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MANAGERtAL AND DECISION ECONOMICS Di'ci.s. Eton. 24: 245-251 (2003)

Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.I002/mde.l 127

The Emergent Knowledge-Based Theory Of Competitive Advantage:

An Evolutionary Approach To Integrating Economics And Management

Russell W. Coff*

Emory University. Allanui, Georgia, USA

This article explores the intersection of management and economics in the strategic managemenl literature. Specifically, it examines knowledge-based advantages from manage- ment and economics perspectives to highlight differences in explanations of: (1) the source of an advantage, (2) determinants of sustainabilitv of an advantage, and (3) the factors that predict rent appropriation patterns from a competitive advantage.

[ conclude that both pi-rspectives contribute to our understanding of why firms perform differently. Furthermore, the gradual or evolutionary integration that has occurred over time is effective and efficient for exploring the nature of strategic management problems. Finally, the dvnaniic competitive and technological environment will continue to yield new opportunities for integration of theoretical approaches. Copyright i 2003 John Wiley & Sons, Ltd.

INTRODUCTION

Economics and management come together at a fairly narrow question reflecting the domain of strategy. "Why do some firms perform better than others?' (Rumelt ei al., 1991). This is depicted in the 'football" shape in the center of Figure I. These fields also address other questions but the point of intersection is v̂ -ell defined.

The overarching question in this volume is whether the economics and strategic management literatures can and should be integrated. This essay speeifically explores the portion of the intersection dealing with the role of knowledge in performance ditTerentials. Both fields explain performance differentials using a mix of ap- proaches linked to knowledge or information asymmetries. Over time, economic perspectives on these issues have been gradually integrated into

'Correspondence to: Goizuelii Business School. Emory Uni- versity. \M)Q Cliflon Road, Ailanta, Georgia 30322. USA. E-mail: Russ...Coff«( hus.emorv.edu

the strategic management literature (Mahoney and Pandian, 1992). Accordingly. I argue that the integratioti of economics and strategic manage- ment has been an evolutionary process.

In describing the integration and compatibility of the tools. I explore three aspects of performanee differentials: rent generation, sustainability. and appropriabiltty. First, we must determine how and why a given firm might have a competitive advantage over others. Seeond. we must understand and predict how long such an advantage will persist. Finally, we need to know who reaps the gains produced by the advantage.

Indeed, we eannot prediet variation in firm performance without understanding all three of these components—^they are at the very eore of the strategic management literature. Therefore, this exereise will explore the contributions of economic and management theory to enhancing our under- standing in eaeh of these ureas.

Table 1 presents some selected tools from each area as they apply to the problem of

246 R.W. COFF

knowledge-based competitive advantages. The tools are arrayed according lo the key element of strategy it addresses. The next three sections explore the tools ihal can be brought lo bear on each ol' these questions. How can these tools inform us to advance our study of the nature and

sources of competitive advantage? Ultimately, these approaches have very different implications for the role of management in building a competitive advantage. These implications are examined in the eoncludina section.

Figure I. Where knowledge, economics, management and strategy intersect.

THE ROLE OF KNOWLEDGE rN RENT GENERATION

The strategy literature has borrowed liberally from economics to define the term rent as a key outcome variable, indeed the forms of rent {Ricardian rents, quasi rents, etc.) described in the economics literature are primary sources of rent generation discussed in the strategy literature. That said. nature and sources of rent do differ somewhat in the literatures.

Management and Knowledge-based Advantages

The strategic literature has focused fairly heavily on the role of unique tirm-lcvel resources as a

Table I. Predicting Performance from Know led f̂ e-based Assets: Selected^ Tools from Economics and Management

i: lools Management lools

What are the snurci-s of c<)inpi'titi\L'

Tninsaction cosi economics ;iiui agency theory iitiaiyze the rirms etlkiency with respect to opportunism and asymmclric information.

Game [hoorciic lools analy/e/predict rivalry and competitor actions in the conle\l of impertecl inlormalion.

Retil opiions apply financial econotnics tools U) strategic investments in a volatile and uncertain environment. 5 forces and SCP frameworks help to

analyze industry structure ;md identify opportunities or niches.

The rfSDurce-basod view Ibeuses on unique capabililies thai may alk»w a firm lo oiitperiorm rivals.

Knowledge-based view foeuses on efficiencies in knowledge creation as a determinant of the lirm's scope.

Structural contingency theory identifies factors (icchnology. environment, etc.) that determine the efficacy of alicrnative organizational forms.

Strategic posiiioning (generic strategies, strategic groups, etc) may afford compeiitive protection.

What makes an adtantaf>e sustainable?

Regimes of appropriabillty (patents, trademarks, elc.) may protect intellectual properly. Barriers to entry and monopoly power

may keep competitors out.

Resource-based view identifies striitegic assets as rare, inimitable, and unavailable to rival firms.

The knowledge literature focuses on impediments lo Iransferring knowledge and capabilities.

Who gets the rent that is generated?

Agency and TCE theories suggest that bargaining power stems from asset specificity, monitoring cosis. incentives, and ownership structure.

Bargaining power among buyers and suppliers is inhcrcnl in the tnarket slruclure.

Bargaining power arises from ihe ability to form coalitions, unique information, and switching costs.

Network structures within and outside of the firm grant individuals political and social power.

' Shaded are only peripherally related lo analyzing compeiitive advantages arising from know ledge-based assets

THE EMERGENT KNOWLEDGE-BASED THEORY 247

source of rent (Barney. 1986: Amit and Schoe- maker. 1993; Peteraf. 1994). Firms may acquire and or develop capabilities that grant them advantages over rivals. Porter (1980, 1996) re- minds us that these eapabilities must be embedded in a unique strategic position.

Put another way. the capabilities are valuable because they give the firm a lower cost structure or a basis of differentiation (Porter, I9S()). A cost advantage might result from an efficient structure or operational system. For example, both struc- ttiral contingency theory and transaction cost economics posii ihat organizational fortii follow from specific attributes of the technology or production system. If a firm is able to identify and adopt a particularly efficient form, it might enjoy a cost advantage. A differentiation advan- tage arises from similar logic. However, in this case, the structure or form grants the firm a capability for which customers are willing to pay a premium.

Knowledge is an important component of valuable capabilities or resources. That is. valuable organisational capabilities are increasingly the result of knowledge creation or recombination (Kogut and Zander. 1992). Real advances in productivity often arise from new technologies that enhance or assist knowledge creation and management.

Accordingly, the tliorny problem of knowledge management is an important part of rent genera- tion. Here, much of the knowledge munagement literature focuses on the difficulties in creating and transferring knowledge (Kogut and Zander. 1992; Nonaka, 1994). Even the older structural con- tingency theory focused on technology as a key determinant of structure beeause of the manage- ment challenges associated with knowledge. If a given firm can deploy these resources more efficiently and effectively than rivuls. it may achieve a substantial advantage.

This brings us to assumptions about managerial cognition. The presumption of bounded rationality is itt the very core of the tnanagement literature. Absent this limitation, most management problems would not exist. Arguably, a sustainable competi- tive advantage simply could not exist if managers were perfectly raiioncd. Indeed, the notion of causal ambiguity presumes managers are boundedly rational. Thus, from this perspective, the focus is on acquiring and developing knowledge-based capabilities that rival firms lack.

Economics and Knowledge-based Performance Differentials

Much of the economics literature assumes a high degree of" rationality (e.g.. no limits on cognitive ability) that stands in stark contrast with the knowledge-management literature. However, the portion of economics that intersects with strategic managetnent (notably transaetion cost economies, agency theory, and hiunan capital theory) expli- citly assumes bounded rationality. Even game theoretic analyses explore issues oi^ imperfect or asymmetric information (thus relaxing the as- sumption oi rationality). Recent interest in real options theory reflects awareness that manage- ment tiiay have very limited information in a turbulent or volatile environment. The too! is designed to facilitate investments in technologies that will ultimately yield an advantage (Kogut. 1991).

Thus, from an economic standpoint, cotiipeti- tive advantages arise fVom management's ability to: (I) make competitive moves that rivals eannot respond to efTectively. (2) acquire and manage human capital in imperfect tiiarkets. (3) design the most efficient production process, and (4) develop technologies that position the firm well in a turbulent environment.

Integrating Perspectives on Rent Generation

Interestingly, all of the economic tools relevant to competitive advantage described above reflect organizational responses to bounded rationality. imperfect information, and opportunism. These same assumptions pervade the management litera- ture. In this way. the economic assumptions about rent getieration are inherently compatible with those in the management literature.

However, the literatures do ofl'er different explanations and pre.scriptions. First, if we exam- ine the approaches to strategizing. we see that economic approaches involve estimating payolTs that rivals would face in order to predict their response to the firm's actions. In contrast, management approaches focus on acquiring and managing valuable, rare and inimitable resources. There is no clear reason why combining these approaches would not yield greater insight and likelihood of generating an advantage.

Similarly. the approaches to efficiency are different but complementary. Agency and

248 R.W. COFF

transaction eost economics involve selecting in- centives, monitoring, and ownership structures in accordance with asset speeificity and the nature of the transaction. The management literature ex- plores efficiencies in knowledge creation and the management of technology associated with differ- ent organizational forms. Again, these approaches are clearly complementary and can be pursued in concert. Over time, these approaches have been integrated into the strategic management literature to de\elop a fairly rich theory of rent generation.

causally ambiguous in that managers cannot identify and confirm a causal link between the assets and the firm's performance (Lippman and Rumrnelt. 1982). Again, the knowledge manage- ment dilemmas prove to be fortuitous as they prevent rivals from eroding the advantage.

An underlying assumption here is that an advantage can be preserved to a greater extent if it is tacit in nature. For example, socially complex or causally ambiguous knowledge is especially diflicult to convey. This fact prevents rivals from obtaining it and thereby eroding the advantage.

KNOWLEDGE AND SUSTAINABILITY OF ADVANTAGES

The durability of an advantage is the seeotid critical question in studying and evaluating com- petitive advantage. In many ways, the strategy literature has foeused primarily on advantages that could be maintained over time as opposed to a temporary gain that will be lost in the next battle. Both the management and strategy literatures offer approaches and explanations for why an advan- tage might be more or less durable. While these approaches are somewhat different, they are compatible. The management literature identifies the attributes of knowledge that hinder knowledge transfer and therefore imitation. In contrast. economics approaches tend to focus on the structure of the industry or intellectual property rights.

Management and Knowledge as a Barrier to Imitation

From a strategic management standpoint, the management challenges embodied in knowledge- based assets are aetually fortuitous. The laek of a competitive factor market is perhaps the most critical explanation of why knowledge-based assets are a source of sustained advantage {Barney. 1986). Such assets cannot be traded easily because they tend to be firm-specific and/or socially complex (Barney, 1991). The lack of a competitive market means that rivals eannot acquire the resource even onee it is clear that it may lead to rent generation.

A seeond source of sustainability may be that rivals cannot figure out what resources are critical. In some eases, knowledge-based assets may be

ECONOMICS AND REGIMES OE APPROPRIABILITY

Most of the economic tools focused on sustain- ability focus on the industry structure. This is tangentially related to knowledge because the nature and dispersion of knowledge in an industry may determine the degree of differentiation among firms and/or the fragmentation of the industry.

While, the industry structure literature tends not to focus much on knowledge it is clear that knowledge or technology can form the basis of a barrier to entry. A firm might have a first mover advantage on a given teehnology and maintain that advantage over time if the conditions are right.

Indeed, the economics literature does focus some attention on the institutional environment that might allow a knowledge-based advantage to endure. Specifically. (Teeee. 1988) describes how regimes of appropriability determine whether an advantage can be sustained. He refers to patent and intellectual property protection that may be associated with the institutional environment as well as the nature of the knowledge itself.

Interestingly, these processes are related to the knowledge management literature in some inter- esting ways. In order to achieve patent protection, the knowledge must be fully and completely codified so rivals cannot use the knowledge. If the knowledge is only partially codified, rivals may find ways to use the knowledge without violating the patent. Thus, regimes of appropriability can provide protection for knowledge that is explicit and codifiable whereas, the knowledge literature focuses on protection due to tacit knowledge.

THE EMERGENT KNOWLEDGE-BASED THEORY 249

integrating Perspectives on Sustainability

Both economics and tnanagement identify tacit- ness as a source of sustainability. However, the economics literature also involves the study of institutional and regulatory means to preserve intellectual property. Thus, it is possible to sustain an advantage from codified or explicit knowledge as well. The management literature also oflers other sources of sustainability such as firm specificity, social complexity, and causal ambigu- ity. Clearly the strategy literature would do well to focus on all of these sources of sustainability.

KNOWLEDGE AND RENT APPROPRIATION

The third and final question is that of who gels the rent once it is generated. This is critical because virtually all measures of firm performance measure some residual after one or more classes of stakeholders have already appropriated their por- tion of the tent. As such, measures of firm performance are not independent of who gets the rent. While both the economics and management literatures have something to offer, this last question is under-researched from all perspectives.

Economies and Rent Appropriation

Since the term rent appropriation arises fVom the economics literature, it is clear that this question stetns more from that line of inquiry. The industry structure, agency, and transaetion cost economics literatures especially ofl'er much in this respect.

The industry structure literature offers a per- spective on rent appropriation within an industry as opposed to within the firm (Porter, 1980). Here, buyers and suppliers may be able to bargain away rents depending on their degree of bargaining power. For example, rents may flow outside of the firm if buyers or suppliers are able to exercise monopoly power. While this is not directly linked to knowledge-based assets, there are indirect links between bargaining power and knowledge. For example, suppliers may have power based on the lack of alternatives for their services. Still, this does not address rent appropriation within the firm.

In contrast, agency theory focuses on manage- rial rent-seeking behavior that may be against the interests of shareholders (Jensen and Mecklinu,

1976). This might include a variety of actions from direct appropriation such as compensation to altering the firm's strategie direction to suit management preferences. In these ways, rent arising from a eompetitive advantage might be diverted away from .shareholders so it is difficult to observe in measures of firm performance (Coff. 1999).

In general, the agency literature focuses on the incentives and degree of monitoring that are appropriate to minimize agency costs. The general a.ssumption is that if agency costs are minimized, more rent will fiow to shareholders and thus the firm will exhibit greater performance. It is worth noting that the risk of agency problems is greater when there is asymmetric information (e.g., like that associated with knowledge). This raises tnonitoring costs and provides opportunities for agents to act opportunistically using information that is not available to others (in particular the principal).

The transaction cost economics literature olTers a similar perspective in that individuals are assumed to act opportunistically to appropriate rents where possible (Williamson, 1975). In parti- eular. this literature seeks to answer the question of how a given transaetion should be governed and, in particular, who should own the critical assets. The focus here is primarily on transaetion specific rent-producing investments. For example, the choice of whether or not to vertically integrate the firm may be determined by the extent to which a supplier will be able to hold up the firm and thereby appropriate rent (Klein et ul.. 1978).

Thus, the transaetion cost economics posits that the risk of rent appropriation increases with asset specificity and information asymmetries. The often-prescribed remedy is some form of owner- ship so that some other owner of the asset cannot hold up the firm. The assumption is that if the firm adopts eflkient governance structures, it will exhibit stronger performanee.

Interestingly, the situations which agency theory and transaction cost economics apply the greatest are those involving firm specific assets and information asymmetries. IndveiL this is precisely ihe seiiiiii^ thai is associated with knowledge-based assets. As such, these tools are particularly useful for predicting rent appropriation arising from a knowledge-based advantage. Nevertheless, some management scholars criticize the economics

250 R.W. COFF

literature as focusing only on problems of appor- tunism (Connor and Prahahid, 1996).

Management and Rent Appropriation

Ironically, the vast majority of the management literature also views individual motivation as an outcome of self-interest (Vroom. 1964). Thus, the assumptions about motivation are quite compa- tible across these two domains for the most part. Admittedly, the foeus in the strategic management literature has not been on problems of opportu- nism in the way that this topic has proliferated the economics literature.

That said, rent appropriation is an area that must be dominated by assumptions of self-interest, if not opportunism. The management literature does otfer some dillerent frameworks to prediet rent appropriation. First the bargaining power and negotiation literattires identify power as stemming from: the ability to form coalitions, access to information, and switching or hold up costs that each party would experience (Hickson ci ul.. 1971).

We ean use these determinants to prediet that knowledge-based assets influence the ability to form eoalitions, aeeess to inft>rmation and the switching eosts that eaeh side might experience. Thus this existing framework is very applicable to predicting rent-appropriation in the context of knowledge-based assets (CotT, 1999).

Integrating PL-rspectivcs on Rent Appropriatifin

Like the other aspects of performance economics and management otTer complementary but distinct perspectives on rent appropriatioti. Much of the economics literature that addresses rent appro- priation foeuses on bargaining power that might arise from asset ownership, asset speciticity.. monitoring eosts. and incentives.

In contrast, the management literature explores the implications of coalition formation, imiqtie information, switehing or exit eosts. network structure, and political power. Again, we can gain better explanatory power using models that integrate these sources of bargaining power thati relying on one approach or (he other.

The underlying assumptions behind eeonomie and management analyses are quite similar and compatible for the most part. Both rest on the assumptions of bounded rationality and asym- metric information. In addition, both traditions

assume that individuals will act to appropriate rent if it is within their power to do so.

That said, the management literature has ioeuscd primarily on rent generation and how It is driven by bounded rationality. In contrast economies literature has focused much more on rent appropriation and how it is driven by problems of opportimism.

Given the importance of knowledge in exploring firm performance diflerentials. it is clear that prob- lems arising both from opportunism and bounded rationality mtist be considered. One eannot explore rent production without studying rent appropriation as well. The later absolutely requires an assumption of opportunism even If the former does not. In this way, it is clear that both approaches are necessary and should bo applied in eoncert.

DISCLSSION AND CONCLUSION

Throughout this essay. I have made assumptions about what is iiiaihigcnwnf and what is economics. However, many of the insights in the management literature have benefited greatly from the interac- tion with economics. In some cases it is hard to identify where a given insight belongs—the line is arbitrarily drawn (Mahoney and Pandian, 1992). Acciirdingiy, it should be apparent to the reader that a great deal of integration has already laken place. The real question is whether further integralion is desirable and/or needed.

The management toolbox is replete with tools at varying degrees of sophistication and develop- ment—many of which actually represent compet- ing perspectives or theories. This diverse toolbox stems, in part, from the mtilti-disciplinary nature of the capstone requirement from which strategy emerged.

In contrast, most of the tools of economics are well developed and well grounded. Indeed, the diversity of management paradigms may hinder coordination in the development of theory and empirical tests. At a minimum, it requires the mastery of multiple languages of inquiry. For this reason, some suggest that management eould be advanced most by adopting some common theo- retical ground or, as it has come to be known. •Pfefferdigm' (Pfeirer, 1993).

However, the diversity of tools and perspectives adds to our explanatory power. If we view our

THE EMERGENT KNOWLEDGE-BASED THEORY 251

predictive power as a function of the tools provided, it is easy to see that adding a tool (management or economics) adds lo our model —the R'^ goes up. However, to extend the metaphor, we must look at the adjusted R' and the incremental improvement in the model's fit. In other words, does each approach add sufficiently to our predictive abilities to justify the degrees of freedom used?

Again, as (Pfeffer. 1993) argued, we need to he aware of the costs as well as the benefits associated with the diversity of perspectives. This article has outlined some of the similarities and difTerences in the approaches to strategic management. It should seem clear that economics and other management disciplines contribute to our understanding of competitive advantage and (irm performance.

Indeed, I would argue that the benefits outweigh the degrees of freedom lost through the lack of paradigmatic clarity. For example, the continued discourse and interaction has lead to the reeent application oC real options theory. This tool promises to help explain competitive advantage in very dynamic or volatile environments.

I would characterize this as theoretical develop- ment in response to a changmg landscape. Such changes in the competitive and technological environment continue to pose ehallenges lor theories. Accordingly, the tnost constructive and conservative approach is to nurture variation so we have aeeess to a full toolbox when new theoretieal problems arise.

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