1. Paper Discussion Market Frictions as Building Blocks of an Organizational Economics Approach to Strategic Management Authors Joseph T. Mahoney and Lihong Qian (Mahoney, Joseph T., and Lihong Qian. "Market frictions as building blocks of an organizational economics approach to strategic management." Strategic Management Journal 34.9 (2013): 1019-1041.) Presented by Ujjal Kumar Mukherjee University of Illinois – Urbana Champaign September 02, 2015

2. Index 1.Introduction: Research Question 2.Fundamental Idea of the Paper: Market Friction Logic 3.Details of Market Friction Logic 4.Conclusion (Recent Developments)

3. Objective of Research To synthesize insights from several organizational economic approaches such as transaction costs, property rights, resource based and real options into an integrated market frictions approach as fundamental building blocks for an organizational economic approach to strategic management.

4. Research Questions  Why do firms exist?  Why do some firms outperform others?  Three primary strategic goals as underpinnings to the above questions:  Cost Minimization  Value Creation  Value Capture  Why do firms exist?  Why do some firms outperform others?  Three primary strategic goals as underpinnings to the above questions:  Cost Minimization  Value Creation  Value Capture

5. Index 1.Introduction: Research Question 2.Fundamental Idea of the Paper: Market Friction Logic 3.Details of Market Friction Logic 4.Conclusion (Recent Developments)

6. First Fundamental Welfare Theorem of Economics Any Walrasian Equilibrium Allocation is Pareto-efficient. Assumptions: 1.Lots of exchange goods, lots of individuals endowed with some of each good. 2.Perfect information. 3.Complete markets (Complete contracting possible) 4.Perfect fungibility of assets (no asset specificity) 5.Constant returns to scale 6.Independence of consumption and production (no inter-firm externalities nor inter-project and intertemporal spillovers) 7.Zero transaction costs 8.Perfectly defined property rights Assumptions: 1.Lots of exchange goods, lots of individuals endowed with some of each good. 2.Perfect information. 3.Complete markets (Complete contracting possible) 4.Perfect fungibility of assets (no asset specificity) 5.Constant returns to scale 6.Independence of consumption and production (no inter-firm externalities nor inter-project and intertemporal spillovers) 7.Zero transaction costs 8.Perfectly defined property rights

7. Violations of the Assumptions of the First Welfare Theorem Markets are not Frictionless Types of Market Frictions: 1.Imperfect and asymmetric information (Holmstrom, 1979). 2.Uncertainty coupled with opportunism (Arrow, 1974; Williamson, 1985). 3.Market power (Caves and Porter, 1977) 4.Non-fungible resources due to sunk costs (Williamson, 1985). 5.Asset specificity (Williamson, 1985). 6.Economies of scale and indivisibilities (Scarf, 1994). 7.Supply-side economies of scope (Teece, 1980). 8.Spillovers and externalities (Coase, 1960; Katz and Shapiro, 1985) 9.Positive transaction cost (Coase, 1937; Williamson, 1985). 10.Poorly or undefined property rights (North, 1990). Types of Market Frictions: 1.Imperfect and asymmetric information (Holmstrom, 1979). 2.Uncertainty coupled with opportunism (Arrow, 1974; Williamson, 1985). 3.Market power (Caves and Porter, 1977) 4.Non-fungible resources due to sunk costs (Williamson, 1985). 5.Asset specificity (Williamson, 1985). 6.Economies of scale and indivisibilities (Scarf, 1994). 7.Supply-side economies of scope (Teece, 1980). 8.Spillovers and externalities (Coase, 1960; Katz and Shapiro, 1985) 9.Positive transaction cost (Coase, 1937; Williamson, 1985). 10.Poorly or undefined property rights (North, 1990).

8. Consequences of Market Frictions

9. Fundamental Idea of Economic Approach to Strategic Management “Strategic Management seeks remedies for these various economic consequences due to market frictions for the purpose of cost minimization, or ways to leverage these market frictions for the purpose of value creation and value capture” - Mahoney and Qian, 2013. “Strategic Management seeks remedies for these various economic consequences due to market frictions for the purpose of cost minimization, or ways to leverage these market frictions for the purpose of value creation and value capture” - Mahoney and Qian, 2013.

10. Index 1.Introduction: Research Question 2.Fundamental Idea of the Paper: Market Friction Logic 3.Details of Market Friction Logic 4.Conclusion (Recent Developments)

11. Organizational Economies Approach to Cost Minimization Reducing transaction costs is the primary organizational economics approach to the strategic goal of cost minimization. Opportunism and Asset Specificity  Poses transactional hazards to other exchange partners  Can cause economic hold-up problems. Opportunism and Asset Specificity  Poses transactional hazards to other exchange partners  Can cause economic hold-up problems. Strategic Approach to Cost Minimization  Internalization to mitigate contractual hazard.  Vertical Integration. Strategic Approach to Cost Minimization  Internalization to mitigate contractual hazard.  Vertical Integration.

12. Organizational Economies Approach to Value Creation Resource based approach considers the strategic goal of value creation, more specifically, the potential economic rents derived from heterogeneous resources and capabilities. Four cornerstones of competitive advantage:  Superior resources.  Ex-post limits to competition.  Imperfect resource mobility.  Ex-ante limits to competition. Four cornerstones of competitive advantage:  Superior resources.  Ex-post limits to competition.  Imperfect resource mobility.  Ex-ante limits to competition. The real options theory provides a theoretical explanation for why firms may make investment decisions that differ from what the (narrowly defined) net present value approach would prescribe.

13. Market Friction Based Approach to Value Creation Competitive access to valuable resources:  Relevant: A resource is relevant if there is a demand for it (Barney, 1991).  Scarce /Rare: Resources are scarce if supply is limited and there are limitations on expansion of supply (Peteraf, 1993). Uniqueness of resource.  Heterogeneity of resources.  Complementarity: Relative magnitude of strategic resource may increase value of other resources. Competitive access to valuable resources:  Relevant: A resource is relevant if there is a demand for it (Barney, 1991).  Scarce /Rare: Resources are scarce if supply is limited and there are limitations on expansion of supply (Peteraf, 1993). Uniqueness of resource.  Heterogeneity of resources.  Complementarity: Relative magnitude of strategic resource may increase value of other resources. Strategic Response:  Low Transferability: Difficulties in pricing, information asymmetry, difficulties in partitioning, and isolation mechanisms such as patenting, trademark enforcement.  Inimitability: Path dependence, social complexity, and causal ambiguity. (Barney, 1991)  Non-substitutability: Imperfect substitution between firm resources. Strategic Response:  Low Transferability: Difficulties in pricing, information asymmetry, difficulties in partitioning, and isolation mechanisms such as patenting, trademark enforcement.  Inimitability: Path dependence, social complexity, and causal ambiguity. (Barney, 1991)  Non-substitutability: Imperfect substitution between firm resources.

14. Real Options Based Approach to Value Creation Advantages:  Low Transferability: Protection against uncertainty.  Flexibility in strategic choice.  Consideration of inter-project and inter-temporal spill-overs.  Evaluating growth options. Advantages:  Low Transferability: Protection against uncertainty.  Flexibility in strategic choice.  Consideration of inter-project and inter-temporal spill-overs.  Evaluating growth options. A real options is the right but not the obligation to undertake certain business initiative such as deferring, abandoning, expanding, staging, or contracting a capital investment.

15. Organizational Economies Approach to Value Capture Resource based approach  Complementarity: Possession of co-specialized resource.  Embeddedness: Cross-sectional and longitudinal interconnectedness of resources. Resource based approach  Complementarity: Possession of co-specialized resource.  Embeddedness: Cross-sectional and longitudinal interconnectedness of resources. Property Rights Theory  Well defined residual control rights.  Patent, trade-mark protection and equity share arrangements are some examples. Property Rights Theory  Well defined residual control rights.  Patent, trade-mark protection and equity share arrangements are some examples. Appropriation of economic rent is a necessary condition for economic value sustainability

16. Building on the same fundamental logic, each theory branches out by emphasizing different but overlapping combinations of market frictions to address its canonical problem. Taking a Stock: Market-frictions logic

17. Using the market-frictions logic  First approach is to start with the research gap identified within the existing literature  Second approach is to start with the strategic phenomenon of interest

18. Recent Development in Organizational Economic Approach  Cost creation coupled with value creation.  Intra-firm spillovers and governance inseparability.  Intra-firm spillovers and economies of scale and scope.  Cost minimization coupled with value capture.  Asset specificities and negative inter-firm externalities.  Asset specificity and loss of positive inter-firm spillovers.  Value creation coupled with value capture.  Poorly or undefined property rights and capabilities with value creation potential.  Asset specificity and positive inter-firm spill-overs.  Cost creation coupled with value creation.  Intra-firm spillovers and governance inseparability.  Intra-firm spillovers and economies of scale and scope.  Cost minimization coupled with value capture.  Asset specificities and negative inter-firm externalities.  Asset specificity and loss of positive inter-firm spillovers.  Value creation coupled with value capture.  Poorly or undefined property rights and capabilities with value creation potential.  Asset specificity and positive inter-firm spill-overs.