How a Firm’s Capabilities Affect Boundary Decisions

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In a world of corporate refocusing, down-sizing, and outsourcing, a critical strategic decision that many senior managers make is determining their firm’s boundary. “Which business activities should be brought within the boundary of the firm?” and “Which business activities should be outsourced?” are essential strategic questions in determining a firm’s boundary. Firms that bring the wrong business activities within their boundaries risk losing strategic focus and becoming bloated and bureaucratic. Firms that fail to bring the right business activities within their boundaries risk losing their competitive advantages and becoming “hollow corporations.”1

Fortunately, a well-developed approach exists for determining a firm’s boundary. Called transactions cost economics, this approach specifies the conditions under which firms should manage a particular economic exchange within their organizational boundary as well as the conditions under which it should be outsourced.2 Not only is this approach well developed, it is remarkably simple, and many of its predictions and prescriptions have received empirical support.3 Indeed, in its most popular version, this approach requires managers to consider only a single characteristic of an economic exchange — the level of transaction-specific investment — in order to decide whether to include an exchange within a firm’s boundary. To date, the simplest conclusion one can make about transactions cost economic analysis of firm boundaries is that it seems to work.

So, in the face of this well-developed, empirically robust approach, why try to develop some new ideas about the best way to determine a firm’s boundary? When I explain transactions cost economics to practicing managers and help them implement it, they often ask: “What role do firm capabilities play in this approach to firm boundaries?” To their great surprise, the answer to this question is: “Very little.” Transactions cost economics does not focus on the capabilities of a firm or on the capabilities of its potential partners when deciding which economic exchanges to include within a firm’s boundary and which to out-source.

Managers are often mystified by this response.



1. The concept of a “hollow corporation” was first introduced in:

N. Jones, “The Hollow Corporation,” Business Week, 3 March 1986, pp. 56–59; and

M. Postin, “The Hollow Corporation,” Executive Excellence, volume 5, May 1988, pp. 11–12.

2. The foundations of transactions cost economics were outlined in:

Ronald Coase, “The Nature of the Firm,” Economica, volume 4, 1937, pp. 386–405.

However, these ideas remained somewhat underdeveloped until the work of Oliver Williamson, beginning in the 1960s. Williamson’s work is summarized in two books:

O. Williamson, Markets and Hierarchies: Analysis and Anti-Trust Implications (New York: Free Press, 1975); and

O. Williamson, The Economic Institutions of Capitalism (New York: Free Press, 1985).

3. Empirical tests of transactions cost economics are reviewed in:

J. Barney and W. Hesterly, “Organizational Economics: Understanding the Relationship between Organizations and Economic Analysis,” in S. Clegg, C. Hardy, and W. Nord, eds., Handbook of Organization Theory (London: Sage, 1996), pp. 115–147; and

J. Mahoney, “The Choice of Organizational Form: Vertical Financial Ownership versus Other Methods of Vertical Integration,” Strategic Management Journal, volume 13, November 1992, pp. 559–584.

Some of the secondary predictions of transactions cost economics and especially those that deal with the role of uncertainty in determining a firm’s boundaries do not receive as consistent support as its primary predictions. Also, many transactions cost predictions do not seem to hold as consistently in high-technology industries. These empirical limitations of transactions cost thinking are important for subsequent sections of this paper.

4. Direct costs, indirect costs, and opportunity costs are relevant in determining the cost of a governance mechanism for a firm.

5. Perhaps, for example, this foreign firm may be owned by the government.

6. More formally, firms will choose nonhierarchical governance when the value of an exchange is greater than the cost of opportunism stemming from transaction-specific investment and when the cost of opportunism from transaction-specific investment is less than the cost of using hierarchical governance.

7. This discussion draws heavily on the resource-based view of the firm. This theory was first outlined in:

B. Wernerfelt, “A Resource-Based View of the Firm,”Strategic Management Journal, volume 5, April–June 1984, pp. 171–180;

R. Rumelt, “Toward a Strategic Theory of the Firm,” in R. Lamb, ed., Competitive Strategic Management (Englewood Cliffs, New Jersey: Prentice-Hall, 1984), pp. 556–570; and

J. Barney, “Strategic Factor Markets: Expectations, Luck, and Business Strategy,” Management Science, volume 32, October 1986, pp. 1512–1514.

The reasons why some capabilities are costly to create are discussed in:

I. Dierickx and K. Cool, “Asset Stock Accumulation and Sustainability of Competitive Advantage,” Management Science, volume 35, December 1989, pp. 1504–1511; and

J. Barney, “Firm Resources and Sustained Competitive Advantage,” Journal of Management, volume 17, January 1991, pp. 99–120.

8. Caterpillar’s unique history is discussed in: M.J. Rukstad and J. Horn, “Caterpillar and the Construction Equipment Industry in 1988” (Boston: Harvard Business School, Case 9-389-097, 1989).

9. These supply relationships and the value they create for Japanese firms are discussed in:

J. Dyer and W. Ouchi, “Japanese Style Partnerships: Giving Companies a Competitive Edge,” Sloan Management Review, volume 35, Fall 1993, pp. 51–63.

10. See J.C. Collins and J. Porras, Built to Last (New York: HarperCollins, 1994).

11. Collins and Porras estimate that $1 invested in their sample of eighteen “visionary firms” in 1926 would have been worth $6,536 in 1995, while $1 invested in a matched sample of firms competing during the same time in the same industries would have been worth $415. See:

Ibid., p. 3.

12. The term “invisible assets” was introduced in: H. Itami, Mobilizing Invisible Assets (Cambridge, Massachusetts: Harvard University Press, 1987).

13. Many of the reasons why the cost of acquiring a firm to gain access to its capabilities can rise are discussed in:

B. Kogut, “Joint Ventures: Theoretical and Empirical Perspectives,” Strategic Management Journal, volume 9, August 1988, pp. 319–332;

J.F. Hennart, “A Transaction Cost Theory of Equity Joint Ventures,” Strategic Management Journal, volume 9, August 1988, pp. 361–374; and

B. Kogut, “Joint Ventures and the Option to Expand and Acquire,” Management Science, volume 37, January 1991, pp. 19–33.

14. For a discussion of the specific antitrust issues in the Intuit-Microsoft case, see:

“Will Regulators Get Tough on M&A,” Mergers and Acquisitions, volume 31, July–August 1996, pp. 42–51.

15. The Publicis and Foote, Cone & Belding alliance is described in:

R.M. Kanter, “FCB and Publicis (A): Forming the Alliance” (Boston: Harvard Business School, Case 9-393-099, 1993).

16. Kogut (1991).

17. M. Porter, “From Competitive Advantage to Corporate Strategy,” Harvard Business Review, volume 67, May–June 1987, pp. 43–59.

18. Of course, firms will want to minimize the threat of opportunism in this situation. This suggests that they will prefer some form of intermediate governance (i.e., a strategic alliance) over market forms of governance to access capabilities that they cannot develop internally and cannot access through an acquisition.

19. The path-dependent nature of manufacturing in biotechnology is described in:

G. Pisano, “Nucleon, Inc.” (Boston: Harvard Business School, Case 9-692-041, 1991).

The path-dependent nature of software development is described in:

J.D. Blackburn, G. Hoedemakear, and L.N. Van Wassenhove,” Concurrent Software Engineering: Prospects and Pitfalls,” IEEE Transactions on Engineering Management, volume 43, May 1996, pp. 179–188.

20. See R. Henderson and I. Cockburn,

“Measuring Competence: Exploring Firm Effects in Pharmaceutical Research,” Strategic Management Journal, volume 15, Winter 1994 (special issue), pp. 63–84.

21. Pisano (1991).

22. Kogut (1991).

23. For a discussion of these time dynamics in rapidly evolving high-technology industries, see:

K. Eisenhardt and S. Brown, “Time Pacing: Competing in Markets That Won’t Stand Still,” Harvard Business Review, volume 76, March–April 1998, pp. 59–69.

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