Economic Foundations of Strategy


Joseph T. Mahoney

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  • Foundations for Organizational Science: A SAGE Publications Series

    Series Editor

    David Whetten, Brigham Young University


    Anne S. Huff, University of Colorado and Cranfield University (UK)

    Benjamin Schneider, University of Maryland

    M. Susan Taylor, University of Maryland

    The FOUNDATIONS FOR ORGANIZATIONAL SCIENCE series supports the development of students, faculty, and prospective organizational science professionals through the publication of texts authored by leading organizational scientists. Each volume provides a highly personal, hands-on introduction to a core topic or theory and challenges the reader to explore promising avenues for future theory development and empirical application.

    Books in This Series


    Edited by L. L. Cummings and Peter J. Frost


    Karl E. Weick


    W. Richard Scott


    Peter J. Frost and M. Susan Taylor


    Noted Scholars Discuss the Synergies of Teaching and Research

    Rae André and Peter J. Frost

    THE PSYCHOLOGY OF DECISION MAKING: People in Organizations

    Lee Roy Beach


    Robert Folger and Russell Cropanzano

    RECRUITING EMPLOYEES: Individual and Organizational Perspectives

    Alison E. Barber


    Arthur P. Brief

    IDENTITY IN ORGANIZATIONS: Building Theory Through Conversations

    Edited by David Whetten and Paul Godfrey

    PERSONNEL SELECTION: A Theoretical Approach

    Neal Schmitt and David Chan

    BUILDING STRATEGY FROM THE MIDDLE: Reconceptualizing Strategy Process

    Steven W. Floyd and Bill Wooldridge

    MISSING ORGANIZATIONAL LINKAGES: Tools for Cross-Level Research

    Paul S. Goodman


    Lex Donaldson

    ORGANIZATIONAL STRESS: A Review and Critique of Theory, Research, and Applications

    Cary L. Cooper, Philip J. Dewe, and Michael P. O'Driscoll


    W. Richard Scott

    ORGANIZATIONAL CULTURE: Mapping the Terrain

    Joanne Martin


    Lawrence R. James and Michelle D. Mazerolle


    Douglas T. Hall

    ORGANIZATION CHANGE: Theory and Practice

    W. Warner Burke

    COMPENSATION: Theory, Evidence, and Strategic Implication

    Barry Gerhart and Sara L. Rynes

    SERVICE QUALITY: Research Perspectives

    Benjamin Schenieder and Susan S. White


    Joseph T Mahoney


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    Editor's Introduction

    One sign of increasing maturity in the strategy field is an increasing attention to cumulative, rather than individual, theory development. Our research journals are requesting clearer theoretical foundations and demanding more significant theoretical contributions. We are systematizing and taking more seriously our sources in economics, sociology, psychology, and other fields. As a result, we are clarifying the nature of the academic discipline. We are better prepared to contribute to practice. And I believe we are in a position to begin giving something back to the base disciplines from which we draw.

    The Foundations of Strategy series contributes to this important development by reviewing the foundations of the strategy field in economics, the behavioral sciences, and psychology. One objective is to specify the most important sources in each tradition for the use of students and for those who are more distant from the field but who have an interest in our subject matter. But a more pressing purpose is to provide the tools for active involvement in theory development. It is our hope, and belief, that the sophistication and standards of the best work from the past will inspire and support the best work for the future.

    In this volume, Joe Mahoney identifies five theories of particular importance to the strategy field and outlines the contributions of particularly influential works in each area. As Oliver Williamson notes in his foreword, these authors provide alternative theories of the firm. To some extent they are complementary accounts, but they also propose alternatives with somewhat different purposes in mind. This book can be used to understand the key issues for strategy raised by theorists taking an economics perspective and, ideally, to further advance answers to five important questions:

    • How can organizations operate efficiently (the basic question of Chapter 1, “Behavioral Theory of the Firm”)?
    • How can firms minimize costs (the basic question of Chapter 2, “Transaction Costs Theory”)?
    • How can firms create and allocate wealth (the basic question of Chapter 3, “Property Rights Theory”)?
    • How can firms align individual self-interest (“the basic question of Chapter 4, “Agency Theory”)?
    • How can resources be acquired, developed, and deployed to improve the likelihood of survival and profitable growth (the basic question of Chapter 5, “Resource-Based Theory, Dynamic Capabilities, and Real Options”)?

    These are big questions, still only partially answered, and the theory of the firm is of contemporary interest as an organized way to answer them. The questions asked also articulate some of the most basic concerns of managers. As Joe notes in his concluding chapter, the works cited here provide important building blocks for new theoretical developments in the field. Thus, our Foundations title applies.

    Anne S.Huff


    An economics of organization has been taking shape over the past 30 years, the origins of which go back at least to the 1930s. As the name suggests, and as described by Joseph Mahoney, much of the economics of organization is interdisciplinary—drawing, as it does, on contributions from economics, organization theory (broadly conceived to include sociology, political science, and social psychology), cognitive psychology, and aspects of the law, especially property and contract law.

    In large measure, the economics of organization arose in response to perceived limitations in the neoclassical theory of the firm, which described a firm as a production function that transformed inputs into outputs according to the laws of technology. Useful as this construction was (and is) for the study of prices and output (and, more generally, of resource allocation), this theory was less useful for understanding the modern corporation and for the making of public policy. The seeds of discontent were planted by Adolph Berle and Gardiner Means (1932), in relation to the separation of ownership from control; by Ronald Coase (1937), with reference to the puzzle of vertical integration and the theory of the firm; by Chester Barnard (1938), who featured adaptation of a cooperative kind accomplished through hierarchy (as opposed to adaptation through the market in response to changes in relative prices); by the marginalist controversy of the 1940s; and by Armen Alchian's (1950) appeal to evolutionary arguments to explain observed economic regularities.

    The short of it is that too much was being asked of the neoclassical theory of the firm. As Harold Demsetz (1988) put it, it is a “mistake to confuse the firm of [orthodox] economic theory with its real world namesake. The chief mission of neoclassical economics is to understand how the price system coordinates the use of resources, not the inner workings of real firms” (1988, p. 189). Efforts to use the neoclassical theory of the firm in an all-purpose way nevertheless persisted. Strange and convoluted interpretations of nonstandard and unfamiliar contracting practices and organizational structures often resulted, and interpretations were sometimes responsible for public policy error.

    A new theory of the firm was evidently needed. But as Mahoney makes clear, what we have is not a new theory (singular) but new theories (plural). The five new theories of the firm (more generally, of economic organization, in that the firm is not a stand-alone entity but is to be examined in relation to the market and other modes of organizing economic activity) described by Mahoney are the behavioral theory of the firm, transaction costs theory, property rights theory, agency theory, and resource-based/dynamic capabilities. In many respects these are complementary in that they illuminate different issues. But sometimes they collide by providing rival explanations for the same phenomena. Ways have nevertheless been found to join parts of these, and more of this is in prospect. As matters stand presently, the study of economic organization is at a preunified state of development.

    Readers of this book will want to ask themselves, as they work their way through successive chapters, what are the strengths and weaknesses of each proposed perspective? What phenomena does each illuminate? What predictions? What is the implied empirical research agenda? Does the theory scale up from the simple (often two-actor) model to complex (many actor) economic organization? What public policy ramifications accrue?

    The new theories of the economics of organization that have taken shape over the past 30 years have vastly expanded the research agenda in both economic theory and organization theory as well as in the applied fields to which Mahoney makes reference: strategic management, agricultural economics, industrial organization, international business, and marketing. Indeed, applications to business and economic history, economic development, transition economics, positive political theory, and the law have also been made and are in progress. The economics of organization is an idea whose time has come. Lucky are the students of economic organization who seize upon the opportunity to run with this proliferation of good ideas.

    Oliver E.Williamson, January 2003


    I have many people to thank on my journey to writing this book. I begin with my mother, who advised me to “be kind.” My father advised me that “no matter what happens to you in life, no one can take your education from you.” My younger sister, Rose, taught me courage, and my younger brother, Jim, whom in many ways I looked up to during our childhood days, taught me caring and thoughtful reflection.

    In terms of education, I first thank all of my grade school and high school teachers who showed dedication to their chosen profession. Studying undergraduate economics in the Faculty of Arts and Sciences at the University of Pennsylvania provided a wonderful foundation that has influenced my thinking, and I especially thank Professors Jacques Cremer, Robert Inman, Irving Kravis, Laurence Seidman, and Sidney Weintraub. In particular, Sidney Weintraub's passion for ideas has had a lasting influence on my life.

    In graduate school, in the study of business economics at the Wharton School of Business of the University of Pennsylvania, I thank Professors Robert Pollak and Harbir Singh for teaching me microeconomic theory and corporate strategy, respectively. I thank Professors Claudia Goldin, Bruce Kogut, and Gordon Walker for serving on my doctoral committee. My dissertation advisor, Professor Almarin Phillips, provided encouragement and guidance. Professor Ned Bowman not only served on my dissertation committee but also was a source of inspiration for me both personally and professionally. Support from the Reginald Jones Center, under Ned's guidance, is gratefully acknowledged. I thank Professor Richard Marston, who gave me wise counsel to work for Ned Bowman at Wharton.

    At the University of Illinois at Urbana-Champaign I thank my numerous colleagues over the past 15 years. I especially thank Irene Duhaime, Anne Huff, and Ravi Madhavan for their friendship and support. I also thank the excellent doctoral students I have worked with over the years, such as Bill Bogner, Jongwook Kim, Yasemin Kor, Sung Min Kim, Chamu Sundaramurthy, and Danchi Tan, among others.

    Finally, I owe so much to my wife, Jeanne Marie Connell, who has been there in good times and in bad. She has been a guiding force and a source of constant love and compassion. To her I dedicate this book. Thank you, Jeanne.


    While writing this research book on the economic foundations of strategy, I kept two issues in mind. Suppose readers (at various levels of previous training) wanted to learn about organizational economics, especially from the perspective of strategic management: What significant themes best capture the directional tendencies of organizational economics today? How did current positions evolve? Suppose readers wanted to develop their own capacity to theorize and carry out research within the tradition of the economics of organization: What unresolved issues in this field are especially relevant to modern strategy research? What concepts are key building blocks? Where is additional empirical evidence needed?

    Organizational economics has been informed by many great minds in social science research, including Nobel Prize recipients in economics, such as Kenneth Arrow, Ronald Coase, Douglass North, and Herbert Simon, and potential future recipients, such as Oliver Hart (for property rights theory) and Oliver Williamson (for transaction costs theory). In addition, research contributions by business school professors such as Alfred Chandler, James March, and Sidney Winter provide a wealth of insights based on business experiences. It is an important field taking a central place in the study of strategy, though of course it has also been useful for policy and other purposes, such as agricultural economics, international business studies, management information systems, marketing, organization theory, and so on.

    In this book, organizational economics includes the following five interrelated theories: (1) a behavioral theory of the firm, (2) transaction costs theory, (3) property rights theory, (4) agency theory, and (5) (evolutionary) resource-based theory. In each area I have summarized my view of the critical observations of a few authors who have shaped the theory. Their work is presented in the present tense—even though a number of contributors unfortunately are no longer alive—because the work itself is very much alive. These books are worthy of careful attention. Not only are these books widely cited, but they also exemplify the way theories are constructed by individual authors and the way the conversation among authors develops over time to create complex and compelling answers to important questions.

    In the conclusion, I discuss complementarities among the theories outlined in this book, while recognizing their distinctive features. Most important, I outline some key questions for the ongoing economic study of organization that draws on these resources. I have written this book because the seminal works cited here are the foundations for so much current research. Key contributions of each author, in my view, are emphasized in italics. It may surprise some readers to find how current these observations sound, and some links to other research literatures are discussed here. But that discussion is limited to accommodate the wide variety of directions these foundational works can support. I hope that many different readers will be as inspired as I am by this classic literature. By understanding and emulating the best of our predecessors we can make more significant contributions today.

    Joseph T.Mahoney, November 2003
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    About the Author

    Joseph T. Mahoney received his BA in economics at the University of Pennsylvania in 1980, his MA in 1984, and his PhD in 1989 in business economics at the Wharton School of Business at the University of Pennsylvania. Joe joined the faculty of the Department of Business Administration at the College of Business at the University of Illinois at Urbana-Champaign in January 1988. Joe was promoted to Associate Professor in 1995, and he was promoted to Full Professor in 2003. Currently, Joe is on the editorial board of Academy of Management Review, Journal of Management Studies, and Strategic Management Journal. From 2000 to 2002, he was the book review editor of Academy of Management Review. He has published in Academy of Management Review, Journal of Business Research, Journal of Management, Journal of Management Inquiry, Journal of Management Studies, Managerial and Decision Economics, and Strategic Management Journal, among others. Joe currently serves on the editorial boards of Academy of Management Review, Journal of Management Studies, and Strategic Management Journal.

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