Organization of Firm, costs versus capabilities

The organizational issues of firm received scant attention in economic theory until the seminal work of

Coase in 1937, which tried to analyze the reason for firm’s existence and the limits to its size. The main

reason for the existence of the firm was the cost of using the price mechanism and the costs of

coordination. Thus, the idea of transaction costs as determining the firm's boundaries came to being. Since

then organizational/governance issues have mainly centered around the transaction cost hypothesis, while

the role of coordination costs went largely unused. Organizational issues came to be dichotomized under

two categories: production and transaction costs. That is, production costs determine technical choices, but

transaction costs determine the division of activities between the market and the firm. The explanations

relying solely on transaction costs, while recognizing the imperfect nature of knowledge, view the problem

of organization as one of creating mechanisms to prevent unproductive rent seeking behavior. They ignore

the role of institutions as creating possibilities for productive rent seeking behavior

The benefit side of productive knowledge embedded in firms views the problem of organization as which

organizational form is suitable to the acquisition of capabilities required by the firm. In other words,

production costs have an equally important role in determining organizational structures. The capability

view of the firm helps understand how firms operate under regimes of rapid technological change. Teece

et al (1997) define dynamic capabilities as the firm's ability to integrate, build, and reconfigure internal

and external competencies to address rapidly changing environments. These capabilities are shaped by

organizational routines, which include patterns of current practices and learning. They are also shaped by

the assets or the endowments of technology, complementary assets, external relations and customer base.

Finally, capabilities are path dependent, which means that firm's previous investment and repertoire of

routines constrain its future behavior