TY - JOUR
AU - Niman, Neil, B.
AB - Abstract Recently, competence/capability has been introduced as a rival and as a complement to the idea of transaction-costs as the foundation for a modern theory of the firm. However, while the competence-based approach may be inspired by evolutionary economics, it does not, in its current form, provide an evolutionary theory of the firm. To transform this competence-based approach into an evolutionary theory, the connection between the firm and Veblen's concept of social knowledge is more fully developed. Once established, the evolutionary theory of the firm is utilised to bypass Marshall's reconciliation problem and solve Cournot's Dilemma. JEL classifications: D21, D23 Introduction Recently, competence/capability (Foss, 1993; Hodgson, 1998A) has been introduced as a rival and as a complement (Langlois, 1992; Langlois and Foss, 1999) to the idea of transaction-costs (Williamson, 1985) as the foundation for a modern theory of the firm.1 Such an addition is viewed as an important contribution to the broader exercise of constructing an evolutionary theory of the economy. However, while the competence-based approach may be inspired by the evolutionary theories of scholars such as Nelson and Winter (1982), it does not, in its current form, provide an evolutionary theory of the firm. To construct an evolutionary theory of the firm, the individual parts of the firm must not only be defined in terms of competences or routines that evolve over time, but the firm itself as a collection of these individual parts must evolve. An evolutionary theory of the firm must be able to explain why new firms are created and how they replace older firms as part of an ongoing selection process. To transform the competence-based theory of the firm into an evolutionary one, the connection between the firm and the work of Veblen contained in Foss (1998) will be more fully developed. Drawing upon the link between Veblen and the biological theory of evolution utilised by Hodgson (1998B), Veblen's concept of social knowledge will be extended to explain both why the firm exists and how the firm as an institutional entity evolves over time. To illustrate the value of such an evolutionary theory of the firm, it will be used to solve one of the oldest conundrums found in microeconomic theory. Originally formulated by Augustin Cournot in 1838, Cournot's Dilemma (Newman, 1960) revolves around the question of why a firm that is experiencing decreasing costs does not expand production to the point where it is the only seller in the industry. Marshall recognised this ‘reconciliation problem’ (Prendergast, 1992; Hart, 1996) as a stumbling block for the development of the supply curve; and it is a problem that remains unresolved. Focusing on the difficulties in Marshall's efforts to graft a biological theory of the firm with a mechanical concept of competitive equilibrium (Niman, 1991A), the evolutionary theory of the firm will provide a solution to this long-standing conundrum. 1 The competence approach as a developmental theory of the firm Foss (1993, p. 129) introduces the notion of the competence-based theory of the firm in an effort to demonstrate that ‘a distinct theory of the firm can be constructed on the basis of evolutionary theory’. By viewing the firm as a repository of competences, Foss is able to argue that the competence-based approach creates a theory where the firm is: (1) a distinct historical entity that is path dependent; (2) an active strategising rather than a passive economising entity; and (3) an entity that responds to changes in inputs, outputs and technology. As a result, he is able to make a connection between evolutionary theory and the theory of the firm. However, placing the firm within the context of an evolving economy does not necessarily create an evolutionary theory of the firm. If evolution means nothing more than movement or change, then it is true that competence-based firms evolve over time as they ‘strategise’ about how best to make use of their specialised assets in order to gain a competitive advantage. However, the biological sciences, in particular, draw a distinction between behaviour that is learned over time and organisms that evolve (Rosenberg, 1994). Human beings are born, educated and adapt to a number of different environments and experiences over their lifetime. However, we do not refer to this change as evolution. Rather, it is the normal process of development andis similar in concept to Marshall's (1961) idea of the life cycle of the firm. For Marshall, the firm grows with the vigour of the entrepreneur and the emergence of new opportunities in the marketplace. However, the firm eventually declines as the entrepreneur's interestand energy fade with old age and changes in the marketplace threaten to leave it one step behind the times. While such a life cycle reflects transition over time, it is by no means evolutionary. For a theory of the firm to be evolutionary, it must explain how variations among firms in an industry are transmitted to future generations within that same industry (Niman, 1994). This issue forms the crux of the problem with Foss' competence-based theory of the firm. The firm (from this perspective) comes into being because not all competences are contractible (Foss, 1993, p. 135). As a result, the entrepreneur in possession of an idiosyncratic idea cannot sell his services, because such a market does not exist, and hence he must start his own firm in order to realise the full economic value of his idea. Once the firm is established, it vertically integrates for the same reason. ‘Only the integrating firm knows precisely what it wants; the relevant knowledge is strongly “impacted” in the firm, residing in its competences.’ Hence, ‘competence is largely non-contractible, or only contractible at exorbitant information costs’ (1993, p. 138). If firms are defined by their competences, but these competences are not contractible, how do they become the basis for explaining the evolution of the firm? Without some mechanism for transmitting these competences to future generations, how is this developmental theory of the firm compatible with the broader concept of evolution? By definition, the process that gives rise to the firm prevents the transmission of competences to other firms and hence evolution cannot take place. To solve this problem, one can either abandon the biological metaphor or change the unit of selection. In Foss (1998), the biological metaphor is preserved while the unit of selection moves from the firm to the competence.2 Rather than looking at how firms evolve over time, Foss focuses attention on how competences change within existing firms. This is evidenced by his shift from Knight (1921) and the problem of information impactedness, to Penrose (1959) and her emphasis on intra-firm learning. The biological concepts of variation, heredity and selection are utilised to explain how ‘intra-firm learning processes and therefore cumulative causation as a result of the interplay between various creating processes and selection processes that are internal to the firm’ (Foss, 1998, p. 483) form the basis for an evolutionary theory. But it is evolution of the competences and not evolution of the firm that Penrose's intra-firm learning is capable of explaining. Hence what we are left with is not an evolutionary theory of the firm, but rather an evolutionary theory of competences within a developmental theory of the firm. 2 The social knowledge base If a competence theory of the firm is to be an evolutionary theory, it must not only recognise the fact that some competences may be unique, but that firms as institutional structures assume importance by giving those competences an economic role to play in the creation of value. The firm provides a framework that creates economically meaningful relationships by constraining and supporting the interaction between individual competences. An evolutionary theory therefore is the product of both changes in these unique competences and in the coordinating mechanism that brings them together in order to create economic value. The importance of evolution at the level of the institution was a key element in the work of Thorstein Veblen. Veblen believed that ‘an evolutionary economics must be a theory of a process of cultural growth as determined by the economic interest, a theory of a cumulative sequence of economic institutions stated in terms of the process itself (1898, p. 77)’. Hence it is the institutions (as well as the competences) that must evolve over time. As noted by Hodgson (1998B), Veblen's thought was influenced by the biologist C. Lloyd Morgan, and it was through Morgan's influence that Veblen came to the realisation ‘the institutional structure of society was not merely “the environment” as Morgan had put it. Veblen indicated that “the environment” consisted of institutional elements that were themselves, like organisms, subject to evolutionary processes of selection’ (Hodgson, 1998B, p. 423).3 In his description of the competence-based theory of the firm, Hodgson (1998A) maintains that knowledge plays a key role in the development of the firm. The importance of knowledge fits with Veblen's views on social capital and provides the key for transforming the firm into an evolutionary entity. For Veblen, human behaviour is guided by the desire to attain self-esteem by comparing favourably with others in terms of wealth. The mechanism for achieving a relative wealth advantage lies in Veblen's concept of social capital. The question of capital ‘is a question of how the human agent deals with his means of life, not of how the forces of the environment deal with man’ (Veblen, 1908, p. 350). Knowledge becomes the lifeblood of the community because it embodies the ways and means for improving the economic lot of each of its members. Thus, capital is viewed as the glue that holds societies together as they are formed around knowledge as a shared asset. As society grows and becomes more complex, this knowledge becomes too large for any single individual to assimilate, and hence it becomes vested in the group at large. It becomes the intangible asset of the community without which ‘no individual and no fraction of the community can make a living, much less make an advance’ (Veblen, 1908, p. 326). Thus, while knowledge is created by the individual, ‘individual initiative has no chance except on the ground afforded by the common stock, and the achievements of such initiative are of no effect except as accretions to the common stock’ (1908, p. 328). As the size of the knowledge pool expands and the division of labour begins to take hold, no individual can grasp the finer points of each task required to provide for the economic health of the community. Therefore, ‘It becomes feasible—for the individual with the strong arm to engross, or “corner”, the usufruct of the commmonplace knowledge of ways and means by taking over such of the requisite material as may be relatively scarce and relatively indispensable for procuring a livelihood under the current state of the industrial arts’ (1908, p. 332). If relative success comes from monopolising a portion of the common knowledge base, how is this success passed on to future generations? One of Veblen's greatest contributions was the idea that society not only creates a value system to guide behaviour, it also exists as a set of institutions designed to foster the creation and preservation of knowledge. Social institutions serve as a repository of ideas, tools and past experience that form the basis for the development of new knowledge for future generations.4 Every time individuals attempt to differentiate themselves through the pursuit of material wealth, their strategy becomes part of the knowledge base reflected by the composition of social institutions. The social context in which individuals reside plays the role of preserving the existing base of knowledge, which is a reflection of those strategies (both successful and unsuccessful) that have been utilised to advance the goal of relative success. Thus, it is not the acquired traits of individuals that are genetically passed on to future generations. Rather, it is the stock of knowledge that exists in the community independent of a single individual that is passed on to future generations. ‘Such a stock of knowledge and practice is perhaps held loosely and informally; but it is held as a common stock … it is transmitted and augmented in and by the group, however loose and haphazard the transmission may be conceived to be, not by individuals and in single lines of inheritance’ (1908, p. 326). Individual insights added to the common stock act as something analogous to mutations by modifying the social knowledge base. As a result, the success of future generations depends not on the ability to pass along acquired characteristics through inheritance (à la Lamarck), but on the ability to tap into the ever-expanding social knowledge base. By accessing the social knowledge base, an individual has a better chance to create a strategy that will provide an advantage relative to the rest of the population. In this way, human evolution becomes culturally determined, because the knowledge base resides in social institutions and not biological genes. As the knowledge base (environment) grows, what constitutes those differentiation strategies that are ‘best adapted’ also changes. Therefore, what is ultimately selected for survival becomes a relative and not an absolute concept. While the genes may help make it easier for one to tap into the knowledge base, physical health and education can play an even greater role in the actual creation and implementation of a successful strategy designed to gain a relative material advantage. Thus it is the ability to access and utilise knowledge rather than the genes themselves that ultimately determines survival. Within this context, the social knowledge base acts as the ‘gene pool’, and entrepreneurs serve the function of ‘chromosomes’ which organise the genes into groupings. These ‘groupings’ become the competences that form the building blocks underlying the firm. Entrepreneurs, either through their unique contribution to the social knowledge base or their idiosyncratic way of reorganising a subset of the existing base of knowledge, develop a competence that merits the formation of a firm. 3 The evolutionary firm While firms comprise a set of competences, does this provide an explanation for why firms exist? Why could not the entrepreneur merely contract with other economic agents to create a set of core competences? For Witt (1998), the explanation lies in the delicate balance that must be struck between the limited information processing ability of a single individual and the seemingly unlimited possibilities represented by a unique business opportunity. The firm exists because it brings together a necessary core of individuals who can help the entrepreneur capitalise on their initial vision. Who becomes an entrepreneur or an employee depends for Witt on something similar to a market contest. Those who believe that they have identified the best market opportunity and therefore find themselves in a position to offer the highest wages become entrepreneurs, while those with less profitable ideas abandon them for wages that offer a higher reward than could have been achieved by their own entrepreneurial efforts. What is left unanswered is exactly what determines which opportunities are superior to others. In a competitive market, the firm that successfully capitalises on a new idea will soon find itself facing a host of imitators who expand industry supply to the point where all firms are earning a normal rate of return. If profits fall as competition equalises the rate of return to the firm, then one would expect wages to fall to their market clearing levels. Hence, if individuals are rational, they will realise that the promise of higher wages is only temporary at best and will only give up the dream of becoming an entrepreneur if the normal rate of profit in equilibrium is higher than the market-clearing wage. What defines a superior opportunity must be one therefore that holds the prospect of generating above normal profits over time. Long-term success depends not so much on the value of the initial idea, but as importantly on whether imitators can be prevented from entering and bidding away all of the above normal profits. If the lure of becoming an entrepreneur is the prospect of defeating the forces of competition by sustaining what began as a temporary advantage, the entrepreneur must try to prevent others from discovering and imitating the idiosyncratic knowledge which formed the basis for identifying and harvesting the initial entrepreneurial vision. As a result, secrecy becomes an important tool for preserving the source of competitive advantage. Whether such an advantage becomes a sustainable advantage depends upon the entrepreneur's ability not only to assemble a unique combination of competences, but also to make sure that others cannot do the same. Gaining such a competitive advantage, therefore, is not the product of the free flow of ideas, but rather emerges from the entrepreneur's success in withholding knowledge from others. By internalising what would otherwise consist of a series of contracts mediated by the market, the entrepreneur can increase the probability that the source of its competitive advantage will not only remain a secret, but is used for its exclusive benefit.5 While it may be possible to write a complete contract which prevents a supplier from revealing a secret, it cannot preclude the supplier from indirectly benefiting from the knowledge that is revealed. Once the secret is known and the supplier develops new ways of doing things based on an expanded knowledge base, it would be prohibitively expensive to construct a contract that effectively prevents the supplier from utilising its enhanced capabilities to design, manufacture, or deliver components that could be used to benefit industry rivals. While a competitor may not be able to draw upon the direct knowledge acquired from a secret, it can indirectly benefit and improve its own competitive position in the market by utilising the enhanced capabilities of the supplier. However, in this case, it is the change in competence and not the dimensions of the transaction that create a contracting problem that is best solved by internalisation. This holds true for both physical components and human capital. An individual who works with trade secrets will have an opportunity to enhance their own set of skills and knowledge base. Once the contract has come to an end, they will then be in a position to leverage their enhanced abilities to garner more lucrative contracts with potential industry competitors. Working to improve the competitive position of industry rivals undermines the interests of the company that initially divulged the secret. As a result, the firm may determine that it is in the long run best interests of the company to hire the individual on a more permanent basis rather than secure the use of their services through a contract. The creation of a more permanent employment relationship ensures not only that the firm continues to benefit from the individual's enhanced capabilities, but also helps to create disincentives that make it less attractive for the employee to consider possible opportunities at other firms.6 The prospective loss of higher wages, stock options, pension or health-related benefits, or a cadre of supportive colleagues can all play a role in helping to create disincentives for abandoning the current employment relationship. The need to both preserve a secret and the desire to capture all of the benefits that accrue from that secret knowledge provides an explanation for why the entrepreneur chooses to create a firm rather than relying on a series of contracts mediated by the market. A firm is created because it reduces the cost of keeping a secret while insuring that the benefits reside exclusively in the hands of the entrepreneur.7 However, while the source of a firm's competitive advantage may be held in secret, its more observable actions are not and hence a slew of imitators will enter the industry each in possession of its own unique combination of competences. This healthy rivalry leads to the type of knowledge sharing that gives rise to what Marshall termed as external economies. As Marshall writes: The mysteries of the trade become no mysteries; but are as it were in the air, and children learn many of them unconsciously. Good work is rightly appreciated, inventions and improvements in machinery, in processes and the general organization of the business have their merits promptly discussed: if one man starts a new idea, it is taken up by others and combined with suggestions of their own; and thus it becomes the source of further new ideas. And presently subsidiary trades grow up in the neighborhood, supplying it with implements and materials, organizing its traffic, and in many ways conducing to the economy of its materials. (Marshall, 1961, p. 271) With the sharing of information that comes from careful observation, differences between rivals become less pronounced. As these differences begin to disappear, the firm is challenged to formulate new strategies in order to preserve its relative competitive position. However, limitations in the firm's existing collection of competences make it difficult to formulate and execute new strategies that require a radical departure from the past. As these constraints eventually become binding and limit further development, the firm will look to expand its set of competences through merger or try to take advantage of the capabilities of others through disintegration (Langlois, 1992). A good example of this pattern can be found in the personal computer industry. IBM ushered in the era of the personal computer with the development of a standard design based on readily available off-the-shelf parts. While many of the basic parts were purchased from outside suppliers, in the early days of the market for IBM ‘clones’, individual computer companies retained control over the design and manufacturing of key components. Subtle differences in the general design and the performance of individual components along with overall control of the final assembly were thought to form the basis for a firm's competitive advantage in the marketplace. However, as competition intensified in the industry, personal computer companies found that their future survival depended upon outsourcing many of their design, engineering and limited manufacturing functions. As a result, component suppliers assumed a larger role in the development and design of the personal computer. In the case of Intel, the company swiftly expanded its business to include not only the microprocessor, but also chipsets and eventually, the complete motherboard for a computer. Relegated to mere assemblers of outsourced components, computer companies have continued to disintegrate by outsourcing even the final assembly of their computers at the low-end of the market. The search for additional capabilities by IBM and other PC companies took place when the secrets that underpinned the formation of the firm or product division no longer provided a wellspring of advantages, and retaining a competitive position in the market depended on drawing upon the capabilities of other firms. With the disintegration of the production process, secrets become revealed and successful strategies and ideas leak into the social knowledge base. As information seeps into the social knowledge base, it expands and becomes significantly richer in content. Such an expansion provides the foundation for the formation of new combinations of ideas and ultimately a new basis for achieving a competitive advantage. Entrepreneurs able to identify these changes in the social knowledge base will create new firms capable of challenging the existing competitive order in an industry. Hence, the evolutionary process is not directed by the behaviour of the firm, but rather the transmission of knowledge from one generation to the next. 4 Cournot's Dilemma While it may be possible to construct an evolutionary theory of the firm, the issue remains why such a theory is necessary or important. Leaving aside the point that such a theory can provide an important component for the development of a broader evolutionary theory, another benefit to such an approach is that it can resolve some issues that the more conventional theory of the firm as a black box cannot. For example, the evolutionary theory of the firm can provide the basis for resolving Cournot's Dilemma. Formulating a solution to Cournot's Dilemma resides in the problem of explaining the existence of some type of competitive balance in an industry where firms are experiencing increasing returns. Alfred Marshall described Cournot's Dilemma in the following manner: Some among whom Cournot himself is to be counted, have before them what is in effect the supply schedule of an individual firm; representing that an increase in its output gives it command over so great internal economies as much to diminish its expenses of production; and they follow inevitably to the conclusion that, whatever firm first gets a good start will obtain a monopoly of the whole business of its trade in its district. (1961, p. 380 iff.) Attempts to solve the Dilemma have been referred to as the reconciliation problem, and most recently have focused on the role that external economies play in the formation and solution of the conundrum. Prendergast (1992) offers the view that the Dilemma cannot be logically resolved without the introduction of external economies. Hart (1996), on the other hand, contends that external economies have only a limited role (if any) to play. To ascertain whether external economies play a role in resolving the Dilemma, one must first ask the question: Is it possible for the firm to reach some type of equilibrium where there is no incentive to increase output despite the fact that is has not fully exhausted all of the available internal economies?8 To answer this question, one need only look more closely at Marshall's own theory of the firm. In his Principles of Economics, Marshall formulates a competence theory of the firm based on biology. For Marshall, the central unity between the laws of nature in the physical and moral world is found in the general rule: ‘the development of the organism, whether social or physical, involves an increasing subdivision of functions between its separate parts on the one hand, and on the other a more intimate connection between them’ (1961, p. 290). A consequence of this law of development is the need to coordinate these subdivisions. The importance of coordination elevates organisation to the status of ‘agent of production’ and becomes the focal point for analysing the firm. Marshall attempts to strengthen the biological connection through the use of his famous ‘trees in the forest’ analogy, where the firm is characterised as a dynamic organism whose organisational properties vary over the firm's life cycle. The view of the firm as maturing along a life cycle completes the analogy of the firm as an organism and enables Marshall to discuss organisational change as a reflection of the selection process characterised by the ‘survival of the fittest’ (Niman, 1991B). Viewing the firm as a collection of competences implies that, while firms may produce identical products, no two firms will produce those products in an identical manner.9 Rather than differentiating their products, firms utilise cost advantages created from their own unique set of competences in order to gain a relative advantage in the marketplace. As the result of differences in how these unique competences are organised to produce a given product, firms can obtain positive economies and, in so doing, differentiate themselves from other firms in the industry. Where it is differences between firms rather than differences between products that create the pattern of competition in an industry, the subsequent process of reaching some form of equilibrium is substantively different. This difference is most apparent in the case where a new firm pioneers the development of an entirely new market for a product that did not previously exist. As output expands, the firm's costs decline as it refines both the method of production and increases the scale of operation. As the firm moves down its cost curve, rising profits signal to other firms the potential of this new opportunity. If possible rivals learn of the firm's secret and are able to imitate perfectly both the product and the cost structure of the innovating firm, then upon entry, the market rapidly degenerates into one characterised by the theory of perfectly competitive markets. If competitors, however, are able only imperfectly to imitate either the product or the cost structure embodied in the way the firm does business, the theory of perfect competition is no longer appropriate. In order to gain entry, firms must first develop a strategy that redefines the existing market in order to create a space capable of supporting their entry. This may take the form of product differentiation and market segmentation on the demand side, but it need not. It may instead take the form of firm differentiation leading to segmentation on the supply side of the market. Under the competence-based approach, firms may produce homogeneous products in dramatically different ways. One firm may have a unique competence that enables it to manufacture the product at a significantly lower cost. Another may find that it has a special ability to procure resources at a substantially lower cost than industry rivals. Alternatively, a third may discover that it has a superior sales and marketing organisation that enables it to supply output at a lower cost. Thus, for example, if the firm that created the new market is the one that enjoys special sales capabilities, the firm who enters with an edge in manufacturing must redefine the market in a way that nullifies the sales advantage so that its manufacturing competence can successfully compete. In the personal computer industry, when IBM single-handedly defined what has become the industry standard, the company possessed a superior sales organisation built from years of experience selling large mainframe computers to business organisations. By selling the personal computer directly to its large base of corporate customers, IBM very successfully dominated the early days of the personal computer industry. Building to an inventory that was available for immediate delivery by its direct sales force, IBM hoped to reduce costs by limiting the number of possible configurations for a particular model of personal computer. In an effort to compete successfully against IBM, Dell Computer adopted a different manufacturing model based on the principle of build to order. Rather than bearing the cost of carrying an inventory of finished product, Dell built a computer only after a particular customer had ordered it. Because it was building to an order rather than inventory, Dell could offer a larger number of possible configurations enabling the customer to purchase a computer built to their own personal specifications. While a Dell computer could run essentially the same software and perform at similar speeds, its manufacturing competence allowed it to offer a customisable solution at a lower cost. Entry by Dell and other competitors effectively segmented the market according to the individual capabilities of industry competitors. For a company to launch an effective challenge outside its own segment in an effort to expand market share required it to tap into capabilities outside the core set it already possessed. As a result, the costs of entering additional market segments are not the same costs the firm experiences when it increases output within its own market segment. To sell beyond its core of corporate clients, IBM tried to sell its computers though retail outlets. However, production for the retail market was substantially different from production in support of direct sales. Since the requirements of the two market segments were drastically different, IBM's expansion into the retail market carried with it significantly higher costs.10 Once a market becomes segmented by the unique competences of individual firms, costs will continue to decline for expansions of output within a market segment defined by the firm's own set of competences. However, while costs may continue to decline, those competences are no longer sufficient to enable the firm to capture the entire market. Once the firm tries to expand output beyond the point where it has captured the entire market segment, the firm will no longer enjoy decreasing costs, because it cannot replicate the same cost conditions for that range of output requiring capabilities that do not exist within the boundaries of the firm. Thus a firm's competences create an effective limit beyond which the firm can no longer expand output and enjoy lower costs. To expand beyond that point requires the firm to move into rival market segments where its competences constrain its ability to reduce costs further and, as a result, costs effectively rise as output increases. Therefore, the profit-maximising firm would not expand production beyond a particular range of output, because doing so would increase costs to the point where profits would fall as the firm strove to push its competences beyond their effective limits. Attaining such an equilibrium position does not fully resolve the question of why the firm that ‘gets a good start’ does not inevitably monopolise an industry. Foiled by entry and therefore unable to continue to expand output at lower costs, the firm may nonetheless try to develop new strategies that will drive competitors out of the market. If successful, the firm might achieve a monopoly position; leaving the Dilemma largely unresolved. The ability to explain how the ensuing competitive struggle does not lead to monopoly is the missing element required to solve Cournot's Dilemma. Both Prendergaast and Hart agree that Marshall's inability to solve the Dilemma stems from the difficulty of reconciling evolutionary theory with the concept of static equilibrium.11 While different but equally matched firms may achieve some type of equilibrium at a moment in time, the evolutionary forces that initially created those differences will ensure that such an equilibrium is only temporary. As firms continue to develop and exploit their unique competences while new ones with their own idiosyncratic sources of advantage enter, the competitive balance between firms is constantly being disrupted. These disruptions are not the result of a process characterised by homogeneous firms who enter and exit until each is earning the normal rate of return. Instead, they are the result of new strategies constantly threatening the status quo as old and new firms attempt to improve their position in the marketplace. Rather than ‘survival of the fittest’ where the most fit is viewed as the firm with the greatest capacity for eliminating its competitors, firms selected for survival are those that are best able to nullify the advantages of their rivals (Niman, 2000). Just as organisms attempt to minimise the advantages of predators in order to preserve their place in nature, firms seek to ensure their survival by making sure that competitors do not manage to place themselves in a superior position.12 Thus, rather than viewing competition as a process where efforts are directed toward vanquishing all potential competitors, it becomes one where firms constantly seek to place themselves in a position where they cannot be harmed by the actions of competitors. Survival depends not on being better, but rather on being sufficiently different so that the advantages of others do not prove to be fatal. Such a competitive process becomes an evolutionary one, because as firms create new market opportunities or respond to competitive challenges, their actions add to the social knowledge base. Entrepreneurs with the ability to recombine existing competences or develop entirely new ones based on the broader array of possibilities made possible by an expanded knowledge base will lead to the creation of firms that are better adapted to take advantage of the opportunities that exist in the marketplace.13 This superior position will lead to greater relative success and place the first mover at a disadvantage. In order to survive, the first mover will find itself in the defensive position of nullification and must develop a set of adaptive strategies designed to counter the threats posed by newer entrants. However, the set of potential responses is limited by the firm's existing pattern for combining competences. Newer firms able to combine competences from a deeper pool of knowledge are able to utilise them to construct a superior position. Thus, from an evolutionary perspective, the hunter eventually becomes the hunted as new combinations of competences give rise to superior business strategies. A good example of the process of nullification can be found in IBM's attempt in 1987 to regain control of the personal computer industry with the introduction of its PS/2 line of computers. Hoping to differentiate its products in an effort to retake market share away from young ‘clone’ manufacturers such as Compaq, the PS/2 introduced three changes to the basic PC design: VGA graphics, a 3.5 inch floppy drive and the micro-channel bus. Competitors immediately copied the VGA graphics standard and began offering it as part of their machines. Rather than forcing the market to make a transition from 5.25 inch floppy disks, competitors offered added value by offering both. Finally, while the micro-channel bus was technically superior, incompatibilities with the existing industry standard would have forced consumers to throw away their old cards while having them pay a premium for new ones that would only work with the proprietary IBM architecture. As a result, the rest of the industry formed an alternative standard (the EISA Bus) that was compatible with existing cards. The PS/2 ultimately did not offer sufficient value to justify the price premium charged by IBM, and hence IBM eventually began building machines that once again adhered strictly to industry standards. What the IBM example illustrates is that, in the short run, experience may enable a firm to nullify most of the advantages created from the combination of new competences. However, over time, either the young become just as experienced or new combinations confer such a large advantage that the old find themselves in a relatively uncompetitive position. First-mover advantages are temporary when part of a long evolutionary process. Such failures occur because over time, the first mover will find that its current ability to reduce costs or add value is no longer a source of competitive advantage. Thus the evolutionary theory of the firm provides us with the missing piece required to solve the reconciliation problem. The key to solving the problem resides in the transmission of knowledge from one generation to the next. As secrets are revealed and new strategies are developed, others are able to learn from past successes or failures and utilise that knowledge to create what will become new challenges to the existing order in an industry. Rather than relying on external economies to fill the vacuum left by Marshall's use of the representative firm, an expanding social knowledge base along with an evolutionary theory of the firm provides the basis for understanding how newer firms displace the old as they utilise their superior set of competences to construct a competitive advantage. 5 Automobiles: a case study Creating an evolutionary theory of the firm placed within the context of a broader evolutionary economy provides not only a solution to Cournot's Dilemma, but also a new perspective for evaluating how industries change over time. A good example can be found in the automobile industry. What had started out as a highly fragmented industry soon became dominated by a single firm: the Ford Motor Company. Ford's introduction of the Model T in 1908 followed by technological innovations such as the development of the moving assembly line in 1913 enabled the company to sell over 15 million units of the Model T before discontinuing production in 1927. At its height in 1921, Ford captured 55.7% of the total market for automobiles sold in the US (Chandler, 1964, p. xi). With its success came a great deal of consolidation and, by the time the Model T went out of production, the number of automobile companies dropped from a high around 350 to approximately 30 (Carroll and Hannan, 1995, p. 206). The important question is why in an industry where a single company possessed such a definite cost advantage; the number of competitors did not drop to zero? This appears to be a prime example of Cournot's Dilemma. In fact, not only did Ford fail to monopolise the industry, after 1930, it lost its leadership position as vehicles produced by General Motors began to outsell those manufactured by Ford. The disparity in sales were so great that by 1940, General Motors held 47.5% of the market while Ford captured only 18.9% of total sales in the US. The failure of Ford to monopolise the industry and the rise of General Motors as the dominant automobile manufacturer provides a good illustration of how evolutionary firms in a changing marketplace reach a competitive balance. In the case of the automobile industry, while Ford possessed a collection of production competences which enabled it to become the low-cost producer in the industry, General Motors was built on a set of organisational competences that made it possible to economically introduce regular styling changes. These style changes offered the perception of additional value to the consumer, and General Motors' multidivisional organisational structure made it possible to deliver them at a price premium which maintained the affordability of the vehicle. Thus, where Ford used single-purpose machine tools to minimise the cost of producing a single model, General Motors' organisational structure enabled the company to utilise more general-purpose machine tools capable of producing differentiated parts that could be used in a variety of vehicles without adding a significant amount to the cost of the vehicle. Hence, the unique set of competences that defined Ford Motor Company and gave the company such a decided cost advantage were more than matched by the competences held by General Motors. As competition between the two companies increased during the 1920s, both began to look to outside suppliers for new competences that could preserve and expand their source of competitive advantage. Hence the Model A following Ford's very successful Model T included many more parts produced by outside manufacturers. In the case of General Motors, it realised early on that closed metal bodies were an important component for fulfilling its strategy of promoting stylised changes between its different product brands. Because it did not possess this needed competence, it entered into a long-term contract with Fisher Body in 1919 which ultimately led to the full integration of the company in 1926. General Motors' acquisition of Fisher Body has provided one of the most compelling examples used to illustrate the value of transactions cost analysis as a tool to explain the phenomena of vertical integration. The argument originally introduced by Klein et al. (1978) and subsequently modified by Klein (1988) and Langlois and Robertson (1989) seeks to use the problem of hold-up to provide an explanation for why GM chose to integrate rather than continue its relationship via long-term contracting. Klein (1988, 2000) contends that it was the rigidity of the long-term contract along with the inability to foresee future events in a changing market that placed Fisher Body in a position where it could hold-up GM. As part of the contract, General Motors agreed to purchase all of its closed metal bodies from Fisher at a price equal to its variable costs plus 17.6%. Hence, according to Klein, Fisher had an incentive to adopt relatively inefficient labour-intensive production methods and to locate its facilities away from General Motors' plants. As a result, he concludes that General Motors purchased Fisher Body to avoid the hold-up problem created by a long-term contract that could not account for changing market conditions and the growing importance of closed metal bodies. The relevant question is whether or not General Motors purchased Fisher Body because of what the company might have extorted by behaving opportunistically, or because such a purchase would have placed the company in a superior competitive position. In order to gain a competitive advantage by making stylised changes to differentiated brands, GM needed to tap into the competence of closed metal body production. However, in order to sustain such an advantage, it needed to limit the ability of other firms to imitate its strategy by purchasing similar bodies from the same source. By remaining independent, Fisher would have been free to share its expertise through the sales of its closed bodies to other automobile companies. In a market where such bodies were in short supply, the removal of a major supplier of such an important component would not only make it difficult for others to compete, but would also deprive them of a needed competence.14 Vertical integration is perceived to be a solution to the hold-up problem because it is thought to solve the problem of a misalignment of incentives between two companies. However, incentives are misaligned in the Fisher Body example, not because of the threat that the company may hold-up General Motors, but rather because what maximises profits for an independent Fisher Body may not maximise profits for General Motors. While General Motors was contractually committed to purchasing all its closed metal bodies from Fisher, the contract permitted Fisher to continue to sell its products to other automobile manufacturers. In order to maximise profits, an independent Fisher Body might expand production to the point where it was able to supply closed metal bodies to all manufacturers that did not already possess that particular capability. Hence if the charge that the company was reluctant to relocate its plants was true, it may not have occurred because it was taking advantage of General Motors, but rather as a logical prerequisite for enabling the company to economically supply bodies to other manufacturers.15 However, if Fisher Body sold to other manufacturers, it would increase the competitiveness of the market to the detriment of General Motors. The success of General Motors was based on its collection of unique competences and its ability to keep them a secret. By making it more difficult for others to gain access to the competences surrounding the production of closed metal bodies, it could place itself in a stronger competitive position. General Motors therefore had an incentive to integrate vertically in order to control how the information and competences associated with the production of stylised branded vehicles could be used to benefit General Motors and not its competitors. As noted by Klein, once acquired, Fisher Body never again sold its closed bodies to a company outside General Motors. Integration during one period of an industry's history does not however preclude disintegration during a later period. Increased competition often forces companies to rethink their business strategies. This is no more apparent than in the recent history of the US automobile industry, where a flood of imported vehicles has challenged what has become a highly concentrated industry. Emerging primarily from Japan, automobile manufacturers such as Toyota, with its lean production system, have been able to produce higher quality vehicles at a lower cost. To nullify this growing competitive threat, US automobile manufacturers have adopted a two-pronged strategy. The first prong is illustrated by Ford's efforts to broaden the potential for economies of scale by building cars based on global platforms. Utilising similar engineering and many of the same parts for cars that would be sold throughout the world, this effort was viewed as a way to a greater spread of development costs over a larger number of vehicles. General Motors adopted a similar strategy seeking to share components between its different brands. Hence a Chevrolet may use the same engine found in a Buick or Pontiac. Thus, while the Japanese may have possessed superior production and management competences, US firms hoped to use their sheer size to gain sufficient economies to offset their weaker competitive positions. This move toward standardisation in the design and implementation of automobile platforms set the stage for the ensuing disintegration of US automobile companies. By moving to standard platforms in an effort to reduce costs, the automobile industry, like the computer industry, began to rely more and more on outside suppliers to provide a significant portion of the value added to the final product. Standardisation reduces many of the benefits associated with secrecy, and relying on the gains from specialisation associated with a broader division of labour can help in terms of nullifying the cost advantages enjoyed by newer competitors. As the gains from specialisation began to outweigh the benefits of secrecy, US automobile manufacturers not only began purchasing more components from outside sources, they eventually spun-off their parts divisions into independent companies. If costs were the only criterion for determining the ultimate success of a competitive struggle between industry competitors, then the newer set of competences that enabled Japanese firms to gain a superior position in the market would be sufficient to herald the end of the American automobile business. However, in the current marketplace, it is trucks and not passenger cars that provide the bulk of profits for US companies. While the number of passenger cars sold hit a peak in 1986 at nearly 11.5 million vehicles, passenger cars as a percentage of total vehicle sales has steadily declined. Between 1986 and 1999, car sales declined by 24%. During that same period, truck sales increased by 76%, and in 1999 the total number of trucks sold exceeded the number of passenger cars. With imports at less then 10% of the total market for trucks, the US advantage in trucks has helped reduce the total share of imports for all motor vehicles from a high of 19.35% in 1986 to 9.21% in 1999 (Ward's Communications, 2000, p. 15). The growth in truck sales and the dominance of US manufacturers in this segment of the market can be attributed to two key product innovations. In 1983, Chrysler introduced the minivan that created an entirely new class of vehicle. In 1990, Ford introduced the Explorer thereby expanding the market for what has become known as sport utility vehicles. Together, these two types of vehicles comprised 57% of the total market for trucks in 1999 and represent nearly one out of every four new vehicles purchased in the US. However, the attempt to nullify the Japanese advantage by shifting the market toward trucks (thereby enabling US manufacturers to draw on old competences) in order to remain competitive is facing new challenges from Japanese competitors. While both market segments expanded between 1995 and 1999, sales of US-produced sport utility vehicles increased 62%, but imported sales eclipsed that figure, growing at nearly three times that rate (171%). In the minivan segment of the market, the numbers are of greater concern. Sales of US-produced minivans fell by nearly 1%, while sales of imported minivans increased by 111% (Ward's Communications, 2000, pp. 22–3). The future for US automobile companies is therefore very uncertain. As the Japanese begin to upsize their vehicles to compete directly against the larger American cars and trucks, US manufacturers are finding it increasingly difficult to maintain their dominant market share. Furthermore, the introduction of new power sources that are found in today's hybrid vehicles (a combination of electric and combustion motors) and the potential shift in the future to fuels cells will represent new challenges for not only US manufacturers, but also those from other parts of the globe whose existing competences reside in a knowledge base steeped in fossil fuels. 6 Conclusion In evolutionary biology, a distinction is often made between an organism's genotype and phenotype. The genotype determined by heredity, acts as a set of constraints which determine the boundaries that place limits on the ability of the organism to carry out various tasks. The phenotype reflects the success (or failure) of the organism as it strives to make the most of its inherited talents within the constraints imposed by that very same inheritance. Within the context of the firm, competences can be viewed as the genetic building blocks that are assembled to provide a context for operationalising the concept of the firm. As the firm's genotype, the collection of competences both shapes and limits the business strategies that are devised to maximise the value of the firm. These business strategies give dimension to what becomes the firm's phenotype. Drawing such distinctions becomes important when trying to construct an evolutionary theory of the firm. For the firm to evolve, something must be passed from one generation to the next. In the theory of evolution, it is the genotype and not the phenotype that provides the basis for some inheritance mechanism. Hence, in constructing an evolutionary theory of the firm, the focus must be centred on the composition of the genotype. In so far as the genotype comprises competences that are themselves a subset of the social knowledge base, it is knowledge that becomes the ‘substance’ that is passed on from one generation to the next. The construction of an evolutionary theory of the firm gains importance not just because it can help to develop more fully a broader evolutionary theory of the economy, but also because it can be utilised to resolve some outstanding theoretical conundrums that have gone largely unsolved. In the case of Cournot's Dilemma, Alfred Marshall realised that a solution depends on a more dynamic form of economic analysis than the more simplistic ‘Foundations’ that were laid out in the static equilibrium analysis of his Principles of Economics. While Marshall constructed a dynamic theory of the firm, he failed in his attempt to place it within the context of a complete evolutionary system. Yet the solution to this question of why the firm that gets a good start does not monopolise an industry rests in this more complete statement of an evolutionary economy. An evolutionary theory of the firm provides the foundation for the construction of just such an evolutionary system and makes it possible to solve the problem of Cournot's Dilemma. * University of New Hampshire. I should like to thank Brian Kench for his helpful comments. 1 Other examples of the competence/capability approach can be found in Nelson (1991), Chandler (1992), Dosi and Marengo (1994) and Fransman (1994). 2 In this more recent statement of an evolutionary theory of the firm, Foss maintains the connection to biology through his contention that a competence-based conceptualisation of the firm: ‘1] helps rationalize variety; 2] provides an analogy to heredity; and 3] provides the foundation for a theory of differences in revealed competitive advantage, that is, a part of the story of the operation of market selection’ (1998, p. 485). 3 As Chandler (1977) has pointed out, changes in the environment (the development of mass transportation and communication) led to substantial alterations in the structure of the firm. As existing organisational structures based upon past competences were no longer adequate to face the new reality, the multi-product firm of the twentieth century (designed to take advantage of the new economies of scale and scope) was vastly different from the single product firm of the nineteenth century. 4 The rise of the Internet represents the best example of how a social institution serves as a repository of ideas. 5 The role of secrets in the formation of the firm from a historical perspective is discussed in Landes (1986). Buckley and Casson (1976) have used the concept of proprietary knowledge in the development of the theory of the multinational enterprise. Difficulties in preserving secrets have been explored by Cheung (1982). 6 Rajan and Zingales (2001) contend that firms exist because entrepreneurs gain greater control over agents through the power that is created when agents make specific investments in support of the entrepreneur's vision. By managing the release of ‘secrets’ within a hierarchy, the entrepreneur can encourage greater loyalty and reduce the threat of expropriation. 7 In an effort to reduce the cost of keeping a secret and the consequences if a secret is revealed, a government may create a system of legal protections that preserves the value of an idea without requiring a firm to bear the full cost of maintaining a secret. Patents are an example of this type of legal protection. 8 The concept of equilibrium used here is one that describes a position where there is no tendency for change. It does not imply any of the conditions commonly associated with achieving economic efficiency in a competitive market. As a result, an equilibrium is reached not in the traditional sense where individual firms must be in equilibrium in order for the industry to reach an equilibrium, but rather in the Marshallian sense where the relative advantage of some firms is balanced against the relative disadvantage of others. 9 Marshall recognised heterogeneity found in the organisation of production. As he writes: ‘Every locality has incidents of its own which affect in various ways the methods of arrangement of every class of business that is carried on in it: and even in the same place and the same trade no two persons pursuing the same aims will adopt exactly the same routes. … Each man's actions are influenced by his special opportunities and resources, as well as by his temperament and his associations’ (1961, p. 428). 10 These higher costs include such factors as the additional cost of using distributors and retailers, the need for additional marketing materials directed toward individual consumers, the heightened difficulty of effectively forecasting demand, managing the appropriate level of inventories at plant, distributor and retailer, and other factors such as expanded warranty claims and a high volume of customer returns. 11 Prendergast concludes her article: ‘the construction of adequate foundations for it (an evolutionary approach) will require something more than an equilibrium theory of value coupled with more frequent recourse to the concept of external economies’ (1992, p. 461). For Hart, ‘What is called into question is the ability of static equilibrium analysis, even when assisted with ‘advances from biology’, to capture adequately the dynamic implications of the increasing returns process (1996, p. 365)’. 12 Examples of nullification might include strategies such as: (1) repositioning—where existing products are repositioned in an effort to generate additional value for the customer; (2) imitation—where the best characteristics of a new product are copied; (3) leapfrogging—where newer or better capabilities are created to construct a superior product; (4) extension—the addition of new capabilities or functions to an existing product; and (5) organisational innovation—where a company positions itself as a superior entity for doing business. 13 As Langlois points out, ‘Coordination means getting everyone on the same wavelength. But the variation that drives an evolutionary learning system depends on people being on different wavelengths—it depends, in effect, on outbreeding’ (1992, p. 120). 14 Support for this position can be found in Freeland (2000) who contends that it was not a hold-up problem but rather General Motors' desire to acquire the talents of the six Fisher brothers that explains the series of events that led to the acquisition of the remaining 40% of the outstanding shares in Fisher Body in 1926. 15 Evaluating the historical record contained in Pound (1934) reveals that Fisher Body did in fact locate body plants adjacent to General Motors assembly plants. This closer look at the historical record has forced Klein (2000) to retreat and narrow his argument to the reluctance on the part of the Fisher brothers to relocate a single body plant from Detroit to Flint in 1925. References Buckley, P. and Casson. M. 1976 . 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(ed.), Natural Images in Economic Thought, Cambridge, Cambridge University Press Niman, N. 2000 . Competition and economic progress, Journal of Bioeconomics , vol. 2 , no. 3, 221 –31 Penrose, E. 1959 . The Theory of the Growth of the Firm, Oxford, Oxford University Press Pound, A. 1934 . The Turning Wheel, Garden City, Doubleday, Doran Prendergast, R. 1992 . Increasing returns and competitive equilibrium—the content and development of Marshall's Theory, Cambridge Journal of Economics , vol. 16 , 447 –62 Rajan, R. and Zingales, L. 2001 . The firm as a dedicated hierarchy: a theory of the origin and growth of firms, Quarterly Journal of Economics , vol. 116 , no. 3, 805 –51 Rosenberg, A. 1994 . Does evolutionary economics give comfort or inspiration to economics?, in Mirowski, P. (ed.), Natural Images in Economic Thought, Cambridge, Cambridge University Press Veblen, T. 1898 . 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TI - The evolutionary firm and Cournot's Dilemma
JO - Cambridge Journal of Economics
DO - 10.1093/cje/28.2.273
DA - 2004-03-01
UR - https://www.deepdyve.com/lp/oxford-university-press/the-evolutionary-firm-and-cournot-s-dilemma-bfXetTKmoC
SP - 273
VL - 28
IS - 2
DP - DeepDyve
ER -