includes (1) the existence of the firm (Coase,1937), (2) the vertical integration of the firm (Williamson, 1975),and (3) the scope of the firm (Teece, 1980).2 Economic rents refer to financial returns that are in excessof the opportunity cost of capital, and can be derived from asustainable competitive advantage. In this sense, the resource-based economics approach (Montgomery and Wernerfelt, 1988)that focuses on economic rents is linked to the resource-basedmanagement approach that focuses on sustainable competitiveadvantage (Barney, 1991).3 In the current paper, the term resource-based approach includesthe resource-based view (Peteraf, 1993; Wernerfelt, 1984), theknowledge-based view (Grant 1996; Kogut and Zander, 1992),and the dynamic capabilities view (Eisenhardt and Martin, 2000;Teece, Pisano, and Shuen, 1997).

1020 J. T. Mahoney and L. Qian

Underpinning these two primary questions arethree distinct yet interrelated strategic goals: costminimization, value creation, and value capture.4

The interrelationship among these different strate-gic goals can be complements or substitutes. Onthe one hand, cost minimization directly con-tributes to value creation and can contribute toeconomic rents. Further, value creation and valuecapture are complementary when an expectationof value appropriation leads decision makers tocarry out value-creating strategies under uncer-tainty. On the other hand, a single-minded pursuitto capture value can lead to lower value cre-ation. Managerial practice must consider simul-taneously the goals of cost minimization, valuecreation, and value capture of a specific strategicchoice.

Theory development in strategic managementhas yet to fully synthesize this managerial chal-lenge, however, although all of the necessarybuilding blocks seem to be in place. Specifically,transaction costs theory regards the transaction asthe unit of analysis to examine better ways toachieve the objective of (production and trans-action) cost minimization through organizationalboundary choices (e.g., make-or-buy decisions)and governance structure designs (e.g., line ofauthority and incentive systems) (Kor, 2006;Williamson, 1996). Property rights theory empha-sizes value appropriation through ownership viaresidual claimancy and residual control rights(Alchian and Demsetz, 1972; Grossman and Hart,1986), as well as the implications of property-rights partitioning for the economic value cre-ation of resources (Jensen and Meckling, 1976;Kim and Mahoney, 2005). Real options theoryincludes interproject and intertemporal dimensionsto organizational boundary decisions and economicvalue creation (Kogut, 1991; McGrath and Nerkar,2004). The resource-based approach (Helfat andPeteraf, 2003; Penrose, 1959) emphasizes the con-tinuing search for economic rents and sustainablecompetitive advantage, as well as individual skillsand organizational routines (Nelson and Winter,1982; Winter, 2003), using the bundle of resources

4 Following the formula for maximizing NPV, we considercost minimization a subset of economic value creation, whichis achieved by (1) increasing revenues, (2) reducing costs,and/or (3) reducing risk in ways that cannot be replicated byshareholders. We separate discussion of cost minimization fromvalue creation to distinguish the different focuses of differentorganizational economics theories on their focal problems.

and capabilities as the unit of analysis (Barney,1991; Teece et al ., 1997).

The discussion above reveals at least threepoints that motivate the current paper. First, eachtheory has its own canonical problem and spe-cialized language, which may impose substantialdifficulties in developing a more fully developedparadigm in strategic management. We maintain,however, that there is a shared organizational eco-nomics logic that enables us to coherently tie var-ious strands of the research literature into onecord. Specifically, we seek to identify an evolv-ing market-frictions logic, which can serve as acommon language to facilitate better communi-cation in the field. Second, these distinct theo-ries attend to different goals (Coff, 2010; Zajacand Olsen, 1993) by emphasizing one or moreof the three primary strategic goals that we iden-tified. For example, while transaction cost eco-nomics emphasizes the minimization of transactioncosts, real options theory also considers the eco-nomic value-creation potential of a strategy (e.g.,the growth options enabled by follow-on invest-ments). As suggested above, cost minimization,value creation, and value capture are often inter-twined in firm-level strategy, and a frameworkthat simultaneously considers these three goals isnot only likely to be more relevant for manage-ment practice but also to be more fruitful forricher theory development in strategic manage-ment (Brandenburger and Stuart, 2005; Chatainand Zemsky, 2011; Dyer and Singh, 1998; Mac-Donald and Ryall, 2004). Third, successful effortshave been made to join organizational economicstheories such as (1) transaction cost economicsand property rights theory (Foss and Foss, 2005;Kim and Mahoney, 2005), (2) property rights the-ory and the resource-based approach (Kim andMahoney, 2002; Miller and Shamsie, 1996), (3)the resource-based approach and transaction costeconomics (Argyres, 1996; Madhok, 2002), and(4) transaction cost economics and real optionstheory (Folta, 1998; Leiblein and Miller, 2003).The pairwise joining of these theories suggeststhe presence of logical coherence, but does notfully reveal the fundamental commonalities amongall these theories. We intend to extend this lineof effort by seeking to identify such fundamentalcommonalities.

We suggest that greater paradigmatic theorydevelopment can be achieved by focusing on

Copyright 2013 John Wiley & Sons, Ltd. Strat. Mgmt. J., 34: 1019–1041 (2013)DOI: 10.1002/smj

Market Frictions as Building Blocks 1021

market frictions5 as the key unit of analysis. Wefirst develop a more complete organizational eco-nomics framework by identifying the concept ofmarket frictions as the common building blocks ofthese different theoretical lenses, through system-atic use of the premises of the first fundamentalwelfare theorem of economics (Arrow and Hahn,1970; Debreu, 1959). We further suggest that thefocus of combining theories per se can be limit-ing, since it can predetermine a cluster of marketfrictions associated with each organizational eco-nomics theory. Moving from the molecular level oftheories as clusters of market frictions to the atom-istic level of the market frictions themselves asthe unit of analysis will remove strategy theorists’constraints for developing new theory. Focusingon market frictions as fundamental building blocksprovides an unconstrained choice of various newcombinations of market frictions. We further lookahead and show that the market-frictions logic canhelp structure the organizational economics litera-ture to enable recognition of paradigmatic themesand to generate new research questions.

The next section develops the market-frictionlogic and discusses its role in the developmentof various organizational economics theories. Thethird section proposes a framework for furtherparadigmatic theory development through joiningmarket frictions underpinning cost minimization,value creation, and value capture, and illustrateshow explanations and predictions of strategic phe-nomena can be achieved by using this framework.The last section provides conclusions.

TAKING STOCK: AMARKET-FRICTIONS LOGIC

The first fundamental welfare theorem ofeconomics demonstrates that a competitiveequilibrium leads to an efficient allocation ofresources (Arrow and Hahn, 1970). Assumptionscontained in this theorem include independencein consumption and in production (e.g., there

5 In this paper, the fundamental concept of market frictions isdefined similarly to Arrow’s (1969) description of the conceptof transaction costs. Market frictions, in general, impede marketefficiency and in particular cases may completely block theformation of markets (e.g., Akerlof, 1970). Thus, the conceptof market frictions (like the concept of transaction costs) is abroad category for capturing “the costs of running the economicsystem” (Arrow, 1969: 48).

are neither interfirm externalities nor interprojectand intertemporal spillovers), perfect information,and complete markets (Debreu, 1959). Under thistheorem, firms are expected to earn zero economicrents in long-run competitive equilibrium (Cyert,Kumar, and Williams, 1993). However, as thestrategy field emphasizes,6 the business world isfraught with market frictions, such as asymmetricand imperfect information (Holmstrom, 1979;Phlips, 1988), uncertainty coupled with oppor-tunism (Akerlof, 1970; Arrow, 1974), nonfungibleresources due to sunk costs and asset specificity(Baumol, Panzar, and Willig, 1982; Nickersonand Silverman, 2003), economies of scale andindivisibilities (Chandler, 1990; Scarf, 1994),demand synergies and supply-side economies ofscope (Penrose, 1959; Teece, 1980), externalities(Coase, 1960; Greenwald and Stiglitz, 1986)coupled with positive transaction costs (Coase,1937; Williamson, 1975), and poorly or undefinedproperty rights (Barzel, 1982; Demsetz, 1967).Table 1 shows how the various theoretical lensesof the organizational economics approach instrategic management systematically relax one (ormore) of the assumptions of the first fundamentalwelfare theorem of economics.7

The economic consequences of a particular com-bination of market frictions may vary in degree,from relatively low to severe: market imperfec-tion, market inefficiency, and market failure. Inthis paper, a market imperfection refers to whenthe price signal does not lead to Pareto optimalityin which resources are allocated efficiently

6 The glue that holds the Ricardian, Coasean, and Penroseanapproaches together is the construct of market frictions.While beyond the scope of the current paper, it is highlywarranted to consider market frictions as not only a unifyingconcept within the strategic management field and within theStrategic Management Journal , but also across the StrategicEntrepreneurship Journal and Global Strategy Journal . Forexample, historical and contemporary entrepreneurship literatureviews entrepreneurship as alertness to price differentials dueto market frictions (Delmar, Wennberg, and Hellerstedt, 2011;Kirzner, 1979). In terms of the international business and globalstrategy literature, the theory of foreign direct investment positsthat, in general, market frictions in capital, final goods, orstrategic factor markets across countries create opportunities forthe firm in one country to benefit by existing in another country(Caves, 1982; Hennart, 2011; Kumar, 2009; Seth, Song, andPettit, 2002).7 In order for the rabbit to be pulled out of the hat, the rabbitmust be placed in the hat. In other words, for any paper to makean economic argument (mathematical or verbal) for why the firmexists or why firm-level rents are realized, the first fundamentalwelfare theorem of economics demonstrates that the paper mustposit at least one market friction.



Table 1. Assumptions about market perfection and market frictions

First fundamental welfare theorem Organizational economics in strategic management

Perfect information Imperfect and asymmetric information (Holmstrom, 1979)Complete markets Uncertainty and incomplete markets (Arrow, 1974)

Market power (Caves and Porter, 1977)Perfect fungibility of assets (i.e., no asset specificity) Asset specificity (Williamson, 1985)Constant returns to scale Indivisibilities and increasing returns to scale (Scarf, 1994)

Economies of scope (Teece, 1980)Independence in consumption and production Spillovers and externalities with positive transactions costs

(Coase, 1960; Katz and Shapiro, 1985)Zero transactions costs Positive transaction costs (Coase, 1937)Perfectly defined property rights Poorly or undefined property rights (North, 1990)

(Arrow and Hahn, 1970). Market inefficiencyoccurs when nonprice governance, such ashierarchy and/or government, allocates resourcesmore efficiently than the market. Williamson(1985) emphasizes that a pragmatic evaluationof efficiency (i.e., transaction cost minimization)requires a comparative assessment of imperfectgovernance alternatives, among which each“discrete structural alternative” (Williamson,1991a) has its corresponding combination ofmarket frictions. Market failure refers to wherea market is incomplete or may even collapse(Akerlof, 1970). Figure 1 represents these logicalrelationships.8

Strategic management seeks remedies for thesevarious economic consequences due to market

8 We note here the relationship among these three concepts andthe overarching concept of market friction. Consider a buyerwho values an item at $50, and a current owner of that itemwho values it at $48. In this case, a Pareto-improving tradeideally would take place to make both this buyer and sellerbetter off (Coase, 1960). Market frictions are the transactioncosts of running the economic system (Arrow, 1969). If the costsof exchange for this item in terms of searching, negotiating, andenforcing an agreement (Coase, 1937) exceed $2, then thesetransaction costs drive a wedge between the buyer’s valuationand seller’s valuation, and thus the trade will not take place.Therefore, market frictions at the most general level are thosecosts that impede a Pareto optimal allocation of resources (Arrowand Hahn, 1970). Using the three terms of the current paper, theconcept of market frictions relating to: (1) market imperfectionis considered by Arrow and Hahn (1970), (2) the more severemarket inefficiency is considered by Williamson (1975), and(3) the most severe result of market failure is consideredby Akerlof (1970). We further note that the phrase marketfrictions has been used in the extant research literature to refernot only to the consequences of market imperfection, marketinefficiency, and market failure, but also to the characteristicsof market exchanges that may lead to these consequences. Theremainder of this paper uses the term market frictions to referto the characteristics of market exchanges, and the terms marketimperfection, market inefficiency, and market failure to refer tothe consequences of market frictions.

frictions for the purpose of cost minimization,or ways to leverage these market frictions forthe purpose of value creation and value capture(Mahoney, 2001; Yao, 1988). To show that marketfrictions are fundamental building blocks for vari-ous organizational economics theories in strategicmanagement, we take stock of the research lit-erature by highlighting how each theoretical lenshas utilized a combination of market frictions toaddress the strategic goals of cost minimization,value creation, or value capture.

Organizational economics approach to costminimization

Transaction costs theory is the primary organiza-tional economics approach to the strategic goalof cost minimization, focusing on the compar-ative efficiency of alternative governance struc-tures in reducing transaction costs. Primary marketfrictions emphasized in transaction costs theoryinclude opportunism, asset specificity, and uncer-tainty (Williamson, 1985).9

Opportunism and asset specificity

The potential for opportunism by one of theexchange partners poses transactional hazards tothe other partners, especially those incurring sub-stantial transaction-specific investments (Hoetkerand Mellewigt, 2009). Internalization can attenuate

9 Analogous transaction-cost-related problems can also arisewithin firms after internalization—that is, that inclusion withinthe firm’s boundary does not eliminate those sorts of problems(Miller, 1992). The key idea is to conduct a comparativeassessment of imperfect governance alternatives (Williamson,1985).



Market frictions1. Asymmetric and imperfect information2. Uncertainty and opportunism3. Sunk costs and asset specificity4. Economies of scale and indivisibilities 5. Demand synergies and economies of scope;6. Externalities (inter-temporal and inter-projectspillovers) and positive transaction costs;7. Poorly- or Un-defined property rights

Market imperfection: Not Pareto optimal, but comparatively still the bestof all feasible alternatives (e.g., Arrow and Hahn, 1970).

Market inefficiency: Hierarchy replaces price systems to minimize positivetransaction costs (e.g., Williamson, 1975).

Market failure: Incomplete market or the market completely collapses(e.g., Akerlof, 1970).

Consequences of market frictions

Figure 1. Factors/consequences of market frictions

the likelihood of an exchange partner acting oppor-tunistically by posing economic hold-up problemsfor other partners (Klein, Crawford, and Alchian,1978). The research literature largely corroboratesthe prediction that higher transaction costs due toopportunism and asset specificity result in highereconomic safeguards such as internalization to mit-igate contractual hazards, and thereby minimizecost (Lajili, Madunic, and Mahoney, 2007; Oxley,1997; Shelanski and Klein, 1995).

Organizational economics approach to valuecreation

The resource-based approach considers the strate-gic goal of value creation and, more specifically,the potential economic rents derived from hetero-geneous resources and capabilities. Barney (1991)suggests that a continuing search for sourcesof sustainable competitive advantage focuses onresources that are in demand (i.e., valuable), rare,inimitable, and nonsubstitutable (i.e., the VRINcriteria), which constitute necessary conditionsfor value creation and economic rents. Relat-edly, Peteraf (1993) develops the four cornerstonesof competitive advantage: superior resources; theex post limits to competition; imperfect resourcemobility; and the ex ante limits to competition. Thereal options theory provides a theoretical expla-nation for why firms may make investment deci-sions that differ from what the net present value(NPV) approach would prescribe, and proposesthat, under certain conditions, real options valuewill comprise a substantial portion of the eco-nomic value of projects, lines of business, andfirms (Dixit and Pindyck, 1994; Trigeorgis, 1996).Below we show that market frictions are an impor-tant basis for value creation, and underpin the

extent and sustainability of economic rents, as wellas the values of real options.

Extent of economic rents

(1) Relevant/valuable: A resource is rele-vant/valuable if there is demand for it, whenit enables a firm to conceive of, or implement,strategies that improve the firm’s efficiency oreffectiveness (Barney, 1991). Peteraf and Barney(2003) define the economic value of a resourceas the perceived benefits from a resource aboveits economic costs. Resource-based logic suggeststhat obtaining such a valuable resource can occurthrough luck and/or asymmetric information(Barney, 1986). (2) Scarcity/rare: Resources arerare if supply is limited, and expansion in supplycannot be easily achieved. Further, resources maybe scarcer for those firms that have less accessto those resources. Peteraf (1993) maintains thatthe possession of superior resources by somefirms in an industry can result from asymmetricinformation about the economic value of thoseresources when firms initially developed them.Another form of resource scarcity is uniquenessof resources, for example, resources that arecreated by a firm and henceforth are specificto that firm. Imperfect information concerningavailability of resources or the way to createresources can reinforce their scarcity. (3) Het-erogeneity: Where does such heterogeneity comefrom (Leiblein and Madsen, 2009; Nelson, 1991)?Our response to this question is the existenceof market frictions, the key being asymmetricinformation about resource attributes and avail-ability. Further, when considering stock-and-flowdynamics (Dierickx and Cool, 1989), informationasymmetry combined with heterogeneity in aresource stock formed at time t influences firms’



future strategies in resource procurement, deploy-ment, and divesture, and over time, heterogeneityacross firms will increase. Thus, the presence offirm-level heterogeneity implies the presence ofvarious market frictions, like causal ambiguityand asset specificity/uniqueness (Lippman andRumelt, 1982; Mahoney and Pandian, 1992).(4) Complementarity: Amit and Schoemaker(1993) consider complementarity as a relationshipbetween resources where the relative magnitudeof the strategic value of one resource may increasewith an increase in the relative magnitude ofother resources (see also Milgrom and Roberts,1990; Teece, 1986). Complementarity can occurthrough positive interproject spillovers, such aseconomies of scope (Teece, 1980), and throughpositive intertemporal spillovers, such as assetaccumulation or interconnectedness over time(Dierickx and Cool, 1989). This resource comple-mentarity can reinforce the difficulty in transfer,imitation, or substitution of any single resource(Parmigiani and Mitchell, 2009), and thus canenhance the extent of potential value creationfrom the resource.

Sustainability of economic rents

Impediments to economic activities (Yao, 1988)or market frictions are especially relevant to sus-tainability of economic rents. Important conceptshere include: low transferability, inimitability, andnonsubstitutability, which are each considered inturn. (1) Low transferability: Imperfect resourcemobility can result from nontradable or cospe-cialized assets. A resource may be nontradablebecause of (i) difficulties in pricing the resourcedue to information asymmetry between sellers andbuyers (e.g., brand image) (Shamsie, 2003); (ii)impediments in transferring due to tacitness andintangibility (e.g., R&D capabilities) (Itami andRoehl, 1987); (iii) difficulties in partitioning (e.g.,team-embodied skills) (Williamson, Wachter, andHarris, 1975); and (iv) isolating mechanisms suchas patent and trademark enforcement (Rumelt,1984). Moreover, even if a resource is tradable,the potential economic rents from this resourcewill be attenuated if it is separated from its cospe-cialized asset(s) (Teece, 1986). (2) Inimitability:The key concept of inimitability is intrinsicallyrelated to low transferability, to the extent thatsome causes of low transferability such as non-tradable or cospecialized resources can lead to

inimitability. Barney (1991) attributes such inim-itability to path dependence (Arthur, 1989), socialcomplexity (Blyler and Coff, 2003), and causalambiguity (Lippman and Rumelt, 1982), whichcan be derived from market frictions of inter-firm externalities, intrafirm spillovers, and asym-metric information. (3) Nonsubstitutability: Sub-stitutability or nonsubstitutability is a relativeterm, since for any resource there can be anotherresource that can at least partially substitute forthe focal one, either cross-sectionally or longi-tudinally (Dierickx and Cool, 1989). Thus, thereis often imperfect substitutability between firmresources.

Value creation through real options

The real options theory holds that in a contextcharacterized by high uncertainty and manage-rial discretion, managerial flexibility to adjust apredetermined course of action upon arrival ofnew information is economically valuable, andinvestments that enhance flexibility will add eco-nomic value to option holders (Dixit and Pindyck,1994; Trigeorgis, 1996). Real options theory con-siders various common real options (e.g., theoption to defer, to abandon, and to grow), andhas been used to examine various strategic phe-nomena (e.g., investment decisions, organizationand governance decisions, and firm valuations)(Li, James, Madhavan, and Mahoney, 2007). Keymarket frictions emphasized in real options the-ory include uncertainty in investment decisions,the (in)flexibility in strategic choice, and the inter-project as well as intertemporal spillovers (Bow-man and Hurry, 1993; Kogut, 1991; McGrathand Nerkar, 2004). The real options lens attemptsto account for these spillover effects within theconstructs of real options to defer, abandon, orgrow (Dixit and Pindyck, 1994), which can cre-ate value by generating future decision rights(McGrath, Ferrier, and Mendelow, 2004). Thereal options perspective is a fundamental contri-bution to strategic management because it con-tributes to designing operational solutions to mar-ket frictions (e.g., dealing with spillover effectsthat would otherwise be improperly priced) forthe purpose of value creation and value capture.Specifically, calculating the option value to deferaddresses the market friction of uncertainty ininvestment decisions, calculating the abandonmentoption addresses the market friction of the level



of (in)flexibility in strategic choice, and calcu-lating growth options addresses interproject andintertemporal spillovers in the presence of marketfrictions.

Organizational economics approach to valuecapture

The resource-based approach also considers valuecapture. Grant (1991) traces the profit-earningpotential of a resource to the extent and sustain-ability of the competitive advantage established,and the firm’s ability to appropriate the economicrents generated. Amit and Schoemaker (1993)consider scarcity, complementarity, and appropri-ability to be important characteristics of theseresources and capabilities that are posited to gen-erate firm-level rents.

Appropriation of economic rents emphasized inthe resource-based approach

Appropriation of economic rents is a necessarycondition for economic value sustainability (Coff,2010). Low appropriability lowers the incentives toinvest in resources, activities, and dynamic capa-bilities in the value-creation process. The appro-priability of economic rents is influenced by com-plementarity, property rights, and embeddedness,which we discuss in turn. (1) Complementarity: Ifa firm possesses a cospecialized resource (Teece,1986), then there is idiosyncratic bilateral syn-ergy (Mahoney and Pandian, 1992: 368) in whicheach firm possessing a cospecialized resource isexpected to appropriate some of the gains from thejoined resources. Further, if one of the resourcesin the combination is held by a firm in a compet-itive factor market while the other firm possessesa valuable, rare (unique), inimitable, and nonsub-stitutable resource, then the firm possessing sucha unique resource will appropriate the entire eco-nomic value created in this resource combination(Barney, 1986). We emphasize that the market fric-tions, which result from asset specificity, not onlyhelp explain why these cospecialized resources areowned by one firm (Teece, 1986) but also whycospecialized resources can lead to economic valuecreation (Mahoney, 2001). (2) Embeddedness: Theconcept of embeddedness involves both cross-sectional and longitudinal interconnectedness ofresources (Dierickx and Cool, 1989). Consider theexample of a professor of chemistry who is tied to

a university-owned research lab relative to a busi-ness school professor who has relatively fewer tiesto the physical resources. The embeddedness logicsuggests that ownership of the physical asset leadsto de facto control over human resources (Grant,1991; Hart, 1995). In particular, the owner of aphysical resource (i.e., the university) is typicallyin the position to appropriate more of the value cre-ation by the chemistry professor than the relativelymore mobile professor of business.

Value capture emphasized in property rightstheory

Well-defined property rights regimes (e.g., patentand trademark protection, and equity-sharearrangements) provide direct mechanisms for eco-nomic appropriability (Barzel, 1989; Eggertsson,1990). In contrast, poorly or undefined propertyrights are key sources of market frictions thatcreate misleading price signals and thus reduceefficiency in resource allocations (Coase, 1960).Assignment of residual claimancy (Alchian andDemsetz, 1972) and residual rights of control(Grossman and Hart, 1986) are important com-ponents of organization design. 10 For example,Grossman and Hart (1986) show that imperfec-tions in residual control assignments (e.g., thecontractual party having the greatest potentialfor increasing aggregate gains is not assignedresidual control rights) can lead to poor resourceallocation. In particular, if the contractual partycontemplating firm-specific investment ex anteis not afforded residual control rights ex post,then a farsighted decision maker will foresee thecontractual hazards of potentially having at leastpart of their investment appropriated, and thusthere will likely be a rational underinvestmentin firm-specific capabilities (Wang and Barney,2006; Wang, He, and Mahoney, 2009).

10 Williamson notes that “whereas transaction-cost economicslocates the main analytical action in the ex post implementa-tion stage of contract (where inefficiencies due to maladaptationarise), Grossman-Hart-Moore (Grossman and Hart, 1986; Hartand Moore, 1990) assume away ex post maladaptation (by invok-ing common knowledge of payoffs and costless bargaining),thereby to focus instead on how different configurations of phys-ical asset ownership (to which residual rights of control accrue)are responsible for efficiency differences at the ex ante stage ofcontract” (2002: 442).



What is the common language?—A synthesisof market-frictions logic

By illustrating how the various organizationaleconomics approaches to the three strategicgoals—cost minimization, value creation, andvalue appropriation—have been developed inthe strategic management field, the precedingdiscussion suggests the following ideas. First,underpinning the three strategic goals are variousmarket frictions. These market frictions interactto create the need for cost minimization, or theopportunity for value creation and value capture.A firm can choose its organizational boundaryand governance design to minimize costs and tocapture value. It can also develop resources andcapabilities that enable value creation and valuecapture (Adner and Zemsky, 2006; Chatain, 2011).Second, each organizational economics theory isderived from a particular subset of the full menuof market frictions. For example, asset specificity,asymmetric information, and uncertainty are theprimary market frictions emphasized in transactioncosts theory, and externalities in the presence ofmarket frictions (Coase, 1960) are emphasizedin property rights theory. Third, although distincttheories emphasize different combinations ofmarket frictions, these combinations are alsooverlapping as some key market frictions arecommonly emphasized, such as asymmetricinformation. Fourth, these theories may share verysimilar concepts, albeit with different terminology.For example, the concept of high asset specificityemphasized in transactions costs theory, theconcept of high-level commitment emphasized inthe resource-based approach, and the concept oflow abandonment option (i.e., high sunk costs)emphasized in the real options theory are allderived from one fundamental construct, thatis, the nonredeployability of assets. While thefirst fundamental welfare theorem of economicsassumes the perfect fungibility of assets, thevarious organizational economics theories relaxthis key assumption.

We use Table 2 as an illustration of the prevail-ing utilization of market frictions in the strategicmanagement literature. Column 1 provides the pri-mary market frictions and the related behavioralassumptions. Column 2 includes constructs derivedfrom these market frictions. Columns 3–6 providerepresentative studies that utilize these correspond-ing constructs. Table 2 indicates a coherent logic

based on market frictions underpinning these vari-ous organizational economics theories. Building onthe same fundamental logic, each theory branchesout by emphasizing different but overlapping com-binations of market frictions to address its canoni-cal problem. By decomposing each organizationaleconomics theory to a combination of differentmarket frictions, we can now identify those fric-tions that are either neglected or seldom exam-ined within a particular theory.11 By consideringtheory integration as a recombination of a sub-set of the underpinning market frictions, we canmove towards the development of a paradigmaticmarket-frictions framework.

LOOKING AHEAD: FROM“MOLECULES” TO “ATOMS”

Having shown that many of the extant researchstudies in strategic management can be logicallyreconstructed as some combination of market fric-tions, we show in this section that it can be moreeffective to view paradigmatic theory develop-ment not simply as a process of joining multipleorganizational economics theories per se, but asintegrating multiple market frictions that underpineach theory and the three strategic goals. 12 Let’sfirst consider recent developments in the orga-nizational economics approach to strategic man-agement, which has started to take an integrativeapproach, to the extent that multiple strategic goalsare examined concurrently, and from multiple the-oretical perspectives. We show that these recenttheoretical developments can also usefully be char-acterized as new combinations of market frictionsthat yield new strategic insights.

11 It should be noted that within Table 2, the construction ofthe organizational economics approach in strategic managementhas been viewed in terms of existing organizational economicstheories (reading Table 2 vertically). This paper suggests thatthe generation of new theory by the next generation of strategicmanagement scholars can be facilitated if we reconstruct theextant research literature by viewing Table 2 horizontally, andmake the construct of market frictions the essential buildingblock and fundamental unit of analysis. Table 3 illustrates thisreconstructed logic.12 While filling gaps in theories is one approach to movingthe strategic management field forward, the current paper alsosuggests an alternative approach: No commitment to any oneorganizational economics theory is required. What is involved,rather, is the selection of market frictions best suited to deal withthe management problem at hand.



Tabl

e2.

Mar

ket

fric

tions

emph

asiz

edby

vari

ous

theo

ries

inor

gani

zatio

nal

econ

omic

s

Mar

ket

fric

tions

Der

ived

cons

truc

tsT

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actio

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theo

ryR

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optio

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Res

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appr

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Asy

mm

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form

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nE

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lun

cert

aint

yD

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(199

7)Si

ngh

and

Kun

du(2

002)

Folta

and

Mill

er(2

002)

Bru

shan

dA

rtz

(199

9)Ta

cit

know

ledg

eTa

nan

dM

ahon

ey(2

006)

Aro

raan

dM

erge

s(2

004)

Kog

utan

dK

ulat

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(200

1)Sz

ulan

ski

(199

6)

Unc

erta

inty

Tech

nolo

gica

lun

cert

aint

yB

alak

rish

nan

and

Wer

nerf

elt

(198

6)Pi

sano

(199

0)Fo

lta(1

998)

Song

and

Mon

toya

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ss(2

001)

Dem

and

unce

rtai

nty

Wal

ker

and

Web

er(1

984)

Nor

ton

(198

8)O

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en,

Folta

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dJo

hnso

n(2

003)

Kor

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(200

8)C

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exity

Task

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(199

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003)

Nic

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004)

Soci

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(198

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997)

Bar

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Hill

(199

0)G

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Har

t(1

980)

Li

(200

8)M

ahon

ey(2

001)

Tru

st/r

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iona

lex

peri

ence

Chi

les

and

McM

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n(1

996)

Gul

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(199

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(200

7)V

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i(2

003)

Ex

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nB

alak

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and

Koz

a(1

993)

Foss

and

Foss

(200

5)Fo

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006)

Ex

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2)C

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996)

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(200

5)

Ex

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hold

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Kle

inet

al.

(197

8)H

art

and

Moo

re(1

990)

Lei

blei

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dM

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(200

3)W

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Bar

ney

(200

6)A

sset

spec

ifici

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spec

ifici

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Zen

ger

(199

8)R

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998)

Sanc

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(200

3)Y

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Rot

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999)

Ass

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spec

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(200

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Teec

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010)

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Un

(201

0)D

yer

(199

6)

Ass

et com

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rity

Teec

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986)

Lie

besk

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(199

6)K

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(200

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elfa

t(1

997)

Prod

uctio

nec

onom

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Eco

nom

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Arr

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(197

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996)

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983)

Lie

berm

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988)

Eco

nom

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Teec

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980)

Lie

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(199

6)V

asso

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Ana

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Folta

(200

4)H

elfa

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Inte

rfirm

exte

rnal

ities

Publ

icgo

ods

Hen

nart

(198

8)C

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(196

0)M

cGra

th(1

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Kim

and

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oney

(200

2)In

trafi

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ers

Kno

wle

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spill

over

May

eran

dSa

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Zha

o(2

006)

Kan

g,M

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and

Tan

(200

9)B

lyle

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off

(200

3)Po

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/un

defin

edpr

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tyri

ghts

Prop

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righ

tsre

gim

eW

illia

mso

n(

1991

b)O

stro

m(1

990)

Reu

eran

dTo

ng(2

005)

Mill

eran

dSh

amsi

e(1

996)



Recent developments in organizationaleconomics approach

(a) Cost minimization coupled with value cre-ation.

Later development in the transaction coststheory literature—largely originating fromthe strategic management field—has startedto incorporate the strategic goal of value cre-ation, pointing to the dual role of governancestructure for both cost minimization and valuecreation (e.g., also including revenue drivers),as well as the interaction between the goals ofcost minimization and value creation (Zajacand Olsen, 1993). These new developmentsare, however, still derived from the funda-mental market frictions, only now with newcombinations of market frictions.Intrafirm spillovers and governance insepa-rability : Argyres and Liebeskind (1999) pro-vide a time dimension to transaction costeconomics to explain firm boundary choicedynamically. In particular, this line of rea-soning maintains that governance choices,such as previous contractual commitmentsentailing sunk costs (asset specificity), mayenable or constrain a firm’s subsequent gov-ernance choices (Aggarwal and Hsu, 2009).This economic logic resonates with the extantresearch literature on dynamic transactioncosts theory (Langlois, 1992). An examplefor positive spillovers occurs when there islearning-by-doing derived from contractingexperience, and thus the decision to contracttoday may positively influence subsequentcontracting capabilities (Mayer and Argyres,2004). An example of negative intrafirmspillovers would be if internal procurement,internal expansion, and program persistencebiases exist in the vertically integrated firm(Williamson, 1975: 118–124), and thereforethese internal organizational distortions thatcould potentially constrain future governancechoices should be included in the decisioncalculus at the outset. Potential value creationembedded within a certain governance choiceis emphasized in this context.Intrafirm spillovers and economies ofscale/scope: Spillovers can occur with pro-duction capabilities that entail economies of

scale/scope (Teece, 1982). Williamson (1975:83–84) and Teece (1980) emphasize thattechnological interdependency or economiesof scope, per se, only explain the colocationof resources. It does not, by itself, explain orpredict the organizational boundary decision,which is determined by the extent of marketfrictions. Therefore, more refined theorybuilding makes clear that when economiesof scope or technical complementarity arecombined with intrafirm spillovers and mar-ket frictions, the decision of internalizationmay be needed to achieve more fully thebenefits of production economies relative tomarkets. The dual role of value creation andcost minimization of a certain governancechoice is emphasized here.

(b) Cost minimization coupled with value capture

The property rights theory informs not onlythe determination of economic value creation,but also enables analysis of value distributionor the strategic goal of value capture (Kimand Mahoney, 2010). Property rights the-ory suggests the importance of well-definedresidual claimancy and residual control rights,which can be either incentives or disincen-tives for firm-specific investment, and actas conduits upon which economic value ofresources can be channeled to high yielduses (Mahoney, 2005; Milgrom and Roberts,1992). In general, externalities when com-bined with positive transaction costs havebeen a concern in the property rights litera-ture (Coase, 1960; North, 1990). The currentpaper also focuses on a context in which mar-ket frictions are likely to be critical, namely,when there is high asset specificity (Gross-man and Hart, 1986; Williamson, 1985).Asset specificity and negative interfirm exter-nalities: As an example, Kim and Mahoney(2002) examine oil field unitization to expli-cate the effects of investments characterizedby high levels of asset specificity, ill-definedproperty rights, and externalities with posi-tive transaction costs. In particular, the neg-ative externalities of oil migration towardsthose oil firms that drill early typically ledto overdrilling at poor location choices. Thus,a substantially suboptimal aggregate amountof oil extraction was experienced for decadesin Oklahoma and Texas (Libecap, 1989). The



lack of oil field unitization for migratory oil,or the difficulty in establishing property rightsto specific assets, negatively impacts produc-tive utilization of these assets. Further, Kimand Mahoney (2002) show in the context ofoil field unitization that asymmetric informa-tion about location-specific assets can impedevalue creation as it stymies mutually bene-ficial trade (Coase, 1960). Also, in terms ofvalue capture, Libecap (1989) shows that dis-tribution conflicts can lead to decision makersactively blocking changes in property rightsthat would otherwise lead to efficiencies.Asset specificity and loss of positive intrafirmspillovers: As Coase (1960) shows, the ini-tial assignments of property rights facilitatesubsequent trade. If property rights are unde-fined, markets may completely break down(North, 1990). Further, if initial propertyrights are poorly defined, the market-frictionconsequences can still be quite substantial(Miller and Shamsie, 1996). The same prob-lem that may occur due to market frictionsin interfirm exchange involving asset speci-ficity and externalities (Libecap, 1989) canoccur with intrafirm exchange involving assetspecificity and spillovers effects (Kang et al .,2009). For example, while a “strategic” out-sourcing of employees may maximize theeconomic returns for a particular division ofa company, the benefits that these employ-ees provided in consultation with people inother divisions of the same company may belost, in which case the economic returns tothe enterprise can be negative.

(c) Value creation coupled with value capture

Poorly or undefined property rights and capa-bilities with value creation potential : Con-sider a multidivisional firm with highlyrelated business units where residual incometo managers is based only on divisional returnon assets. Such property rights within thisfirm are poorly defined since the managers ofthese highly related businesses are unlikelyto share information in this compensationsystem. With a lack of knowledge trans-fer, the realized capabilities of such a firmwill be far from its potential capabilities. Achange in the property rights regime of thefirm, where divisional managers are rewarded

based on corporate ROE, for example, wouldlikely improve information sharing in thefirm due to improved incentive alignment,and thereby facilitate greater capability devel-opment. Thus, property rights and dynamiccapabilities are tightly linked (Ghemawat,1991).Asset specificity and positive intrafirmspillovers: one example of a substantialpositive intrafirm spillover is R&D, inwhich knowledge creation may have positivespillover applications to other divisions inthe company (Argyres and Silverman, 2004;Helfat, 1997). However, due to potentialmultidivisional negotiating problems involv-ing investments with high levels of assetspecificity, these potential positive spilloversmay not be fully realized. In other words,the marginal benefits of R&D investmentfor a particular division may be smallerthan the marginal costs for that division, inwhich case the investment might not occurdespite the fact that the net impact of theR&D investment at the firm level would bepositive when the full costs and benefits areaccounted for.

The discussion above reinforces the importanceof a paradigmatic market-frictions framework forthe strategic management literature. It shows thenecessity to develop a framework that can morecompletely analyze the three intertwined strategicgoals. Considering more than one strategic goalhas already enabled greater theory development,which offers more explanatory and predictivepower for various strategic phenomena. Further,it shows that a paradigmatic framework has beenemerging within the strategy field in which thevarious market frictions are the fundamentalbuilding blocks. This paper maintains that moreself-conscious intention by scholars within thestrategy field to continue in this direction is likelyto be fruitful for both strategic management theoryand practice.

Extending beyond the two primary questions:a generalized market-frictions approach

As Table 2 suggests, each market friction hasbeen, or can potentially be, incorporated intoeach organizational economics lens. Focusing onthe concept of market friction as the key unit



of analysis may prove useful in explaining thetwo primary questions in the strategy field—whyfirms exist and why some firms outperformothers—and, more broadly, in our collectiveefforts to generate novel research questions andto develop a more coherent paradigmatic approachfor the strategic management field. Below weprovide two examples to show the usefulness ofthis approach, and then proceed with discussion ofa more generalized market-frictions approach.

Alchian and Demsetz (1972) emphasize theissue of team production in which observation ofthe output is insufficient for providing rewardssince the marginal productivity of each worker isunknown. Due to this nonseparability problem, exante free-riding (shirking) and ex post hagglingcan occur. Hierarchical monitoring is suggested asa solution to this problem. Within a hierarchy, oneteam member serves the role of “monitor” andreceives all the residual returns, while all otherteam members become interchangeable employeesand their inputs are undifferentiated. Rajan andZingales (1998) build upon the nonseparability ofteam production and join it with the market frictionof asset specificity emphasized in Williamson(1979) to develop a more general theory of powerin organization. In their model, each team membermakes firm-specific investments, which have littleor no economic value outside the joint production.Contrary to the recommendations by propertyrights theory, which suggests the assignment ofownership to the team member whose firm-specific investment is most critical to the jointproduction (Grossman and Hart, 1986; Hart andMoore, 1990), Rajan and Zingales (1998) notethat assigning ownership to that team member mayreduce incentives in firm-specific investment by allteam members, including the one that is assignedownership. Rajan and Zingales’ (1998) proposal isto use the property rights mechanism of restrictedaccess to critical assets, instead of ownership, forthe purpose of promoting firm-specific investmentand thus economic value creation.

The theory by Rajan and Zingales (1998) helpsto explain a variety of real-world institutionalarrangements. Blair and Stout (1999) draw uponthe idea of third-party ownership from Rajan andZingales (1998) to develop a team productionapproach to the public corporation. The idea ofthird-party ownership suggests that an “outsider”to the actual productive activity can be grantedaccess to the team’s assets and incentivized by the

reward of a nominal share of the team’s output.Blair and Stout (1999) thus explain that the roleof a board of directors in public corporations is notsimply to reduce agency costs, as most principal-agent model proponents would suggest, but toalso encourage firm-specific investment essentialto certain forms of team production by all membersof a corporation, including managers, employees,and other key stakeholders. Team members of acorporation voluntarily relinquish important con-trol rights over firm-specific inputs and outputs toan independent board of directors and address con-tracting problems inherent in team production via amediating hierarchy (Blair and Stout, 1999). Withhigh firm-specific human capital, shareholdersmight welcome labor representation on the boardof directors (Osterloh and Frey, 2006).

This detailed example shows the fruitfulnessof theory development obtained by joining newcombinations of market frictions—which is a keymessage of the current paper. In particular, join-ing two different market frictions, asset specificityand the nonseparability problem in team produc-tion, Rajan and Zingales (1998) provide a novelexplanation of one source of power in the firm,that is, the restricted access to critical assets, whichfurther offers rich insights for both strategic man-agement theory and for management practice. Blairand Stout (1999) extend the theory by applyingRajan and Zingales’ (1998) novel explanation tothe role of the board of directors in the law of thepublic corporation.

A second example to show the fruitful the-ory building through consideration of numerousmarket frictions is Chi (1994) from the Strate-gic Management Journal . Chi (1994) uses multiplemarket frictions that cut across the boundaries ofseveral organizational economics theories, includ-ing asymmetric information that leads to poten-tial adverse selection and moral hazard prob-lems, asset specificity that resides in comple-mentarities of strategic resources from two firms,the economic hold-up problem that may arise intrading such strategic resources, resource inim-itability and immobility that characterize thosestrategic resources, and property rights assignmentregarding residual claimancy and residual controlrights. By integrating these various market fric-tions, Chi studies the transactional problems intrading strategic resources between two firms, theantecedents of these problems, and the remedyingmechanisms for these problems. By developing a



rich framework, Chi (1994) is able to address aseries of questions, such as “Under what condi-tions, if any, can imperfectly imitable and imper-fectly mobile resources be gainfully traded acrossfirms? What are the main difficulties of trading insuch resources? What mechanisms can be used tomitigate the various trading difficulties and howthe exchange structure between the trading partiesmay be affected by the adoption of those mech-anisms?” (1994: 272) It is also noteworthy thatChi’s (1994) framework considers all three strate-gic goals considered in the current paper: (1) thetrading of strategic resources may be subject totransaction costs or problems of adverse selection,moral hazard, cheating, and economic hold-up, andthus the trading partners must design an exchangestructure to minimize these costs; (2) the comple-mentarities between resources of two firms are thevalue creation potential, and by trading strategicresources through a certain exchange structure, thetrading partners can create economic rents; and(3) the apportionment of residual claimancy andresidual control rights becomes important remedy-ing mechanisms for the purpose of value capture.In all, a unique combination of market frictionsin Chi (1994) enables a more penetrating analy-sis of the exchange structure in trading of strate-gic resources among firms than would be possiblewith any one theory in isolation. In terms of man-agerial significance, Chi and Roehl (1997) applythis framework to explain the apportionment ofresidual bearing and the assignment of manage-rial control in exchanges of business know-howbetween exchange partners of international collab-orative ventures.

Theory development achieved by Rajan andZingales (1998) and by Chi (1994) providesexemplar support for our thesis that by focusingon new combinations of market frictions, whichserve as the unit of analysis, we can usefully gaingreater explanatory power for a variety of strategicphenomena including the two primary questionsof strategic management: why firms exist and whysome firms outperform others.13 The preceding

13 Mahoney (2001) and Makadok (2003) tightly link the firstquestion of why firms exist to the second question of why somefirms outperform others. Makadok states that “the Mahoney(2001) conjecture—that whatever set of economic frictions isa sufficient condition for the existence of sustained economicrents will also be a sufficient condition, although perhaps not anecessary condition, for the existence of a firm. That is, the setof frictions that is required to generate the existence of a firm

discussion suggests that the market-frictions logicinforms cost minimization, value creation, andvalue capture. Cost minimization (utilizing marketfrictions primarily emphasized in transactioncosts theory), value creation (utilizing marketfrictions primarily emphasized in the resource-based approach and real options theory), andvalue capture (utilizing market frictions primarilyemphasized in property rights theory) can beusefully joined by the “glue” of market frictions.We submit that to understand more fully either theorganizational boundary question or the economicrents question, it is necessary to consider all threestrategic goals. More specifically, we suggestthat the market-frictions logic enables us toexplore the intertwined relationships between theeconomic rents question and the organizationalboundary decision, instead of treating these twoquestions in isolation. Thus, we propose thatby focusing on the common building blocks ofdifferent organizational economic theories, thatis, the various market frictions, theories typicallyregarded as informing the organizational boundaryquestion can be used to explain economic rents,and theories typically regarded as informing theeconomic rents question can help explain organi-zational boundary decisions. Greater paradigmaticdevelopment is feasible if we continue with therecent developments in organizational economicsapproaches that have started to incorporatemultiple strategic goals and new combinations ofmarket frictions, for the purpose of understandingboth the organizational boundary question and theeconomic rents question.

We first show that the organizational bound-ary decision, which has typically been consid-ered through a cost minimization lens (Williamson,1985), can be further examined through a valuecreation and value capture lens (Dyer, 1997; Zajacand Olsen, 1993) via learning, dynamic capabili-ties, and knowledge spill-in from exchange part-ners (Hoetker, 2005; Leiblein and Miller, 2003).For example, extending the transaction as theunit of analysis to incorporate intratemporal andintertemporal spillover effects offers new insightsabout the organizational boundary decision. Forinstance, Kang et al . (2009) find that OEM sup-pliers are willing to make unilateral relationship-specific investments with buyers such as Dell,

is a subset of the set of frictions that is required to generate theexistence of sustained economic rents” (2003: 1045).



and suggest that OEM firms make these decisionsbased not only on economic benefits with theircurrent exchange partners, but also on the potentialbenefits to be gained through established exchangerelationships with these powerful buyers. If thereare future (dynamic capabilities and real options)benefits in forming an exchange relationship, atransaction party may choose to tolerate the risksof potential opportunistic behaviors, and makea firm boundary decision contrary to the trans-action cost economic (cost-minimization) predic-tion based on the single transaction as the unitof analysis. Qian, Agarwal, and Hoetker (2012)also emphasize intertemporal spillover effects inthe context of industry evolution, where industryentrants design their firm boundary by taking intoaccount the entry timing or the different industryevolution stages. In particular, this study finds thatfirms entering later to an industry are less likely tointernalize transactions than those entering earlier,suggesting that some transaction costs are enduringwhile some other transaction costs are transient.

Not only will potential value-creation consider-ations influence the organizational boundary deci-sion, but potential value destruction will alsoimpact this decision. For example, Argyres andLiebeskind (1999) emphasize that past (sunk cost)commitment to a specific transaction partner maybecome an important path-dependent factor in thecurrent organizational boundary decisions. Focus-ing on the single transaction as the unit of anal-ysis may neglect potentially important intrafirmspillover effects that can occur across multi-ple transactions (Argyres and Liebeskind, 2002).Attempting to separate two interdependent bound-ary decisions may cause a loss in economic value.

Moreover, the strategic management field’spredictive power for the economic rents questioncan be improved when market frictions relatedto organizational boundary choice are considered.A more complete theory of economic rents needsto incorporate (interdivisional and intertemporal)spillover effects. Utilizing the individual resourceas the unit of analysis will have limitations since itmay neglect important intrafirm spillover costs andbenefits to the bundle of resources that the decisionmaker either currently possesses or may possessover time (Penrose, 1959). For instance, researchon activity systems (Kauffman, 1993; Milgromand Roberts, 1990) suggests an important unitof analysis for developing a theory of economicrents. An activity system approach emphasizes

complementarities among activities (Porter, 1991),which reinforces resource (re-)bundling processes(Kor and Mahoney, 2000; Teece, 1986; Wern-erfelt, 1984). More generally, the current papersuggests that a richer resource-based analysisof economic value creation will be achievedwith greater attention to the intrafirm spillovereffects of resources in the decision calculus, andgovernance structure designs that can account forthese potential intrafirm spillover effects.

Further, consideration of market frictionsunderpinning an organizational boundary decisionenriches a theory of economic rents by addressingnot only potential, but also realized value creation(Gottschlag and Zollo, 2007; Kim and Mahoney,2002), by taking into account an appropriate gover-nance design. The resource-based logic in Barney(1991) and Peteraf (1993) provides criteria forpotential economic rents derived from resources.However, the potential economic rent of a resourceis unlikely to be fully realized if property rights areunder- or overdefined (Ziedonis, 2004). A moresystematic examination of market frictions, ingeneral, and property rights (governance), in par-ticular, is required to ascertain the economic valueof resources (Mahoney, 2005; Makadok, 2001).

Using the market-frictions logic

The interrelated work of Rajan and Zingales(1998) and Blair and Stout (1999), as well asthe work of Chi (1994) and Chi and Roehl(1997), are exemplars of utilizing the market-frictions logic for development of nuanced insightsand the generation of new questions. With aparadigmatic thinking based upon the market-frictions logic, students in doctoral programs inthe strategy field are equipped with a roadmapfor conducting research with an organizationaleconomics approach. These examples also suggestthat there are at least two ways that strategyresearch can approach their research questionsusing the market-friction logic. For analyticalpurposes, the first approach is to start withthe research gap identified within the existingliterature, and the second approach is to start withthe strategic phenomenon of interest. Below webriefly discuss these two approaches.

First, new research questions can be generatedby studying the research gap in existing literaturein organizational economics theories. We useTable 3 as an example to illustrate this approach.



Table 3. Exemplar studies joining multiple organizational economics theories

Original theorypairings Exemplar studies

Insights gained fromjoining the market

frictions emphasized by therespective theories

Sample of new questions generatedby incorporating other market

frictions typically not emphasizedby those theory pairings

Transaction coststheory and propertyrights theory

Hennart (1988) Scale joint ventures (JVs): whenparents seek to internalize a failingmarket, but indivisibilities due toscale or scope economies make fullownership of the relevant assetsinefficient.

Link JVs: simultaneous failing ofmarkets for services of two ormore assets as firm-specific publicgoods, and acquisition of the firmholding them incurs significantmanagement costs.

The choice of equity JVinfluences flexibility of eachparent firm involved, as wellas interparent firm spillovers.How might consideration ofthese influences impact thegovernance choice of JVtypes from the beginning?

Transaction coststheory andResource-basedapproach

Silverman (1999) Rent-generating resources areconsidered to have high assetspecificity, and thus are less likelyto be utilized in contractualalternatives (e.g., licensing) thanthrough diversification.

Consider also the real optionsimplications of decisionmaking under uncertaintyfrom two alternative modes:licensing and diversification.

Transaction coststheory and realoptions theory

Folta (1998) Technological uncertainty plays animportant role in the preference forequity collaboration (overacquisition) in domains of higherasset specificity.

How would arrangement of theresidual claimancy andresidual control rightsembedded in the two modes(equity collaboration andacquisition) affect the role oftechnological uncertainty?

Property rights theoryand resource-basedapproach

Luo (2002) “While capability exploitation isassociated with the use of whollyowned entry mode, capabilitybuilding is linked to the jointventure mode. MNEs seeking localmarket expansion also deploygreater capability exploitation andbuilding than those seeking exportmarket growth” (p. 48).

Consider the role of theproperty-rights regime(whether there iswell-defined or poorlydefined property rightsprotection) in the MNEs’entry mode choice and itsimplications on performance.

Property rights theoryand real options

Miller and Folta(2002)

“Optimal timing for exercising realoptions depends on currentdividends, possibilities forpreemption, and whether the optionis simple or compound, proprietaryor shared” (p. 655).

How would a firm’spath-dependent capabilitydevelopment change theattributes (possibilities ofpreemption; proprietary) of areal option?

Resource-basedapproach and realoptions

Kogut andKulatilaka(2001)

“Managers cannot easily adjust thewrong set of organizationalcapabilities to the emergence ofmarket opportunities . . . firms thathave made investments incapabilities appropriate to theseopportunities are able to respond”(p. 744).

What are the roles ofgovernance inseparability(Argyres and Liebeskind,1999) and intertemporalspillovers in strengtheningthe irreversibility oforganizational capabilities,and further impacting theheuristics of managers inmaking capability investmentdecisions?



Column 1 in Table 3 lists six potential pairs oftwo organizational economics theories; Column 2presents exemplar research of the pairwise joiningof the corresponding theories; Column 3 providesinsights gained from joining market frictionsemphasized by the respective theories; and Col-umn 4 suggests new questions that can be raisedby incorporating other market frictions that aretypically not emphasized by those theory pairings.

For a thought exercise, consider Silverman(1999), which examines the diversificationchoice through industry entry versus other con-tractual modes (e.g., licensing) for firms thatintend to exploit their technological resources.Technological resources with strong applicabilityto a different industry provide potential economicvalue creation through exploiting those resourcesin that industry. However, the extent of realizedvalue creation through exploitation is subject tothe difficulty in appropriating returns to inno-vation, or the appropriability regime of a givenindustry. Accordingly, Silverman (1999) predictsthat if the target industry is characterized by highsecrecy, a high learning curve, or low feasibilityof using licensing, contractual hazards will behigh, and diversification will be a preferredmethod for exploiting a technological resource.Based upon these predictions, there are manyother questions a reader can probe further. Forinstance, what other market friction aspects ofthe choice between industry entry and contractuallicensing may impact the choice itself? Industryentry through diversification provides strongereconomic safeguards for appropriation of returnsto innovation, but also requires stronger resourcecommitment or possible sunk costs than othercontractual methods. In addition, exploitingexisting technological resources through diversifi-cation may prevent the focal firm from exploringnew resources and new knowledge that can bepotentially spilled in if cooperative modes withother partner firms were chosen. By raising suchquestions, we can gain a better understandingof the boundary conditions for research findingsfrom Silverman (1999) and, more importantly,generate new research questions. Similar thoughtexercises can be carried out for all the otherpapers included in Table 3.

The second approach starts with the strate-gic phenomena of research interest. Because themarket-frictions logic outlined in this paper attendsto all three strategic goals of strategy, it can be

applied to a wide range of strategic phenomena,such as competitive advantage, diversification,and divestment, and the scope of the firm (e.g.,alliance, joint venture, and M&A) (Capron,Duassauge, and Mitchell, 1998; Ramanujam andVaradarajan, 1989). Identifying and selecting themarket frictions most relevant to a particularmanagerial problem, however, requires carefulevaluation of which goal is most relevant for theproblem at hand. Some market-frictions problemsrequire managers to primarily attend to cost mini-mization, while other problems may require greaterattention to value creation and capture. Havingidentified the priorities of different strategic goalsconcerned in the strategic problems or phenomena,a strategy scholar proceeds by selecting a com-bination of relevant market frictions underpinningthose strategic goals. A more challenging nextstep is to examine the interrelationships amongthese identified market frictions, and to teaseout potentially different or overlapping drivingforces for each market friction. For instance,measurement cost may lead to asymmetric infor-mation, and can also cause difficulty in delineatingproperty rights with greater precision. Havingchosen the primary market frictions and havinganalyzed the interrelationships among them, thefinal step of theory development is to consideradditional market frictions that may be relevantto the focal problems or phenomena but are lessemphasized in existing research literature, as wehave suggested in Table 2. Incorporating thesemarket frictions is likely to produce novel insights.

Two research streams can illustrate the useful-ness of this approach. Consider first strategic out-sourcing. To examine this phenomenon with ourmarket-frictions logic, we can start by asking ques-tions like: What market frictions are involved ina strategic outsourcing decision? How can thesemarket frictions be recombined to better explainthis organizational boundary question? On the onehand, prevailing information technologies reduce(1) information asymmetry and search costs, (2)nonseparability problems in team production, and(3) asset specificity (small-numbers) problems dueto increased connectivity, which mitigate marketfrictions (Lajili and Mahoney, 2006). On the otherhand, outsourcing a business function to anotherfirm involves knowledge transfer and potentiallyinvoluntary knowledge spillovers, which requiresappropriate property rights allocation. Thus, apractice of recombining market frictions can prove



useful in examining strategic outsourcing. A sec-ond research stream concerns employee mobilityand entrepreneurship. Considered as agents for“creative construction” (Agarwal, Audretsch, andSakar, 2007), employee entrepreneurs can lever-age the underutilized knowledge of the parentfirms and channel knowledge spillovers to venturecreation. Here the market frictions both within andbeyond the parent firms play important roles inemployee mobility, in that information asymme-try and knowledge spillovers spur value-creationopportunities for those employees who break awayfrom the existing firm boundary. While strategicoutsourcing attends to the cost minimization goal,the employee mobility phenomenon focuses oneconomic value creation. It is clear that whethera strategic phenomenon points to vertical integra-tion or deintegration (e.g., new venture creation oroutsourcing), the organizational economics princi-ple of examining market frictions remains durableacross these phenomena.

CONCLUSIONS

This paper both takes stock and looks ahead con-cerning the role of market frictions as buildingblocks of an organizational economics approachto strategic management. We take stock of thisresearch literature (i.e., transaction costs, prop-erty rights, real options, and resource-basedapproaches) to identify an evolving paradigmaticapproach that has taken place over the past quartercentury. We illustrate the rich connections amongthese theories via market frictions, and we showthe usefulness of combining market frictions fromvarious theories in novel ways.

We then apply the market-frictions logic toorganizational boundary and economic rentsquestions to show how joining cost minimization,value creation, and value capture can be achievedthrough considering various market frictions.More generally, we maintain that it is useful toview market frictions as the fundamental buildingblocks of strategic management, and the analysisof new combinations of market frictions mayprovide new strategic insights. Recombinationsof market frictions can be achieved by joiningvarious organizational economics theories, but thatis not the only path to gaining such insights sincethese theories typically emphasize a particularcluster of market frictions. Instead of focusing

exclusively on joining different “molecules” (i.e.,the different organizational economics theories),we can fruitfully join various “atoms” (i.e., themarket frictions themselves). Joining theories perse is likely to restrict the choice set of possiblecombinations of market frictions. Thinking interms of the “primitives” of these market frictionsthemselves can open the theory space for newstrategic insights to emerge.

Developing the market-frictions logic is alsopromising for providing key managerial implica-tions. Managers—along with researchers—canproactively consider market frictions that enablecost minimization and the generation of firm-leveleconomic rents. For example, managers have theopportunity to provide economic value in businesssituations where market frictions exist and pricesignals are not sufficient. Thus, the managerialcalculus should include the intrafirm spilloverbenefits and costs that are not typically pricedin standard discounted cash flow formulations.Such strategic connections show that the market-frictions logic enables us to better join theory withmanagement practice. Indeed, Yao (1988) suggeststhat both practitioners and researchers will obtainmore penetrating insights from considering fun-damental market frictions than the relatively lessprecise (i.e., more aggregated) concepts of entryand mobility barriers that strategic managementborrowed from industrial organization economics(Porter, 1991).

Finally, we note that while transaction costs the-ory was relatively well developed at the time ofYao’s (1988) seminal paper, the strategic man-agement field has since developed the resource-based and real options approaches, and has begunto make progress in utilizing property rights the-ory. In an important sense, the current paper hasattempted to reconstruct the field’s theory devel-opment in the past two decades from a market-frictions lens to show the evolving paradigmaticdevelopment that has occurred over time. Indeed,designing operational solutions to attenuate marketfrictions to minimize costs or to leverage mar-ket frictions for the purpose of value creation andvalue capture is at the core of the economic foun-dations of strategy. It is anticipated that a moresystematic examination of market frictions for fur-ther exploration of the organizational boundarydecision, the sustainability of firm-level economicrents, and other strategic issues will enable the next



generation of research within our evolving strate-gic management field to do even better.

ACKNOWLEDGEMENTS

We thank Rajshree Agarwal, Nick Argyres, JanetBercovitz, Daniel Elfenbein, Jovan Grahovac,Glenn Hoetker, Yasemin Kor, Steve Michael,Doug Miller, Jackson Nickerson, Deepak Somaya,and Todd Zenger for useful comments and sugges-tions. We also thank Rich Bettis and the anony-mous reviewers for their counsel, which helpedimprove the paper significantly. The process ofwriting this paper reinforces the view that thevirtues of an argument depend upon the virtuesof its audience. Finally, we thank participants atresearch seminars at the University of Illinois atUrbana-Champaign and at Washington Universityin St. Louis. We also thank participants at the Octo-ber 2009 Strategic Management Society (SMS)meeting in Washington, DC. The usual disclaimerapplies.

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MARKET FRICTIONS AS BUILDING BLOCKS OF AN … · market frictions as building blocks of an organizational economics approach to strategic management joseph t. mahoney1* and lihong

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