38 Figure 2.2: The economic and institutional sphere of firm activity – a framework.
2.4.1 Institutional Environments and Investment under Economic
39 2001, p. 49) so that firms develop distinct advantages depending on the form of institutional context they are embedded in. This was already outlined with the example of firms that operate under an institutional logic of radical innovation, focusing on ‘switchable assets’ (Hall & Soskice, 2001).
According to this logic, institutions can affect the rate of return on certain types of investments, e.g., increasing the costs of low-capital intensive investments by maintaining strong labor market institutions, or through legitimizing investment that was deemed illegitimate before. The process of financialization provides a good example of the latter. As global financial markets became increasingly deregulated in the 1980s, profits in heretofore regulated industries began to soar, and firms started to invest in these new opportunities amidst a relatively weak state of industrial capital at the time (Milberg, 2008). This guidance of capital flows towards whole economic sectors is of course only one manifestation of the directional vector on the macro-scale. On the micro-level of the firm, where the uncertainties of the competitive process prevail, the sense of direction and predictability established by institutions may be critical to support any strategic investment at all.
Strategic Fit vs. Strategic Agency
At this point I come back to the previously raised issue of how strategic fit is viewed in IB versus the CC approach. IB approaches that build on the NIE maintain that individual behavior is explained through a set of exogenous preferences: ‘[f]or transaction cost economics […] institutions do not fundamentally alter the strategic preferences of actors’ (Allen, 2004, p. 100). In this case, strategic fit is simply the choice-within-constraints framework outlined and criticized by Jackson and Deeg (2008). Contrary to this, the CC approach recognizes that institutions can affect these preference structures (see Allen, 2004, p. 89). This explains why the institutional function of a directional vector for strategic actions is difficult to integrate into the NIE, namely because the direction of lowering transaction costs is hard-wired into the system so that other options of strategic behavior cannot be fully recognized.
In the NIE view, strategic behavior of firms is characterized by optimization according to price signals, i.e., transaction costs, and history unfolds as a sequential chain of such optimizing decisions. Institutions can only matter in each slice of time as an outcome condition for transaction costs. The extended view presented here
40 argues that strategic agency goes beyond optimization according to transaction costs. Generally, strategic agents make decisions not merely based on current variables, but by considering their potential unfolding in the future, which is essentially the problem of investments under uncertainty that was laid out in the introduction. The institutional environment is of special importance since the market endogenously generates the uncertainties that make optimization decisions impossible, as argued in Section 2.3.2.
As opposed to the endogenous uncertainty of the economic environment, institutions are sticky and path-dependent precisely to enable long-term orientation for agents (Thelen, 2009). In the VoC approach, firms assess their institutional environment to derive a directional vector that reduces otherwise radical uncertainty about strategic investments. This directional vector is part of a firm’s judgement or expectation about the future. This connects to the basic Keynesian position that investment is driven by expectations and enabled by the confidence that entrepreneurs have in them (Dequech, 1999; Ferrari-Filho & Conceição, 2005).
But instead of assuming that radical uncertainty is ubiquitous and, thus, ‘animal spirits’ and conventions determine investments (Akerlof & Shiller, 2010)17, we can take the VoC approach into account. Here, sticky and path-dependent institutions generate a topology of broad profitable areas for investment which firms utilize in order to form their expectations. This does not mean that institutions determine particular investment projects, but that they generate some information for the firm that can be used to generate a credible expectation about the future of the investment. In other words, firms are enabled to be strategic about an otherwise very uncertain future.
In this context, Beckert (1999) emphasized that any form of strategic agency must rely on institutions as these ‘reduce uncertainty by creating expectations of what others will do’ (Beckert, 1999, p. 782), and so form ‘the basis for rational assessment of means-ends relationships’ (ibid., p. 786). Dequech (2004) proposes that institutional structures have a second function besides achieving transactional efficiency, namely a cognitive function. This function goes beyond the equalization of knowledge asymmetries between individuals in exchange and refers to the role of
17 It is popular to interpret Keynes approach to expectations through animal spirits as a reference to pure emotions. However, what objective factors may trigger these animal spirits seems to be of relevance as well.
41 institutions in reducing the variability of reality through time. Dequech (2004) points out that radical uncertainty comes in degrees; hence, the amount of traction that institutions have on fixing the variables of relevance for decision-makers over time may directly affect their confidence in the expectations they hold (he calls this the ‘informational-cognitive-function’).
In summary, I propose that institutions are an important source of predictability in an economic environment that tends to generate radical uncertainties endogenously. Instead of thinking of investment as a by-product of some optimization function, I follow the alternative view of strategic investments.
Institutions enable strategizing and may directly affect the relative profitability of broad areas of investment as in the VoC. From this, I induce two potential mechanisms that would affect the investment activity of firms in cases where institutions are in flux, namely (1) due to organizational disintegration, and (2) due to a loss of confidence in expectations.
(1) Organizational Integration, Knowledge Generation and Investments
New investment, understood as the growth of the firm in some strategic direction, is characterized by a material component of capital expenditure which is underpinned by the generation of experience and knowledge (Penrose, 1995). These cognitive resources are the source for identifying new investment opportunities and enable the firm to support the planning and implementation of strategic investments. Lazonick (2015) refers to this as the ‘social conditions of innovative enterprise’ (p. 24) and suggests that strategic investment programs require the
‘essential social condition […] to engage in and make use of collective and cumulative, or organizational, learning’ (p. 24).
The precondition for organizational learning is the existence of prerequisite structures to organize and accumulate knowledge (Kogut & Zander, 1993). Lazonick (2015) refers to these structures as ‘organizational integration’ necessary for the generation, transfer and, especially, accumulation of knowledge. The latter point is also prominent in evolutionary accounts were institutional structures serve as organizational memory (Nelson & Winter, 1982) and even as the basis for technological paradigms (Dosi & Nelson, 2010). If these firm-internal institutional structures are, as the VoC and related approaches emphasize, strategically
42 embedded in wider institutional environments, radical institutional change could lead to disordered unembedding.
In the extreme case of radical (intense and persistent) institutional change, organizations may have to fall back to ad-hoc structures and their very capacity of generating structures to support the generation of new knowledge is reduced.
Newman (2000) provides some empirical evidence of this micro process in the transition economy context, showing that, in the rapidly changing environment of the Czech Republic, many firms had trouble establishing new organizational structures and those that did initially lost their capacity of further adjustments due to organizational disintegration.
(2) Future Expectations and Institutional Systems
Jackson and Deeg (2008) argued that institutional environments should be viewed as configurations or systems of institutions with high degrees of interdependency.
This explains why institutional changes are prone to result in radical uncertainty as their interdependence (or complexity) will generate unforeseen consequences (see North, 2005). Moreover, this generates another point of contact to the theory of the firm in the tradition of Penrose. Penrose (1995) described the process of building expectations of the future as driven by an ‘image’ of the environment that guides entrepreneurial judgment. While this image is subjectively construed, it is partly based on an interpretation of the external environment over time (Foss, 1998;
Blundel, 2015). Such a broad interplay of subjective and objective views of reality implies that firms will not be focused on a single institutional structure such as property rights. Instead, the image is generated in relation to the interplay of the structure with the activities of the firm so that even a disturbance of non-market institutions could reduce the confidence in new investments.
The persistence of institutional change is likely to be a crucial factor in distorting the relationship between expectations and experience as it causes the directional vector of institutions to break down. As a response, Penrose suggested that when
‘expectations are disappointed, a sharp curtailment of investment plans may follow’
(Penrose, 1995, p. 73). Beckert (1999) points out that the failure to develop stabilizing institutions in Eastern Europe has suppressed ‘a rational type of entrepreneurship’
(p. 782). In cases where institutional change undermines the institutional support for future expectations, firms may refrain from bearing the uncertainties of
long-43 term investments altogether. This situation is exemplified in Figure 2.3, where I take the example of a potential investment in an assembly subsidiary, i.e., an investment with moderate complexity whose effective return depends strongly on labor costs.
Figure 2.3: The effect of radical institutional change on strategic investment.