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Analysis of Dynamic Capabilities and Transaction Cost

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Comparative Analysis of Dynamic Capabilities and Transaction Cost Theories
Differences and Complementarities of Two Theories
Joint Studies of Dynamic Capabilities and Transaction Cost
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Comparative Analysis of Dynamic Capabilities and Transaction Cost Theories


The significant variance of dynamic capabilities and transaction cost theories in the interpretation of the role of the firm can serve as a basis for their joint interpretation. Here I present such an attempt and elaborate on the criticism of both theories in more detail by analyzing existing studies which combine the two approaches and identifying conceptual gaps that still exist in each of them.

Differences and Complementarities of Two Theories


The transaction cost theory rationalizes the firm as a solution for problems associated with transactions involving specific assets. Thinly and non-traded assets that are valuable and scarce could trigger opportunistic behavior that is why the theory prescribes their integration inside the firm. Advocating the benefits of a hierarchical form of corporate governance, the transaction cost theory focuses on the analysis of make vs. buy decisions that define the internal assets of the firm. This analysis concentrates on the market interface providing a spectrum of available alternatives influencing a firm’s transaction decisions. The make vs. buy decision is considered to be efficient if there is no equally good or better alternative available on the market. The efficiency level of individual decisions accumulated over time, according to this theory, forms the efficiency level of the entire firm. However, considering that the character of each decision is highly situational and depends on particular circumstances under which this decision is made, the principles underlying it will be short-term. The perception of a firm through its accumulated transactions (make vs. buy decisions), which are featured as highly situational, implies that the firm is itself a short-term oriented market player.

In contrast, the dynamic capabilities theory rationalizes the firm as a bundle of capabilities that differentiates it from competitors. Neither efficient transactions nor firm-specific resources distinguish the firm on a continuous basis. It is only capabilities nurtured in the firm that are able to create a bottleneck in the industry value chain and ensure sustainable competitive advantage. However, such a bottleneck will not last long unless the firm continually learns and, on the basis of the newly gained knowledge improves its capabilities. Therefore, the efficiency of a firm could be mainly achieved through its constant learning and innovation processes. Obviously, this approach implies a long-term perspective on a corporate development with current decisions on capability development pre-conditioning future results, and to a large extent, determining whether the firm sustains its competitive advantage.

A problematic characteristic of the dynamic capabilities theory, which becomes more vivid if the theory is compared with the transaction cost theory, is that it does not directly elaborate on the existence of a firm-market interface. It not only broadly neglects transaction costs, but also leaves unexplained how non-core, redundant or irrelevant corporate resources are handled. In other words, if a firm is a learning organization it creates new resources and capabilities and combines them in new ways, so that some resources will inevitably become obsolete or redundant. This implies that a firm, in order to stay flexible, will need to eliminate its redundant resources and capabilities. The proponents of the dynamic capabilities theory accept this argument and confirm that the theory favors disintegrated organizational structures (Winter, 2003). However, dynamic capabilities theory neither discusses the process supporting disintegration of irrelevant resources nor provides any insights on a firm’s capability to maintain and improve such a process.

Transaction cost theory, on the contrary, offers a profound analysis of the firm-market interface. However, due to its focus on the efficiency of individual transactions, the short-term orientation of this theory (defined in some works as static), (Foss and Foss, 2004a) does not provide space for the rationalization of capabilities. Therefore, the transaction cost theory does not account for the existence of capabilities in a firm (Williamson, 1999).

It seems that these criticisms could be partially resolved through a combination of the principles of dynamic capabilities and transaction cost theories (Table 2).

Table 2: Comparative Analysis of Two Underlying Theories

Dynamic Capabilities Theory
Transaction Cost Theory

Unit of analysis
  • firm specific capability, characterized by astute initial asset selection and their continuous reconfiguration
  • transaction, characterized by its frequency, uncertainty, and involvement of specific assets

Human actors
  • bounded rational

capability to learn
  • favor trust

see benefits in fair relationships
  • able to foresight

this ability is uniformly distributed
  • possess intra- and entrepreneurial skills which are also uniformly distributed
  • bounded rational

and, therefore, produce incomplete contracts
  • opportunistic

guided by self-interest
  • able to foresight

rather than being myopic

Explanation of the firm
  • firm is distinguished by capabilities determining sustainable competitive advantage over time
  • characterized by involved routines, employed business model, and available investment choices
  • firm is governance structure
  • characterized by incentive intensity, administrative controls, and legal regime

Favored organizational structure
  • disintegrated flexible structure
  • integrated hierarchical structure

Purposes served
  • make better use of own resources and knowledge
  • coordinate learning process efficiently than the market
  • economize on transactions
  • economize on bounded rationality through cognitive specialization
  • mitigate hazards that accrue to opportunism by the means of governance suppressing conflict
  • apply foresight to let the firm evolve

Time horizon
  • long-term
  • process of shaping capabilities is endogenous to the evolutionary system
  • short-term
  • transaction-oriented decisions temporarily influence competition in the industry

Efficiency criterion
  • efficiency is dynamic and happens through learning and innovation
  • the condition for which no feasible superior alternative can be described and implemented with expected net gains is presumed to be efficient

Source: Modified and extended from Williamson, 1999


Presumably, because these conceptualizations rarely interact, the recommendations on their improvement are often directed toward a higher degree of incorporation of any logic intrinsic in either of them. For instance, the dynamic capabilities theory is criticized for its suppression of the role of an external environment and, hence, incomplete incorporation of the transaction cost arguments. Another point of criticism is that this theory, due to its theoretical background, is inclined to be biased toward growth (Penrose, 1959). The concept of transaction costs is neutral in this respect and, therefore, provides an alternative perspective.

The transaction cost theory, with its assumption of a contracting setup, is on the contrary criticized for being too static. Furthermore, its arguments are based on the assumption of an actor’s opportunistic behavior, which, in the light of the findings of the theory of the firm and dynamic capabilities theory, appears to be incomplete.15

Furthermore, while both dynamic capabilities and transaction cost theories acknowledge that a firm is not a “black box”, their explanations of a firm are quite different. The transaction cost theory emphasizes benefits of vertical integration, explains the hierarchy as a way of protecting against market opportunism, and defines the boundaries of a firm through its make vs. buy decisions. In the dynamic capabilities theory, competitive advantage is seen more in the internal idiosyncratic capabilities of a firm than in its formal market transactions. Due to their unique characteristics such capabilities distinguish a firm from competitors strongly enough to compete on these characteristics rather than on the underlying transaction costs.

Despite this controversial logic, both theories share some commonalities in assumptions, in problems, and in the fact that, as yet, they are not fully validated empirically (Table 3).

Table 3: Comparative Analysis of Two Underlying Theories (continued)

Dynamic Capability Theory
Transaction Cost Theory

Common Assumptions
  • bounded rationality of human actors
  • organization matters (not a black box)
  • distinguished antecedents

Common Problems
  • tautological reputation
  • difficulties to operationalize
  • lack of actionable research studies

Potential Mutual Complementarities
  • transaction as a moderating factor
  • elaboration of the firm-market interface
  • elaboration of the mechanism of placement redundant resources outside corporate boundaries
  • dynamics of transaction cost
  • learning
  • acknowledgement of capabilities existence

Empirical evidence
  • single examples of success stories (case studies)
  • ex-post rationalizations
  • dispersed studies started in 1980’s

Source: Modified and extended from Williamson, 1999


The empirical testing and application of the transaction cost theory appears to be more advanced when compared to the dynamic capabilities theory. As Paul Joskow concurs: “This empirical work (TCT) is in much better shape than much of the empirical work in industrial organization generally” (1991: 81). However, transaction cost theory still accounts for a relatively small number of empirical studies (Williamson, 1999). Similarly, while Teece, Pisano and Shuen (1997) outlined the dynamic capabilities approach, they did not provide empirical evidence to help to understand how these capabilities are developed. Following this approach, a handful of models have been proposed to explain how resources and capabilities are built over time (e.g. McGrath et al., 1996; Miyazaki, 1995; Oliver, 1997). These models are empirically supported. However, they have all followed a factor-oriented, or variance theory approach. Process theories focusing on sequences of activities to explain how and why particular outcomes evolve over time (Mohr 1982, Shaw and Jarvenpaa, 1997) are less common in the resource-based literature and dynamic capabilities theory (Montealegre, 2002). Even so, they appear to be essential to explain the process of capability development and have yet to be developed.

Joint Studies of Dynamic Capabilities and Transaction Cost


There are few studies analyzing the combination of dynamic capabilities and transaction cost theories (Odagiri, 2003; Jacobides and Winter, 2005). There is, however, a proliferation of research based on the comparative analysis of a more general approach of resource-based theory and the transaction cost theory. The studies in this vein analyze differences in the feasibility of both theories to exploit rent-generating assets (Montgomery and Hariharan, 1991) and the role of opportunism and motivation of hazard mitigation as determinants of the organizational form (Chi, 1994; Connor and Prahalad, 1996). For example, the study by Brian Silverman (1999) integrates transaction cost reasoning into the resource-based view and concludes that while conflicts between the two theories do exist, the strong complementarities between them should not be ignored. Similarly, Foss and Foss (2004a) argue that transaction cost theory has the potential to remedy a number of weak spots in the resource-based theory, particularly, the absence of attention in the resource-based theory to the interaction between value creation and value appropriation. They further argue that integrating the transaction cost theory with the resource-based theory adds new insights into the analysis of sustainable competitive advantage (Foss and Foss, 2004b). Steensma and Corley (2001) made a complementary study in which they argue that only a combination of transaction cost theory, resource-based theory, and strategic options perspective allows the boundaries of a firm to be explained.

Particularly relevant for the comparative analysis of the dynamic capabilities and transaction cost theories in the case of knowledge intensive assets is the recent investigation made by Russell Coff (2003). He pursues a comparative analysis of knowledge-based and transaction cost principles and mitigates the assumption of the knowledge-based theory that an increase in knowledge intensity in decisions of organizational boundaries leads to the switch from opportunism to knowledge management concerns. The logic of the knowledge-based theory implies that as the intensity of R&D increases, knowledge-based principles should gain explanatory power over transaction cost logic, in which opportunism is the primary driver. Interestingly, this study shows that problems of opportunism increase with R&D intensity. Coff concludes that both knowledge-based and transaction cost theories seem to gain explanatory power as knowledge intensity grows.

The major contributors to the dynamic capabilities and transaction cost theories have acknowledged that there is a high potential for synergies between these theories. Oliver Williamson expressed it as follows: “I see the relation between competence and governance as both rival and complementary – more the latter than the former” (1999: 1106). Similarly, Rumelt, Schendel and Teece observe that: “Of all the new fields of economics, the transaction cost branch of organizational economics has the greatest affinity with strategic management” (1994: 14). David Teece has further commented on transaction cost theory and its potential refinement: “In order to fully develop its capabilities, transaction cost economics must be joined with a theory of knowledge and production” (1990: 59). The factors of knowledge and production mentioned in this citation are the strong focus of the dynamic capabilities theory and provide a key for the combination of two theories.16