TITLE

HOW UNCERTAINTY IMPACTS BIOTECHNOLOGY FIRMS’ GOVERNANCE

DECISIONS: A TRANSACTION COST ECONOMICS PERSPECTIVE

ABSTRACT (200 words)

Through a specific governance structure, either hierarchical and within the firm, or through
partnership in the market, a firm may find a balance in reducing direct costs while keeping
indirect costs to a minimum. This paper aims to understand the impacts of different types of
uncertainty on firms’ decisions to adopt market versus hierarchical governance structures within
the biotechnology industry. The purpose is to draw attention to the potential benefits or risks of
adopting an open innovation model, which can be understood as an extreme case of market
governance method. Adopting theories from Transaction Cost Economics and Business-to-
Business Relationship Marketing disciplines, we suggest a set of hypotheses to explore the
impact of different types of uncertainty on the firms’ governance decisions. The proposed
hypotheses are intended to be empirically tested through a field survey.

1. INTRODUCTION
Innovation in many industries requires a combination of working processes and significant
investments either directly or indirectly. Within the biotechnology industry, innovation requires a
mixture of direct costs as a result of research and development, product design, testing,
engineering, manufacturing, distribution, and many other procedures involved in the
development of new products or processes (Pisano, 1990). The big question that many of these
firms face is whether it is more worthwhile to undertake the development of a new product or
process through their own efforts or seek the market for collaborative relations, joint ventures,
and many other contractual mechanisms. The idea is that through a specific governance
structure, either hierarchical and within the firm, or through collaboration in the market, a firm
may find a balance in reducing direct costs while keeping indirect costs to a minimum. Through
the market, it may be possible to reduce those direct costs associated with innovation, yet there
are indirect costs associated with opportunistic behavior, uncertainty between firm relations and
the possibility of firms trying to take advantage of their partners, and also uncertainty within the
environment as well, in the form of an unstable market, or uncertainty of sourcing technology.
These are all various factors that may influence a firm’s decision between a hierarchical form of
governance and that of a market form of governance. Pisano (1990) seems to believe that the
biotechnology industry prefers a form of closed innovation that prioritizes hierarchical
governance structures rather than openly innovating within the market. For the sake of lowering
costs and having access to massive amounts of capital, biotechnology firms would only partner
with commercial firms or established corporations rather than other biotechnology firms.
Furthermore statistics from this study in 1987 show that biotechnology companies were fulfilling
80% of their manufacturing needs in-house rather than approaching collaborative efforts through
the market. Becoming less dependent on partners also allowed many biotech firms to hold on to
manufacturing, and marketing rights, also allowing these firms to see greater revenue for their
own products.

To better understand the case of open innovation in the biotechnology industry, it is important to
examine current day biotechnology alliances, or firms within the industry that have preferred
vertical integration through hierarchical governance. This paper aims to better understand the
effects of uncertainty within the biotechnology industry in an effort to draw attention to the
potential benefits of open innovation in the industry. The major comparison is the potential direct
costs of R&D, and other costs associated with the development of new products or processes,
versus the indirect costs as a result of uncertainty between allied firms in the form of behavioral,
and environmental uncertainty. Though many of the papers within this study bring up the
potential influences of environmental uncertainty or behavioral uncertainty on a governance
structure decision, their application in the biotechnology industry is quite limited. The basis for
the paper will be extended from the Transaction Cost Economics theory as defined by
Williamson (1973), to gain a better quantification for indirect (transaction) costs. This
framework as seen in various other industries will be applied to gain valuable insight into the
effects of uncertainty as a whole on governance decisions within the biotechnology industry and
showcase a comparison between direct and indirect costs of open and closed innovation.

2. LITERATURE REVIEW
2.1 Transaction Cost Economics
Transaction Cost Economics or TCE is a framework used in organizational boundaries and the
respective decisions surrounding such. Scholars widely acknowledge TCE as a fundamental
theory in understanding organizational behavior and decision-making processes, particularly in
the context of business relationships and alliances. TCE posits two kinds of governance
structure, market and hierarchical, which is influenced by transaction costs. These costs include
the expenses incurred in searching for information, negotiating contracts, and monitoring and
enforcing agreements (Williamson, 1973).
With the rise of biotechnology companies and increasing interests in their governance decisions,
scholars have turned their attention to the application of Transaction Cost Economics (TCE) in
this area. TCE helps analyze how transaction costs influence the choice between internalizing
transactions or engaging in external alliances (Williamson, 1973). Santoro and McGill's (2005)
research extensively analyzed the impact of uncertainty and asset co-specialization on the
governance of biotechnology alliances. Biotechnology firms face unique challenges due to the
nature of their industry, characterized by high technological uncertainty, asset specificity, and
information asymmetry. TCE offers insights into how these factors influence the formation and
sustainability of alliances in the biotechnology industry. Therefore, TCE provides a theoretical
framework to understand why and under what circumstances biotechnology firms might be
hesitant to form alliances, shedding light on the intricate relationship between transaction cost

2.2 Governance Structures

2.2.1 Market governance structure
Market governance structure plays a significant role in understanding how transactions are
organized and governed in the dynamic landscape of the biotechnology industry. Williamson
(1973) believes that market governance structures involve the strategic choices firms make
between market transactions and hierarchical arrangements. Geyskens et al. (2006) contribute to
this understanding by delving into the "Make, Buy, or Ally" decision-making process, shedding
light on the factors that influence market governance structures. Uncertainty and asset co-
specialization were previously found to have an impact on firm alliances in the biotechnology
industry (Santoro and McGill 2005). The findings highlight the challenges faced by biotech firms
in determining the appropriate market governance structure, especially under conditions where
transaction costs associated with external collaboration outweigh the benefits.

2.2.2 Hierarchical Governance Structure

Hierarchical governance structure emphasizes a larger role within a particular firm rather than
across two different firms. The hierarchical governance structure is also known as vertical
integration within a particular firm. Williamson (1973) asks whether a transaction is performed
more efficiently within a firm (vertical integration) or outside of it (market transaction).
Hierarchical governance or vertical integration is defined by internal organization, and
transactions within the aforementioned internal organization. Geyskens et al. (2006) defines
hierarchical governance through vertical integration as “the performance of a transaction within a
firm.” Rindfleisch and Heide, (1997) also further distinguish the market and the firm itself as
alternative governance structures. Transaction costs are what truly differentiate the two
ideologies. As noted above, Transaction costs are the indirect costs of performing a transaction,
for example, negotiating contracts, or monitoring, and enforcing agreements. Under certain
circumstances, such costs of conducting economic exchanges in a market may exceed the costs
of the same within the firm itself. This is where it is essential to consider hierarchical governance
structures as an alternative to seeking the market, as a reduction in transaction related costs may
outweigh the reduction of any direct costs as a result of collaboration with the market.

These two governance structures depict the choices that firms must consider in the process of
research and development of new products and services. To further understand the potential
influences on such decision making, there are several factors of Transaction Cost Economics that
must be considered. Of the various factors, the ones discussed in this paper are related to
uncertainty. These variables of uncertainty are further elaborated on in the following section.

2.3 Environmental uncertainty

2.3.1 Technological uncertainty
In this study we discuss the two components of Environment uncertainty: Technological
uncertainty and Market uncertainty. Firstly, Technological uncertainty is a critical concept within
the Transaction Cost Economics (TCE) framework. Teece (1986) and Santoro and McGill
(2005) underscore the intricate relationship between technological uncertainty and the propensity
of biotechnology firms to form alliances. Teece (1986) also argues that technological uncertainty
introduces complexity into strategic decisions, affecting firms' choices between internalizing
activities and engaging in external alliances. Moreover, Santoro and McGill (2005) suggest that
high levels of technological uncertainty can discourage firms from forming alliances due to the
challenges associated with coordinating and sharing highly specialized knowledge and resources.
Technological uncertainty impacts the choice of governance structures, particularly in the
biotechnology sector. Firms facing high levels of uncertainty may opt for internalization to retain
control over sensitive information. On the contrary, low levels of uncertainty may lead to
external collaborations to share risks and costs (Williamson, 1985). The governance structure
becomes a strategic response to the challenges posed by technological uncertainty. In conclusion,
technological uncertainty plays a pivotal role in shaping the decisions of biotechnology firms,
particularly in the context of alliances. Understanding how uncertainty influences governance
structures is crucial for comprehending the intricacies of strategic decision-making in the ever-
evolving biotechnology landscape.

According to the previous research, this study posits that as technological uncertainty increases
in the biotechnology industry, firms are more likely to opt for market forms of governance or
alliances.

Hypothesis 1: There is a positive relationship between technological uncertainty and likeliness

to opt for a market form of governance or an alliance.

Add “Contractual safeguards” as another control variable

Figure 1: Conceptual model
Navigating the complex terrain of the biotechnology industry involves a careful consideration of
governance structures, especially when influenced by factors like technological uncertainty. A
critical aspect in this exploration is the moderating variable of firm size, which plays a pivotal
role in shaping alliances within the biotech sector. As exemplified by Harada et al. (2021), the
rapid pace of innovation and inherent uncertainties in biotechnology necessitate a nuanced
understanding of how firm size influences the likelihood of forming alliances (Harada et al.,
2021).

Technological uncertainty, a central theme in the literature, underscores the challenges faced by
biotechnology firms. As identified by Scillitoe et al. (2015), external contexts significantly
impact alliance governance decisions in biotech-pharmaceutical collaborations, reflecting the
intricate relationship between contextual factors and governance choices (Scillitoe et al., 2015).
Ebers and Oerlemans (2016) further emphasize the variety of governance structures beyond
traditional models, highlighting the need for tailored approaches in alliance formation (Ebers &
Oerlemans, 2016).

Considering the impact of firm size as a moderating variable introduces a layer of complexity to
the governance choices made by biotechnology firms. We have:

Hypothesis 1a: The positive relationship between technological uncertainty and market form of
governance or an alliance will be weakened for larger firms; larger firms will likely opt for
hierarchical governance, such as in-house R&D initiatives, when there is high technological
uncertainty.
Hypothesis 1b: The positive relationship between technological uncertainty and market form of
governance or an alliance will be strengthened for smaller firms; smaller firms will likely seek
external governance structures, such as strategic alliances, when there is high technological
uncertainty.

In this exploration, the study aims to contribute insights into the nuanced conditions under which
biotechnology firms, varying in size, are either discouraged or encouraged to form alliances
amidst the uncertainties of technological advancements.

2.3.2 Market Uncertainty

Market uncertainty is the second component of Environmental Uncertainty. Krishnan, Martin,

and Noorderhaven (2006) define environmental uncertainty as results of changes in economic
conditions faced by a firm that are outside the realm of its control and harder to anticipate. The
market in this case refers to the market environment in which firms can act in a hierarchical or
market governance structure. To maintain performance between two firms in an unpredictable
environment, partners will need to constantly monitor changes and adjust their alliance strategy
accordingly. Uncertainty in the environment limits cognitive efforts and can cause strategic
blindness. This blindness refers to insensitivity towards changes within the market or
environment as firms in an alliance commit resources, effort, and time and are, as a result, wary
of potential actions that could harm their relationships. In these situations, firms are more likely
to weigh losses that come from the result of responding to the changing environment, more than
the gains, due to those investments along with the possibility of having to cut previous
relationships, building new trust, and various other potential requirements of the changing
market environment.

Huo, et al. (2018) brings to attention another aspect of environmental uncertainty. They argue
that environmental uncertainty results in an adaptation and evaluation problem that increases
transaction costs in terms of both coordination costs and transaction risks. Prior contractual
agreements between firms might not cover every contingency creating room for further
uncertainty, and even potential for opportunistic behavior. Therefore, we set competing
hypotheses for the relationship between market uncertainty and likeliness to opt for a market
form of governance or alliance.

Hypothesis 2: There is a positive/negative relationship between market uncertainty and likeness

to opt for a market form of governance or alliance.

2.4 Behavioral Uncertainty

Behavioral uncertainty lies in the evaluation of performance. Geyskens (2006) extends the notion
that behavioral uncertainty occurs when firms must determine whether full contractual
compliance has taken place. The solution according to TCE is simply through vertical integration
due to the idea that greater control is required in a circumstance where there is potential for
greater behavioral uncertainty. If firms cannot assess between themselves whether full
contractual compliance has been achieved or not, then they cannot fully evaluate each others’
performance, leading to increased uncertainty. This study provides the idea that in an
environment of potential behavioral uncertainty, firms are more likely to opt for vertical
integration to mitigate the effects of that uncertainty. To test this idea, this paper will examine
Behavioral Uncertainty under the lens of Opportunism, and Perceived Opportunism across firm
alliances.

2.4.1 Opportunism

In Markets and Hierarchies, Williamson (1973) defines opportunism and opportunistic behavior
as an effort to retain individual gains in an alliance through lack of candor or honesty in a
transaction. An example of opportunistic behavior between firms includes disclosure of
information in a strategic manner that places some individuals or firms at an advantage over their
partners, harming original negotiations between two firms. According to Deeds, and Hill (2019),
opportunism occurs because “one or more participants chooses at their own advantage to
maximize individual returns at the expense of their partners.” In order to deter opportunistic
behavior, it is important to reduce the potential benefits either party of an alliance may see from
opportunistic behavior to begin with. This is usually through equity investments, contingency
claim contracts, and contractual safeguards that protect firms in the situation of perceived partner
opportunism. The potential for opportunistic behavior is a possible source for transaction costs
due to the necessity of contractual safeguards, monitoring costs, and these other protections for
firms in an alliance or transaction. TCE does not assume that all actors in an alliance are
opportunistic, but that it is difficult and expensive to distinguish those ethical actors from the
potentially opportunistic ones. Any firm entering an alliance may be placing specific assets, and
risks both themselves and the assets to opportunistic behavior. For this reason our third
hypothesis states that there is a negative relationship between perceived partner opportunism and
likeliness to opt for a market form of governance or alliance, simply due to the riskiness
associated with the potential for opportunistic behavior with any new firm partners.

Hypothesis 3: There is a negative relationship between perceived partner opportunism and

likeliness to opt for a market form of governance or an alliance.

Behavioral Uncertainty can also take the form of opportunistic behavior by a firm partner
(Mellewigt, 2015). Knowledge is a good shared between firms that cannot be valued until after it
is shared. Once it is shared between the firms, there is no longer a real “incentive” to pay for the
newly obtained knowledge. If the value of a particular firm’s knowledge can only be
acknowledged through the combination of another firm’s knowledge, then the alliance faces the
potential for opportunistic behavior. Value creation in knowledge sharing and management
provides an additional source for opportunistic behavior, as shown in Williamson’s original
example of strategic disclosure of information. The level of this perceived opportunistic behavior
can influence how much firms may have to be wary of resulting transaction costs, and therefore
contribute to the choice of governance form to reduce those costs overall.

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