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R&D AND THE FIRM

Pier Paolo Saviotti

Published in Handbook of the Economics and Theory of the Firm, Dietrich M. Krafft J.(Eds) , pp. 405-

423, Cheltenham, Edward Elgar (2012)

INTRODUCTION

In this chapter we are going to discuss the relationship between R&D and the firm on the basis of

three components. First, R&D is anew activity which emerged in the economic system towards the

end of the XIXth century. Since that time a growing number of firms, especially large ones, have

adopted R&D as one of their internal functions. Second, starting from the industrial revolution the

firm has been undergoing very profound transformations. Thus, the type of firms which use R&D and

the uses which they make of it have not been constant but have been changing in the course of time.

Third, during the XXth century and until the present the theories of the firm that economists have

created underwent changes at least as important as the firms themselves. In this chapter the

emergence of R&D as a new function and the evolution of the firm , including the internalization of

R&D, are going to be discussed as a background to the analysis of the theories of the firm that

economists have developed in the course of time.

2) THE EMERGENCE OF R&D AS A NEW ECONOMIC ACTIVITY

2.1) TECHNOLOGY AND THE FIRM

Organizations constituted by a group of people and operating to achieve objectives which were at

least partly economic have existed for a very long time. Antecedents of such organizations can even

be located at roman times (Rosenberg, Birdzell, 1986). Important examples of such organizations are

the medieval guilds and the chartered corporations, such as the East India Company. However, these

organizations differed from the modern corporation in that they required a special permission to

operate, or sometimes a monopoly, issued by the state (Ibid). The concept of a corporation which

could be formed by a group of individuals to trade or to manufacture and which could hold property

rights, act as moral person and accept liability, as opposed to its individual members only emerged in

the second half of the XIXth century, mostly in the UK and in the USA (ibid). It is probably no

coincidence that such joint stock corporations became a permissible legal form during the second

part of the industrial revolution when they represented the most appropriate form to exploit the

productive potential such revolution had unlocked.

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The evolution of the modern firm is in many ways closely linked to technological evolution. Before

the industrial revolution the scale of most manufacturing firms was small and essentially based. For

example, the textile industry was dominated by the so called cottage industry (Ref). The large

machines and the consequent capital requirements of the factory system started the growth in size

of the manufacturing firms (Marx), growth which was to accelerate considerably towards the end of

the XIXth century (Chandler1962, 1977; Hannah, 1976). Such further spurt of growth in firm size was

due to a combination of new technologies and of the resultant process of market expansion. The

new technologies which contributed to the emergence of large corporations were of two types: first,

there were the new technologies which led to the creation of new sectors, thus providing new

productive opportunities. Examples of these could be found in the chemical and electrical industries.

Second, other technologies were enabling in the sense that they allows the transport and

communication required for the geographical enlargement of markets. Examples of such

technologies were the railways, refrigeration and the telegraph. According to Chandler (1977, pp

287-289) the modern corporation was created by the integration of mass production with mass

distribution.

Thus, technology has shaped and accompanied the evolution of the modern firm since the industrial

revolution. However, the mechanisms whereby technology affected industry and the firm changed

substantially with the institutionalization of R&D.

2.2) THE INSTITUTIONALIZATION OF R&D

Today R&D is a common function of both modern economic systems and of most manufacturing

firms, at least in developed countries and, even in developing and emerging countries a growing

percentage of firms do some R&D. However, R&D as an independent economic function is little more

than a hundred years old. We could say that R&D is the result of an increasing division of labour,

influenced partly by the growing utilization of science in industry during the XIXth century and partly

by the considerable enlargement of markets that such utilization of science indirectly contributed to.

R&D is a result of an increasing division of labor in the sense that although both learning and

knowledge had always been part of human activities, in previous times learning had generally been

obtained as a joint product of production activities. Using a modern terminology, before R&D

activities existed learning had occurred by 'learning by doing'. The institutionalization of R&D gave

rise to a separation of learning activities from production activities. We could say that R&D differed

from learning by doing because it was learning by not doing. In this sense Freeman and Soete (1997)

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are right when they consider that the emergence of R&D was a true revolution fundamentally

changing modern industry.

The word revolution implies that R&D was a complete break with respect to past trends. Of course,

scientific activities had previously existed, but their volume was extremely low with respect to even

that of R&D in the late XIXth century. Furthermore, until the second half of the century the evolution

of technology tended to be separate from that of science. Technologies themselves were called the

industrial arts. During the XIXth century, and even before large R&D laboratories were created,

science started to exert a growing influence on technology. Historians differ as to the extent of such

influence. For example, although most historians would probably agree that innovations in some

industries (textiles, steam engine, railways, steel etc) fundamentally contributed to the industrial

revolution , there is still disagreement about the extent to which such innovations were affected by

science (see Landes 1969; Hobsbawm, 1968; Musson, Robinson1969; Mokyr, 1990, 2010; Lipsey,

Carlaw, Beckar, 2005). While it seems that science started having some effect on industry during the

industrial revolution such effect could not be measured by R&D expenditures or by the citation of

scientific work by patents. The institutionalization of R&D had to wait until the end of the XIXth

century.

Two very important events marked the beginning of the institutionalization of R&D. First, around the

mid XIX the century the German, or von Humboldt, university system for the first time combined

systematically higher education and research (ref). Second, during the second half of the XIX the

century some firms, mostly in Germany and the USA, stated to create their own internal R&D

laboratories (Murmann, 2004, Mowery, Rosenberg,1989, Freeman, Soete, 1997 ). The German

University system was later largely imitated and improved upon. The adoption of R&D by firms

proceeded rapidly, but it is only after the second world war that R&D became a systematic

component of both the economic system and of firms in developed countries ( Mowery, Rosenberg,

1989, Freeman, Soete, 1997).

Two very questions can be raised t this point: first, why did the internalization of R&D occur at this

particular moment? and second, why was R&D internalized in vertically integrated corporations

rather than being produced in specialized research institutions? A tentative answer to the first

question could be that only at this moment science had made enough progress to be applied to

systematically to industry. This answer is subject to many caveats. It is undoubtedly true that the

progress of disciplines like chemistry and physics had been particularly fast in the period between the

end of the XXth century and the beginning of the XXth century. However, it is clear that the

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relationship between science and technology had not been then and did not become subsequently

one of passive application of science to technology. On the contrary, especially during the early part

of the XIXth century the role of science tended to be mainly concentrated on support activities like

chemical analysis, or in general and often ex-post rationalization of processes which had been

developed empirically. Important examples are the use of chemical analysis in the selection of iron

ores in steel making (Mowery, Rosenberg, 1989) and the development of thermodynamics following

the progress of the steam engine. The contribution of academic research to development of the

German chemical industry was probably the an exceptional case, and it was largely due not only to

the organization science but to the co-evolution of scientific institutions, of intellectual property

rights and of political institutions (Murmann, 2004). Furthermore, Layton (1974) and Vincenti (1990)

have shown the technology creates knowledge in a form different from that of science.

The second question was related to the organization of industrial R&D. In principle three modes of

organization could have expected to occur: fist, industrial R&D could have been carried out in

academic institutions; second, it could have been located specialized firms or research organizations;

third, it could have been done in large, vertically integrated corporations. Although examples of all

three types of organization existed; by far the most common form of internalization of industrial R&D

was the internalization in large, vertically integrated corporations. In this sense the

institutionalization of industrial R&D proceeded in parallel with the emergence of the large

corporation.

The reasons for the dominance of this form of organization of industrial R&D can be found in the

particular features of knowledge as a product of human activities. Knowledge is an at least partly

public good in the sense that (i) a given piece of knowledge can be reused indefinitely without being

consumed and that (ii) it is difficult to prevent agents who have not paid for the creation of a given

piece of knowledge from using it. In this sense , internalization into large, vertically integrated

corporations would have largely reduced the risk that knowledge created by a specialized

organization external to the corporation could be equally available to its competitors. The

internalization into large corporations was the dominant form of organization industrial R&D from

the end of the XIXth century until the 1970s.

Starting from the 1970s a process of vertical disintegration, or externalization, of R&D started to be

observed (Langlois, 2004). This process occurred in the form of inter-firm technological alliances,

sometimes described as innovation networks (see for example Freeman (1991), Hagedoorn (1993,

1995), Saxenian (1991), Mowery (1989), Powell, Koput, Smith Doerr (1996), Hakansson (1987), Callon

et al (1991)). This phenomenon seemed to be a reversal of the previous trend and it part of the

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evidence used by Langlois (2004) to argue that Chandler's visible hand was vanishing. This does not

seem to be happening (Dosi et al, 2007). However, in a number of knowledge intensive sectors high

tech start ups and innovation networks have become a new form of industrial organization in

addition to large, vertically integrated corporations. The precise reasons for this transition are related

both to the dynamics of knowledge and to and to the evolution of industrial organization. The

general evolution of the firm will be discussed in greater detail in the next section.

During the period 1950-1990 there has been a change described by Das Gupta and David (1994) as

the transition between the old and the new economics of science. The old economics of science

(Nelson, 1959; Arrow, 1962) insisted on the public character of science and in particular on its lack of

appropriability. Such public good features would have resulted in the social organization of

knowledge production. For example, in most circumstances highly risky fundamental research was

likely to be carried out in public research organizations (PRO) while firms and private research

organizations would focus on more applied and less risky research. Furthermore, IPRs needed to be

designed to protect the interests of the inventor by granting him/her a temporary monopoly as an

inducement to innovate. Also, in these conditions the internalization of R&D in corporations seemed

eminently sensible as a way of limiting the possible leakages of knowledge outside the boundaries of

the firm.

The new economics of knowledge differed from the old one by stressing not only the influence of the

properties of knowledge but also that of the social organization of knowledge production. Thus,

amongst other differences, the new economics of science differed from the old one as to the cost of

imitating a given piece of knowledge relative to that of creating it. The basis for the existence of

patents is the need to compensate for the relative cheapness of imitation by awarding the inventor a

temporary monopoly. However, as Cohen and Levinthal (1989) pointed out, imitation of a given

technology requires carrying out R&D in the same technology in order to create the required

absorption capacity. To the extent that the cost of creating the required absorption capacity

becomes comparable to that of innovating knowledge turns out to be much less public than it was

previously thought, thus substantially undermining the case for IPRs .

The recognition the importance of spillovers was another important development which took place

in the 1980s . Although the involuntary character of spillovers can be rather doubtful, the large

amounts of knowledge above the one internally created by a corporation can exert a powerful

impact on the economic system at different levels of aggregation. At the macroeconomic level

spillovers are the externalities resulting from increasing returns to knowledge generation that can

account for the long run continuation of growth (Romer, 1990). At the level of the firm spillovers pass

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from being an expression of waste in knowledge production that of being a powerful resource which

enhances the collective performance of industries and economies.

Another change which is likely to have an important impact of the firm and on industrial

organization is the rate of knowledge production and utilization. According to Agarwal and Gort

(2001) the average delay between the creation of a new idea and its industrial utilization fell from 39

years at the end of the XIXth century to 3 years at the end of the XXth century. This increased rate of

utilization is likely to have stretched the capabilities of incumbent large firms to learn, thus favoring

the emergence of high tech start ups and of innovation networks.

3) THE EVOLUTION OF THE FIRM

Until the industrial revolution most firms were small. Some large organizations existed (for example

the East India Company) but they were the exception rather than the rule. Furthermore, until the

mid XIXthe century the creation of an organization which could carry out the type of functions which

are nowadays carried out by corporations required the permission of the state (Rosenberg,

Birdzell,1986). Only in the second half of the XIXth century western countries started to confer the

legal status of persons on groups formed for economic purposes without requiring an act of

legislature or other political authority (ibid, p. 207). Thus, the modern its origin to a legal change.

However, it seems unlikely that this legal change occurred when it did just by chance. As it has

already been pointed out, the emergence of railways, of the telegraph and of refrigeration

technology enabled the creation of large corporations which could serve customers in very distant

and scattered markets. The legal change itself cannot be considered the cause of the emergence of

the large corporation but one of the factors that contributed to it. The changes in technology which

started occurring from the beginning of the industrial revolution provided a potential for the

creation of new firms which could not have been realized unless an adequate legal framework was

established. Thus, neither legal changes nor changes in technology can be interpreted as the cause

of the emergence of large corporations. Rather, these two factors have been co-evolving in the

sense that changes in technology induced the establishment of a new type of institution. In a more

general sense it is clear that the modern firm could not have emerged the way it did without the

changes in technology which took place since the industrial revolution.

Until the industrial revolution the organization of the textile industry, the first modern industry was

described as a 'cottage industry', in which textile merchants would take fibers (cotton, wool etc) or

cloth to the houses of the spinners or weavers and pick up later the output. This organizational form

lasted until the early years of the industrial revolution when it was gradually replaced by the factory

system. Such a system consisted of large purpose built buildings containing not just workers but very

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large machines, which greatly enhanced the efficiency of production. While not yet reaching the size

of today industrial firms those of the factory system were systematically larger than those which had

preceded them. Thus, the first systematic enlargement of the firm and its distinction from handicraft

production began during the industrial revolution in the UK. The emergence of the factory system

coincided with that of capitalism. As the new capital goods became larger and more powerful they

required a much greater investment and gave rise to the class of the capitalists. The emergence of

the capitalist economy was brilliantly analyzed by Marx in The Capital. Thus, the first systematic

enlargement of the firm was partly driven by changes in technology, the innovations of the industrial

revolution, accompanied by changes in legal and financial institutions which allowed the increased

investment required during the industrial revolution to be made.

In spite of their increased size, the firms of the industrial revolution were still small with respect to

today's ones. A further spurt of growth in firm size came from a combination of new technologies

and of enlarged market sizes. The fist example of this new period of firm growth began in the United

States towards the end of the XIXth century. The main technologies which contributed to this

development were the railways, the telegraph and refrigeration technology (Chandler, 1962).

Railways allowed goods to be transported over very large distances covering even a country of the

size of the USA. The telegraph allowed the different points of shipping and of arrival of the goods to

be coordinated. These technologies allowed the creation of large corporations having many offices

and factories scattered over very large geographical areas. Refrigeration technology allowed the

transport of perishable goods, such as meat, over very long distances, thus increasing the number of

sectors in which large corporations could be created. This development was not unique to the USA,

but occurred, although more gradually, in other countries, such as Britain and Germany. Large

corporations similar to those existing today stated to be created then. Of course, not all the firms

became big. Many small firms continued to exist and were numerically dominant but they were

secondary characters in the corporate economy. This type of industrial organization dominated most

developed economic systems between the end of the XIXth century and the 1970s.

As Alfred Chandler, perhaps the greatest interpreter of the corporate economy, pointed out

increased firm size could not occur without adequate organizational changes (1962, 1977). The large

corporation was not simply a larger version of the previous firms but a large firm organized according

to very different principles. In his early work (1962) Chandler used the concepts of strategy and

structure to interpret the evolution of large corporations. He defined strategy as the set of broad

objectives of the corporation and structure as the corporation's internal organization. According to

Chandler the strategy defined the prevailing structure. The first type of corporation to emerge, the

multifunctional or U form, was characterized by having many functional divisions, each

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corresponding to a function, such as finance, production, sales etc. In other words, the firm

organization could not remain flat as its size increased by orders of magnitude. A form of division of

labor had to be introduced not only at the individual level but also at that of the corporation as a

whole. Thus, there was a division of labor with different divisions corresponding to different

functions, but also a hierarchical structure at the top of which was the general office. The general

office not only coordinated the activities of divisions of the firm but it carried out the new function of

planning. In other words, the general office not only provided the coordination of existing activities,

but tried to anticipate future evolutions and the possible adaptations or creation of new activities

required.

As the economy grew during the XXth century and as standards of living improved markets for higher

quality and more differentiated goods and services provided firms with new profit and the

opportunities. Both the strategy and the structure of the firm needed to change accordingly. This

change in the economic environment induced the transition from the multifunctional to the

multidivisional or M form corporation. In this new structure each division was responsible for a

different product or market. Thus, a change in the economic environment induced a change of

strategy, which in turn entailed a change in structure. Of course, the concept of strategy is here to

be interpreted in a very general way, such as pursuing market growth in a series of relatively

homogenized markets or shifting to more highly differentiated markets.

The emergence of the corporate economy was held by Chandler (1977) to have substantially changed

the mechanisms of the capitalist economy by replacing Adam Smith's invisible hand with the visible

hand of the large corporation.

As we have previously seen, the largely increased size of the corporation and the consequent

organizational changes were, at least in part, induced by new technology. It is to be observed that

both in the USA (Chandler, 1962) and in the UK (Hannah, 1976) the multifunctional form was

pioneered by the railways, probably the first industry to attain a very large firm size. However, not

only the corporate economy shaped and was shaped in a co-evolutionary pattern by new

technologies, but it also had a fundamental influence on the institutionalization of R&D. Given the

considerable progress in science which occurred in the XIXth century three options were in principle

possible for the organization of R&D. First, R&D could have been carried out in universities or in

research institutes; second, it could have been carried out in organizations specializing in R&D; third,

it could have been internalized into large firms. Although all these forms were used to a certain

extent the first and the third became dominant, but they were not carrying out the same type of

research. Typically universities and research institutes performed fundamental research while

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industrial firms performed applied research. A number of firms specialized in R&D existed at all

times, but they declined as a percentage of total R&D activity in the course of the XXthy century

(Mowery, Rosenberg, 1989).

A number of studies have been carried out of the firms which pioneered the R&D function. Du Pont,

General electric, Bayer etc were amongst the first firms to establish internal R&D laboratories. in

these firms the problems which would have been recurrent in R&D management started to present

themselves. For example, the location and nature of research became immediately the subject of

controversy. The temporal horizon of R&D projects as well as the degree of centralization of R&D

labs kept occurring within the history of firms (Hounshell, Smith, 1988; Reich, 1985). In summary,

from the end of the XIXth century to the 1970s the main organizational form of industrial R&D was its

internalization within vertically integrated corporations. The coincidence of the institutionalization of

industrial R&D and of the emergence of the corporate economy did not occur by chance. On the one

hand to establish separate R&D laboratories could be easier in a large firm, especially in presence of

the general office one of the functions of which was to define the firm strategy. On the other hand,

the decision to internalize R &D rather than purchasing it from external suppliers depended on the

nature of knowledge, which would have the results of external R&D equally available to the firm

purchasing it and to its competitors. During the whole period 1900-1970s R&D was predominantly

carried out in universities and research institutes when it was fundamental or in large vertically

integrated corporations when it was applied. This division of labour was later justified by the lack of

appropriability, common to all knowledge, and to higher level of risk inherent in fundamental

research (Nelson, 1959; Arrow, 1962).

During the 1970s a growing trend towards vertical disintegration started to be observed (Langlois,

2004) with examples of large firms externalizing a growing number and percentage of their

functions. This trend did not replace large corporations with small firms or with market relations

(Dosi et al, 2007) but provided opportunities for the entry of a new type of firms, high technology

startups, and significantly changed inter firm relations. Examples of these new organizational

arrangements included the rise of firms like the ill fated ENRON or the emergence of what were

alternatively called technological alliances or innovation networks (see for example Freeman (1991),

Hagedoorn (1993, 1995), Saxenian (1991), Mowery (1989), Powell, Koput, Smith Doerr (1996),

Hakansson (1987), Callon et al (1991)). These were essentially two distinct phenomena, although

they were in different ways related to the mechanisms whereby firms learn and use knowledge.

Some forms of knowledge can be conveniently externalized when they become modular and when

they do not involve core competencies (Prahalad, Hamel, 1990) of the firm. Other types of

knowledge can be so new and disruptive for incumbent firms that internal learning is likely to be

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inferior to alliances with startups highly competent in these types of knowledge. The latter category

is both very different from pre-existing types of inter-firm collaboration and highly dependent on the

dynamics of knowledge. When they first emerged in the 1970s technological alliances were

interpreted by many economists as a temporary phenomenon unlikely to last for a long time. At that

time markets and large hierarchical corporations were considered the only to two stable forms of

industrial organization. However, in some sectors such as ITC and biotechnology, technological

alliances continue to be an important form of industrial organization. This seems to indicate that they

are not a temporary phenomenon but a new form of industrial organization. While in spite of a large

amount of research the dynamics of has not yet been fully understood, it has some clear implications

for the theory of the firm. Inter-firm collaboration can provide a greater increase in performance

than the sum of the individual efforts of isolated firms. The increase in the rate of creation of new

knowledge and in its variety and the presence of knowledge discontinuity are amongst the s possible

causes of this phenomenon.

The collaboration of large diversified firms and of high technology startups in technological alliances

seems to be a combination of the two mechanisms by means of which Schumpeter (1934, 1942)

thought innovations were introduced into the economic system. High technology startups are

typically entrepreneurial while large diversified firms represent the corporations that the late

Schumpeter (Mark 2) thought would have replaced entrepreneurs as innovators and would have

routinized the creation of innovations. Technological alliances are a proof that entrepreneurs have

not disappeared and that innovation cannot be routinized. Both entrepreneurs and large diversified

firms are required to innovate in the present economic system.

3) THE EVOLUTION OF THE THEORIES OF THE FIRM

The previous description gave evidence of what the object firm is and helped to define what should

be the main objectives of a theory of the firm. Greatly simplifying we could summarize these

objectives under four headings:

i) The firm as an organization

ii) Knowledge and the firm

iii) The firm and its external environment

iii) The evolution of the firm

In what follows I will attempt to analyze the way in which the various theories of the firm which were

proposed during the XXth century attempted to clarify these issues or did not do so. For reasons of

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space the following part of the chapter will not be a complete analysis of theories of the firm. Only

selection of theories and authors will be discussed in order to focus attention on how each theory

dealt with the above issues.

The standard neoclassical theory of the firm, which still occupies most of the space in economics

textbooks, does not deal with the firm as an organization. In this theory the firm is treated as if it

were an individual, or a firm point (Coriat, Weinstein, 1995). In the same theory knowledge is

assumed to be perfect. The main objective of this theory is to make it compatible with the theory of

markets and equilibrium (Ibid, Ricketts, 1987). In a sense the standard neoclassical theory of the

firm only takes into account point iii), the adaptation of the firm to its external environment. The

external environment is here extremely simplified by making it constant. The firm's adaptation then

occurs by profit maximization. Of course, no serious analysis of the evolution of the firm would be

possible in this case. The firm can only adapt to changes in prices by moving along a production

function. Any change in knowledge would be completely exogenous to the firm and the firm could

instantaneously and at a zero cost adapt to it by moving to a new production function. Questions

such as 'is the firm is large or small', 'what is its productive specialization', 'how do firms change in

the course of time' find no answer in this theory. Of course, today most economists would agree

that this theory of the firm is far too limited. However, it is interesting that even in very widely used

microeconomics textbooks of the 1990s (see for example Varian, 1992) the word firm was not

present in the index.

3.1) Transaction costs and agency theory

That the firm was an organization and that its role was not simply to complete the theory of markets

and equilibrium became clearly established with the work of Coase first and of Williamson later.

Coase (1937) started raising the basic question 'Why do firms exist?'. His answer was that there are

costs involved in using the market and that, as a consequence, many transactions can be carried out

at a lower cost within firms. The lower cost of such transactions is due to the fact that within the firm

the costly contracts required to cope with market uncertainty are replaced by the less expensive

transactions defined by the internal rules of a hierarchical organization. Coase did not specify the

nature of the transactions but his undoubted merit was to have raised a question to which

economists had been miraculously blind. In fact Marx's analysis of the capitalist firm (Marx in

Putterman 1986; pp.44-60) provided ample evidence that it existed as an organization and that it had

plenty of internal transactions.

The organization of the firm was further articulated by Williamson (1985). He combined Coase's point

of departure with Simon's analysis of the limited rationality of human agents. Simon (1978, 1981)

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criticized the assumption that agents had perfect knowledge and that they could optimize. Even

optimization had been possible in principle the computational cost of it would had been so high as to

make it impossible or not convenient to achieve in most economic situations. As a consequence

agents' rationality could be of two types, substantive or procedural. The former coincided with the

best solution of a problem while the latter was the type of rationality which would determine the

choice of agents with limited computational ability and which depended on their present

circumstances. In view of the above limitations in most situations agents would choose a course of

action which was satisificing as opposed to the optimum. Williamson combines Coase's objective of

defining the firm as the locus of the transactions which could be carried out more effectively there

than in the market with Simon's analysis of human rationality. In fact, for Williamson the limited

rationality of human agents becomes the root cause of the existence of organizations. As a

consequence contracts are inevitably incomplete and the incompleteness of contracts leads to

opportunism. According to Williamson transactions have three dimensions (Williamson 1985; Coriat,

Weinstein, 1995; Milgrom, Roberts, 1992):

Asset specificity

Uncertainty

Frequency

An asset is specific when it is only used in very special applications. This completely changes the

nature of transactions with respect to those occurring in a market where standardized assets are

exchanged between anonymous agents. The importance of asset specificity in Willimason's work is

not related to technological reasons, but to its implications for behavior, when it is combined with

limited rationality, opportunism and uncertainty to induce a durable personal dependence between

the parties involved has been created.

Uncertainty had been stressed by Knight (1921) as the fundamental cause of the existence of the

firm. Coase had accepted the important role played by uncertainty but did not consider it the root

cause of the existence of the firm. Williamson places uncertainty in a very central position in his

theory of transaction costs but clearly states that he focuses mainly on one dimension of uncertainty.

In particular, Williamson stresses that the main type of uncertainty relevant for transaction costs

theory is behavioral. By this he means uncertainty of a strategic kind attributable to opportunism,

arising from the possibility that 'parties make strategic plans in relation to each other that are the

source of ex-ante uncertainty and ex-post surprises' (Williamson, 1985, pp 57-58).

The frequency of a transaction is important because no firm is likely to internalize transactions which

occur very infrequently, especially if they require a specific investment.

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There would have been potential links to innovation and knowledge in Williamson's analysis of

uncertainty but he did not exploit them. For example, both asset specificity and uncertainty could be

expected to vary during the lifetime of a technologies, as in the different phases of a dominant

design (Abernathy, Utterback, 1975) orb of a technological paradigm (Dosi, 1982). We will come

back to these considerations later in this chapter. Here it is worth noting that the lack of emphasis on

knowledge and innovation was not oversight but an explicit objective of Williamson's analysis. In fact

Williamson explains his lack of interest in technology as a compensation for the excessive attention

previously paid to it, an opinion which would certainly have set him apart from evolutionary

economists.

An aspect in which Williamson's work went beyond Coase is the boundaries of the firm. While Coase

(1937) only briefly dealt with the relationship between small and large firms, Williamson raises the

question of the boundaries of the firm. These cannot be considered as fixed but we can expect them

to shift in the course of time as the relative costs of transactions change. However, this more

dynamic aspect of transaction costs was never fully exploited by Williamson. Phenomena like

technological alliances or outsourcing were definitely not within his interest in the early part of his

work. In more recent work he made some gestures towards both acknowledging their existence and

arguing that transaction costs theory could be modified to explain them (1985, p. 83). Even

recognizing this belated interest in new organizational forms Williamson's work was mainly

conceived to explain the existence and the boundaries of firms in the corporate economy when only

the market and firms large and small were the only stable forms of industrial organization. Extensions

of transaction costs theory to technological alliances or to outsourcing are not too difficult to

imagine, but they are unlikely to be developed without taking into account the nature of the

knowledge created and used by firms.

Whatever its limitations transaction costs theory was an important progress in the theory of the firm

focusing on its behavioral and organizational aspects. However, although it had a considerable

following, transaction costs theory was never integrated within the theory of the firm accepted by

the core of the economics of profession. A number of aspects could explain this reluctance to accept

it, amongst which the opposition to the concept of opportunism and the difficulties encountered in

mapping and measuring transaction costs. However, the problem of the firm as an organization

would not simply disappear. Other attempts to explain the existence of the firm and to deal with its

organization more in line with the assumptions of neoclassical theory were developed in the 1970s

and 1980s.

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In a general sense these theories of the firm can be grouped together for two reasons: first, they are

an attempt to generalize micro economic theory to the study of economic institutions preserving the

essential foundations of neoclassical theory; second, they are largely relying on an analysis of

property rights(Coriat, Weinstein, 1995, p. 78). The neoclassical assumptions and methods which are

preserved are:

stable preferences

perfectly rational behavior

an analysis of individual behavior and of the relationships between agents by means of the

equilibrium method

The progress these theories made with respect to standard microeconomics is based on the

introduction of imperfect information, on the existence of information asymmetry amongst agents,

and on the costs of exchange, or of transaction, that follow from such asymmetries (Coriat,

Weinstein, 1995, P. 79).

Alchian and Demsetz (1972) tried to explain the existence of the firm by representing it as a team.

Why would we need to form teams to produce? Because it is difficult or impossible to measure the

performance of individuals within teams. Given this difficulty the team can only be viable if someone

is in charge of measuring and coordinating the activities of the members of the team. The person in

charge of this would become the residual claimant, he/she who has the right to receive any net

income that the firm produces. The net income would be what is left over after all revenues have

been collected, and all debts, expenses and other contractual obligations have been paid (Milgrom

Roberts,1992, p. 291).

Alchian and Demsetz analysis follows from the importance attached to property rights. Property

rights play a fundamental role in economic activities because they induce individuals to create,

conserve and give value to assets. Assets themselves are heterogeneous ad have different

attributes . Thus, they are partitionable, separable and alienable in the sense that different agents

can have different rights on the same asset. The modern firm relies on this idea that property rights

can be partitioned so that several agents can have rights on the same asset (Coriat, Weinstein, 1995,

p. 84). A firm can then be considered a set of contracts which establish a given structure of property

rights (Rickett, 1987). This concept of the firm underlies not only Alchian and Demsetz's approach but

also the agency theory of the firm.

The name of the agency theory of the firm owes its origin to the observation of Berle and Means

(1932) that there can be a conflict between the objectives of the owners and those of the managers

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of the firm. Such conflict does not in general arise from mangers' laziness or incompetence but from

the possibility that they can pursue goals other than maximizing the long run value of the firm

(Milgrom, Roberts, 1992, p.181). Jensen and Meckling (1976) define the agency relationship as 'a

contract under which one or more persons (the principal(s)) engage another person (the agent) to

perform some service on their behalf which involves delegating some decision making authority to

the agent'. Jensen and Meckling maintain that the agency relationship is very general and occurs in

many organizations, not just in firms. The principal can avoid divergences of the agent from his/her

expected behavior by establishing appropriate incentives and by incurring monitoring costs. The

agent, on the other hand, will need to expend resources either to make sure he/she does not harm

the principal or protect him/herself from the principal's claims of wrong behavior (bonding costs).

Furthermore, however perfect the arrangements devised to control and limit the divergence

between the agent's decisions and those decisions which would maximize the welfare of the

principal, some re divergences will remain. This reduction in welfare experienced by the principal can

be called a residual loss. Thus, the agency relationship gives rise to three types of costs:

(i) the monitoring expenditure by the principal

(ii) the bonding expenditure by the agent

(iii) the residual loss

As a consequence of the above and in presence of information which is both limited and

asymmetrically distributed amongst agents, contracts are necessarily incomplete and the principal

does not have the means to control the agent (CW p 94). Any organization, and not just a firm, can

then be defined as a nexus of contracts. In this sense Jensen and Meckling (1976) and Fama and

Jensen (1983) claim that their theory is more general than that of Alchian and Demsetz (1972).

Within agency theory the firm as a nexus of contracts is a legal fiction. Jensen and Meckling (1976)

stress that the firm is not an individual. Therefore, it does not make any sense to ask questions as

'Who is the owner of the firm?' (Fama, 1980) or 'What are the firm's objectives?' ,'Does the firm

maximize?' and, if so 'what does it maximize?' (CW p 97; Putterman, 1986).

In this theory all transactions are reduced to inter-individual contractual relationships between the

owners of the factors of production and their customers. In this sense intra-firm relationships are

reduced to are no different from market relationships. Both of them are ruled by the need to choose

efficient contractual firms Pertinent questions are the consequences of different types of contracts

and the way in which exogenous changes, such as changes in technology, can affect contractual

relationships.

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Thus, the concept of the firm looses all its significance as an organization and no opposition can be

found between the firm and the market. In this respect agency theory is strikingly different from

Coase and Williamson.

Agency theory can have extensions to the explanation of the difference between small and large

firms. According to Fama and Jensen (1983) the central problem in analyzing the organizational

structure of a firm consists of identifying the main contracts which define the rules of the game, the

rights of contractants and the evaluation systems. Two characteristics are particularly important in

defining this organizational structure:

(i) the attribution of residual claims, and

(ii) the attribution of decision power to agents.

Condition (ii) leads to the separation between management and control functions of an organization.

Depending on the nature of the organization the management and control functions can be

combined on a small number of agents or attributed to a large number of them. An organization is

called complex or non complex if the information specific to the firm is owned by a large or by a small

number of individuals respectively. In a non complex organization it is more efficient to attribute

both the management and control functions to the small number of agents owing the firm specific

information. Conversely, in a complex organization firm specific information is distributed amongst a

large number of agents. In this case it is more efficient to take advantage of specialization attributing

decision powers to the agents who have the information, an arrangement which is likely to reduce

costs.

The previous theories of the firm, starting from Coase and Williamson and ending with Alchian and

Demsetz and agency theory, have in common a focus on explaining the firm as organization but differ

in a number of ways. Coase and Williamson are perceived as having departed from at least some

aspects of neoclassical microeconomic theory while Alchian and Demsetz and agency theory are

attempts to reconstruct a theory of the firm following strictly the neoclassical assumptions . To put

things in perspective we have to bear in mind that both Coase and Williamson intended to construct

a theory of the firm under a series of constraints, including the difficulties which could arise in using

market due, for example, to opportunism and asset specificity . None of these difficulties are

acceptable to Alchian and Demsetz and to agency theorists. Their objective is to show that no

deviation from neoclassical principles of behavior can arise either in the market or in the firm. All

transactions are interpreted as if they were between individual contractants the very same concept

of the firm looses most of its significance by becoming a legal fiction although one designed to make

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the behavior of the firm indistinguishable from that of the market as both of them are the outcome

of a complex equilibrium process (Putterman, 1986, p 216). In spite of these differences all these

theories have in common the neglect of two fundamental aspects of a firm: power and knowledge.

The former aspect will not be treated here not because it is considered irrelevant but because the

latter aspect is more closely aligned with the title of the chapter. The next section will deal with

evolutionary theories and with the way they have dealt with the problem of the use of knowledge in

the firm

3.2) Evolutionary theories

The period after the second world war saw an unprecedented expansion of the R&D function, first in

developed countries and later in emerging and less developed countries. The enormous increase in

investment which this entailed could not have occurred without raising interrogations on the

effectiveness of such investment. The resulting innovations started to be studied and soon a field

called innovation studies arose with its new institutions. Innovation turned out to be a phenomenon

very difficult to analyze by means of existing economic theories which tended to assume perfect

knowledge on the part of firms. A series of studies of innovation followed, which created what could

be called a natural history of innovation. Soon this empirical approach led to the attempt to create

new concepts and a new theoretical framework, later called evolutionary economics, which seemed

more appropriate to interpret the evolution of innovations. The new concepts which emerged were

intended to represent patterns of evolution in technologies.

The concept of dominant design was proposed by Abernathy and Utterback (1975) to explain the

evolution of automobile technology, but deemed to be in principle applicable to many industries. The

underlying idea was that a technology would follow a life cycle starting with a multiplicity of product

designs, most of which would become extinct and give way to a dominant design on which all

product would subsequently converge. Nelson and Winter (1977) introduced the similar concept of

technological regime, exemplified by the convergence of aircraft producers on a common design the

prototype of which was the Douglas DC3, and the related concept of natural trajectories. Dosi (1982)

called a technological paradigm the common approach to production which was expected to emerge

in a given technology upon which all producers would converge. A technological paradigm would

include both dominant designs and the common knowledge that engineers and designers would use

after a paradigm was established. These new concepts had two important features: first, they

established that the knowledge used to create innovations would not develop by random

accumulation of new discoveries but would evolve according to specific patterns; second, they

introduced the idea that there were discontinuities in the evolution of technology and of knowledge.

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All these concepts were not immediately related to the existence of the firm, but they implications

for the way in which firms were expected to behave. Thus, once a given technological paradigm had

been established all firms using the corresponding technology were expected to converge upon it.

This raised interesting questions about what would happen when a old technological paradigm would

give way to a new one. To the extent that a knowledge discontinuity existed firms wanting to make

the transition between the old and the new paradigm could be expected to introduce drastic changes

in their competencies. This point was clearly stated by Tushman and Anderson (1986) who

distinguished technological change in competence destroying and competence enhancing.

What is today called evolutionary theory arose from the combination of a number of research

traditions. These include the work ok of Schumpeter (1934, 1942) and his emphasis on the role

played by innovation in economic development, some concepts of biological origin, such as variation

and selection, the conceptual approach to knowledge and rationality by developed b Simon

(1969,1978), Cyert and March (1963), the work of Alchian (1950) and Penrose (1959) . These

different research traditions were for the first time combined in a book by Nelson and Winter (1982).

We can now very briefly survey the main evolutionary concepts relevant for the analysis of R&D and

the firm. Variation gives rise to changes in the attributes of the members of a given population (of

firms, of products etc) leading either to the internal differentiation of the population or to the

emergence of new populations. Selection eliminates a number of the new entities created by

variation. Heredity reproduces some relevant features of the members of a population across time.

Variation in economics is created by innovation, whether of the radical or of the incremental type.

Selection occurs mostly by competition, although competition is conceptualized in evolutionary

economics differently from neoclassical economics. In particular, one can contrast the static

approach to competition in an equilibrium framework with the more dynamical one in evolutionary

economics . In evolutionary economics selection processes can be expected to eliminate firms with

lower than average fitness, but they do so in ways which depend on the selection environment

present (Metcalfe, 1998).

Two concepts which are crucial in the representation of firms in evolutionary economics are those of

routines and of search activities (Nelson and Winter, 1982). Firms are not expected to optimize or to

have a perfect knowledge but to have a rational behavior in presence of imperfect knowledge. Thus,

firms construct repertoires of routines which they keep using as long as some threat or failure does

not suggest that such routines are becoming inadequate. Routines play a number of roles in the firm.

They are its memory, in the sense that the firm needs to keep practicing them to remember (ibid. pp

99- 107). Furthermore, routines can establish a truce in inter-organizational conflict (ibid. pp 107-

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112). Thus, routines are not changed frequently but have a considerable persistence in the firm. In

this sense the presence of routines indicates that the firm does not instantly adapt to changes in its

external environment but does it infrequently and shows a degree of inertia. In principle, both events

internal to the firm and external events, for example a change in technological paradigm, can induce

a firm to change its routines. The ingredients required to change come from search activities, a term

introduced by Nelson and Winter (1982) to represent a general a analogue of R&D. Search activities

can be considered all the activities by means of which firms scan the external environment looking

for new knowledge which could later be used to create new routines when required. Thus, search

activities would be carried out all the times and their results would be used when needed.

Firms can be expected to be subject to common constraints, for example when they operate in

presence of a common technological paradigm, and to differ for their routines and search activities.

Even in a very static external environment firms need to keep learning. Given that knowledge is

cumulative for each firm, learning is likely to depend on past knowledge. Furthermore, the learning

of each firm depends on its organizational capabilities. Routines are partly tacit and thus difficult to

transfer. As a consequence the diversity of firms is likely to persist (Dosi, Teece, Winter, 1990). What

differentiates a firm from another are its organizational capabilities. This point combines the

emphasis of evolutionary economics on technology and on knowledge with a focus on the nature of

the organization.

The concepts of competencies and capabilities occupy a central place in the evolutionary conception

of the firm. Both concepts find their roots in the work of Penrose (1959). In a way competencies and

capabilities are concepts more specifically linked to the technologies a firm uses and to the products

it produces than routines and search activities. Not only firms need different competencies to make

shoes or semiconductors, but such competencies need to be combined, or coordinated, within the

firm. According to Teece et al (1994) such coordination is more likely to be effective in a coherent

firm than in a conglomerate. They obtained this result by measuring the coherence of a large sample

of firms in the USA. Nesta and Saviotti (2005, 2006) and Nesta (2008) measured the coherence of the

knowledge base of a sample of firms and showed that it affected the performance of those firms. The

concept of coherence is very important in the evolutionary theory of the firm because it combines

the organizational and technological aspects of the firm.

No treatment of evolutionary economics, however short, can neglect to mention the work of

Schumpeter (1912,1934, 1942) and his emphasis on the entrepreneur. In his early work Schumpeter

(1912,1934) considered the entrepreneur the character who introduced innovations into the

economic system. However, in the later part of his work (1942), and particularly after he had

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emigrated to the United States, he shifted his emphasis to the large corporations which were then

beginning to carry our systematically R&D. Schumpeter then predicted that such corporations would

routinize the production of innovations, implicitly leading to the demise of the entrepreneur. If this

prediction could have seemed almost right during the corporate economy of the period 1900-1970, it

seems increasingly inadequate after more than thirty years of technological alliances. These alliances

combine large diversified firms with entrepreneurial high technology start ups.

The previous very brief notes have given an idea of how the main focus of evolutionary economics is

on processes which allow firms to learn and to innovate. In this sense we could say that evolutionary

economics has given rise to a cognitive theory of the firm. This theory is partly concentrated on

internal firm processes, but also pays attention to the external environment of the firm by means of

concepts such as innovation systems and the co-evolution of technologies and institutions. The

influence of the external environment can be perceived in concepts such as technological paradigms

and trajectories, which are common to many firms and reflect knowledge structures at a higher level

of aggregation than the firm itself. However, the external environment is much more explicitly

present in innovation systems and the co-evolution of technologies and institutions.

Innovation systems can be national, sectoral or regional (Freeman, 1987; Lundvall, 1992; Edquist,

1997; Malerba,2005). They exist because firms and research organizations do not create innovations

in an institutional vacuum but interact with many other firms and other types of institutions which

affect the choices of projects and their development. The co-evolution of technologies and

institutions (Nelson,1994) occurs because no important technology likely to have a major impact on

the economy can develop without appropriate institutions. Such institutions can then be said to be

complementary to the technology .

In both of the above cases the evolution of the firm does not occur in an isolated way due only to

internal resources but involves the interaction with many different institutions. Thus, the time path

of the evolution of the firm can be fully understood only by taking into account the interactions with

the innovation system of which they are a part and with the institutions and organizations with which

they need to co-evolve. This is a subject which is still poorly understood and one of the frontiers of

the theory of theory firm.

4) SUMMARY AND CONCLUSIONS

In this chapter it has been shown that the existence of the modern firm could not have been

conceived without the changes in technology which started the with the industrial revolution. The

increasing capital intensity, the emergence of R&D within the firm , the new products and services

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which it has been capable to supply played a fundamental role in the evolution of the modern firm.

This does not mean that science and technology were the only cause of the emergence of the firm.

The enlargement of markets and institutional changes of various types affected heavily its evolution.

Any theory of the firm should explain why all these factors and conditions were combined to create

the firm, how its organizational structure evolved and how the relationships with its external

environment affected its evolution. This chapter could hardly do justice to the wealth of literature

written about the theories of the firm which were here very briefly surveyed. The limited evidence

that could be presented here is intended to show stress a fundamental point: all theories of the firm

which have so far been created are partial, in the sense that each of them focuses on one or few of

its aspects. The standard neoclassical approach to the firm was only concerned with making it

compatible with a general theory of markets and equilibrium. Transaction costs theory, with the

contributions of Coase and Williamson, focused on the existence of the firm as an organization and

on its boundaries and stressed the difference between firma and markets. Alchian and Demsetz and

agency theory tried to conceive firms as 'nexus of contracts', but mostly, tried to conceive the firm as

a legal fiction, the transactions and contracts of which were in principle not different from those in

the market. These theories focused on the firm as an organization and diverged as to its difference

with respect to the market and to the rationality that economic agents were endowed with. None of

them paid any serious attention to technology, innovation and knowledge. These aspects were

instead central to evolutionary economics. It seems quite clear that this research tradition has

contributed more to the analysis of R&D and the firm than any of the previous ones.

Whatever the merits of each of the theories of the firm briefly surveyed here, each of them focuses

on different aspects. None of them can be called a comprehensive theory on the firm. The object

firm, in spite of the frequency with which it occurs and of its recognized importance in the capitalist

system, still eludes us in all its complexity. One could imagine to try and combine all these theories

and the aspects of the firm they describe. Any such synthesis is likely to be exceedingly difficult given

that these theories start from different and often contrasting assumptions.

Whatever their limitations all these theories amount to a considerable progress in the analysis of the

firm. An aspect about which all of them are virtually silent is the transformations that the firm

underwent in the course of its history and their relationship with the external environment of the

firm. The analysis of this aspect is likely to involve an approach based on the co-evolution of

technologies, institutions and organizational forms.

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