By David R. Clough (@David_Clough1)
The 2020 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was awarded to Paul Milgrom and Robert Wilson for their contributions to auction theory. In this blog post, I briefly outline how their work acts as a foundation to a central theory in strategic management, the Resource-Based View of competitive advantage. I then proceed to describe how Milgrom’s work in organizational economics deeply informs our understanding of complementarities between strategic choices.[1]
Auction Theory and the Resource-Based View
The goal of much strategy research is to explain how firms can achieve competitive advantage and, consequently, achieve supernormal profits. The resource-based view (RBV) has emerged as a central pillar in our field’s understanding of competitive strategy. In essence, the RBV draws attention to the fact that even when a firm has a product market advantage, it may be unable to appropriate profit from that advantage if it ends up paying for key resources, such as fixed assets and key employees, at prices that fully reflect that advantage. As a result, strategy research ought to pay as much attention to strategic factor markets as product markets, and strategy practitioners should account for the firm’s portfolio of resources and competences when developing prescriptive recommendations.
Once you start to view competitive advantage in terms of strategic factor markets, a key question that arises is how does a firm achieve a factor market advantage? One source of factor market advantage is luck: as Barney points out in his classic 1986 article, “To the extent that a firm has less than perfect expectations, luck can play a role in determining a firm’s returns to implementing its strategies” (1986: 1234). Another source of factor market advantage is superior managerial insight into the value of resources whose true value is, at first, unknown. Here is where auction theory comes into the story. Auction theory provides a framework with which we can formalize the rivalry over a scarce resource. In particular, the theoretical advances for which Milgrom and Wilson were recognized by the Nobel committee include ways to model auctions where the true value of the resource is unknown ex ante, and where bidders’ perception of resource value—as well as their degree of uncertainty over value—differs. This enables a formal analysis of superior managerial insight, thereby addressing one prior criticism of the RBV.[2]
The integration of auction theory into the RBV was undertaken by Makadok in his 2001 SMJ article, “Toward a synthesis of the resource‐based and dynamic‐capability views of rent creation.” In this article, Makadok formalizes resource-picking and capability-building sources of advantage in a mathematical model. He shows that resource-picking ability—modeled as the receipt of a noisy signal about the value of a resource—adds to firm profit by helping the managers pass on resources it would otherwise overpay for; decisions not to acquire certain resources are an important, perhaps overlooked, attribute of effective strategy. This paper, and others that followed it, place the RBV on secure, formalized footing which continues to inspire theoretical advances to this day.
Organizational Economics and Strategic Choices
While working on auction theory, Milgrom developed rich mathematical apparatus for analyzing whether two inputs are complements or substitutes in generating a given output.[3] His later work applied these ideas to managerial decision-making, proving hugely influential in the fields of organizational economics and strategy. When two strategic choices exhibit a strong complementarity, it is best for the two choices to be coordinated—i.e. made by the same actor at the same time—and it is best to select either both choices or neither. When two strategic choices are substitutes, it is best to make one or the other, but not both.
An effective strategy therefore consists of a bundle of strategic choices that maximizes complementarity while avoiding substitutes, which imply a trade-off must be made. This key idea forms the essence of Michael Porter’s famous 1996 HBR article, “What is Strategy?” which characterizes strategy-making as creating “fit” amongst a firm’s activities. It also informs the intuition behind the NK model of search on a rugged landscape, which has become a mainstay of research on organizational design and competitive imitation.
Value creation through the coordination of interdependent choices remains a vibrant area of strategy research today. The coordination of complementary activities is not just important within the firm; it is of central importance across firms and even across industries, especially in the technologically complex settings that we refer to as innovation ecosystems. As we continue exploring this important topic in our research it is well worth revisiting the classic ideas that laid the foundations for our field.
[1] Milgrom and Wilson have also made important contributions to game theory, agency theory, industrial organization, and institutional economics. Comprehensively reviewing their influence on strategy research is beyond the scope of one blog post. If, reading this, you are inspired to contribute a follow-up post to the SMS blog please contact me (david.clough@sauder.ubc.ca)!
[2] For thought-provoking dialogue see Priem and Butler (2001) and Barney (2001).
[3] See Milgrom and Weber (1982) and Milgrom and Roberts (1990). In a nutshell, a function f(x,y) is complementary in the two inputs, x and y, if the second partial derivative d2f/dxdy is positive. Milgrom’s work (with John Roberts) describes the property of supermodularity, a generalization of the concept of complementarity that allows for situations where x and y are vectors and the function f is neither differentiable nor concave.
