Adaptation, specialization, and the theory of the firm foundations of the resource based view

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Birger Wernerfelt
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Adaptation, Specialization, and the Theory
of the Firm

This invaluable book provides the foundations for a new theory of
the firm, drawing on Birger Wernerfelt’s landmark work on economic
theory and the resource-based view of the firm. It addresses a vigorous
and long-standing academic debate over what exactly a “firm” is, both
in the field of management and economics. Wernerfelt revisits his
classic articles, including an extensively revised “A Resource-Based
View of the Firm” (1984), which have been updated and synthesized
to provide precise and accessible concepts and predictions. By offering
future directions for research and practice, this book will be of interest
to students and scholars of management and economics alike.
birger wernerfelt is the J. C. Penney Professor of Management at
the MIT Sloan School of Management.

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Birger Wernerfelt
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Adaptation, Specialization,
and the Theory of the Firm
Foundations of the Resource-Based View
Birger Wernerfelt
MIT Sloan School of Management

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Birger Wernerfelt
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DOI: 10.1017/9781316466872
© Birger Wernerfelt 2016
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A catalogue record for this publication is available from the British Library
Library of Congress Cataloging-in-Publication Data
Names: Wernerfelt, Birger, author.
Title: Adaptation, specialization, and the theory of the firm : foundations of
the resource-based view / by Birger Wernerfelt, J. C. Penney Professor of
Management, MIT Sloan School of Management.
Description: Cambridge, United Kingdom : Cambridge University Press,
[2016] | Includes index.
Identifiers: LCCN 2016017702| ISBN 9781107134409 (Hardback) |
ISBN 9781107595781 (Paperback)
Subjects: LCSH: Industrial organization (Economic theory) | Economic
specialization. | Diversification in industry.
Classification: LCC HD2326 .W467 2016 | DDC 338.5–dc23 LC record
available at />ISBN 978-1-107-13440-9 Hardback
ISBN 978-1-107-59578-1 Paperback
Cambridge University Press has no responsibility for the persistence or accuracy
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accurate or appropriate.

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Birger Wernerfelt
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For Bjoern

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Birger Wernerfelt
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Contents

List of Figures
List of Tables
Preface

Part I

Agenda

1 Introduction
2 Preview: Small Forces, High Frequencies, and
Large Firms
Part II

The Main Argument

page ix
x
xiii

1
3
10
31

3 Adaptation Costs in One Dimension: Firms, Contracts,
and Price Lists

33

4 Adaptation Costs in Three Dimensions: Firms, Markets,
and Contracts

58

5 All Adaptations Are Not the Same: The Scope of Firms
and the Size of Markets

83

6 Resources and the Scope of the Firm
Part III

Implications

101

113

7 The Allocation of Asset Ownership

115

8 Communication within and between Firms

128

9 The Power of Incentives within and between Firms

150

10 Decision-Making in Large Organizations

161

vii

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Birger Wernerfelt
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viii

Contents

Part IV

Empirical Tests

179

11 Bargaining Costs: Existence and Sub-Additivity

181

12 Adaptation Frequency and the Boundary of the Firm

201

13 Asset Ownership and Externalities

229

Part V

251

Foundations

14 Endogenously Incomplete Contracts

253

15 Multiple Equilibria and Firm Heterogeneity

272

16 On the Endogenous Amplification of Small Differences

284

Part VI

299

Postscript

17 Summary and Final Reflections
Index

301
303

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Birger Wernerfelt
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Figures

2.1
2.2
2.3
3.1
4.1
4.2
4.3
5.1
6.1
6.2
6.3
6.4
7.1
8.1
8.2
8.3
11.1
11.A-1
14.1
15.1

Most efficient mechanisms and changing needs 1
page 18
Most efficient mechanisms and changing needs 2
19
Most efficient mechanisms and changing needs 3
20
Most efficient mechanisms

41
Most efficient mechanisms by frequency of change and
switching costs
72
Most efficient mechanisms by frequency of change and
gains from service specialization
72
Most efficient mechanisms by frequency of change
and number of needs
75
A two business–two service economy
90
Resource–product matrix
103
Sequential entry
107
Exploit and develop
109
Stepping stone
110
The value–depreciation frontier
117
Conditional posterior density of cl if the seller did not
find the new design (F = U)
136
Conditional posterior densities of cl if seller found, but
did not offer, new design (F = U)
137
Conditional posterior densities of ch if seller offered the
new design (F = U)

139
Schematic screen-shot of the bargaining environment
for the buyer
185
Frequency of settling times by experimental treatment
200
{k, r │The buyer will cede decision d to the seller}
265
Possible linear codes when V = 4
276

ix

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Birger Wernerfelt
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Tables

3.1
3.2
3.3
4.A-1
7.1
11.1

11.2
11.3
11.4
11.5
12.1
12.2
12.3
12.4
12.5
12.6
12.7
12.A-1
12.A-2
12.A-3
12.A-4

Kendall rank correlations
Correlation coefficients
t-Values from regressions
Components of efficiency and performance
of mechanisms
Questionnaire
The tendency to pool for increasing costs of pooling
The tendency to pool for different costs and benefits
of pooling
The role of time-savings in the tendency to pool
The role of anonymity in the tendency to pool
Number of offers in one period negotiations and
pooling prices
List of parts

Descriptive statistics by production system
Probability of pair-wise co-production by adaptation
frequency
Sum of internalized adaptation frequencies by
production system
Models of max Σijxij(β)[βfij + eij]
Sum of squared production system residuals (SSR)
by alternative models
Sum of squared firm residuals (SSR) by
alternative models
Adaptation frequencies from interviews and
co-production data for production system A
Descriptive statistics by production system
Probability of pair-wise co-production by
adaptation frequency
Sum of internalized adaptation frequencies by
production system

page 51
52
52
79
123
187
189
189
190
191
207
208

210
212
217
219
220
224
226
226
227

x

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Birger Wernerfelt
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List of Tables

12.A-5 Models of max Σijxij(β)[βfij + eij]
12.A-6 Sum of squared production system residuals (SSR)
by alternative models
12.A-7 Sum of squared firm residuals (SSR) by alternative
models
13.1 Summary statistics
13.2 Rank-order correlation of the measures

13.3 Multivariate analysis
13.4 Modified multivariate analysis
15.1 Number of rounds when one member uses code A
and the other uses code B
15.2 Number of rounds when both members use code A
15.3 Number of rounds when both members use code B

xi

227
228
228
240
245
245
248
278
278
278

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Birger Wernerfelt
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Preface

This book is based on fifteen papers written over a thirty-year period.
Two of them, “A Resource-Based View of the Firm” (proposing what is
now called the RBV) and “On the Nature and Scope of the Firm”
(proposing what is here called the “Adaptation Cost,” or just AC, theory
of the firm1) were written a few years apart in the 1980s. While both
papers aim to characterize the sets of activities that should and should not
be undertaken by firms, I long considered them incompatible. One was
about excess capacity of certain productive assets and the other was
about the costs of adapting contracts. Only when writing what is now
Chapter 4 did I realize that the sub-additive bargaining costs underlying
the AC theory could make productive assets de facto indivisible and
capable of existing in excess capacity, thus taking me directly to the RBV.
The main purpose of the book is to clarify the AC–RBV relationship
and this is done in two steps. In “Adaptation Costs in Three Dimensions:
Firms, Markets, and Contracts,” I derive the AC theory under gains
from specialization, and in “All Adaptations Are Not the Same: The
Scope of Firms and the Size of Markets,” I develop the resulting theory
of the scope of the firm and compare it to the RBV. To make the linkage
as clear as possible, the four key chapters have been placed in sequence
at the start of the book. The remaining eleven chapters look, theoretically and empirically, at important implications and foundations of
the AC/RBV.
Most chapters have their basis in a single stand-alone paper, some
published several years ago. All have been rewritten for consistency
of notation and terminology and updated to reflect other literature
published between their original publication date and now. I do not flag
the parts that are most extensively rewritten, but the reader should be
aware that there may be significant differences between the original
1

In its first incarnation, the theory was, at the suggestion of a referee, labelled the
“Adjustment Cost” Theory. However, that term is also used in the macro literature
where it denotes a different phenomenon.

xiii

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Birger Wernerfelt
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xiv

Preface

articles and the versions found here. It should also be mentioned that
the introductions to individual chapters may repeat a bit of material
covered in earlier chapters. This is done to make each chapter almost
self-contained and thus allow readers to skip one or more chapters.
The title page before each part contains a note about the extent to which
the chapters depend on each other.
Since the ideas in the book have been developed over such a long time,
I have benefited from a very large number of colleagues, readers, seminar
audiences, referees, and editors. The most important and consistent of
these have been Bob Gibbons, Oliver Hart, and Steve Tadelis. I have
learned a lot from them and the work is profoundly influenced by their

willingness to repeatedly discuss on my premises. I would also like to
thank Tore Ellingsen, Nicolai Foss, Drew Fudenberg, Bengt Holmstrom, Patrick Legros, Jin Li, Niko Matouschek, Roger Myerson, Mike
Powell, Peter Norman Soerensen, Jean Tirole, Mike Whinston, and
Oliver Williamson for one or more discussions, questions, or comments
that ended up being important to some of the ideas presented here. More
generally, I would like to thank everybody who has been a member of the
vibrant Organizational Economics community in Cambridge at any point
during the last twenty-five years.
Three of the chapters are based on papers coauthored with colleagues
and I would like to acknowledge the collaborations of Boris Maciejovsky,
Sharon Novak, and Duncan Simester. A couple of papers would not have
been possible without the help of research assistants and I particularly
want to thank Carol Meyers for her help with what is now Chapter 12.
In the later stages of the manuscript preparation, Xinyu Cao provided
excellent proofreading and checking assistance.
As mentioned above, most of the Chapters are based on previously
published work. Chapter 2 is based on “Small Forces and Large Firms:
Foundations of the RBV” (Strategic Management Journal, 34, no. 6,
pp. 635–43, 2013); Chapter 3 is based on “On the Nature and Scope
of the Firm” (Journal of Business, 70, no. 4, pp. 489–514, 1997); Chapter 4 is based on “The Comparative Advantages of Firms, Markets, and
Contracts” (Economica, 82, no. 236, pp. 350–67, 2015); Chapter 6 is
based on “A Resource-Based View of the Firm” (Strategic Management
Journal, 5, no. 2, pp. 171–80, 1984); Chapter 7 is based on “Why Should
the Boss Own the Assets?” (Journal of Economics and Management Strategy, 11, no. 3, pp. 473–85, 2002); Chapter 8 is based on “Bargaining
Before or After Communication?” (Journal of Institutional and Theoretical
Economics, 164, no. 2, pp. 211–29, 2008); Chapter 9 is based on “Robust
Incentive Contracts” (Journal of Institutional and Theoretical Economics,
160, no. 4, pp. 545–54, 2004); Chapter 10 is based on “Delegation,

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xv

Committees, and Managers” (Journal of Economics and Management
Strategy, 16, no. 1, pp. 35–51, 2007); Chapter 11 is based on “Costs of
Implementation: Bargaining Costs Versus Allocative Efficiency” (with
Boris Maciejovsky in Journal of Economic Behavior and Organization, 77,
no. 3, pp. 318–25, 2011); Chapter 12 is based on “On the Grouping of
Services into Firms: Make-or-Buy with Interdependent Parts” (with
Sharon Novak in Journal of Economics and Management Strategy, 21,
no. 1, pp. 53–77, 2012); Chapter 13 is based on “Determinants of
Asset Ownership: A Study of the Carpentry Trade” (with Duncan I.
Simester in Review of Economics and Statistics, 87, no. 1, pp. 50–58,
2005); Chapter 14 is based on “Renegotiation Facilitates Contractual
Incompleteness” (Journal of Economics and Management Strategy, 16,
no. 4, pp. 893–910, 2007); Chapter 15 is based on “Organizational
Languages” (Journal of Economics and Management Strategy, 13, no. 3,
pp. 461–72, 2004); and Chapter 16 is based on “Why Do Firms Tend to
Become Different?” (Chapter 9, pp. 121–33 in Constance Helfat (ed.),
Handbook of Organizational Capabilities, Malden, MA and Oxford, UK:
Blackwell, 2003). I am grateful for the respective publishers for granting

permission to use their articles in this volume and to Jason Clinkscales
of MIT for collecting those permissions.
I would like to thank the University of Michigan, Northwestern
University, the University of Copenhagen, and particularly MIT for
providing me with stimulating work environments. And last, but not
least, Paula Parish of the Cambridge University Press for believing in
the project and helping me through the writing and publication process.

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Part I

Agenda

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1

Introduction

“A Resource-Based View of the Firm” (RBV), a paper I wrote in 1984,

has gone on to become very influential in the management literature. It
introduced ideas that are taught in strategy, personnel, marketing, and
often several other fields, in virtually every MBA program in the world.
The implications resonate with practicing managers, have intuitive
appeal, and are easy to apply. At the same time, the paper has spurned
a vigorous academic debate about its theoretical foundations (Foss,
1998; Priem and Butler, 2001).
Meanwhile, another foundational debate, over what exactly a “firm” is,
has been raging in economics. Although two Nobel prizes have been
awarded for answers to this question, the only agreed-upon proposition is
that we, as of 2016, do not have a commonly accepted theory of the firm.
Drawn to foundational topics, I have struggled with the question over the
last thirty years, gradually refining the “Adaptation Cost” (AC) theory
and making several other contributions to the economic literature on the
firm. While these papers are written for an economics audience, the main
forces at work will seem first order to managers, and it turns out that the
theory portrays firms as acting in accordance with the RBV.
In contrast to the influence enjoyed by the RBV, my economic papers
have remained on the fringes of the debate in that field. There are at least
two reasons for this. First, economists rightly have very conservative
beliefs about what constitutes first order effects. Second, I failed to
stress to the profession that the theory rings true to the people modeled –
those who make decisions about the scope of real firms. In my defense, it
is not an easy case to make. Economists value that kind of external
validity in a theory, but most know relatively little about how top managers think about the scope of the firm, and find it hard to interpret the
facts in a way that allows them to bridge the gap to theory. My hope is
that the RBV can serve as an intermediate point on such a bridge.
Taken as a whole, the collection of papers contained in this volume
could thus contribute to two debates, about the foundations of the RBV
and the theory of the firm. At the moment, almost no management

3

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4

Introduction

scholars know about my work in economics and economists are often
unfamiliar with the RBV.
Compared to other recent theories of the firm, the essential assumption behind the AC theory is that bargaining costs, incurred when
adapting contracts, are sub-additive. This leads to a concept of employment as a cost-minimizing mechanism and explains why labor inputs
may be economically indivisible. The other important assumption, which
is much less controversial, is that workers are more efficient when they
specialize. There are advantages of specialization in both business and
service dimensions and this means that production costs are higher when
workers have to change from one business and/or service to another.
These two types of adaptation costs, contractual and productive, are
both incurred when demand shortages make complete specialization
impossible, and the AC theory depicts economic institutions as attempts
to minimize the total costs of adaptation. In particular, the employment
relationship, which is used to define the firm, is found to be more
efficient when frequent adaptations are needed. A firm has incentives
to expand its scope when sub-additive bargaining costs makes it most
efficient to realize gains from specialized use of inputs inside the firm.
This means that the firm can enhance efficiency by expanding into

businesses that are new but “related” in the sense that the same expertise,
in business and service dimensions, can be used with little loss of efficiency in all of them. The RBV looks at the special case in which
expertise differs between firms, but the AC theory does not require that.1
Since the paper forming the basis for Chapter 2, “Small Forces and
Large Firms: Foundations of the RBV,” contains a sketch of the argument made in this book, I will use the present chapter to place the
individual components in the context of previous and current literature.

1.1

Strategy, Human Resource Management, and Marketing

“A Resource-Based View of the Firm” did not, as some have thought,
start as a generalization of Edith Penrose’s (1959) theory about firms
growing to utilize excess capacity of managerial time. Rather, it was a
reaction, inspired by game theory, to Michael Porter’s “five forces
analysis” of industries (1980). My thinking was simply that it is normatively inconsistent to recommend the same industries to everybody.
Since competition will erode profits, recommendations can only be
1

of use,

A lot of foundational debate in strategy focuses on explaining how initial differences arise
and are preserved (Lippman and Rumelt, 1982; Rumelt, Schendel, and Teece, 1991;
Foss, 2011). I make my own contributions in Chapters 15 and 16.

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Strategy, Human Resource Management, and Marketing

5

consistent with equilibrium if they send different firms in different
directions. Seen in a broader perspective, this reaction and the timing
of it were not surprising at all: Porter’s book followed the lines of Joe
Bain’s (1956) Industrial Organization economics and this branch of
economics was, in the mid-eighties, being turned upside down by economists newly armed with the tools of game theory (e.g., Tirole, 1988).2
To generate different operational recommendations for different firms,
I took as a starting point that firms have different productive assets and
that this matters for their production possibilities. More precisely,
I assumed that firms differ in terms of their economically inalienable
productive assets – their resources. A productive asset is economically
inalienable from a firm f if it is inefficient to have any part of its capacity
used by a firm other than f. Sub-additive price determination costs may
make it inefficient to trade fractions of an asset, such that it cannot be
efficiently exploited by trade, although it could be used by the firm itself.
It is not required that the firm use 100 percent of the asset’s capacity,
only that it is inefficient to have a fraction of the capacity used by another
firm. So these are the assets of which the firm may have excess capacity
even in equilibrium.3
The RBV paper was not an immediate success and I did not promote it
or even cite it in the first several years. However, things changed when
three later papers proposed closely related ideas with more or less different terminology: Prahalad and Hamel (1990) on Core Competencies,
Barney (1991) on Resource-Based Theory, and Teece, Pisano, and
Shuen (1997) on Dynamic Capabilities. These papers all share the
assumption that firms are different and suggest that they should leverage
excess capacity of what they are good at. The strategy community realized the similarities, and the success of my paper is in no small measure
due to the “sales job” done by these other authors.
These similarities notwithstanding, the RBV paper differs significantly

from the later contributions in its treatment of the firm’s development of
new resources. This is a tricky issue because symmetric competition
would result in rents from this type of innovation being competed away.
In the RBV paper, the initial asymmetry in resources creates asymmetric
positions in both output and resource markets, and the firm should
2
3

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As further described in Lockett, O’Shea, and Wright (2008), I was also influenced by the
mathematical concept of duality as well as the idea that firms could “learn by doing.”
The step from excess capacity to expansion of the firm has been known at least since
Penrose (1959). For example, in Transaction-Cost Economics, multiproduct firms are
seen as resulting from indivisibilities and “market failure” (Williamson, 1975; Teece,
1982). The point here differs because ontological indivisibility is not necessary, while it is
critical that bargaining costs be sub-additive.

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6

Introduction

leverage both of these. So the result is that firms should do what they are
good at and get better at things they are good at getting better at. In
Teece, Pisano, and Shuen (1997), it is posited that some firms have a
special resource that allows them to be good at learning (thus the name

“dynamic capabilities”). It may be hard to empirically distinguish
between the two theories, but the fact that firms tend to grow within
the same general area would seem to suggest that any generalized learning somehow is tied to the firm’s initial resources.
Very soon after the RBV had diffused into strategy, it was applied to
human resource management (personnel), and is now often thought of as
forming the foundation of that field. For example, Allen and Wright
(2007, p. 90) write that the RBV is “the guiding paradigm on which
virtually all strategic HRM [human resource management] research
is based.”
After a brief delay, the ideas made quick inroads into marketing and
now play a substantial role in that field – though they are less central there
than in strategy and personnel. Specifically, in very few years, the dominant conceptual framework in that field changed from being the “4P’s”
(Product, Place, Promotion, and Price) to being the “3C’s and the 4P’s.”
The idea is that the C’s (Company, Customers, and Competitors),
are more or less given, and that the P’s are contingent on them. I do
not know why this change occurred, and but the factors raised under
“Company” are typically those that would be suggested by the RBV.
Even the terminology is similar, as in the “Resource-Advantage Theory”
of Hunt and Morgan (1996), and in often used labels like “Capabilities”
or “Competencies.”
1.2

Economics: Sub-Additive Bargaining Costs

The concept of bargaining costs have proved vexing for the economics
profession. One reason for this is that it has been hard to explain, in a
fully satisfactory way, why bargaining should be costly. One celebrated
attempt, by Grossman and Hart (1986) and Hart and Moore (1990) was
undone by a set of sophisticated mechanisms proposed by Maskin and
Tirole (1999). Specifically, players can eliminate the bargaining inefficiencies exploited by Hart et al. by using the so-called Moore-Rupello

(1988) mechanisms. (Yes, it is the same Moore.) Other justifications
have been based on Myerson and Satterthwaite’s (1983) result that
bargaining with two-sided incomplete information necessarily is inefficient if a player cannot be forced to trade at a loss. However, if the parties
can write a binding contract ex ante, they can commit themselves to trade
no matter what.

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Economics: Sub-Additive Bargaining Costs

7

There are many ways to confront this problem, none of which is fully
satisfactory. Among others, we have proofs that the Moore-Rupello
mechanisms are not robust (Aghion, Fudenberg, Holden, Kunimoto,
and Tercieux, 2012), postulates that contracting is costly per se (Bajari
and Tadelis, 2001), and appeals to bounded rationality (Williamson,
1979; Hart and Moore, 2008).
In this book, I justify the reliance on bargaining costs in several
different ways. First, I show, in a series of experiments, that they exist
and are sub-additive (Chapter 11). Second, I note that bargaining
requires communication and that this is costly per se (Chapter 3).
Third, I argue that some bargainers will spend resources trying to learn
each other’s private valuations (Chapter 4). More generally, it makes
a difference that I define the firm by the employment relationship.
In most countries, the law protects labor from overly aggressive penalties, thus allowing them to opt out of contracts if the conditions

turn out to be too onerous.4 Once again, I admit that none of these is
fully satisfactory.
These theoretical discussions aside, most people believe that bargaining costs exist. However, another barrier to their widespread use is the
intuition that they are in some sense “small” and thus cannot be first
order causes of any important phenomena. This is very reasonable if one
is trying to explain large capital investments (as is done in most of the
literature on integration), but much less so when, as in this book, the
focus is on large numbers of small labor services. Making this point in
numerous seminars, I have never had anyone disagree that “an executive
does not want to negotiate a separate fee for every little service his or her
secretary performs.” The AC theory highlights how the governance
of trading relationships depends on the number of adaptations needed
per unit time.
While bargaining costs, in various guises, have been the subject of a lot
of debate, I have never seen any mention of the second part of the
premise, that these costs are sub-additive in the number of items covered
in the negotiation. And yet, this is critical. Without this assumption,
occasion-by-occasion bargaining by the above-mentioned executive
would be just as efficient as a once and for all negotiation covering the
entire set of relevant services – an arrangement we will call an “employment relationship” and use to define the firm (Chapter 3).
Fortunately, sub-additivity is intuitively appealing: Compared to thirty
item-by-item negotiations, most people would prefer to bargain once

4

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It is harder to dispute that binding ex ante contracts can be written for trade in products.

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8

Introduction

about a price for the bundle of thirty items. In fact, this is exactly what
Boris Maciejovsky and I find in the experiments reported in Chapter 11
of this book. Based on countless conversations with economists, my
strong sense is that the profession considers the sub-additivity assumption relatively unproblematic compared to the resistance to any use of
bargaining cost in the first place.
After this historical/sociological preamble, the next Chapter contains a
preview of the book.

References
Aghion, Philippe, Drew Fudenberg, Richard Holden, Takashi Kunimoto, and
Olivier Tercieux, “Subgame-Perfect Implementation Under Information
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2

Preview
Small Forces, High Frequencies, and Large Firms

2.1

Introduction

This book is about firms. Many readers will be teaching about firms and/
or doing research about them. And yet, we have no generally accepted

answers to the most basic questions about them. What is a firm? When
should we use them? How do they work differently than markets? Why do
some of them diversify?
Most research in business and economics is conducted by taking a
trading mechanism, typically a firm, a market, or a contract, as given.
The researcher then imposes some subset of a standard set of assumptions, and answers questions about the resulting actions and outcomes.
While this procedure has proven very fruitful, it raises some deeper
questions: What determines the choice of mechanism in the first place?
And why are firms, markets, and contracts so commonly used? On these,
we are well short of a theory which is unified in the sense that it can
explain all three mechanisms and do so without relying on assumptions
different than those normally imposed in analyses taking each of the
mechanisms as a given.
In the following chapters, we propose an Adaptation Cost (AC) theory
of the firm that speaks to these questions and at the same time provides
a micro-foundation for the Resource-Based View (RBV) of the Firm
(Chapter 6).
The argument starts with a worker who has provided a particular
service for an entrepreneur whose needs now have changed. The
worker’s productive efficiency will suffer if he changes to another service
or another entrepreneur and in either case some costs may be incurred in
the process of reaching agreement on the terms of the new trade. We look
for the most efficient way to balance these three sources of adaptation
costs (inefficiency) in three stages. In Chapter 3, we hold production
costs constant and consider bargaining costs only. This allows us to
compare bilateral mechanisms, including employment and contracts.
In Chapter 4, we introduce advantages of specialization such that
10

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Introduction

11

changes between services or entrepreneurs result in higher production
costs. This allows us to expand the set of alternatives to include markets,
as well as firms. We finally, in Chapter 5, introduce a distance metric on
the sets of services and businesses such that some changes are more
costly than others. By thus treating firms and markets in a somewhat
similar way, we are able to derive predictions about the optimal scope of
firms and the optimal size of markets. Let us now discuss the three types
of adaptation costs in a bit more detail.
We start with a “small” force; the difference in bargaining costs
between negotiating a single average price for a lot of services versus
negotiating separate prices for each individual service. It is not counterintuitive to think of bargaining costs as being subject to economies of
scale in this sense: When faced with the service of trading thirty small
items, most people would prefer to negotiate once over the bundle rather
than thirty times on an item-by-item basis. In Chapter 3, we show how
sub-additivity of bargaining costs can help explain why we use the
employment mechanism to govern trading relationships in need of frequent adaptation.
The costs of worker adaptation are not just those of bargaining over
payments. It is also costly, in the form of lower productivity, to change
between services and to transition from one business to another. While it
is possible for workers to provide different services for different entrepreneurs in each period, they have to adapt less if they specialize in providing
a single service, stay in a bilateral relationship (specialize in working for

one business), or do both. So an advantage of either type of specialization
is that it reduces the amount of adaptation needed. In Chapter 4, we use
this insight to extend the AC theory to explain the comparative advantages of markets, relative to firms and contracts.
A worker is most efficient if he can be “doubly specialized,” continually providing the same service to the same business. If this is impossible,
because demand facing the business is too small to use a full-time service
specialist, it will often be second best to specialize in one of the two
dimensions and deal with the occasional adaptation in the other. Some
such adaptations, whether between two services or two businesses, are
more costly than others. In Chapter 5, we therefore define a measure of
distance or “relatedness” between pairs of services or businesses. So a
worker who is specialized in one dimension, say a service (business), can
approximate double specialization by focusing on a small set of related
businesses (services). This perspective allows us to further extend the AC
theory and predict the scope of firms and the size of markets.
To see how this leads to a theory of the scope of the firm, consider a
worker who cannot be doubly specialized because the business has too

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12

Preview: Small Forces, High Frequencies, and Large Firms

little demand for the service in question. Assume further that subadditive bargaining costs make it prohibitively expensive for the worker
to hold two employment positions at the same time. In this case the
worker could use his extra time performing the specialized service for

another business operated by the same entrepreneur or he could match
up with a different entrepreneur through the market. Since the former
may entail more bargaining costs, the two businesses operated by the
focal entrepreneur must be related in the sense that not too many gains
from business specialization are lost going back and forth between them –
compared to what could be expected if the other business is found in the
market. In this scenario, then, the scope of the firm is expanded to
leverage excess capacity of productive assets up to the point where the
component businesses become too different.
We have now arrived at the central message of the RBV. Define
“resources” as productive assets that are economically inalienable in
the sense that it is more efficient to use excess capacity inside the
boundary of the firm. (More precisely, an asset is economically inalienable from a firm f if it is inefficient to have any part of its capacity used by
a firm other than f.) Just like the AC theory, the RBV says that firms with
excess capacity of resources should look to leverage them and deploy
them in related businesses. (We normally think of the RBV as being
concerned with the case in which firms have different resource endowments, but the argument coming out of the AC theory also applies to
homogeneous firms. Furthermore, the resources do not have to be
ontologically indivisible, we just require that sub-additive bargaining
costs makes it inefficient to divide them.)
Since the example concerns a single worker, it may seem unappealing
in light of the very large firms that dominate modern economies. However, we can readily extend the argument to groups of employees and
other productive assets, as long as they are subject to sufficiently subadditive bargaining (price determination) costs. With this preamble,
Chapter 6 then contains an updated version of the RBV paper with more
explicit emphasis on the point that resources matter to the extent that the
firm has excess capacity.
The relationship with the RBV is an important strength of the AC
theory of the firm, because we know that the RBV rings true to many of
the managers who make decisions about the scope of their firms – the
very decisions that all theories of the firm try to reconstruct. Beyond that,

the predictions of the theory are consistent with many stylized facts about
firms: They are used when more frequent and diverse adaptations are
needed, when workers’ benefits of specialization in individual services are
smaller, and when it is costly to switch from one business to another.

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Introduction

13

Having thus developed the AC/RBV theory of the firm, we look, in
Chapters 7–10, at several implications about differences between firms
and markets: Who should own the productive assets? How does the
steepness of incentives compare? How do the patterns of communication
differ? And who should make which decisions?
In contrast to the complex interactive effects favored by much recent
theoretical literature on the firm, many of the arguments offered here rely
on comparatively simpler and more direct forces. This simplicity often
has the effect of turning received wisdom on its head. Instead of “I am
the boss because I own the assets” (Grossman and Hart, 1986), it is
“I own the assets because I am the boss.” Employment contracts are lowpowered, not because employees are supposed to, by themselves, allocate
some time to aspects of the job that are not contractable (Holmstrom and
Milgrom, 1991), but because the boss might intervene and order them to
do something not covered by the incentives. There is less communication between than within firms, not because firms can commit to treat
bad news gently, but to protect the firm’s bargaining power. Decision

rights are not yielded to enhance investment incentives (Aghion and
Tirole, 1997), but because it is too costly to agree on everything.
Part IV of the book contains three chapters that test the most unique
aspects of the theory. The first reports on a series of experiments (Chapter 11) showing that subjects act as if they incur sub-additive bargaining
costs. In the second (Chapter 12), we use interview data to conduct a
very general make-or-buy study of several supply chains in the automobile industry. Aiming to test the AC theory directly, we show that
components needing more frequent mutual (coordinated) adaptation
are much more likely to be produced by the same firm. The third (Chapter 13) contains a test of the theory of asset ownership – a key difference
between the AC and Property Rights theories (PRT). Again using interview data, we show that employees own productive assets when their
actions are critical determinants of the rate at which these assets
depreciate.
In Part V of the book, we discuss three critical assumptions. Chapter 14
is about incomplete contracts. It is clear that we cannot have a theory of
the firm without some sort of contractual incompleteness, and while most
people find it natural to assume that not all contingencies can be anticipated, it is still considered an ugly assumption by many economists. We
make use of bargaining costs to turn the argument on its head. If it is costly
to negotiate agreements about what should happen in each contingency,
parties may prefer to leave it unspecified. So rather than, “since contracts
are incomplete, they can be renegotiated” (Hart and Moore, 1990), it is
“contracts can be left incomplete, because they can be renegotiated.”

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