UNIVERSITY OF CALGARY

Implications of Comparative Institutional Analysis for Firm-Level Strategic Governance

by

Liena Kano

A THESIS

SUBMITTED TO THE FACULTY OF GRADUATE STUDIES

IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE

DEGREE OF DOCTOR OF PHILOSOPHY

HASKAYNE SCHOOL OF BUSINESS

CALGARY, ALBERTA

JULY, 2013

© Liena Kano 2013

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 ABSTRACT

In this thesis I explore implications of comparative institutional analysis (CIA), embodied

in internalization and transaction cost economics (TCE) theories, for firm-level strategic

governance. I investigate applications of CIA to various governance forms, namely the

family firm, the multidivisional corporation, and the multinational enterprise. Further, I

explore how CIA explains strategic governance decisions related to a range of

contemporary phenomena in international business and strategic management, such as

regionalization, emerging economy multinationals, trading favours and sustainability.

My thesis includes eight essays representing conceptual and empirical applications of

CIA to the above subject matter. More specifically, the eight studies address: 1) the

properties of internalization theory as a general theory of international strategic

management; 2) internalization theory treatment of the regionalization phenomenon as

compared to alternative theoretical frameworks; 3) application of internalization theory in

the emerging economy context; 4) extension and refinement of TCE behavioural

assumptions in the context of a multidivisional industrial enterprise; 5) analysis of family

firm-type governance from a TCE perspective; 6) application of TCE to investigate

determinants of longevity and survival of family-type governance; 7) application of TCE

to explore comparative efficiency of trading favours; and 8) application of CIA to

strategic governance challenges in the context of corporate sustainability. I conclude that

CIA provides a valuable conceptual lens to explicate the essence of strategic governance;

I hope that this dissertation has laid a foundation for a unified CIA approach that brings

together various streams of literature, namely work in the realm of international business,

strategic management, entrepreneurship and sustainability.

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 ACKNOWLEDGEMENTS

My deepest gratitude goes to all those who helped me fulfill my academic dream.
I would like to thank my family, starting with my husband Grant Huszti, who has
patiently supported me through many years of graduate school and acted as a single
parent too many times over the past four and a half years. I wish to thank my daughters
Miriam and Naomi for being my cheerleaders, and a daily source of joy. Finally, I would
like to thank my parents Dita and Lev Kano for teaching me how to learn at a very young
age, encouraging my intellectual curiosity, and supporting me unconditionally in
everything I do. My parents looked after my kids, walked my dog, and cooked dinner for
my family while I studied; their help allowed me to fulfil the requirements of the PhD
program without the rest of my world falling apart.
On the academic side, I would like to sincerely thank my research supervisor, Dr.
Alain Verbeke, for his generous support and exceptional level of involvement throughout
my PhD studies. Alain helped me find my research path, motivated and inspired me,
challenged me intellectually, and ultimately made my time in the program enjoyable and
productive. Everything that I have achieved in my short academic career I owe to Alain’s
clear guidance and wise council. I am looking forward to being his research colleague
for many years to come. Many thanks go to Dr. Loren Falkenberg, our Associate Dean
Research, for her enduring and vocal support of my work, as well as for her monumental
(and successful!) effort to enhance the PhD program experience for our entire cohort. I
am grateful to the Social Sciences and Humanities Research Council of Canada, the
Faculty of Graduate Studies and Haskayne School of Business for generous financial
support. I would like to thank my supervisory committee members Dr. Birgitte Grøgaard
and Dr. Teri Bryant, my external-internal examiner Dr. Hetty Roessingh, and my external
examiner Dr. Bernard Wolf for the time and effort devoted to the process, and for their
helpful guidance and feedback. I would also like to thank Birgitte for her enormous
support during my first teaching term (including answering panicked phone calls). Last
but not least, I would like to thank Dr. Daphne Taras and Dr. Nicole Coviello, my role
models and mentors of many years. Nicole in particular inspired me to become an
academic, and has been coaching and encouraging me, unwaveringly, since we first met
fourteen years ago. I would not be writing this thesis if it were not for Nicole.

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 TABLE OF CONTENTS

ABSTRACT ii
ACKNOWLEDGEMENTS iii
LIST OF TABLES viii
LIST OF FIGURES ix
LIST OF ABBREVIATIONS x
INTRODUCTION 1
ESSAY 1. INTERNALIZATION THEORY AS THE GENERAL THEORY OF 13
INTERNATIONAL STRATEGIC MANAGEMENT: PAST, PRESENT AND FUTURE
INTRODUCTION 13
INTERNALIATION THEORY: ESSENTIAL ARGUMENT, ANTCEDENTS AND HISTORY 15
EVOLUTION OF INTERNALIATION THEORY 21
Entry mode choice 21
MNE’s international expansion strategy: The four dimensions of distance 26
MNE internal governance: Differentiated network MNE 27
MNE internal governance: M-form versus metanational solution 29
Theory of regional strategy and structure 30
Internalization theory and evolutionary view of the MNE 32
Multinationality-performance relationship 35
A note on the changing nature of FSAs 36
Section conclusion: Internalization theory in four types of international strategic 38
management research
THE FUTURE OF INTERNALIZATION THEORY: A FEW EXTENSIONS 40
International entrepreneurship and ‘born-globals’ 40
Emerging economy MNEs 43
CONCLUSION 49
ESSAY 2. AN INTERNALIZATION THEORY RATIONALE FOR MNE REGIONAL 52
STRATEGY
INTRODUCTION 52
ALTERNATIVE INTERPRETATION OF REGIONALIZATION PROPOSITIONS 55
H1 (based on the theory of new regionalism) 55
H2 (based on the theory of new economic geography) 57
H3a and 3b (based on the theory of the knowledge economy) 60
H4a, 4b and 4c (based on psychic distance theory) 63
H5 (based on escalating-commitment theory) 68
H6 (based on population ecology) 70
H7a and 7b (based on neo-institutional theory) 71

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 EXISTING EMPIRICAL SUPPORT AND POTENTIAL EMPIRICAL TESTS 74
CONCLUSION 76
ESSAY 3. NO NEW THEORY NEEDED TO STUDY MNEs FROM EMERGING ECONOMIES 79
INTRODUCTION 79
INTERNALIZATION THEORY: PAST AND PRESENT 81
A QUEST FOR NEW THEORIES TO STUDY EMNEs 87
INTERNALIZATION THEORY AS A GENERAL THEORY OF THE MNE: DEBUNKING 89
THE MYTHS
Internalization theory ≠ Static focus on transaction costs in established MNEs 89
Institutional differences are reflected in transaction costs 90
EMNEs do possess FSAs 91
Motivations for internationalization are addressed in the context of matching FSAs with 95
CSAs
ILLUSTRATION: ‘WORLD CLASS EMERGING MULTINATIONALS’ 96
FSAs 97
Recombination capabilities 100
Internationalization drivers 101
AN IMPORTANT NUANCE: STATE-OWNED ENTERPRISES 102
CONCLUSION 105
ESSAY 4. TRANSACTION COST ECONOMIZING AND THE RISE OF THE MODERN 108
CORPORATION: REVISITING THE NATURE OF MAN IN ALFRED CHANDLER’S
OEUVRE
INTRODUCTION 108
TCE AND CHANDLER 112
THE ENVELOPE-CONCEPT OF BOUNDED RELIABILITY (BREL) 116
METHODOLOGY 118
Data 118
Theory building 119
RESULTS AND DISCUSSION 121
BRel in the making of the modern corporation: Extant categories 121
The extended model: New categories of benevolent preference reversal 127
IMPLICATONS 138
CONTRIBUTIONS, LIMITATIONS AND DIRECTIONS FOR FUTURE RESEARCH 140
ESSAY 5. TRANSACTION COST ECONOMICS AND THE FAMILY FIRM 146
INTRODUCTION 146
TCE AND THE FAMILY FIRM 147
BEHAVIOURAL ASSUMPTIONS OF TCE: INTRODUCING BOUNDED RELIABILITY 150
BOUNDED RATIONALITY, BOUNDED RELIABILITY AND THE FAMILY FIRM 152

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 CONCLUSION 160
ESSAY 6. THE TRANSACTION COST ECONOMICS THEORY OF THE FAMILY FIRM: 162
FAMILY-BASED HUMAN ASSET SPECIFICITY AND THE BIFURCATION BIAS
INTRODUCTION 162
BEHAVIOURAL ASSUMPTIONS OF TCE 167
TCE AND THE FAMILY FIRM 170
BIFURCATION BIAS 173
Bifurcation bias as an effect of family firm professionalization 173
Bifurcation bias and the agency/stewardship paradox 174
Psychological origins of bifurcation bias 178
Bifurcation bias and transaction cost economics behavioural assumptions 179
Bifurcation bias in managerial practice 181
When is the bifurcation bias important? 189
CONCLUSION 193
LIMITATIONS AND DIRECTIONS FOR FUTURE RESEARCH 195
ESSAY 7. THE TRANSACTION COST ECONOMICS THEORY OF TRADING FAVOURS 198
INTRODUCTION 198
TRANSACTION COST ECONOMICS’ FOUNDATIONAL CONCEPTS 202
Main tenets 202
Core assumptions 203
Extending behavioural assumptions of TCE: Bounded reliability 204
TRADING FAVOURS: ORIGINS, FOUNDATIONS, AND MANIFESTATIONS 206
Anthropological, economic and cultural foundations 206
Manifestations of trading favours in Russia and China: Blat and guanxi 209
TCE-BASED THEORY OF TRADING FAVOURS 212
Working definition and key questions 212
When is trading favours efficient 214
What enforcement mechanisms facilitate trading favours? 222
Types and impacts of trading favours 224
CONCLUSION 229
ESSAY 8. STRATEGIC GOVERNANCE FOR SUSTAINABILITY: EXPLORING THE 235
NATURE OF SUSTAINABILITY CRISES
INTRODUCTION 236
STRATEGIC GOVERNANCE FOR SUSTAINABILITY 238
RESEARCH SETTING: SUSTAINABILITY CRISES 240
RESEARCH QUESTIONS 242
RQ1: Why do sustainability crises occur? 242

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 RQ2: How do the three pillars of sustainability interact in a crisis situation? 243
RQ3: How does entrepreneurial action affect sustainability crises and their mitigation? 243
METHODOLOGY 244
Data 244
Theory building 247
WHY DO CRISES OCCUR? THREE BROAD THEMES 249
THE ROLE OF ENTREPRENEURIAL CONTEXT: THE ENTREPRENEURSHIP-CRISIS 250
MODEL
Directly unproductive profit-seeking crisis (DUP) 252
Unintended negative spillovers (UNS) 255
Entrepreneurship-sustainability crisis cycle 259
THE ROLE OF THE ECONOMIC PILLAR AND INTER-PILLAR SPILLOVERS 262
Economic pillar as a crisis catalyst 262
Inter-pillar spillovers 263
BENEVOLENT CONFLICT AMONG STAKEHOLDERS 264
A NOTE ON STRATEGIC GOVERNANCE 266
IMPLICATIONS AND CONTRIBUTIONS 267
LIMITATIONS AND DIRECTIONS FOR FUTURE RESEARCH 271
CONCLUSION 272
THESIS CONCLUSION 282
REFERENCES 288
APPENDIX 3.1. Cases analyzed on the ten EMNEs 320
APPENDIX 3.2. Inventory of EMNE FSAs, home country LAs, host country CSAs, and 323
internationalization drivers
APPENDIX 4.1. Corporate backgrounds: Du Pont and General Motors 330
APPENDIX 8.1. Cases analyzed on the twelve MNEs involved in sustainability crises 333
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 LIST OF TABLES

2.1 Complementary social science theories embedded in internalization 78

theory concepts

3.1 EMNE motivation for international expansion versus existing motivation 107
framework

3.2 List of EMNEs analyzed 107

4.1 Commitment continuum for the extended model of bounded reliability 143

4.2 Economizing on new categories of bounded reliability 144

8.1 Data sample 274

8.2 Examples of coding categories 274

8.3 Examples of coding categories – inter-group analysis of crisis locus 275

8.4 Examples of representative vignettes 275

8.5 Evidence of entrepreneurial context 276

8.6 Evidence of unmitigated entrepreneurship 276

8.7 Economic pillar as crisis catalyst: Evidence from data 277

8.8 Stated/acted commitments to ethical and sustainable practices 278

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 LIST OF FIGURES

I.1 Strategic governance matrix 12

I.2 Positioning of dissertation essays in the strategic governance matrix 12

1.1 Generic types of international strategic management studies 51

4.1 Extended model of bounded reliability 145

7.1 Trading favours U-curve hypothesis for the macro level 233

7.2 A classification of trading favours types 234

7.3 Four storylines on trading favours’ impacts 234

8.1 Cases analyzed and the three pillars of sustainability 280

8.2 Types of crises by locus and behavioural assumptions 280

8.3 Entrepreneurship-sustainability crisis cycle 281

8.4 Inter-pillar sustainability outcome spillovers 281

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 LIST OF ABBREVIATIONS

AC Air conditioning

ASA Alliance-specific advantage

BP Beyond Petroleum (BP plc.)

BRat Bounded rationality

BRel Bounded reliability

BRIC Brazil, Russia, India, China

CIA Comparative institutional analysis

CNOOC China National Offshore Oil Corporation

CSA Country-specific advantage

DUP Directly unproductive profit seeking

EJV Equity joint venture

EMNE Multinational enterprise from an emerging economy

EPS Earnings per share

E/R Earnings to revenues ratio

EU European Union

FDI Foreign direct investment

FSA Firm-specific advantage

GDP Gross domestic product

GNT Generic nontradeable (assets)

GM General Motors Corporation

HP Hewlett-Packard Company

HQ Headquarters

HR Human resources

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IB International business

ITA Aeronautical Technology Institute, Sao Jose dos Campos, Brazil

JIT ‘Just in time’ manufacturing

LA Location advantage

LB FSA Location bound firm-specific advantage

LLL Linkage, leverage, and learning

M&A Mergers and acquisitions

M-form Multidivisional form of governance

MNC Multinational corporation

MNE Multinational enterprise

NLB FSA Non-location bound firm-specific advantage

OEM Original equipment manufacturing

OLI Ownership, Location, Internalization (eclectic paradigm)

P&S Products and services

PMI Post merger integration

PROEX Interest-equalization program by the Brazilian government to finance

Embraer’s export, 1996

R&D Research and development

RBV Resource-based view of the firm

SOE State-owned enterprise

SOX Sarbanes-Oxley Act

SSA Subsidiary-specific advantage

TCE Transaction cost economics

TCI Transaction cost internalization

U-form Unitary (functional) form of governance

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UNS Unintended negative spillovers

VISTA Vietnam, Indonesia, South Africa, Turkey, Argentina

ZZJYT zizhu jingying ti: ‘self-managed teams’ (at Haier Group)

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 INTRODUCTION

Comparative institutional analysis (CIA), as applied in firm-level studies, builds

on the premise that economic actors will select and retain the most efficient governance

mechanisms to conduct economic exchange. More specifically, economic actors will

select economic institutions (markets versus firms versus clans), as well as coordination

and control methods (the price system versus hierarchy versus normative integration) that

are the most efficient for organizing a given transaction or set of transactions (Hennart,

1993).

CIA therefore offers an explanation for the existence of firms: Firms are

purposefully created when able to organize production more efficiently than other

governance forms, especially (external) markets. Important in the context of strategic

management is the view of the firm as not only a nexus of contractual relationships

linking various resource owners, but also as a governance form specialized in value

creation through internal production, whereby competitive advantage arises primarily

from choosing the appropriate, economizing mix of internal contracts and contracts with

actors outside of the firm’s boundaries. This mix of contracts may need adjustments over

time as a function of ‘changed circumstances’, i.e., changes in transaction characteristics,

as a result of environmental changes such as demand uncertainty, technological

uncertainty, etc. and/or economic actors’ decisions, such as an intentional shift towards

higher or lower usage of dedicated assets (compare with Hennart, 1994).

The term ‘governance mechanisms’ refers to the organizational framework within

which economic exchange takes place, including the processes associated with the

exchange (Zaheer & Venkatraman, 1995). At the macro level, firms that populate

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industries and national economic systems can be considered mechanisms of governance,

as discussed above. At the micro level, an important distinction must be made between

structural governance and strategic governance. The former refers to the actual

organizational structure governing economic activities, e.g., the usage of the

multidivisional form versus the functional form of firm-level organization (Williamson,

1996). In contrast, strategic governance is concerned with the micro-economic detail of

economic actors’ routines or other managerial practices being deployed within a given

type of organizational structure (Zaheer & Venkatraman, 1995; Schmidt & Brauer, 2006).

In other words, strategic governance is largely about orchestrating the usage of a firm’s

resources through routines and other processes in relation to strategic decisions that have

long-term implications for the firm. This manuscript is mainly concerned with strategic

governance, which unfolds within certain types of organizational structures but can also

influence these structures, thus co-evolving with structural governance.

CIA has a number of branches, including Williamsonian transaction cost

economics (TCE) theory (Williamson, 1975, 1981a, 1981b, 1985, 1991, 1996) and its

international business (IB) version – internalization theory (Buckley and Casson, 1976),

sometimes referred to as TCI, or Transaction Cost Internalization. TCE and

internalization theory share the same economic essence of CIA, namely that economic

actors will select and retain the most efficient governance mechanisms to conduct

transactions, but differ slightly in their emphasis and applications, as well as their units of

analysis, as discussed in detail in this thesis. With the main concern of both theories (and

of the CIA approach to the study of the firm) being the selection and retention of the most

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efficient forms of governance, the most critical decisions related to selection and

retention of governance mechanisms can be summarized as following:

1. Establishing boundaries of the firm – that is, the ‘make or buy’ decisions (Grøgaard &

Verbeke, 2012), or establishing which economic activities should be performed inside

the firm, and which should be conducted outside of the firm in the external market;

2. Organizing the interface with the external environment for the ‘buy’ activities, i.e.,

activities transacted in the external market; this may involve choosing among short

and long-term contracts, strategic alliances of different forms etc.;

3. Organizing ‘make’ activities, i.e., activities performed inside the firm; this involves

such decisions as the choice of an organizational structure and administrative

relationships, establishment of incentive systems, etc. (Grøgaard & Verbeke, 2012).

Given the three sets of decisions defined above, the comparatively more efficient

governance mechanisms are those that, on balance, will allow for:

1. Superior economizing on bounded rationality (BRat) of economic actors involved in

activities; bounded rationality refers to economic actors’ behaviour that is “intendedly

rational, but only limitedly so” (Simon, 1961: xxiv), meaning that human actors have

a limited capacity to process information, address complexity, and make optimal

choices;

2. Superior economizing on bounded reliability (BRel) of economic actors involved in

activities; bounded reliability refers to economic actors’ behaviour that is intendedly

reliable, but only limitedly so (Verbeke & Greidanus, 2009) and explains instances of

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 commitment non-fulfillment and failure to make good on open-ended promises in an

organizational setting;

3. Creating a favourable organizational context for managing innovation in its entirety,

namely for managing the entire process of knowledge acquisition or development,

absorption, diffusion and exploitation (Verbeke & Kenworthy, 2008).

As such, strategic governance choices, in the context of the CIA approach, could

be presented in the form of a 3x3 matrix, distinguishing among three key components of

strategic governance and three main objectives pursued through strategic governance, as

presented in Figure I.1.

(Figure I.1 about here)

The purpose of my dissertation is to explore real-world applications of CIA in the

strategic governance context in each cell of Figure I.1. More specifically, my research

focuses on applying CIA (embodied in TCE and internalization perspectives) in various

organizational settings, from family firms to large multinational enterprises (MNEs), and

in relation to various contemporary phenomena in organizational and international

business (IB) studies, such as emerging economy multinationals (EMNEs), trading

favours, regionalization, entrepreneurship, and sustainability, in order to explore what

types of governance are more or less efficient in these particular organizational

circumstances. My thesis is essay-based and includes eight studies representing

conceptual and empirical applications of CIA to the above types of subject matter. As a

set, the eight essays cover all cells of the strategic governance matrix, as outlined below:

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Essay 1. Internalization theory as the general theory of international strategic

management

In this essay I provide an overview of internalization theory and analyse the

theory’s impact on IB research. In particular, this essay lays out essential arguments of

internalization theory, reviews its history and intellectual foundations, and discusses its

key applications in the field of international business, such as, inter alia, analysis of the

MNE’s entry mode choice, international expansion strategy, internal governance, and

regionalization. The essay includes a projection of internalization theory’s future

contributions to management research. In terms of the strategic governance matrix, Essay

1 sets the stage for the matrix and covers all cells (cells 1 – 9 in Figure I.1).

Essay 2. An internalization theory rationale for MNE regional strategy

Following from Essay 1, this conceptual essay presents an in-depth analysis of

one of the critical applications of internalization theory – the regionalization

phenomenon. In this essay I demonstrate that internalization theory, as a ‘complete’

theory of the firm, is particularly well equipped to analyze MNE regional strategies,

which are seen as the most efficient strategic governance responses to economizing

challenges that exist outside of a firm’s home region. The argument is built upon recent

work by Wolf, Egelhoff, and Dunemann (2012) to show that internalization theory’s

predictions on MNE regional strategy are superior to those suggested by several other

conceptual frameworks. In terms of the strategic governance matrix, the essay focuses on

establishing firm boundaries (all cells of the first row: 1, 4, 7).

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Essay 3. No new theory needed to study MNEs from emerging economies

This essay continues to explore contemporary applications of internalization

theory outlined in Essay 1, namely to studying MNEs from emerging economies

(EMNEs). The objective of this essay is to demonstrate that contemporary internalization

theory is sufficient to address the complexity of EMNEs, including the impact of

institutional specificities and the unique nature of EMNEs’ capabilities and

internationalization motivations. To demonstrate that internalization theory’s predictions

on MNEs’ strategic governance choices hold in the emerging economy setting, I analyze

ten successful large EMNEs. In the strategic governance matrix, Essay 3 focuses on

establishing firm boundaries (the first row: 1, 4, 7), but with interactions with internal and

external organization (the second and third rows: 2, 5, 8 and 3, 6, 9).

Essay 4. Transaction cost economizing and the rise of the modern corporation:

Revisiting the nature of man in Alfred Chandler’s oeuvre

This essay represents an effort to develop an extended model of bounded

reliability (BRel) in the historical context of the rise of the modern corporation,

elaborating on Verbeke and Greidanus’ (2009) original framework. The model augments

TCE’s conventional behavioural assumption of economic actors’ opportunism

(Williamson, 1981, 1985, 1993) by proposing bounded reliability as a new framework to

explain failed human commitments. I revisit Alfred Chandler’s classic history of the Du

Pont and General Motors corporations (Chandler & Salsbury, 1971) to investigate

whether opportunism was a key factor in the making of the modern corporation. The

essential argument is that BRel corresponds more accurately to Chandler’s view of the

nature of man than TCE’s conventional assumption of opportunism – as such, adopting

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BRel as a central concept for the study of the firm may increase the legitimacy of TCE.

In terms of the strategic governance matrix, Essay 4 focuses on interactions between firm

boundaries and internal organization (the first and second rows: 1, 4, 7 and 2, 5, 8), with

implications for external interface (the third row: 3, 6, 9).

Essay 5. TCE and the family firm

In this essay I further explore the concept of BRel developed in Essay 4, this time

in the context of the family firm. The objective of this essay is to investigate how the

nature of BRel challenges in a family firm may differ from that in a traditional

Chandlerian hierarchy (such as the Du Pont and General Motors corporations analyzed in

Essay 4). The essay uses Gedajlovic and Carney’s (2010) application of TCE to family

business as a starting point, and lays a foundation for developing a unified TCE-based

theory of the family firm by introducing the concept of family-based human asset

specificity. In the strategic governance matrix, Essay 5 focuses mainly on internal

organization (the second row: 2, 5, 8).

Essay 6. The TCE theory of the family firm: Family-based human asset specificity and

the bifurcation bias

This essay continues the foray into family business theory. Here, the objective is

to build upon the concept of family-based human asset specificity developed in the

previous essay to arrive at a full-fledged TCE-based theory of the family firm in an effort

to contribute to a fundamental understanding of what separates successful family firms

from failing ones, in strategic governance terms. The central concept developed in this

essay is ‘bifurcation bias’ – a dysfunctional expression of BRel that represents

asymmetric treatment of family versus non-family employees. Conducted through an

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examination of real-life family business cases, this conceptual study suggests that

absence of bifurcation bias is critical for successful achievement of economizing

objectives and innovation in family business functioning. In the strategic governance

matrix, Essay 5 focuses on internal organization (the second row: 2, 5, 8), but with

implications for decisions related to the boundaries of the firm (the first row: 1, 4, 7), as

well as for interfaces with external actors (the third row: 3, 6, 9).

Essay 7. The TCE theory of trading favours

In this essay I apply CIA to the contemporary IB phenomenon of trading favours

– a pervasive business practice especially characteristic of emerging economies. This

study blends EMNE analysis and BRel development conducted in the previous essays to

arrive at a TCE-based theory of trading favours. TCE is adopted to analyze systematically

trading favours as a strategic governance element, and an economizing practice serving

efficiency purposes. Micro and macro level implications and spillovers of trading favours

are also discussed. This essay focuses mainly on interactions with external environment

(the third row of the strategic governance matrix: 3, 6, 9).

Essay 8. Strategic governance for sustainability: Exploring the nature of sustainability

crises

In my eightth and final essay, I explore strategic governance challenges in the

context of corporate sustainability – an increasingly prominent topic in management

studies, amplified by a host of corporate governance scandals that have occurred over the

past decade. In this empirical essay, I analyze twelve high profile cases of corporate

sustainability crises in large MNEs. In each case a crisis linked to either social,

environmental, or economic/financial issues led to disastrous consequences for societal

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actors, the environment and the firm involved (in terms of performance and negative

reputation effects). Specifically, I look at (1) the role of BRel and BRat in the origination

of the crises; (2) spillovers of both causes and consequences of the crises among the three

pillars of sustainability (economic, social and environmental); and (3) the role of

entrepreneurial context in the crises. I find that various concepts developed and explored

in the prior essays, such as conditions exacerbating BRel and BRat, bifurcation bias (in

cases of family ownership) and favour-trading, play a role in the origination and

mitigation of sustainability crises. In terms of the strategic governance matrix, Essay 8

focuses on internal and external organization (the second and third rows: 2, 5, 8 and 3, 6,

9), with possible implications for firm boundary changes (the first row: 1, 4, 7).

As can be seen from the above synopses, all eight essays touch upon all three

objectives of strategic governance (that is, the two economizing objectives and the

higher-order capability in managing the innovation process in its entirety in the columns

of the matrix) to a certain extent. However, each essay has a specific starting point of

analysis, in terms of its focus on a particular economizing objective or higher-order

capability. Figure I.2 depicts how the eight essays fit within the matrix (here, the numbers

refer to the essays’ order in the dissertation, and not to matrix cells as in Figure I.1). As

most of the concepts and issues are interrelated, the boundaries between the cells become

somewhat blurred – hence the lack of visible borders in the matrix. In other words, the

essays are placed in the matrix according to the starting point and the main focus of the

analysis, but the reader should remember that sets of implications and interactions likely

tie each essay with multiple rows of the matrix.

(Figure I.2 about here)

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 It should be noted that the only section of the matrix not covered (other than by

the foundational first essay) is the top right corner, which focuses on firm boundary

changes decisions with the objective of managing innovation in its entirety. Work that

would fit in this section includes, for example, strategic governance analysis of mergers

and acquisitions, and strategic alliances. Research on this topic is abundant and falls

outside of the scope of this dissertation.

To date, five of the eight essays have been published. Essay 1 is forthcoming as a

chapter in the Handbook of Managerial Economics, published by Oxford University

Press. Essay 2 was published in Multinational Business Review in 2012. Essays 5 and 6

were published in Entrepreneurship Theory and Practice in 2010 and 2012, respectively.

Essay 7 was published in the Asia Pacific Journal of Management in 2013. Essay 3 was

presented at the Academy of International Business 2012 meeting in Washington, DC

(USA), and was included in the conference proceedings, while Essay 4 is scheduled for

presentation and inclusion in the proceedings of the 2013 Academy of Management

Annual Meeting in Orlando (USA).

Arguments developed in all eight essays build upon key tenets of CIA, embodied

in TCE and internalization theory. My focus is on the strategic governance choices of

firms, whereby I rely extensively on the key behavioural assumption of bounded

reliability. As these essays were developed as individual studies aimed at publication in

different academic outlets (albeit united by the common strategic governance matrix), the

eight papers include brief reviews of theory and key concepts in order to facilitate a

logical flow from assumptions to conclusions, and therefore, some necessary overlap

exists among the eight essays, especially between the introductory Essay 1 and Essay 3

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on EMNEs (see footnote on the overlapping section, in Essay 1). I have retained the

overlapping sections in this manuscript in order to maintain the integrity of each

individual essay.

The following sections of the dissertation contain the eight essays introduced

above, followed by an overall conclusion and suggested potential research avenues that

logically stem from the analysis conducted and the concepts developed in this thesis.

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Figure I.1. Strategic governance matrix

Strategic governance objectives

Economizing on Economizing on Managing
BRat BRel innovation in
its entirety
Strategic governance
Strategic governance

of firm boundary 1 4 7
changes
components

Strategic governance
2 5 8
inside the firm

Strategic governance
3 6 9
of external interfaces

Figure I.2. Positioning of dissertation essays in the strategic governance matrix

Strategic governance objectives

Economizing on Economizing Managing
BRat on BRel innovation in
its entirety
Strategic governance
Strategic governance

of firm boundary 2:R 4:AC

changes
components

Strategic governance 5:FF

1:IT 3:EM
inside the firm 6:BB

8:SC
Strategic governance
of external interfaces
7: TF
!
1. Internalization theory as the general theory of international strategic management (IT)
2. An internalization theory rationale for MNE regional strategies (R)
3. No new theory needed to study MNEs form emerging economies (EM)
4. Transaction cost economizing and the rise of the modern corporation: Revisiting the
nature of man in Alfred Chandler’s oeuvre (AC)
Essays

5. TCE and the family firm (FF)

6. The TCE theory of the family firm: Family-based human asset specificity and the
bifurcation bias (BB)
7. The TCE theory of trading favours (TF)
8. Strategic governance for sustainability: Exploring the nature of sustainability crises
(SC)

12
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 Essay 1

INTERNALIZATION THEORY AS THE GENERAL THEORY OF

INTERNATIONAL STRATEGIC MANAGEMENT:

PAST, PRESENT AND FUTURE

In this essay, we analyze internalization theory’s impact on international business (IB)

research. The essay lays out essential arguments of internalization theory, reviews its

history and intellectual foundations, and discusses its key applications in the field of

international business, such as, inter alia, analysis of the multinational enterprise’s

(MNE’s) entry mode choice, international expansion strategy, internal governance, and

regionalizaton. We trace evolution of internalization theory and distinguish between ‘old’

or conventional internalization theory, which focused predominantly on parameters

stimulating firms’ cross-border activity and entry mode choices, and ‘new’ or

contemporary internalization theory, which shifts attention to firm-level strategic

governance issues. Our analysis indicates that the contemporary version of

internalization theory can enrich scholars’ understanding of a wide range of new and

emerging issues, both in IB and in the broader field of strategic management. The essay

concludes with a projection of internalization theory’s future contributions to

management research.

INTRODUCTION

Internalization theory, as the general economic theory of the multinational

enterprise (MNE), has contributed enormously to explaining the existence and

functioning of MNEs during the past four decades (Buckley & Strange, 2011).

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Internalization theory’s key point, as a positive theory of the firm, is that exploiting and

augmenting the firm’s knowledge-based assets across national boundaries can be

performed through a variety of operating modes, whereby a limited number of parameters

determine the ‘optimal’ mode to be selected and retained. International activities are

sometimes most efficiently undertaken ‘internally’—that is, within the MNE’s

hierarchical structure. Built largely on Coasean (1937) transaction cost economics

foundations, and first formulated in Buckley and Casson’s (1976) classic work, the

internalization approach has strongly influenced the international business (IB) literature

since its inception (Safarian, 2003). The theory has been the subject of substantial

scholarly dialogue, and various refinements and extensions have made it the analytical

tool par excellence for the study of international strategic management decisions, more

specifically in the context of three types of governance choices: (1) the choice of the

firm’s boundaries; (2) the structuring of the interfaces with the external environment; and

(3) the firm’s internal organization (see Casson, 1979, 1986, 1987; Rugman, 1981;

Buckley, 1983, 1998a, 1998b; Hennart, 1982; Teece, 1983).

As the IB research field has matured, so has internalization theory. Conventional

internalization theory, exemplified by the work of Buckley and Casson (1976), Hennart

(1982) and Rugman (1981), focused primarily on the parameters stimulating firms to

expand across borders and on MNE entry mode choices. It largely ignored internal

governance issues and the selection of organizational structures within the MNE.

Subsequent internalization theory developments, brought inter alia by Rugman and

Verbeke’s work (1992, 2003, 2004), constitute what can be called the ‘new’

internalization theory, with the focus shifting to the MNE’s internal organization and

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network capabilities. This expanded focus was achieved by infusing a ‘dynamic

capabilities’-like perspective into transaction cost economics thinking, with an emphasis

on generating, exploiting, and rejuvenating firm-specific advantages (FSAs), especially

those related to knowledge-based assets (Rugman & Verbeke, 2008b). This integration of

complementary conceptual perspectives has made internalization theory particularly

powerful as a general theory of the firm. The new internalization theory can explain the

choice of MNE boundaries, as well as the firm’s internal governance and its interactions

with external environmental forces. Parsimonious, in addition to being relevant to

managerial decision making, internalization theory covers a variety of aspects of the

MNE’s functioning while building upon a limited number of foundational principles

(Rugman & Verbeke, 2008b).

In this study, we analyze internalization theory’s impact on IB research. We

review its intellectual foundations and key applications, and conclude with a projection of

internalization theory’s future contributions to IB research. We show how an

internalization perspective can enrich analysis of various contemporary IB phenomena.

INTERNALIZATION THEORY: ESSENTIAL ARGUMENT, ANTECENDENTS

AND HISTORY

Internalization theory was first conceptualized by Buckley and Casson (1976) and

has its origins in a number of studies, including the work of Coase (1937), Hymer (1968,

1976) and McManus (1972). Coase (1937), who sought to explain the existence of

hierarchies as opposed to markets by analyzing transaction costs involved in effecting

exchanges, provides perhaps the most critical antecedent to internalization theory. In

Coase’s view, a hierarchy supersedes the market if the costs of organizing exchanges

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within a firm are lower than the market transaction costs; internalization theory extends

these arguments developed for the domestic context to the MNE. To ‘internalize’ means

to perform a transaction within the firm, and internalization theory essentially describes

the MNE as an internal market that operates across national boundaries (Verbeke &

Greidanus, 2009). The theory focuses on the relative costs and benefits of coordinating

cross-border economic activities internally, through managerial fiat, rather than externally

through the market (Buckley & Strange, 2011). The core argument is that profit-

maximizing firms internalize markets for intermediate goods (especially various types of

knowledge and experience embodied in intangible assets such as technology, production

know-how, patents, brand reputation, etc.) across national borders in the face of various

market imperfections. These imperfections can take the form of information asymmetries

between buyers and sellers, government-imposed trade barriers, unenforceable national

patent systems, the lack of future markets for knowledge generation, imperfect

knowledge pricing, etc. (DeGennaro, 2005; Rugman, Verbeke & Nguyen, 2011). Market

imperfections can be bypassed by bringing economic activities under common ownership

and control; if these activities are located in different countries, then an MNE will result

(Buckley & Strange, 2011). Further, the MNE will organize bundles of activities

internally so as to enable development and exploitation of FSAs in intermediate products:

The proprietary ownership and internal deployment of these FSAs serves to overcome the

sometimes formidable challenges of assessing the value of knowledge and pricing it in

external markets, with the pricing outcome being influenced by expected future value

creation and value capture by the parties involved. Internalization becomes a governance

mechanism for managing the FSA development and exploitation process in its entirety

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(Rugman & Verbeke, 2008b).

Developed by Hymer ([1960] 1976, 1968), the concept of FSAs is deeply

embedded in Buckley and Casson’s (1976) work and is often viewed as the starting point

for internalization decisions (Safarian, 2003). Hymer’s insight was that foreign direct

investment (FDI) only takes place when the benefits of exploiting FSAs through

internalization are higher than the additional costs of conducting business across borders.

These additional costs may include, inter alia, information costs facing MNEs vis-à-vis

host country rivals, discriminatory treatment by governments and foreign exchange risks.

Zaheer (1995) later coined the phrase ‘liability of foreignness’ to describe these costs of

doing business abroad. Hymer focused primarily on institutional differences among

nations and the resulting hazards facing foreign MNEs (Eden & Miller, 2004). However,

Hymer did not really develop a complete theory of optimal operating mode choice.

Internalization theory, in contrast, explicitly addresses this issue. Assuming that the MNE

commands FSAs sufficient to compensate for the additional costs of doing business

abroad, internalization theory seeks to explain how the MNE overcomes market

imperfections (Buckley & Casson, 1976; Casson, 1979). Here, Hymer’s concept of FSAs

and his focus on market imperfections in final product markets is extended:

internalization of intermediate product markets becomes the core of a theory to explain

FDI and the MNE’s existence (Rugman, 1981; Rugman et al., 2011a).

Hymer correctly viewed FDI as a firm-level strategy decision driven by FSAs

rather than as a mere financial investment decision determined by interest rate

differentials across nations (Dunning & Rugman, 1985). The latter perspective

represented the prevailing orthodoxy in international economics research at that time.

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Hymer essentially pioneered a firm-level industrial organization approach, as opposed to

a financial portfolio investment approach, to explain FDI. Hymer’s approach was

popularized by Kindleberger (1969), and later through Dunning’s (1981) eclectic

paradigm, termed so for its comprehensive melding of several theory streams on FDI

(Rugman, 1986). Also known as the Ownership-Location-Internalization (OLI) paradigm,

Dunning’s model combines ownership, internalization, and location advantages to

explain foreign entry mode choices and their economic efficiency implications. Location

advantages capture differences among countries and regions, whereas ownership and

internalization advantages reflect firm-level strategy decisions and their outcomes. While

representing a comprehensive framework to explain foreign entry mode choices and the

economic efficiency implications thereof, the eclectic paradigm suffers from a relative

lack of parsimony when compared with internalization theory (Rugman et al., 2011a). As

explained above, a critical challenge for MNEs is to select the governance structure (e.g.,

internalization versus usage of the external market) that will be the most effective one

among feasible, real world alternatives to exploit and further develop FSAs. Here, the (O)

advantage is closely intertwined with the (I) advantage, because to ‘internalize’ means to

perform a transaction within the firm, which is often a necessary condition for profitable

FSA exploitation to occur. (O) is also inseparable from the (L) advantage, as costs and

benefits derived from FSA ownership are unavoidably influenced by location factors

(Itaki, 1991).

Rugman (1981) emphasized that each MNE commands an idiosyncratic set of

FSAs, which gives it a competitive advantage over rivals. These FSAs relate to special

knowledge or capabilities unavailable to or inimitable by competitors, except at a high

18
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cost and in the long run. This line of reasoning invites a comparison with the

contemporary resource-based view (RBV) of the firm pioneered by Barney (1991). While

the FSA concept predates the RBV by a full decade, it does have its origins in the

pioneering work of Edith Penrose (1959), whose view of the firm as an evolving

collection of resources was incorporated in modern RBV thinking (Rugman & Verbeke,

2002). Similar to Penrose’s view that economic value creation stems from effective and

innovative management of resources, internalization theory posits that the MNE’s

international success is determined by effective FSA utilization. Internalization theory’s

departure from its Penrosean roots, however, is manifested in its view of the

environment: While Penrose believed that constraints to the firm’s growth resided with

the entrepreneur (or entrepreneurial management team), internalization theory ascribes a

more active role to the environment and sees it as a constraining or enabling force, as

embodied in the notion of country-specific advantages (CSAs) (Rugman, 1981). CSAs

(e.g., natural resources, low-cost labor available in a particular location, etc.) reflect the

attractiveness of particular expansion targets distributed across geographic space to the

MNE and essentially determine, along with the firm’s FSAs, whether or not internal

organization of the MNE’s international activities is the most effective governance mode.

As mentioned above, internalization theory is deeply rooted in the transaction cost

economizing logic — and could therefore be referred to as ‘transaction cost

internalization’, or TCI. Internalization theory, however, goes beyond Oliver

Williamson’s (1975) TCE focus on the possibility of redeploying assets involved in a

transaction without the loss of economic value (i.e., managing ‘the transaction in its

entirety’; see below), toward a broader interest in dynamic processes of efficiently

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developing and exploiting FSAs across borders (i.e., managing the ‘innovation process in

its entirety’). From an internalization theory perspective, the MNE as an institution

becomes itself a governance mechanism specialized in resource recombination: The TCE

foundations are thus augmented with a dynamic capabilities-like perspective (Teece,

Pisano & Shuen, 1997). Fittingly, the unit of analysis shifts from TCE’s focus on the

individual transaction to internalization theory’s focus on the firm. Interestingly, the core

idea that the MNE is an internal market operating across national boundaries was

developed by so-called ‘Reading School’ scholars (Buckley & Casson, 1976; Rugman,

1981) independently of the foundational TCE work of Oliver Williamson (1975, 1981a,

1981b). The two streams developed in parallel (Rugman, 1986), and the obvious link

between both only became apparent as a result of two influential publications. First,

Williamson’s former student David Teece crafted an extension of Williamson’s

conceptual framework (largely based on a mainly domestic American institutional

context) to include an international dimension (Teece, 1981, 1983). Second, Jean-

Francois Hennart published his 1977 doctoral dissertation on internalization theory and

the MNE (Hennart, 1982; Rugman & Verbeke, 2008b).

Beyond its role in marrying the two transatlantic streams of thought on MNE

theory (Rugman, 1986), Hennart’s work can be seen as the beginning of a shift toward

the ‘new’ internalization theory, as he was the first scholar to address internal

organizational issues involved in internalization. Specifically, Hennart focused on

managing interdependencies between economic actors located in different countries,

which involved accessing, recombining, and orchestrating the productive usage of

various sets of geographically dispersed resources within the MNE (Hennart, 1982).

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Hennart’s significant contribution is his drawing attention to the role of complementary

resources of foreign actors that the MNE may require for exploiting its own FSAs.

MNEs’ foreign expansion decisions thus depend on the availability of such

complementary resources. This line of thinking was further developed in Hennart’s most

recent work, where he argues that boundaries between FSAs and CSAs are blurrier than

commonly assumed, and that host country CSAs are not necessarily readily accessible to

the expanding MNE. In this context, the MNE’s international expansion is seen as an

equilibrium outcome of strategic decisions made by MNE managers, and by the

economic actors who own or control host nation CSAs (Hennart, 2009).

EVOLUTION OF INTERNALIZATION THEORY

The central concerns of early internalization theory (Buckley & Casson, 1976;

Rugman, 1981) included economic efficiency, identification of parameters that stimulate

international expansion, and entry mode choice. While respecting the above concerns, the

focus of more recent extensions of internalization theory (Hennart, 1982, 2009; Rugman

& Verbeke, 1992, 2003) has shifted to internal organization, alternative governance

choices within the MNE, and MNE network analysis. Broadly speaking, new

internalization theory aims to establish linkages with the strategic management

perspective on the MNE (Rugman & Verbeke, 2008b); see below.

Entry mode choice

The term ‘foreign operation mode’ is generally accepted to mean the MNE’s way

of operating in foreign markets; more specifically, it has been defined as “the

organizational arrangements that a company uses to conduct international business

activities” (Benito, Petersen & Welch, 2009: 1458). The mode of entry into a foreign

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market has long been a frontier issue in international management research (Madhok,

1997), and has predominantly been conducted from the internalization viewpoint

(Buckley & Casson, 1976; Rugman, 1980). According to this perspective, FDI will result

when internalizing transactions within the MNE is more efficient than performing

transactions with an external market partner (Madhok, 1997). Hennart’s (1992) treatment

of entry mode choice postulates that the FDI decision depends on the nature of the

transaction beyond its costs in a narrow sense—for example, on such characteristics of

the transaction as the risk of proprietary knowledge dissipation, the risk of adverse effects

on brand name reputation, the relative ease (or lack thereof) of accessing requisite

complementary knowledge held by third parties, and the possibility (or lack thereof) of

pricing and protecting knowledge in the foreign market.

Rugman (1980, 1981) expanded the analysis of entry mode choice by contrasting

FDI with alternative entry mode choices such as licensing, franchising, and joint venture

formation. Further, Rugman offered a dynamic extension by showing that the mode of

entry may change over time as the relative costs and benefits associated with each entry

mode strategy change, and by constructing potential switchover points for each possible

entry mode over time. Specifically, switchover points depend on the relative costs of

servicing foreign markets and the potential to avoid dissipation of the rents derived from

FSAs: Typically, exporting to foreign markets with the FSAs embodied in final products

is the first step, followed by engaging in FDI and, finally, licensing a foreign producer

when the technology licensed reaches the point of no longer determining the firm’s

survival (Rugman, 1980; Fina & Rugman, 1996).

Interestingly, this model of foreign operation mode stages contradicts a theory of

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the internationalization process, developed by a group of Scandinavian researchers and

frequently referred to as the Uppsala model. Internationalization theory draws upon the

behavioural theory of the firm (Cyert & March, 1963) and proposes that international

expansion is a function of the MNE’s past international experience and knowledge base

(Johanson & Wiedersheim, 1975; Johanson & Vahlne, 1977, 1990; Luostarinen, 1979).

The model postulates that firms undertake international expansion in an incremental and

path-dependent manner, typically entering a foreign market by exporting and progressing

to establish a sales subsidiary, to invest in local assembly and packaging, to form a joint

venture, and finally to move to full scale local production and marketing by a wholly

owned subsidiary once enough experiential market knowledge is gained (Aharoni, 1966).

From the internalization theory perspective, this model neglects two critical elements:

First, it is the nature of the MNE’s FSAs that determines potential internalization

benefits, and second, the presence or absence of market imperfections affects the

possibility of external market transactions (Rugman et al., 2011a). Further, the Uppsala

model has been criticized for its lack of serious conceptual grounding and

generalizability, as well as its vague treatment of key concepts such as geographic

proximity and experiential learning (Rugman, 2005).

Contemporary research on entry mode choice continues the dynamic extension of

internalization theory. Benito et al. (2009) propose a dynamic model of the choice and

evolution of foreign operation modes, whereby firms do not necessarily choose among

well-specified discrete alternatives, but rather select mode packages, and engage in

frequent within-mode adjustments and mode role changes. The model allows for the

simultaneous presence of multiple modes in various types of combinations, and

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recognizes that the choice of mode is as likely to be an emergent response to

environmental circumstances as a deliberate strategic decision. Similar to the Uppsala

model, the mode choice and change framework draws on the behavioural theory of the

firm and acknowledges path dependency of entry mode decisions, but here experiences

with an operation mode can in themselves be seen as the firm’s FSAs to be drawn upon

for international operations. Further, CSAs are recognized as influencing entry mode

choices, as well as their combination or recombination. This creative extension of entry

mode theorizing introduces a history, context, and process-oriented dimension to

internalization theory, and offers a richer, more dynamic, and, importantly, more realistic

conceptualization of international expansion.

Chen (2005) extends internalization theory’s treatment of entry mode choice to

include alternative market institutions such as arm’s length comarketing, contractual

comarketing, and original equipment manufacturing (OEM). The core argument is that

the choice of an optimal entry mode depends on the relative costs and benefits of both the

market for technology and the market for manufacture; while technology transfer across

borders, and the related choice between, inter alia, licensing and FDI, has been addressed

by internalization theory, other value chain activities have been largely neglected. Chen’s

model positions technology transfer in the broader context of the entire value chain,

including the manufacturing/marketing linkages with the final products market. The

model specifically recognizes the role of strategic assets controlled by host country-based

economic actors in the MNE’s final choice of an operating mode.

Another recent state-of-the-art extension of internalization theory’s treatment of

entry mode choice can be found in Hennart (2009), who, as mentioned above, focuses on

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transactional characteristics of complementary local assets and models foreign market

entry as the assignment of equity between MNEs and owners of complementary local

FSAs. At the core of Hennart’s argument is the recognition that CSAs have owners, and

that the optimal mode of entry will maximize the welfare of those owners as well as that

of the MNE (Chen, 2005; Hennart, 1988, 1989, 2000; Yeung & Mirus ,1988). Traditional

internalization theory, while acknowledging the role of CSAs in internalization, does not

explicitly recognize their transactional characteristics. In contrast, Hennart builds on

Teece’s (1986) insight that owners of specialized complementary assets play a greater

role than generally understood. He argues that entry mode choice is essentially a choice

of an assignment of residual rights between the MNE and host country CSA owners, and

that the selected configuration will typically maximize total potential rents by assigning

residual rights to the party whose behaviour is the most difficult to constrain—that is,

equity will be held by the MNE or by local firms or shared between them. This will

determine whether the MNE will enter a foreign market through greenfields, brownfields,

licensing, partial acquisitions, or acquisitions. If both parties’ behaviours are equally

difficult to constrain, an equity joint venture (EJV) will result. Hennart uses his bundling

model to predict how entry modes will evolve over time, showing that the deepening of

the MNE’s commitment in a host country (e.g., from licensing to FDI) depends largely on

the efficiency of the markets for complementary local assets and for the MNE’s own

FSAs. Hennart’s bundling approach makes a significant contribution to internalization

theory by drawing attention to the inappropriateness of the conventional MNE-centric

approach, and by explaining the evolution of the MNEs’ entry modes in foreign

countries.

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MNE’s international expansion strategy: The four dimensions of distance

Critical to understanding CSAs is the notion of distance between the home and

host country. Ghemawat (2001) describes four dimension of distance—cultural,

administrative (or institutional), geographic (or spatial), and economic—and argues that

distance still matters in assessing host country advantages despite advances in

information and communications technologies that are supposed to make the world a

smaller place. From the internalization theory perspective, distance is a critical

phenomenon that affects transferability, deployability, recombination, and exploitation of

FSAs across borders.

As distance — whether economic, cultural, institutional, or merely geographic —

increases, so do the costs of doing business abroad, as well as challenges in effectively

deploying FSAs in a host environment. Distance exacerbates both bounded rationality

challenges (Simon, 1959) by making it more difficult for head office managers to

understand the subsidiary environment, and bounded reliability problems (Verbeke &

Greidanus, 2009) by limiting the extent to which the head office can engage in proper

monitoring, correction and goal alignment with the subsidiary.

To add to the complexity of the notion of distance, various distance dimensions

are not independent of each other, but rather intertwined and mutually influencing each

other—for example, regional economic integration fosters institutional coordination,

which in turn may contribute to decreasing cultural distance through improved mobility

of labor and managerial best practices. It is then the compounded distance, defined as the

need to manage various distance dimensions simultaneously, that has the most substantial

effect on the firm’s ability to deploy successfully and efficiently its FSAs abroad

26
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(Rugman et al., 2011a). The internalization perspective suggests that the level of the

MNE’s multinationality and its geographic scope will be determined by the extent to

which the MNE is able to deploy and recombine its FSAs to cope with compounded

distance between the home and host countries.

MNE internal governance: Differentiated network MNEs

Rugman and Verbeke (1992) have provided what is perhaps the most important

substantive extension of internalization theory, namely the distinction between location-

bound and non-location-bound (LB and NLB) FSAs. NLB FSAs are those FSAs that are

easily transferable across borders and are available to the entire MNE network. Typically,

such FSAs are developed at headquarters (HQ) and include technological, marketing, or

administrative knowledge. LB FSAs, on the other hand, are available only to certain

affiliates within the MNE, whether the headquarters or subsidiaries.

LB FSAs may also include capabilities in local responsiveness (in order to

overcome various dimensions of distance) developed at the subsidiary level in host

countries. One of the most interesting strategic aspects of LB FSAs is that some of them

can become ‘best practices’, and can be transformed into NLB FSAs and transferred to

the MNE network.

The above distinction has led to a fundamental evolution in internalization theory

thinking: From the view of the MNE as a monolithic organization fully controlled

through hierarchical decisions about FDI from the head office (Rugman & Verbeke,

2001) toward an analysis of the MNE as a differentiated network. The point here is that

each MNE affiliate commands idiosyncratic FSA bundles. The content, development, and

exploitation trajectory of these FSA bundles over time determine each affiliate’s role in

27
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the MNE and drive interactions with other affiliates (Rugman & Verbeke, 2003, 2008).

What follows is recognition that the MNE can have multiple patterns of FSA

development and deployment. Verbeke (2009) identifies ten patterns of FSA

development depending on their place of origin, transferability, upgradeability,

deployability across the MNE network, and the level of head office control. The MNE’s

key role is then to master this variety of FSA development patterns through recombining

resources and establishing linkages with CSAs and complementary resources of external

actors. The recombination capability in itself becomes the MNE’s highest-order FSA

(Verbeke, 2009)—akin to the dynamic capabilities school’s high-order capability to

maintain competitiveness through enhancing, combining, protecting, and reconfiguring

the enterprises’ intangible and tangible assets (Teece, 2007).

This notion of multiple potential patterns of FSA development gave rise to the

concept of subsidiary-specific advantages (SSAs)—i.e., strengths developed at the

subsidiary level (Rugman & Verbeke, 2001)—which are embedded in subsidiaries and

cannot be simply transferred to the rest of the MNE work, although they do have

international exploitation potential. The SSA concept recognizes the subsidiary’s

potentially complex roles in FSA generation and exploitation: If a particular subsidiary

has this kind of special expertise, it may be wisest to let that subsidiary expand beyond its

initially assigned charter, and to stimulate the exploitation of its SSAs internationally

(Bartlett & Ghoshal, 1986). Further, each subsidiary can be simultaneously associated

with multiple roles and FSA development patterns within the MNE.

A similar logic applies to the concept of alliance-specific advantages (ASA), or

advantages that are embedded in alliances and cannot be simply transferred to the

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individual partner firms (Verbeke, 2009). Like SSAs, ASAs have international

exploitation potential, but cannot be simply diffused within the partner firms because of

alliance-specific isolating mechanisms (McGee & Thomas, 1986), which exist

predominantly due to tacitness, context-specificity, and embeddedness of knowledge

within the alliance. The introduction of the concept of ASA represents an important

extension of internalization thinking to MNE alliance networks.

MNE’s internal governance: M-form versus metanational solution

With its greater focus on internal MNE governance, the new internalization theory

has been instrumental in analyzing the efficacy of specific organizational forms, such as

the multidivisional, or M-form (Chandler, 1962), versus the metanational form (Doz,

Santos & Williamson, 2001). In their highly influential book, Doz et al. proposed a new

set of governance principles reflecting, in their minds, a ‘metanational’ model of the

MNE, whereby the company is organized around three distinct activity levels: sensing,

mobilizing, and operationalizing innovations. To perform and coordinate these activities,

the MNE utilizes sensing and magnet units, which work outside the realm of the MNE’s

operating divisions. Sensors identify and seek out geographically dispersed, unique

bodies of valuable knowledge, while magnets recombine the various unique pieces of

knowledge identified by the sensors into commercially viable products. Operating

divisions then implement the new solutions put forward by the sensors and magnets.

Internalization theory, however, suggests different governance principles likely to

improve the efficiency and effectiveness of the MNE’s functioning. From an

internalization theory perspective, the sensor, magnet, and operating division units should

be assessed in terms of their capacity to recombine novel resources to turn them into

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actual NLB FSAs (Verbeke & Kenworthy, 2008). Internalization theory looks at

innovation— represented in the MNE by resource recombination—in its entirety;

consistent with Buckley’s (2009) concept of the global factory, this means that R&D and

other efforts to develop and access new knowledge cannot be structurally divorced from

production, marketing, and sales. To achieve innovation, the MNE must engage in

integrative resource recombination practices throughout its value chain. It follows, then,

that structural separation of innovation activities in sensor and magnet units, from the rest

of the organization—i.e., the operating divisions—is unlikely to help the MNE innovate,

and the metanational form of governance is therefore unlikely to displace the

conventional M-form organizational structure (Verbeke & Kenworthy, 2008; Rugman et

al., 2011a). Empirical evidence will, of course, be the ultimate judge of the metanational

governance form’s validity; current reality, however, suggests that most MNEs still fit

under the M-form umbrella.

Theory of regional strategy and structure

Globalization or the increased economic interdependence among nations has been

the subject of much debate in the IB literature. Proponents of a ‘globalization’ framework

argue that consumer needs are becoming increasingly homogenized, largely due to

technological advances, and correspondingly, markets are becoming globalized, which

means that the MNE must design ‘global strategies’ (Levitt, 1983; Yip, 2002).

Specifically, the MNE should standardize its products and services worldwide in order to

achieve economies of scale, and should implement uniform strategies throughout the

value chain and across all markets.

Yet, very few MNEs are truly global. A global company can be defined as having

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less than 50% of sales (or assets) in its home region, and at least 20% of sales (or assets)

in each of the triad regions, the triad being defined as consisting of NAFTA, the

expanded European Union, and Asia, with these three regions representing the bulk of

worldwide technological innovations and demand for products embodying these

innovations (Rugman & Verbeke, 2004). Empirical evidence suggests that increases in

international sales occur predominantly within the MNE’s home region of the triad, and

that substantial barriers to trade and FDI among regions of the triad still exist (Rugman,

2000). In a study of intraregional sales of the world’s 500 largest companies, 380 firms

had available geographic segment data; these firms accounted for 79.2% of the total

revenue of the 500 largest firms and had an average sales volume of $29.2 billion in

2001. The study showed that the average intraregional sales across these 380 firms

represented 71.9%; further, only 9 of the 380 firms (2.4%) were in fact global (Rugman

& Verbeke, 2004). There is no trend toward globalization, and the world’s largest MNEs

remain highly intraregional in their sales and assets (Oh & Rugman, 2007; Rugman &

Verbeke, 2008b).

From an internalization theory perspective, the false assumption made by global

strategy advocates is that NLB FSAs, embodied in standardized products, production

processes, and marketing routines, can easily overcome distance. In reality, the non-

location-boundedness of FSAs is often overstated. Distance and a strong liability of

foreignness, which remain at both regional and national levels, lead to challenges in

transferring, deploying, and profitably exploiting FSAs across borders (Rugman &

Verbeke, 2008b). Location-bound FSAs must still be developed in host environments to

achieve national responsiveness. Development of such LB FSAs is associated with a cost

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of doing business abroad, which rises with the increase of cultural, economic, geographic,

and institutional distance across regional boundaries. In the end, adaptation costs may

turn out to be so high that home region expansion is preferred over global expansion. It

follows, then, that it may be appropriate for the MNE to tailor its strategy to fit a specific

role in each triad region, rather than to impose an integrated strategy throughout its

network (Rugman & Verbeke, 2004, 2007). The key strategic challenge is to achieve the

right balance between NLB and LB FSAs in each region where the MNE has a presence

(Rugman & Verbeke, 2003).

In terms of striking such balance, the internalization theory lens can also be

applied to the so-called ‘transnational solution’ to MNE management proposed by

Bartlett and Ghoshal (1989). These authors’ integration/responsiveness framework

assumes that the focus on socialization (‘normative integration’) inside the MNE is

sufficient to make the differentiated network MNE function effectively, and to achieve

both national responsiveness and global integration. In reality, however, internal MNE

governance requires a mix of socialization, price-based coordination, and hierarchical

control to function effectively. The transnational solution, requiring classification and

coordination of affiliates based on their FSA bundles, and the subsequent coordination of

these affiliates in a network through normative integration, may become too complex,

and may therefore be replaced by a regional solution (Rugman & Verbeke, 1992).

Internalization theory and evolutionary view of the MNE

In their milestone JIBS article, Kogut and Zander (1993) develop a new view of

the MNE, informed by the behavioural (Cyert & March, 1963) and evolutionary (Nelson

& Winter, 1982) theories of the firm. They suggest that the MNE represents a superior

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governance mechanism for transferring tacit knowledge across borders because it

possesses combinative capabilities. MNEs exist not because of external market

imperfections, but because they act as repositories of embedded knowledge, whereby

internal routines allow for effective knowledge transfer. The knowledge transfer process

itself is a platform for future knowledge generation and transfer, grounded in a social

context. Kogut and Zander argue that internalization theory focuses on the minimization

of transaction costs rather than on potential value generation, that it overemphasizes

opportunism (“self-interest seeking with guile”, Williamson, 1981b: 1545), and that it

focuses on individual transactions, in terms of transfer of proprietary knowledge bundles

across borders, without considering the broader context that should include the MNE’s

past and future, as well as its social nature.

While the above criticisms usefully suggest that it is beneficial to adopt a more

eclectic approach to studying international expansion than focusing merely on narrow

transaction cost parameters (Verbeke, 2003), their validity is questionable, especially if

assessed from the ‘new’ internalization theory perspective. First, while conventional

internalization theory indeed focused mainly (though not exclusively) on TCE-based

parameters to explain MNE expansion patterns and technology transfer choices, new

internalization theory focuses on managing innovation in its entirety—it is therefore

concerned not merely with single-transaction economizing, but also with strategizing for

value creation purposes. Second, Kogut and Zander’s questioning of the opportunism

assumption is useful, as the concept of opportunism has indeed been the subject of much

academic debate. Opportunism has been criticized for its narrow conceptual focus,

inaccurate portrayal of human nature and the lack of sufficient empirical support (Tsang,

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2006), and it has even been argued that concerns surrounding the behavioural assumption

of opportunism reduce the legitimacy of TCE as a general theory of the firm (Verbeke &

Greidanus, 2009). Yet, in this particular case, the criticism is perhaps misdirected. While

the assumption of opportunism is indeed central to Williamson’s version of TCE, it is not

a focus of internalization theory, which is much more concerned with the behavioural

assumption of bounded rationality. In addition, bounded reliability (Verbeke &

Greidanus, 2009)— which represents a broader envelope-concept to explain failure of

economic actors to make good on open-ended promises irrespective of intent—is more

relevant than opportunism and has had a larger role in internalization theory (Rugman &

Verbeke, 2008b). Third, internalization theory does not divorce specific transactions from

prior or future transactions—rather, every transaction is considered in the broad context

of managing the MNE’s network, whereby it is prior investments that permit the

development of organizational routines to allow know-how to be transferred abroad

(Verbeke, 2003). In other words, it is rather naive to assume that combinative capabilities

held by a firm simply appear and make the firm superior to external markets: Investments

are required to create the combinative capability, and these investments are driven by

internalization theory considerations on the firm’s boundaries. Fourth, an MNE

possessing combinative capabilities to perform tacit knowledge transfers is not a

sufficient condition for internalization: The benefits and costs of alternative governance

forms must be assessed simultaneously. For example, external actors such as key

distributors, suppliers, or industry partners may command complementary FSAs, so that

cooperative governance may be more efficient. In addition, if bundles of tacit knowledge

do not fit with the MNE’s core businesses, de-internalization may still be comparatively

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more efficient (Rugman & D’Cruz, 2001).

Multinationality-performance relationship

Over the past fifty years, the IB literature has suggested various linkages between

multinationality and performance, and a number of authors have tried to find a systematic

relationship between the increase in the degree of the firm’s multinationality and its

bottom line. These studies have been published in credible outlets, yet their results are

largely inconsistent (Verbeke & Brugman, 2009). Most recently, multinationality-

performance research has identified an S-curve relationship between multinationality and

performance, allegedly the outcome of three distinct stages during the MNE’s

internationalization process: In the first stage, an increase in multinationality induces a

decline in performance as the firm learns how to operate in foreign markets and

overcome the liability of foreignness and newness; in the second stage, performance

starts to rise with the increase in multinationality; in the third stage, large foreign

operations become too difficult to manage, and the firm’s performance again declines as

the firm overextends itself. On the surface, this research has important normative

implications for managers, suggesting that higher multinationality is likely to yield higher

performance until an overextension threshold is reached.

The above S-curve multinationality-performance reasoning, however, contradicts

the most basic principles of internalization theory—as, in fact, does the mere notion that a

fixed, systematic multinationality-performance relationship should exist in the MNE

(Hennart, 2007; Verbeke, Li & Goerzen, 2009). From an internalization theory

perspective, the MNE will select entry modes and geographic configurations to best

match its FSAs, with the environment acting as a constraining or facilitating force.

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Domestic and international success will therefore be determined by the firm’s ability to

develop, transfer, deploy, and exploit its FSAs rather than by its geographic scope per se.

To illustrate this point, Verbeke and Brugman (2009) conducted a quality test of extant

empirical research on the multinationality-performance relationship by examining the

twenty most influential multinationality-performance publications. This exercise

uncovered serious conceptual and measurement challenges that essentially invalidate the

results of most past studies. Verbeke and Forootan’s (2012) subsequent study updated

and replicated the analysis. Kirca et al. (2011) conducted a meta-analysis of 120

independent samples reported in 111 studies to test the predictions of internalization

theory in the context of the multinationality-performance relationship, and found that the

multinationality-performance relationship is moderated by FSAs, and that the impact of

FSAs on the multinationality-performance relationship is influenced by a number of

elements, including the type of FSA, industry characteristics, and the firm’s R&D and

advertising intensity. Essentially, the meta-analysis’ results confirm the key point that no

generalizable recommendation can be formulated on an optimal degree of

multinationality without an in-depth knowledge of individual firms’ FSAs and

environments (Verbeke & Brugman, 2009; Verbeke & Forootan, 2012) — an insight

particularly relevant for practitioners, who might otherwise engage in a misguided quest

for optimal multinationality instead of focusing on FSA development capabilities.

A note on the changing nature of FSAs

Conventional empirical studies adopting an internalization theory lens have

traditionally focused on two types of FSAs: technology-based ones and marketing-related

ones (e.g., brand names), with the strength of these FSAs approximated by the MNE’s

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R&D and advertising spending, respectively. These imperfect proxies may have

represented an acceptable approximation for the MNE’s FSAs in the past, but certainly

did not capture the MNE’s uniqueness in qualitative terms. For example, such uniqueness

could reside in the MNE’s absorptive capacity to digest different cultures and to employ

productively managers of many nationalities. Contemporary internalization theory, which

embodies a dynamic capabilities-like view of the firm, recognizes the role of higher-order

FSAs beyond those associated with branding and technology — for example, FSAs in

managerial expertise, which are often at the heart of achieving superior performance, yet

are not easily measured in quantitative terms. In his plea to rethink IB research

methodology, Yair Aharoni (1993) argued it is very difficult, if not impossible, to capture

MNE success stories by using industry averages and statistical tests. Outlier stories

typically get buried in statistical databases, so that the uniqueness of MNEs is not truly

captured. Aharoni suggests that IB scholars would understand much more about

companies’ FSAs if they relied more on the tools of the business historian than those of

the mainstream economist. He also argues that statistical analysis of performance

differentials among firms should be complemented with historical, case-based analysis

and longitudinal research in order to understand the underlying FSAs of outlier

successful MNEs, as well as the absence of needed FSAs in failed firms.

The warning against overgeneralization when studying FSAs is particularly

poignant in the context of emerging economy MNEs (EMNEs), whose key competitive

strengths are often not measurable by traditional proxies. EMNEs may have dramatically

different FSAs as compared to developed economy MNEs, and their trajectory of FSA

development may also be different—for example, many large EMNEs typically build

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technological capacity by purchasing technology or entering into alliances to gain access

to existing technology instead of investing in R&D. The point here is that with the

growing awareness of the complexity, uniqueness, and intangibility of MNEs’ FSAs

comes an added challenge of capturing these FSAs empirically. Here, the RBV literature

may be useful: RBV scholars have been instrumental in developing a multitude of proxies

for empirically measuring a firm’s resource base (see Newbert, 2007, for a

comprehensive overview of RBV-grounded empirical articles). New proxies will

undoubtedly aid in evaluating the unique FSAs of a range of unique MNEs (including

EMNEs).

Section conclusion: Internalization theory in four types of international strategic

management research

In his classification of IB research, Sjoerd Beugelsdijk (2011) suggests that most

research questions in international strategic management fall within one of four general

categories, based on 1) their focus on the firm versus the environmental context; and 2)

their ‘comparative’ versus ‘interactive’ approach. What results is a two-by-two matrix,

with the following types of research questions relevant to each quadrant, as shown in

Figure 1.1.

(Figure 1.1 about here)

1. In quadrant 1, the focus is on the comparative analysis of firms, holding contextual

variation constant. For example, how do firms from one particular domestic context

organize their activities in one specific foreign context (e.g., Japanese MNEs’ entry

into the United States)?

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2. Quadrant 2 includes the interactive analysis of firms, with contextual variation held

stable. In other words, how do relationships unfold between firms from context A and

firms from context B (e.g., how do joint ventures evolve between European and

American firms in the high technology sector in California)?

3. In quadrant 3, the central research issue is the international comparative analysis of

contexts, with no variation in firm characteristics. In other words, how do contextual

differences affect supposedly ‘identical’ firms (e.g., what is the impact of country-

level institutional quality on the choice of MNE head office location)?

4. Finally in quadrant 4, an interactive analysis of different contexts is performed, with

no variation in firm characteristics. How do the characteristics of pairs of locations, or

changes in these characteristics affect supposedly ‘identical firms’? (E.g., what is the

managerial impact of particular scores on a Kogut and Singh (1988) index of cultural

distance? What is the impact of trade agreements on FDI: Does increased trade

complement or substitute for FDI?)

In the first type of studies, differences in FSAs among companies matter the most,

suggesting that these studies can be categorized as international RBV applications, but

with internalization considerations featuring prominently in predicting MNE strategic

choices. In the second type of studies, interactions between FSAs from firms with

different nationalities matter the most. Each company’s FSAs are believed to embody

home country CSAs. Here, higher distance typically leads to higher transaction costs and

higher complexity in making strategy choices. In the third type of IB research, only

differences in CSAs matter: The message is often that particular CSAs (such as a

properly enforced patent protection regime or high institutional quality) will reduce

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transaction costs for MNEs at the macro level, thereby attracting and fostering the growth

of particular types of economic activities. The fourth type of studies deals with

interactions between CSAs of different countries, and the changes therein over time. This

can be a key input for the second type of studies.

Contemporary internalization theory-based work can be largely positioned in

quadrants 2 and 4 in Figure 1.1. Internalization theory’s analytical approach is interactive

in nature, with its key concern being the recombination of the MNE’s LB and NLB FSAs

with home and host countries’ CSAs, whereby access to the latter may actually be

controlled by host country actors. In one of the newest iterations of internalization theory,

namely Hennart’s (2009) bundling approach discussed above, quadrant 4 is collapsed into

quadrant 2: Here, CSAs are not exogenous macro parameters, but are controlled by

resource owners in a host country and not necessarily readily accessible by the MNE.

Accessing CSAs requires further recombination capabilities and FSA development on the

MNE’s part.

THE FUTURE OF INTERNALIZATION THEORY: A FEW EXTENSIONS

As an efficiency-based, positive theory of MNE functioning and organization

(Rugman & Verbeke, 2008b), internalization theory can be readily augmented to explain

a wide range of emerging issues in IB. In this section, we consider a few potential

application areas.

International entrepreneurship and ‘born-globals’

International entrepreneurship involves the identification and exploitation of

opportunities for international exchange (Ellis, 2011). International entrepreneurship

research, which has been argued to be a critical emerging area in IB (Dimitratos & Jones,

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2005; Styles & Seymour, 2006; Young, Dimitratos & Dana, 2003; Zahra, 2005; Ellis,

2011), distinguishes itself from other IB theories by its emphasis on the entrepreneurial

recognition and exploitation of business opportunities. International entrepreneurship

researchers argue that internalization theory focuses on large, well-established MNEs,

and neglects the pursuit of entrepreneurial opportunities (Autio, 2005); further,

internalization theory is believed to tend toward one-sided, firm-centric explanations of

IB activity (Toyne, 1989), to the neglect of a variety of governance options available to

the entrepreneur. International entrepreneurship research, in contrast, began as a response

to the globalization of markets, and encompasses so-called ‘born-globals’: These are

firms that internationalize while still young and small (Knight & Cavusgil, 1996;

McDougall & Oviatt, 2000), and whose expansion is rapid and opportunity-driven

(Zahra, Korri & Yu, 2005) as opposed to incremental and inhibited by risk aversion.

Born-globals’ rapid and dedicated internationalization from inception is believed to be

driven by entrepreneurs’ ideas and knowledge which may have potential global

application; while small ideas may incubate local firms, big ideas will incubate MNEs

(Buckley & Casson, 2009). Born-globals are most frequently ‘market seekers’ in their

internationalization motives (Verbeke, 2009): This kind of international expansion

pattern is particularly prevalent among firms operating in small open economies (e.g.,

New Zealand, Israel, Denmark, etc.) where domestic demand is limited (Knight, Bell &

McNaughton, 2001).

However, closer scrutiny of the born-global phenomenon reveals that born-

globals’ international sales are achieved largely within their home regions. Research

found that Danish born-globals generated the vast majority of their international sales in

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Europe (predominantly in Germany, which accounted for 50% of their sales), while

American born-globals generated 53% of their total sales domestically (Knight, Madsen

& Servais, 2004). Despite a vast amount of literature on born-globals, there is a paucity

of robust empirical evidence of any true born-global firms, in the sense of having an

equal presence in all regions of the triad, other than a few technology firms from India

and some small firms from Israel (Rugman & Almodovar, 2011). This suggests that born-

globalism may be no more than an illusion (Rugman et al., 2011), and that born-globals

can often be more accurately described as born-regionals (Rugman, 2000; Fisch &

Oesterle, 2003; Lee, 2010; Lopez, Kundu & Ciravegna, 2009).

Similar to its treatment of the regionalization phenomenon, internalization theory

explains born-globals’ lack of ‘globalness’ by difficulties in overcoming interregional

economic, cultural, geographic, and institutional distance and liability of foreignness and

newness. Shortage of sufficiently developed FSAs to support FDI likely explains the fact

that born-globals’ opportunistic foreign sales usually take a form of exporting. It should

also be noted that the so-called globalization of markets that supposedly gave rise to the

born-global phenomenon is not supported by internalization theory thinking — distance,

as convincingly shown by Ghemawat (2001), still matters. While it is certainly

conceivable that a big idea will breed global demand (e.g., imagine a pharmaceutical firm

that develops a cure for cancer), global implementation requires an expert recombination

of the company’s FSAs with multiple CSAs in diverse locations, which is extremely

challenging. Global governance will likely prove difficult for a young firm, presenting

multiple challenges throughout the firm’s value chain (i.e., finding reliable distribution

systems and local partners throughout the world), and leading to consequent bounded

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reliability and bounded rationality challenges.

In response to criticism from international entrepreneurship scholars cited above,

it should be noted the new internalization theory has long moved away from its MNE-

centric focus (see Hennart’s 2009 study, tellingly titled “Down with MNE-centric

theories!”). Internalization theory recognizes the complex and multilateral nature of

international exchange, is no longer restrictive in its treatment of expansion options

available to the MNE, and is presently well equipped to explain the born-global

phenomenon—including the relative scarcity of born-globals and their prevailing regional

rather than truly global nature.

Emerging economy MNEs1

Emerging economies, comprised of countries with a rapid pace of development

and government policies that favor economic liberalization, are assuming an increasingly

prominent position in the world economy (Wright, Filatotchev, Hoskisson & Peng, 2005),

as well as in MNE strategic activity (Verbeke, 2009). Hoskisson, Eden, Lau & Wright

(2000) identified sixty-four emerging economies, of which fifty-one were rapidly

growing developing countries, and thirteen were in transition from centrally planned to

market economies. The growth of emerging economies is reflected in an upsurge of IB

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
1
Internalization theory’s application to EMNEs is explored in greater depth in a

separate essay included in this dissertation (Essay 3). However, EMNEs provide an

important context for contemporary internalization theory’s application, and a

significant avenue for internalization theory’s future extension – and therefore must

not be amiss in this section on the future of internalization theory. This section

essentially represents a summary of Essay 3.

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research on the topic over the past decade. The emerging economies phenomenon offers

three broad areas for consideration by IB scholars: situations where firms from developed

economies enter emerging economies, situations where firms from emerging economies

enter developed economies, and situations where firms from emerging economies enter

other emerging economies.

The last two areas of research have spurred a vivid debate among IB scholars

regarding the relevance of extant IB frameworks to explain EMNE behaviour. As many

MNEs from the BRIC (Brazil, Russia, India, and China) and VISTA (Vietnam,

Indonesia, South Africa, Turkey, and Argentina) countries, as well as from Mexico and

Thailand, achieved success in their international expansion, a question arose as to

whether existing IB theories can accommodate the new phenomenon, or whether a

significant adjustment to extant theory, or even an entirely new theory is required to study

EMNEs. To date, no consensus has emerged on the topic (Ramamurti, 2009). A sizeable

group of researchers (see Child & Rodrigues, 2005; Filatotchev, Strange, Piesse & Lien,

2007; Luo & Tung, 2007; Mathews, 2002a, 2002b, 2006a, and 2006b; Peng, Lu, Shenkar

& Wang, 2001) believe that EMNEs represent a new class of firms that pursues

internationalization patterns drastically different from developed country MNEs, and

therefore call for new theory development. Others (see Buckley et al., 2007; Dunning,

2006; Hennart, 2011; Narula, 2006; Rugman, 2009) suggest that EMNEs’

internationalization patterns and internal organization can be easily addressed within

existing IB paradigms. Yet, a third group of authors (see Cuervo-Cazurra & Genc, 2008;

Guillen & Garcia-Canal, 2009; Ramamurti, 2009) posit that extant IB theories can be

applied to EMNEs, but only if substantially adapted and augmented.

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 Unfortunately, the rejection of existing IB theories, and especially internalization

theory as the general theory of the MNE (including the EMNE) appears to be associated

with an incomplete understanding thereof. Proponents of a new or a significantly

augmented theory issue three main charges against the internalization paradigm:

The first one relates to the fact that EMNEs operate in an institutional

environment significantly different from that prevailing in developed economies (Peng et

al., 2001), and therefore require a new institution-based theory. However, internalization

theory has been successful in dealing with institutional distance, including institutional

distance between developed and emerging economies, which is reflected in differential

transaction costs. Transaction costs are likely to rise due to economizing challenges

presented by institutional differences (Wright et al., 2005). For example, MNEs from

developed economies competing in emerging economies face such consequences of

increased institutional distance as a lack of transparency, lax intellectual property rights

protection, weak legal and financial systems, etc. This is likely to create bounded

rationality and bounded reliability challenges (Verbeke & Greidanus, 2009), potentially

increasing transaction costs. In contrast, local competitors and EMNEs from other

emerging economies will have a competitive advantage over their rivals from developed

countries due to the lower institutional distance (or a complete lack thereof) and will,

consequently, face lower transaction costs. In other words, from the internalization theory

perspective, institutions matter due to their potential to affect the additional costs of doing

business abroad.

The second charge against the use of internalization theory for EMNE research

relates to internalization theory’s focus on development and exploitation of FSAs.

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Proponents of a new theory suggest that emerging economy multinationals do not in fact

possess FSAs and thus internationalize to acquire new FSAs rather than to exploit

existing ones. For example, Mathews (2002a, 2002b, 2006a, 2006b) suggests that Asian

EMNEs, which he terms Dragon multinationals, are essentially resource-poor, yet have

successfully expanded abroad without FSAs. This is argued to make EMNEs unsuitable

for theoretical analysis driven by the notion of FSAs—the very feature that EMNEs

supposedly lack. We believe that this misconception stems from the confusion

surrounding the notion of FSAs, and from the failure to differentiate between

conventional internalization theory and its contemporary form. As discussed in the

previous section, conventional proxies for empirical measurement of FSAs — R&D and

advertising spending — are meaningless in the emerging economy context: First,

EMNEs’ key competitive strengths are not necessarily related to technology and

branding, and second, even if EMNEs do cultivate technological and branding FSAs,

these FSAs may not be measurable by traditional proxies, as their development path may

not be associated with R&D and advertising spending. The point here is that EMNEs’

FSAs are different from those of developed economies’ MNEs, rather than absent

altogether. Examples of nontraditional FSAs found in EMNEs include entrepreneurial

quality of management (as seen in India’s Tata Group’s innovative Nano product),

expertise in managing international mergers and acquisitions (as demonstrated by

Mexico’s Cemex), etc.

Many IB scholars have recognized the differential nature of EMNEs’ FSAs and

acknowledge that those FSAs can be exploited through FDI (see Cuervo-Cazzura &

Genc, 2008; Guillen & Garcia-Canal, 2009; Ramamurti, 2009; Zeng & Williamson,

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2007). Some EMNE-specific FSAs mentioned in the literature include a better

understanding of emerging market customers and ability to adapt technology to develop

products suited for special needs customers (relevant when expanding to other emerging

economies and competing with developed country MNEs), cost innovations and

operational excellence forced by sparse resources, privileged access to home countries’

CSAs, adversity advantage (ability to effectively function in difficult conditions),

networking skills, political know-how, etc. Still, we argue that internalization theory

predictions stand despite the idiosyncratic nature of EMNEs’ FSAs, which essentially

represent recombination capabilities (Verbeke, 2009). The nature of an MNE’s FSAs

(higher-order ones versus technology-based ones) does not affect internalization theory’s

main prediction that the firm’s international success will depend on its ability to

successfully match its set of FSAs with host country CSAs. It is the generic

characteristics of these FSAs (e.g., transferability across borders and inimitability) and

CSAs (easily transacted in open markets or not), rather than the FSAs’ specific

characteristics (branding, technology or higher-order) that will determine optimal entry

mode choice and subsequent governance of developed country MNEs and EMNEs alike.

Related to the above point, the third proposed rationale for a new EMNE-based

theory is the EMNEs’ alleged, unique motivation to internationalize, which is to

mitigate/eliminate relative competitive disadvantages as opposed to exploiting

advantages as developed country MNEs do (Child & Rodrigues, 2005). Noneconomic

objectives for expansion are argued to produce different internationalization patterns.

Guillen and Garcia-Canal (2009) identify nine motivations for EMNEs’ FDI documented

in the literature: backward linkage into raw materials, forward linkage into foreign

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markets, home-country government curbs, spreading of risk, movement of personal

capital abroad, following a home-country customer to foreign markets, investment in new

markets in response to economic reforms in the home country, acquisition of intangible

FSAs, and exploitation of intangible FSAs. A closer look at the motivations listed above

will reveal that many could be found in developed country MNE expansions, as well. In

fact, all of those strategic goals fit neatly into an existing typology of internationalization

motivations: natural resource seeking, market seeking, strategic resource seeking, and

efficiency seeking (Dunning & Lundan, 2008; Verbeke, 2009), and as such hardly

necessitate a new theory.

All of this is not to say that the emerging economy context does not warrant a

unique approach—it does indeed, but internalization theory’s emphasis on matching

FSAs and CSAs (Rugman, 1981, 1996) is particularly relevant to address this uniqueness.

Let us look, for example, at developed country MNEs entering emerging economies.

MNEs are required to engage in novel activities for new business creation in a foreign

country, rather than simply seek to sell a product or service (Yiu et al., 2007). FSA

development patterns for an MNE entering an emerging economy will be unique, with

extant NLB FSAs necessarily combined with substantial bundles of LB FSAs developed

in the host country (Verbeke, 2009). Developing LB FSAs in national responsiveness and

higher order FSAs in resource recombination becomes particularly critical, as does

enlisting complementary FSAs of external actors. Such enlisting may be critical given

comparative deficiencies in the rule of law, as well as entrenched networks among

government agencies, various local organizations, and local and foreign firms that

typically characterize emerging economies (Zhou & Poppo, 2010).

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 To conclude, the new internalization theory, with its blend of TCE and RBV

components, its dynamic view on FSAs and its focus on finding an optimal combination

of FSAs and CSAs, is well equipped to handle additional complexities presented by the

emerging economy context. Unfortunately, it is currently underutilized in the study of

emerging economies; to date, four conceptual perspectives—TCE, agency theory, RBV,

and institutional theory—have been identified as leading theories in the field (Hoskisson

et al., 2000; Peng et al., 2001; Meyer & Peng, 2004). Internalization theory, which

effectively blends the transaction costs and RBV/dynamic capabilities perspectives, and

systematically takes into account institutional context, can significantly enhance our

understanding of both EMNEs and developed country MNEs’ expansion into emerging

economies.

CONCLUSION

Internalization theory is a powerful and comprehensive IB research tool that

“represents a quantum leap in our understanding of the MNE” (Hennart, 1986: 801).

Standing on the shoulders of such giants such as Coase and Penrose, internalization

theory has evolved considerably since its inception over forty years ago, from a relatively

static, narrow economic efficiency-based model to a dynamic theory focusing on

developing, deploying, exploiting, and augmenting complex FSA bundles in equally

complex location-specific contexts. The range of internalization theory’s applications has

also widened from the early focus on entry mode choices to explaining such

contemporary phenomena as MNE strategy-structure choices, regionalization strategies,

and emerging economy MNEs.

Internalization theory provides a simultaneous focus on the firm, commanding

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FSAs and attempting to economize on transaction costs so as to effect value creation and

capture, and on the environment as an influencing force. Internalization theory thereby

offers a comprehensive view of the interactions between the firm and its environment,

much needed in strategic management theory (Hoskisson, Hitt, Wan & Yiu, 1999).

Internalization theory can assist in the efforts to blend TCE and RBV-thinking that

mainstream strategic management scholars have been undertaking during the past two

decades.

One of internalization theory’s great strengths is its managerial relevance and

significant normative agenda. At the micro level, internalization theory is concerned with

identifying and correcting short- and medium-term inefficiencies, such as wrong entry

mode choices, excessive internalization, non-adaptation of governance structures to new

environmental conditions, etc. At the macro level, internalization theory has far-reaching

public policy implications: Only if public policy makers and regulators understood

correctly the drivers of MNE behaviour could the positive societal spillover effects of

MNE activities be optimized through appropriate macro level governance (Rugman,

1981). In line with Teece’s (1984) thinking on the benefits of blending theories and

managerial best practices, we conclude by suggesting that internalization theorists should

work with practitioners and regulators so as to combine research findings with best

practices in business and public policy. Such blending will further increase internalization

theory’s substantive contribution to IB scholarship and to the broader field of strategic

management.

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Figure 1. 1. Generic types of international strategic management studies

(adapted from Beugelsdijk, 2011)

Source of variation
Analytical
approach Firm-level Location

1. Differences in FSAs 3. Differential location

matter most characteristics matter
Comparative (international most (competitive
application of RBV) advantage of nations)

2. Interactions between 4. Interactions between

MNEs’ FSAs from location characteristics
different countries of country pairs mater
Interactive
matter most most

Contemporary internalization theory

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 Essay 2

AN INTERNALIZATION THEORY RATIONALE FOR MNE

REGIONAL STRATEGY

This essay demonstrates that internalization theory, as a ‘complete’ theory of the firm, is

particularly well equipped to analyze MNE regional strategies, thanks to its joint

transaction cost economics and resource-based foundations. The essay builds upon

recent work by Wolf, Egelhoff, and Dunemann (2012) to show that internalization

theory’s predictions on MNE regional strategy are superior to those suggested by several

other conceptual frameworks. For each of the eleven hypotheses formulated by Wolf and

his co-authors, an alternative is proposed here that is consistent with internalization

theory predictions. MNE regional strategy is an important empirical phenomenon, and

internalization theory, as a powerful conceptual framework with general applicability,

simplicity and accuracy, allows in-depth analysis of MNE regional strategies. A broad

theoretical implication is that international business scholars should embrace

internalization theory as the general theory of the MNE, rather than looking for insight

from theories not intended – nor properly equipped – to study strategies of the world’s

most complex entrepreneurial organizations.

INTRODUCTION

Wolf, Egelhoff and Dunemann (2012), in a provocative piece published in The

Multinational Business Review (MBR), have argued that the phenomenon of multinational

enterprise (MNE) regionalization, defined as the concentration of foreign sales in the

home region as opposed to a more balanced distribution across the globe, cannot be

explained fully through transaction cost economics reasoning. In their view, a broader

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and more multi-faceted explanation is required of the regionalization phenomenon. The

authors utilize seven complementary theories from economics, psychology and sociology

to develop a set of propositions explaining the MNE’s home-region orientation.

We agree with Wolf et al. (2012) that the study of MNE internationalization

patterns, and regional strategy/structure choices in particular, requires more than a mere

focus on conventional transaction cost economics parameters (Verbeke, 2003). However,

Wolf et al.’s perspective represents an incomplete exposé on the regionalization

phenomenon as advanced by Rugman (2005) and Rugman and Verbeke (2004, 2005).

First, Rugman and Verbeke’s theory of regionalization is not based on conventional,

Williamsonian transaction cost economics (TCE) (Coase, 1937; Williamson, 1975,

1981a, 1981b, 1996), but rather on the theory’s ‘international version’, called transaction

cost internalization (TCI) or internalization theory, which was developed largely

independently of the Williamsonian version. First formulated in the classic work of

Buckley and Casson (1976), contemporary internalization theory goes beyond

concentrating on transaction cost economizing to recognize a variety of strategic and

managerial issues involved in internationalization, and to focus on managing the

innovation process in its entirety. This broad focus, as compared to Williamsonian TCE

and early internalization thinking, is achieved by infusing a ‘dynamic capabilities’-like

perspective into TCE thinking, with an emphasis on generating, exploiting and

rejuvenating firm-specific advantages (FSAs) and matching these with country-specific

advantages (CSAs) of host countries. Contemporary internalization theory explains the

choice of MNE boundaries, as well as the firm’s internal governance and its interactions

with external environmental forces (Rugman et al., 2011a; Verbeke, 2009).

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 Second, Wolf’s and his colleagues’ description of the TCE foundational

assumptions is not entirely accurate. Contrary to the authors’ claim (see Table I in Wolf

et al., 2012), TCE explicitly rejects the conventional notion of ‘homo economicus’ in

favour of the bounded rationality behavioural assumption (Simon, 1959; see Williamson,

1996). The concept of bounded rationality is central to internalization theory and to the

explanation of the regionalization phenomenon, as bounded rationality of MNE managers

is largely responsible for difficulties in transferring, deploying and recombining FSAs

across regional borders. Further, also contrary to what the authors imply, TCE

acknowledges the level of uncertainty as a principal characteristic of transactions

(Williamson, 1996), as does internalization theory. Consequently, internalization theory

does not view international expansion decisions as choices among well-specified, discrete

alternatives even if much empirical work has been based on this assumption (Benito et

al., 2009). Nor does internalization theory assume hyper-rational, MNE-centric decision

processes (Hennart, 2009). As a general theory of the MNE, internalization theory is

actually able to explain MNE behaviour while encompassing the spatial, behavioural and

social considerations explored by Wolf et al. through complementary theories. In the

following section, we explore how the authors’ propositions can be reinterpreted through

an internalization theory lens, and, where necessary, restated. We conclude by discussing

internalization theory’s capacity to explain the phenomenon of regionalization, and by

assessing the value of Wolf et al.’s contribution to the current explanation.

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 ALTERNATIVE INTERPRETATION OF REGIONALIZATION

PROPOSITIONS

H1 (based on the theory of new regionalism)

New regionalism refers to the politically induced process that started in the early

1990s, characterized by trade liberalization of regions through reduction of intra-regional

trade barriers (Hettne, Inotai & Sunkel, 1999). The authors argue, following the logic of

new regionalism, that MNEs are incentivized to concentrate the bulk of their business

activities within the boundaries of a regional integration agreement. They propose the

following (for purposes of consistency in the present paper, we will always use the words

multinational enterprise - MNE, instead of multinational corporation - MNC).

H1. A multinational enterprise’s (MNE’s) degree of home-region orientation will

be positively related to the degree of economic liberalization which existed in its

home region at the time foreign investment decisions were made.

From the internalization theory perspective, macro level liberalization policies by

themselves will not determine the scope of the MNE’s geographic expansion; rather, this

scope will be determined by the MNE’s ability to link its FSAs with CSAs of locations

within or outside of its host region. Regional integration agreements may influence this

ability: They promote intra-regional coherence and thereby reduce the MNE’s need to

develop new location-bound FSAs or adapt existing FSAs to host-country CSAs if a host

country is located within the home region (Rugman & Verbeke, 2005), thus indeed

providing an incentive for intra-regional rather than inter-regional investment. It should

also be noted that most region-based liberalization policies are reactions to a history of

collaboration within the region and to geographic proximity and/or

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cultural/economic/institutional similarities among countries in the region; they can be

interpreted as the removal of unnatural market imperfections (Rugman, 1981; Buckley,

Clegg, Forsans & Reilly, 2003) to further the ease of FSA adaptation, which was already

partially enabled by comparatively low cultural, geographic, economic and/or

institutional distance (Ghemawat, 2001).

An MNE home-regional focus is thus merely facilitated by region-based

liberalization. In addition, this ‘incentive’ for home-region firms will not necessarily act

as a deterrent for outsider firms whose international expansion is motivated by strategic

resource seeking, if these strategic resources cannot be obtained within their own home

region. Consider, for example, an emerging economy MNE expanding into a developed

economy (i.e. a host region), in order to access technological know-how (Guillen &

Garcia-Canal, 2009), or a developed economy MNE entering an emerging economy (e.g.

China – again, located in a host region) in search of cheap labour. The point here is that

region-based liberalization policies may indeed affect the regional scope of MNE

international activities, but will not determine such scope. The key determinant of the

MNE’s geographic scope is the firm’s ability to recombine FSAs with CSAs in order to

reach its strategic goals. H1 can therefore be restated as follows:

H1 - internalization theory version. While region-based liberalization provides

incentives for intra-regional FDI, each particular MNE’s international expansion

pattern will be determined mainly by micro level parameters, including the firm’s

internationalization motives and the nature of its FSAs. Therefore, no fixed,

generalized relationship can be proposed between a region’s level of economic

liberalization and the home-region orientation of this region’s MNEs.

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 Wolf et al.’s hypothesis is in fact disproved by Rugman and Verbeke’s (2004)

empirical data. Among the three regions of the Triad (defined as Europe, North America

and Asia-Pacific), Europe can be seen as the most integrated, as it is characterized by far-

reaching administrative and political harmonization in addition to economic integration,

whereas North America and Asia only benefit from the latter. Therefore, if Wolf et al.’s

prediction were true, European MNEs would be underrepresented in the group of truly

global and host-region oriented companies, and would account for the majority of home-

region oriented firms. The empirical data, however, show that the opposite is true:

European MNEs account for the lowest percentage of home-region firms and the highest

percentage of host-region ones, while the nine truly global MNEs are evenly distributed

among the three regions of the Triad (Rugman, 2005).

A relevant point in this context is that internalization theory does implicitly

consider the phenomenon of new regionalism, but it does so in the context of MNE

strategic positioning and its ability to link its FSAs with host country CSAs. Thus,

internalization theory provides a deeper, more firm-centric, and therefore more

strategically and managerially relevant perspective than the theory of new regionalism,

while the latter considered in isolation yields an incorrect prediction that contradicts the

empirical evidence.

H2 (based on the theory of new economic geography)

The theory of new economic geography stems from Marshall’s (1922) work on

the physical concentration of business firms, and attempts to explain the occurrence of

economic agglomeration. According to the new economic geography, two opposing

forces cause the spatial agglomeration of business. First is the force of agglomeration, fed

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by market size effects, condensed labour market effects, and effects stemming from

increasing returns in production. Second is the force of dispersion, driven by the

immobility of resources and the costs of increased economic activity in a particular

location (Krugman, 1998). The authors adapt the theory of new economic geography,

particularly the agglomeration side of the argument, to the Triad region level, and suggest

the following:

H2. MNEs from regions with a greater level of relevant agglomeration will tend

to be more home-region oriented than MNEs from regions with a lower level of

relevant agglomeration.

We agree with the authors’ view that a Triad region is too broad a geographic

context within which to consider agglomeration, and that relevant clusters need to be

investigated within each Triad region. Industrial clusters, such as Silicon Valley or

Boston’s Route 128, would provide a better unit of analysis. From an internalization

theory viewpoint, such industrial clusters offer incumbent MNEs a variety of CSAs, or, in

this case, location- rather than country-specific advantages, such as easy access to a

highly skilled professional labour pool and state-of-the-art technical knowledge due to a

superior educational infrastructure (e.g. proximity to leading technical universities and

business schools), easy access to venture capital, and access to knowledge held by

industry leaders. If these location advantages (LAs) are relevant to MNEs from the home

region and these MNEs have comparatively easy access to them, a home-region

orientation may result. Potential availability of complementary resources of external

actors (e.g. existing supplier networks; partnership opportunities) may also encourage

expansion inside a cluster. However, whether or not the expansion in fact occurs (and is

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successful) will be determined not by the MNE’s location near a particular innovation

cluster, but by its ability to gain access to the region’s LAs that may be held by local

actors (Hennart, 2009), and then to establish a match between its own FSAs and the

region’s LAs.

The dispersion side of the argument also needs to be considered: for example,

firms that possess FSAs superior to those of competitors and are vulnerable to

appropriation by competitors or third parties may shy away from locating in

agglomeration clusters in order to avoid proprietary knowledge dissipation. Further, there

is an industry effect on the level of clustering: e.g. firms in industries where knowledge is

highly idiosyncratic (e.g. financial and professional service firms) may not have a great

need to learn from competitors (Nachum & Wymbs, 2007). It should also be noted that

relevant LAs are likely to attract investment not only from home region MNEs, but also

from MNEs outside of the region – consider, for example, inward FDI in Silicon Valley

by Japanese MNEs (Teece, 1992). The above leads to the following prediction:

H2 - internalization theory version. Strong agglomeration in a region will not by

itself attract investment from MNEs, whether from within or outside the region.

Whether or not a home-region MNE chooses the region’s agglomeration cluster

as an expansion target depends on the potential synergies of melding the MNE’s

FSAs with the LAs of the region.

Extant empirical literature supports this internalization-theory-based proposition.

Nachum and Wymbs’s (2007) study on the location choices of financial and professional

services firms shows that LAs, including relevant agglomeration, do not determine MNE

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location choices – rather, location choices are influenced by the interaction between LAs

and the MNE’s FSAs.

H3a and 3b (based on the theory of the knowledge economy)

The theory of the knowledge economy argues that contemporary firms rely on

intellectual capabilities to a greater extent than on physical inputs and natural resources

(Powell & Snellman, 2004), and therefore sourcing, processing and exploiting knowledge

are critical tasks for these firms (Dunning, 2000). The label ‘knowledge economy’ covers

a wide variety of research streams (Powell & Snellman, 2004). It includes literature on

knowledge networks, which argues that knowledge is rarely possessed by a single firm

and resides within networks of firms and institutions in a particular environment (Dicken,

1999), and literature on knowledge spillovers, which studies the effects of inter-firm,

intra-industry knowledge spillovers on R&D and innovation (Cohen & Levinthal, 1989).

Wolf et al. combine knowledge networks and knowledge spillover arguments to

hypothesize a strong linkage between low geographic distance and various types of

effective knowledge transfer:

H3a. The more knowledge intensive an MNE is, the more it will pursue a home-

region orientation.

Even if only strategic asset seeking expansion is pursued, the above proposition

may hold solely in cases whereby the home region of the knowledge-intensive MNE

considered has relevant knowledge clusters, so that valuable knowledge recombination

can occur inside the region. If not, the MNE may undertake an expansion into host

regions where desired knowledge is located, as illustrated by Japanese FDI in Silicon

Valley (see the previous section). From an internalization theory perspective, this

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expansion serves the purpose of accessing relevant LAs, either within or outside the

home region. In addition, in case of market seeking expansion, a higher knowledge

intensity could foster more globalization rather than regionalization, depending on the

non-location boundedness of the knowledge at hand.

In any case, access to proximate knowledge clusters does not guarantee

innovative performance. The development of new economic theories, such as the new

economic geography and the theory of the knowledge economy, has led to a tendency to

overemphasize the importance of the region at the expense of the firm-level factors

(Dicken & Malmberg, 2001; Maskell, 2001). Empirical evidence in the strategic

management literature suggests that FSAs remain ultimately more important for an

MNE’s ability to produce innovations than the regional environment (Beugelsdijk, 2007).

Related to this point, different firms will benefit from LAs offered by knowledge clusters

to a different extent. Firms possessing the most advanced technologies may have

incentives to locate away from clusters in order to protect their core capabilities from

dissemination to weaker competitors (Nachum & Wymbs, 2007). Microsoft’s location in

Seattle rather than in Silicon Valley is a case in point. Taking the above elements into

account, we can restate H3a as follows:

H3a - internalization theory version. Higher knowledge intensity of an MNE will

not result in a stronger home-region orientation.

Wolf et al. (2012) further suggest that different activities within the MNE are

associated with different requirements for knowledge transfer, with the knowledge

generated in the upstream parts of the value chain (such as R&D) being more valuable

than knowledge generated in the downstream parts (such as sales and marketing).

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Combined with the previous reasoning on intra-regional knowledge transfer, this led to

the following proposition (where upstream value chain activities are considered more

knowledge-interdependent than downstream value chain activities):

H3b. The more knowledge-interdependent [i.e., upstream] activities of an MNE

will pursue more of a home-region orientation than the less knowledge-

interdependent [downstream] activities.

Internalization theory suggests that the extent of home-region orientation can be

different for different value chain activities, namely downstream vs. upstream activities,

but offer a reverse prediction: globalization, when it does occur, happens predominantly

in the upstream end of the value chain, with the downstream activities maintaining a

stronger home region focus. This proposition is empirically supported by the data in

Rugman and Verbeke’s (2004) flagship study, which shows that many large MNEs do

have a strong geographic dispersion of their R&D, sourcing and production, but are not

capable of achieving a global distribution of sales. The reason is that FSAs required in

upstream activities to achieve global sourcing of R&D outputs, raw materials,

intermediate inputs, labour and capital, and production are very different from the FSAs

required in downstream activities to achieve global distribution of sales. Adaptation of

downstream activities requires a higher level of local responsiveness, as the knowledge

bundles that have to be accessed and deployed at the downstream end in a host region are

likely quite different from the knowledge combinations effective in the home region

(which does not necessarily hold for more upstream activities). Upstream activities, on

the other hand, provide the greatest potential for scale economies, whereby a

concentration of these activities often can be achieved in home regions (Verbeke, 2009).

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 Further, MNEs differ in their ability to adapt upstream and downstream activities

separately, i.e. in their decoupling flexibility (Rugman & Verbeke, 2008a). Strong

decoupling flexibility means that upstream and downstream activities can be easily

adapted separately; most brand-named goods fall into this category. Weak decoupling

flexibility means that upstream and downstream activities have to be performed

simultaneously/cannot be separated, as is the case in many professional knowledge-

intensive services, such as engineering services or management consulting. This

distinction is partially responsible for a comparatively higher home-region orientation of

knowledge-based services vs. manufacturing MNEs, as demonstrated in Rugman and

Verbeke’s (2008a) empirical study, which shows that services MNEs’ decoupling

flexibility is usually considerably weaker than that of manufacturing MNEs. Building

upon the above, H3b can be restated as follows:

H3b - internalization theory version. Assuming strong decoupling flexibility, i.e.

being able to separate upstream and downstream adaptation, MNE downstream

value chain activities will tend toward home region orientation more than

upstream activities.

Perhaps part of the problem with Wolf et al.’s (2012) proposition is that they

view upstream activities as more knowledge-interdependent than downstream activities.

In reality, downstream activities require an expert recombination of complex bundles of

knowledge related, inter alia, to foreign cultures, customer preferences and institutions.

H4a, 4b and 4c (based on psychic distance theory)

Psychic distance, when applied in the international business context, reflects

MNE managers’ perceptions of differences in business-relevant characteristics between

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home and host countries (Brewer, 2007). Psychic distance is influenced by a variety of

cultural, political, economic, as well as personal factors (e.g. language, religion,

education, etc.). As psychic distance is believed to vary systematically with the

geographic distance between countries, the authors propose the following:

H4a. The greater managers’ perception of the psychic distance between the home

region and other regions, the more the respective MNE will be home-region

oriented.

Observing that Asian countries are likely more psychically distant from European

and North American countries than the latter are from each other, they further predict

that:

H4b. When other factors are controlled for, Asian MNEs will tend to be more

home-region oriented than European and North American MNEs.

The concept of psychic distance is somewhat similar to the four distance

dimensions between the home and host country – cultural, administrative (or

institutional), geographic (or spatial) and economic (Ghemawat, 2001) – that is central to

internalization theory. From the internalization theory perspective, distance is a critical

concept that affects the transferability, deployability, recombination and exploitation of

FSAs across borders. If any dimension of distance increases, so do the costs of doing

business abroad, as well as the challenges of effectively deploying FSAs in a host

environment. Distance creates new bounded rationality challenges for managers who

must understand drastically different subsidiary environments, as well as bounded

reliability problems (Verbeke & Greidanus, 2009) to the extent that it becomes difficult

for the head office to achieve proper monitoring and goal alignment with the subsidiary.

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 To add to the complexity of the notion of distance, the various distance

dimensions are not independent of each other, but rather intertwined and interdependent.

For example, regional economic integration fosters institutional coordination, which in

turn may contribute to decreasing cultural distance through improved mobility of labour

and managerial best practices. It is then the compounded distance, defined as the need to

manage various distance dimensions simultaneously, that has the most substantial effect

on the firm’s ability to deploy successfully and efficiently its FSAs abroad (Rugman et

al., 2011a). The concept of compounded distance is essentially equivalent to psychic

distance.

The assumption that greater compounded distance between regions might lead to

a greater home-region orientation may seem plausible at first sight. However, a general

statement about a positive relationship between inter-regional distance and MNE home-

region orientation would appear somewhat simplistic. First, macro level distance may be

different in different parts of the value chains, e.g. upstream vs. downstream, as discussed

in the previous section. Consider North American Levi Strauss: its sales are strongly

home-region oriented, yet the entire bundle of upstream activities is located in Asia and

Latin America (Rugman, Verbeke & Yuan, 2011b). Second, the foreign entry motive

may also moderate the influence of distance on the MNE’s decision to make an

investment abroad. A strategic resource seeking MNE may find a high-distance market

particularly instrumental to learning opportunities potentially unavailable in low-distance

locations (Verbeke, 2009). Similarly, a natural resource seeking MNE may expand into a

distant country/region due to unavailability of sought resources in the home region, or in

more proximate regions, as shown in Benito and Gripsrud’s (1992) analysis of FDI by

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Norwegian MNEs. The internalization perspective suggests, again, that the level of the

MNE’s geographic scope will be determined by the extent to which the MNE is able to

deploy and recombine its FSAs to cope with compounded distance between the home and

host countries while reaching its strategic goals.

Similarly, the influence of the home region itself on the propensity toward a

home-region orientation, as hypothesized in H4b, is a macro level observation that

ignores firm-specificity (Verbeke, 2009). In reality, firm-level distance could be smaller

than macro level distance due to, for example, senior management’s extensive business

experience in the host region or a presence of relevant business and/or government

connections.

Rugman and Verbeke’s (2004) empirical results confirm the above reasoning.

Contrary to Wolf et al.’s prediction, Asian MNEs do not tend to be the most home-region

oriented – while they are more home-region oriented than their European counterparts,

they are significantly less home-region oriented than North American companies

(Rugman, 2005). Granted that ‘all other factors’ were not necessarily controlled for, this

nevertheless points at limitations of macro level distance analysis. We therefore propose

the following:

H4a,b - internalization theory version. There is no generalized relationship

between compound inter-regional distance and the degree of MNE’s home-region

orientation. Decisions on FDI into a high-distance host region are moderated by:

• The MNE’s foreign entry motives;

• the specific activities in the value chain for which expansion is

considered;

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 • the micro level distance between the firm and the host region; and

• the MNE’s command of requisite recombination capabilities necessary to

overcome distance.

Exploring psychic distance theory further, the authors combine it with the

Uppsala model, which focuses on the internationalization process. The Uppsala model

proposes that international expansion is a function of the MNE’s past international

experience and knowledge base (Johanson & Wiedersheim, 1975; Johanson & Vahlne,

1977, 1990; Luostarinen, 1979), and postulates that firms undertake international

expansion in an incremental and path-dependent manner. The following proposition

results:

H4c. The greater the international experience of an MNE, the more global will be

its orientation and the less it will exhibit a home-region orientation.

Here, the logical flow from theoretical assumptions to the proposition is not

entirely clear. First, host region expansion targets are not necessarily distant on all

dimensions (e.g. Spain and Mexico are located in different regions of the Triad but share

a common language and cultural heritage). Second, it is not clear how international

experience is defined (e.g. the number of countries where the MNE has a presence, the

extant diversity of subsidiaries, the number of employees in different countries, etc.).

The level of international experience alone would not necessarily lead to a greater ease in

entering a distant region, as the MNE ultimately needs to address incremental, or added,

distance (Hutzschenreuter, Voll & Verbeke, 2011). Even a higher level of diversification

of the MNE’s current locations does not necessarily imply a greater incentive for - and

ease of further expansion into - distant countries, as the ease of further expansion

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(meaning really ease of FSA adaptation and recombination) depends on a particular

expansion target, as well as the presence of recombination capabilities and relevant

experience within the MNE’s current international portfolio. Further, empirical evidence

suggests that extant cultural diversity of the MNE’s subsidiary network will actually

reduce the rate of subsequent internationalization, because heterogeneity among

subsidiaries increases complexity and ties up managerial resources that could otherwise

be dedicated to further international expansion (Hutzschenreuter et al., 2011). With the

above considerations in mind, we suggest the following:

H4c – internalization theory version. There is no generalized relationship

between the MNE’s level of international experience and its home-region

orientation.

H5 (based on escalating-commitment theory)

Escalating-commitment theory draws on behavioural aspects of managerial

decision-making to describe situations whereby managers hold on to - and continue to

reinvest in - certain actions (i.e. ‘escalate’ their commitment to these actions) even if

these actions have failed to achieve strategic goals in the past and are unlikely to do so in

the future (Brockner, 1992). The authors blend escalating-commitment theory with two

IB concepts: administrative heritage and the multinationality-performance relationship.

Administrative heritage describes the firms’ key routines and tacit knowledge that often

develop at the time of inception and are influenced by the vision of the founder and the

firm’s set of external circumstances. The literature distinguishes among four archetypes

of administrative heritage: centralized exporter, international projector, international

coordinator and multi-centered MNE (Verbeke, 2009). The literature on the

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multinationality-performance relationship suggests that a systematic, fixed relationship

exists between the MNE’s degree of multinationality and its performance. In this

context, Wolf et al. cite evidence that home-region oriented MNEs typically perform

worse than global, bi-regional or host-region oriented MNEs. The blending of the

implications of the above research streams results in the following proposition:

H5. MNEs’ development from a home-region orientation towards a global

orientation is a slow (longsome) process. The effect of the amount of a MNE’s

international experience on its home-region orientation is low.

It should be noted that this proposition directly contradicts H4c.

Internalization theory rejects the notion that a fixed, systematic relationship

should exist between the MNE’s geographic scope and its performance (Hennart, 2007;

Verbeke & Brugman, 2009; Verbeke et al., 2009; Verbeke & Forootan, 2012) and

consequently between its degree or regionalization and performance, as domestic and

international success will be determined by the firm’s ability to develop, transfer, deploy

and exploit its FSAs rather than by its geographic scope per se. As such, contrary to

Wolf et al.’s reasoning, performance factors are unlikely to drive the MNE’s commitment

towards a specific geographic scope, whether this entails maintaining home-region

orientation or moving toward globalization.

This notwithstanding, internalization theory adopts a Penrosean (Penrose, 1959)

view of MNE international expansion being a path-dependent process, with the path-

dependency being driven by the availability of resources and the need for new FSA

development and current FSA adaptation possibilities. Further, an MNE’s extant

international experience does not necessarily influence its home-region orientation, as

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discussed in the previous section. Internalization theory thus yields the following

prediction, very similar to Wolf et al.’s, but following a different logic:

H5 - internalization theory version. MNE’s development from a home-region

orientation towards a global orientation depends upon its resource recombination

trajectory. There is no systematic effect of the level of an MNE’s international

experience on its home-region orientation.

H6 (based on population ecology)

Developed in Hannan and Freeman’s (1977) classic article, population ecology

theory emphasizes the influence of selection pressures from the external environment on

a firm’s survival. The argument is that profit maximizers are selected, while the ability

itself to maximize profits depends on the organization’s ability to adapt to the

environment. This explains persistence of organizational forms over time. Wolf et al.

develop a population ecology argument for regionalization, proposing the following:

H6. If, in the population of MNEs, the degree of home-region orientation

decreases over time, this will rather be the consequence of a selection process

than an assimilation process.

Internalization scholars agree that regionalization is an open-ended phenomenon

over time, in the sense that there is nothing deterministic about the international

expansion trajectory followed by individual MNEs (Rugman & Verbeke, 2004). The

reality of a multinational firm, however, is such that globalization by selection appears to

be a simplification, since a combination of environmental factors and firm-specific

factors influence firm-level action. In fact, globalization may never occur, as

regionalization may be chosen as the preferred strategic alternative, based on cost-benefit

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calculus (Rugman & Verbeke, 2004). Alternatively, globalization may occur suddenly as

a result of a strategic acquisition. Internalization theory focuses on the interaction

between firm-level strategies and the environment, whereas population ecology

emphasizes selection pressures by the external environment, thereby neglecting firm-

specific factors.

When globalization does occur, it will likely be driven by a combination of

changes occurring at the level of the population of relevant firms, and adaptation at the

firm level. Koza and Lewin (1998) argue that new organizational forms resulting from

MNE internationalization are an outcome of the co-evolution of the competitive and

institutional environments, and firm intentionality. Rugman and Verbeke (2004) apply

this thinking to the regionalization phenomenon and argue that MNE regional strategies

are embedded in – and co-evolve with – the broader competitive, organizational and

institutional contexts at the regional level. This suggests the following proposition:

H6 - internalization theory version. An MNE’s development from a home-region

orientation towards a global orientation results from firm-level strategy and

environmental factors; therefore, globalization may never occur, may occur

slowly or may occur suddenly. When globalization does occur, it is driven by a

combination of selection and adaptation processes.

H7a and 7b (based on neo-institutional theory)

Institutional theory’s basic tenet is that a firm’s behaviour is largely driven by

isomorphic pressures from the social and institutional environment in which the firm is

embedded (DiMaggio & Powell, 1983; Haveman, 1993; Meyer & Rowan, 1977; Tolbert

& Zucker, 1983). While institutional theory pays little attention to firm-specific drivers

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of behaviour, neo-institutional theory ascribes a more active role to the firm as an active

carrier of change and innovation (Dacin, Goodstein & Scott, 2002; Leblebici, Salancik,

Copay & King, 1991; Sherer & Lee, 2002). Applying neo-institutional theory to the

regionalization phenomenon, Wolf et al. argue that different industries are subject to

different institutional pressures, which leads to the following prediction:

H7a. MNEs from different industries vary in terms of their degree of home-region

orientation.

The authors further suggest that competitors and suppliers are highly relevant to

the MNE’s legitimization process, and therefore:

H7b. If the competitors and suppliers of an MNE are home-region oriented, this

firm will also have a relatively strong tendency towards the home region.

Internalization theory, with its focus on blending firm-specific and environment-

specific factors, supports institutional theory’s key assumption of firms’ social and

institutional embeddedness. As argued in the previous section, MNE strategic choices,

including regional strategy, are believed to evolve interdependently with changes in

prevailing industry practices, legitimate organizational forms, government regulations

etc. (Rugman & Verbeke, 2004), and therefore MNEs from different industries may

indeed vary in their regional strategies. Further, MNEs from different industries differ in

their inter-regional expansion potential, which depends largely on their ability to de-

couple upstream and downstream activities (as discussed under H3b above), and on the

extent of their supply-side autonomy of location choices (Rugman & Verbeke, 2008a).

As such, internalization theory supports H7a:

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 H7a - internalization theory version. MNEs from different industries vary in terms

of their degree of home-region orientation.

Much empirical support can be found for this proposition in extant literature.

Rugman’s (2005) classic text on regionalization offers a breakdown of regionalization

levels by industry; studies conducted by Oh and Rugman (2006) and Rugman and Girod

(2003) explore regionalization in specific industry contexts, and Rugman and Verbeke

(2008a) present empirical evidence of different levels of regionalization in service

industries versus manufacturing.

MNEs are likely to strive to maintain proximity to relevant supplier networks.

However, suppliers’ locations will not necessarily dictate MNE location choices.

Whether or not an MNE will be compelled to follow a supplier’s geographic strategy

depends on the transactional features of the buyer-supplier relationship. A large MNE

with strong FSAs and significant purchasing size (Porter, 1980) may in fact be followed

by a supplier, rather than being a follower itself. In terms of competitors, MNEs may

indeed attempt to gain access to relevant knowledge spillovers and therefore locate close

to competitors; however, they may also choose to put some distance between themselves

and competitors in order to avoid dissipation of their own competitively relevant

knowledge. This, again, is particularly true for large MNEs with strong FSAs that are

vulnerable to appropriation by other firms due to their public goods’ nature (Grøgaard &

Verbeke, 2012). Whether or not the MNE follows its competitors geographically

depends on the extent to which the firm’s technological knowledge is critical to its

existence, and more generally on the nature of the firm’s FSAs as discussed under H2

above. Location choices depend on the interaction of LAs (in this case, availability of

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supplier networks and proximity of relevant competitive knowledge) with the firm’s

FSAs. Wolf et al.’s H7b thus appears at odds with internalization theory:

H7b - internalization theory version. There is no systematic relationship between

the MNE’s home-region orientation and that of its suppliers and competitors.

As discussed above under H2, current empirical evidence supports this

proposition.

EXISTING EMPIRICAL SUPPORT AND POTENTIAL EMPIRICAL TESTS

As noted above, some of our new propositions formulated from the internalization

theory perspective have already been empirically tested in extant research. For example,

Rugman’s (2005) book contains an analysis of intra-regional sales by region that supports

the lack of a relationship between the region’s level of economic liberalization and the

degree of home-region orientation of firms headquartered in this region, as hypothesized

in H1. The same data support the lack of a higher degree of home-region orientation of

Asian MNEs suggested by H4b. A study by Nachum and Wymbs (2007) demonstrates

that MNE location choices are not determined solely by LAs, including the presence of

relevant agglomeration, but rather by an interaction of those LAs with the firm’s FSAs;

their results provide support for our H2 and H7b. H3b is supported by Rugman and

Verbeke’s (2004) data showing asymmetry between upstream and downstream

regionalization. Studies conducted by Oh and Rugman (2006), Rugman (2005), Rugman

and Girod (2003) and Rugman and Verbeke (2008a) present empirical evidence of

different levels of regionalization in different industries hypothesized in H7a.

H3a can be tested using Rugman and Verbeke’s (2004) data by assigning various

levels of knowledge intensity to companies based on three sources of economic

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knowledge – industry R&D, skilled labour, and the size of the pool of basic science for a

specific industry (Audretsch & Feldman, 1996), and by regressing home-region

orientation on knowledge intensity. Similarly, H4c and H5 on the lack of a systematic

relationship between MNE international experience and its home-region orientation could

be statistically tested using data from Rugman and Verbeke’s (2004) study, with the level

of international experience operationalized as the number of countries where the MNE

has a presence (a more sophisticated test would involve a measure of the MNE’s extant

diversity; extant diversity could be operationalized as the sum of the cultural distances

between the countries of every pair of subsidiaries, consistent with Hutzschenreuter et al.,

2011).

We should, however, not lose sight of methodological limitations of statistical

tests, and should keep in mind Yair Aharoni’s (1993) warning against relying solely on

databases and industry averages in explaining MNE performance and behaviour.

According to Aharoni, statistical tests do not capture the MNE’s uniqueness, which could

reside, for example, in the MNE’s absorptive capacity to digest different cultures and to

employ productively managers of many nationalities, or in its managerial experience and

entrepreneurial qualities. These higher-order FSAs are often at the heart of achieving

superior performance, yet are not easily measured in quantitative terms. In our case, this

is particularly true for H4, H5 and H6, which deal with such complex and

multidimensional constructs as foreign entry motivation, micro level distance,

recombination capabilities, path dependence, experience and FSA adaptation. These

constructs are difficult to operationalize accurately, without losing valuable rich data that

are unique to each particular MNE. Here, in-depth case analyses would likely be more

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helpful than quantitative methods in uncovering the linkages among the MNE

international expansion targets, its FSAs and its regionalization strategies.

CONCLUSION

Wolf and his colleagues have usefully suggested that a multifaceted,

interdisciplinary approach can enrich our understanding of MNE regional strategy and

structure. Indeed, in a field as complex and multidimensional as international strategic

management, interdisciplinary reflection can add much value by facilitating the cross-

pollination of ideas, broadening the scope of available methodologies, and increasing the

pool of knowledge and experience on an important subject matter. This is precisely why

internalization theory has been so influential as a general theory of the MNE.

Internalization theory implicitly but powerfully blends key ingredients from paradigms

used in strategic management, such as TCE, RBV and the dynamic capabilities approach,

and is tied to broader concepts from disciplines beyond strategic management, such as

psychology, cultural anthropology, geography, history, political science and sociology.

Even mainstream TCE, upon which the economic argument of internalization theory is

based, is not a ‘pure-play’ economic theory, but rather a comprehensive blend of

economics, law and organization science (Williamson, 1996).

Wolf et al. appropriately recognize the need for a broad social focus when

explaining regionalization and offer much needed support for this phenomenon, but we

question the substantive value added beyond the extant internalization theory explanation.

They offer a list of hypotheses, but the question arises whether these hypotheses really

constitute theory (Sutton & Staw, 1995) – especially when considering that some

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hypotheses contradict each other (e.g. H4a and H5), or offer essentially the same

prediction but from a different angle (e.g. H2 and H3a)

Ultimately, the authors have formulated a set of somewhat disconnected

propositions analyzing the regionalization phenomenon through seven separate

conceptual lenses. It could be argued that enriching extant theory would require the

various conceptual lenses adopted to be used in a complementary fashion. Internalization

theory already achieves this goal: it relies on multiple ‘neighbouring’ concepts and in fact

embeds, in its own logic, all of the theories described by Wolf et al. (2011), as reflected

in the core concepts of bounded rationality, bounded reliability, compounded distance,

FSAs, CSAs, LAs, recombination, complementary resources and co-evolution (see Table

2.1). Internalization theory’s broader and more nuanced view of the MNE likely explains

contradictions that exist between the authors’ original hypotheses and the restated

internalization theory hypotheses.

(Table 2.1 about here)

A good theory, as famously stated by Weick (1979), has general applicability,

simplicity and accuracy. Internalization theory, particularly its contemporary version,

does have such general applicability in that it covers a wide variety of aspects of MNE

functioning, simplicity in that it builds upon a limited number of foundational principles

(Rugman & Verbeke 2008b), and accuracy in that it yields managerially relevant

predictions that have been supported by empirical evidence. Wolf et al.’s set of

hypotheses, though intellectually interesting, adds an unnecessary layer of complexity

because no attention was devoted to parsimony. In contrast, internalization theory does

provide a complete and parsimonious explanation of the regionalization phenomenon.

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Table 2.1. Complementary social science theories embedded in internalization theory
concepts
Complementary social science
theory (Wolf et al., 2012)
New regionalism
New economic geography
Knowledge economy
Psychic distance
Escalating commitment
Population ecology
Neo-institutional theory
!
Corresponding internalization theory concepts
(core or coopted concepts)
• Institutional, geographic, and economic distance
(proxies for additional costs of doing business
abroad)
• Government-imposed market imperfections (trade
barriers)
• LAs/CSAs
• Geographic distance
• Markets for intermediate products (various types
of knowledge)
• Complementary resources of external actors
• LAs/CSAs
• Geographic distance
• Compounded distance
• Cultural distance
• Bounded rationality
• Bounded reliability
• LB versus NLB FSAs
• Bounded rationality
• Bounded reliability
• Resource recombination trajectories
• Administrative archetype (reflected in higher order
FSAs, namely routines)
• Resource recombination trajectories
• Co-evolution of FSA-CSA bundles
• Administrative archetype
• Co-evolution of FSA-CSA bundles
• Complementary resources
• Institutional distance
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 Essay 3

NO NEW THEORY NEEDED TO STUDY MNEs FROM EMERGING

ECONOMIES

The recent surge of emerging economy multinational enterprises (EMNEs) has prompted

a debate on whether existing international business (IB) theory, i.e., internalization

theory, can accommodate this phenomenon, or whether new theory is required to study

EMNEs. Advocates for a new theory cite three alleged shortcomings of internalization

theory. First is its MNE-centric nature and related inability to account for institutional

differences between emerging and developed economies. Second is the EMNEs’ alleged

lack of firm-specific advantages (FSAs), which makes it inappropriate to study these

companies through a conceptual lens that assumes strong FSAs. Third is the EMNEs’

unique set of motivations for internationalization. Our view is that these flawed

contentions stem from an incomplete understanding of internalization theory. We

demonstrate that EMNEs indeed possess FSAs, and that contemporary internalization

theory is sufficient to address the complexity of EMNEs, including the impact of

institutional specificities and the unique nature of EMNEs’ FSAs and FDI motivations.

We illustrate our argument with examples of ten large successful EMNEs from Asia and

the Americas.

INTRODUCTION

Emerging markets, comprised of countries with a rapid pace of development and

government policies that favour economic liberalization, are assuming an increasingly

prominent position in the world economy (Wright et al., 2005), in MNE strategic activity

(Verbeke, 2009), and, consequently, in international business (IB) research. Hoskisson et

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al. (2000) identified sixty four emerging economies, of which fifty one were rapidly

growing developing countries, and thirteen were in transition from centrally planned to

market economies. The growth of emerging economies is reflected in an upsurge of IB

research on the topic, offering three broad areas for consideration by IB scholars:

situations where firms from developed economies enter emerging economies, situations

where firms from emerging economies enter developed economies, and situations where

firms from emerging economies enter other emerging economies. The last two areas of

research have been of particular interest to IB scholars over the past two decades, since

many MNEs from the BRIC (Brazil, Russia, India and China) and VISTA (Vietnam,

Indonesia, South Africa, Turkey and Argentina) countries, as well as from Mexico and

Thailand, have embarked on successful international operations. The rapid rise of

emerging economies’ multinationals (EMNEs) has prompted the question – cleverly

termed “the goldilocks debate” by Cuervo-Cazurra (2012: 153) – of whether existing IB

theories can accommodate the new phenomenon, or whether a significant adjustment to

extant theory, or even an entirely new theory is required to explain EMNEs’ patterns of

internationalization, as well as their broader strategy and organization. To date, no

consensus has emerged on the topic (Ramamurti, 2009). A number of authors (see Child

& Rodrigues, 2005; Filatotchev et al., 2007; Luo & Tung, 2007; Mathews, 2002a, 2002b,

2006a and 2006b; Peng et al., 2001) argue that EMNEs represent a new class of firms

that follow patterns of international expansion completely different from those of MNEs

from developed countries, and therefore call for a new theory. Others (see Buckley et al.,

2007; Dunning, 2006; Hennart, 2011, 2012; Narula, 2006, 2012; Rugman, 2009) suggest

that extant IB theory, especially as exemplified in contemporary paradigms, is well

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equipped to describe and explain EMNE internationalization patterns. Yet, a third group

of authors (see Cuervo-Cazurra & Genc, 2008; Cuervo-Cazurra, 2012; Guillen & Garcia-

Canal, 2009; Ramamurti, 2009) subscribe to a mid-point view that existing core IB

theories can be applied to the EMNE phenomenon provided that they are substantially

revised and augmented.

The dominant theory of the MNE is internalization theory, which combines

transaction cost economics (TCE) and resource-based foundations, subscribes to a

dynamic view of firm-specific advantages (FSAs) and views the MNE as a network

organization. In this paper, we argue that internalization theory is sufficient to address the

reality and complexity of MNEs from emerging economies. In the following sections, we

provide a brief history and overview of internalization theory, follow up with a review of

the debate on the theory’s capacity to address the EMNE phenomenon in terms of

explaining MNE internationalization patterns, and conclude with a demonstration of

internalization theory’s parsimonious applicability to a wide range of IB phenomena,

including EMNE functioning. We illustrate our argument by applying internalization

logic to ten large EMNEs and show that main internalization theory tenets still hold in the

emerging economy context.

INTERNALIZATION THEORY: PAST AND PRESENT

Internalization theory provides a credible rationale for the existence of the MNE,

and has guided much IB research during the past thirty five years (Buckley & Strange,

2011). It has been characterized as a general theory of the MNE (Rugman, 1981). First

conceptualized by Buckley and Casson (1976), internalization theory has its roots in the

work of Coase (1937), Hymer (1968, 1976) and McManus (1972). The Coasean

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transaction cost approach, according to which a hierarchy supersedes the market if it can

organize transactions more efficiently, provides perhaps the most critical antecedent of

internalization theory. Internalization theory has extended Coase’s arguments,

conventionally applied in a domestic context, to the MNE, which is viewed as an internal

market operating across national borders (Verbeke & Greidanus, 2009). Here, the focus is

on comparing the relative costs and benefits of coordinating cross-border economic

activities internally by the firm’s management with the cost of managing transactions

externally through the market (Buckley & Strange, 2011). The core argument of

internalization theory is that exploiting and further augmenting a firm’s knowledge-based

assets across national boundaries is often more efficiently undertaken internally, within

the MNE hierarchy, than through the use of market mechanisms. Firms aim to maximize

profits by internalizing their intermediate markets for knowledge and experience across

national borders in the face of various market imperfections such as information

asymmetries, government interventions in the form of trade barriers, issues associated

with national patent systems, the lack of future markets, imperfect pricing of knowledge

etc. (De Gennaro, 2005; Rugman et al., 2011a). MNE internal organization is aimed to

enable exploitation and further development of FSAs in intermediate products, whose

proprietary ownership helps MNEs overcome the externality of knowledge being a public

good. MNE resulting from the internalization process can thus be seen as a governance

mechanism for developing and exploiting FSAs (Rugman & Verbeke, 2008b). However,

internalization theory is as much a theory about conducting transactions internally, as it is

about considering alternative governance modes such as contracts and alliances when

these are likely more efficient than hierarchy.

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 First proposed by Hymer (1960, published in 1976; 1968) and consequently

developed in Buckley and Casson’s (1976) work, the concept of FSA yields the core

insight that foreign direct investment (FDI) only takes place when the benefits of

exploiting FSAs through internalization can help overcome the additional costs and risks

of doing business abroad, i.e., the liability of foreignness (Zaheer, 1995). International

expansion thus becomes a firm-level strategy decision rather than simply a financial

portfolio decision determined by interest rate differentials across national borders

(Dunning & Rugman, 1985).2

The idea of idiosyncratic bundles of FSAs, which relate to special knowledge or

capability unavailable to competitors (Rugman, 1981) and give the MNE the potential to

compete in host nations, foreshadowed the modern resource-based view’s concept of

VRIO (valuable, rare, inimitable and organized in such a way as to allow a firm to

achieve competitive advantage) resources (Barney, 1991), and had its origins in the

pioneering work of Edith Penrose (1959). Yet, unlike Penrose who believed that

constraints to the firm’s growth resided entirely with the entrepreneur, internalization

theory ascribes a more active role to the firm’s environment, seeing it as a constraining or

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
2
Hymer pioneered a firm-level, industrial organization approach to FDI that was later

popularized in Dunning’s (1981, 1988) Ownership-Location-Internalization (OLI)

paradigm, which combines ownership, internalization and location advantages to explain

MNE foreign entry mode choices. Dunning’s OLI paradigm is frequently referred to as

an “eclectic paradigm” because of its comprehensive blend of several theory streams on

FDI.

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enabling force. This perspective is reflected in the concept of country-specific advantages

(CSAs) (Rugman, 1981). CSAs (e.g. natural resources, low cost labour, etc.) refer to the

attractiveness of particular locations for MNE international expansion. It is a combination

of CSAs and the firm’s FSAs that determines whether internal organization of the MNE’s

international activities will be efficient in a comparative institutional sense.

As such, internalization theory augments the TCE logic with a dynamic

capabilities-like perspective. The focus is not only on exploiting existing FSA bundles in

foreign markets, but also on managing the international FSA development and transfer

processes in their entirety, i.e., from early creation to subsequent usage across the MNE

network. Internalization theory in its current, most modern, iteration took a long time to

develop. Almost immediately after its inception (Buckley & Casson, 1976),

internalization theory was followed by a number of useful refinements and extensions

(see Buckley, 1983, 1998a, 1998b; Casson, 1979, 1986, 1987; Rugman, 1981; Teece,

1983). Still, early internalization theory, exemplified by the work of Buckley and Casson,

and Rugman, focused primarily on explaining which parameters would stimulate firms to

expand across borders and on investigating entry mode choice, and largely ignored

internal governance issues and organizational structures within the MNE. Subsequent

internalization theory developments, represented by the work of Hennart (1982) and

Rugman and Verbeke (1992, 2003), among others, led to what can be called the ‘new’

internalization theory, with the emphasis shifting to the MNE’s internal organization and

network capabilities. Hennart‘s early (1982) work, which focuses on managing

interdependencies between economic actors located in different countries and draws

attention to the role of complementary resources of foreign actors that the MNE may

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require in order to enable the exploitation of its own FSAs, can be seen as a beginning of

a shift toward the ‘new’ internalization theory. This line of thinking is further developed

in Hennart’s subsequent research, where he argues that host country CSAs are not

necessarily readily accessible to the expanding MNE. As a result, the MNE’s

international expansion is an equilibrium outcome of some strategic decisions made by

the MNE and other ones by owners of local CSAs (Hennart, 2009). In his most recent

work, Hennart (2011, 2012) uses his bundling model, which gives equal importance to

FSAs and CSAs, to analyze EMNE behaviour, predicting that EMNEs will make FDI

investments to access not only generally available CSAs, but also FSAs embedded in

foreign firms. Such FSAs may be accessible, inter alia, through employment contracts

with personnel located abroad and that can be ‘poached away’ from local rivals, or

through service contracts, e.g., to use local distribution networks, or through acquisitions

if the coveted FSAs are embedded in local firms and cannot be isolated from other assets.

The shift from the early internalization theory’s focus on economic efficiency and

identification of parameters that stimulated international expansion toward the new

internalization theory’s concern with internal organization and alternative governance

choices within the MNE is evident in the work of Benito et al. (2009) and Chen (2005,

2010). Benito et al. propose that the choice of foreign entry mode is not necessarily a

choice among well-specified discrete alternatives, but rather reflects a messier reality

where mode packages, within-mode adjustments and mode role changes frequently take

place, and the simultaneous presence of multiple modes in various types of combinations

is possible. Chen acknowledges the presence of various alternative market institutions

such as arm’s length co-marketing, contractual co-marketing and original equipment

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manufacturing (OEM), arguing that the choice of an optimal entry mode depends on the

relative costs and benefits of both the market for technology and the market for

manufacture. Like Hennart and Benito and colleagues, Chen specifically recognizes the

role of complementary assets controlled by host country-based economic actors in the

final choice of an operating mode. These dynamic extensions of internalization theory

significantly augment the early MNE-centric thinking, which indeed neglected the roles

of external actors and the complex functioning of market-based institutions.

Rugman and Verbeke (1992) offered a critical extension of internalization theory

by introducing the concept of location-bound versus non-location-bound (LB versus

NLB) FSAs. NLB FSAs are typically developed at headquarters (HQ) and are easily

transferable across borders to the entire MNE network. Examples of NLB FSAs include

technological, marketing or administrative knowledge – e.g., Toyota’s manufacturing and

quality control capabilities can be considered NLB FSAs. Conversely, LB FSAs are tied

to select affiliates within the MNE, whether the HQ or subsidiaries, and can include

stand-alone resources linked to location advantages in home markets (e.g. a network of

privileged retail locations), resources which may lose value when transferred across

borders (e.g. reputational resources), local best practices and routines, capabilities in local

responsiveness in a particular market etc. (Verbeke, 2009). The concept of LB versus

NLB FSAs has invited an important shift in internalization theory thinking: from the view

of the MNE as a hierarchical organization subsumed under HQ (Rugman & Verbeke,

2001), toward a more realistic analysis of the MNE as a differentiated network. Further,

this extension of internalization theory has led to the concepts of subsidiary-specific and

alliance-specific advantages (SSAs/ASAs), i.e., distinct strengths developed at the

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subsidiary or alliance level (Rugman & Verbeke, 2001; Verbeke, 2009), and embedded in

subsidiaries/alliances. Valuable SSAs offer potential for international exploitation, but

cannot necessarily be automatically dispersed throughout the rest of the MNE network.

Similarly, ASAs are embedded in the network and are lost when the MNE leaves the

network, as is the case with international airline alliances. The concepts of SSA and ASA

exemplify respectively the new internalization theory’s focus on MNE network

capabilities and internal governance, and its extension to MNE alliance networks.

A QUEST FOR NEW THEORIES TO STUDY EMNEs

During the past decade, the growth of emerging economies has invited an

increasing number of research studies on the topic, which has led to a vivid debate in the

IB scholarly community: Can extant IB theory explain EMNEs’ existence and

international expansion patterns, and can it be used to predict their profitability and

survival (Hennart, 2011)? A sizable group of IB scholars believes that EMNEs represent

an entirely new phenomenon and follow a pattern of expansion completely different from

that of their developed country counterparts. These scholars therefore advocate

developing a completely new theory.

First, internalization theory has been characterized as focusing on large, well-

established MNEs, and neglecting the pursuit of entrepreneurial opportunities (Autio,

2005), which are often at the heart of the EMNE’s international expansion decisions. In

this context, internalization theory has also been accused of tending toward one-sided,

firm-centric explanations of international business activity (Toyne, 1989), to the

exclusion of a role of formal and informal institutional underpinnings that largely shape

MNEs’ business environment, strategies and performance (Hoskisson et al., 2000; Peng,

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Wang & Jiang, 2008; Wright et al., 2005). The fact that EMNEs operate in an

institutional environment significantly different from that prevailing in developed

economies is considered a justification for a new, institution-based IB theory (Peng et al.,

2008).

Second, some authors have pointed at a disconnect between existing IB paradigms

and the very nature of EMNEs. While internalization theory, in particular, focuses on

FSA exploitation by MNEs, emerging economy multinationals are argued de facto not to

possess FSAs; according to this logic, they internationalize to acquire new FSAs rather

than to exploit existing ones (Mathews, 2002a, 2002b, 2006a and 2006b). These new

FSAs acquired through international expansion are then used as a springboard for further

internationalization (Luo & Tung, 2007). The fact that EMNEs essentially lack the very

feature supposed to drive internalization theory-based analysis is presented as evidence

that a new conceptual lens is needed to study EMNEs.

Third, related to the above point, EMNEs’ unique, key motivation to

internationalize, namely to mitigate/eliminate relative competitive disadvantages as

opposed to exploiting advantages as developed country MNEs do, is also cited as a

rationale for new theory development (Child & Rodrigues, 2005). In some cases, non-

economic objectives for expansion are argued to produce completely different patterns of

international expansion – Chinese state-controlled MNEs that may be pursuing a socio-

political agenda such as promoting industrialization, advancing technology and defending

national interests (Vernon, 1984), in addition to economic goals, are often cited as

examples.

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 Unfortunately, the above contentions appear to have been associated with a lack

of critical analysis as to the real application potential of contemporary internalization

theory by IB scholars working within the emerging economy context. Currently, four

separate, conceptual perspectives – TCE, agency theory, RBV and institutional theory –

have been proposed as leading theoretical frameworks for studying emerging economies

(Hoskisson et al, 2000; Meyer & Peng, 2004; Peng et al, 2001). However, internalization

theory, with its blending of TCE and RBV elements, and with its simultaneous focus on

analyzing transaction costs and effectively matching the firm’s FSAs to its environment,

can likely be instrumental in addressing EMNEs’ international expansion and

performance. We argue that rejection of internalization theory as a general theory of the

MNE, including the emerging economy MNE, stems largely from poor or incomplete

understanding of the theory, as we demonstrate in the next section of the paper.

INTERNALIZATION THEORY AS A GENERAL THEORY OF THE MNE:

DEBUNKING THE MYTHS

Internalization theory ≠ Static focus on transaction costs in established MNEs

Since its first iteration in Buckley and Casson’s classic work, internalization

theory has undergone a considerable evolution, from a relatively static economic

efficiency-focused model based mainly (though not exclusively) on TCE parameters, to a

dynamic theory focusing on development, deployment and exploitation of complex FSA

bundles in complex location-specific contexts. Unfortunately, this evolution has often

gone unnoticed by IB scholars, who tend to emphasize internalization theory’s early

transaction cost-based version without acknowledging its more recent dynamic

extensions (see Ellis, 2011; Kogut & Zander, 1993; Madhok; 1997). It is important to

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recognize that contemporary internalization theory actually does focus on managing

innovation processes in their entirety, and is therefore concerned not merely with

economizing, but also with strategizing for value creation purposes, including in the

context of subsidiary entrepreneurship, as discussed above.

In response to the charge that internalization theory has been derived primarily

from research on large western enterprises and is therefore predominantly MNE-centered,

to the exclusion of the role of external actors, countries and institutions, it should be

noted that the new internalization theory has long moved away from its MNE-centric

focus and has fully recognized the complex and multilateral nature of international

exchange. Hennart’s bundling model (2009, 2011, 2012), developed as an extension of

internalization thinking, takes into account interactions among MNEs, local firms and

host governments. Hennart successfully uses his bundling model to analyze EMNEs’

FDI. He predicts that EMNEs will expand abroad to access FSAs that are embedded in

foreign firms and accessible through employment contracts with overseas personnel.

Here, monopoly control of CSAs allows EMNEs to capture value from the joint

contribution of these CSAs and foreign-controlled FSAs (typically held by developed

economy MNEs), with FDI as one possible vehicle to generate bundling of these CSAs

and FSAs. Similarly, Chen’s (2010) multi-market framework integrates various

institutional modes available to MNEs and explicitly considers institutional contexts in

which MNEs operate, in addition to the firms’ FSAs.

Institutional differences are reflected in transaction costs

The difference in institutional environments between developed and emerging

economies hardly warrants an entirely new theory – rather, it is effortlessly handled

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within internalization theory and is reflected in differential transaction costs. Institutional

differences between developed and emerging economies are likely to give rise to

different levels of transaction costs associated with alternative entry modes, and to

present new economizing challenges (Wright et al., 2005). For example, MNEs from

developed economies competing in emerging economies face such consequences of

increased institutional distance as a lack of transparency, lax intellectual property rights

protection, deficiencies in legal enforceability etc. This is likely to exacerbate bounded

rationality and bounded reliability problems (Verbeke & Greidanus, 2009), thus bearing

on transaction costs and putting developed country MNEs at a competitive disadvantage

when compared to indigenous firms and EMNEs from other emerging economies. In

other words, institutions do matter in internalization theory because they can affect the

normally occurring additional costs of doing business abroad.

EMNEs do possess FSAs

As noted above, some scholars posit that EMNEs do not possess FSAs, and thus

their behaviour cannot be explained within the traditional FSA-centric framework.3 One
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
3
Some internalization theory scholars also subscribe to the position that EMNEs lack

FSAs (Rugman, 2009; Lessard and Lucea, 2009). According to this mistaken viewpoint,

EMNEs rely entirely on their access to CSAs (e.g. oil and gas in Russia, cheap labour in

China, etc.) – a strategy that is not sustainable in the long run. Unlike proponents of

EMNE-centric theories, these authors apply internalization theory to conclude that

EMNEs will not be successful abroad due to their lack of FSAs. In response to this line

of reasoning, it can be argued, in accordance with Hennart’s (2009, 2011, 2012) bundling

perspective, that even domestic CSAs are not readily accessible to all home country

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of the most well-known advocates of this viewpoint, Mathews (2002a, 2002b, 2006a,

2006b) argues that Asian EMNEs, which he terms Dragon multinationals, are essentially

resource-poor, yet have successfully expanded abroad without FSAs. Mathews’ LLL

framework, based on the premises of resource Linkage, Leverage, and Learning, suggests

that EMNEs internationalize to acquire FSAs from their established counterparts.

This misconception potentially stems from the confusion surrounding the notion

of FSAs, and from the failure to let go of conventional internalization theory in its earliest

iterations. Conventional empirical studies in internalization theory have focused on two

types of resources: 1) technological or R&D resources, as measured by the MNE’s R&D

spending; and 2) the value of the company’s brand, as measured by its advertising

expenditures. These very imperfect proxies for the firm’s true technological and

marketing capabilities may, in the past, have provided a reasonable approximation for an

MNE’s FSAs, but are largely inapplicable in the emerging economy context, where firms

may utilize completely different approaches to building technological capacity (including

technology purchases and early alliance formation), and may lack a history of advertising

in a traditional sense, i.e., as measured by advertising expenditures. Technology and

branding may indeed not be EMNE’s critical competitive strengths. Yet, this does not

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
MNEs. Access to these resources and the ability to utilize them in a profitable way should

be seen as distinct FSAs. In the emerging economy context, this access may imply an

extensive local business network or beneficial government connections – both

idiosyncratic resources that form a critical part of the firm’s bundle of FSAs, in addition

to the entrepreneurial capacity of many EMNE founders and senior managers.

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mean that EMNEs do not possess FSAs – only that their FSAs may be dramatically

different from those of developed economies’ MNEs. Here, the quality of management

plays a crucial role. Teece (2007) has convincingly argued that entrepreneurial

management is a critical, higher-order dynamic capability shaping the company’s

evolutionary fitness. This FSA in entrepreneurial quality largely accounts for the success

of the Indian Tata Group’s innovative Nano product (the world’s cheapest car), and for

the competitive worldwide presence of Taiwanese Acer Inc. Mexico’s Cemex, in turn,

owes its past international success to another complex managerial capability – its superior

system for managing international merger and acquisition processes. A Chinese ‘dragon’

Haier, while indeed expanding into developed countries in order to capitalize on

technology and knowledge assets, was able to do so largely due to its highly

entrepreneurial management, superior market research capabilities, and innovative

organizational structure.

A substantial group of IB scholars (Cuervo-Cazzura & Genc, 2008; Guillen &

Garcia-Canal, 2009; Ramamurti, 2009; Zeng & Williamson, 2007) have acknowledged

that EMNEs do possess FSAs, which can be exploited through FDI, though those FSAs

differ from traditional ones described in the IB literature on developed country MNEs.

FSAs mentioned include a better understanding of emerging market customers and ability

to adapt technology to develop products suited for special needs customers (relevant

when expanding to other emerging economies and competing with developed country

MNEs), cost innovations and operational excellence forced by sparse resources,

privileged access to their countries’ CSAs, adversity advantage (ability to effectively

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function in difficult conditions), fewer core rigidities and greater entrepreneurial freedom

as compared to large established MNEs,4 networking skills, political know-how, etc.

Yet, the argument that the dramatically different nature of FSAs requires a new

theory to study EMNEs is deeply flawed. All the EMNE FSAs listed above are examples

of higher-order FSAs, referred to in new internalization theory as recombination

capabilities – capabilities to combine and recombine existing and accessed resources

across borders in a way that creates value for the MNE (Verbeke, 2009). The fact that

EMNE strengths reside primarily in such higher-order FSAs rather than in more

conventional, technology-based ones, is hardly a reason for revising existing theory.

Irrespective of the nature of an MNE’s FSAs, internalization theory’s main prediction

still holds: The firm’s international success will depend on its ability to match

successfully its set of FSAs with host country CSAs. It is the generic characteristics of

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
4
Some of the FSAs frequently ascribed to EMNEs, such as greater flexibility to respond

to environmental changes and freedom to implement organizational innovation (Guillen

& Garcia-Canal, 2009), are obviously not EMNE-specific but can typically be found with

equal likelihood in smaller developed country MNEs at an early stage of

internationalization and growth.

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these FSAs (e.g., transferability across borders and inimitability) and CSAs (easily

transacted in open markets or not) that will determine optimal entry mode choice and

subsequent governance. In its parsimony, internalization theory can explain the particular

utilization of a wide range of FSAs, in terms of international deployment patterns

(location choices) and governance mechanisms selected, including those adopted by

emerging economy multinationals.

Motivations for internationalization are addressed in the context of matching FSAs

with CSAs

As a final point, international expansion decisions always serve particular

strategic goals or motivations, which then lead to particular desired FSA - CSA

combinations, and subsequent location choices and operating mode selections. In this

context, Guillen and Garcia-Canal (2009) summarize nine motivations for EMNEs’ FDI

documented in the literature: backward linkage into raw materials, forward linkage into

foreign markets, home-country government curbs, spreading of risk, movement of

personal capital abroad, following a home-country customer to foreign markets,

investment in new markets in response to economic reforms in the home country,

acquisition of intangible FSAs, and exploitation of intangible FSAs. However, these

‘unique’ motivations for international expansion do not necessitate a new theory either.

Many of the motivations identified for EMNEs can be found in developed economy

MNEs, as well, and, generally speaking, fit as subcategories into the four main FDI

motivations described in the extant, mainstream IB framework: natural resource seeking,

market seeking, strategic resource seeking, and efficiency seeking (Dunning & Lundan,

2008; Verbeke, 2009), as shown in Table 3.1. Whether or not EMNEs need to upgrade

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their capabilities while achieving their international expansion objectives is an issue of

matching FSAs with CSAs (Rugman, 2009), and is addressed fully by internalization

theory.

(Table 3.1 about here)

ILLUSTRATION: ‘WORLD CLASS EMERGING MULTINATIONALS’

In order to demonstrate the validity of the conceptual perspective developed

above, we now turn to the analysis of the expansion trajectories of real-world EMNEs, in

an effort to investigate whether EMNEs indeed possess FSAs, whether these FSAs are

similar to or different from FSAs of developed country MNEs, and whether EMNEs’

supposedly unique motivations to internationalize indeed create different

internationalization patterns. In other words, we apply internalization theory principles to

EMNEs to observe whether internalization predictions still hold in this context.

As a starting point of our analysis, we looked at the twenty five “world-class

emerging multinationals” described in Van Agtmael’s (2007: 59) classic book. We then

assessed which MNEs out of this group of twenty five companies had been the subject of

detailed business school cases, addressing their international expansion trajectories. This

led to inclusion of ten MNEs in our analysis, including five Asian-based ones, with the

other five being headquartered in the Americas. We then analyzed a total of fifty three

teaching cases on the selected EMNEs, supplemented by Van Agtmael’s (2007)

description of the sample companies. Table 3.2 and Appendix 3.1 present a list of the

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EMNEs studied, and corresponding lists of teaching cases5. Appendix 3.2 offers a

summary of vignettes taken directly from our data to illustrate our argument.

(Table 3.2 about here)

FSAs

Our reading of the data clearly showed that all ten EMNEs studied possessed

FSAs beyond access to home-country LAs. Some FSAs were indeed based on

preferential access to home CSAs – for example, Infosys’ and Tata Group’s access to top

engineering talent and to cheap skilled labour in India, or Concha Y Toro’s proximity to

Chile’s unique terroir (ideal conditions for wine-making). Yet, the EMNEs in our sample

relied on complex bundles of FSAs, both LB and NLB. Staring with LB FSAs, we

observed the following:

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
5!It should be noted that the use of teaching cases as secondary research data has

sometimes been criticized for unreported data bias (Kieser, 1994; Liang & Wang, 2004),

and two levels of abstraction (Miller & Friesen, 1977). However, teaching cases are

currently being legitimized as a reliable proxy for field research in management –

provided that they are used properly (Ambrosini, Bowman & Collier, 2010), which

means that cases should be selected through purposive sampling and drawn from

recognized case producers to ensure sufficient quality of information, and that multiple

cases and/or supplemental information should be used for each company to triangulate

the data. We followed this recommended protocol and, as a result, gained access to rich

micro level detail, as well as a longitudinal perspective, of teaching cases, while

controlling for potential bias.

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• Embeddedness in local networks, including extensive distribution and sales networks:

observed, for example, at Tata, Cemex and Lenovo.

• Government connections: Tata, Lenovo, Embraer, Samsung and Petrobras derived

extensive benefits from local government connections. Embraer and Petrobras had

strong ownership ties to governments; Samsung enjoyed extensive government

support as part of economic development efforts.

• Knowledge of local markets: Evident in particular at Haier, Tata, Cemex, and Lenovo,

superior knowledge of local markets allowed EMNEs to respond to local consumer

needs more effectively and efficiently than rival MNEs from emerging economies.

Among NLB FSAs, we identified the following:

• Entrepreneurial agility: Infosys’ innovative model for delivering IT services, or

Haier’s superior capability to identify and quickly fill vacant market niches, as well as

its innovative organizational structure, stand out in respect to entrepreneurial quality

of management.

• Commitment to innovation: Embraer is known across the globe for its technological

expertise and engineering prowess. Tenaris invests heavily into R&D. Cemex’ has a

long history of nurturing innovation, both in products and processes; its management

has confessed to having a ‘technology fetish’.

• FSA in local responsiveness/flexibility: This goes beyond simple knowledge of local

markets, as companies that possess this FSA have processes and routines in place to

respond to changing needs of diverse customer groups, within or outside of home

countries. Tata Group routinely adapts its products and services to serve a particular

client group. Haier translates its market research capabilities into product

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 modifications in various markets. Cemex has successfully combined a global

business model of standardized processes and systems to serve specific needs of local

customer groups. Lenovo quickly responds to local market demands with product

customization. Petrobras stands out against other state-owned oil companies in Latin

America through its flexible and responsive management structure.

• Experience in operating in difficult environments, or adversity advantage: Tenaris has

translated its history of building plants in difficult environments into superior

management capabilities.

• Access to global distribution network: Haier’s investment in logistics and distribution

paid off in a successful global distribution system. Similarly, Tenaris boasts

sophisticated Techint Commercial Network – a direct global distribution network.

• Higher order management capabilities/sophisticated routines: Cemex’ successful

integration of multiple international acquisitions is a result of its sophisticated post

merger integration (PMI) methodology. Petrobras developed and followed an

elaborate managerial decision making process. Haier’s ‘ZZJYT’ (self-managed

teams) exemplify its innovative organizational structure, designed to foster

entrepreneurial thinking and customer responsiveness.

So far, all FSAs outlined above differ from ‘traditional’ NLB FSAs typically

ascribed to developed economy MNEs, such as brand and technological strength. Yet,

we found substantial evidence of those ‘traditional’ FSAs in the EMNEs we studied:

Tata’s, Cemex’ and Samsung’s strong brands are a powerful expression of this point, as

is the undeniable technological sophistication of Samsung, Embraer and Tenaris. Yet, as

we predicted, EMNE’s way of developing brand and technological strengths diverge

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from traditionally assumed paths of advertising and R&D investment. Lenovo’s brand,

for example, became internationally known through Lenovo’s purchase of IBM’s

personal computing business. Likewise, Samsung’s technological strength is not an

exclusive result of proprietary R&D. In its early years, Samsung licensed much of its

semiconductor technology, and formed alliances with Japanese companies to access

technological know-how. On the other hand, Embraer owes much of its technology

investment to the government’s efforts to promote aeronautics. As such, our earlier

contention holds: EMNEs do possess FSAs, both LB and NLB; some of these FSAs can

be dramatically different from those found in their developed country counterparts, and

some are very similar; yet, paths of developing FSAs may diverge from traditionally

assumed advertising and R&D investments, and therefore cannot always be measured by

traditional proxies.

Recombination capabilities

In line with internalization theory logic, the EMNEs in our sample did not owe

their international success exclusively to home country CSAs – Haier in fact had an

explicit strategy not to rely extensively on cheap labour as a source of competitive

advantage, as competitive advantage based on low costs alone was seen as an

unsustainable proposition. Rather, the ability to compete was determined by the EMNEs’

abilities to effectively bundle and recombine their FSAs with CSAs of home and host

countries to transform their LB FSAS into NLB ones, and to develop new LB FSAs in

host countries. Infosys, for example, built its entire strategic approach on recombination.

Its “Global Delivery Model” means sourcing capital from where it is cheapest, producing

where it is most cost effective, and selling where it is most profitable. Likewise,

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Samsung was able to take advantage of its flexible manufacturing processes to establish a

global manufacturing network. Tenaris gained experience in multicultural relations

through navigating alliance relationships, and later used this capability to manage its

international network of subsidiaries. Haier was able to increase its host country

responsiveness by staffing its subsidiaries locally, conducting extensive market research

in host countries, and entering into alliances to access host country knowledge-based

CSAs. In all cases, in line with internalization theory predictions, recombination became

the highest-order capability that essentially determined the EMNEs’ success in

international markets.

Internationalization drivers

As expected, we were able to categorize our sample EMNEs’ internationalization

drivers according to the traditional classification of strategic resource seeking, market

seeking, efficiency seeking, and natural resource seeking. Strategic resource seeking was

perhaps the most prominent motivation, lending some limited credence to the claim that

EMNEs internationalize partially to escape competitive disadvantage. For example,

Haier’s stated objective of expansion into developed markets was to “observe, digest,

imitate” technology and processes in the developed world. Similarly, one of Samsung’s

major goals for internationalization is to tap into top global talent. However, creating

competitive advantage through FSA exploitation and eliminating competitive

disadvantage through FSA acquisition are not mutually exclusive. For example,

Samsung was able to take advantage of global talent due to its NLB FSA in innovative

personnel management and promotion of a knowledge culture.

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 Market seeking was a prominent internationalization driver among the EMNEs

studied. Lenovo’s international expansion was a response to the maturation of the local

PC market and increased competition from international retailers, while Concha Y Toro

sought to escape from a small and unsophisticated domestic market for wine.

Efficiency seeking was one of the primary internationalization drivers for Infosys,

which engaged in “nearshoring” by locating subsidiaries close to customers in order to

serve them more efficiently. For Cemex, internalization served as a way of managing the

cyclical nature of the cement industry.

Finally, natural resource seeking was a primary expansion driver for Petrobras,

who sought to reach promising exploration areas in South America. We have thus

demonstrated that EMNEs’ internationalization drivers fit within the existing paradigm,

and that internalization theory’s predictions are not affected by internationalization

motives.

AN IMPORTANT NUANCE: STATE-OWNED ENTERPRISES (SOE)

The sharp rise of EMNEs brought the phenomenon of state owned enterprises

(SOE) to the forefront of IB research. State ownership is in no way exclusive to

emerging economies: SOEs are major economic players in many industrialized nations,

accounting for large shares of gross domestic product (GDP) (particularly in Europe),

representing significant percentages of national investment and exports, providing jobs,

and competing with leading corporations in various industries (Hafsi, Kiggundu, &

Jorgensen, 1987; MacCarthaigh, 2011). That being said, SOEs are possibly more

common in emerging markets, namely when the state plays an active interventionist role

in economic transformation from central planning to the market economy (Hu & Lin,

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2013). With internationalization processes of SOE EMNEs being driven, at least partly,

by political objectives, will their internationalization patterns be different?

We argue that, from the internalization theory perspective, SOEs may indeed

possess a set of unique FSAs, such as access to cheap capital, increased latitude for risk,

and ready access to decision-making bodies in the government and consequent ability in

influence, potentially, national policy. Further, SOEs from emerging economies may be

exempt from stringent regulations and policies to which their private counterparts are

subjected – e.g., human rights codes or environmental regulations. This latter point has

become a strongly debated topic in the West following increasing inward investment by

foreign SOEs, such as the Chinese National Oversees Oil Corporation’s (CNOOC)

purchase of Nexen Inc. (Canada), the Petronas (Malaysian state-owned oil company)

purchase of Progress Energy Resources (Canada) (Boothe, 2013), and the Aluminum

Corporation of China’s purchase of a stake in Rio Tinto of Australia (Woetzel, 2008).

These FSAs, however, are only advantageous if the EMNE’s goals are consistent with

home government goals (Rugman & Verbeke, 1998) – as is the case of Chinese oil

companies, whose cross-border expansion (e.g. into Africa and Canada) advances

China’s energy security strategy. If the goals of the enterprise and the government are in

conflict, the EMNE will either be privatized, or its FSAs will turn into serious strategic

disadvantages should government influence and funds be dedicated to goals contrary to

those of the MNE’s. Consider Embraer’s near-collapse in the 80’s, when the company’s

dependency on its relationship with the Brazilian military became destructive following

the fall of military dictatorship and a consequent sharp decline in military contracts

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(Embraer was finally privatized in 1994 and went through a remarkable turnaround over

the following two decades).

It is important to remember that all SOEs were not created equal and range greatly

in the degree of government ownership and involvement, the type of involvement, the

level of government involved, and, most importantly, in the SOEs’ strategy, objectives

and competitive characteristics. It has in fact been argued that the line between SOEs and

private enterprises in emerging economies is beginning to blur, namely when outdated

SOE assets are sold in the open market, and SOEs strive to become leaner, more

competitive organizations. SOE-specific advantages are fading somewhat, as well – in

China, for example, the policy of separating government functions from business

operations is becoming increasingly applied, and SOEs’ access to capital at below market

rate is becoming limited (Woetzel, 2008).

With this in mind, we argue that it is not the ownership, but rather the

recombination capabilities of SOEs that determine their success or failure in the

international market. The conditions faced by SOEs and private firms in international

markets are similar; yet SOEs’ FSAs related to government ownership are more likely to

be LB. SOEs’ challenge is therefore to effectively transfer and recombine their FSAs

with host country CSAs. Lenovo and Haier (where the Chinese government is a

significant shareholder) have managed this process successfully, while Changhong

Electric, a Chinese government-owned consumer electronic giant, failed its entry into the

US market due to its inability to link with the local distributors.

It should also be noted that shelter-based behaviour is found in developed

economies, exemplified in national champions, infant industry protection and quasi-

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public monopolies. The benefits of shelter-based behaviour break down if it fails in the

first-order economizing respect – that is, if it is accompanied by excessive resource

waste. As such, internalization theory holds for SOEs, whether emerging or developed

country-based.

CONCLUSION

Advocates for a brand new theory to study EMNEs typically cite three alleged

shortcomings of the extant IB theoretical framework if applied in the emerging economy

context: 1) its MNE-centric nature and related inability to take into account drastic

institutional differences between emerging and developed economies; 2) EMNEs’ lack of

FSAs, which makes them unsuitable for analysis through a lens whose core foundation is

based on exploiting existing FSAs abroad; and 3) EMNEs’ unique set of motivations for

FDI. Our view is that these contentions are flawed and caused by an incomplete

understanding of internalization theory, or by the lack of familiarity with its most recent

extensions and refinements. We have argued that the contemporary version of

internalization theory: (a) does consider the impact of institutional environments on

transaction costs and MNE functioning; (b) can handle EMNEs’ idiosyncratic FSAs,

though we do agree that these FSAs can be significantly different from those of

developed country MNEs; and (c) does make predictions that are not fundamentally

affected by motivations for international expansion. We have used detailed examples of

ten successful, large EMNEs, showing that internalization theory predictions hold in the

emerging economy context – not surprisingly, as a ‘good theory’ should explain firm

behaviour in general, and not just under particular circumstances (Cuervo-Cazurra, 2012).

As such, we do not need a new theory to study EMNEs – rather, we need a new set of

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proxies to measure EMNEs’ FSAs, as our examples clearly demonstrate that traditional

proxies are not necessarily applicable to EMNEs, even when FSAs are in fact traditional.

Arriving at those proxies, however, may be challenging in empirical settings due

to the complex and intangible nature of many EMNEs’ FSAs. Here, IB scholars could

benefit from turning to the modern RBV literature: While little predictive work has been

done within this theoretical framework, RBV scholars have been instrumental in

developing a multitude of proxies for empirical measurement of a firm’s resources (see,

for example, Newbert (2007) for a comprehensive overview of RBV-based empirical

articles). It is also possible that application of internalization theory to EMNEs will

require IB scholars to rethink their research methodology. Extant internalization theory-

based empirical studies have demonstrated that it is very difficult to capture the messy

and complex reality of international business by industry averages and statistical tests

(Aharoni, 1993). These difficulties are amplified in the emerging economy context,

where research subjects are fewer and many constructs are new, unique and poorly

understood. As insightfully suggested by Aharoni (1993) two decades ago, we would

understand much more about companies’ FSAs if we relied more on the tools of the

business historian than those of the mainstream economist. Extending this logic to

studying EMNEs, we are likely to advance our knowledge further and faster by

supplementing conventional statistical approaches of large samples with case studies and

longitudinal research. This type of work would likely validate our main point that

internalization theory indeed remains the general theory of the MNE, irrespective of this

firm’s home country being a developed or an emerging economy.

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Table 3.1. EMNE motivation for international expansion versus existing motivation
framework

4 motivations for international EMNE’s motivations for international

expansion in existing IB framework expansion identified in extant literature
(Dunning & Lundan, 2008; Verbeke 2009) (Guillen & Garcia-Canal, 2009)
Natural resource seeking • Backward linkage into raw materials

Market seeking • Home-country government curbs

• Investment in new markets in response to
economic reforms in the home country
• Following a home-country customer to
foreign markets
• Forward linkage into foreign markets

Strategic resource seeking • Movement of personal capital abroad

• Acquisition of intangible FSAs
• Exploitation of intangible FSAs (i.e.
recombination of intangible FSAs with
borrowed technology)

Efficiency seeking • Spreading of risk

Table 3.2. List of EMNEs analyzed

Asia The Americas

1. Lenovo 6. Embraer
2. Infosys 7. Petrobras
3. Tata 8. Cemex
4. Haier 9. Tenaris
5. Samsung 10. Concha Y Toro

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 Essay 4

TRANSACTION COST ECONOMIZING AND THE RISE OF THE

MODERN CORPORATION: REVISITING THE NATURE OF MAN IN

ALFRED CHANDLER’S OEUVRE

Alfred Chandler, the greatest business historian of our time, is often regarded as an

intellectual father of Transaction Cost Economics (TCE) – one of the leading

organizational studies paradigms, for which Chandler’s work became an important

antecedent. TCE has invited much criticism for its key behavioural assumption of

opportunism – a concept that Chandler, despite his close ties with TCE, does not appear

to endorse. We revisit Chandler’s classic history of the Du Pont and General Motors

corporations to investigate whether opportunism was indeed a key factor in the making of

the modern corporation, and propose an alternative framework to explain failed human

commitments. By using a modified grounded theory approach, we elaborate on the

existing theory and create a new set of behavioural assumptions to complement and

augment the current assumptions of TCE. We argue that the proposed model of bounded

reliability (BRel) corresponds more accurately to Chandler’s view of the nature of man

than TCE’s conventional assumption of opportunism. We suggest that adopting BRel as a

central concept of the study of the firm may increase the legitimacy of TCE, and lay the

foundations for further theorizing BRel.

INTRODUCTION

Alfred Chandler’s contribution to the field of management in general, and to the

discipline of business history in particular, is profound and lasting. Chandler has been

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called “the most influential business historian of the twentieth century” (John, 2011: 185)

and has been lauded for “almost inventing the field of strategic management” (Winter &

Teece, 2010: 365). His monumental works, such as “Strategy and Structure” (1962),

“Pierre S. Du Pont and the Making of the Modern Corporation” (1971), “The Visible

Hand” (1977) and “Scale and Scope” (1990), set the standards for business and economic

history, a field that he revolutionized (Freeland, 2007), profoundly affected strategic

thinking of generations of managers and researchers, and provided a platform for

consideration of future business trends (Curtean, 2010). Of particular interest for the

purpose of this paper is Chandler’s complex relationship with transaction cost economics

(TCE), a core theory of management science into whose development Chandler was de-

facto co-opted by Oliver Williamson – TCE’s creator who earned the 2009 Nobel Prize in

Economics largely based on his contributions to the theory.

As one of the leading perspectives in the management and organizational studies

field (David & Han, 2004), TCE has received much attention from a broad range of

audiences (Rindfliesch & Heide, 1997), but has also invited much criticism, mainly for its

key behavioural assumption of opportunism. In Williamson’s version of TCE, human

agents that populate firms and markets have an inherent proclivity toward opportunism,

defined as “self-interest seeking with guile” (Williamson, 1981b: 1545), or “calculated

efforts to mislead, distort, disguise, obfuscate or otherwise confuse” (Williamson, 1985:

47). Governance structures should therefore be designed so as to safeguard against

economic actors’ potential opportunistic behaviour. As such, opportunism is the ultimate

cause of market failure and of the existence of hierarchies (Williamson, 1993).

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 A key behavioural assumption of a core paradigm in the organization studies

field, opportunism has come to occupy a significant place in management research; yet,

its legitimacy has been continually questioned in the academic literature (Conner &

Prahalad, 1991; Ghoshal, 2005; Ghoshal & Moran, 1996; Hodgson, 2004). This

effectively reduces the legitimacy of TCE as a general theory of the firm, as realistic

behavioural assumptions play a pivotal role in strategic management theory development.

As Simon famously pointed out, “nothing is more fundamental in setting our research

agenda and informing our research methods than our view of the nature of the human

beings, whose behaviour we are studying. It makes a difference, a very large difference,

to our research strategy…” (1985: 303). It is therefore important that behavioural

assumptions that form the basis of theory be appropriately tested, at least if this theory is

to be relevant to the practice of strategy. Unfortunately, Tsang (2006) argues that tests on

behavioural assumptions at the core of TCE – bounded rationality, risk neutrality and

opportunism – are largely absent in empirical research. To illustrate his point, Tsang cites

David and Han’s (2004) systematic assessment of the empirical support for TCE. David

and Han examined 308 statistical tests of TCE constructs from 63 articles and found that

only 19 tests involved opportunism as a variable, while most of the tests invoked the

assumption of opportunism implicitly or explicitly. In addition to scarce and inconclusive

empirical support, opportunism has been criticized for its narrow conceptual focus and,

broadly speaking, for inaccurate portrayal of the human nature (Verbeke & Greidanus,

2009). Jolls, Sunstein and Thaler (1998) argue that the assumption of unbounded self-

interest is as unrealistic as the neoclassical assumption of unbounded rationality, rejected

by TCE scholars in favour of the bounded rationality (Simon, 1961) construct. The

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objective of this paper is to explore alternative factors that may, in addition to or in place

of opportunism, drive TCE-based predictions on the evolution of governance – and,

specifically, could be behind Williamson’s interpretation of Alfred Chandler’s work on

the ‘making of the modern corporation’.

Alternative behavioural assumptions have been explored in social science

literature, but have not as of yet made major inroads into management science. In their

pioneering article on a behavioural approach to law and economics, Jolls et al. (1998)

introduced bounded willpower and bounded self-interest as complements to the

assumption of bounded rationality, yet these constructs do not fully explain non-

fulfillment of commitments in an organizational setting, nor have they been adopted by

TCE scholars as alternatives to opportunism. The first significant extension of TCE’s

behavioural assumptions was offered by Verbeke and Greidanus (2009), who proposed

an envelope concept of bounded reliability (BRel) as a way to advance TCE-based

thinking and extend Williamson’s treatment of mechanisms underlying failed

commitments by explaining non-fulfillment of commitments even in the absence of

intentional deceit. In this paper, we extend Verbeke and Greidanus’ model by suggesting

additional dimensions of BRel. We do this by analyzing Alfred Chandler’s classic

history of the Du Pont and General Motors corporations (Chandler & Salsbury, 1971), in

an effort to identify behavioural patterns related to failed commitment in the context of a

substantial organizational transformation. Chandler’s work offers fertile ground for our

analysis mainly because of Chandler’s role in the creation of Williamson’s version of

TCE: Our prediction is that Chandler’s view of the human nature is much different from

Williamson’s, despite Williamson’s explicit and implicit connections to Chandler’s work.

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In the remainder of the paper, we discuss the behavioural assumption of opportunism as it

pertains to Chandler’s work, outline key elements of the new envelope-concept of

bounded reliability, show how this concept is reflected in the ‘making of the modern

corporation’ (Chandler & Salsbury, 1971) and finally extend this concept by suggesting

some additional dimensions of BRel. We finish by outlining implications of the new

dimensions of bounded reliability.

TCE AND CHANDLER

Williamson’s connection to Chandler’s work in the context of TCE development

is evident in the fact that the multidivisional enterprise theory has often been referred to

as “the Chandler-Williamson M-form hypothesis” (Rumelt, Schendel & Teece, 1991: 14).

Williamson uses Chandler’s work as an antecedent that has a bearing on the TCE

approach to the study of economic institutions in general and, in particular, to the study of

the modern corporation, especially when it comes to the changing structure of the

corporation over the past 150 years (Williamson, 1981, 1985). !Williamson has

essentially formulated Chandler’s analysis of the two prototype structures (McGee &

Thomas, 1986); his interpretation of Chandler’s oeuvre is that the M-form, as a

governance mechanism, was introduced as a safeguard against opportunism by

attenuating subgoal pursuit by functional departments, prevailing in the unitary (U-form)

enterprise (Williamson 1981, 1996). The key reason for the existence of M-form is

therefore to economize on opportunism.

Williamson is correct in that Chandler was mainly concerned with the description

rather than explanation of organizational change (Williamson, 1981b), and that his

detailed account of events that led to the formation of a modern corporation was therefore

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open to interpretation. Chandler’s concern is mainly with the interaction between the

largest M-form corporations and their competitive environments (Ghemawat, 2002), as

well as with the virtuous paths of learning (John, 1997), which the M-form is better able

to coordinate and manage as the degree of diversification and internationalization

increases (Binda, 2012). As such, there is no apparent direct contradiction between

Chandler’s and Williamson’s take on the origins of the M-form structure. Yet, while

strategic factors that are central to Chandler’s oeuvre undoubtedly depend on personal

action (Barnard, 1968; Ghemawat, 2002), Chandler did not pay explicit attention to

behavioural assumptions. Here, Williamson’s interpretation of Chandler’s work is an

exaggeratedly parsimonious one. It is questionable whether opportunism is indeed the

best explanation for the behaviour of characters that populate Chandlers’ business

history, and whether it is a key factor that necessitated organizational transformation.

Chandler, it seems, has a broader perspective of human nature, and may be sending a

different message through his careful and rich descriptions. During their transition from

loosely run family businesses to giant modern enterprises, growing firms such as Du Pont

and General Motors are bound to encounter challenges and conflicts, and many of these

challenges are bound to have a human dimension. Conflicts between personal and

impersonal values, business’ intrusion on kinship, a need to cope with change, a capacity

to process new information and absorb new ways of doing business are but a few

problems encountered by employees and managers of Du Pont and General Motors in

their journey toward a modern corporation. Many of these problems are related to

bounded rationality and, indeed, opportunism, which triggered failed commitments, i.e.,

the non-fulfillment of promises. However, malevolence is clearly insufficient as a

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universal explanation of such failures; Chandler indeed described other important

behavioural drivers.!

Chandler’s relationship with transaction cost theory is a complex one. It seems

that Chandler, despite some of his reservations about TCE’s treatment of R&D, HR, and

growth through diversification (Chandler, 1982), was pleased and flattered by being co-

opted into its creation by the “leading figure of this approach” (Chandler, 1992: 85).

Stating that he had been enlightened by Williamson (Chandler, 1982), Chandler agrees

that the TCE approach is particularly relevant when studying the evolution of the large

industrial corporation, and that it “provides one of the sharpest, most precise means yet

devised to analyze the impact of technological and market changes on the structure of the

enterprises and the industries” (Chandler, 1982: 128). Chandler further cultivated his

connection to TCE and its author by thanking Williamson “for his imperialistic efforts to

join transaction cost economics with business history” (Chandler, 1982: 129). Chandler

operates with TCE concepts in his discussions of managerial capitalism (visible hand of

managerial direction vs. invisible hand of market mechanism – Chandler, 1981), and

attempts to embrace TCE in The Visible Hand (Chandler, 1977), although his use of TCE

as a conceptual lens did not extend much past the beginning of the book and did not

appear to have illuminated the story (Winter & Teece, 2010). In his later writings,

Chandler seems to turn away from TCE; he articulated his reservations with it as a theory

of the firm in his 1992 Journal of Economic Perspectives article (Chandler, 1992).

Unlike Williamson, who views the individual transaction as the basic unit of analysis

(Williamson, 1985), Chandler regards the cost of making business transactions as of

secondary concern (John, 2011) and focuses instead on the firm and its specific physical

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and human assets, with the emphasis placed on production rather than exchange, and

learning and knowledge creation rather than boundaries between the firm and the market

(John, 1997). Convinced that the unit of analysis in a theory of the firm must be the firm,

Chandler writes that “only by focusing on the firm can theory predict the firm’s

continuing role as an instrument of economic growth and transformation, and assist in

developing policies and procedures for maintaining industrial productivity and

competitiveness in an increasingly global economy” (Chandler, 1992: 99).

This fundamental difference in the unit of analysis is perhaps a key to

understanding the difference in Williamson’s and Chandler’s approach to behavioural

assumptions of economic actors. Imperfect effort, and opportunism in particular, is more

observable at the level of an individual transaction than at the level of the firm – this is

perhaps why Chandler does not seem to share Williamson’s concern with opportunism.

We argue that the most relevant unit of analysis of economic actors’ imperfect

effort is in between Williamson’s and Chandler’s – namely, at a level of a class of

transactions. Strategies and processes are not created at the transaction level, and thus

economizing mechanisms will not be developed for each individual transaction. At the

firm level, on the other hand, observability is limited because the existence of the firm,

particularly the M-form, is in itself an economizing mechanism. At the level of a class of

transactions, however, we have core practices and routines within a particular

organizational function; these core practices essentially define an organization. This is

where critical change processes take place, and this is also where economizing

mechanisms reside, as routines inherently leave less room for imperfect effort than an

individual transaction due to built-in correction mechanisms. This level offers a great

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vantage point from which to observe and understand complex intra-firm processes and

contributions of separate functional units. Further, at this level, economic actors’

imperfect effort is likely to be explained by factors beyond opportunism to a greater

extent than at the too-narrow level of the individual transaction, or at the too-broad level

of the firm.

To explore multiple behavioural drivers of failed commitments, we analyze

Chandler’s classic book, “Pierre S. Du Pont and the Making of the Modern Corporation”

– a renowned detailed account of the functioning of various parts and sections of the Du

Pont and General Motors corporation, written from the point of view of Pierre S. Du

Pont, a prominent business figure of his time and a critical force behind both

corporations’ unprecedented growth and success observed during the years the book

spans. We carefully revisited Chandler’s analysis to uncover patterns in behaviour of

employees, managers, directors and business partners that may explain failed

commitments for reasons other than intentional deceit. We approach this search from the

level of a class of transactions, and, in doing so rely on the bounded reliability (BRel)

concept developed by Verbeke and Greidanus (2009).

THE ENVELOPE-CONCEPT OF BOUNDED RELIABILITY (BREL)

The broad concept of bounded reliability complements the bounded rationality

construct and extends the assumption of opportunism by including the many situations

where parties may fail to deliver on commitments while not intentionally engaging in

self-interest seeking with guile. Bounded reliability reflects the often-observed reality of

failed commitments caused by a variety of factors including but not limited to intentional

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deceit (but excluding technical error, human incompetence or exogenous circumstances),

and includes the following categories of bounds on reliability:

1. Opportunism as intentional deceit

2. Benevolent preference reversal associated with reprioritization

3. Benevolent preference reversal associated with scaling back on overcommitment

Good faith reprioritization captures instances whereby economic actors make ex

ante commitments in good faith (with benevolent intent), but the importance of those

commitments diminishes over time (preferences are reordered). Time discounting bias

(placing a lower value on future events than more proximate events) can also cause

economic actors to reprioritize, and postpone efforts to make good on commitments to

the point that such commitments can no longer be fulfilled. Scaling back on

overcommitment is the tendency of managers to make ex ante commitments that then

need to be scaled back ex post. Psychologically, overcommitment stems from the

behavioural phenomena of impulsivity and self-assessment bias. Overcommitment can

also be attributed to the planning fallacy, whereby planners rely on best-case scenarios

when making a commitment. Having conceptualized the critical drivers of failed

commitments captured by the bounded reliability concept, Verbeke and Greidanus

identify a large number of mechanisms for economizing on the three facets of bounded

reliability. In practical terms, these mechanisms may include realistic goal-setting, regular

reviews of targets, cultivation of informal connections among actors, development of

clear guidelines, joint strategic planning by participating parties, frequent budgetary

reviews and imposition of limits on the size and scope of new activities.

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 While this framework was developed in the context of the multinational enterprise

(MNE), it is certainly applicable to a broader organizational context and in particular to

the context of a multidivisional corporation, with many MNEs actually being

multidivisional companies. In Williamson’s words, the MNE uses “the M-form structure

to extend asset management from a domestic base to include foreign operations. Thus the

domestic M-form strategy for decomposing complex business structures into semi-

autonomous operating units was subsequently applied to the management of foreign

subsidiaries” (Williamson, 1981: 1561). As such, the behaviour drivers identified by

Verbeke and Greidanus for MNEs are likely also to be observable in the multidivisional

corporations’ history narrated by Chandler, whether or not those corporations engaged in

cross-border business activity at the time of observation.

METHODOLOGY

Data

Our analysis of the content of Chandler’s book, “Pierre S. Du Pont and the

Making of the Modern Corporation”, focuses on underlying intentions involved in

managerial decision-making and commitment (Verbeke & Greidanus, 2009). Chandler’s

writing, characterized by rich and detailed descriptions, offers ample opportunities for

observation and illustration of managerial behaviour, and is therefore a reliable

information source for qualitative theory building. Our revisiting of Chandler’s

foundational business history piece allowed identifying the context and reasons for

several instances of non-fulfilment of commitments, i.e., broken promises, and provided

insight into which elements composing the ‘nature of man’ truly affect organizational

action and outcomes.

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Theory building

The purpose of this paper is to elaborate on existing theory, TCE (Pratt, 2009), by

closing the critical gap created by the insufficiency of present behavioural assumptions,

and creating a new set of new behavioural assumptions to complement and augment the

existing ones. We adopted elements of the grounded theory approach (Strauss, 1987),

and followed procedures outlined by Glaser and Strauss (1967) and subsequently

modified and extended by other researchers espousing qualitative methods (Corbin &

Strauss, 1990; Glaser, 1978; Martin & Turner, 1986; Strauss & Corbin, 1990; Turner,

1981, 1983). Our analysis involved two broad stages. We started our data analysis with

the insights presented in Verbeke and Greidanus’ (2009) exploration of bounded

reliability (the observed three facets of bounded reliability), and built additional insights

through the iterative analysis process. That is, in the first stage, we analyzed the book to

identify examples of the three dimensions of bounded reliability described by Verbeke

and Greidanus (opportunism, reprioritization and scaling back on overcommitment), by

coding the text according to the three categories pertaining to the above dimensions. In

the second stage, we searched for emerging themes and patterns of managerial behaviour

that may extend the existing BRel framework by offering additional insights into reasons

underlying non-fulfillment of commitments. Here, we used emergent coding and

followed the principles of the constant comparative method (Shah & Corley, 2006). As

soon as we formulated provisional themes (Locke & Golden-Biddle, 1997) of BRel, we

compared the examples to clarify the themes. At the same time, emerging themes

directed us to other potentially relevant examples in the text. Finally we grouped each set

of related examples forming an emerging theme into additional categories of BRel

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(Corbin & Strauss, 1990; Strauss & Corbin, 1996). For example, executives’ reluctance

to accept new roles following Du Pont’s Executive Committee in 1903 and Du Pont

family members’ active resistance to a major reorganization in 1911 were labeled as

“benevolent resistance to change”. The creation of each category directed us to further

refine its properties and relationships through continuous text analysis (Locke & Golden-

Biddle, 1997).

In scrutinizing the text, we intentionally excluded incidents that led to failed

commitments due to technical errors, functional incompetence or environmental factors,

and focused exclusively on behavioural reasons for failed commitments. In addition to

identifying new categories of BRel, we created a special category of content related to

safeguarding against BRel. Labeled “economizing”, this category encompassed instances

of managerial behaviour directed at preventing BRel of any specific type. Economizing

instances were tied to each specific BRel category.

In building theory, we utilized theoretical memoranda about emerging categories

and their relationship to each other, all the while continuing to refer to the text in an

attempt to gain a deep understanding of the nuances of the data (Locke & Golden-Biddle,

1997). Our objective was to tell a cohesive story (Pratt, 2009) of how different categories

of BRel fit together and with the previously suggested model, how they fix the current

gap in TCE behavioural assumptions, and the role they played in the making of the

modern corporation. To put our story into its proper context, we included backgrounds of

the two firms examined in the text (see Appendix 4.1).

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 RESULTS AND DISCUSSION

Our analysis revealed a number of behavioural patterns related to failed human

commitments, including (but not limited to) the three existing categories of BRel. We

start by citing incidents of these categories in Chandler’s work, including examples of

economizing that pertain to each category.

BRel in the making of the modern corporation: Extant categories

Opportunism. Predictably, incidents of opportunism as intentional deceit were

present in Chandler’s historical account. One glaring example is found in an incident of

embezzlement, when, in 1904, one of the Du Pont company’s most trusted and respected

West Coast managers attempted to deliberately cheat the company out of $47,000 (p.

169). Other examples occurred at the time of a financial crisis. During a severe

economic downturn of 1907, Du Pont’s long-standing supplier of one of the most critical

resources – nitrate of soda – used Du Pont’s dependable position to demand a change of

contract on very short notice (p. 219). The supplier requested deposit of collateral, which

had not been a part of the previous arrangement. After the request was granted, the

supplier proceeded to make additional demands, insisting on obtaining exclusivity of all

Du Pont’s transactions and imposing additional requirements for the deposit of collateral.

While it is plausible that the supplier broke the existing arrangements to fulfill new

internal requirements in light of extraordinary circumstances (in which case this event

could be characterized as reprioritization), it is more likely that these demands – which

Pierre Du Pont described as “obnoxious” (p. 219) – were a manifestation of strong-form

self-interest, as the supplier attempted to use the circumstances – a severe financial crisis

and the business partner’s high dependence on the supplied product – to achieve financial

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gain. This example concerns Du Pont’s entire relationship with its supplier and therefore

represents a set of transactions, rather than an individual transaction or the entire firm,

confirming our earlier statement that a class of transactions may well be the most

appropriate level of analysis to study expressions of BRel.

A notorious antitrust lawsuit against Du Pont (observed from the point of view of

a set of transactions/interactions that led to the lawsuit outcome), which eventually

triggered the company’s dissolution, offers more examples of opportunistic behaviour

(pp. 259-300). The lawsuit was first brought about by a former employee, who could not

adapt to new ways of doing business after Du Pont’s restructuring in the early 1900s, and

resigned to start his own company. Bitter from losing his privileged position, Robert

Waddell launched a crusade against his former employer, accusing Du Pont of

monopolizing the market and using unfair competitive tactics to drive smaller industry

players out of business. The motivation for Waddell’s behaviour was probably twofold:

First, it was partly personal vendetta; second, he was hoping to collect damages by

proving that his own company was a victim of unfair competitive practices. In

implementing his attack, Waddell did not shy away from distorting facts and using false

premises (e.g. stating that Du Pont was selling at a loss for the purpose of destroying

competitors, deliberately portraying Senator Henry A. du Pont as Du Pont Company’s

head to create negative publicity, accusing Du Pont of a premeditated plan to practice

extortion upon the government, etc.) – as such, this was another example of intentional

deceit for self-serving purposes.

Reprioritization. One key example of reprioritization can be found in Coleman’s

reversal of his commitment to build a highway to run from Wilmington to Maryland,

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made initially in 1911 (p. 326). Although representing Coleman’s private commitment,

only indirectly related to Du Pont’s corporate activities, this incident nevertheless

provides an excellent illustration of a change in proximity of a commitment inherent in

reprioritization (Verbeke & Greidanus, 2009). Coleman planned to finance the road

construction himself, and to donate the highway to the people. The commitment was

likely a political move aimed at enhancing Coleman’s reputation, as at the time he had

serious political ambitions as a member of the Republican Party. The highway

construction was suspended due to difficulties encountered with downstate farmers who

were asked to sell land for a right of way, and for a while, Coleman focused on other

priorities. It was not, however, an opportunistic abandonment of a promise made to the

public: the commitment was postponed (as is often the case with benevolent

reprioritization), and construction resumed in 1926 and was brought to a close one bit at a

time.

Overcommitment. Overcommitment accounts for a considerable portion of non-

fulfillment of promises in the context of a multidivisional corporation. One example can

be found in the way General Motors Corporation was managed prior to Pierre Du Pont’s

becoming involved with the company in 1915. General Motors’ President and founder,

William C. Durant, ran the company in a “fast-moving, free-wheeling manner” (p. 456),

without much financial or administrative control. Durant insisted on being personally

involved in all intricacies of the company’s operations and must have greatly

overestimated his ability to single-handedly control the complex corporation, without

much method or system, without an adequate decision-making body and without active

involvement of the company’s Board. As a result, the company ended up in a financial

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crisis and was unable to meet its obligations to shareholders. Some of the problem is

related to bounded rationality (i.e. the natural limits of both Durant’s knowledge on

various functional aspects of the business, and his intellectual capabilities), but the

President’s overconfidence in his ability to manage the corporation in the absence of

proper governance support and without much reliance on specialized expertise in

functional areas must have been at the heart of the issue. It must be noted that, despite

the broad nature of the issue, this example deals not with the firm in its entirety, but

rather with a set of transactions pertaining to general management issues – and more

specifically, as affected by Durant’s general management style.

General Motors’ Executive Committee’s decision to cancel a copper-cooled

engine program in 1922 is likely related to the BRel challenge of overcommitment (pp.

544-546). Substantial resources and time had been committed to the development of this

important innovation. Pierre Du Pont, who was inspired by this innovation and foresaw a

great future for it in the automobile industry, actively pushed the production of the new

engine. However, Pierre must have overestimated the company’s ability to develop, test

and refine the engine in time to meet production deadlines. His overcommitment was

further fuelled by unrealistic promises of R&D and production managers, who were

unable to meet their proposed schedules. At the end, the combination of

overcommitment at different levels in the organization led to the engine’s market failure:

the newly engineered engine performed poorly, and the market’s reception of copper-

cooled cars was unfavourable. The Executive Committee decided to reprioritize, focusing

on an expansion program for Chevrolet instead of the further development of the copper-

cooled engine, to the great disappointment of Pierre Du Pont and Charles Kettering,

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General Motors’ engineer in charge of R&D. Kettering attributed this preference reversal

to “an organized resistance within the Corporation” (p. 544); however, it was more likely

a rational decision driven by the poor performance of the prototype copper-cooled engine,

which, in turn, was due to management’s and R&D’s initial overestimation of the

company’s ability to produce the innovation. Here again, we are dealing with a class of

routines and practices within a specific organizational function (R&D), therefore

representing a class of transactions, rather than an individual transaction or a firm as a

whole.

Examples of overcommitment can also be seen in the government’s antitrust suit

against the Du Pont company (pp. 259-300), already discussed above in the

‘opportunism’ section. At the onset, Du Pont’s management did not take the attack

seriously. Overconfident in the power of Du Pont’s reputation and political connections

and perhaps over-relying on the government’s and the court’s good will, management did

not believe in the possibility of a negative ruling, and as a result did not adopt strategies

and tactics aggressive enough to fight off the assault. Bounded rationality played a role

in the critical lack of attention to Waddell’s attack. However, BRel is at the heart of the

matter: Protests against concentration of economic power in the hands of large American

corporations were wide-spread at the time, and a negative public reaction was predicted

by Arthur Moxham, one of Pierre’s original mentors and a key member of Du Pont’s

executive team, at the time of the formation of the company. Limited knowledge and

inability to foresee the negative outcome are therefore not the only issues – rather,

overestimation of the company’s power led to the neglect of the critical information

which, at least partially, was at the company’s disposal. Most critically, the Du Pont

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management neglected an urgent need to finalize the merging of all properties and

interests and to once and for all do away with “tricky” (p. 271) business practices of the

pre-consolidation times, when the Powder Company operated as an association of

separate firms and indeed used unfair competitive practices and agreements to restrain

trade. Despite insistence on the part of some executives (Arthur Moxham, James

Townsend and Pierre Du Pont), the Executive Committee overestimated the company’s

political and market stance and was in no hurry to completely eliminate “embarrassing

vestigial remains” (p. 271) of the past trade deceit. This failure to complete the merger

made it difficult for management to demonstrate that the modern firm bore little

resemblance to the past trade association. Whether the outcome of the lawsuit would have

been different had the Du Ponts correctly estimated their position is unclear; however, at

least some of the devastating effects of the suit could perhaps have been avoided. The

antitrust decree resulted in broken promises to shareholders and partners, and at least part

of this outcome was related to managerial overconfidence.

It is interesting to observe how Du Pont’s management safeguarded against this

type of mistakes in the future. Following the court’s dissolution decree, the company’s

President wrote to his chief counsel: “It is our desire to carry out not only the letter, but

the spirit of the Decree to the utmost and rather than have our people do anything that

could be considered in any way stretching the Decree in a way that would favour us, they

should be instructed to lean the other way and even give up trade or lose business rather

than put themselves in a position where their smallest act would be open to criticism” (p.

298). Management was thus instructing employees to exhibit compliance in an

exaggerated manner, committing to a position of under- rather than overconfidence in

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terms of maintaining a crystal-clear public image as far as antitrust dealings are

concerned.

The extended model: New categories of benevolent preference reversal

The above analysis shows that benevolent preference reversal, and not just

opportunism, accounts for many cases of commitment non-fulfillment in Chandler’s

narrative. In addition to reprioritization and overcommitment, our analysis revealed three

additional dimensions of benevolent behaviour underlying failure to make good on

promises: benevolent reframing of reality, benevolent resistance to change, and

benevolent conflict (Figure 4.1). In the following sections, we discuss these new

dimensions and their expressions, as identified in Chandler’s work. As with the initial

BRel model, we include instances of economizing pertaining to each BRel category.

(Figure 4.1 about here)

Reframing of reality. Reframing of reality occurs when original goals and

commitments are revised in favour of a conflicting set of goals, leading to the complete

abandonment of the original commitment. Economic actors may redefine (expand or

simply swap) the moral circle whose interests matter in a particular issue (Jordan &

Audia, 2012); the issue then becomes reframed so as to serve a new set of interests.

Pierre Du Pont’s purchase of Coleman’s shares aimed at obtaining full control of

the company represents an interesting example of the benevolent preference reversal

associated with reframing of reality. “Pierre and his five associates conducted their

negotiations with Coleman and their final purchase of his stock with great speed and in

absolute secrecy” (p. 335) from his cousins Alfred and William Du Pont, as well as from

other members of the Executive Committee which would certainly not have permitted the

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transaction had they had any knowledge of it. From Alfred and William’s viewpoint, the

move was “a breach of faith” (p. 336) which marked the beginning of a serious family

conflict that eventually split the family, and therefore, could be classified as an act of

opportunism if considered from this perspective. Chandler, however, offers a different

angle. “If Pierre was to stay in,” – he writes, – “if he was to be responsible for the future

of the Powder Company, he wanted the necessary authority to carry out this

responsibility” (p. 337). Further, Pierre wanted to give key executives a substantial claim

on the profits, following his belief that “the success of a modern large corporation

depended on making its executives “partners” in the business by permitting them to

consider themselves owners as well as managers” (p. 136) – a move that, in Pierre’s

view, would only be possible through his purchase of Coleman’s stock. We have,

therefore, a situation whereby conflicting goals prompted an action that can be considered

opportunistic in relation to some goals, but well intended in relation to other ones.

Chandler suggests the lack of a malevolent intent. Pierre felt that “he had to choose

between the needs of the enterprise and the continuance of family solidarity” (p. 358); in

order to remain committed to his vision of the company and to the task of carrying out

this vision, he had to knowingly and consciously breach his cousins’ trust and therefore

break his prior commitment to preserving harmony and peace among family clans. He

traded off his commitment to Alfred and William for a commitment that he deemed more

important – the commitment to “the future of the Powder Company” (p. 338) and to its

key executives. The reality was therefore reframed: The moral circle of the family was

traded for an expanded moral circle of those affected by the future of the corporation,

deemed more relevant and important. Here, we are once again dealing with sets of

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commitments within a particular and identifiable range of transactions, rather than at the

level of a single transaction or the level of the firm as a whole.

This theme can be observed with particular clarity in Chandler’s account of Du

Pont’s transformation from a family firm to a modern enterprise, and can be traced

through other instances where the goals of the enterprise (as seen by Pierre) clashed with

the goals of the family. In Chandler’s words, “the most critical period in the history of

any modern large impersonal corporation comes when the founder or his family have to

make terms with the requirements of large-scale enterprise” (p. 357). Pierre was acutely

aware of this conflict between kinship and business and worked to mitigate it – mostly,

by means of negotiations, arbitration, sensitivity “to other people’s feelings” (p. 283) and

“care and diplomacy in making changes” (p. 499). In some instances, this effort served

as a successful mechanism to economize on conflicting commitments before they resulted

in reframing of reality; yet, for the company to “continue long as a force in its industry,

the needs of the enterprise must come before those of the family” (p. 357) -- hence the

reframing of reality described above. In more general terms, it would be reasonable to

hypothesize that benevolent preference reversal associated with reframing of reality may

be a frequently observed phenomenon in family enterprises.

The difference between reprioritization and reframing of reality is that the former

delays the original commitment, making it less cognitively and/or temporally proximate,

while the latter invalidates the original commitment, swapping it for an alternative set of

objectives which are mutually exclusive with the original. Scaling back on

overcommitment, in contrast, means acknowledgement of the commitment combined

with the recognition of the impossibility of its achievement. Table 4.1 illustrates a

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temporal continuum of the relationship between various facets of the extended model of

bounded reliability and corresponding commitments.

(Table 4.1 about here)

Benevolent resistance to change. Change plays a central role in Chandler’s

oeuvre. After all, it addresses the making of the modern corporation, describing nothing

less than two examples of massive change: 1) the metamorphosis of the Du Pont

company – first from a family partnership to a national business enterprise, and then from

a U-form to an M-form corporation; and 2) General Motors’ transformation from a

disjointed, loosely run company to one of the largest and the most successful enterprises

of its time. In the course of these transformations, tensions often arose and commitments

failed due to people’s resistance to change. In his critique of the design school of

strategic management, Mintzberg (1990) cautions against confusing organizational

learning with opportunism. He identifies four different psychological sources of

implementers’ resistance to a new strategy: narrow-mindedness (extreme attachment to

traditional ways), small-mindedness (lack of understanding of the new strategy), bloody-

mindedness (general unwillingness to comply) and right-mindedness (desire to serve the

organization in the best possible way). In TCE terms, narrow-mindedness, small-

mindedness and ill-informed right-mindedness represent expressions of bounded

rationality, while bloody-mindedness is perhaps akin to opportunism. In relation to the

new facets of BRel associated with resistance to change, we are particularly interested in

the first and last categories: narrow-mindedness, which can also be described as genuine

difficulties in unlearning (Tsang, 1997) the old methods because of a mere “force of old

habit” (p. 126), and right-mindedness, or a genuine belief that the old ways were better.

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In those instances, initial commitments to a new course could perhaps be described as

ceremonial and are followed by resistance to implement. Below, we cite Chandler’s

account that pertains to benevolent resistance to change. Readers should be reminded

that, in analyzing benevolent resistance to change, we essentially deal with replacing (or

failing to replace) one set of routines with another; again, the appropriate unit of analysis

is a class of related transactions.

“The extent that this is now done on the part of [Harry Haskell and Hamilton

Barksdale – Du Pont’s senior executives], it is not with intent but from force of old habit,

and it will be some time before the two of them get straightened out,” (p. 126) – wrote

Arthur Moxham to Coleman Du Pont (then President) in 1903 of difficulties experienced

in implementing a new organizational structure, according to which senior executives

were to keep their attention on broad overall policy and leave operational details to

department heads. Haskell and Barksdale, both members of Du Pont’s Executive

Committee, accepted the new arrangement and professed to comply, but in reality could

not abandon their old ways, continuing to attend to minute matters in their departments

and failing to focus on more important duties. This was not opportunism, as no self-

interest was sought through these actions. They simply could not unlearn their old

behaviour. Their outdated knowledge and routines prevented them from obtaining new

knowledge (Hedberg, 1981; Nystrom and Starbuck, 1984), and discarding the outdated

routines proved challenging. This clearly is behaviour not associated with malevolent

intent, but representing more than just a case of bounded rationality: Vocal acceptance of

the new arrangements signals full understanding, while the absence of malevolent intent

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is unambiguous. Yet, commitment to the new arrangements remained unfulfilled, due to

the factors associated with change-driven, benevolent preference reversal.

History repeated itself during another reorganization of 1911-1914, when

Coleman and Pierre attempted to explicitly separate long-range policy making from

routine administration (pp. 314-321). The objective was to train a new generation of

leaders by allowing young executives to rise into key operational jobs while limiting the

Executive Committee’s role to raising funds, planning future capital expenditures and

evaluating existing operations. Yet, the Executive Committee members found it hard to

remove themselves from their former roles, continuing to micromanage operations and

interfering with succession planning by preventing the new generation of executives from

acquiring skills necessary to run the business in the future. After three years of

unsuccessful struggle with the new structure, it became apparent that “the solution lay in

a change of men rather than of organization” (p. 319), as “the traditions that had been

established for years were so strong that simply drawing an organization chart could not

change the company’s administration” (p. 319). The company’s succession planning

efforts, as well as the smooth functioning of governance mechanisms, suffered as a result

of the Executive Committee members’ inability to embrace their new roles.

It is not quite clear from Chandler’s description how the issues with the 1903

reorganization were resolved, but it was most likely through Pierre Du Pont’s sensitivity

to others’ feelings and diplomacy in implementing new practices. Chandler believes that

the reason of Pierre Du Pont’s success at both Du Pont and General Motors was his

understanding of the demands of the new and changing situation, combined with his

desire to retain old values. Pierre recognized the needs of a new enterprise and promoted

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employment of professional managers, adoption of new technologies and utilization of

new management techniques, while keeping the loyalties, commitments and incentives

that existed in a small family partnership. This personal relationship building must have

been Pierre’s way of economizing on bounded reliability that was associated with change.

Yet, Pierre Du Pont’s above approach did not always work. The reorganization of

1911-1914 resulted in a massive family squabble, at the end of which Pierre and his

siblings obtained full control of the company, thus achieving the “change of men” (p.

319) that allowed Pierre to move forward with the change of structure. The lesson to be

learned here is that, hard as it is, replacing old blood with new may sometimes be the

only way for an organization to unlearn. A similar scenario emerged in a restructuring of

General Motors, when Durant had to resign in order for the reorganization to take place

under Pierre Du Pont’s guidance (pp. 475-491). Finally, this change of men economizing

strategy is evident in Pierre Du Pont’s own reaction to the swift and deep economic and

political changes of the 1930s (p. 590). Unable to grasp the meaning of the change he

was facing, Pierre responded by removing himself from the business world. Having

embraced change for his entire life, and having seen others destroyed by change, he

perhaps recognized a point where unlearning would be difficult, and chose to withdraw.

Sometimes resistance to change occurs when there is a genuine belief that the old

ways are better and more beneficial for the company than the new, and when there is a

scepticism and distrust of the new order. This type of behavioural response is most

evident in Alfred Du Pont’s, one of the company’s executives prior to the 1914

reorganization, reaction to the proposal by Coleman and Pierre: “... [the company] during

its existence, thrived under the old plan of organization to a remarkable extent; and ... this

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success has been due largely to past methods, and not in spite of them.” (p. 307). This

lack of acceptance of the new methods led to a bitter family fight, a lawsuit and Alfred’s

eventual departure from the company.

Often, this type of resistance can be moderated by targeted leadership practices

and relationship building, and, in Chandler’s words, “care and diplomacy in making

changes” (p. 499). An excellent example of such economizing mechanism can be seen in

Pierre’s efforts to recover and regenerate General Motors when he took over Durant as

the company’s President (pp. 509-510). Pierre worked diligently to win the confidence of

managers who had looked up to Durant with respect and affection, and to restore

employees’ faith in the company’s future. He visited plants, had face-to-face meetings

with managers and made a point of personally meeting local businessmen and civic

leaders in cities and towns where General Motors’ plants and offices were located. By

doing this, Pierre was able to reassure General Motors’ staff, executives, suppliers and

stakeholders that the company would remain solvent and become prosperous, and that the

new management was competent, concerned about employees’ well being and willing to

learn.

To underscore the importance of resistance to or acceptance of change as a

behavioural driver, it is useful to quote one of Chandler’s concluding remarks about

Pierre Du Pont: “In business maters he never favoured maintaining the status quo. His

achievements resulted from an accommodation, not a resistance, to change” (p. 604). For

Pierre, understanding and acceptance of change became an enabler for creating two of the

most successful corporations of his time and for meeting these corporations’ obligations

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to their stakeholders. He also realized that resistance to change and inability to unlearn

old routines can create serious obstacles to meeting these obligations.

Benevolent conflict. Benevolent conflict is a multi-actor achievement barrier,

whereby conflicting commitments occur at one point in time among various actors in the

organization, due largely to poor coordination; actors then start working against each

other, thus undermining goals and commitments of the organization as a whole.

Benevolent conflict deals with classes of transactions within two or more functional units

– more specifically, routines and practices that, due to the lack of proper, coordination-

focused organizational routines, come in conflict with each other. Our analysis brought

to light several instances of benevolent conflict, where non-fulfillment of commitment by

different parties was due to these parties’ diverging interests. This was not opportunism,

as all parties were acting with the corporation’s best interest in mind; however, the

objectives of the various parties were not properly aligned with each other, nor with the

overall interests of the corporation.

An excellent example of such behaviour can be seen in a conflict of interests that

existed between Powder Company departments during the financial panic of the early

1900s. (pp. 222-225) A study of the company’s inventory demonstrated that Du Pont’s

Purchasing Department’s spending was undermining the company’s short-term financial

requirements. The head of the Purchasing Department attempted to capitalize on

favourable prices for essential materials during the time of the crisis, which resulted in a

large increase in working capital at the exact time when consumption was dropping,

leading to excessive inventories in the Essential Materials Department. Naturally, the

Essential Materials Department was aiming to reduce inventory cost, while the

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Purchasing Department’s goal was to reduce long-term cost of supplies. Conventional

TCE would explain this issue simply by pointing to alleged opportunistic behaviour of

the two managers, who were engaging in subgoal pursuit in order to advance their

respective functional departments’ interests. However, in reality both managers believed

that they were acting in the best financial interest of the firm. The problem was that

neither of the managers was aware of the firm’s overall financial position. Pierre Du

Pont, who at the time was the company’s treasurer and thus possessed the best knowledge

of the firm’s financial requirements, had to act as an arbitrator between the conflicting

interests, and initiated a comprehensive review of the issue in an effort to simultaneously

achieve the advantages of large-scale, long-term buying and minimum inventories. This

review eventually led to a decision to integrate vertically. From the BRel perspective, the

point of this incident is that both departments failed to help the company achieve its

financial goals, mainly because their operations were not harmonized.

This problem was particularly significant at General Motors, where divisions

traditionally operated independently and with very little cooperation and coordination.

This resulted in redundancies in product lines, operational difficulties, frequent conflicts

between “line and staff men” (p. 528) and, eventually, non-achievement of financial

goals. The problem was remedied by creation of interdivisional committees. The first

interdivisional committee, called a “General Technical Committee” (p. 547), was struck

to bridge the gap between engineering and product development as a response to the

copper-cooled engine fiasco. The General Technical Committee proved successful, and

the company followed by setting up similar General Sales, Works Managers and Power

and Maintenance committees in 1924. These permanent interdivisional committees with

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their own staff and funds strengthened the corporation considerably by harmonizing the

interests and activities of different departments without impairing their autonomy. These

committees acted as a safeguarding mechanism against commitment non-fulfillment due

to poor coordination or lack of a big picture understanding by participating parties.

The intra-company material transfers at Du Pont in 1904 (pp. 151-157) offer

another example of non-harmonized divisional behaviour that resulted in negative

consequences for the firm. At the time, Pierre Du Pont was establishing new costing and

pricing policies, which stipulated that interdepartmental billing, should be based on costs

rather than market prices. Thus, if intra-company prices were higher than suggested by

the market, the buying units ended up penalized by having to purchase supplies at greater

expense. As the company integrated vertically, it began to control a larger portion of its

supplies, and interdepartmental transfers became more common. Pierre insisted on

charging within the company at cost in order to adhere to proper accounting procedures;

consequently, some departments suffered losses. In addition, individual performance of

departments could not be easily assessed under the cost system, as it was not immediately

apparent which selling units’ costs were too high to match current, external market prices.

As a result, targets were missed due to inappropriate handling of interdepartmental

transfers. Much later, during his tenure at General Motors, Pierre accepted the market

view on intra-company billing, whereby interdepartmental prices were set through

negotiations (this practice, termed internal markets (Reger, 1999; Ouchi, 1979), has been

addressed in the management literature as one of the main coordinating mechanisms in

multidivisional and multinational enterprises.

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 IMPLICATIONS

Our analysis proposes an extension to Verbeke and Greidanus’ envelope-concept

of BRel by introducing additional dimensions of good-faith behaviour that results in

negative consequences for the firm. These dimensions include behaviour caused by

conflicting commitments, difficulties in implementing change, poor coordination or

harmonization of interests of various involved parties (Figure 4.1).

This extension of BRel theory advances the thinking that good faith preference

reversal is a more realistic mechanism for explaining failed commitments than

opportunism as intentional deceit, and offers additional considerations as to when and

why non-fulfillment of commitment is likely to occur, and how companies can safeguard

against broken promises. Understanding the nature of failed commitments in these

additional dimensions is quite important. For instance, there is a widespread belief that

organizational change is inevitable and continuous (Mirza, 2009), and academics and

practitioners alike have dedicated much effort to understanding how businesses can

embrace change. The specific facets of BRel associated with change offer new ways of

conceptualizing change in the context of TCE; their practical relevance is in describing

mechanisms to economize on BRel associated with resistance to change.

Likewise, harmonization of departmental activities is a crucial issue for a

multidivisional enterprise, as interdependencies and integrated activities among parts of

the organization often serve as important sources of competitive advantage for M-form

enterprises (Ingham, 1992). Formal and informal coordination mechanisms have been

regarded in the literature as fundamental structural elements, or the glue that keeps the

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organization together (Mintzberg, 1991). It is, therefore, important to understand how

coordination can remedy bounded reliability issues in a multidivisional firm.

Reframing of reality is particularly relevant for any firm operating in a complex

organizational, technological or environmental setting, where the circle of those affected

by a particular decision or commitment is diverse and expandable. Multinational

enterprises, for example, face a set of multiple realities associated with home versus host

countries. Further, as hypothesized above, reframing of reality may be a persistent issue

for large family firms, whereby effective management requires embracing the needs of

the family as well as the needs of the enterprise, which may sometimes be at odds. Again,

our findings illuminate reframing of reality as a source of BRel, and suggest safeguarding

tactics.

Related to the above point, each new dimension of BRel is tied to distinct

economizing strategies. When benevolent reframing of reality can occur, economizing

strategies aim at meshing conflicting commitments before they occur, and include

diplomacy, negotiations and arbitration. For BRel associated with benevolent resistance

to change, economizing strategies aim at helping participating parties unlearn pre-

existing, dysfunctional organizational practices. In the context of Du Pont and General

Motors, this was achieved through personal leadership, relationship building and

communication and, in extreme cases, through change of men, whereby those who were

unable to learn the new practices either withdrew or were forced to withdraw from the

company. Finally, benevolent conflict of divisional interests is economized upon through

formal and informal coordination mechanisms. Formal mechanisms include centralization

of decision-making processes, structural coordination bodies and planning and control

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(Reger, 1999). Du Pont and General Motors adopted such mechanisms in the form of

comprehensive reviews, interdivisional committees and internal markets. Informal, or

person-oriented mechanisms include socialization and culture (Reger, 1999), which, in

this case, took a form of arbitration and relationship building through personal contacts.

Table 4.2 summarizes economising mechanisms for the newly identified BRel

dimensions.

(Table 4.2 about here)

One common theme that is apparent in the above analysis of economizing

mechanisms is the use of communication and relationship building. While the three

economizing mechanisms – goal alignment, organizational routines to help unlearn old

practices, and coordination mechanisms – are distinct, communication and relationship

building are present to some extent in all three types of organizational routines aimed at

reducing BRel. This further emphasizes the role of interpersonal dynamics in the

functioning of a corporation, and underscores the importance of realistic behavioural

assumptions in order to understand fully the nature of business transactions involving

individuals. In TCE terms, this dimension of economizing could be viewed as a

relational, or implicit, portion of contracting – but our research highlights that this

contracting is necessitated not merely by opportunism, but by a significantly broader

array of BRel dimensions.

CONTRIBUTIONS, LIMITATIONS AND DIRECTIONS FOR FUTURE

RESEARCH

Our analysis has confirmed that Chandler’s historical accounts can hardly be

considered a testament to TCE’s core assumption of opportunism. Rather, Chandler

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describes multifaceted and complex actors, whose decisions are driven by a variety of

factors among which opportunism is often not of critical importance. Chandler’s oeuvre

is really a story of change; it is therefore not surprising that factors related to change are

shown to underlie many decisions, including those that led to failed commitments. It is

interesting to observe that those failed commitments originate not only within divisions,

as Williamson’s interpretation of the M-form structure suggests, but in all corners of the

organization: Executive Committees, divisional managers, suppliers, sales agents, board

members, government officials and company Presidents have taken turns reprioritizing,

overcommitting and rejecting change in Chandler’s detailed account of corporate

transformation. Even Pierre Du Pont, the book’s unquestionable protagonist, is not

immune to breaking promises. Yet, Chandler would not attribute to Pierre any sort of

malevolence. This observation supports the contention that opportunism is not a

sufficient behavioural assumption upon which to build a theory; the true behavioural

foundation that underlies failed commitments is likely much more complex.

By introducing BRel as a new central concept in the study of the firm, our paper

augments the deficient assumption of opportunism and thus increases the legitimacy of

TCE as a general theory of the firm. Importantly, the adoption of BRel as a key

behavioural assumption in TCE would reverse the theory’s “ideology-based gloomy

vision” (Ghoshal, 2005: 82) by refuting the claim that all commitment non-fulfillment has

a malevolent nature. Our paper establishes the foundation for theorizing on BRel and, in

practical terms, has far-reaching managerial implications by suggesting that managers

should develop tools for economizing not only on potential opportunistic behaviour, but

also on various other facets of BRel.

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 The present study has focused on one – albeit rich and abundant – source of data,

in one particular organizational context. Consequently, the proposed new facets of BRel

were developed in the context of a single multidivisional corporation. Yet, the first two

dimensions, namely reframing of reality and benevolent resistance to change, likely

stretch beyond the boundaries of the enterprise as a stand-alone operation. It is easy to

imagine how resistance to change, for example, can plague relationships between

suppliers and buyers, arms-length business partners or firms and governments, and can

thus lead to broken promises and unfulfilled obligations. However, the third dimension –

benevolent conflict due to poor coordination of interests – is more suitable for explaining

failed commitments within a single enterprise, as it focuses on harmonizing activities of

different parts of the firm in order to achieve a common goal or deliver on common

commitments. This dimension could be also applicable to hybrid organizations that have

strong structural interdependencies and common incentives and thus operate much like

hierarchies. Future work needs to examine dimensions of BRel and their

interrelationships in a variety of contexts, including family firms, MNEs, emerging

economy multinationals, hybrid organizations and global factories (Buckley, 2009), in

various industries and stages of organizational development. In this process, new

important dimensions of BRel could be uncovered. For now, this paper straddles the

disciplines of business history and strategic management in an attempt to strengthen TCE,

strategic management’s history-rooted core paradigm. This might be the beginning of a

long-lasting friendship conducive to better governance.

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Table 4.1. Commitment continuum for the extended model of bounded reliability

Importance of original commitment at various

time points
Facet of BRel
t0 t1 t2

Opportunism (ex Not important Not important Not important

ante)

Opportunism (ex Important Not important Not important

post)

Benevolent Important Not important Important

reprioritization

Scaling back on Important Important but Important but

overcommitment impossible impossible

Reframing of reality Important Not important Not important

Benevolent Important Important Important

resistance to change

Benevolent conflict Important Important/Not Important

important

This table illustrates shifts in economic actors’ attitudes toward original

commitments over time. E.g., with ex ante opportunism, the commitment was never

viewed as important, whereas with ex post opportunism, the commitment lost importance

with the onset of alternative self-interests. With benevolent reprioritization, the

commitment becomes less proximate while maintaining its ultimate importance. With

scaling back on overcommitment, the original commitment remains important, but is no

longer achievable starting at t1 time period. With benevolent reframing of reality, the

original commitment loses its importance in favour of an alternative commitment that fits

the new reality. With the benevolent resistance to change, the commitment remains

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important throughout, but impossible to achieve without overcoming the resistance. With

the benevolent conflict, the ultimate importance of commitment remains, but, at time t1,

depends on a view point of a particular economic actor: that is, the commitment may be

important to some but not other actors.

Table 4.2. Economizing on new categories of bounded reliability

BRel Reframing of reality Benevolent Benevolent conflict

categories resistance to change

Economizing Goal alignment Organizational Formal and informal

mechanisms
Reduction of potential
friction among multiple
realities
Specific • Diplomacy
examples of • Negotiation
economizing • Arbitration
• External experts
routines to help coordination mechanisms
unlearn old practices
• Leadership and Informal:
relationship • Arbitration / personal
building contacts
• Training
• Communication Formal:
• “Change of men” • Comprehensive
reviews to harmonize
activities of various
parties
• Interdivisional
committees / task
forces
• Internal markets

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 Figure 4.1. Extended model of bounded reliability

Bounded'Reliability'

Opportunism!as! Benevolent! Reframing!of! Benevolent! Benevolent!

intentional!deceit! preference!reversal! reality! resistance!to!change! conflict!

Reprioritization! Overcommitment!
New'categories'of'BRel'
 Essay 5

TRANSACTION COST ECONOMICS AND THE FAMILY FIRM

Gedajlovic and Carney’s (2010) application of transaction cost economics (TCE)

thinking to the family business builds on TCE’s concept of asset specificity. Our analysis

augments this application. We focus on TCE’s behavioural assumptions, which act as

drivers of failed human commitments. We show that both the exposure and response to

bounded rationality and bounded reliability challenges may be different in family firms

versus Chandlerian hierarchies, and introduce the new concept of family-based human

asset specificity.

INTRODUCTION

Oliver Williamson earned the 2009 Nobel Prize in Economics, largely based on

his contributions to transaction cost economics (TCE) theory. TCE has emerged as a core

paradigm in the management and organizational studies literature (Hill, 1990). Quickly

becoming one of the leading perspectives in the field (David & Han, 2004), it has

received much attention from a broad range of audiences (Rindfleisch & Heide, 1997)

and has been subject to numerous empirical tests (Tsang, 2006). It is therefore

commendable that the authors of “Markets, hierarchies, and families: Toward a

transaction cost theory of the family firm” (Gedajlovic & Carney, 2010) use TCE

thinking to address various fundamental questions related to the existence, functioning,

and performance of family firms. As family business research expands and matures, an

increasing range of theories is being applied to the context of this particular governance

form (Wiklund, 2006). Agency theory has frequently been used to explain family firm

performance; stewardship and resource-based view theories have also been applied in

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analyses of the family firm (see Chua, Chrisman & Sharma, 2003; Dyer, 2006; Westhead

& Howorth, 2006). Gedajlovic and Carney’s article represents a welcome addition to the

conceptual thinking on the family firm.

In the following discussion, we augment Gedajlovic and Carney’s (2010)

perspective. We demonstrate the usefulness of TCE as a conceptual lens to study the

family firm.

TCE AND THE FAMILY FIRM

Gedajlovic and Carney argue that the family firm as an economic institution has

been largely ignored by TCE. They portray the family firm as a discrete structural

alternative, whereupon Williamson’s (1975, 1985, 1996) ‘market vs. hierarchies’

classification of polar governance forms can be applied. The authors focus on

Williamson’s asset specificity concept, and argue that family firms are characterized by a

distinct class of assets, which are firm specific but at the same time generic in application,

termed generic nontradeables (GNTs). The authors identify four key types of GNTs:

bonding of social capital, bridging of social capital, reputational assets, and tacit

knowledge. Although the authors do not insist that these GNTs are unique to family

firms, it is important to make it clear that they can also be found in nonfamily firms.

Indeed, most Chandlerian hierarchies have an incentive to keep up a good reputation

because professional managers can be fired and only have their reputation when applying

for a job elsewhere. Furthermore, in certain cases, family firms may possess

disadvantages in developing these GNTs, or their development may lead to adverse

consequences. For example, close social ties may promote unreliability, as the case of the

fallen Wall Street money manager Bernard Madoff, and his family business, Madoff

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Investment Securities LLC, clearly illustrates.

The analysis of GNTs is also actually common in the more general, non-

Williamsonian version of TCE, namely internalization theory. Internalization theory

argues that firms exist because they command a set of idiosyncratic resource bundles,

called firm-specific advantages (FSAs), which can be more efficiently exploited and

rejuvenated inside the firm than through the use of alternative governance forms.

Internalization theory suggests that some FSAs can be deployed and augmented across a

variety of related markets, whether product markets or geographic markets, i.e., they are

generic (within limits) in application. This holds especially for the company’s higher-

order FSAs, such as routines and recombination capabilities (Verbeke, 2009). In other

words, any firm, whether a venture capital firm, a family firm, or a Chandlerian

hierarchy, commands a mix of FSAs, some of which can be deployed solely in extant

activity domains or for specific transactions and other ones that have a much wider

applicability (e.g., General Electric’s capacity to absorb new acquisitions very rapidly in

its existing operations). In addition, each firm coordinates a mix of tradable and

nontradeable resources, with the nontradeable ones (such as entrepreneurial judgment,

reputational assets, etc.) representing the essence of the company. Here, what counts is

not so much governing single transactions or narrow transaction classes in their entirety

in a Williamsonian sense, but rather governing innovation processes (and related FSAs)

in their entirety, i.e., from sustained idea generation to the continued profitable selling of

products (Verbeke & Kenworthy, 2008).

Family firms are therefore not the governance form of choice in external

environments where any GNTs are expected to contribute comparatively more to

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efficiency than transaction-specific or product-domain-specific assets. Nor do family

firms’ relative strengths and weaknesses vis-à-vis other governance forms derive largely

from the extent to which the former can economize (and generate value) by combining

GNTs with other asset classes (with other governance forms assumed comparatively

weak in this area). However, family firms may well represent the most efficient

governance alternative to exploit particular types of GNTs, but this requires credible,

comparative institutional analysis. We discuss such a GNT type, namely family-based

human asset specificity, in the last section of this paper.

Is the family firm indeed a discrete structural alternative? While different from a

conventional, Chandlerian managerial hierarchy operated by professional managers and

monitored by arm’s length shareholders (Walsh & Seward, 1990), the family firm is still

a firm, or a Williamsonian hierarchy, from a TCE perspective. The family firm is

supported by a distinct form of private ordering, different from that supporting markets

and hybrids (Williamson, 1996), and exhibits all characteristics of any other type of firm,

including authority, employment relationships, informal organization, and an

economizing orientation (Barnard, 1938). Even Williamson himself has actually

considered the particularities of family businesses and the phenomena Gedajlovic and

Carney describe as GNTs. Williamson (1996: 78–79) explicitly acknowledges the family

firm, with its comparative strengths and weaknesses, in terms of economizing properties,

and discusses how firms use private ordering systems of networks, profession-related

punishment routines, and contract enforcement through societal culture, reputation bonds,

and informal organization, to avoid—and provide sanctions against—rule violation.

These economizing mechanisms represent little else than the bonding of social capital,

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bridging of social capital, reputational assets, and tacit knowledge, and are utilized by

family firms and managerial hierarchies alike (e.g., all firms rely on informal

enforcement mechanisms rather than formal contracts in environments lacking strong

legal enforceability (Zhou & Poppo, 2010). These mechanisms are not dedicated to

individual transactions but support a variety of transaction classes. This is why

Williamson views them as economizing mechanisms rather than ‘assets’ (GNTs). Here,

some types of firms may be better equipped than other ones to access and efficiently

utilize such mechanisms.

Assuming, fully in accordance with mainstream TCE logic, that Gedajlovic and

Carney’s GNTs as economizing mechanisms are useable not only by family firms but by

all firms, the important question becomes whether family firms are better or more poorly

equipped to use some of these mechanisms for economizing and value-creating purposes.

To answer this question, we briefly review and extend TCE’s core behavioural

assumptions.

BEHAVIOURAL ASSUMPTIONS OF TCE: INTRODUCING BOUNDD

RELIABILITY

TCE’s core behavioural assumptions are bounded rationality and opportunism.

Bounded rationality refers to economic actors’ behaviour that is “intendedly rational, but

only limitedly so” (Simon, 1961: xxiv). In other words, human actors have a limited

capacity to process information, address complexity, and make optimal choices. In the

presence of bounded rationality, all contracts are necessarily incomplete. In Williamson’s

view, human agents who populate firms and markets also have an inherent proclivity

toward opportunism, which manifests itself in “calculated efforts to mislead, distort,

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disguise, obfuscate or otherwise confuse” (Williamson, 1985: 47). Opportunism has been

defined as “self-interest seeking with guile” (Williamson, 1981b: 1545). Governance

structures should therefore be designed so as to economize on bounded rationality and

safeguard against economic actors’ potential opportunistic behaviour.

While behavioural assumptions play a pivotal role in theory development, many

leading management theories are arguably built on assumptions that do not represent

reality in a complete and accurate way (Tsang, 2006). In particular, the concept of

opportunism has been the subject of significant controversy (Conner & Prahalad, 1996;

Ghoshal, 2005; Ghoshal & Moran, 1996; Hodgson, 2004). It has invited much criticism,

both for its narrow conceptual focus and for the lack of sufficient empirical support

(Tsang, 2006). It has been argued that concerns surrounding the behavioural assumption

of opportunism reduce the legitimacy of TCE as a general theory of the firm (Verbeke &

Greidanus, 2009). Yet alternative explanations of failed human commitments are scarce.

Until recently, scholars have largely addressed the deficient nature of the opportunism

assumption by ignoring or rejecting it (see Conner & Prahalad, 1996; Ghoshal & Moran,

1996). However, Verbeke and Greidanus (2009) have proposed the new envelope concept

of bounded reliability as a way to advance TCE-based thinking. Bounded reliability

extends the assumption of opportunism by including the many situations where parties

may fail to deliver on commitments while not intentionally engaging in self-interest

seeking with guile. Bounded reliability reflects the often-observed reality of failed

commitments caused by a variety of factors including but not limited to intentional deceit.

In other words, bounded reliability includes two broad classes of failed commitment:

opportunism and benevolent preference reversal. Benevolent preference reversal, in turn,

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can be associated with good faith reprioritization or with scaling back on

overcommitment; the preliminary model proposed by Verbeke & Greidanus thus contains

three facets of bounded reliability: opportunism, benevolent preference reversal and

overcommitment.

Good-faith reprioritization describes ex ante commitments that were made in

good faith but become reordered because their importance diminishes over time, or

because more proximate (spatially or temporally) events take higher priority. Scaling

back on overcommitment captures managerial tendency to make impulsive or poorly

planned (but benevolently intended) ex ante commitments that then need to be scaled

back ex post. As part of their conceptual development, Verbeke and Greidanus identify a

number of safeguarding mechanisms for the three facets of bounded reliability, e.g.,

realistic and clear goal setting, regular reviews of targets and budgets, development of

informal connections among actors, joint strategic planning, and imposition of limits on

the size and scope of new activities.

BOUNDED RATIONALITY, BOUNDED RELIABILITY AND THE FAMILY

FIRM

Gedajlovic and Carney (2010) usefully define a family firm as a unique

governance archetype with three inherent characteristics: parsimony, personalism, and

particularism. These three characteristics can be used for purposes of comparative

institutional analysis, building on the bounded rationality and bounded reliability

concepts. If we start from observing a particular family firm, the question could be asked

as to the likelihood that family firm governance will be sustained, rather than shift toward

another governance type, such as a Chandlerian hierarchy. Below we briefly discuss a

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few key parameters likely to affect (in a testable fashion) the occurrence of such a shift,

building especially on the particularism characteristic of family firms, in cases where it

likely leads to dysfunctional rather than economizing outcomes.

First, the impact of complex technology in a high-growth context. Rapidly

growing family firms that use complex technologies are more likely to suffer from

bounded rationality challenges than nonfamily businesses. Here, particularism represents

a liability in recruitment and utilization of skilled and professional talent, as well as in the

management of complex technical systems. Family firms’ propensity to select and

promote employees on the basis of particularistic criteria rather than their skills and

professional expertise leads quasi-automatically to a narrowing of the talent pool

available to the firm, thus exacerbating the managerial team’s inherent scarcity of mind

(Williamson, 1996), especially in the case of rapid growth in a complex technology

sector. In addition, particularistic rather than expertise-based selection of top

management creates a technically inferior group of decision makers to address new

challenges imposed by the external environment. This is a liability especially in firms that

require highly specialized knowledge of rapidly evolving technologies. A similar point

holds for large, diversified firms that are organizationally complex and need sophisticated

routines to determine the firm’s boundaries, its allocation of resources for purposes of

innovation, and more generally, its internal organization (Dyer, 2006; Verbeke &

Kenworthy, 2008). Here, the bounded rationality issue faced by the family firm is

twofold: The family firm suffers from a restricted quantity of mind, and the quality of

mind available to the firm may also be inferior. The prediction is therefore a governance

shift toward nonfamily-type firms.

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 Second, the impact of investments in management professionalization. Assuming

again a complex technology and a high-growth environment, the question arises whether

management ‘professionalization’ by hiring and delegating more authority to nonfamily

managers (Chua et al., 2003; Gedajlovic, Lubatkin, & Schulze, 2004) can be effective in

addressing the above bounded rationality challenge and sustaining family firm

governance. Here, it is important to recognize that this course of action can itself create

unique, internal bounded reliability problems in firms using particularistic human

resources management practices. Professionalization creates unique challenges associated

with evaluation and compensation systems, whereby asymmetric treatment of family and

nonfamily managers creates severe bounded rationality and bounded reliability problems

and may ultimately lead to inferior economic performance (Chua, Chrisman, & Bergiel,

2009). Gedajlovic and Carney (2010) correctly point out that insider-oriented hiring and

promotion policies can alienate nonfamily workers and lead to perfunctory contributions,

thus contributing to bounded reliability, rather than economizing on it. Compensation

policies commonly practiced by family firms, such as withholding stock options from

nonfamily managers to avoid dilution of family control and uncertainty of incentive pay

(Park, 2002), can have the same effect. Empirical evidence suggests that nonfamily

managers in family firms are often dissatisfied with the relative lack of equity in

compensation and potential for upward mobility (Poza, Alfred, & Maheshawi, 1997),

which can again trigger bounded reliability problems, in terms of reduced commitment.

In this context, bounded reliability issues in a family firm can be exacerbated by

asymmetric altruism (Chrisman, Chua, Kellermanns & Chang 2007; Chrisman, Chua &

Litz, 2004; Chua et al., 2009; Corbetta & Salvato, 2004; Lubatkin, Schulze, Ling & Dino,

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2005)—a phenomenon whereby firm owners tend to be altruistic (generous) toward

family employees in the firm even when the latter “free ride and lack the competence

and/or intention to sustain the wealth creation potential of the firm” (Chrisman et al.,

2004: 338). Asymmetric altruism makes it difficult to enforce the explicit and implicit

contracts between family owners and family members working in the firm and promotes

unreliability by coloring performance evaluations (Chua et al., 2009). Family members’

reluctance to monitor, evaluate, and discipline each other can be a source of significant

bounded reliability issues (Dyer, 2006). The ineffective or nonexistent self-monitoring

and evaluation of employees can lead to shirking (an expression of opportunism), as was

pointed out by Weber (1946), and more generally to imperfect efforts to make good on

open-ended commitments inside the firm.

The prediction is therefore that investments in management professionalization

will only serve economizing purposes and prevent a shift away from family firm

governance in high-growth, complex technology environments, if the entire bundle of

human resources management practices can be professionalized and liberated from

dysfunctional particularism.

Third, the impact of complementary asset requirements. Let us assume again the

environmental context of complex technology and high growth. But let us add the

complexity that the family firm can only keep up with competitors if it secures access to

the complementary FSAs of outside partners. The problem of particularism is that family

objectives may gain priority over business objectives (Westhead & Howorth, 2006),

creating what Chandler and Salsbury (1971) described as a conflict between kinship and

business, between the family ways and the requirements of the environment, and between

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personal and impersonal values. An additional complexity is that conflicting goals,

psychodynamic effects such as sibling rivalry, children’s desire to differentiate

themselves from their parents, marital discord, and identity conflict (Kellermanns &

Eddleston, 2004) as well as differing views within a family—especially on subjects such

as distribution of ownership, compensation, risk, and responsibilities (Dyer, 2006)—are

likely to lead to various expressions of benevolent preference reversal and opportunism,

especially when debating the role that complex contractual agreements with third parties

could play in sustaining the business. Strong familial bonds can be a source of

disadvantage in relationships with outside partners, especially if a family exhibits

“amoral familism” (Banfield, 1958: 83), characterized by distrust of outsiders (Dyer,

2006). This distrust can interfere with utilizing any GNTs in bonding and bridging of

social capital and is likely to lead to a vicious cycle of increased bounded reliability

challenges when interacting with business partners, thereby preventing efficient

contracting to access necessary, complementary FSAs. Here, the stronger presence of

amoral familism is likely to make a family business less sustainable and to facilitate a

shift toward an alternative governance form.

Given the above potential sources of bounded rationality and bounded reliability

unique to family firms, it is important to recognize that not all family firms are created

equal. Family firms differ vastly in their characteristics, and these differences have given

rise to multiple family firm typologies developed by family business researchers (see

Dyer, 1986, 2006; Gersick, Davis, Hampton, & Landsberg, 1997; Landsberg, 1999).

Family firms’ unique characteristics—such as the nature of family assets and liabilities in

terms of their fungibility and alternative deployment potential—to a large extent

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determine the firms’ performance (Dyer, 2006) and, naturally, affect bounded rationality

and bounded reliability issues faced by these firms. When analyzing family firms’ unique

bounded rationality and bounded reliability challenges, it is therefore important not only

to compare family firms with Chandlerian hierarchies in generic terms, but also to look at

how a particular family firm type may affect both the exposure and potential responses to

bounded rationality and bounded reliability.

Yet a family firm’s efforts to economize on bounded rationality and bounded

reliability in generic terms are likely to differ from those in nonfamily firms. The typical

‘contract’ between the family firm as a governance structure and the family members

involved in this structure is fundamentally different from equivalent employment

contracts with outsiders because of the presence of family-based human asset specificity:

1. Involvement in the business arises out of the family context, rather than out of

natural talent, genuine, content-driven interest, educational background, or past

experiences; in other words, the ‘contracting’ typically begins long before the

moment that the family member actually takes on a job in the firm or signs a formal

employment contract.

2. The early involvement of family members in the business, possibly long before a

position is assumed or an employment contract signed, means more possibilities at

socialization as a coordination and control mechanism, as compared with

formalization or pricing. In addition, the seeds are planted for economizing on

bounded reliability, e.g., as a result of shared knowledge, used inter alia to prevent

overcommitment. Family members develop substantial experiential knowledge

over long periods of time, on each other’s range of capabilities that can reduce

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 individual evaluation bias and thereby overcommitment.

3. Given the importance of socialization, entry barriers to assume a managerial

position in the firm are higher for nonfamily members. Higher entry barriers result

from a particular form of time compression diseconomies, meaning there are limits

to the extent that socialization can be accelerated. In contrast, exit barriers are

higher for family members as compared with those facing nonfamily members,

because exit typically has further-reaching implications for the exiting manager’s

private life in case his or her own family firm is involved.

4. Family firms are less able to hire and fire managers to adjust to new external

circumstances; in other words, they cannot adjust their human resources base as

quickly and effectively as other firms. This becomes dysfunctional especially in

high-growth, complex technology environments, as noted above.

5. Family firms can rely to a higher extent on the loyalty of family member managers

and vice versa, than is the case with nonfamily firms and nonfamily managers.

Dysfunctionality arises when such loyalty leads to an absence of across the board,

professionalized human resources management practices (especially to overcome

asymmetric altruism), and the presence of amoral familism. This holds especially in

a high-growth, complex technology environments, where complementary FSAs of

outsiders must be accessed.

The paradox of family firms is thus that they have unique access to a stable and

loyal human resource base, leading to family-based human asset specificity and

Williamsonian bilateral dependency in this context, but at the same time, both the

quantity and quality of this resource base may be suboptimal. A prediction is therefore,

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ceteris paribus, that families that are larger (leading to more options in quantitative terms

as to which family members can perform specific activities for the family business) and

invest most in the business-related professional education of family members (leading to

higher quality resources, which become the subject of family-based, human asset

specificity), are likely to be the most successful in the long run. Such families are the least

likely to experience the disappearance of their family firm, especially if the professional

education also creates awareness of the dysfunctionalities of asymmetric altruism and

amoral familism. Investment in training, which, according to Gedajlovic and Carney

(2010), is somewhat atypical for family firms, can be instrumental to economizing on

both bounded rationality and bounded reliability. Training reduces bounded rationality

challenges by developing the skills and competencies of family members (Westhead &

Howorth, 2006), but it can also signal the founders’ commitment to employees and

outsiders that any family members active in the firm will be held to the same professional

standards as nonfamily members, thus strengthening loyalty from the latter, and

achieving interest alignment with nonfamily members, necessary to safeguard against

bounded reliability. Here, functionally incompetent family members will not operate in

the firm, nor will they be rewarded because of kinship, thereby eliminating the

occurrence of dysfunctional family-based human asset specificity, an important source of

demotivation/alienation of professional managers.

Professional human resources practices in the areas of compensation are equally

important. Chandler and Salsbury (1971) describe how the DuPont Corporation became

the first American company to allow outsiders to purchase stock in the family business,

out of a belief that the success of a modern corporation depended on making key

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employees partners in the business. Ownership-based compensation practices can help

curb bounded reliability challenges by aligning employees’ interests with those of the

founders, even when the founding family remains largely in control of the business.

Importantly, a greater influence of nonfamily managers may also reduce the

dysfunctional effects of amoral familism, thereby supporting the sustainable existence of

the family firm in cases where survival and growth depend on access to complementary

FSAs provided by outsiders.

CONCLUSION

Gedajlovic and Carney’s (2010) “Markets, hierarchies, and families: Toward a

transaction cost theory of the family firm” applies TCE to the important, ubiquitous, and

arguably under-researched governance form of family firms. The authors focused their

analysis on Williamson’s asset-specificity concept, which was the starting point for

assessing family firms’ strengths and weaknesses vis-à-vis other governance forms. Our

view, however, is that reflecting on TCE’s behavioural assumptions in the context of the

family firm is no less important. We considered how TCE’s assumption of bounded

rationality and the new envelope concept of bounded reliability could apply to the family

firm, and how family firms can best economize on bounded rationality and bounded

reliability. It appears that some bounded rationality and bounded reliability challenges,

especially those related to family-based human asset specificity, are indeed unique to

family businesses. However, many bounded rationality and bounded reliability issues

faced by individual firms are determined by a variety of idiosyncratic characteristics

more so than by their family versus nonfamily status. A useful direction for future

research would be to take an in-depth look at what type of family firm may be better

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equipped than other types of family firms to economize on bounded rationality and

bounded reliability challenges in particular situational contexts, in the spirit of more

conventional research comparing functional and multidivisional governance of large

business firms.

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 Essay 6

THE TRANSACTION COST ECONOMICS THEORY OF THE FAMILY

FIRM: FAMILY-BASED HUMAN ASSET SPECIFICITY AND THE

BIFURCATION BIAS

We develop a transaction cost economics theory of the family firm, building upon the

concepts of family-based asset specificity, bounded rationality, and bounded reliability.

We argue that the prosperity and survival of family firms depend on the absence of a

dysfunctional bifurcation bias. The bifurcation bias is an expression of bounded

reliability, reflected in the de facto asymmetric treatment of family versus nonfamily

assets (especially human assets). We propose that absence of bifurcation bias is critical

to fostering reliability in family business functioning. Our study ends the unproductive

divide between the agency and stewardship perspectives of the family firm, which offer

conflicting accounts of this firm type’s functioning. We show that the predictions of the

agency and stewardship perspectives can be usefully reconciled when focusing on how

family firms address the bifurcation bias or fail to do so.

INTRODUCTION

Family firms are of critical importance to their local and national economies

(Gomez- Mejia, Haynes, Nunez-Nickel, Jacobson & Moyano-Fuentes, 2007). They

represent a dominant type of listed corporations around the world (Shim & Okamuro,

2011) and 35% of the Fortune 500 companies (Perman, 2006). Family firms are major

contributors to economic growth, wealth creation, job generation, and competitiveness

(Westhead & Cowling, 1998). The long-term trajectory of the individual family firm,

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however, is not always a ‘happily ever after’ storyline. Extant research suggests that only

one third of family firms survive the second generation (Ward, 2004), and for the

remaining two thirds, the life span is reduced with each successive generation (Jivraj &

Woods, 2002), with the average life expectancy of U.S. family firms estimated to be 24

years (Lee, Lim & Lim, 2003)—a number roughly equivalent to the average tenure of the

founder (Beckhard & Dyer, 1983). Some of these firms cease to exist as family firms,

while other ones simply cease to exist.

Yet, other family-owned businesses survive and prosper for centuries, passing

ownership from generation to generation, living through world wars and natural disasters,

and staying in business during periods of extreme financial turmoil. The Henokiens, an

association of centuries old family firms formed in 1981, represents financially sound

family businesses that are at least 200 years old (Bennedsen, Van der Heyden & MBA

Students of Family Business Management, 2010). Some family firms—Wal-Mart, BMW,

and LVMH, to name but a few—have expanded across borders (Banalieva & Eddleston,

2011) and have made their way into the ranks of the most admired, internationally

operating corporations. What is it that fundamentally separates these successful family

firms from failing ones? What factors affect their continuity and success as family

businesses? In this paper, we answer these questions by applying the conceptual lens of

transaction cost economics (TCE) theory to the domain of family business.

Despite the significance of the family firm in the world economy, family firm

research has not yet achieved full maturity, nor has it been fully integrated into

mainstream management research (Gedajlovic, Carney, Chrisman & Kellermanns, 2012).

Family firms have been analyzed from a range of theoretical perspectives (Wiklund,

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2006). Agency and stewardship theories, as well as the resource-based view (RBV) of the

firm, have been utilized most frequently in conceptual and empirical studies on family

firms (see Chua et al., 2003; Dyer, 2006; Gedajlovic et al., 2012; Westhead & Howorth,

2006). There have been a few worthwhile attempts to advance a TCE-based theory of the

family firm (see Gedajlovic & Carney, 2010; Lee et al., 2003; Memili, Chrisman & Chua,

2011a; Memili, Chrisman, Chua, Chang & Kellermanns, 2011b; Pollak, 1985), but no

unified TCE-based theory of the family firm has been developed yet. We expand on past

scholarly efforts with a view to develop a general TCE theory of the family firm.

TCE has unique potential to explain the existence and survival of family-type

governance, thanks to its powerful foundational assumptions. First, TCE’s core

assumption of asset specificity is particularly relevant to qualify the idiosyncratic

characteristics of a family firm’s employee base, as well as other foundational assets held

by the firm. It could be argued that the RBV in strategy is even more powerful than TCE

in describing the details of a firm’s resources reservoir, as well as the processes of

resources selection, access, combination, exploitation, and rejuvenation. However, what

the RBV misses is ex-ante guidance (rather than ex-post rationalization) on how best to

‘govern’ particular resources and resource bundles, including the specific types of human

assets employed by the family firm. In other words, the RBV may be able to provide an

unmatched description of resources’ value, uniqueness, inimitability, and internal

organizational deployment, but lacks the analytical apparatus to assess the types of

‘contracts’ to be used for governing particular types of resources, whereas the asset

specificity concept in TCE provides the intellectual basis of such apparatus.

Second, TCE incorporates explicit behavioural assumptions, which allow for the

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study of intentionality, but with the possibility of biases, predictably occurring in specific

situational contexts. Agency and stewardship theories both assume a stronger-form

rationality of economic actors than TCE, which builds upon the bounded rationality

concept, with a focus on limited information processing capabilities. Bounded rationality

challenges can be avoided and/or mitigated through proper contractual (and

organizational) design. In addition, TCE’s assumption of bounded reliability (Verbeke &

Greidanus, 2009) enables an exploration of unique types of commitment nonfulfillment

in various governance contexts, including family firms. The presence of explicit and

realistic behavioural assumptions is also an advantage of applying TCE to the family firm

domain as compared to the RBV. The RBV has little predictive or prescriptive capacity,

largely because it lacks behavioural foundations beyond the conventional profit-

maximizing assumption and the quest for superior profits attributed to the firm itself. In

fact, given the content of a firm’s resources reservoir, which can be described in detail

through a RBV lens, TCE provides guidance on how to govern efficiently that reservoir

and how to protect and augment it further through bounded rationality and bounded

reliability economizing.

Third, TCE was specifically designed to explain firm boundaries as well as the

interface with actors outside of these boundaries. TCE is therefore particularly well

equipped to theorize about the relationship between family firm owners and the firm’s

full range of stakeholders (employees, external service suppliers, etc.) with whom

contractual relationships (whether formal or informal) have been established. In contrast,

agency and stewardship theories have mainly focused on interactions involving a

narrower range of actors, typically including shareholders, bondholders, and managers. In

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other words, TCE with its focus on the governance of transactions is by its very nature

‘all-inclusive’: The governance of any transaction (or bundle of transactions) involving

the firm and one of its stakeholders can be assessed in terms of ‘economizing’ properties

vis-à-vis real-world alternatives.

Fourth, agency and stewardship theories build upon diverging assumptions and

yield conflicting predictions (Banalieva & Eddleston, 2011), making the family business

scholarly literature somewhat dispersed and divided (Le Breton-Miller & Miller, 2009),

while TCE can contribute to resolving existing tensions between these competing

theoretical perspectives. In the present paper, we expand especially on the concept of

family-based human asset specificity, which we view as the cornerstone of a TCE-based

theory of the family firm.

As a final introductory point, we follow Le Breton-Miller and Miller (2009) in

defining the family firm as one where a family controls enough votes to influence

significantly corporate conduct. In doing so, we do not discount the importance of family

involvement in operational matters, nor in higher-level governance, but rather argue that

family control will strongly affect both daily management and strategic decision-making

in the corporate governance sphere. Similarly, we acknowledge the importance of family

goals and vision but suggest that these express how the controlling family intends to

exercise control, for example, in terms of substantive decisions on the choice of products

and markets, and as regards organizational design. In other words, we treat these aspects

as design variables that family firms can influence endogenously, rather than as criteria to

be included in the definition of the family firm.

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 BEHAVIOURAL ASSUMPTIONS OF TCE

TCE, as a core paradigm in the management and organizational studies literature

(David & Han, 2004; Hill, 1990), regards the transaction as the basic unit of analysis and

posits that the organization of economic activity is to be understood in transaction cost

economizing terms. Economic efficiency is served by aligning governance structures (and

components thereof) with the attributes of transactions in discriminating, i.e., ‘transaction

cost economizing,’ ways (Riordan & Williamson, 1985). Oliver Williamson, the leading

figure of TCE, built his version of the theory upon three core assumptions: asset

specificity, bounded rationality, and opportunism (Williamson, 1996). Asset specificity

means that particular assets, involved in a transaction (or class of transactions), cannot be

easily redeployed elsewhere without significant loss of economic value. Asset specificity

encompasses physical, organizational, and human assets, and is considered the most

important attribute of a transaction, largely responsible for observable differences in

transaction costs. Greater asset specificity increases transaction costs associated with

simple, short-term contracting, and leads to bilateral dependency between exchange

partners, and therefore to more complex, longer term contracting schemes, including

hierarchical governance (Williamson, 1996). This effect of asset specificity is closely

related to two assumed behavioural characteristics. First, bounded rationality refers to

economic actors’ behaviour that is “intendedly rational, but only limitedly so” (Simon,

1961: xxiv), meaning that human actors have a limited capacity to process information,

address complexity, and make optimal choices. In the presence of bounded rationality, all

contracts are necessarily incomplete, which creates problems especially when asset

specificity is involved. Second, opportunism is defined as “self-interest seeking with

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guile” (Williamson, 1981b: 1545). It manifests itself in “calculated efforts to mislead,

distort, disguise, obfuscate or otherwise confuse” (Williamson, 1985: 47). In

Williamson’s version of TCE, human agents who populate firms and markets have an

inherent proclivity toward opportunism. Here, opportunism is the ultimate behavioural

driver of both market failure and the rise of hierarchy (Williamson, 1993). It is important

particularly when asset specificity is involved because aggrieved or vulnerable parties

cannot simply walk away from a transaction without incurring high costs from trying to

salvage and redeploy the assets committed. The latter behavioural assumption has been

the subject of significant controversy in the organizational sciences field (Conner &

Prahalad, 1991; Ghoshal, 2005; Ghoshal & Moran, 1996; Hodgson, 2004) and a reason

for much criticism directed at TCE. The opportunism assumption has been criticized for

its narrow conceptual focus and an inadequate portrayal of reality, as well as for the lack

of sufficient empirical support (Tsang, 2006). In the absence of convincing evidence that

opportunism is indeed a universal driver of economic actors’ behaviour, and therefore a

universal driver of governance choices (so as to prevent opportunism or mitigate its

consequences) as suggested by Williamson, there is a real possibility that TCE-based

predictions on the evolution of governance may actually be correct, but driven at least in

part by factors unrelated to opportunism.

To address this issue, Verbeke and Greidanus (2009) have proposed the new

envelope concept of bounded reliability as an alternative explanation of failed human

commitments. Bounded reliability supplants the opportunism assumption by including

the many situations in which parties’ failure to deliver on commitments is not explained

by a strong form of self-interest. Reflected in this construct is the often-observed reality

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of failed commitments caused by a variety of factors including but not limited to

intentional deceit (but excluding technical incompetence), such as benevolent preference

reversal associated with reprioritization and with scaling back on overcommitment.

Good faith reprioritization captures instances whereby economic actors make ex-

ante commitments in good faith, but the importance of those commitments diminishes

over time. Preferences may become reordered due to more spatially proximate

commitments taking precedence (e.g. local projects trump global projects at an MNE

subsidiary), or due to time discounting bias, i.e. placing a lower value on future events

than on more proximate events. Scaling back on overcommitment results from the

tendency of managers to make excessive commitments ex ante, that then need to be

scaled back ex post. In both cases, initial commitments can no longer be fulfilled.

Verbeke and Greidanus identify multiple mechanisms for economizing on bounded

reliability, including realistic goal setting, regular reviews of targets, cultivation of

informal connections among actors, development of clear guidelines, joint strategic

planning by participating parties, frequent budgetary reviews, and imposing limits on the

size and scope of new activities, obviously taking into account that such management

practices have costs as well as benefits. The main insight is that individuals engaged in

economic transactions may fail to make good on open-ended commitments for a variety

of reasons unrelated to intentional deceit, whereby these reasons cannot be reduced to a

bounded rationality problem, because the information on the likely occurrence and the

effects of unreliability is fully known in advance. Correcting for such failures can then be

achieved without invoking value-laden concepts such as ‘breach of trust’ or ‘dishonest

behaviour.’

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 TCE AND THE FAMILY FIRM

Family-based human asset specificity refers to a unique employee base available

to the family firm that then triggers unusual contracting as compared to typical

employment contracts between the family firm and ‘outsiders,’ or between a nonfamily

firm and its employees. Unusual contracting appears for a number of reasons. Family

members typically become involved in the business early on in life, or even at birth—

before any formal contracting takes place. This early involvement, which often has

hereditary rather than professional roots, continues through adolescence (e.g., in the form

of summer jobs) and extends through actual employment with the firm in different

capacities (Le Breton-Miller, Miller & Steier, 2004; Memili et al., 2011a). Socialization

thus becomes a primary coordination mechanism in the family firm, which invests

heavily in family members for very long periods of time, so as to prepare them for future

leadership roles. As a result, nonfamily managers, who have not been socialized into the

company since birth and therefore do not possess the highly idiosyncratic knowledge

specific to family insiders (Lee et al., 2003), face higher entry barriers when it comes to

assuming key roles within the company. The pursuit of family-centered, noneconomic

goals (Chrisman et al., 2007; Gomez-Mejia et al., 2007), such as family harmony, family

status, family dynasty, socio-emotional value, ability to exercise family influence, etc.,

further raises entry barriers for nonfamily managers, as achieving these goals requires

very specific skills and behaviour that can be expected from family members, but would

be difficult to obtain from a nonfamily employee (Memili et al., 2011a). Exit barriers, on

the other hand, are significantly higher for family managers, because economic

relationships in the family firm are entwined with significant personal ones. Exit may

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mean disruption of family dynamics, and in certain cases sanctions ranging from conflict

to ostracism and expulsion from the family (Pollak, 1985).

It should be noted that the concept of family-based asset specificity, which is at

least in part related to the family’s noneconomic goals (though it may serve economizing

purposes, too), applies not just to human assets, but also to other types of assets

controlled by the family firm. Such assets may include the initial head office estate where

the company started, product lines introduced by the founders, original locations of

manufacturing operations, etc. Family firms’ ‘connections’ to such assets typically arise

from their noneconomic goals (Memili et al., 2011a), such as the desire to keep alive and

even reinforce family history/legacy and the values of the founders. Here, family-based

asset specificity may become dysfunctional, namely when it manifests itself in

unwillingness to shed unprofitable product lines and business activities that have

historically defined the firm (Sharma & Manikutty, 2005), or in the attachment to a

particular location, a building, or any other asset that is no longer strategically relevant.

While beyond the scope of this paper’s analysis, family-based ‘other’ (i.e., nonhuman)

asset specificity is an important component of a TCE-based theory of the family firm.

What results is, on the one hand, a uniquely stable and loyal human resource base

with limited danger of adverse selection (absent cognitive biases), because each family

member’s strengths and weaknesses are known to the fullest (Pollak, 1985). On the other

hand, both the quantity and quality of this resource base may be suboptimal. Family-

based bilateral dependency creates both high exit barriers to eliminate unproductive

human assets, and high entry barriers to acquire potentially much more productive

‘professional’ assets. In other words, the main problem here is not so much the absence of

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external opportunities to redeploy without economic loss highly valuable assets uniquely

linked to the family firm, but rather the letting go or reallocation of individuals who

contribute little to economic value, but whose high human asset specificity may be

related to the family’s noneconomic goals. Particularistic selection criteria characteristic

of family firms (Carney, 2005) further reduce the family firm’s capacity to adjust its

resource base swiftly as a function of economic change, and exacerbate bounded

rationality challenges introduced by family-based human asset specificity. Family firms

have three options that can be used individually or in combination to address the above

challenges:

1. Focus on growing the family, as a larger family will lead to more options in

quantitative terms as to which family members can perform specific activities for

the family business. This course of action (also seen in the context of ‘royal

families’ supposed to produce ‘heirs to the throne,’ as exemplified by the British

monarch Henry VIII, who was consumed with the goal of fathering a male

successor), however, can hardly qualify as a business strategy. Growing the family

is usually outside of the family firm’s control, even though suitability criteria,

applied when selecting a partner for marriage with the family firm’s (future) owner,

may include adequate procreative capabilities, i.e., the ability to father/mother—

and nurture—multiple healthy children.

2. Invest in the business-related professional education of family members, leading to

better quality embedded in the highly specific, family-based human assets.

Investment in training economizes on bounded rationality by developing family

members’ skills and competencies (Westhead & Howorth, 2006), and further

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 safeguards against bounded reliability by strengthening the loyalty of family and

nonfamily employees alike, and aligning their interests. A focus on professional

education signals the owners’ commitment to employees and outsiders that any

family members active in the firm will be held to the same professional standards

as nonfamily members. However, despite these obvious benefits, investment in

training is somewhat atypical in family firms (Gedajlovic & Carney, 2010).

3. ‘Professionalize’ the firm by hiring—and delegating more authority to—nonfamily

managers (Chua et al., 2003; Gedajlovic et al., 2004). Professionalization can

alleviate constraints imposed by family-based human asset specificity in terms of

quality and quantity of firm resources. Here, employment contracts with ‘external’

economic actors complement usage of family members as managers.

BIFURCATION BIAS

Bifurcation bias as an effect of family firm professionalization

We focus our analysis on the third course of action above, as it leads to unique,

internal bounded reliability problems. Professionalization may create two distinct classes

of employees (family vs. nonfamily) within the firm that may result in potential

asymmetries in each category of employees’ treatment by the firm, as well as in each

category’s perceptions of the firm’s leadership. Dysfunctionality arises if and when

family firms as standard practice apply asymmetric treatment, whereby family employees

are treated by default as highly valuable, firm-specific assets, being ‘on the inside for the

long run,’ and as loyal stewards with a long-term commitment to the firm, while

nonfamily employees are dealt with as easily substitutable, commodity-like, short-term

assets, and as self-serving agents who ultimately remain ‘outsiders’ even if

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used/internalized temporarily by the firm. When uncorrected in the long run, such

unequal treatment of family and nonfamily employees that is not grounded in an

economic efficiency logic amounts to a bifurcation bias.

Bifurcation bias and the agency/stewardship paradox

At this point, it is useful to review briefly agency and stewardship theory-based

treatment of the family firm, as both agency and stewardship thinking feed directly into

the bifurcation bias concept. Agency and stewardship theorists form two distinct camps

that provide competing perspectives on the family business (Banalieva & Eddleston,

2011). Both theories focus on goal alignment (or the lack thereof) between the firm’s

owners and its managers (Arthurs & Busenitz, 2003), but fundamentally diverge on

whether family and nonfamily managers in family firms behave as agents or stewards

(Chrisman et al., 2007).

Agency theory represents one of the dominant paradigms in organizational

economics. It assumes that owners (principals) and managers (agents) have conflicting

goals, whereby managers may pursue their own goals to the detriment of the owners.

Owners can minimize agency costs by imposing internal controls to restrain managers’

self-serving behaviour, and by aligning the interests of managers with those of owners

through incentives, though always facing some level of dead loss (Fama & Jensen, 1983;

Jensen & Meckling, 1976). Early agency theory work (e.g., Fama & Jensen, 1983; Jensen

& Meckling, 1976) assumed that family firms are immune to agency issues: Conflicts

between owners and managers are minimized due to ownership and control overlapping,

and the entwining of economic and personal relationships offers monitoring advantages

(Pollak, 1985). However, more recent applications of agency theory thinking to family

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business suggest that family involvement creates unique agency challenges, such as

asymmetric altruism, self-control problems of parents, nepotism, and free riding

(Chrisman et al., 2004, 2007; Chua et al., 2009; Lubatkin et al., 2005; Schulze, Lubatkin,

Dino & Buchholtz, 2001).

Unlike agency theory, stewardship theory has its roots in theology (Thompson,

1960) and relies extensively on concepts from psychology and sociology, such as self-

actualization, social contribution, loyalty, and generosity. In contrast with agency

theory’s assumption of managers’ inherent self-serving goals, stewardship theory

suggests that organizational leaders are motivated to act in the organization’s best

interest, serve its mission, and behave as loyal stewards of their firm and its owners

(Davis, Schoorman & Donaldson, 1997). Family business scholars have adopted

stewardship thinking (Pearson & Marler, 2010) as a way to explore family firms’

potentially unique competitive strengths, stemming from family leaders’ inherent

proclivity toward stewardship behaviour (see Corbetta & Salvato, 2004; Davis, Allen &

Hayes, 2010; Eddleston & Kellermanns, 2007; Miller, Le Breton-Miller & Scholnick,

2008; Zahra, Hayton, Neubaum, Dibrell & Craig, 2008). It has been argued that kinship,

a single family name, and a common history promote a shared identity in family firms

and contribute to building enduring social capital that can be relied upon through

generations (Arregle, Hitt, Sirmon & Very, 2007; Banalieva & Eddleston, 2011; Sirmon

& Hitt, 2003).

Agency and stewardship theories rely on almost opposite sets of basic

assumptions about the motivation and behaviour of economic actors, yet they coexist in

the field of family business research, and each has a strong following. Family business

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theorists have attempted to reconcile this duality, providing some empirical support for

either theory (see Chrisman et al., 2007; Gomez-Mejia et al., 2007; Schulze, Lubatkin &

Dino, 2003; Schulze et al., 2001, for empirical studies supporting agency theory;

Eddleston & Kellermanns, 2007; Eddleston, Kellermanns & Sarathy, 2008, for empirical

studies in support of stewardship theory). The evidence to date suggests that each theory

may hold under specific contingencies/in specific circumstances, e.g., depending on the

extent of economic actors’ embeddedness in the family (Le Breton-Miller & Miller,

2009), the extent of separation of ownership and management (Corbetta & Salvato,

2004), the geographic focus of internationalization (Banalieva & Eddleston, 2011), the

family’s perception of the management team’s reliability and the context of the agency

contract (Cruz, Gomez-Mejia & Becerra, 2010), the firm’s position in its life cycle, etc.

We contribute to solving the above agency/stewardship contradictory views by

proposing that both theories can be correct at the same time, and within a single firm.

Given the range of possible motivations and effort levels of various employees/managers,

both agency and stewardship-type behaviour can indeed be expected to occur inside the

family firm. The insight drawn from studying the bifurcation bias in family firms is that

stewardship thinking is applied by default to all family employees who are treated as

loyal stewards with a long-term commitment to the firm, while agency thinking is applied

by default to all nonfamily employees who are seen as self-serving agents.

Let us assume that the family firm hires professional, nonfamily managers (and

highly specialized employees). Bifurcation bias then refers to the default asymmetric

treatment of family and nonfamily managers. Family members are automatically assumed

to be more desirable than a mere agent (Lee et al., 2003) and expected to remain ‘on the

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inside for the long run.’ They are ascribed stewardship traits such as loyalty, maximum

commitment and effort, as well a potentially high, long-term contribution to value in the

firm, regardless of their actual levels of skill, commitment, and effort. In contrast,

professional nonfamily managers are treated by default as short-term, easily replaceable,

and potentially disloyal (self-serving) resources, who will not be committed to the firm

and will exert minimum effort, again regardless of their actual levels of skill,

commitment, effort, and uniqueness of contribution to the firm. This approach is

epitomized in the words of Giovanni Agnelli, Jr. of the Fiat Group, who famously

declared that managers came and went but the Agnellis stayed (Toninato & Tapies,

2005).

It should be noted that in practice, the presence or absence of bifurcation bias may

not be absolute, but rather a matter of degree. However, the prevalence of noneconomic

goals, e.g., the preservation of family values, harmony, and social capital, maintaining

family control of the business, engagement of future generations in the business, etc.,

may make some level of biased treatment inevitable. Therefore, most family firms likely

find themselves at some point on a continuum from biased to bias-free. As one example,

at Magid Glove, a world leader in industrial safety equipment, family employees are

permitted flex time while nonfamily employees are not, yet family members are

evaluated according to a higher set of expectations, and are required to gain outside

experience prior to joining the business (Ward & Pericelli, 2005). For the purposes of our

discussion, we view a firm as biased if asymmetric treatment of family versus nonfamily

members is embedded in overarching managerial practices, i.e., firm-level routines

applied systematically and by default. An example is the documented and systematic pay

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discrepancies between family and nonfamily employees at the advisory investment bank

Lazard LLC, see Subramanian and Sherman (2007). A firm is seen as unbiased if it exerts

a visible and consistent effort toward unbiased practices throughout the organization.

A powerful example of an effort to weed out bias is the family education

programs implemented at the Finnish forest industry company Ahlstrom (Magretta, 1998)

in an effort to create ‘enlightened ownership.’ Other examples include the merit-based

recruitment criteria adopted at the chemical and pharmaceutical firm Merck KGaA

(Neumann & Tapies, 2006a, 2006b) and the company-wide profit sharing practiced at the

science-based products and services firm Du Pont (Chandler & Salsbury, 1971).

Psychological origins of bifurcation bias

Bifurcation bias can be attributed to the ‘affect heuristic’—an often-observed bias

in the applied psychology literature (Gilovich, Griffin & Kahneman, 2002; Slovic,

Finucane, Peters & MacGregor, 2002, 2007). The affect heuristic represents a rule of

thumb, whereby decision makers experience ‘good feelings,’ i.e., a positive affect, when

considering one choice alternative, thereby attributing higher expected overall benefits to

it than warranted by the objective attributes of this choice alternative. In contrast, when

decision makers experience ‘bad feelings’ toward another alternative, this leads to lower

expected overall benefits than warranted by the objective attributes of that alternative. In

other words, when the affect heuristic is in play, the ‘affect-rich attributes’ of choice

alternatives dominate selection. In the case of family firms, the attribute of being a

‘family- insider’ in the context of hiring and promotion decisions triggers an automatic

‘stewardship-type’ expectation, whereas being a ‘family-outsider’ triggers an ‘agency-

type’ expectation. When the affect heuristic becomes embedded in managerial practices,

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bifurcation bias results.

Bifurcation bias and transaction cost economics behavioural assumptions

Theoretical relationship. The affect heuristic and the resulting bifurcation bias

can be seen as an expression of bounded rationality. The bifurcation bias prevents an

‘objective,’ systematic, comparative institutional assessment of alternative contracting

features to govern different types of assets, more specifically family-based versus

nonfamily-based ones. The bifurcation bias thus means that the family firm’s modus

operandi is to keep for too long and at an excessive cost a set of unproductive family-

based human assets, thereby paradoxically even enhancing their non-redeployability

elsewhere, while at the same time systematically short changing highly valuable

nonfamily human assets, thereby unintentionally enhancing their redeployability instead

of anchoring them inside the company. Rather than crafting contracts properly aligned

with the competences, expected professional services, and uniqueness desired from its

managers and employees, bifurcation bias leads to a division of a firm’s human assets

into two groups based on family status, and the ‘affect-rich’ attributes associated with this

status.

This modus operandi serves as a unique trigger of bounded reliability, in the sense

that the resulting portfolio of human assets in place may not serve efficiency purposes but

may have dysfunctional effects in the sense of lacking an optimal contribution to

economic wealth creation. Importantly, the bifurcation bias may even be detrimental to

achieving some noneconomic goals such as continuity of family firm governance:

Assuming that noneconomic goals are complementary to economic goals, bifurcation-

biased governance increases bounded reliability in the system, in the sense that less

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competent, less skilled, and less performing managers will now be responsible for

achieving both sets of goals. An interesting situation may arise when noneconomic goals

are in conflict with economic goals. Here, the bifurcation bias will typically favor the

noneconomic goals of family members who govern the firm over economic goals. In

other words, decision makers are less likely to fulfill their most important fiduciary duty,

namely the goal of safeguarding the profitability—and, consequently, survival and

growth—of the firm. However, if family managers are less qualified than nonfamily ones,

with the latter driven out of the firm or becoming more unreliable owing to the family’s

exclusionary practices, the achievement of noneconomic goals may be adversely affected

as well.

Bifurcation bias, bounded reliability, bounded rationality, and family firm

performance: Main proposition. We argue that family firms subject to bifurcation bias

are susceptible to a bounded reliability squeeze from both ends, that is, from unreliable

family members wrongly qualified as ‘stewards,’ as well as from potentially reliable and

competent, but having become disgruntled nonfamily employees whose allegiances de

facto reverse as a result of their wrongful treatment as short-term ‘agents.’ More

specifically, family managers, in the absence of effective economizing mechanisms, are

free to exhibit all possible facets of bounded reliability. Lax monitoring structures leave

family managers open to benevolent preference reversal (in terms of not making good on

their commitments to the firm), while the promise of a default lifetime tenure may

stimulate intentional opportunism in the form of shirking and free riding. On the other

hand, professional managers, demotivated and alienated by the bifurcation bias

influencing the controlling family’s decisions, may themselves become responsible for

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new bounded reliability problems, namely when withdrawing or reducing their efforts

and commitment to the firm. Reduced effort and commitment can have very real

economic consequences for the family firm, as empirical evidence suggests that

nonfamily employees’ commitment levels positively and significantly influence the

profitability, survival, and continuity of family firms (Vallejo, 2009). Additional bounded

rationality issues arise from particularistic recruitment, which, if practiced systematically,

staffs a biased firm with archaic, improperly skilled, unproductive assets with limited

economic value.

We therefore propose that the bifurcation bias affects the firm’s ability to

economize on bounded rationality and bounded reliability and, consequently, reduces its

overall performance and weakens its ability to compete. Our main proposition is that

firms free of bifurcation bias will be more able to grow and prosper while sustaining

their family governance structure over the long haul. Conversely, those family firms that

suffer from bifurcation bias will face severe performance issues potentially leading either

to their demise, or to the shift of their family governance toward another governance

type, such as a Chandlerian hierarchy.

It should be noted again that bifurcation bias can affect not only human resources

management, but also decision making on many other types of assets such as businesses

and product lines (‘foundational’ versus ‘non-foundational’), production locations, etc.

Bifurcation bias in managerial practice

Manifestations of bifurcation bias in family firms. Some key forms of the

bifurcation bias are well documented in the family firm literature. Asymmetric altruism

(Chua et al., 2009; Chrisman et al., 2004, 2007; Corbetta & Salvato, 2004; Lubatkin et

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al., 2005) describes firm owners’ tendency to be altruistic (generous) toward family

employees in the firm, even when the latter “free ride and lack the competence and/or

intention to sustain the wealth creation potential of the firm” (Chrisman et al., 2004: 338).

While altruism in general serves to limit opportunistic behaviour within the family

(Pollak, 1985), asymmetric altruism interferes with properly designing and enforcing the

explicit and implicit contracts between family owners and family employees, and makes

it difficult to perform correct performance evaluations (Chua et al., 2009). Consequently,

family members’ reluctance to monitor, evaluate, and discipline themselves and each

other can invite significant bounded reliability challenges (Dyer, 2006), ranging from

deceit and shirking (Weber, 1946), to more general imperfect effort to make good on

open-ended commitments inside the firm. Here, the bifurcation bias takes the form of

misguided stewardship thinking applied to family members.

As a mirror image of the above, “amoral familism” (Banfield, 1958: 83) is

characterized by misguided agency thinking applied to nonfamily members, and

represents another well-documented form of bifurcation bias. Defined as distrust of

outsiders (Dyer, 2006) and stemming from strong familial bonds, amoral familism can

damage relationships with outside partners and nonfamily employees alike and lead to the

absence of across-the-board, professional human resources management. A vicious cycle

of increasing bounded reliability results, thereby preventing efficient contracting to

access requisite, complementary assets held by other firms. In the context of intra-firm

relationships, amoral familism expresses itself as the distrust of people who work in the

firm but are not members of the owning family, e.g., the family board’s distrust of

nonfamily chief executive officers (CEOs) at Ahlstrom Corporation led to a number of

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poor operational and strategic decisions, and significant losses in the late 1970s

(Magretta, 1998).

In managerial practice, bifurcation bias can manifest itself in (1) recruitment and

promotion, (2) performance evaluation, and (3) compensation systems, as discussed

below.

Recruitment. Insider-oriented hiring and promotion means application of highly

particularistic selection criteria with the default adjudication of key roles to family

members regardless of their level of competence. Gedajlovic and Carney (2010) point out

that such hiring and promotion policies can alienate nonfamily workers and lead to

perfunctory contributions. Multiple instances of bifurcation bias in recruitment and

promotion systems can be found both in the academic literature and through casual

observation of managerial behaviour in family firms. The ‘seat-warmer strategy,’ which

entails appointing an outsider to run the firm temporarily until suitably qualified family

offspring becomes available to take the outside manager’s place (Lee et al., 2003), is one

example of bifurcation bias in recruitment. In his classic corporate culture text, Edward

Schein (1999) discussed bifurcation-biased practices at Jones Food, where only family

members were allowed to occupy key managerial positions; having skilled professional

managers working under them masked their incompetence. Predictably, the company

experienced severe bounded reliability problems, with incompetent family members free

riding and shirking, and competent but disgruntled nonfamily employees engaging in

‘underground’ antifamily behaviour. One of the key nonfamily managers branched out to

start a competitive business. Eventually, the family was forced to sell off the company

due to financial problems and leaders’ inability to bridge the gap between the family and

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nonfamily employee camps.

Some scholars suggest that particularistic hiring is a rational, transaction cost

economizing strategy rather than an expression of bias: Lee et al. (2003), for example,

argue that appointing family managers as successors is a rational economic response to

increased appropriation risks (and, consequently, transaction costs) brought by

employment of professional managers. We see Lee et al.’s sweeping generalization as an

unfortunate reinforcement of bifurcation-biased thinking, building upon the mistaken

assumption of professional managers being unreliable by default. In reality, comparative

reliability and desirability of family versus nonfamily successors depends on a number of

factors, among these the professional qualities of the candidates in question, the nature of

the firm’s legal environment—in particular, the quality of available legal protection

(Burkart, Panunzi & Shleifer, 2003), culture, industry, and the ease of metering

productivity, as discussed in more detail in the following sections. We consider the

attribution by default of a higher level of reliability to family managers as a driver of

systematic contractual misalignment, rather than as a source of rational alignment.

Rational alignment entails engaging in systematic and careful comparative institutional

analysis, whereby decision makers design optimal ‘contracts,’ including features of ex-

post governance, for all managers employed by the firm (and more generally for all

employees, whereby special attention needs to be devoted to employees with highly

specialized skills).

Performance evaluation. Asymmetric altruism and family members’ consequent

unwillingness to monitor and evaluate each other trigger skewed performance

monitoring. The absence of proper accountability mechanisms amplifies bounded

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rationality problems as well as bounded reliability challenges: Those family employees

inherently prone to shirking may abuse lax monitoring structures by engaging in free-

riding behaviour, which would not be possible if proper performance evaluation were in

place, while nonfamily employees may withdraw their effort as a result of perceived

unfairness. It is plausible for a family firm to be populated by a whole class of family

employees—and employees in general—who are not prone to shirking and indeed behave

as loyal stewards while possessing all the competencies necessary to perform their tasks.

Still, effective monitoring systems are necessary even in the absence of obvious agency

behaviour. First, bounded rationality in the face of unexpected contingencies means that

an infusion of additional knowledge and experience may occasionally be required.

Second, bounded reliability, as opposed to the conventional assumption of opportunism,

does not imply malevolent intent: That is, even well-meaning ‘stewards’ may veer from

the path most beneficial to the firm due to benevolent preference reversal. As such, lax

accountability structures encouraged by bifurcation bias can be damaging regardless of

the actual level of reliability of family employees.

Compensation systems. Asymmetric compensation policies such as withholding

stock option rewards to nonfamily managers are fairly common in family firms, as

families strive to avoid dilution of family control and uncertainty of incentive pay (Park,

2002). Empirical evidence suggests that nonfamily managers in family firms are typically

dissatisfied with the relative lack of equity in compensation (Poza et al., 1997), which can

trigger bounded reliability problems, in terms of reduced commitment, as exemplified by

the near collapse of Mondavi Wineries, where B shares were held only by family

members (Miller & Doyle, 2004). Salary discrepancies among family and nonfamily

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employees at the same hierarchical level have an even sharper negative effect, as was the

case at Lazard LLC: ‘Secret’ compensation practices and unequal pay led to a severe

talent drain and consequent drop in profitability in the early 2000s (Subramanian &

Sherman, 2007).

Economizing on the bifurcation bias. Micro level economizing: In line with our

main proposition, family firms’ performance and survival is contingent upon their ability

to economize on bounded rationality and bounded reliability problems related to the

bifurcation bias. On the micro level, this means addressing the presence of family-based

human asset specificity by (1) capturing the benefits from the unique human assets at the

firm’s disposal, while (2) avoiding or mitigating dysfunctional effects arising from this

human asset specificity. This can be done, first, by investing heavily in training programs

for family members in order to economize on bounded rationality problems associated

with particularistic selection criteria. Targeted investments in family education can take

various forms, from special in-house programs aimed at family members, as observed in

Ahlstrom Corporation, to specific educational trajectories that family members involved

in the business must follow, as observed in the financial securities’ firm LG Investments

(Hess, 2009), Du Pont Corporation, food retailer Loblaw (Papyrina & Hardy, 2007), and

Johnson Family Enterprises (Ward & Zsolnay, 2004). Training and education are

particularly critical in environments characterized by high technological intensity or

managerial complexity, where absence of requisite skill levels can lead to—or amplify—

competitive disadvantage of family firms. Additionally, investment in training of family

members can economize on bounded reliability of nonfamily employees by signaling that

family members will be held to the same level of professional standards. This is

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important particularly because proper signaling can allow the company to attract high-

quality nonfamily employees and improve the quantity and quality of its resource base,

thus creating a virtuous cycle of reduced bounded rationality.

Second, dysfunctional outcomes of family-based human asset specificity can be

controlled for by economizing on various expressions of bifurcation bias in human

resource practices. Specifically, this may mean instituting explicit equal opportunity

programs for family and outsiders as observed at Ireka Construction Berhad (Francesco,

2004), and appointing professional managers to key positions as practiced at the Hong

Kong-based conglomerate Harilela Enterprises (Tran, Sambamurthy & Mansinghka,

2006). Good practices in this area also include offering compatible compensation and

benefits packages to family and nonfamily alike, e.g., implementing company-wide profit

sharing, as is the case at the media giant Bertelsmann (Neumann & Tapies, 2006c), Du

Pont, and the publication firm Spiegel-Verlag (Villalonga, Beyersdorfer & Dessain,

2009). In general terms, what matters most is crafting managerial practices that embody

unbiased family values, including justice and equality among owners, managers, and

employees. Many successful family businesses (e.g., Johnson & Johnson, Ahlstrom

Corporation) make their core value of unbiasedness explicit in the form of codified

guidelines or a family constitution. Finally, it is important that bundles of multiple

unbiased practices be adopted in order for a firm to shift on the bifurcation bias

continuum, which ranges from fully biased to unbiased governance. The conclusion is

therefore that for a family firm to economize effectively on bounded rationality and

bounded reliability, the entire bundle of human resources management practices must be

professionalized and, if possible, liberated from the dysfunctional bifurcation bias. It is

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important for this professionalization to take place at all organizational levels, and to

include employees, managers, and board members.

Rigorous selection policies that take into account the education and training of

family members, and require significant outside work experience, may point to an actual

‘reversal’ of bifurcation bias in some unbiased firms. Such reversal reflects an extreme

economizing mechanism aimed at creating reliable role models and signaling the values

of fairness and equality to family outsiders. In this case, family members wishing to join

the business are held to a higher standard, and their professional and personal

qualifications are subjected to a higher degree of scrutiny as compared to nonfamily

employees (Cadbury, 2000; International Financial Corporation, 2007; Peter Leach &

Partners, 2008; Steen, 2006; Ward, 2004). Reversed bifurcation bias has been observed in

the context of family business daughters, struggling to make their way in the family firm

(Day, 2008).

An interesting case of bifurcation bias, and a tentative illustration of our

proposition, can be found in Ahlstrom Corporation, which moved from a biased to an

unbiased firm. The transition was evident in the formal training of family members, the

adoption of a family constitution, the qualification requirements for family members to

join the business, the formal monitoring practices, and the appointment of professional

CEOs. The transformation was accompanied by a dramatic reversal in the company’s

fortunes, from losing money in the main line of business to growing the business by $2

billion over a 15-year time period (Magretta, 1998).

Macro level economizing: At the macro level, regulatory practices separating

ownership and control of family firms can serve as mechanisms to economize on the

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bifurcation bias. Legal systems in The Netherlands, France, and Germany, unlike the

Anglo-American system, dictate a strict division of powers among the firm’s top

management, its management board, and its supervisory board (Klein, 2000). In practical

terms, this means that a family member who sits on the company’s board cannot

simultaneously be employed as a manager, and vice versa. Historically, such practices

originated as measures to protect minority shareholders (Burkart et al., 2003), but their

usage may have affected the evolutionary paths of family firms in different parts of the

world, possibly contributing to the widespread success and persistence of family

businesses in Germany (Ehrhardt, Nowak & Weber, 2006).

When is the bifurcation bias important?

While the bifurcation bias is a consequence of family-based human asset

specificity and therefore a feature of family firms, it does not affect all family firms

equally. The extent of its damaging consequences depends on a number of factors, most

notably technological complexity, firm size, organizational structure, the ease of metering

performance, the involvement of the family firm in joint innovation, the firm’s cultural

and institutional environment, and the nature of the firm’s goals.

Casual observation reveals a high number of reasonably successful small family

businesses operating in low-tech environments for generations, e.g., corner grocers,

neighborhood florists, or mom-and-daughter teams offering cleaning services in the local

community. Here, family-based human asset specificity is not an issue, as the skills

required for successful business operations are not highly specialized and are easily found

within the confines of an individual family. Family-based human asset specificity

becomes a liability in high-growth, complex technology environments, and in

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environments where specialized knowledge and talent are required (Pollak, 1985), but

whereby particularism restricts recruiting and effectively utilizing/rewarding needed

external talent.

Similarly, the sheer size of a family firm amplifies the damaging effect of

bifurcation bias. Larger firms typically have greater potential to exploit scale economies

in segments of the value chain, as well as scope economies across product lines or

geographic markets, but earning such scale and scope economies often depends on the

presence and ability of professional nonfamily managers in these value chain segments

(Pollak, 1985). A bifurcation-biased firm is limited in its capacity to attract, properly

motivate/reward, and retain professional managers, which will therefore undermine its

ability to gain scale and scope economies.

A similar point holds for diversified and multinational firms that are

organizationally complex, and need sophisticated routines to determine the firm’s

evolving boundaries, its allocation of resources for purposes of innovation, and, more

generally, its internal organization (Dyer, 2006; Verbeke & Kenworthy, 2008). Here,

bifurcation bias is particularly deadly: It impairs the firm’s ability to control for the

dysfunctional side of family-based human asset specificity and thus to economize on

bounded rationality, creating a technically inferior group of employees and decision

makers, and putting the firm at a disadvantage when having to address challenges

imposed by new business environments in which the firm has expanded. Internal lack of

specialized knowledge required when expanding into new businesses or geographic

markets can often be overcome through access to complementary resources of external

actors. Here again, the bifurcation bias creates a liability when it breeds amoral familism

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interfering with efficient access to necessary resources, especially specialized knowledge

from external actors

The ease of metering behaviour and performance will influence the consequences

of bifurcation bias. When monitoring is costly and difficult to implement, slack behaviour

or poor performance of family members is more likely to persist (Pollak, 1985), leading

to a vicious cycle of unreliability. Here, shirking by unreliable family managers will not

be corrected, and resentment will breed among nonfamily employees, leading to further

infractions and reduced contribution.

The nature of the exchanges in which a family firm is involved has a further

impact on the severity of bifurcation bias’ consequences. Recurrent, frequent transactions

with the same partners that entail swift adaptation to changes in these partners’ needs,

e.g., in the context of joint development of prototypes or managerial practices, will

increase the requisite specificity of assets involved in these transactions. Bifurcation bias

in this context of joint innovation is likely to exacerbate the dysfunctional aspects of

family-based human asset specificity and will therefore inflict more damage as

transaction frequency for joint innovation increases. Ineffective family-based human

assets and demotivated professional managers are unlikely to be the family firm’s best bet

for the success of joint innovation efforts.

We predict that the impact of bifurcation bias will vary across societies and will

be significantly affected by national culture. Bifurcation bias will likely have a less

damaging effect in relational contracting cultures where family and nonfamily members

alike are expected to act loyally, as is the case in Japan (see Williamson, 1996). Here,

national culture can serve as an informal monitoring tool to reinforce loyalty at the

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expense of exit, thereby curbing unreliability from nonfamily employees. In cultures that

focus less on relational contracting and more on formal contracts, with loyalty having less

value, as is the case in North America and Western European countries, bounded

reliability from nonfamily employees driven by the bifurcation bias represents a stronger

threat to the survival of family firm governance.

The nature of the firm’s institutional environment, as well as being a cause of

bifurcation bias, also affects the impact of that bias, especially at the macro level. In

environments characterized by institutional voids and severe problems of formal

contracting with external actors, bifurcation bias can exacerbate the mistrust of outsiders,

and retard the development of institutions and property right protections which lead to

practices with negative societal spillovers such as political rent seeking or tunneling

(Bertrand, Mehta & Mullainathan, 2002; Bertrand & Schoar, 2006).

Finally, the extent to which a family firm pursues noneconomic goals, and the

complementarity of these noneconomic goals with economic ones, is important in

determining the impact of the bifurcation bias on firm performance. It has been

demonstrated that noneconomic goals may conflict with financial goals: Family firms

may strive to preserve their socio-emotional wealth, even at the expense of performance

(Gomez-Mejia et al., 2007), and business goals such as wealth generation may be

subservient to family goals such as family control, ability to exercise influence over

management, etc. (Mahto, Davis, Pearce & Robinson, 2010).

When economic and noneconomic goals of a company are congruent (e.g., when

noneconomic goals include preservation of the business for future generations), the effect

of the bifurcation bias is straightforward: By negatively affecting the company’s

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economic performance, bifurcation bias impedes noneconomic goal achievement as well.

An interesting dilemma presents itself in circumstances where noneconomic goals are in

conflict with economic goals, e.g., when noneconomic goals include the continued

concentration of power in the hands of the family, job creation for incompetent family

members, and other objectives that may interfere with wealth creation. Here, the

bifurcation bias is likely to favor achieving noneconomic goals at the expense of

economic performance. The bifurcation bias may therefore be particularly damaging in

circumstances where conflicting economic and noneconomic goals coexist.

CONCLUSION

Using the conceptual lens of TCE, whereby we have focused on family-based

human asset specificity, bounded rationality, and bounded reliability, we have argued that

the survival and prosperity of family firms depend on the absence of a dysfunctional

bifurcation bias. The bifurcation bias, as an expression of bounded reliability, refers to

the asymmetric treatment of all ‘assets’ viewed as being on the ‘inside for the long run’

(especially family members) versus on the ‘outside’ and having mere ‘commodity status.’

Here, the default position is to treat family members as long-term stewards, while

nonfamily employees are considered de facto as agents, with ‘commodity status’ and an

expected short time span serving the firm.

We have suggested that the bifurcation bias manifests itself in the family firm’s

governance and (human resources) management practices. The main reason for the

bifurcation bias’ critical influence on the family firm’s destiny is its further impact on the

company’s ability to economize on bounded rationality and bounded reliability. A

bifurcation-biased company suffers from bounded rationality challenges associated with

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its particularistic selection criteria, its inability to attract ‘outside’ professional talent, and

the attrition of any such talent it was able to hire. This firm also faces further bounded

reliability problems associated with the unwillingness of the family members who control

the company to monitor and discipline the ‘inside-for-the-long-run’ assets, including

unreliable family members. In addition, reduced effort can be expected from ‘commodity

status’ human assets, such as alienated professional managers, whose employment

contracts, including relational contracting features, do not fit their actual ‘asset

characteristics.’

Our paper proposes a TCE-based theory of the family firm with the presence or

absence of bifurcation bias influencing heavily the firm’s economizing capabilities. We

have proposed specific contingencies explaining which types of family firms are likely to

experience particularly damaging effects of bifurcation bias on economic performance,

i.e., firms in technology-intensive and complex industry environments; large diversified

firms and multinational firms; firms characterized by frequent, recurring exchange with

particular partners; firms operating in cultural environments characterized by high

bounded reliability (often referred to as ‘low-trust environments’); firms where

performance metering is difficult; firms in environments characterized by institutional

voids; and finally firms characterized by sharp conflicts between economic and

noneconomic goals.

We have explored specific manifestations of bifurcation bias in human resources

management practices, and discussed mechanisms for economizing on the bifurcation

bias at both micro and macro levels. Finally, we have advanced theory to close the long-

debated gap between the agency and stewardship views of the family firm, by showing

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that both perspectives are actually correct, in terms of their description of real-world

phenomena in the family firm. The observation that both theoretical perspectives can be

useful simultaneously in explaining, at least partially, family firm functioning precisely

reflects an implicit assumption in each theory on the absence versus presence of a

bifurcation bias.

LIMITATIONS AND DIRECTIONS FOR FUTURE RESEARCH

TCE’s focus on transaction cost economizing enables analysis of family firm

governance’s comparative efficiency, but does not address the full complexity of family

firm behaviour in the presence of noneconomic goals. This is perhaps the key limitation

of TCE as a general theory of the family firm. TCE assumes that family firms surviving

and thriving in the long run have economizing capabilities equal or superior to alternative

governance forms, and that they will fine-tune contracts and internal organizational

design where efficiency considerations dictate such changes. TCE views noneconomic

goals as a potentially dangerous deviation from the economizing script, unless these goals

could actually be attributed an economizing purpose, in which case their qualification as

‘non- economic’ would be wrong. We have briefly explored the relationship between

economic and noneconomic goals as a possible contingency factor to assess the presence

and impact of the bifurcation bias, but future research, preferably in the form of in-depth

case studies, could provide more thorough analysis of noneconomic goals’ influence on

family firm governance.

Various contingency factors that we have not addressed may influence the

presence or absence of a bifurcation bias in the family firm. The founders’ and early

owner-managers’ personalities and leadership styles are likely to shape the firm’s values

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and routines in terms of nonfamily employee treatment. For example, Johnson Family

Enterprises’ enlightened employee policies are a legacy of the second generation of

owner-managers from the early 1900s (Ward & Zsolnay, 2004). Oscar de la Renta’s

personal democratic views became the driving force behind the company’s collaborative

and inclusive culture (Anad, Carpenter & Jayati, 2004). Harold Jones’s assumptions

about the role of the family shaped Jones Foods’ ideology and culture (Schein, 1999).

The Du Pont corporation, which was the first North American firm to allow nonfamily

employees to purchase stock in the company, owes this legacy to the personal views of

Pierre S. Du Pont, who believed that “the success of a modern large corporation depends

on making its executives ‘partners’ in the business by permitting them to consider

themselves owners as well as managers” (Chandler & Salsbury, 1971: 136).

The extent and outcomes of bifurcation bias are further contingent on industry-

specific factors, e.g., the presence or absence of tight professional networks, complexity/

technology intensity, availability of talent, degree of vertical integration, competitiveness,

etc. Individual firms’ strategic choices, ownership structures (sibling partnerships, cousin

consortium, controlling owner, etc.), and the nature of family assets and liabilities (Dyer,

2006) may also affect the extent of a firm’s bifurcation bias, as may and macro and meso-

level factors such as legislative environments, the broader institutional context, and

cultural settings. Our study has sketched the overarching role and main drivers of

bifurcation bias in family firm governance, but has not systematically addressed the

above contingencies, which can be accomplished in future research. An interesting

avenue for future exploration is the role of bifurcation bias in the treatment of ‘non-

human’ family firm assets, especially ‘foundational’ assets, such as the original head

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office location and real estate, the firm’s original production facilities and organizational

apparatus, and all assets associated with the firm’s initial product lines. Finally, more

large-scale empirical research is needed to test the main proposition developed here that

the bifurcation bias matters.

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 Essay 7

THE TRANSACTION COST ECONOMICS THEORY OF TRADING

FAVOURS

Trading favours is a pervasive business practice, especially in emerging economies. To

date, a range of theories has been utilized to explore trading favours, but most extant

studies focus especially on negative aspects of favours, e.g. corruption and bribery. We

adopt transaction cost economics (TCE) to analyze systematically trading favours as an

economizing practice serving efficiency purposes. From the TCE perspective, trading

favours is a component of the relational contracting portion of transaction governance,

and contributes to economizing on bounded rationality and bounded reliability. We

hypothesize that trading favours will be more prevalent in (a) macro contexts

characterized by a vacuum of formal institutions as well as by excessive formal rules; (b)

cultural contexts where in-group membership is highly valued; (c) high bounded

rationality/low bounded reliability contexts where frequent opportunities exist for

indirect reciprocity; and (d) cases where no asset-specific investment(s) in innovation

need to be made by the supplier of the favour. Enforcement mechanisms such as in-group

sanctions, access to formal contracting as a complement to favours, possibility of image

scoring and incentive compatibility can function as critical components of the trading

favours practice. We suggest a classification of favour-trading practices based on their

link to formal contracting and rate of recurrence, and describe a range of likely impacts.

INTRODUCTION

Trading favours, meaning the informal transfer of goods, services, or

opportunities based on expected reciprocation in the future, is a common business

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practice. Trading favours is found especially in emerging economies, where formal

market institutions are typically less developed (Myrdal, 1970), and weak contractual

rights protection is pervasive. In conceptual terms, trading favours can be described as

the utilization of informal modes of exchange within the formal sector (Li, 2007;

Mudambi, Navarra & Delios, 2011). This practice can occur in any part of a value chain

and at any organizational level, but also at the macro level and in the public sphere;

favours can range from gifts, commissions and financial inducements, to granting

employment or business contracts and exchanging valuable information. The rise of

emerging economies, where trading favours is not just a commonly observed business

practice, but often also a necessary one, has brought this long-lived phenomenon to the

forefront of international business research during the past two decades. A number of

theoretical frameworks from a range of social science disciplines have been utilized to

explore trading favours, including economic rent-seeking theory (Besley & McLaren,

1993; Murphy, Shleifer & Vishny, 1993), institutional theory (Collier, 2002; Puffer,

McCarthy & Boisot, 2009), property rights theory (Jagannathan, 1986), game theory

(Macrae, 1982; Von Hippel, 1987; Yamagishi, Mifune, Liu & Pauling, 2008), the risk-

taking paradigm (Lee, Qian, Yu & Ho, 2005), sociocultural perspectives (Armstrong,

1992; Davis & Ruhe, 2003; Husted, 1999; Treisman, 2000) and transaction cost

economics (TCE) (Husted, 1994). Most of these studies have focused on the negative

aspects of favours, especially in the context of corruption and bribery, and on the public

dimension of the exchange, e.g. when it occurs between corporations/entrepreneurs and

governments.

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 TCE has been largely underutilized as a conceptual lens to study trading favours,

in spite of its analytical power (Husted, 1994). First, TCE’s economizing orientation

enables analysis of trading favours’ economizing properties (if any). Second, its focus on

comparative institutional analysis facilitates an evaluation of the costs and benefits of

trading favours against the costs and benefits of other real world alternatives for

governing transactions. Third, TCE recognizes that outcomes at the micro level can be

fundamentally affected by macro level shift parameters. Macro level shift parameters do

not simply refer to institutional changes over time in one jurisdiction or well-defined

geographic area. Macro level shift parameters refer to all the variables that could

reasonably affect the adoption, the specific governance features and the outcomes of a

practice, and that may differ from one jurisdiction or geographic space to the other. One

example is the property rights protection regime, which can differ substantially between

countries. As a result, TCE can easily accommodate variables that are the main focus of

complementary conceptual perspectives, likely needed to explore fully trading favours as

a business practice. Such variables include, inter alia, government regulation of business,

cultural elements, institutional voids, industry structure etc. Fourth, internalization

theory, which is essentially the international business extension of TCE (and is for that

reason sometimes referred to as ‘transaction cost internalization’), embodies a dynamic

capabilities view of the firm, thereby providing a robust and integrated conceptual

platform from which to analyze multinational activities with all their complexities,

including network aspects (Rugman, D’Cruz & Verbeke, 1995; Grøgaard &Verbeke,

2012).

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 The above suggests that TCE can provide a valuable conceptual lens to analyze

the trading favours phenomenon. A small number of researchers has considered the TCE

implications of trading favours (see Fisman & Wang, 2010; Kalla, 2010; Mudambi et al.,

2013; Von Hippel, 1987), but Husted’s 1994 article remains the only published piece to

date to use TCE as an analytical tool for exploring the trading favours phenomenon in a

systematic way. Still, Husted’s pioneering piece focused rather narrowly on one

particular negative aspect associated with some transactions ruled by trading favours,

namely corruption. Husted indeed describes corruption-related trading favours in TCE

terms, with the purpose of designing strategies to safeguard against it. While providing

an insightful perspective of corruption, analyzed in TCE terms, Husted’s study did not

lead to a broad and unified TCE-based framework to analyze trading favours.

We set out to fill this void by analyzing trading favours as an economizing

practice serving efficiency purposes in a particular institutional and broader macro level

context, without assuming that negative spillovers will necessarily occur (in contrast to,

e.g., the case of corruption). We assume on the contrary that, subject to a number of

conditions being fulfilled, trading favours represents a business practice consistent with

farsighted contracting and/or managing the innovation process in its entirety, and can

have positive consequences both for the firm and for society at large by enabling

transactions that otherwise may not take place (e.g. political connections enabling

corporate diversification in China as described in Li, He, Lan & Yiu, 2012). We adopt

TCE as a credible conceptual lens to analyze the economizing properties of trading

favours, and formulate a number of unambiguous and testable predictions related to this

business practice. In the next two sections, we briefly review TCE and offer some history

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and context for the trading favours phenomenon. In the fourth section, we explore the

applicability of TCE to trading favours, conceptualize trading favours in TCE terms and

formulate testable hypotheses. We conclude with theoretical implications and directions

for future research.

TRANSACTION COST ECONOMICS’ FOUNDATIONAL CONCEPTS

Main tenets

TCE is widely recognized as a core paradigm in the management and

organizational studies literature (Hill, 1990; David & Han, 2004). Rooted in the

pioneering work of Coase (1937), TCE in its current form largely owes its existence to

Oliver Williamson – the leading figure of TCE, whose contribution to the field was

rewarded with the 2009 Nobel Prize in Economics. Coase sought to explain the existence

of hierarchies as opposed to markets by analyzing transaction costs involved in effecting

exchanges, positing that a hierarchy supersedes the market if the costs of organizing

exchanges within a firm are lower than the transaction costs of performing the same

exchange in the market. Williamson’s version of TCE builds upon Coasean thinking by

intersecting the theory’s economic foundations with law and organization, and by posing

“the problem of economic organization as a problem of contracting” (Williamson, 1985:

20). The transaction, which “occurs when a good or service is transferred across a

technologically separable interface” (Williamson, 1985: 1), is TCE’s basic unit of

analysis; the organization of economic activity is thereby to be understood in transaction

cost economizing terms. Economic efficiency is achieved by aligning governance

structures with various attributes of transactions in discriminating (‘transaction cost

economizing’) ways (Rjordan & Williamson, 1985).

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Core assumptions

Three core assumptions about the nature of the ‘assets’ involved in a transaction

and about economic actors’ behaviour underlie TCE: asset specificity, bounded

rationality, and opportunism (Williamson, 1996). Asset specificity means that particular

assets (physical, organizational or human) involved in a transaction or class of

transactions cannot be easily redeployed elsewhere without significant loss of economic

value. Differences in degree of asset specificity are largely responsible for observable

differences in transaction costs: The more specific the assets, the costlier the transaction,

because more safeguards must be introduced in contract content and process to protect

the owner of the specific asset against economic loss. Over the long run, greater asset

specificity not only increases transaction costs associated with simple, short term market

contracting, but also leads to bilateral dependency between exchange partners. This

bilateral dependency translates into more complex, longer term contracting schemes,

including a transition from market exchange to hierarchical governance (Williamson,

1996).

The effect of asset specificity is closely related to two assumed behavioural

characteristics of economic actors involved in transactions. First, bounded rationality

refers to economic actors’ behaviour that is “intendedly rational, but only limitedly so”

(Simon, 1961: xxiv), meaning that human actors are limited in their capacity to process

information, address complexity, and make optimal choices, both because of the natural

boundaries of the human mind, and because of the unavoidable incompleteness of

available information. In the presence of bounded rationality, all contracts are necessarily

incomplete, which creates problems especially when asset specificity is involved.

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 Second, human agents who populate firms and markets are assumed to have an

inherent proclivity toward opportunism. Williamson has defined opportunism as “self-

interest seeking with guile” (1981b: 1545), which manifests itself in “calculated efforts to

mislead, distort, disguise, obfuscate or otherwise confuse” (1985: 47). Opportunism has a

particularly damaging effect on transaction costs when asset specificity is greater,

because aggrieved parties cannot abandon a transaction without incurring high costs from

trying to salvage and redeploy the assets committed. Here, opportunism is the ultimate

behavioural driver of both market failure and the rise of hierarchy (Williamson, 1993).

The normative, short and medium term implications of the combined three assumptions

are thus that governance mechanisms (including labour contracts and human resources

management systems) should be designed so as to economize on economic actors’

bounded rationality and opportunism.

Extending behavioural assumptions of TCE: Bounded reliability

It should be noted that the behavioural assumption of opportunism has been the

subject of significant controversy in the organizational sciences field (Conner &

Prahalad, 1991; Ghoshal & Moran, 1996; Hodgson, 2004; Ghoshal, 2005; Tsang, 2006).

It has been criticized for its narrow conceptual focus, an inadequate portrayal of reality,

and the lack of sufficient empirical support. In the absence of convincing evidence that

opportunism is indeed a universal driver of economic actors’ behaviour and consequent

governance choices as suggested by Williamson (1993), there is a need for an alternative

explanation of humans’ non-fulfilment of commitments that drives TCE-based

predictions on the selection and retention of governance mechanisms. Verbeke and

Greidanus (2009) filled this void by proposing the envelope concept of bounded

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reliability as an alternative explanation of failed human commitments. Bounded

reliability supplants the assumption of opportunism by including the many situations in

which parties’ failure to deliver on commitments is not necessarily explained by a strong

form of self-interest, but is caused by a variety of factors including but not limited to

intentional deceit. Verbeke and Greidanus conceptualize these additional factors as

benevolent preference reversal associated with (1) reprioritization, meaning that ex ante

commitments made in good faith are reversed due to their importance diminishing over

time, or due to more proximate commitments taking urgent precedence; and with (2)

scaling back on overcommitment, meaning that ex ante unrealistic (albeit good faith)

commitments are reduced or eliminated ex post. Bounded reliability is distinct from

bounded rationality; while bounded rationality reflects the scarcity of mind, bounded

reliability refers to the scarcity of effort to make good on open-ended promises. To

summarize the interrelationships among bounded reliability, bounded rationality and

opportunism: Human actors engaged in economic transactions may fail to make good on

open-ended commitments for a variety of reasons that cannot be reduced to a bounded

rationality problem, but may at the same time be unrelated to self-interest seeking with

guile (i.e., intentional deceit).

In the remainder of the paper, we will use the extended behavioural assumptions

of TCE, substituting the incomplete and ideology-laden assumption of opportunism with

the broader, non-ideological assumption of bounded reliability. We assume that there is a

systemic tendency for transactions to suffer from benevolent preference reversal, ranging

from breaking a specific and explicit promise at the project level, to not respecting a

broader and more implicit promise, such as working towards shareholder utility

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maximization. Optimal governance choices (e.g. the choice of markets vs. hierarchies or

hybrid forms of governance, as well as the choice of more narrow governance

mechanisms with their distinct economizing properties) are thus driven by the asset

specificity of transactions, as well as by the bounded rationality and bounded reliability

of the economic actors involved in these transactions.

Given the above, our comparative analysis of trading favours as part of a

governance mechanism, to be compared with other ones, will consider the specificity of

assets involved in trading favours, and trading favours’ economizing properties in terms

of safeguarding against bounded rationality and bounded reliability problems.

TRADING FAVOURS: ORIGINS, FOUNDATIONS, AND MANIFESTATION

Anthropological, economic and cultural foundations

According to Nobel laureate Vernon Smith, “all humans, of all cultures, engage in

the trading of favours” (Smith, 1998: 4). The practice of trading favours can be described

as non-monetary trade in goods, services or opportunities (Kalla, 2010). The practice is

rooted in humans’ universal propensity “to truck, barter, and exchange” (Smith, 1998: 4),

which dates back at least two million years, i.e., a time period when our hominid

ancestors lived as hunter-gatherers in extended families and tribes (Klein, 1989; Semaw

et al., 1997). Trade in the conventional economic sense has likely grown directly out of

social exchange among kin and out of gift exchange common in hunter-gatherer societies,

see Freuchen (1961) for an account of the Greenland Eskimos’ gift exchange. The

transformation of social exchange into formal trading relationships allowed the gains

from an exchange to be extended beyond the reach of one’s family or tribe and ultimately

became the root cause for the allocation of property rights. When our ancestors broke out

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of local exchange patterns and started to engage in more long-distance exchange (Smith,

2005), impersonal formal markets gradually replaced the informal social exchange of

goods and various types of favours. In Europe, for example, the dissolution of feudal

bonds and greater labour mobility led to the expansion of trading relationships - and the

consequent weakening of local networks - at the beginning of the 16th century (Puffer et

al., 2009), marking what Sir Henry Sumner Maine famously termed the movement “from

status to contract” (Maine, 1959: 182).

This is not to say that social exchange disintegrated – only that it was now mainly

applied in the domain of a small grouping of one’s kin, whereas the world of markets had

become separate and distinct. Frederick Hayek’s famous quote summarizes the conflict

between intimate and formalized relationships inherent in the transition to markets: “Part

of our present difficulty is that we must constantly adjust our lives, our thoughts and our

emotions, in order to live simultaneously within different kinds of orders according to

different rules. If we were to apply the unmodified, uncurbed rules (of caring

intervention to do visible ‘good’) of the micro-cosmos [personal exchange] ... to the

extended order of the macro-cosmos [impersonal exchange], as our instincts and

sentimental yearnings often make us wish to do, we would destroy it. Yet if we were

always to apply the rules of the extended order to our more intimate groupings, we would

crush them. So we must learn to live in two sorts of world at once” (Hayek, 1988: 18).

Development of formal economic and societal institutions served to separate

further the two worlds of impersonal and personal exchange. Obviously, greater

development of formal market institutions led to greater separation. Consequently, in

emerging markets, where the growth of formal institutions was slower (Puffer et al.,

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2009), and the evolution from informal to formal institutions commenced later (Peng,

2003), impersonal and personal exchange remained intertwined to a greater extent,

reflecting the current “informal embeddedness or interconnectedness with dominant

institutions” (Peng, Lee & Wang, 2005: 623). Lesser population mobility in developing

countries (due to lesser wealth) serves to tie individuals to local communities, further

strengthening the importance of local networks. Yet, historic and present differences in

socioeconomic characteristics of different societies are not solely responsible for these

societies’ different levels of engagement in favour trading.

Let us reiterate that formal trade and informal exchange share the same

foundation: humans’ universal capacity for reciprocity (Smith, 1998). While reciprocity

is believed to have universal functionality, its specific norms guiding exchange are a

product of culture, which makes forms of reciprocity “endlessly variable” (Smith, 1998:

p. 4). The variability of trading favours practices across societies exists because “actors

do not respond directly to situations, but respond to them through mediating orientations”

(Mudambi & Navarra, 2003: 39), rooted in the underlying culture(s) within which

individual actions are performed. Informal favours are thus significantly affected by

cultural factors (Lee et al., 2005): For instance, relational cultures that emphasize strong

interpersonal involvement will be more prone to widespread adoption of the trading

favours practice (and will exhibit a higher tolerance to its negative spillovers) (Mudambi

et al., 2013). Such cultures are known for the pervasive intermingling of business

practices with tight interpersonal connections, as exemplified in such phenomena as blat

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in Russia, protetzia6 in Israel, guanxi in China, wa in Japan, inhwa in Korea, cuna in

Chile, palanca in Mexico etc. To illustrate the practice of trading favours, we will take a

closer look at two of these practices: blat and guanxi.

Manifestations of trading favours in Russia and China: Blat and guanxi

Blat. Blat is a hard-to-translate Russian word referring to “an exchange of

‘favours of access’ in conditions of shortages and a state system of privileges”

(Ledeneva, 1998: 37). Blat is often equated to corruption in the Western literature, yet it

is very distinct from illegal practices and open abuses (e.g. bribery) associated with

corruption. Rather, it is an openly condoned form of networking that facilitates business

exchanges – “a favour one renders to someone else without any immediate personal profit

or direct violation of law” (Shalin, 1999: 588).

The noun ‘blat’ stems from the nineteenth-century adjective ‘blatnoi’, denoting a

person or object related to criminal activity, though the modern version of the word

carries no criminal connotations, nor moral opprobrium (Shalin, 1999). In its present

meaning, the term was established during the years of socialism, when consumer goods

were in short supply, and special privileges were required to gain access to desirable

goods or services. Blat did not imply payment for access, as goods were more valuable

than money in the absence of a free market system; gradually, blat developed into an

“alternative procurement system” (Shalin, 1999: 559) routinely activated to gain access to

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
6
Linguistically, protetzia is in fact a borrowing from the Russian “протекция”, literally

meaning “protection”. Both the word and the practice were likely influenced by

extensive Russian emigration to Israel.

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better housing, rare consumer goods, theatre tickets, jobs, hotel reservations, sought-after

doctor appointments, an injection of an anaesthetic in a dental office, etc. The idea is that

a recipient utilizes his or her network of friends and acquaintances to find an individual

with ties to the desired goods; this individual (the donor) does not expect payment

beyond perhaps a token gift of appreciation, but may require a reciprocation of the favour

at some point in the future. Failure to reciprocate may result in informal sanctions within

the network, such as disapproval, withdrawal of privileges, exclusion and, in extreme

cases, ostracism.

With the collapse of the socialist economy in Russia and the onset of the free

market, blat has lost its importance as an alternative procurement enterprise; some believe

that the institution of blat is beginning to disintegrate, taking with it the fabled Russian

friendship which is giving way to commercial arms-length relationships (Ledeneva, 1998;

Shalin, 1999). Yet, in the current situation characterized by undeveloped legal and

financial infrastructure, excessive administrative discretion and corruption in government

offices, restrictive taxation, high interest rates, inflation and frail property rights (Puffer et

al., 2009), blat continues to act “as an oil in the wheels of Russian business” (Barnes,

Crook, Koybaeva & Stafford, 1997: 540) and to facilitate many business transactions.

Additionally, blat is deeply embedded in the Russian culture, rooted in traditional

Russian values of friendship and mutual help. With the transition to the market economy,

the role of blat as a redistribution system may indeed diminish, yet it is quite likely to

linger in the future, remaining an openly condoned form of business networking. It is

difficult to predict unambiguously the role that blat will continue to play in modern day

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Russia; future empirical research should determine whether the practice’s importance has

continued to diminish over time.

Guanxi. Guanxi has been defined as pre-existing relationships of classmates,

people from the same native place, relatives, colleagues, people who served in the same

combat unit and so forth (Yang, 1988), and “involves a hierarchically structured network

of relationships embedded with mutual obligations through a self-conscious manipulation

of ‘face’, ‘renqing’ and related symbols” (Wong & Tam, 2000: 58). Face refers to one’s

reputation within the network; renqing refers to a set of social norms inherent in

belonging to a network, such as dynamic reciprocity, long-term orientation and, often,

unequal exchange (Luo, 2000). Unlike blat, which is an exchange among equals, guanxi

is a hierarchical institution whereby status matters. Guanxi therefore has a broader

meaning than blat: While Guanxi can and does occasionally involve mutual ‘back-

scratching’, which is the essence of blat, it includes belonging to a network of trusted

individuals (Puffer et al, 2009). Guanxi’s relationship to trading favours is that it can

facilitate the latter if necessary by enforcing interpersonal obligations within the network.

Guanxi is deeply rooted in the Chinese culture with its strict Confucian codes of

ethics, filial piety and shame inculcation (Wong & Tam, 2000), as well as the high value

attached to family ties. Chinese socialist history has complemented the tradition of

guanxi (Wall, 1990): In an environment of controlled pricing and limited access to goods,

the utilization of private connections became a way to give and receive important

favours.

Like blat, guanxi is not synonymous with corruption, though it is easy to imagine

how “excessive guanxi” (Wall, 1990: 23) could take the form of corruption, especially

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under current conditions of underdeveloped market and financial institutions and weak

legal enforceability. Today, the Chinese population’s increasing wealth and the general

alleviation of scarcity of goods and services is lowering the need for special favours and

thereby the scope of guanxi (Puffer et al., 2009). Still, being a deeply embedded practice,

both culturally and socially, guanxi is likely to remain a prominent informal institution in

the Chinese society for decades to come.

TCE-BASED THEORY OF TRADING FAVOURS

Working definition and key questions

The starting point of our analysis is to determine what trading favours actually is

from the TCE viewpoint. It is not a distinct, generic governance structure, and therefore

not the equivalent of markets, firms or hybrids. Nor is it a generic coordination

mechanism such as the price mechanism or hierarchy (i.e., decision making by fiat),

utilized by parties to support the governance of transactions.

Williamson suggests that a transaction “occurs when a good or service is

transferred across a technologically separate interface” (1985: 1). All transactions are

subject to governance through some form of contracting. TCE subscribes to a conception

of contract as framework as opposed to contract as legal rules (Williamson, 1996). The

notion was developed by Karl Llewellyn, who argued that a contract between two parties

“almost never accurately indicates real working relations, but… affords a rough

indication around which such relations vary, an occasional guide in cases of doubt, and a

norm of ultimate appeal when the relations cease in fact to work” (1931: 737). All formal

contracts are therefore necessarily incomplete. A complete contracting framework

governing any transaction can be seen as consisting of two components: 1) formal

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contracting, referring to codified information (e.g. contract documents); and 2) relational

contracting, referring to informal aspects of contracting as measured by the collaborative

attitude of parties, sharing of goals, reliance on unwritten promises etc. The specific

content of the second, relational component of contracting is largely a reflection of

socially derived norms and social ties between the contracting parties. The main

contractual action resides in the private ordering; a personal or group-driven relationship

between parties enables easier ex post governance should any problems arise.

The interesting feature of trading favours is that it implies the presence of at least

two transactions, whether within a market structure, a hierarchy or a hybrid. A ‘favour’

also implies expected or intended reciprocation in a sequence of exchanges, which are

based on socially derived norms and social ties. This reciprocation may or may not be

delayed, and does not necessarily reflect a direct response to the original favour. Given

the above, we offer the following definition of trading favours:

Trading favours is a component of the relational contracting portion of

transaction governance. It involves the norm of reciprocity and includes

enforcement mechanisms. It occurs when at least two transactions take place,

with the roles of favour supplier and receiver being reversed in sequential

transactions. The reciprocity can be delayed and be indirect. It contributes to

economizing on bounded rationality and bounded reliability involved in these

transactions. 7

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7
Our viewpoint is different from Husted’s (1994), who looked solely at corruption

(associated with an extreme type of trading favours with substantial negative spillovers)

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 If trading favours is supposed to function as a relational contracting component

and to perform an economizing role, two questions arise:

1. When is trading favours efficient (at the macro, group and micro levels) and when is

it not? In other words, if trading favours did not exist as part of relational contracting,

how would the relevant set of transactions be conducted?

2. What enforcement mechanisms can be used to guarantee the (possibly delayed)

reciprocal portion of the exchange?

When is trading favours efficient?

In general terms, trading favours can be considered efficient if it is superior to

other contracting alternatives at economizing on bounded rationality and bounded

reliability in the context of governing a particular transaction or set of transactions. As

trading favours is observed at the macro, group and micro levels, we explore specific

conditions for its efficiency at each of these three levels.

Macro level. There is a consensus in the literature on trading favours that this

practice is most frequently observed in developing and transition economies.

Institutional theory, which has been adopted as one of leading conceptual frameworks for

studying emerging economies (Hoskisson et al, 2000; Meyer & Peng, 2004; Peng et al.,

2001), explains the common occurrence of the practice by the fact that informal

institutions - including trading favours as a relational contracting component - are used to

fill voids in the realm of formal institutions such as private property rights protection,

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as a distinct class of transactions, involving a private exchange between two parties, and

associated with abuse of a public or collective responsibility.

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judicial and financial systems, contract-enforcing government institutions as well as local

intermediary firms supplying services through formal contracts. RBV researchers concur

that informal transactions will be more important in the absence of well-developed

institutional infrastructure, due to the fact that efficient institutions facilitate the securing

of strategic resources in the open market and thus reduce the need for favours as a

mechanism to access resources (Wan, 2005; Li et al., 2012). TCE offers a parallel

explanation, suggesting that trading favours will be the relational contracting component

of choice in contracting situations where bounded rationality and bounded reliability

challenges are strong, and formal rules and institutions represent an insufficient

governance response. For example, institutional voids in capital, labour and product

markets create bounded rationality challenges for firms trying to access potential partner

companies, employees and customers. The lack of enforceable accountability rules (e.g.,

in the realm of transparency and disclosure) exacerbates information asymmetries

between parties (Chen, Ding & Kim, 2010), thereby further contributing to bounded

rationality challenges. Absence of transparency and disclosure also hinders proper

evaluation of business partners’ efforts to fulfil commitments, thus creating severe

bounded reliability problems (Verbeke, 2009). The absence of efficient local

intermediary firms, such as specialized market research firms, end-to-end logistics

providers, human resources management firms, etc., creates bounded rationality and

reliability challenges by hindering access to requisite market information, distribution

services, and an optimal employee reservoir (Khanna & Palepu, 1997). Bounded

reliability challenges are further compounded by weaknesses in legal enforceability

mechanisms often found in emerging economies. In such situations, trading favours can

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serve as a ‘bond’ to secure transactions, facilitating both information exchange and

enforceability. Thus, TCE provides substantive content to institutional theory’s

contention that trading favours will prevail in contexts characterized by institutional

voids. This line of thinking is to some extent supported by empirical evidence: Zhou and

Peng (2012) demonstrate on the basis of a large-cross-country sample of 2,686 firms that

informal favours are utilized to a higher level when embedded in under-developed

institutions.8 Li et al. (2012) convincingly show, building upon a longitudinal sample of

1,280 Chinese public firms, that favours are more instrumental to firm growth when

market mechanisms and intermediate institutions are less developed.

An additional analytical dimension brought by TCE is that excessive formal rules

and other institutions may also inhibit efficient transacting. For example, Mudambi et al.

(2013) demonstrate that higher levels of government regulation in an economy can lead

to higher levels of corruption (a negative spillover of favour-trading). A regulatory

environment where firms face excessive legal obstacles to enter an industry or to operate

a business, or one that imposes excessive antitrust regulations on outsiders, can create

bounded reliability challenges by favouring industry incumbents over new entrants,

prompting new entrants to seek favours trading in order to overcome policy-induced

barriers to trade and investment. In addition, excessive formal rules and other institutions

can cause bounded rationality challenges through information overload, thereby also

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
8
Zhou and Peng’s study focused specifically (and more narrowly) on bribery. To the

extent that bribery can be interpreted as a specific (albeit potentially damaging) form of

favours, their study does provide partial evidence that favours are more prevalent in

underdeveloped institutional contexts.

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inviting favours as a safeguard for firms to ease their way through a non-transparent and

dysfunctional web of obligations imposed by society. In contrast, well-established market

institutions, characterized by transparent and smoothly implementable rules and

regulations, will reduce incentives for trading favours (Mudambi et al., 2013) by

alleviating potential bounded rationality and bounded reliability problems. We

hypothesize that both an institutional vacuum and institutional overkill create bounded

rationality and bounded reliability challenges that can be usefully alleviated by trading

favours.

Hypothesis 1: Trading favours - U-curve hypothesis (macro level): Trading

favours will be more prevalent in contexts characterized by (a) a vacuum of

transaction-supporting formal rules and institutions (including their enforcement

features), and/or (b) excessive, transaction-burdening formal rules and

institutions that hinder efficient transacting9 (Figure 7.1).

(Figure 7.1 about here)

Group-level. A group is a collection of individuals who share particular features, which

may include social norms, social interactions, common experiences, etc. An in-group
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9
It should be noted that in real world situations a complete vacuum of formal rules is

unlikely, as even newly emerging economies usually possess burdensome regulations in

some policy areas. However, these economies simultaneously suffer from the lack of

efficient, local intermediary firms. The institutional voids referred to in Hypothesis 1

pertain to the vacuum of helpful /business-friendly regulations and institutions that

facilitate transactions and ensure their transparency, the information disclosure associated

with them, and their legality.

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exchange of favours (often to the detriment of those outside of the group) appears to be a

widely practiced phenomenon in both emerging and developed economies, with groups

ranging from ethnic minorities and castes to university alumni networks (Bramoulle &

Goyal, 2009; Chua, 2003; Pande, 2003; Kramarz & Thesmar, 2006) and informal trading

networks among individuals with common professional interests (von Hippel, 1987).

Research shows that operation of the group heuristic is stronger in some cultures

than in others (Yamagishi et al., 2008). In cultures and regions that downplay belonging

to a network, firms will tend to rely more on arm’s-length relationships and formal

contracting (Cai, Jun & Yang, 2010). In contrast, in cultural contexts where in-group

membership is highly valued, reputation and social bonds can act as a system of private

law, enabling widespread informal exchange (Bernstein, 1990). Favour-trading

transactions thus become socially embedded in close-knitted communities (Granovetter,

1985). The ‘close-knittedness’ of any group is likely to facilitate frequent and recurrent

transactions, creating situations of bilateral dependency and consequent contracting

hazards (Williamson, 1996). Trading favours comes in as an economizing mechanism

against these hazards in recurring transactions.

Finally, groups are characterized by sharing a perceived distance vis-à-vis out-

group members, which is evident even in groups sharing the seemingly most trivial,

common characteristic (Yamagishi et al., 2008). Williamson (1996) describes a

community of Jewish diamond traders, where in-group to out-group distance is a partial

result of long-term discrimination by outsiders, and entry is restrictive. The size of the

in-group vis-à-vis the overall reference population is likely to affect the in-group to out-

group distance. Olson’s (1965) theory of groups suggests that the size of a group is

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inversely related to individual information levels. Membership of smaller groups is

therefore more valuable in order to alleviate bounded rationality caused by information

asymmetries (Mudambi, Navarra & Nicosia, 1996). The end result is a more ‘exclusive’

group with a larger, common distance to out-group members. Such distance can be

reinforced through a system of extra-legal rules (e.g., rules emanating from religion or

geography, or community-based ones) that govern the group but do not apply to out-

group members. In ‘exclusive’ groups, trading favours will prevail as a mechanism that

can economize on bounded reliability more cost-effectively than alternative (i.e., legal or

formal) systems of rules, see hypothesis 2.

Hypothesis 2: Trading favours - group distance hypothesis: Trading favours will

be more prevalent in cultural contexts where in-group membership is highly

valued. This prevalence will be stronger in the presence of recurrent transactions

and a higher perceived distance vis-à-vis out-group members.

Micro level (private transactions). A private transaction is a transaction that

occurs between two actors with no (or limited) ex ante information dissemination to third

parties. Williamson (1996) describes the breakdown of a farmer’s hay baler with the

prospect that the crop would be ruined by rain. The farmer is saved by a neighbour’s offer

to help bale the hay without charge except to reimburse for the gasoline. Williamson

views the situation as an example of informal organization: informal, reciprocal favours

represent a component of this type of governance. Direct reciprocation is not required,

but a similar act of (emergency) assistance is expected in the future should another

member of the small community need it, thus creating a circle of recurrent, calculative

support (making this situation somewhat analogous to the one described above for the

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group level). This type of perpetual good news, however, is only possible if the relevant

community is able to apply sanctions effectively for failure to reciprocate, with sanctions

ranging from moral suasion to ostracism. In the presence of such safeguards and

assuming a sufficiently small community (‘where everybody knows your name’),

bounded reliability problems are unlikely to occur. Here, spontaneous cooperation

between two parties is fostered by the presence of a high reliability environment.

Bounded rationality, on the other hand, may be high, with tacit information carried in the

mind of each transacting party, and with a general lack of knowledge as to when a

reciprocal transaction might occur, and what its substance would be. However, it is

precisely because the timing, scope and scale of the private exchange of favours, and

even the identity of the contracting parties may be unknown ex ante, that trading favours

can contribute to economizing as compared to the use of formal contracts required in a

situation of “less spontaneous cooperation” (Williamson, 1996: 263). As a final point on

micro level exchange, the cost of each favour as perceived by the supplier must

systematically be lower than the benefits perceived by the recipient; this situation is likely

to occur when the demand for a favour results from a ‘crisis event’ in the life of the

favour recipient, but ultimately requires only an incremental effort from the supplier to

solve this crisis.

Hypothesis 3: Perpetual good news hypothesis for private transactions: Trading

favours will be more prevalent in contexts (1) with severe bounded rationality

problems, but only minor bounded reliability challenges; (2) where frequent

opportunities exist for indirect reciprocity; and (3) where c<b, with c as the cost

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 of each favour perceived by the supplier, and b as the benefit of each favour as

perceived by the recipient.

Let us clarify that the above severe bounded rationality problems refer to high

levels of uncertainty about future transactions, e.g. in terms of their actual occurrence,

timing, frequency, content, magnitude, required investments etc. In contrast, absence of

severe reliability problems is usually observed when formal and informal sanctions are

readily available to enforce transactions, and/or when the loyalty of actors involved in

transactions, as a driver to make good on their commitments, is very high. A well-

functioning family is an example of a high bounded rationality/low bounded reliability

context: the organization is small, the future is unforeseeable, and a spontaneous

exchange of favours is expected among members (excluding perhaps dysfunctional

families). In the business context, this extends to family firms that are characterized by

family-based human asset specificity, meaning that such companies may suffer from a

shortage in terms of both the quantity and quality of required human resources. At the

same time, family-based human asset specificity implies unique access to a stable and

loyal human resources base with limited adverse selection (Pollak, 1985), meaning low

bounded reliability within the firm and frequent opportunities for both direct and indirect

reciprocity. Our prediction, therefore, is that trading favours will be more prevalent

within family firms than in, for example, Chandlerian hierarchies.

Similarly, R&D organizations in turbulent environments, where uncertainty is

high and technological systems are complex, will find it challenging and costly to engage

in farsighted formal contracting for completely unproven, emerging technologies. In such

environments, trading favours, especially when the exchange of pieces of technological

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know-how inside the firm is involved (and even outside of it, in the presence of co-

located companies operating in the same pre-competitive cluster), can facilitate cost-

reducing innovation (von Hippel, 1987).

All levels. From a transaction cost-economizing perspective, supplier investment

in the favour should not exceed the perceived benefit to the recipient at any level of

favours trading, in order for the transactions to occur. Assuming that asset specificity -

and especially vulnerable, state-of-the-art innovations embedded in specific assets -

drives transaction costs associated with transactions, greater asset specificity over time

will lead to more bilateral dependency between contracting parties. While trading

favours may then still operate as a relational component of contracting, it may no longer

be satisfactory as a primary mechanism to govern complex classes of bilaterally

dependent transactions, and will either move to a substitute role, or will be completely

supplanted by longer term and more complex forms of contracting. This leads to

hypothesis 4.

Hypothesis 4: Absence of supplier asset specificity hypothesis (all transaction

levels): Trading favours will be more prevalent in cases whereby no asset-specific

investments/investments in innovation need to be made by the supplier of the

favour. This also holds for the supply of the reciprocal favour.

What enforcement mechanisms facilitate trading favours?

In the absence of formal contracting, and in the presence of informal exchange

governing how favours are extended and honoured, enforcement mechanisms represent a

critical part of the practice in order to guarantee the reciprocal transaction. These

enforcement mechanisms can take several forms:

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1. In-group sanctions can be utilized in tight-knit communities to enforce reciprocation.

In-group punishments can be facilitated by close social ties, and can range from mild

reprimand to ostracism (consider blat and guanxi networks discussed above). Easy

aggregation and dissemination of information in close groups enables in-group

sanctions (e.g., diamond traders practice displaying pictures of non-trustworthy

individuals in trading rooms).

2. Access to formal contracting as a complement to trading favours may be necessary in

cases where highly asset-specific investments are unavoidable, in order to prevent an

obsolescent bargain. Obviously, this is an option only in an environment with fully

functioning institutional checks and balances (and thus may not be available to

transacting parties in emerging economies, as discussed above).

3. Possibility of image scoring refers to situations whereby granting a favour may raise

an individual’s /organization’s image or status as perceived by others. The supplier

of the favour therefore benefits from indirect reciprocity, which compensates for

potential loss of value should the favour not be reciprocated by the original recipient.

Invoking this enforcement mechanism, however, requires an organizational capacity

to assess and readjust images when required.

4. In cases of indirect reciprocity (as in the above situation of image scoring), each party

involved in the practice becomes a residual claimant (Alchian & Demsetz, 1972) of

benefits arising from the system of favours. In this case, incentive compatibility

among all actors involved must be established for the indirect reciprocity incentive to

be effective in safeguarding the transactions.

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Types and impacts of trading favours

Classification of trading favours practices. It follows from the above discussion

that the practice of trading favours can come either as a complement to formal

contracting (as is often the case at the macro level, especially in developed economies

where formal contracting is accessible and enforceable), or as a complete substitute for

formal contracting (in private transactions and in informal groups/networks). In terms of

frequency, trading favours ranges from unique, two-way reciprocity between two

transacting parties to recurrent, multiple-way reciprocity within a network of actors.

Figure 7.2 summarizes a typology of trading favours.

(Figure 7.2 about here)

Based on the above classification, we can distinguish among four generic types of

trading favours, as identified in Figure 7.2. In the first quadrant are unique two-way

trading favours practices that complement rather than replace formal contracting, e.g.,

large scale one-time infrastructure projects that are impossible to implement without a

formal contract but are necessarily complemented by an informal exchange of favours

(e.g. building a pipeline in Russia requires a formal contract with government, as well as

deployment of favours in order to gain land access and building permits). In the second

quadrant are unique two-way favours that substitute for formal contracting, perhaps best

exemplified by Don Corleone’s famous quote in The Godfather: “Some day, and that day

may never come, I’ll call upon you to do a service for me. But until that day – accept this

justice as a gift on my daughter’s wedding day”. This type of trading favours need not

have mafia connotations; the literature and cinematography are teeming with examples of

great life-saving and life-changing stories that fall within this category of transactions. In

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the third quadrant are recurrent multi-way favours that complement formal contracting,

such as favour trading within formal business networks, e.g. know-how trading in

professional associations, trading favours among Jewish diamond dealers; Williamson’s

hay baler example also belongs in this quadrant, assuming that all farmers engage in

some formal joint purchasing of inputs, joint marketing and distribution, etc. The fourth

quadrant is occupied by recurrent, multiple-way favours with no intrinsic link to formal

contracting – examples include blat and guanxi, as well as exchanges of favours within

any informal network (e.g. informal know-how sharing among engineers not belonging to

a formal association (von Hippel, 1987).

Impact of trading favours. The potential negative impact of trading favours

(related to corruption and unethical business practices) has been well documented in the

literature (see, inter alia, Chan & Unger, 1982; Chen et al., 2010; Cockcroft, 1996;

Groseclose, 1996; Husted, 1994; Jensen, Li & Rahman, 2010; Lee et al., 2005; Mudambi

et al., 2013; Volkema, 1999). Its positive impacts, in terms of enabling transactions and

economizing on bounded rationality and bounded reliability has garnered less attention to

date. We take a separate look at the micro and macro level impacts of favours trading.

At the micro level, we distinguish between trading favours practices that serve an

economizing versus an exclusion purpose. At the macro level, we look at the societal

impacts of micro level behaviour, whereby we distinguish between the impacts filling

institutional voids and those serving entrenchment, as summarized in Figure 7.3.

Government policies and mainstream societal practices can obviously reinforce or

discourage prevailing micro level approaches to trading favours and their impacts.

(Figure 7.3 about here).

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 In the first quadrant, micro-economizing practices reflect efficiency-oriented

behaviour that unfortunately leads to negative societal spillovers, for example when

dedicating a scarce resource to a particular favour recipient de facto withdraws that

resource from others. Unintended discrimination of outsiders by practicing in-group

favouritism also falls within the first quadrant.

The second quadrant, which can be viewed as ‘malevolent’, refers to the

combination of micro-exclusion and macro-entrenchment outcomes. Think, for example,

of illegal favour-trading between banks and financial analysts on Wall Street that is

insufficiently monitored and punished, as a result of archaic legislation and under-

resourced enforcement. Pyramidal control structures characteristic of many countries

outside the West (e.g. China, India and other emerging economies), whereby a few

wealthy families control large corporations without making a commensurate equity

investment, also generate quadrant-two-type impacts: These ownership structures reflect

corporate governance problems (i.e. resource misallocation) at the micro level, while

affecting macroeconomic outcomes in the form of rates of innovation, economy-wide

resource allocation and economic growth (Morck, Wolfenzon & Yeung, 2005). Profit

tunnelling in Indian business groups is yet another example: here, owners of business

groups (single shareholders who completely control several independently traded firms

but have significant cash flow rights in only a few of them) expropriate minority

shareholders by tunnelling resources from firms where they have low cash flow rights to

firms where they have high cash flow rights. This practice can have disastrous societal

consequences by hindering equity market growth and overall financial development,

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clouding accounting and essentially reducing the transparency of the entire economy

(Bertrand et al., 2002).

Favour-trading practices that fall into the third – micro-economizing/macro-void-

filling – quadrant of Figure 7.3 tell a conventional TCE story. For example, trading

favours can be used at the micro level to increase efficiency of transactions in situations

where requisite macro level, efficiency-enhancing (formal) institutions are absent. The

cumulative effect of micro level trading favours practices may then de facto fill an

institutional void. Indian business groups (collections of publicly traded firms in a wide

variety of industries, with a significant presence of common ownership and control, also

prevalent in other emerging countries), replicate the functions of institutions missing in

emerging markets10. These services that in advanced economies are delivered by a variety

of intermediary institutions – such as information provision in product, labour and capital

markets, as well as some forms of contract and property rights enforcement, etc. – are

costly for individual firms to produce themselves. However, large diversified business

groups fill the void by investing in internal structures and processes to perform the

intermediation function. In the best-case scenario, the payoff comes in terms of higher

performance of diversified conglomerates at the micro level, and an economic boost at

the macro level (Khanna & Palepu, 2000). Social welfare may also be enhanced by

business group-government liaisons should that relationship support taxation and fiscal

policy (Khanna & Yafeh, 2007).

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
10
Here, we assume that business groups do not engage in questionable practices such as

profit tunneling discussed in a previous example, and we use business group governance

only as a generic illustration of how institutional voids can be filled.

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 Finally, the fourth quadrant of Figure 7.3 pertains to micro-exclusion practices

that have a void-filling impact at the macro level. This storyline is characteristic of non-

democratic societies, where private interests are sacrificed for the so-called greater good,

typically driven by intermingling of governments and firms through high-level network

connections (e.g. imposing a 95% tax on oil revenues greater than $100 per barrel on

foreign oil and gas multinationals in Venezuela, which creates an unfair advantage for the

dominant state oil company). In such cases, substantial favour-trading between the ruling

government and the micro level beneficiaries of government favours occurs in parallel

with discriminatory measures against other micro level actors. This is a complex issue

with mixed evidence as regards outcomes. Khanna and Yafeh tap into the grey area with

an investigation into whether business groups in emerging markets are “paragons or

parasites” (2007: 331). They find that business groups, while serving to fill institutional

voids, can engage in rent-seeking through exercising power over incumbent businesses,

thereby negatively affecting competition and industry structures.

Having thus considered all potential combinations of trading favours’ impacts, we

can conclude that trading favours practices that serve efficiency purposes at the micro

level without negative spillovers at the macro level (quadrant 3) – that is, purely

economizing trading favours practices – are likely to be sustainable in the long run.

Entrenchment and exclusion practices, in contrast, lead to costs associated with negative

spillovers, such as corruption costs, welfare losses from monopolies and rent-seeking

behaviour etc. From a purely transaction cost-economizing perspective, these costs will

in the long run lead to changes in the macro level shift parameters to eliminate this type

of inefficiency and reduction of societal welfare, leaving room only for efficiency-

! 228
oriented favours trading. Unfortunately, a range of considerations beyond economics –

psychological, sociological, cultural etc. – may interfere with the realism of this

prediction. In other words, we would like to conclude with the prediction that negative

spillovers of favours trading are likely to be eliminated in the long run and that only

economizing expressions of the practice will survive; however, at this point, it may be

more reasonable simply to echo Lee and colleagues’ (2005) view that such spillovers do

negatively affect the long-term effectiveness and efficiency of how business is conducted

world-wide, and, eventually, the welfare of the global economy.

CONCLUSION

Previously overlooked as an analytical tool to study trading favours, TCE

provides a credible conceptual lens for evaluating trading favours’ economizing features

as compared to alternative, real world governance mechanisms to manage transactions. In

this conceptual study, we have developed a TCE-based theory of trading favours. We

have defined trading favours as a component of the relational contracting portion of how

transactions are governed. We have identified the characteristics of transactions that

would render trading favours efficient, and have formulated testable hypotheses to

investigate trading favours’ efficiency features at various levels (micro, group, macro and

multiple levels). We have described enforcement mechanisms necessary for the effective

utilization of trading favours, and have developed a classification of different forms of

this practice in terms of the conditions for their occurrence and their micro and macro-

impacts. We have concluded that trading favours, as an economizing practice, is

sustainable over the long run when serving efficiency purposes at both the micro and

macro levels.

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 By virtue of its parsimony and predictive capacity, TCE provides a road map to

reflect on the practice of trading favours. It allows for an analysis of various complex

contexts in which trading favours occurs, and allows for a realistic analysis of the

phenomenon through the concepts of bounded rationality and bounded reliability, while

assuming economizing properties of this practice. Yet, the TCE-based analysis of trading

favours presented here is not without its limitations.

While enabling sound prescriptions based on trading favours’ economizing

properties, TCE does not address fully complex ethical and moral questions related to this

practice, nor its anthropological roots and social embeddedness. Further, though TCE

acknowledges the possibility of power asymmetries and can actually address the related

governance challenges when these asymmetries are endogenous (e.g. resulting from

managerial choices), it does not offer an optimal response in cases of extreme,

exogenously imposed power asymmetries. The latter include, inter alia, cases of giving

in to extortion where kidnapping of employees is involved. The strength of TCE, though,

is that this lens can easily accommodate complementary perspectives. Other theoretical

approaches can be productively utilized to complement conventional TCE analysis and

predictions. For example, the internalization theory version of TCE, which blends the

Coasean transaction cost economizing perspective with the resource-based and dynamic

capabilities views of the firm, can add value by analysing the linkages between trading

favours and firm-specific advantage (FSA) development patterns. As one example, in the

case of transactions between a large multinational enterprise (MNE) operating in an

emerging economy and a local partner with strengths in national responsiveness, one

would expect trading favours to occur for: (1) MNE products involving ‘old

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technologies’, rather than those embodying the MNE’s newest technologies and related

firm-specific advantages (FSAs), and (2) local services that may be difficult to access by

the MNE but can easily be deployed by the local partner through economies of scope, and

without having to dedicate ‘production capacity’ in an exclusive and costly fashion to the

MNE (e.g., networking contacts).

Finally, it may be useful to reflect on future research directions. Emerging

economies, frequently associated in the literature with trading favours, offer a particularly

interesting situational context for trading favours analysis. First, emerging economies are

often characterised by the presence of U-curve institutional conditions, including

elements of both institutional vacuum and overkill (e.g., in terms of protectionist local

policies). These conditions facilitate testing the trading favours U-curve hypothesis at the

macro level. Second, trading favours practices are comparatively more visible in

emerging economies than in developed countries, partly because of their higher

legitimacy and open acceptance. Third, encouragement versus discouragement of trading

favours in emerging economies may have substantial, and again very visible,

distributional implications for multinational enterprises and local economic actors.

Fourth, both institutional and cultural specificities, as macro level shift parameters,

influence the application and impacts of trading favours in each emerging economy.

Such specificities should allow for useful comparisons among these nations, and in our

view this represents a fascinating, multidisciplinary research opportunity.

As a closing note, our study has important practical implications for managers and

policy-makers alike: Trading favours is not synonymous with unethical business practices

and therefore does not necessarily need to be fought as a societal evil. Its often deep

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societal roots would make fighting it difficult, if not futile. The managerial challenge is

not to chase trading favours from governance design and from conducting transactions,

but rather to understand how to use it efficiently, and to focus on appropriate enforcement

mechanisms to ensure a mutually beneficial, reciprocal exchange, while preventing

negative spillovers.

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Figure 7.1. Trading favours U-curve hypothesis for the macro level

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Figure 7.2. A classification of trading favours types

SCOPE

Unique 2-way Recurrent multiple-

reciprocity way reciprocity

Q1 Q3
Complements Large scale Formal business
LINK WITH infrastructure projects networks
FORMAL
CONTRACTING
Q2 Q4
Substitutes The Godfather, Part 1 Blat, guanxi, protetzia,
palanca, cuna etc.

Figure 7.3. Four storylines on trading favours impacts

MACRO LEVEL IMPACTS

Entrenchment tool Institutional void filler

Q1 Q3
• Unintended • Business groups
Economizing spillovers of micro-
economizing
practices
• In-group favouritism
MICRO LEVEL
IMPACTS Q2 Q4
• Favour-trading • Favour trading between
Exclusion between banks and government and local
Wall Street beneficiaries
• Pyramidal control (Venezuelan oil tax)
structures
• Profit tunneling

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 Essay 8

STRATEGIC GOVERNANCE FOR SUSTAINABILITY: EXPLORING

THE NATURE OF SUSTAINABILITY CRISES

In this study, we explore strategic governance challenges in the context of corporate

sustainability – an increasingly prominent topic in management studies, further amplified

by a host of corporate governance scandals that have occurred over the past decade. We

analyze twelve high profile cases of corporate sustainability crises. In each case, a

sustainability-related crisis, linked either to social/employment,

health/safety/environment, or economic/financial issues, led to disastrous consequences

(in terms of impacts on performance and negative reputation effects) for the firm

involved, in addition to obvious negative impacts on the environment and/or society. The

objectives of our study are to investigate why sustainability crises happen, to explore

spillover interactions of both causes and consequences of the crises among the three

pillars of sustainability (economic, social and environmental), and to analyze the role of

entrepreneurial action (or the lack thereof) inside the firm in both the origination of and

responses to the crises. We find that an entrepreneurial context, in the absence of

mechanisms to economize on bounded rationality and bounded reliability, can to some

extent ‘facilitate’ the occurrence of a crisis. We distinguish between two types of

sustainability crises – those characterized by intentional ‘dark’ entrepreneurship, and

those where negative societal and environmental impacts were unintended spillovers of

otherwise productive entrepreneurial activities; we argue that these two types of crisis

are driven by different mechanisms underlying managerial behaviour, and typically

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occur in different pillars of the sustainability tripod. We further discover that economic

pressures are at the core of all crises, regardless of the visible loci of sustainability

impacts. Finally, we identify a presence of a benevolent conflict among diverse

stakeholder needs, and describe how deficiencies in simultaneously managing diverging

stakeholder needs can lead to sustainability crises.

INTRODUCTION.

Sustainability is generally defined as a development that meets the needs of the

present generation without compromising the ability of the future generations to meet

their own needs (WCED, 1987). Corporate sustainability, more specifically, means

integrating social, environmental and economic impacts of the corporation’s activities

(Epstein, 2008). Together, these three areas of impacts form the so called three pillars of

sustainability (World Summit United Nations General Assembly, 2005) and give rise to

the term ‘triple bottom line’ – implying that the three pillars are not mutually exclusive

and can, in fact, be mutually reinforcing (Smith, 2011).

With the business world’s growing realization that corporations must address

sustainability (Searcy, 2012), the issue has moved to the forefront of academic research in

management, and has found its way into business school curricula around the world

(Stead & Stead, 2010). Yet, the idea of sustainability and social responsibility is perhaps

as old as business itself (Lolescu, 2009), and has been explored by such prominent

administrative scientists as Barnard (1938) and Bowen (1953) long before it became a

mainstream topic in management research. That being said, sustainability research is a

relatively new field within the broader discipline of management studies, and is naturally

fraught with growing pains. Governance research in particular is struggling to incorporate

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an appropriate sustainability angle. Current governance practices and, significantly,

research direction (at least in management theory) are for the most part focused rather

narrowly on internal control and compliance with existing regulations (Clarke, 2007); yet,

considering the widespread movement toward integrating sustainability in business, this

narrow focus is no longer appropriate. Practitioners and researchers alike are facing a

challenge of “bridging the great divide” (Clarke, 2007: 267) between governance and

sustainability. This paper represents a move toward closing this gap, with a particular

focus on strategic governance aspects. More specifically, we explore how different types

of strategic governance affect the origination, nature and mitigation of sustainability-

related crises – a particularly relevant research setting given the wave of corporate ethics

scandals that has swept the business world since the Enron collapse in 2001 (Fombrun &

Foss, 2004).

In the following sections, we review central concepts of the study – those of

strategic governance and sustainability crisis, discuss research questions and

methodology, and present results. We conclude with implications for practice and future

research.

It must be noted that we adopt an inductive, interpretive research design and

employ the constant comparative method (Glaser & Strauss, 1967; Strauss & Corbin,

1990), whereby data is collected and analyzed simultaneously. A pure form of iterative

research presentation would involve a mixed discussion of data collection, analysis and

theoretical insights (Suddaby, 2006). We chose to structure our discussion following a

more traditional sequence, with at least some of the theory preceding data collection and

analysis, and results sections (consistent with Nag, Corley, & Gioia, 2007). This

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presentation form does not directly reflect the temporal sequence of our research,

whereby data was collected and analyzed simultaneously and theoretical insights

emerged directly from the data (though guided by relevant extant theory), but it offers

greater clarity to the reader.

STRATEGIC GOVERNANCE FOR SUSTAINABILITY

Governance refers to the organizational framework within which economic

exchange takes place, including the processes associated with the exchange (Zaheer &

Venkatraman, 1995). At the macro level, firms represent mechanisms of governance, as

they are purposefully created when they are able to organize production more efficiently

than other governance forms, i.e. external markets (Williamson, 1996). At a micro level,

however, an important distinction must be made between structural governance and

strategic governance. The former refers to the actual organizational structure governing

economic activities, e.g., the usage of the multidivisional form (M-form) versus the

functional form (U-form) of firm-level organization, firm-level administrative

relationships, level of centralization of decision-making etc. In contrast, strategic

governance is concerned with the micro-economic detail of economic actors’ routines or

managerial practices (Zaheer & Venkatraman, 1995) and refers to “dynamics of actual

behaviour in respect to strategic decision making” (Schmidt & Brauer, 2006: 14).

Broadly speaking, strategic governance is about orchestrating the usage of resources,

through routines and other processes, with the focus on allowing for two types of

economizing and for the ‘highest-order capability’ creation:

1. Superior economizing on bounded rationality (Simon, 1959) of economic actors

involved in activities;

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2. Superior economizing on bounded reliability (Verbeke & Greidanus, 2009) of

economic actors involved in activities;

3. Highest-order capability creation, namely a supportive entrepreneurial context for

managing innovation in its entirety, namely for managing the entire process of

knowledge acquisition or development, absorption, diffusion and exploitation

(Verbeke & Kenworthy, 2008).

From the perspective of comparative institutional analysis (Hennart, 1994), the

most efficient governance mechanisms will be those that, on balance, allow for superior

contributions to the two economizing objectives, and for superiority in managing the

innovation process in its entirety. This last element can be viewed as the dynamic

equivalent of Williamson’s plea to achieve superiority in managing transactions in their

entirety. In Williamson’s oeuvre such superiority arises mainly from addressing properly

the level of asset specificity at hand in transactions. In our work, superiority arises mainly

from addressing properly the extent to which innovation is needed by the firm, with a

special focus on the entrepreneurial context for value creation and capture from

innovation.

Furthermore, the pursuit of (1) economizing on bounded rationality and bounded

reliability, and (2) creating an entrepreneurial context for managing the innovation

process in its entirety, through selecting and retaining specific governance mechanisms

will affect decision making in three key areas:

1. Establishing the boundaries of the firm – that is, the ‘make or buy’ decisions

(Grøgaard & Verbeke, 2012), or establishing which economic activities should be

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 performed inside the firm, and which should be conducted outside of the firm in the

external market;

2. Organizing the interface with the external environment for the ‘buy’ activities, i.e.,

activities conducted by actors external to the firm; this may involve choosing among

short or long-term contracts, strategic alliances of different forms etc.;

3. Organizing ‘make’ activities, i.e., activities performed internally, within the firm; this

involves such decisions as the choice of an organizational structure and administrative

relationships, establishing incentive systems, etc. (Grøgaard & Verbeke, 2012).

Each of the above three focal points of comparative institutional analysis applied

to three categories of decisions, combines strategic and structural elements. However, our

study is concerned mainly with strategic governance in a sustainability context – that is,

we explore how managerial behaviour, as expressed in routines and other processes, lead

to or address challenges in economizing on bounded rationality and bounded reliability

involved in establishing sustainable business practices, and how they facilitate or hinder a

supportive entrepreneurial context for sustainability innovations. In terms of the types of

decisions analyzed, our study addresses mainly the internal routines and other processes,

and the interactions with multiple external stakeholder organizations. We do not seek to

address firm boundary choices directly, though recognizing possible implications for firm

boundary changes.

RESEARCH SETTING: SUSTAINABILITY CRISES

A crisis means a severe disruption of a firm’s prevailing routines and other

processes, which triggers redirection of resources and leads to significant negative

consequences for stakeholders. In our case, these negative impacts cause disruption in

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one or more sustainability pillars – that is, they are linked to social,

health/safety/environment, and/or economic/financial issues that negatively impact

internal and external stakeholders of the firm.

We investigate crises that occur in each of the three pillars of sustainability, which

is significant given the current scholarly debate surrounding a win-win paradigm for

sustainability. The win-win paradigm reflects the general consensus that sustainability

occurs at the intersection of environmental, social and economic organizational outcomes

(Bansal, 2005), and that the three pillars of sustainability may coexist in relative harmony

(Hahn, Figge, Pinkse & Preuss, 2010). Consequently, a ‘business case’ argument for

sustainability suggests that companies can leverage social and environmental

undertakings to achieve economic benefit (Yuan, Bao & Verbeke, 2011). The win-win

paradigm has been criticized from a philosophical perspective for subordinating social

equity and environmental integrity under economic prosperity (Hahn & Figge, 2011), and

from a normative perspective for overlooking potentially significant trade-offs and

conflicts among the social, environmental and economic aspects of organizational

management and performance (Hahn et al., 2010). While several scholars have attempted

to address trade-offs and spillovers among the three sustainability pillars (see Dyllick &

Hockerts, 2002; Walley & Whitehead, 1994; Young & Tilley, 2006; Holt & Watson,

2008; Kaptein & Wempe, 2001; Margolis & Walsh, 2003; Hahn et al., 2010; Hahn &

Figge, 2011), most research in the field focuses on simultaneous achievement of

environmental, social, and economic well-being (Bansal, 2005). What is missing in both

research streams, however, is attention to the process of how integration is achieved,

and/or how spillovers and trade-offs shape organizational, environmental and societal

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outcomes. Our study takes an in-depth look at the interdependencies, spillovers, and

trade-offs among the three pillars of corporate sustainability. By using crisis situations as

a starting point of the analysis, we create a particularly favourable context for exploring

breakdowns in strategic governance in relation to some or all of the three sustainability

pillars.

RESEARCH QUESTIONS

Our study addresses three main research questions (RQs):

RQ1. Why do sustainability crises occur?

While there is no shortage of crises-related management literature, especially

following a wave of highly visible corporate scandals in the USA and Europe over the

last decade (Fombrun & Foss, 2004), the mainstream academic literature on this topic

tends to be either too general – and, as a result, not applicable in specific situational

contexts – or, at the other end of the spectrum, too issue-specific and lacking normative

conclusions that would hold in a broader context. On the broad side, sustainability crisis

is viewed from a global or macro perspective, e.g. in the context of global warming and

global resource depletion (Trainer, 1997), various government regimes’ responses to

crisis (Morck & Yeung, 2009), etc. While this macro level view is undeniably valuable

for policy-making purposes, it does not offer actionable micro level insights. At the

micro level, however, much management literature focuses on particular aspects of

handling crises, e.g. effective communication (Sosa, Eppinger, & Rowles, 2007),

stakeholder trust (Pirson & Malhotra, 2008), managing employees’ inappropriate self-

interest (Finkelstein, Whitehead, & Campbell, 2009), etc. These studies are often

published in managerially oriented outlets and may have some practical implications.

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However, due to their situational context, they do not lead to a broad understanding of the

nature of sustainability crises. The purpose of our study is to advance this understanding

by creating a parsimonious theory of sustainability crises.

RQ2. How do the three pillars of sustainability interact in a crisis context?

As mentioned above, few studies have addressed trade-offs and spillovers among

the three dimensions of sustainability, especially at the organizational level, where the

dominant ‘business case’ paradigm implies search for conflict-free situations. It must be

noted that it is not our intention to criticize the win-win paradigm – on the contrary, our

results, as will become evident later, support the business case logic. Rather, our

objective is to investigate how the three pillars interact at the time of a crisis, and whether

there are any patterns of negative outcome spillovers from one dimension of

sustainability to another.

RQ3. How does entrepreneurial action affect sustainability crises and their

mitigation?

We adopt Teece’s (2007) view of entrepreneurial action as an entrepreneurial

quality embedded in an organization. Teece coined a term “entrepreneurial managerial

capitalism” (2007: 1346), which involves recognizing trends, redirecting resources, and

reshaping structures to create a favourable environment to address opportunities. This

view of entrepreneurship is closely aligned with the strategic governance perspective,

where entrepreneurship refers to activities directed at creating a favourable context for

managing innovation. With supportive entrepreneurial context being a critical component

of strategic governance, we felt that it was important to explore the role of

entrepreneurship in sustainability crises (which signal governance breakdowns).

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 METHODOLOGY

We adopt an exploratory case-study-based research design (Eisenhardt, 1989;

Yin, 2003; Nag et al., 2007) and interpretive methodology with elements of grounded

theory (Strauss, 1987). Yin (2003) and Maxwell (1996) suggest that ‘how’ and ‘why’

questions (which precisely describe our research questions) lend themselves particularly

well to inductive and qualitative methods. Further, grounded theory-like (Strauss, 1987)

research design is useful for capturing unanticipated phenomena, common in areas that

lack prior research (Maxwell, 1996), which is the case for research related to

sustainability crises. The notion of an ‘interpretive’ approach means that we strive to

discern, through careful data analysis, motivations and sense-making of actors involved

in events analyzed. We, as researchers, fulfill the task of further interpreting actors’

behaviour (Nag et al., 2007) and elevating our interpretations to a conceptual level; in

developing our conceptual model, we are guided by both the research context and prior

theoretical insights (Strauss & Corbin, 1990; Nag et al., 2007).

Data

Our data set includes sixty one teaching cases of high-profile sustainability-

related crises that occurred in twelve large multinational enterprises (MNEs),

representing ten industries.

The cases were selected through purposive sampling, which, according to Yin

(2003), is a suitable sampling method for inductive research design. The companies

analyzed were selected based on the following criteria:

1. High profile of a crisis, as evidenced by the number of teaching cases written about

the crisis, and by the amount of media and scholarly attention to the crisis.

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2. Availability of supplemental information. To triangulate and verify our research data,

we used the following additional secondary information sources:

• Court documents (i.e. statements prepared for hearings, witness testimony

transcripts, information on damages)

• News articles

• Journal articles

• Press releases

• Annual reports

• Corporate sustainability reports

• Corporate websites

Availability of such documents for a corporation was one of our criteria for including

this corporation in our sample.

3. Balance of content among the three dimensions of sustainability. As one of the

objectives of our study is to explore drivers for crises with different sustainability

loci, we needed a case sample that would allow us to search for within-group

similarities and inter-group differences (Eisenhardt, 1989). We classified our cases

by linking their negative impacts to one of the three pillars, e.g. accounting and

investment scandals were classified as ‘economic’ crises, crises related to consumer

safety risks or environmental damage were classified as ‘environmental’ crises, and

crises related to human rights violations (whether concerning employees or broader

communities) were classified as ‘social’ crises. We selected our data so as to have

four sets of cases in each sustainability pillar. Figure 8.1 illustrates how our research

data fits into the ‘sustainability tripod’.

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 (Figure 8.1 about here)

In terms of selection of the actual teaching studies, we drew cases from

recognized case producers only, and looked for sufficient quality and detail describing

managerial behaviour and motives, and sufficient longitudinal organizational context to

allow us to interpret nuances of both micro and macro-environments within which the

behaviour took place.

Table 8.1 and Appendix 8.1 present a summary of our research data and a list of

cases analyzed, respectively.

(Table 8.1 about here)

The use of teaching cases as research data is sometimes criticized for potentially

incomplete description of the situation and lack of precision (Kieser, 1994), possible

subjectivity (Liang & Wang, 2004), and the presence of two levels of abstraction (Miller

& Friesen, 1977). We argue that, if used properly, teaching cases present a legitimate,

reliable and practical secondary data source for management research. We followed

Ambrosini et al.’s (2010) protocol for using teaching cases in research in order to address

potential concerns with the methodology. First, to overcome potential bias, we used

multiple teaching cases for each company and extensive supplemental information to

triangulate the data; using court documents whenever available helped us increase

‘objectivity’ of our supplemental information. Further, we used cases from reputable

producers only, which reduced the probability of information distortion due to the

rigorous process associated with writing and publishing cases. Cases produced by such

top case publishers as Harvard Business Publishing, Darden Business Publishing and

Ivey Publishing are typically written by experienced faculty members, include the

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minimum of two interviews with companies’ key decision makers in addition to

extensive base information, and are tested in the classroom prior to publication. In terms

of criticisms related to the second level of interpretation, it should be noted that case

writers are specifically encouraged not to interpret data, and to “act as a reporter,

describing as closely as possible what has occurred” (Naumes & Naumes, 1999: 15). It

is, of course, impossible to unambiguously assert complete objectivity of teaching cases;

however, due to the nature of the requirement to convey rather than to interpret

information, and to accurately reflect ambiguity of real-life business situations without

‘leading’ students to a solution, teaching cases might in fact be among the less biased

secondary data sources available to researchers. Second, purposive sampling dealt with

the issue of incompleteness and potential emphasis on certain teaching points at the

expense of other relevant information. Further, it should be noted that the selected cases

were specifically written to highlight crisis situations, which exactly matched our

research questions. Third, teaching cases are argued to be written on organizations that

portray extreme examples of a situation or an issue (Ambrosini et al., 2010) – this may

indeed be true, but did not hinder our research agenda, as crises exemplify extreme

situations of governance breakdown. With the limitations of our data duly addressed, our

sample presented us with unique research opportunities. Through using teaching cases,

we gained access to longitudinal data (Miller & Friesen, 1977) spanning generations,

which would be very difficult, if not impossible, to obtain in the field. We were also able

to work with rich and nuanced micro level information while maintaining sample breadth,

which allowed us to discern patterns at the macro level without sacrificing idiosyncratic

micro level detail. Related to the above point, our data enabled us to combine micro and

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macro levels of analysis in order to satisfy our research agenda. At the micro level,

managerial action became a unit of analysis, while at the macro level, we were able to

devise patterns by focusing on a firm as a unit of analysis.

Theory building

The purpose of this paper is to elaborate on an existing theoretical framework

(Pratt, 2009), namely comparative institutional analysis, in order to develop a

comparative institutional theory of sustainability governance. To arrive at our conceptual

framework, we adopted modified grounded theory approach (Strauss, 1987), and adhered

to procedures outlined by Glaser and Strauss (1967) and subsequently modified and

extended by other qualitative researchers (Corbin & Strauss, 1990; Glaser, 1978; Martin

& Turner, 1986; Strauss & Corbin, 1990; Turner, 1981, 1983). We used emergent coding

and constant comparison techniques (Shah & Corley, 2006) to analyze our data, which

meant that data and theory were compared constantly and continually throughout the data

collection and analysis process (Isabella, 1990).

In the initial stage of our analysis, we coded each case separately, paying

particular attention to circumstances and behaviours that may have led to the crises.

After analyzing multiple cases, we began discerning patterns across the data, which

allowed us to formulate provisional themes (Locke & Golden-Biddle, 1997). As soon as

provisional themes were formulated, we compared the examples to clarify the themes,

and searched the data for other potentially relevant examples. We collapsed each set of

related codes forming an emerging theme into broad categories (Corbin & Strauss, 1990;

Strauss & Corbin, 1995), for example: evidence of entrepreneurial context, unmitigated

entrepreneurship, conditions exacerbating bounded rationality/bounded reliability.

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Finally, coding categories were elevated to the broad conceptual level, leading us to three

main themes related to crisis origination: 1) entrepreneurial context; 2) the role of crisis

locus; and 3) the role of benevolent conflict among stakeholders’ needs. As such, our

three research questions collapsed into one, whereby the role of entrepreneurial context

and the role of crisis locus became two of the three themes that explained sustainability

crisis. Table 8.2 provides example of themes and categories used to code the data.

(Table 8.2 about here)

As a separate step in theory building, we combined cases into three categories

based on the locus of crisis, and searched for within-group similarities and inter-group

differences (Eisenhardt, 1989) in existing codes. This exercise led us to develop

additional categories related to the interaction between the locus of crisis and managerial

behaviour, and to the directions of spillovers among the three loci. Table 8.3 provides

examples of themes and categories related to inter-group crisis locus analysis.

(Table 8.3 about here)

Once the first read of the cases and supplemental information was completed, the

data were systematically re-examined to ensure they fit into the formulated themes and

categories. To ensure accuracy of coding, we extracted text vignettes that represented the

core of our themes and recorded them separately, consistent with a procedure followed by

Isabella (1990). Table 8.4 shows representative examples of verbatim vignettes and

corresponding codes.

(Table 8.4 about here)

Throughout the theory building process, we wrote theoretical memoranda about

emerging categories and their relationships to each other, which directed us back to the

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data (Locke & Golden-Biddle, 1997) and helped augment evolving theory (Isabella,

1990). The final conceptualization presented in the remaining sections arose from a

“fluid movement between theory and data” (Isabella, 1990: 12), combined with continual

reconceptualization through further reflection.

WHY DO CRISES OCCUR? THREE BROAD THEMES

Our analysis disclosed that the twelve organizations (and their macro

environments) involved in high-profile sustainability crises shared three key

characteristics that became instrumental in creating conditions eventually leading to the

crises:

1. High level of entrepreneurial context

2. Presence of internal and/or external financial pressures (i.e., crisis drivers related to

the economic pillar)

3. Presence of benevolent conflict among stakeholder needs

As such, the second and third research questions, as mentioned above, became

subsumed under the first one – that is, the role of entrepreneurship (RQ2) and the role of

crisis locus (RQ3) became two of the three broad themes explaining the occurrence of

crises (RQ1). In the following sections, we discuss our findings related to the three broad

themes.

THE ROLE OF ENTREPRENEURIAL CONTEXT: THE

ENTREPRENEURSHIP-CRISIS MODEL

Our analysis revealed that each of the twelve companies was characterized by a

highly entrepreneurial/innovative culture. Consider a testimony by WorldCom’s

whistleblower – former VP of Internal Audit Cynthia Cooper:

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 “These guys were entrepreneurs…. It was a very exciting place to be. We were

moving and shaking and acquiring companies.”

Table 8.5 offers several other examples of entrepreneurial context evidence in our

data set.

(Table 8.5 about here)

What is the connection between entrepreneurial context and sustainability crises?

We argue that in the twelve companies studied, entrepreneurial context reached

unmitigated extremes that, to some extent, facilitated sustainability crises.

It has been convincingly argued and empirically demonstrated that momentum is

both a dominant and a pervasive force in organizations (Cyert & March, 1963; Miller &

Mintzberg, 1974; Miller & Friesen, 1980). Miller and Friesen (1980) argue that any

organizational tendency, whether functional or dysfunctional, is to some extent associated

with momentum. This is true of entrepreneurial orientation, that is, entrepreneurial firms

can be taken by momentum to dangerous “entrepreneurial extremes” (Miller & Friesen,

1982; 2), and mitigating mechanisms may be required to ward off these dangers. Miller

and Friesen (1982) describe a number of mitigating influences to attenuate momentum-

induced entrepreneurial extremes, such as information processing devices, structural

integration devices and decision-making methods. From a strategic governance

perspective, these mitigating influences can be seen as mechanisms for economizing on

bounded rationality and bounded reliability of economic actors involved in the

organization’s activities (Verbeke & Greidanus, 2009).

The twelve companies were characterized by a variety of conditions exacerbating

bounded rationality and bounded reliability; these conditions included, inter alia, high

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geographic, cultural, economic and institutional distance (Ghemawat, 2001) between

locations where companies operated (e.g. DaimlerChrysler, Chiquita, Mattel, Talisman),

complexity of organizational structures, transactions and/or products and associated

information (e.g. Enron, Goldman Sachs, WorldCom, Adelphia, Merck, BP, Talisman),

and high turnover and/or lack of continuity among key decision makers (e.g. HP, Enron).

At the same time, mechanisms to economize on bounded rationality and bounded

reliability were absent or insufficient – in other words, prime conditions existed for

unmitigated momentum-induced entrepreneurial extremes. Table 8.6 illustrates select

examples of conditions exacerbating bounded rationality and bounded reliability,

combined with unmitigated entrepreneurship, in the companies we studied.

(Table 8.6 about here)

We argue that in the absence of sufficient economizing mechanisms to mitigate

momentum-induced extremes, entrepreneurial context can lead an organization to

sustainability crisis, especially under conditions of heightened bounded rationality and

bounded reliability challenges. However, our data led us to distinguish between two

types of crises based on actual managerial behaviour: (1) crises characterized by

managers engaging in directly unproductive profit seeking activities (Bhagwati, 1982) –

or, simply speaking, fraud; and (2) crises characterized by managers’ failure to prevent

unintended negative economic, societal, and environmental spillovers of business

activities. We suggest that the two types of crises have different behavioural drivers and

occur in different pillars of the sustainability tripod, as shown in Figure 8.2 and discussed

below.

(Figure 8.2 about here)

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Directly unproductive profit-seeking crisis (DUP)

Mechanisms underlying managerial behaviour. In the poignant words of

Enron’s former vice president and whistleblower Sherron Watkins, “the dark side of

innovation is fraud” (2003: 11). The four DUP cases in our sample, namely Enron,

WorldCom, Goldman & Sachs and Adelphia, were affected by this unfortunate reversal.

Like all cases analyzed, the DUP cases exhibited entrepreneurial context, the presence of

conditions exacerbating bounded rationality and bounded reliability, and the lack of

sufficient economizing mechanisms. Yet, a distinct managerial behaviour trend separated

DUP cases from the rest of the sample – there was abundant evidence of opportunism

practiced at the time of the crisis, with the purpose of self-enrichment by those involved

in fraud; moreover, opportunistic behaviour followed a clear path dependency pattern, as

evident in long histories of ethical lapses by top managers and general embeddedness of

these lapses in corporate cultures. Consider Enron’s long-standing policy of using a

travel agency owned by the CEO’s sister for all Enron’s and Arthur Andersen’s corporate

travel, or WorldCom’s CEO’s systemic view of any form of a corporate code of conduct

as a “colossal waste of time” (Zekany, Braun & Warder, 2004: 103).

We would like to illustrate our argument with an example of Adelphia. The

company’s entrepreneurial roots shaped its culture, which encouraged aggressive risk-

taking and pushing the limits of convention (and, as it eventually turned out, law). This

entrepreneurial context, however, existed under conditions of high bounded rationality

and bounded reliability risks. The organization was complex and decentralized, having

grown through acquisitions that were not systematically integrated. The conditions of

bounded reliability and bounded rationality were further exacerbated by the founding

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family’s extreme bifurcation bias – a unique expression of bounded rationality and

bounded reliability found in some family firms, characterized, inter alia, by family

members’ full control of the company and unwillingness and/or inability to monitor each

other. As Fortune magazine mused after Adelphia’s demise, the company’s CFO “ran the

financial side of the business like a Saudi prince” (Fortune, 2002: 144), with no external

or internal controls, and no accountability to either the board or the audit committee. The

apparent unmitigated entrepreneurship (i.e. entrepreneurial orientation combined with the

lack of checks and balances) was overlaid by a culture of opportunism, evident in

Adelphia’s leaders’ history of ethical transgressions from the company’s inception to its

demise. From the early days of Adelphia’s existence, the CEO’s secretary “was forever

going to the bank and moving funds from account to account so that her boss could stay

ahead of creditors” (Fortune, 2002: 142). Inappropriate self-interest permeated the

business: Subscriber numbers were inflated, the family’s additional businesses were

providing services for Adelphia, shareholders’ funds were used to fund the family’s

luxurious lifestyle. Adelphia’s former VP of Finance testified that lying was an integral

part of Adelphia’s corporate culture. To summarize, we argue that Adelphia’s

entrepreneurial orientation, combined with conditions exacerbating bounded rationality

and bounded reliability, and the lack of economizing mechanisms, created conditions that

enabled sustainability crisis, while the company’s history of opportunism has primarily

determined the type of crisis as DUP.

Williamson wrote that “culture serves as a check on opportunism” (1993: 476),

meaning that cultures that discourage opportunism decrease economic actors’ propensity

toward opportunistic behaviour. Our data suggest that the opposite may also be true:

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cultures (in our case, corporate cultures) that have accepted or institutionalized

opportunism increase the probability of opportunism’s most blatant and extreme

manifestations; if laid over conditions conducive to sustainability crisis, an opportunistic

culture may lead to a DUP crisis.

Locus of DUP crises. All four DUP crises where behaviour of economic actors

was characterized by opportunism occurred in the financial/economic pillar of the

sustainability triangle – that is, the only crises that took a DUP form were those with the

visible financial locus, i.e. accounting and investment frauds. It is indeed easy to see how

a strong form of self-interest would affect strategic decision-making where personal

material gains are involved, and how it would lead to breakdowns in strategic

governance. The important point here is that we did not find strong evidence of

opportunism in cases pertaining to the remaining two pillars (social and environmental);

crises whose visible loci were environmental and social are better described as

unintended negative social and environmental spillovers of intendedly productive

business activities, as discussed in the following sections.

Unintended negative spillovers (UNS)

Mechanisms underlying managerial behaviour. As mentioned above, we did not

find evidence of a strong form of self-interest in economic actors involved in UNS cases.

These cases exhibited the common ingredients of the entrepreneurship-crisis model

discussed above: entrepreneurial orientation, conditions exacerbating bounded rationality

and bounded reliability, and the lack of sufficient economizing mechanisms. However, in

terms of main mechanisms underlying managerial behaviour, three distinct but related

trends stood out:

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1. Bounded awareness, or “cognitive blinders” (Bazerman & Chugh, 2005: 3) that

promote a myopic focus on a certain goal while at the same time limiting awareness

of controversial evidence. Consider BP’s plight to get its dramatically over-time,

over-budget Deepwater Horizon project back on track: The single-minded focus on

commencing drilling may have limited safety awareness and allowed critical

mistakes.

2. Overconfidence, or unrealistic believe in one’s abilities. Such was Ford’s confidence

in the quality of its own and its partner’s product (bred by a long-term productive

partnership with Firestone) that multiple and readily available warning signs of the

product’s potential safety problems were ignored.

3. Impulsivity. Hewlett Packard’s unauthorized surveillance of board members was a

result of some rather rash decision-making on the part of the board in response to an

urgent and panicky perception that ‘something has to be done about a major

information leak’.

Interestingly, all three of the above traits have been commonly associated with

entrepreneurship. It has been argued that myopic decision-making, or bounded

awareness, is characteristic of entrepreneurs (Moore, Oesch & Zeitsma, 2007). Classic

entrepreneurial literature has also frequently associated entrepreneurs with

overconfidence (Kahneman & Lovallo, 1993; Busenitz & Barney, 1997; Zahra, Yavuz &

Ucbasaran, 2006). Finally, impulsivity has been discussed as a feature of entrepreneurial

firms (Miller & Friesen, 1978). This connection justifies the presence of these underlying

behavioural mechanisms in our entrepreneurship-crisis model. Further, overconfidence

and impulsivity have been described as psychological sources of overcommitment – one

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of the facets of bounded reliability (Verbeke & Greidanus, 2009), which further confirms

their link to our entrepreneurship-crisis model.

Note that we do not argue that bounded awareness, overconfidence and

impulsivity were not present in DUP cases. On the contrary, multiple examples

demonstrate that these traits can coexist with opportunism. Consider Enron, where elitist

culture was promoted, and where employees were so confident in the company’s

revolutionary business model that they continued to believe they were making the world a

better place long after evidence of the contrary was revealed. What separates UNS cases

is the prevalence of other drivers of managerial behaviour over opportunism.

Admittedly, it is difficult to completely exclude the possibility of opportunistic

motivation in all actors involved in a crisis. Some corner-cutting or excessive risk-taking

behaviour by managers may indeed have led to/been motivated by direct and indirect

personal benefits in terms of reputation, promotion, continued employment etc. Our

argument is that in UNS cases, self-enrichment was not the predominant, institutionalized

motivation that led to crises, even though we cannot state that none of the actors involved

exhibited any degree of opportunism at any point in time. This conclusion was prompted

by nuanced analysis of case data.

In the hypothesized absence or near-absence of opportunism, it was bounded

awareness, overconfidence and impulsivity that became the key psychological drivers.

Combined with entrepreneurial context, conditions exacerbating bounded rationality and

bounded reliability, and the lack of economizing mechanisms, these drivers appear to

have facilitated crises.

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 Merck’s Vioxx recall can serve as a classic illustration of an environmental UNS

crisis. Merck’s entrepreneurial orientation was evident in its innovative culture,

commitment to organic growth through R&D (somewhat atypical in the industry that

tended to grow largely through diversification), and perhaps in the total of five Nobel

prizes won by Merck’s scientists. Yet, the environment in which Merck’s product launch

took place was rather challenging from the bounded rationality and bounded reliability

standpoint. The research on Vioxx safety was incredibly complex, and the results were

conflicting and ambiguous. Time pressure to get the product to market inhibited the

company’s ability to implement thorough checks and balances, and insufficient scrutiny

by the FDA eroded macro level economising mechanisms.

In examining our data, we were able to find abundant – and, in our view,

convincing – evidence of the company’s overall ethical stance. For decades, Merck has

been regarded as one of the best employers in Europe, and has been known for its firm

adherence to the founding principles that patients come first. Many respected public

figures have vouched for the ethics of the company’s former CEO in charge of the Vioxx

launch (Bazerman & Chugh, 2005); it seems safe to conclude that opportunism was

indeed not the key reason for the crisis. Other, more complex dynamics were at play as

far as managerial behaviour was concerned. First, a competitive race to get Vioxx to

market ahead of a major rival, amplified by significant investment into the drug and

pending expiry of key patents, created a single-minded focus on launching the drug, and

limited management’s awareness of critical evidence of the drug’s potential side effects;

it seemed as though managers convinced themselves of Vioxx’ safety, instead of seeking

additional relevant data. Second, managers’ excessive optimism and overconfidence in

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the drug was evident in their reaction to controversial research data: that of shock and

disbelief. Indeed, the first impulse seemed to be to doubt accuracy of the Vioxx test

results. So it seems that rather than intentional breach of ethics, it was the quality of

strategic decision making that led to the Vioxx crisis. The combination of bounded

awareness and overconfidence, enforced by the entrepreneurial momentum, complex data

and severe time pressures may have facilitated the negative health and safety

consequences of the Vioxx launch.

Locus of UNS crises. We identified the eight cases with visible social and

environmental loci (Ford/Firestone, Mattel, Merck, BP, DaimlerChrysler, Hewlett-

Packard, Chiquita and Talisman) as UNS crises – that is, crises where damaging

sustainability consequences were a result of unintended spillovers of activities, due to

behavioural factors unrelated to management’s intentional deceit. This tentative finding

is particularly important in light of the society’s increasing perception of large

corporations’ social and environmental misbehaviour, especially following multiple

sustainability scandals of the past decade. Public trust in corporate ‘big guys’ seems to

be eroding quite rapidly; large MNEs, for example, earned a negative trust rating by a

majority of respondents to the World Economic Forum’s 2006 survey (Coursey, 2006).

Corporations have responded with urgent efforts to restore public trust – and thus, the

questions of ethics and morality have become the focus of much corporate activity around

the world. Chief Ethics Officers have been appointed, codes of conduct drafted, and

attempts made to infuse ethical values into corporate cultures (Fombrun & Foss, 2004).

While there is certainly nothing wrong with designing and promoting ethical guidelines

(although we would like to point out that Enron had an elaborate sixty four page Code of

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Ethics), it is important to realize that promoting corporate morality will not necessarily

safeguard against UNS crises situations, where negative consequences are not caused by

immoral behaviour. The important practical implication therefore is that in order to

prevent crisis, corporations must economize on expressions of all facets of bounded

reliability and not just opportunism.

Entrepreneurship-sustainability crisis cycle

We have argued that unmitigated entrepreneurship may facilitate sustainability

crisis, especially under conditions of heightened bounded rationality and bounded

reliability. However, our analysis suggests that crisis itself can stimulate entrepreneurial

activity and innovation, both at micro and macro levels. We observed a recurring

entrepreneurship-crisis pattern in the cases we studied: Initially, firm-level

entrepreneurial context, in the absence of proper checks and balances, facilitates crisis.

Here, two outcomes are possible: Depending on the severity of the crisis, the firm may

either cease to exist (as was the case with Enron, Adelphia and WorldCom), or it may

engage in a new round of innovation to respond to the crisis and to prevent future

occurrences (e.g. advanced safety features of 2002 Ford Explorer following the massive

Ford/Firestone recall in 2000). Economizing on bounded rationality and bounded

reliability of actors (or implementing requisite checks and balances) becomes a

significant component of the new round of innovation.

Interestingly, post-crisis entrepreneurship is not limited to the firm affected:

Multiple stakeholders at the micro, group and macro levels engage in post-crisis

innovation (consider, for example, various industry-level regulatory measures

implemented to prevent future crises). In this sense, macro level entrepreneurship may

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occur regardless of whether the firm survived its crisis – e.g., the Sarbanes-Oxley Act

(SOX) was a regulatory response to corporate fraud and consequent bankruptcies at

Enron, Adelphia and WorldCom. Figure 8.3 graphically represents the entrepreneurship-

crisis cycle.

(Figure 8.3 about here)

As an illustration, let us review the case of Mattel. Mattel’s toy recall due to high

lead content and critical design flaws led to a number of design and testing innovations at

the company level, e.g. new methods for securing previously easily detachable magnets,

and portable lead detectors to test paint content during production. Macro level

innovations occurred in multiple jurisdictions. In China, the government took steps to

help local manufacturers innovate, create their own designs, and build their own brands to

lessen dependence on foreign partners. Mattel’s recall also prompted an introduction of

the first Chinese system for recall of unsafe products, as well as a four-month nation-wide

food and drug safety campaign. In North America and Europe, regulators engaged in

reviews of consumer safety mechanisms, and proposed third party testing by

manufacturers as a way to address regulating bodies’ under-capacity. All over, industry

players pushed for mandatory global safety standards for toys. Mattel’s crisis also gave

rise to a flurry of entrepreneurial activity by Mattel’s competitors, mostly revolving

around promoting ‘Made in USA’ labels.

Is sustainability crisis then necessary to promote sustainability innovation? We

do not think so. Post-crisis entrepreneurship, while potentially yielding environmentally

and societally beneficial results, is always a second best solution – and is usually not

perfect. The jury is still out, for example, on whether SOX benefits outweigh its multiple

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tangible and intangible costs, which include increased audit and legal fees, decreased

stock exchange listings, diversion of management’s attention, and potential decrease of

risk taking and entrepreneurial activity on behalf of managers. Companies now receive

higher-priced, more conservative audits from a smaller number of providers, while true

integrity “cannot be legislated” (Sayther, 2003: 6) and is still not guaranteed. Consistent

with Williamson’s (1996) view of firm-level governance being bracketed by macro and

individual-level features, we think that effective governance for sustainability is a result

of complex interactions among the firm, its economic actors, and its macro-environment

(including all relevant stakeholders). Where crises are involved, this interaction often

takes a trial-and-error form. Managerial implications of the entrepreneurship-crisis cycle

are therefore not to wait for a crisis to happen before devising entrepreneurial solutions,

but rather to economize on bounded rationality and bounded reliability in order to protect

all those stakeholders who give the firm its so-called social license to operate. In

practical terms, it could be useful to identify potential areas of conflict where multiple

stakeholders are involved and implement preventative safeguards. Conflict is not

necessarily bad: Freeman reportedly believed that “where there is a conflict, innovation

kicks in and more value gets created” (Laplume, Sonpar & Litz, 2008: 1179).

THE ROLE OF THE ECONOMIC PILLAR AND INTER-PILLAR SPILLOVERS

Economic pillar as a crisis catalyst

It is our view, based on the analysis of the cases, that all crises, regardless of their

visible loci, originated in the economic pillar – that is, all companies we researched

experienced severe financial pressures that led managers to seek shortcuts, take

unjustifiable risks, and make costly mistakes. These pressures could be external (e.g.

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rising material costs, downward pressure on prices, industry saturation, trade restrictions)

or internal (e.g. pressure on corporate balance sheets, dangerous levels of leverage,

declining share prices). Table 8.7 provides evidence of economic pressures in all of the

cases we studied.

(Table 8.7 about here)

The significance of this finding is in that it provides support and context for the

business case argument for sustainability. The business case argument has been criticized

for its “bounded instrumentality” (Hahn & Figge, 2011: 325) and unjustified dominance

of the economic aspect of sustainability over the social and environmental ones; yet, our

data show that problems at the economic end are likely to bring on breakdowns in social

and environmental pillars. In other words, economic realities of business must be tended

to before positive societal and environmental impacts can be realistically achieved – not

unlike the International Civil Aviation Organization’s commonly known safety

instruction to always secure one’s own oxygen mask before assisting others. This may

seem self-serving and immoral; yet, the simple fact remains that one is not in a position to

help another (even more vulnerable) being unless one is in fact breathing.

Williamson (1991) claimed that economizing is the best strategy. More than 20

years later, this controversial claim appears to receive validation in the context of

governance for sustainability: That is, if a firm’s business is flawed in first-order

economizing respect (Williamson, 1991), the firm will be hard pressed to make positive

contributions to society and the environment, no matter how honourable its social and

environmental intentions are.

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Inter-pillar spillovers

Our analysis showed that not only did all crises originate in the economic pillar,

but most inter-pillar impact spillovers also cycled through the economic pillar: That is,

economic pressures may have given rise to a crisis of a social or environmental nature,

which in turn worsened the economic condition further, creating a vicious cycle of

bounded reliability. Worsened economic conditions led to further damaging

environmental and social effects, and the cycle continued until either the firm collapsed,

or the crisis was resolved through implementation of economizing mechanisms and/or

new rounds of innovation. As an illustration, consider, again, the case of Mattel:

Economic pressures promoted a subcontracting system designed to push down costs and

speed up delivery. These pressures became among factors leading up to insufficient

inspection and release to market of dangerous goods (environmental breakdown). The

total cost of recall to Mattel amounted to $68.4 million; share price fell dramatically

(further economic breakdown). Mattel withdrew its license to export from Lee Der – its

Chinese contractor responsible for manufacturing toys with high lead content – leaving

Lee Der with large inventory and no business prospects (economic breakdown). Lee Der,

known as one of the better employers in the industry, was forced to close the factory;

2,500 workers lost their jobs, and Lee Der’s director Cheung killed himself (social

breakdown). Figure 8.4 illustrates inter-pillar spillover cycles.

(Figure 8.4 about here)

An exception to the cycle, as shown in Figure 8.4, is represented by

environmental crises where environmental and social impacts are difficult to separate:

For example, the BP Deepwater Horizon rig blowout created environmental damage and

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simultaneously deeply affected coastal industries, such as fishing and tourism, whose

continuity and survival depended solely on the state of the environment. The practical

implication here is that managers should consider both social and environmental risks

when designing environmental policies.

BENEVOLENT CONFLICT AMONG STAKEHOLDERS

Intriguingly, each of the analyzed firms displayed outward commitment, stated or

inferred, to ethical and sustainable practices (refer to Table 8.8 for examples). It is easy

to cynically assume, in light of the major sustainability crises that occurred, that those

espoused sustainability values were simply window-dressing – and perhaps they were in

some cases, particularly where opportunism and DUP activities were involved. However,

our view, based on analysis of detailed case data, is that in the remaining cases the

commitment to sustainability was real, and the dramatic diversion of corporate reality

from the firms’ stated values was due to the poor quality of strategic governance rather

than greenwashing.

(Table 8.8 about here)

The challenge was that issues central to the crises tended to span organizational

boundaries and affected multiple stakeholders with diverging needs. Some companies

failed to develop capabilities in managing these diverging needs simultaneously: Jürgen

Shrempp, Daimler Benz CEO and the principal architect of the DaimlerChrysler merger,

was revered by shareholders around the world and earned the nickname of ‘Mr.

Shareholder Value’; at the same time, his second nickname, ‘The Rambo of Europe’,

reflected his ruthless attitude towards the workforce, which he continued to methodically

slash in an effort to increase shareholder value, even in the face of European labour

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unions’ exceptional strength. Other companies were able to develop stakeholder

management capabilities in their home countries, but failed to transfer them to host

countries where crises occurred: Talisman, for example, appeared to have a solid

sustainability record and showed evidence of good intentions in Sudan, but must have

overestimated its ability to transfer its stakeholder management capability to Sudan, and

underestimated the impacts of others’ actions (e.g., the Sudanese government and

military, as well as various NGOs) related to the company’s operations on the local

community.

It is often perceived that when stakeholder needs are in conflict, shareholders’

interests always take precedence due to companies’ fiduciary responsibilities, as well as

strong incentives to maximize shareholder value (Pirson & Malhotra, 2008). However,

our data show that it is not necessarily so. At DaimlerChrysler, employees’ interests

were indeed subsumed under shareholder value. Yet, at Chiquita, employees’ wellbeing

was the reason behind protection payments to Colombian paramilitary groups, which,

clearly, undermined the wellbeing of local communities. At Adelphia, the local

community was showered with benefits – as it turned out later, at the expense of

shareholders. And at Merck, a conflict existed within the same stakeholder group – while

some patients suffered from dangerous side effects of Vioxx, others were vying for the

drug’s return to market. The commonality is not in the exclusion or dominance of a

particular stakeholder group – rather, the common thread here is that the conflict was

either not managed, or was managed partially, to the exclusion of one or more

stakeholder groups.

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 We argue that except for the DUP/fraud cases, the stakeholder conflict was

benevolent. In DUP cases, corporate cultures accommodated opportunism, and actors

pursued personal gains at the expense of various stakeholder groups, which was not the

case with UNS crises.

Interestingly, some conflicts were characterized by firms engaging in favour-

trading practices with select stakeholders. BP, like many other oil companies,

intermingled with Mineral Management Services, which resulted in industry insiders

being in charge of their own industry’s oversight. Enron, as is widely known, engaged in

illegal favour trading with its auditor Arthur Andersen. While the intent of favour trading

was not necessarily malevolent, the resulting impact, in our cases, was almost certainly

entrenchment at the macro level, and exclusion of stakeholder groups at the micro level.

A NOTE ON STRATEGIC GOVERNANCE

It is our observation that structural governance matters less than strategic

governance in a crisis situation, that is, crises can occur regardless of the type of micro-

structure for decision making adopted in an organization. Let us look at the level of

decision-making centralization, for example. Much has been written about comparative

benefits of centralization and decentralization; decentralization analysis goes back to

Chandler’s (1962) and Williamson’s (1971) M-form hypothesis, where the M-form

corporation is seen as a way to decentralize decision-making to increase overall

efficiency. While all of the companies we analyzed are large M-form MNEs, they do in

fact differ in their levels of centralization and decision-making authority allocation. At

Enron, for example, decentralization was extreme; DaimlerChrysler and Adelphia,

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however, were at the opposite end of the spectrum, with decision-making highly

centralized and hierarchical.

Centralization has been described as having a number of beneficial coordination

effects (Aoki, 1986; Zabojnik, 2002), and it would be logical to assume that it could play

a role in coordinating stakeholder needs to manage benevolent conflict. Yet, our data

clearly demonstrate that crises can happen in both centralized and decentralized

environments. There was, however, a common thread: Severe information asymmetries

present in both centralized and decentralized decision-making processes, and the lack of

governance for bounded rationality and bounded reliability that arose from those

information asymmetries. Our broad conclusion is that it is the decision-making

processes and routines, rather than the structures and administrative relationships guiding

these routines, that determine the ultimate outcome of governance.

IMPLICATIONS AND CONTRIBUTIONS

A key revelation of our study is the link between entrepreneurship and crisis.

While the concept of dark entrepreneurship is certainly not new and has been previously

explored in various academic contexts, including, inter alia, small business and

entrepreneurship (Beaver & Jennings, 2005; Zahra et al., 2006), political economy

(Bhagwati, 1982; Baumol, 1990), and criminology and terrorism (Lockwood, Teasley,

Carland & Carland, 2006; Abdukadirov, 2010), no explicit link has, to the best of our

knowledge, been made between dark entrepreneurship and sustainability crises. While

we cannot generalize the cause and effect relationship between entrepreneurship and

crises to the entire population due to the nature of our qualitative data, we were able to

show the process by which entrepreneurial context facilitated a crisis in the firms we

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studied. Most importantly, we distinguish between true dark entrepreneurship, which we

term DUP following Bhagwati (1982), and unintended negative spillovers (UNS) of

productive entrepreneurship, and show that these two types of entrepreneurship are linked

to crises through different behavioural drivers. For managers in entrepreneurial

organizations, implications are twofold: 1) entrepreneurship, which is typically viewed in

a positive light and fostered in any organization with an innovation imperative, should

not be allowed to gain momentum to a point of a dangerous entrepreneurial extreme –

safeguards are necessary along the way to keep bounded rationality and bounded

reliability in check; and 2) those safeguards should not be aimed exclusively at

preventing opportunism; while we cannot completely discount the possible presence of

opportunism as a crisis trigger, our nuanced data analysis shows that opportunism is

actually not the only, nor a key behavioural driver of crises in cases where

entrepreneurship is not truly dark, and where negative societal and environmental

spillovers are unintended. Safeguarding against opportunism alone would lead managers

to ignore other, situational rather than dispositional, crisis triggers.

Related to the above point, we have found that environmental and social crises,

unlike economic ones, were of the unintended variety. This is particularly significant

considering a current trend, both in the academe and in the broader society, of blaming

and shaming big corporations (Wickert & Schaefer, 2011) for their moral

misdemeanours. Yet, our data lead us to conclude that it was not BP executives’ intent to

damage flora and fauna along the Gulf of Mexico coast, nor was it Mattel’s managers’

purpose to poison children with lead paint. While responsibility for costly breakdowns in

strategic governance should certainly lie with corporations, it is important to understand

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that infusing morality into business will not necessarily address these breakdowns, nor

prevent negative consequences. For management scholars, this means that we should

perhaps extend our sustainability research agenda to study real causes of sustainability

failures at the micro level, with an emphasis on developing actionable solutions. For

practitioners, the key implication of our study is that developing a code of ethics alone

may not prevent negative sustainability impacts on society and environment; rather,

promulgation of ethical values should be combined with implementing practical

mechanisms to improve the quality of strategic governance, and to economize on specific

causes of bounded reliability found in our study – specifically, bounded awareness,

overconfidence, impulsivity and benevolent conflict.

We have also shown that the link between entrepreneurship and sustainability

crisis is not linear, but rather cyclical, and multilevel in that multiple stakeholders at both

micro and macro levels engage in post-crisis entrepreneurship (see Figure 8.3).

Practically, this does not mean, however, that managers should wait for a crisis to happen

in order to engage in innovation; rather, they should consider innovating pre-emptively,

by identifying potential areas of conflict through managerial tools such as scenario

planning or reference forecasting (Lovallo & Kahneman, 2003).

Our second significant insight deals with the role of the economic pillar in

sustainability crisis. We found that all sustainability crises, regardless of the loci of their

visible impacts, resulted from economic pressures on the firms involved. At the risk of

venturing into the dangerous territory of the business case paradigm argument, we think

that our findings back up the logic of the business case model for sustainability.

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 While the business case paradigm is typically criticized for being restricted to

conflict-free solutions (Hahn at al., 2010), we have actually approached the issue of

sustainability from the conflict end, and discovered that the conflict was in fact ignited by

business case (economic) deficiencies. To put aside the philosophical question of which

pillar of sustainability should come first, our research shows that, in a practical sense,

economic realities of the business must be taken care of before sustainable business

practices can be implemented. Failure to do so may result not only in the lack of positive

societal and economic impacts, but also, potentially, in significant negative impacts

should a crisis erupt. The somewhat evident but nowadays muted implication for

managers is that only an economically healthy business can have positive impacts on its

multiple stakeholders.

One of the main contributions of our study is the infusion of behavioural

assumptions into sustainability research, which is particularly significant given the

current state of the field. To date, stakeholder theory has been the most widely applied

theoretical framework for research on corporate sustainability (Searcy, 2012).

Stakeholder theory’s main tenet is that corporations have obligations to individuals and

groups both inside and outside the organization (Freeman, 1984) – therefore, there is an

obvious natural fit between stakeholder theory and the issue of sustainability. Yet,

stakeholder theory is not explicitly concerned with assumptions about human nature,

which are critical for understanding sustainability behaviour of corporations, especially in

a crisis context (Watkins, 2003). Nor does stakeholder theory explain governance

choices made by firms in addressing sustainability issues. From this angle, our study

broadens the sustainability research agenda by including strategic governance and

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behavioural perspectives. Going forward, our understanding of sustainability could be

greatly improved if we could link traditional stakeholder perspectives with a comparative

institutional approach.

LIMITATIONS AND DIRECTIONS FOR FUTURE RESEARCH

Every empirical study has its limitations, and ours is no exception. First, we have

investigated and described root causes of sustainability crises and processes that

essentially led to the crises, but we were not able to study solutions and preventative

measures that companies employ to mitigate crises. In other words, we know why a

crisis may happen, but we can only speculate, rather broadly, what the solution should be.

Further research (of firms that have successfully avoided or recovered from crises) is

needed to explore crisis mitigation strategies.

Second, our data set of teaching cases has allowed us to link micro and macro-

perspectives and to conduct temporal analysis of internal and external processes, but we

have not had personal access to economic actors involved in these processes in a way that

primary data from interviews and observations would have afforded. Essentially, our

study is subject to all typical limitations of secondary data research, e.g. unreported data

bias, potential incompleteness (Jennings, 1997) and two levels of abstraction (Miller and

Friesen, 1977). We do think that we have minimized the impact of these limitations

through our careful case selection, the use of multiple cases, and the addition of

supplemental information, thus turning our data set into a reliable proxy for fieldwork.

Still, future primary field research could complement this study – possibly through an in-

depth analysis of one of the firms in our data sample (one that has survived its crisis).

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 Our study highlighted some interesting instances of governance breakdowns and

commitment non-fulfillments that could be instrumental in further refining the construct

of bounded reliability. For example, bounded awareness could be included in the

bounded reliability model as a psychological driver that leads to commitment non-

fulfillment. Further, benevolent conflict has been previously explored as an internal

multi-actor achievement barrier, but this study extended the concept of benevolent

conflict from inside the firm to inter-organizational, multi-stakeholder environment. This

could pave the way for further conceptualization of benevolent conflict.

CONCLUSION

Strategic governance for sustainability means orchestrating the usage of

resources, through routines and other processes, to economize on bounded rationality and

bounded reliability so as to avoid negative sustainability impacts, and to create a

supportive entrepreneurial context for managing sustainability initiatives. We have

shown that failure to economize on bounded rationality and bounded reliability can result

in significant sustainability governance breakdowns (and consequent negative spillover

impacts for various stakeholders). Further, we have shown that simply fostering

entrepreneurial context is not enough – it should be sufficiently managed in order to

prevent dangerous extremes and to achieve optimal sustainability outcomes. These

results provide context for comparative institutional analysis logic, according to which

the most efficient governance mechanisms (including governance for sustainability) will

be those that, on balance, allow for superior achievement of the above economizing and

innovation objectives.

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 In terms of strategic governance components, we dealt mostly with internal

strategic governance and strategic governance of external interfaces, i.e., the relationships

with the macro environment and the multiple stakeholders involved in - or affected by - a

corporation’s activities. Even though we did not focus on the selection of firm

boundaries, our study does have implications for that particular governance challenge:

Governing for sustainability may require firms to redirect resources, to reshape routines

and other processes, and to engage in new activities. Whichever level of strategic

governance decisions the firm is engaged in, and whichever stakeholders are involved,

we should follow Sherron Watkins’ (2003) advice to recognize human nature. Simon has

famously stated that the issue of human nature “makes a difference, a very large

difference” (1985: 303) in everything we study. The managerial analysis of sustainability

strategies in business firms is certainly no exception.

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Table 8.1. Data sample

Company # of Additional Industry Locus of crisis

cases material?
1 Enron 6 ✔ Trading Economic
2 WorldCom 4 ✔ Telecom
3 Goldman Sachs 6 ✔ Banking
4 Adelphia 3 ✔ Cable
5 Ford/Firestone 3 ✔ Automotive Social
6 Mattel 11 ✔ Toys
7 Merck 8 ✔ Pharmaceutical
8 BP 5 ✔ Oil & Gas
9 DaimlerChrysler 4 ✔ Automotive Environmental
10 HP 3 ✔ Technology
11 Chiquita 4 ✔ Food
12 Talisman 4 ✔ Oil & Gas

Table 8.2. Examples of coding categories

Provisional theme Example Coding category Final broad theme:

Influence on crisis
Lax internal At Enron, employees were Unmitigated Role of
control allowed to move forward on entrepreneurship entrepreneurship in
new ideas without approval sustainability crisis
Poor At DaimlerChrysler, high Conditions Role of
communication cultural distance between exacerbating entrepreneurship in
across organization countries and corporations bounded sustainability crisis
hindered information flow rationality
Pressure on Adelphia’s financial situation Economic pillar Role of crisis locus
balance sheet was characterized by as a crisis catalyst
increasing fixed costs and
extreme leverage

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Table 8.3. Examples of coding categories – inter-group analysis of crisis locus

Provisional theme Example Coding category Final broad theme:

Influence on crisis
Bounded Single-minded focus on getting Unintended Role of crisis locus
awareness Vioxx to market limited negative
awareness of controversial spillovers (type of
evidence at Merck crisis found in
environmental
and social pillars)
History of ethical According to former VP of Directly Role of crisis locus
transgressions Finance, lying was a part of unproductive
Adelphia’s corporate culture profit-seeking
from inception activities (type of
crisis found in
economic pillar)

Table 8.4. Examples of representative vignettes

Case Verbatim vignettes Provisional Coding category

theme
Enron “With Enron’s success, Lay [CEO] became a Paradoxical Opportunism as a
highly respected business leader, spokesman for evidence of behavioural
deregulation, and philanthropist…. He was also a CSR driver of crisis
member of the President’s Council on Sustainable
Development…. He was an active philanthropist,
creating a family foundation with assets of $52
million in 1992, which supported causes such as
former US first lady Barbara Bush’s literacy
drive, M.D. Anderson Cancer Center, Houston’s
Holocaust Museum, and animal shelters.”
Mattel “Mattel…beefed up product safety measures. It Reactive Post-crisis micro
increased random inspections of vendors and safety level
adopted a three-step process for testing paint for measures entrepreneurship
lead… In addition, every production run was
tested before the final product was shipped.”
Daimler “One trade union representative expressed the Conflicting Benevolent
Chrysler opinion that the obsession with increasing needs of conflict
shareholder value rides roughshod over the stakeholders
interests of employees, the environment and
society.”

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Table 8.5. Evidence of entrepreneurial context

Company Evidence of entrepreneurial context

Enron Creating an entrepreneurial culture is “like planting seeds… our objective is to
have a lot of seeds planted” (Jeff Skilling, CEO)
Job applicants screened for “a sense of urgency”; “hiring only the best and
brightest and rewarding them like spoiled rock stars while at the same time
demanding that they innovate, innovate, innovate” (Sherron Watkins, VP)
HP “…the culture of innovation, freedom of manoeuvre and creativity are seen as
essential to value creation” (Patricia Dunn, Chair)
Merck Five Nobel prizes, highest R&D investment in the industry
Chrysler One of the most innovative vehicle line-ups in the industry: “…if the vehicle is in
demand… you can bet Chrysler’s making it” (Forbes, 1996)

Table 8.6. Evidence of unmitigated entrepreneurship

Company Evidence of conditions Lack of economizing mechanisms

exacerbating bounded rationality (unmitigated entrepreneurship)
and bounded reliability
Enron Opaque industry reporting practices Employees allowed to move forward on
Lack of formal communication new ideas without waiting for approval
system from the top, as long as the ideas can
High employee turnover/low generate new business
continuity “There was no budget per se” (Tom Gros,
trader)
BP Insufficient industry monitoring No formal system for evaluating risks
Ambiguous procedural guidelines
Complex web of contractors
WorldCom Dispersed/fragmented organization “Wild and woolly cowboylike culture”;
resulting from acquisitions of sixty “chaos” (former employees)
companies with incompatible systems
(which were never formally
integrated)

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Table 8.7. Economic pillar as crisis catalyst: Evidence from data

Company Evidence of pre-crisis economic pressures Locus of crisis

Enron Tremendous pressure to maintain EPS growth Economic
Need to find new sources of revenue
Large investments in major project
Delayed earnings
Immediate pressure on the balance sheet
High leverage
WorldCom Industry growth slow-down
Overcapacity
Severe pressure on E/R (expenditures-to-revenue) ratio
(most important performance indicator in the industry)
Goldman Eve of global financial meltdown
Sachs
Adelphia Increasing fixed costs
Extreme leverage
Need to finance new acquisitions
Hewlett- Aftermath of a botched multi-billion-dollar acquisition Social
Packard
Daimler Industry plagued by excess capacity
Chrysler Escalating development and supply chain costs
Chiquita Financial strain due to new trade restrictions imposed by the
EU
Talisman Low commodity prices (aggressive expansion and
acquisition strategy to outdo the fall in prices with increased
production volume)
BP Macondo well $58 million over-budget Environmental
Ford/ Commoditization/downward pressure on tire prices and
Firestone profits
High raw material costs
Global overcapacity
Mattel Rising production and raw material costs
Downward pressure on prices from retailers
High overhead
Manufacturers’ razor-thin margins
Merck Patents on bestselling drugs close to expiry
Market share loss
$1bln investment in Vioxx R&D

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Table 8.8. Stated/acted commitments to ethical and sustainable practices

Company Evidence of espoused or acted commitments

Enron Elaborate 64 page code of ethics
Ken Lay (CEO): Highly respected business leader and philanthropist
WorldCom Bernie Ebbers (CEO) was widely admired in the community as a volunteer, a
spokesman for the underprivileged, and a generous supporter of non-profit
organizations, e.g. Mississippi Children’s Home Society, CARES Center, Inc., and
the Baptist Children’s Village
Goldman The first Wall Street bank to give shareholders a vote on executive compensation
Sachs (ahead of legislation)
Considered to be the best employer in the industry
Adelphia John Regas (CEO/founder) was a major benefactor of the community. Revered by
the community and regarded as “our Greek God”
Hewlett- Patricia Dunn (Chair) known in the industry for her adherence to strict ethical
Packard standards
Daimler Merger announced as a ‘merger of equals’
Chrysler Stated objective of the merger: To minimize adverse effects on employees and
executives of both companies
Chiquita Completely overhauled environment and employment standards in the late 1990s:
Phased out toxic pesticides, built new warehouses to store chemicals, began
monitoring water quality, provided workers with better safety equipment, started
recycling programs
“It would be a challenge to find a company that has come so far and so fast.”
(Rainforest Alliance, 2006)
Uniform documented standards for corporate responsibility across the company
History of contributions to the development of transportation and communications
infrastructure in Latin America
Talisman Engaged in an extensive dialogue with the Sudanese government to promote a
peace process
Completed fifteen independent community development projects
Implemented an Ethical Business Conduct Management System
BP Leader in alternative energy investment
Reputation for being an oil company with a regard for the environment
Included among top ‘green brands’ by Marketing Week
Personal safety is a stated major priority
Ford/ Ford Sustainability Office established in 2000 to spearhead production of smaller
Firestone vehicles and increase fuel efficiency across the line-up

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Company Evidence of espoused or acted commitments
Mattel Compared to peers, manufactured a high proportion of toys in house to have more
control over safety
The first global consumer products company to apply Global Manufacturing
Principles to its facilities and core contractors on a worldwide basis
Pioneered collaboration with the Consumer Product Safety Commission to develop
industry safety and testing standards
Sterling reputation in the industry for being a good corporate citizen (especially in
regards to Chinese operations)
Merck Reputation as one of the best employers in Europe
Universal recognition of the founding principle: “We try to never forget tat
medicine is for the people. It is not for the profits. The profits follow, and if we
have remembered that, they have never failed to appear. The better we have
remembered it, the larger they have been.” (George W. Merck)
“Whatever decision we make… is going to be based on the science and what’s in
the best interest of the patients” (Ray Gilmartin, CEO)
Ray Gilmartin (CEO) widely known for his uncompromising ethics

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Figure 8.1. Cases analyzed and the three pillars of sustainability

Financial/Economic+
1.  Enron+
2.  WorldCom+
3.  Goldman+&+Sachs+
4.  Adelphia+

1.  Ford/Firestone+ 1.  DaimlerChrysler+

2.  Ma@el+ 2.  Hewle@HPackard+
3.  Merck+ 3.  Chiquita+
4.  BP+ 4.  Talisman+

Environmental+ Social+

Figure 8.2. Types of crises by locus and behavioural assumptions

Financial/Economic+
•  Enron+
•  WorldCom+
Opportunism+ •  Goldman+&+Sachs+
•  Adelphia+

Benevolent+
preference+
reversal+
•  Ford/Firestone+ •  DaimlerChrysler+
•  Ma;el+ •  Hewle;BPackard+
•  Merck+ •  Chiquita+
•  BP+ •  Talisman+

HS&E+ Social+

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 Figure 8.3. Entrepreneurship-sustainability crisis cycle

Economizing%on%
Mul2ple)levels)) The)End.)
BRat%and%BRel%
Mul2ple)stakeholders)
Severity%
Economizing%on%
BRat%and%BRel%
Firm%level)
entrepreneurship) Crisis)

Lack%of%proper%
checks%and%balances%

Figure 8.4. Inter-pillar sustainability outcome spillovers

Economic'

!
!

Environmental' Social'

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 THESIS CONCLUSION

As mentioned in the third essay, a good theory is sufficiently general (meaning it

has broad applicability), simple and accurate (Weick, 1979). As shown in this

manuscript, both TCE and contemporary internalization theory are general, i.e.,

applicable to a wide range of conventional and contemporary business phenomena,

simple in terms of their parsimonious approach (Rugman & Verbeke, 2008b), and

accurate in that their predictions have been largely supported by empirical evidence

found in scores of studies over the past three decades (see Rindfleisch & Heide, 1997;

Gibbons, 2010). Most recently, Crook and colleagues’ meta-analysis of 143 TCE-based

studies showed that TCE’s core predictions are strongly supported by empirical evidence,

and concluded that the theory’s “enormous influence” (Crook, Combs, Ketchen &

Aguinis, 2013: 73) is therefore justified. TCE and internalization are thus, according to

Weick’s quality standards, good theories; their prominence in the strategic management

and IB fields is a testament to their quality.

That being said, both theories (naturally) have their predictive boundaries, and the

impact and reach of each could be further enhanced through exploring those boundaries.

Williamson (2013) himself acknowledged the challenges of creating a composite theory

to explain simultaneously all aspects of governance and strategy. While he repeatedly

argued that economizing should be at the core of any business strategy theory

(Williamson, 1991), he recognized the hyper-complexity of social sciences and TCE’s

consequent boundary conditions, especially when it comes to ‘dynamic’ analysis of

issues involving disruptive innovation, real time responsiveness and disequilibrium

contracting: “A comprehensive theory that sweeps up internal coordination,

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entrepreneurship, resource allocation and technical progress simply asks too much.

Several workable theories that uncover and explicate the operative mechanisms for each

of these four classes of activity taken separately… is, I think, a more promising way to

go” (Williamson, 2013: 4). Williamson’s suggested solution is to use a pluralist,

interdisciplinary approach, whereby efficiency-based, economizing paradigms like TCE

should focus on internal coordination and resource allocation, while ‘strategizing’

(namely, RBV-based) approaches should concentrate on entrepreneurship and innovation.

Interestingly, this viewpoint has not resonated with strategy researchers, who have

been pursuing a quest for “a coherent theory of effective internal coordination and

resource allocation, of entrepreneurship and technical progress” (Rumelt et al., 1991: 19)

for decades. TCE supporters in particular have been concerned with infusing resource-

based perspective into transaction cost economizing. Almost thirty years ago, Teece

issued a call to bring “together the theories and various findings of research” (1984: 107),

and is to this day an advocate for a synergistic blend of dynamic capabilities,

entrepreneurship and transaction cost foundations of industrial organization theory

(Teece, 2009). Synergies between TCE and the RBV have also been explored

empirically (Combs & Ketchen, 1999; Zhou & Poppo, 2009), with a view that infusing

RBV into transaction cost economizing can better explain managers’ organizing

decisions – i.e., such infusion can at the same time isolate and take into account the

impact of asset specificity and the impact of the assets’ strategic value on managerial

decision-making (Crook et al., 2013). It has also been argued that RBV can offer

alternative interpretations of empirical studies conducted from a TCE perspective

(Masten, Meehan & Snyder, 1991; Masten, 1996; Monteverde, 1995a, 1995b), which

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further suggests potential complementarity between the RBV and TCE approaches

(Carter & Hodgson, 2006).

Surprisingly, and somewhat contradictory to both Williamson’s view of TCE’s

stand-alone status in relation to ‘strategy research’ and other scholars’ urgent plea to

blend TCE and RBV thinking, such synergistic combination already exists in

internalization theory, which has its roots both in resource-based and transaction cost

traditions. As discussed in the first essay, internalization theory has not ‘taken off’ in the

broader field of strategic management, despite its coveted balanced view of internal

organization and the role of externalizing. Adopting internalization theory beyond IB

could be a first way in which to push the current boundaries of the theory.

This could be accomplished through creating a broad unifying framework that

shows how CIA, exemplified by TCE and internalization theory, explains strategic

governance decisions at various levels. The study of strategic governance is complicated

by “governance inseparability” (Argyres & Liebeskind, 1999: 49), meaning that a firm’s

governance choices are to some extent path-dependent, as well as by the presence of a

relational component in a firm’s governance practices (Zaheer & Venkatraman, 1995;

Zaheer, McEvily, & Perrone, 1998; Dyer & Singh, 1998). The challenge, therefore, is to

incorporate relational, social and historical aspects of decision-making into the CIA

framework. In this respect, methodological pluralism may be helpful, meaning the

combination of case research and longitudinal analysis to address in an in-depth fashion

the complexity of strategic governance decisions.

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 The second way in which the influence and relevance of TCE and internalization

theory could be further enhanced is through refining conventional Williamsonian

behavioural assumptions. Adopting bounded reliability as a more realistic approach to

explain managerial behaviour could be the first step, followed by further developing and

refining this novel concept.

My hope is that this dissertation has laid a foundation for such a realistic

approach, as I have applied CIA to a wide range of strategic governance decisions, and

have utilized the concept of bounded reliability in each instance of strategic governance

analysis. I think that this work could serve as a starting point for further exploration.

Below are a few key ideas for academic research projects I intend to pursue and that

could usefully build on the present thesis:

1. Strategic governance textbook. A unified CIA framework could be explained in a

managerially oriented book bringing together various streams of literature explored in

this thesis, namely work in the realm of IB, EMNEs, regionalization, favours,

entrepreneurship, and sustainability. Such book would offer both a parsimonious

overview of the subject matter of strategic governance and a rich, coherent set of

actionable recommendations to managers to improve the practice of governance.

2. Further applications of CIA to contemporary business phenomena. In particular,

business at the base of the pyramid (Hammond, Kramer, Katz, Tran & Walker, 2007)

and the global factory (Buckley, 2009, see Essay 1) are new IB concepts that by

nature involve complex decisions and conflicting commitments by multiple actors

across various dimensions of distance, and would therefore present a fertile and

interesting context for the CIA approach. Work on EMNEs, favours and

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 sustainability (Essays 3, 7 and 8) included in this thesis, as well as Essay 4 dedicated

to the development of BRel, would serve as antecedents for the base of the pyramid

study. The study of strategic governance within a global factory setting would stem

from Essay 1, while also relying on the BRel concept developed in Essay 4, and

taking into account strategic governance issues explored in Essay 8.

3. Rethinking portfolio management. One would be hard-pressed to find a modern

management textbook that does not include either the BCG growth-share matrix, or

its successor, McKinsey’s nine-cell industry attractiveness-competitive strength

matrix, as tools for managing a diversified portfolio of businesses. Yet, as shown in

this manuscript, vastly complex strategic management decisions may not always

conform to recommendations that would arise from analyzing industry attractiveness

and unit strength. Contrasting and comparing strategic governance-related decisions

and their economizing properties with the traditional portfolio management approach

would present a fascinating avenue for applying CIA. One result of such a study –

possibly conducted as a case analysis of a large MNE with a diverse portfolio of

subsidiaries – would be an overlay of a strategic governance matrix and a portfolio

management matrix to determine business units’ or subsidiaries’ attractiveness and

role in the MNE.

4. Further development of BRel. This thesis has merely scratched the surface of BRel’s

potential. Full development of the BRel concept, if taken seriously by the scholarly

community, is likely to become the subject of much future research and several

academic careers. For now, this thesis is offering some additional avenues to explore

and refine BRel. For example, bounded awareness – a psychological source of UNS

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 crises observed in entrepreneurial managers, see Essay 8 – could be conceptualized as

an additional facet of BRel (note that bounded awareness is distinct from bounded

rationality, as it is not a consequence of information-related deficiencies; rather,

managers subject to bounded awareness have access to all required information, yet

fail to seek and use it due to an overwhelming presence of conflicting commitments).

Similarly, Essay 8 provides a context for extending the benevolent conflict facet of

BRel from an intra-organizational, multi-actor achievement barrier as first

conceptualized in Essay 4, to that applicable to multiple stakeholders both within and

outside of the organization. Essay 8 also showed that centralization, suggested in

Essay 4 as a mechanism to economize on benevolent conflict, did not work in the

presence of information asymmetries, thus setting a boundary condition for the

previously identified safeguard. These new conceptualizations can be incorporated

into the BRel model.

5. Testing the BRel model. Once the concept of BRel is sufficiently developed, it could

be operationalized and tested empirically. Finding empirical support for BRel (and

thus ‘rehabilitating’ TCE’s flawed behavioural assumptions) would be the final link

required for making TCE/internalization theory the ‘complete’ theory of the firm.

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 APPENDIX 3.1. Cases analyzed on the ten EMNEs

Company Cases
1 Lenovo Lenovo: Countering the Dell Challenge. (Pan & Sethi, 2075. Asia Case
Research Centre, The University of Hong Kong, Hong Kong).
2 Infosys Infosys in India: Building a Software Giant in a Corrupt Environment.
(Abdelal, Di Tella, & Kothandaraman, 2007. Harvard Business School
Publishing, Boston, MA).
Infosys Consulting in 2006: Leading the Next Generation of Business
and Information Technology Consulting. (Burgelman & Capur, 2006.
Stanford Graduate School of Business, Stanford, CA).
Infosys Consulting in 2011. (Burgelman & Schifrin, 2011. Stanford
Graduate School of Business, Stanford, CA).
Infosys: The Challenge of global Branding. (Saperstein, Murty, &
Desai, 2005. Yvey Publishing, London, Ontario, Canada).
Infosys Technologies: Powered by Intellect, Driven by Values.
(Velamuri & Mitchell, 2006. IESE Business School, Navarra, Spain).
Infosys Technologies. (Nanda & Delong, 2002. Harvard Business
School Publishing, Boston, MA).
3 Tata Tata Consultancy Services: Selling Certainty. (Ghemawat & Altman,
2011. Harvard Business School Publishing, Boston, MA).
NTT DOCOMO – Joint Venture with Tata in Indian Mobile Telecom.
(Chen & Chandrasekhar, 2010. Yvey Publishing, London, Ontario,
Canada).
Tata Consultancy Services: Sustaining Growth Momentum in China
2010. (Geok, Gilbert & Buche, 2010. Nanyang Technological
University, Singapore).
Tata Consultancy Services: Globalization of Software Services.
(Roberts, Dheer, & Viard, 1995. Stanford Graduate School of
Business, Stanford, CA).
Tata Consultancy Services: Globalization of IT Services. (Roberts &
Mekikian, 2009. Stanford Graduate School of Business, Stanford, CA).
Tata Consultancy Services: A Systems Approach to Human Resource
Development. (Geok & Buche, 2012. Nanyang Technological
University, Singapore).
Tata Motors’ Acquisition of Daewoo Commercial Vehicle Company.
(Singh, Harish, & Singh, 2008. Yvey Publishing, London, Ontario,
Canada).
Tata Motors’ Integration of Daewoo Commercial Vehicle Company.
(Singh, Harish, & Singh, 2008. Yvey Publishing, London, Ontario,
Canada).
House of Tata: Acquiring a Global Footprint. (Khanna, Palepu, &
Bullock, 2009. Harvard Business School Publishing, Boston, MA).
Tata Consultancy Services. (Deshpande & Schulman, 2009. Harvard
Business School Publishing, Boston, MA).

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 Company Cases
House of Tata – 1995: The Next Generation (A). (Khanna, Palepu,
Conneely, & O’Neil-Massaro, 2006. Harvard Business School
Publishing, Boston, MA).
House of Tata – 2000: The Next Generation (B). (Khanna, Palepu, &
Wu, 2006. Harvard Business School Publishing, Boston, MA).
Tata Consultancy Services: High Technology in a Low-Income
Country. (Kennedy, 2001. Harvard Business School Publishing,
Boston, MA).
4 Haier Haier: Taking a Chinese Company Global. (Khanna, Palepu, &
Vargas, 2006. Harvard Business School Publishing, Boston, MA).
Haier: Taking a Chinese Company Global in 2011. (Khanna, Palepu,
& Andrews, 2011. Harvard Business School Publishing, Boston, MA).
Haier: Management Control on a Tactical Level. (Lau & Han, 2007.
Asia Case Research Centre, The University of Hong Kong, Hong
Kong).
Haier: How to Turn a Chinese Household Name into a Global Brand.
(Farhoomand, 2007. Asia Case Research Centre, The University of
Hong Kong, Hong Kong).
5 Samsung Samsung Electronics. (Siegel & Chang, 2009. Harvard Business
School Publishing, Boston, MA).
Maintaining the “Single Samsung” Spirit: New Challenges in a
Changing Environment. (Khilji, Oh, & Manikoth, 2011. Yvey
Publishing, London, Ontario, Canada).
Design Strategy at Samsung Electronics: Becoming a Top-Tier
Company. (Freeze & Chung, 2008. Design Management Institute,
Boston, MA).
Samsung China: The Introduction of Color TV. (Choi, Beamish, &
Sharp, 2002. Yvey Publishing, London, Ontario, Canada).
Samsung Electronics and LCD Technology (A). (Dhanaraj & Kim,
2004. Yvey Publishing, London, Ontario, Canada).
Samsung Electronics and LCD Technology (B). (Dhanaraj & Kim,
2004. Yvey Publishing, London, Ontario, Canada).
Samsung Electronics and LCD Technology (C). (Dhanaraj & Kim,
2005. Yvey Publishing, London, Ontario, Canada).
Samsung Electronics (A): Entering India. (Chakraborty, Sharma, &
Ray, 2006. Yvey Publishing, London, Ontario, Canada).
Samsung Electronics (B): In India. (Chakraborty, Sharma, & Ray,
2006. Yvey Publishing, London, Ontario, Canada).
Samsung International, Inc. (1986. Harvard Business School
Publishing, Boston, MA).
Samsung Electronics Company: Global Marketing Operations.
(Quelch & Harrington, 2008. Harvard Business School Publishing,
Boston, MA).
6 Embraer Embraer: Shaking Up the Aircraft Manufacturing Market (Lopes,
Zimath, Maat, Silva, & Chen, 2007. Darden Business Publishing,

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 Company Cases
Charlettesville, VA).
Embraer: The Global Leader in Regional Jets. (Ghemawat, Herrero, &
Monteiro, 2009. Harvard Business School Publishing, Boston, MA).
Bombardier Aerospace: The CSeries Dilemma (Taleb & Hebert, 2011.
Yvey Publishing, London, Ontario, Canada).
7 Petrobras Petrobras in Ecuador (A). (Musacchio, Goldberg, & De Pinho, 2009.
Harvard Business School Publishing, Boston, MA).
Petrobras in Ecuador (B). (Musacchio, Goldberg, & De Pinho, 2009.
Harvard Business School Publishing, Boston, MA).
Drilling South: Petrobras Evaluates Pecom. (Desai & De Pinho, 2004.
Harvard Business School Publishing, Boston, MA).
8 Cemex CEMEX (A): Building the Global Framework (1985-2004). (Kanter,
Yatsko, & Raffaelli, 2009. Harvard Business School Publishing,
Boston, MA).
CEMEX (B): Cementing Relationships (2004-2007). (Kanter, Yatsko,
& Raffaelli, 2009. Harvard Business School Publishing, Boston, MA).
CEMEX’s Foundations for Sustainability. (Kanter, Yatsko, &
Raffaelli, 2009. Harvard Business School Publishing, Boston, MA).
Cementing the Bottom of the Pyramid: A New Direction at CEMEX?
(Rodriguez, Monsegur, & Zagazeta, 2006. Darden Business
Publishing, Charlettesville, VA).
CEMEX in Mexico: Constructing the Path to Responsible
Competitiveness. (Serrano & Diaz-Saenz, 2006. SEKN – Social
Enterprise Knowledge Network, Harvard business School Publishing,
Boston, MA).
CEMEX: Transforming a Basic Industry Company. (Lee & Hoyt,
2005. Stanford Graduate School of Business, Stanford, CA).
CEMEX: Global Competition in a Local Business. (Podolny, Roberts,
Han, & Hodge, 2007. Stanford Graduate School of Business, Stanford,
CA).
CEMEX: Global Growth through Superior Information Capabilities.
(Chung, Paddack, & Marchand, 2003. International Institute for
Management Development, Lausanne, Switzerland).
The CEMEX Way: The Right Balance between Local Business
Flexibility and Global Standardization. (Chung, Marchand, &
Kettinger, 2005. International Institute for Management Development,
Lausanne, Switzerland).
The Globalization of CEMEX. (Ghemawat & Matthews, 2004. Harvard
Business School Publishing, Boston, MA).
9 Tenaris Tenaris: Creating a Global Leader from an Emerging Market.
(Catalano & Roberts, 2004. Stanford Graduate School of Business,
Stanford, CA).
10 Concha Y Toro Concha y Toro. (Deshpande, Herrero, & Reficco, 2010. Harvard
Business School Publishing, Boston, MA).

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 APPENDIX 3.2. Inventory of EMNE FSAs, home country LAs, host country CSAs, and internationalization
drivers

EMNE Nature of LAs LB FSAs NLB FSAs Host CSAs Recombination Internationalization
ability drivers
Infosys Cheap skilled Engineering talent Entrepreneurial quality of Availability of Local responsiveness Market-seeking
India labour ‘Nearshoring’ management capital (nearshoring) Strategic resource-
locations: FSAs Innovation in the delivery Demand for Subscribing to norms seeking
in local of IT services services/ of good corporate
responsiveness Cost-effective global potential conduct in host
delivery model profitable sales countries
Management of Access to Long term
geographically dispersed knowledge re: relationships with
projects best clients (adopting
Strong brand management managerial practices)
Service quality practices
Data security
Intellectual property
protection
Culture of meritocracy
Tata Access to Local reputation Internal capabilities to Access to Synergistic blending Market seeking
Group foreign capital Brand strength manage/integrate M&As knowledge & of acquisitions into Strategic resource
India (requirement for Embeddedness in Entrepreneurial quality R&D existing businesses seeking
foreign MNEs to networks Umbrella operations to Access to Replicated business
tie up with a Government facilitate global business markets models in similar
domestic connections in a cohesive manner markets (global
company) while maintaining delivery model
Cheap skilled decentralization across emerging
labour Ability to adapt P&S to a markets)
Raw materials particular client group
security
EMNE Nature of LAs LB FSAs NLB FSAs Host CSAs Recombination Internationalization
ability drivers
Haier Cost advantages Brand reputation Commitment to quality Access to Ability to capitalize Market seeking (fill
China Government Local (both products and after- technology on access to vacant niches e.g.
connections responsiveness sale service) Access to technology and compact computer in
DID NOT rely Knowledge of Entrepreneurial quality of powerful knowledge (‘observe, the USA)
extensively on local management (ability to distributors digest, imitate’; Strategic resource
local market/consumers identify and fulfill vacant licensing seeking
personnel/low (advantage over market niches) agreements)
cost as sources foreign MNEs) Market research Organization of
of competitive capabilities (translated overseas markets
advantage into product (overseas promotion
overseas (low modifications) division)
cost alone not Customer-centric business Established
seen as a Innovative organizational connections with
sustainable structure (ZZJYT – self- sought after
competitive managed teams) distributors (Wal-
advantage) Investment in logistics Mart) due to high
and distribution quality of products
Alliance formation
Local staffing
Local research =
responsiveness

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EMNE Nature of LAs LB FSAs NLB FSAs Host CSAs Recombination Internationalization
ability drivers
Cemex Access to Brand recognition Sophisticated managerial Access to Used learning from Market seeking
Mexico skilled/ educated Local distribution routines operations and Spanish companies Efficiency seeking
personnel network Technology (automated management to improve Strategic resource
Access to Expertise in sales, accounting, practices operations at home seeing
resources developing logistics; CEO’s Leveraged Synergistic
Fewer countries ‘technology fetish’ expertise integration of
institutional Employer of Sophisticated operating in acquired operations
pressure than in choice in Mexico methodology for developing Flexibility in
developed integrating acquisitions countries to set implementing the
markets (PMI – post merger up operations Cemex Way locally
integration) in Asia and the Right balance
Strong culture Middle East between local
Flexibility/local business flexibility
responsiveness and global
The Cemex Way – global standardization
business model of
standardized processes
and systems
Innovation (long history
of; nurturing)
Lenovo Access to Extensive sales Customization/quick Access to 20% increase in Market seeking
China technologies network response to market established marketing/promotion (maturation of local
developed by Government demands (value-added brand budget (leveraging market/increased
state R&D support development based on marketing strength) competition from
Knowledge about local requirements) Gradual transition direct sale retailers)
local market and from IBM to Lenovo
consumer needs brand
Strong brand

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EMNE Nature of LAs LB FSAs NLB FSAs Host CSAs Recombination Internationalization
ability drivers
Concha y Terroir– ideal Support of wine Reputation for ‘value for Demand Ability to adapt Market seeking:
Toro conditions for trade associations money’ brand strategy to Relatively small and
Chile wine making Ability to produce good local demands unsophisticated
quality wine Leveraged price domestic market
Sophisticated brand strategy to gain
strategy access to global
distribution
Embraer Access to highly Ties to the Technological Demand Ability to fill vacant Market seeking:
Brazil skilled government expertise/engineering Access to niches in foreign filling a niche in 70-
engineering (government’s prowess alliance markets to 120-seat market
talent (ITA) efforts to promote Entrepreneurial agility partners Responsiveness to Efficiency seeking:
aeronautics): Extensive global partner customer needs risk-sharing with
benefit of SOE network to outsource non- globally global network of
resources, core services Alliances to supplier-partners
funding, tax Customer streamline
advantages focus/responsiveness to operations, share risk
(before needs and gain access to
privatization) new markets
PROEX program
to help finance
exports

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EMNE Nature of LAs LB FSAs NLB FSAs Host CSAs Recombination Internationalization
ability drivers
Samsung Highly skilled Government Brand value/reputation Access to Early alliance Strategic resource
Korea human resources support (as part of Technology (licensed; market formation to develop seeking: team of
(National HR economic developed/invested in) Access to new technology Korean Americans
development; development Customization ability knowledge/ Responsiveness to with experience in
long term efforts) Innovative HR practices industry customer needs semiconductor
investment in Geographic Commitment to experience globally industry n California,
people) proximity of innovation Access to top Leveraged home top talent around the
Economic design and Reputation for design talent around reputation to become world
growth production Knowledge culture the world one of the most Market seeking
One of the most (facilitated ‘Single Samsung’ Access to recognized brands (demand for AC in
technologically interaction/ initiative cheap labour globally (global India due to
advanced enhanced user- Flexible manufacturing (increasing brand strategy) expanding middle
countries in the trend research) processes/advanced labour cost in Design research to class/higher
world Distribution manufacturing techniques Korea – understand local disposable incomes;
Culture of hard network (India) political needs increased
work reforms Used manufacturing competition in
abandoning flexibility to domestic market)
regulated establish global
wages) manufacturing
network/take
advantage of cheap
labour

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EMNE Nature of LAs LB FSAs NLB FSAs Host CSAs Recombination Internationalization
ability drivers
Petrobras Natural Partial Access to cheap capital Promising Processed excess of Natural resource
Brazil resources government Modernized governance exploration heavy crude oil seeking (promising
Access to heavy ownership/ model/managerial areas abroad exploration areas in
crude oil support; access to decision making process, Natural gas Gained access to Latin America)
Access to some senior decision flexible/responsive Processing natural gas Market seeking: in
of the largest makers in management structure capacity for Built a position in response to
pre-salt deposits government (stood out against SOE oil heavy crude energy market in privatization/opening
of light crude oil Dominant companies in Latin oil South America of country to foreign
in the world position in both America) Local management in ownership
upstream and host countries to Efficiency seeking:
downstream navigate diversification to
activities at home politics/secure access reduce risk
to public policy Strategic resource
decision makers seeking: help from
international oil
companies to handle
technical challenges
(high levels of
carbon dioxide in
offshore discoveries)

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EMNE Nature of LAs LB FSAs NLB FSAs Host CSAs Recombination Internationalization
ability drivers
Tenaris Ample supply of Reputation for Direct global distribution Demand for Experience in Market seeking: lack
Argentina people to work quality network (Techint products, multicultural of domestic growth
in Strong industry Commercial Network) access to long relations through prospects, increased
manufacturing standing allowed European engineering term alliances international
to attract the most traditions/common customers Alliance to competition at home
qualified engineering language Access to coordinate export due to opening of
Argentine across cultures skills and sales globally/ market to imports
graduates Quality commitment expertise allocate production Efficiency seeking:
Customer responsiveness among mills procurement for steel
Adversity advantage pipe and other steel
(history of building plants businesses
in difficult environments)
JIT allowed to supply
customers with
comprehensive pipe
management services on a
continuous basis
Long term/on-going
customer relationships
Technology (investment
in R&D)

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 APPENDIX 4.1. Corporate backgrounds: Du Pont and General Motors

DU PONT DE NEMOURS & COMPANY (DU PONT)

Du Pont was founded in 1802 by Eleuthere Irenee du Pont, who left France in

1800 to escape the French Revolution. The company was started at the Eleutherian Mills,

on the Brandywine Creek, near Wilmington, Delaware, USA, as a manufacturer of

gunpowder. It grew quickly, becoming the largest supplier of gunpowder to the US

Army by the middle of the 19th century. In the early 1900s, Du Pont continued to expand,

moving into the production of dynamite and smokeless powder. Du Pont’s President,

Eugene du Pont, died in 1902, at which point the company was sold to the three great-

grandsons of the original founder: Alfred Du Pont, T.T. Coleman Du Pont and Pierre S.

Du Pont. Pierre handled finance; Alfred ran the black powder operations, and Coleman

became President, and remained in this position until Pierre bought Coleman’s shares of

the company and assumed presidency in 1914 (Wilkins, 1991).

In the decades leading up to the Second World War, Du Pont acquired ownership

in automotive, cellophane, and rayon segments, and introduced new technologies to the

market. Throughout the Second World War, Du Pont became a major producer of war

supplies, and played a major role in the Manhattan Project in 1943. After the war, the

company continued its emphasis on materials science, making a critical contribution to

the success of the Apollo Space program and to the development of modern body armour

(Datamonitor, 2012).

Today, Du Pont is a global science company, employing more than 60,000

thousands people worldwide and offering a diverse array of products in a variety of

industrial segments, including agriculture, electronics & communication, industrial

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biosciences, nutrition & health, performance chemicals, performance materials, safety &

protection, pharmaceuticals, building & construction, and transportation (Thomson

Reuters, 2013).

GENERAL MOTORS COMPANY (GM)

GM was founded in 1908 in Flint, Michigan, as a holding company for Buick,

then controlled by William C. Durant. Over the following years, GM acquired

Oldsmobile, Cadillac, Elmore, Oakland and several other companies. In 1910, Durant

lost control of GM to a bankers’ trust due to the large amount of debt taken on to finance

the acquisitions (Deebe, 1996), but gained back control of the company after starting

Chevrolet Motor Car Company in 1911 and secretly purchasing a controlling interest in

GM (www.gm.com).

In 1914, Pierre Du Pont invested in GM’s stock, and the following year joined

GM’s board of directors, of which he was eventually appointed Chairman. The Du Pont

company assisted the struggling automobile firm with a further stock purchase. Shortly

thereafter, Durant again lost control of GM after the new vehicle market collapsed, and

Pierre Du Pont was elected President. Under his guidance, GM became the number one

automobile company in the world. After Pierre’s retirement, Alfred P. Sloan took charge

of the corporation and led it to its post-war global dominance. The company’s great

financial success of the 1920s was expunged by the Great Depression of the 1930s.

During World War II, GM was transformed into a prominent supplier of war materials,

providing $12.3 billion worth of defence product between 1940 and 1945 (Deebe, 1996).

In 1957, the Du Pont corporation was forced to divest itself of its GM shares

under Clayton Antitrust Act action. Still, the 1950s was marked by record sales and

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innovations in styling and engineering. GM’s unprecedented growth lasted into the early

1980’s, when it employed 349,000 workers and operated 150 assembly plants around the

world. At that point, the company started losing market share to its successful offshore

competitors. In 2009, the global economic recession significantly reduced vehicle sales,

leaving GM critically short of operating income. The company was granted bankruptcy

protection by the US Government under the condition of restructuring (www.gm.com).

This restructuring led to an initial public offering and the emergence of today’s GM – a

smaller, leaner automobile company (Thomson Reuters, 2013).

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 APPENDIX 8.1. Cases analyzed on the twelve MNEs involved in
sustainability crises

Company Cases
1 Enron The Enron Collapse. (Hamilton & Francis, 2004. International Institute
for Management Development, Lausanne, Switzerland).
The Fall of Enron. (Healy and Palepu, 2012. Harvard Business School
Publishing, Boston, MA).
Innovation Corrupted: The Rise and Fall of Enron (A). (Salter,
Levesque, & Ciampa, 2005. Harvard Business School Publishing,
Boston, MA).
Consulting by Auditor (C): Aftermath of the Enron Collapse. (Nanda &
Prusiner, 2006. Harvard Business School Publishing, Boston, MA).
What Happened at Enron? (Moffett, 2004. The Garvin School of
International Management, Glendale, Arizona).
Broken Trust: Role of Professionals in the Enron Debacle. (Nanda,
2003. Harvard Business School Publishing, Boston, MA).
2 WorldCom Cynthia Cooper and WorldCom (A). (Werhane & Mead, 2009. Darden
Business Publishing, Charlettesville, VA).
Accounting Fraud at WorldCom. (Kaplan & Kiron, 2007. Harvard
Business School Publishing, Boston, MA).
WorldCom Inc.: What Went Wrong? (Gollakota & Gupta, 2005. Yvey
Publishing, London, Ontario, Canada).
Restoring Trust and WorldCom. (Lorsch & Robertson, 2004. Harvard
Business School Publishing, Boston, MA).
3 Goldman Sachs Goldman Sachs and Its Reputation. (Baron, 2011. Harvard Business
School Publishing, Boston, MA).
SEC versus Goldman Sachs (A). (Li & Green, 2010. Darden Business
Publishing, Charlettesville, VA).
Goldman Sachs: A Bank for All Seasons (A). (Goldberg & Obenchain,
2010. Harvard Business School Publishing, Boston, MA).
Goldman Sachs: A Bank for All Seasons (B). (Goldberg & Obenchain,
2010. Harvard Business School Publishing, Boston, MA).
Goldman Sachs: A Bank for All Seasons (C). (Goldberg & Obenchain,
2010. Harvard Business School Publishing, Boston, MA).
Internal Governance and Control at Goldman Sachs: Block Trading.
(Salter & Sarkar, 2004. Harvard Business School Publishing, Boston,
MA).
4 Adelphia Adelphia Communications Corp.’s Bankruptcy. (Gilson, Villalonga &
Hartman, 2010. Harvard Business School Publishing, Boston, MA).
The Lessons of Adelphia’s Cash Fraud. (Johnson & Rudolph, 2007.
Wiley InterScience, New York, NY).
Restoring Trust in Auditing: Ethical Discernment and the Adelphia
Scandal. (Barlaup, Dronen, & Iris, 2009. Managerial Auditing Journal,
Emerald, Bingley, West Yorkshire, UK).

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 Company Cases
5 Ford/Firestone After Job 1: Actions and Reactions in the Ford/Firestone Recall (A).
(Sullivan, Lelyveld, & Geary, 2005. Harvard Business School
Publishing, Boston, MA).
The Firestone/Ford Tire Controversy (A). (Narayanan & Nieves, 2001.
Harvard Business School Publishing, Boston, MA).
The Firestone/Ford Tire Controversy (B). (Narayanan & Nieves, 2001.
Harvard Business School Publishing, Boston, MA).
6 Mattel Mattel’s Strategy after Its Recall of Products Made in China.
(Jiangyong, Zhigang, Linhui, & Loo, 2009. Asia Case Research
Centre, The University of Hong Kong, Hong Kong).
Mattel’s China Experience: A Crisis in Toyland. (Teagarden, 2008.
Thunderbird School of Global Management, Glendale, AZ).
Unsafe for Children: Mattel’s Toy Recalls and Supply Chain
Management. (Lee & Hoyt, 2008. Stanford Graduate School of
Business, Stanford, CA).
Mattel: Crisis Management or Management Crisis. (Baron, 2008.
Stanford Graduate School of Business, Stanford, CA).
Mattel’s Long Hot Summer. (Wei-Skillern, Marciano, & Passy, 2008.
Harvard Business School Publishing, Boston, MA).
Mattel Toys – Made in China (A). (Jackson & Xiubao, 2008. Asia Case
Research Centre, The University of Hong Kong, Hong Kong).
Mattel Toys – Made in China (B). (Jackson & Xiubao, 2008. Asia Case
Research Centre, The University of Hong Kong, Hong Kong).
Mattel Toys – Made in China (C). (Jackson & Xiubao, 2008. Asia Case
Research Centre, The University of Hong Kong, Hong Kong).
Mattel and the Toy Recalls (A) (Bapuji & Beamish, 2008. Yvey
Publishing, London, Ontario, Canada).
Mattel and the Toy Recalls (B) (Bapuji & Beamish, 2008. Yvey
Publishing, London, Ontario, Canada).
Mattel Toys (A): The Financial Realignment. (Moffett, 2008.
Thunderbird School of Global Management, Glendale, AZ).
7 Merck Merck: Managing Vioxx (A). (Simons, Rosenberg, & Kindred, 2009.
Harvard Business School Publishing, Boston, MA).
Merck: Managing Vioxx (B). (Simons, Rosenberg, & Kindred, 2010.
Harvard Business School Publishing, Boston, MA).
Merck: Managing Vioxx (C). (Simons, Rosenberg, & Kindred, 2009.
Harvard Business School Publishing, Boston, MA).
Merck: Managing Vioxx (D). (Simons, Rosenberg, & Kindred, 2009.
Harvard Business School Publishing, Boston, MA).
Merck: Managing Vioxx (E). (Simons, Rosenberg, & Kindred, 2009.
Harvard Business School Publishing, Boston, MA).
Merck: Managing Vioxx (F). (Simons & Kindred, 2010. Harvard
Business School Publishing, Boston, MA).
Merck: Managing Vioxx (G). (Simons & Kindred, 2009. Harvard
Business School Publishing, Boston, MA).

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 Company Cases
Vioxx: Too Risky for Merck? (Petersen & Singhal, 2007. Kellogg
School of Management, Chicago, IL).
8 BP BP and the Gulf of Mexico Oil Spill. (Roberto, 2011. Yvey Publishing,
London, Ontario, Canada).
Accounting for Catastrophes: BP PLC and Union Carbide
Corporation (B). (Hawkins & Sesia, 2011. Harvard Business School
Publishing, Boston, MA).
BP: Beyond Petroleum. (Yemen, Lenox, & Harris, 2011. Darden
Business Publishing, Charlettesville, VA).
Drilling Safety at BP: The Deepwater Horizon Accident. (Kaufman &
Wing, 2012. Harvard Business School Publishing, Boston, MA).
BP’s Macondo: spill and Response. (Rotemberg, 2012. Harvard
Business School Publishing, Boston, MA).
9 DaimlerChrysler Crafting a Vision at Daimler-Chrysler. (Golden & Nolan, 2002. Yvey
Publishing, London, Ontario, Canada).
Daimler-Benz A.G.: Negotiations between Daimler and Chrysler.
(Bruner, Christmann, Spekman, Kannry, & Davies, 1998. Darden
Business Publishing, Charlettesville, VA).
Daimler-Chrysler: The Post-Merger Integration Phase. (Morosini &
Radler, 2003. International Institute for Management Development,
Lausanne, Switzerland).
Daimler-Chrysler: Post-Merger News. (Airey, Gepp, Harris, &
Menard, 2003. Yvey Publishing, London, Ontario, Canada).
10 HP Unauthorized Disclosure: Hewlett-Packard’s Secret Surveillance of
Directors and Journalists. (Lawrence, Harris, & Baack, 2008. Case
Research Journal, Keystone, CO).
Hewlett-Packard (A) (Deshpande & Schulman, 2006. Yvey Publishing,
London, Ontario, Canada).
Hewlett-Packard (B) (Deshpande & Schulman, 2011. Yvey Publishing,
London, Ontario, Canada).
11 Chiquita Blood Bananas: Chiquita in Colombia. (Schotter & Teagarden, 2010.
Thunderbird School of Global Management, Glendale, AZ).
Chiquita in Colombia. (Mead, Wicks, & White, 2010. Darden Business
Publishing, Charlottesville, VA).
Chiquita Brands International (A). (Spar & Mulligan, 2007. Harvard
Business School Publishing, Boston, MA).
Chiquita Brands International (B). (Spar & Huntsberger, 2001.
Harvard Business School Publishing, Boston, MA).
12 Talisman Talisman: An Unexpected War? (Verbeke, 2009. Cambridge
University Press, New York, NY).
Business Ethics and Development in Conflict (Zones): The Case of
Talisman Oil. (Idahosa, 2002. Journal of Business Ethics, 39: 227-246,
Springer, NY.).
Talisman Energy, Sudan, and Corporate Social Responsibility.

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 Company Cases
(Carmody, 2000. The Canadian Yearbook of International Law, 38:
237, UBC Press, Vancouver, Canada).
Oil and Politics: Talisman Energy and Sudan. (Kobrin, 2004.
International Law and Politics, 36: 425, NYU Law, NY.)

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