How a firm's capabilities affect boundary decisions

Determining which business activities to bring inside a firm and which to o utsource is a critical strategic decision. Firms that bring in the wrong bu siness activities risk losing strategic focus; those that fail to bring the right business activities within their boundaries risk losing their compet itive advantage. A well-developed approach for determining a firm's boundary, called transac tions cost economics, specifies the conditions for managing a particular ec onomic exchange within an organizational boundary and the conditions for ch oosing outsourcing. A popular version of transactions cost economics requir es managers to consider a single characteristic of an economic exchange - i ts level of transaction-specific investment. Three concepts aid in understanding transactions cost economics as applied to firm boundary decisions: governance (the mechanism through which a firm manages an economic exchange), opportunism (taking unfair advantage of othe r parties to an exchange), and transaction-specific investment (any investm ent that is significantly more valuable in one particular exchange than in any alternative exchange). Firms can use governance mechanisms to mitigate the threat of opportunism. Traditional transactions cost economics does not focus on the capabilities of a firm or its potential partners, even though economic exchanges involve (1) cooperating with firms that possess critical capabilities, (2) develop ing capabilities independently, or (3) acquiring another firm that already possesses needed capabilities. The author describes the conditions under which a firm's decisions on manag ing its business activities should be affected by its capabilities and thos e of its partners. When these conditions hold - conditions particularly com mon in rapidly evolving high-technology industries - firms should make boun dary decisions that differ significantly from what would be suggested by tr aditional transactions cost analysis.