Organizational theories

2nd xQ1B3-Shi-2017-External-corporate-governance-and-f Q2-Zander-2007-Do-you-see-what-i-mean-an-entrepren Q1B1-ahn2020 Levitt-1988-Organizational-learning

Be sure to answer ALL PARTS of the questions and clearly indicate which part you are answering within your overall response. Use only the literature at the very down below to make your points. Citations are required, but references are not.

Question 1

Organization theory has enjoyed contributions from social psychology, sociology, and economics.

a. Explain and summarize two important perspectives or theories that have developed from each of these disciplines (two for each discipline). Be as comprehensive as possible. (1 single spaced page)

b.

Next, describe a recent study that advanced or extended one perspective or theory from each discipline (three total). Be specific about how each study represented an important theoretical contribution. (1 single spaced page; third of a page for each)

Question 2

Organization theorists have long been concerned with two related questions: (1) why do firms exist? and (2) what determines the boundaries of the firm?

a. Describe why the answers to these questions are important for academic research. (half single-spaced page)

b. Summarize two theories that answer both questions. (half single-spaced page)

c. Explain how the underlying assumptions or tenets of each theory overlap or contradict one another. (half single-spaced page)

d. Take stock of the practical significance of this body of knowledge. To what extent do managers benefit? (half single-spaced page)

References and instructions in how to answer:

QUESTION 1A: Answer writing about the following theories

Psychological:

P1: Organizational learning – Uses this content and references as source of inspiration:

This one must be in the answer:
Levitt & March, 1988 – Review on Organizational Learning. Much started with Cyert & March, 1963 and Nelson & Winter, 1982. Learning from experience and from others, developing frameworks for interpreting the experience. Routine-based, path-dependent, and target-oriented. Lockout and competency trap.

Argote & Epple, 1990 – Learning Curves. As organizations produce more of a product, the unit cost of production typically decreases at a decreasing rate. Variation on the rate that organizations learn may be due to organizational “forgetting”, employee turnover, transfer of knowledge, and the failure to control for other factors, such as economies of scale, when estimating learning curves.

March, 1991 – Exploration and Exploitation. Balance is important.

Cohen & Levinthal, 1991 – Absorptive Capacity. The ability of a firm to recognize the value of new, external information, assimilate it, and apply it to commercial ends. Path dependent (lock out). Your path locks you out of things you have not experienced.

Zahra & George, 2002 – Absorptive Capacity. Potential vs realized.

Szulanski, 1996 – Knowledge transfer of best practices internally. The major barriers to internal knowledge transfer are knowledge-related factors such as the recipient’s lack of absorptive capacity, causal ambiguity, and an arduous relationship between the source and the recipient.

Vermeulen & Barkema, 2001 – Learning through Acquisitions (M&As). Exploitation of a firm’s knowledge base through greenfields eventually makes a firm simple and inert. In contrast, acquisitions may broaden a firm’s knowledge base and decrease inertia, enhancing the viability of its later ventures. Over time, firms strike a balance between the use of greenfields and acquisitions.

Levinthal & Rerup, 2006 – Bridging Mindful and Less-Mindful Perspectives on Organizational Learning. The role of established action repertories that facilitate the response to novel stimuli and how routines and established role structures enable mindfulness to be sustained across time and the span of the organization.

Lavie & Rosenkopf, 2006 – Exploration & Exploitation in Alliance Formation. Absorptive capacity and organizational inertia impose conflicting pressures for exploration and exploitation with respect to the value chain function of alliances, the attributes of partners, and partners’ network positions. Although path dependencies reinforce either exploration or exploitation within each of these domains, firms balance their tendencies to explore and exploit over time and across domains.

Barkema & Schijven, 2008 – Learning to Acquire (M&As). Three more recent streams of research—negative experience transfer, deliberate learning mechanisms, and learning from others.

Yang et al., 2010 – Knowledge Spillovers. When an originating firm’s spillovers are recombined with complementary knowledge by recipient firms, a spillover knowledge pool is formed, containing opportunities for the originator to learn vicariously from recipients.

Bingham & Davis, 2012 – Learning sequences. *Process research generally focuses on understanding the temporal dynamics of organizational phenomena such as learning (Van de Ven, 1992; Langley, 2007). For example, as noted earlier, research on trial-and-error learning describes how firms engage in an action and then the consequences of that action influence subsequent action (Van de Ven & Polley, 1992).

Bingham et al., 2015 – Concurrent Learning. Process theory. Concurrent learning of dynamic capabilities is aided by three activities: initiating structure (i.e. dedicated corporate group that begins knowledge codification), generalizing structure (leveraging initial structure for one process into multiple processes concurrently), and backward-chaining structure (codification of phases in reverse chronological order).

Reus et al., 2015 – Dark Side of Knowledge Transfer (M&As). One of the first to empirically test knowledge transfer.

Puranam et al., 2015 – Modelling Bounded Rationality in Organizations. Various models of organizational learning.

P2: Prospect theory – Uses this content and references as source of inspiration:

FEW IDEAS ON IT (NOT FLUID AND NOT PLAGIARISM FREE:

Attempts to explain individual choice under uncertainty. Individuals judge outcomes relative to a reference point. The theory assigns values to the difference between the outcome and the reference point. The function for values differs for outcomes above and below the reference point. The value function is concave for outcomes above the reference point (risk averse), convex for outcomes below the reference point (risk seeking), and has a substantially steeper slope for negative than positive outcomes. Choice depends on a sum of these values weighted by a function that depends on the probabilities of the outcomes. The weighing function generally under weights outcomes with mid-range probabilities but over weights extremely low probabilities, and may assign zero weight to very low probabilities (Kahneman & Tversky, 1979).

▪ As with much of BDT, prospect theory attempts to explain how individuals differ from the predictions of expected utility maximization (see Schoemaker, 1982 for a review of expected utility model).

1. Prospect theory proposes that people derive utility from gains and losses relative to a reference point, while utility theory assumes that people derive utility from total wealth or consumption.

2. Prospect theory’s value function differs in the domain of gains from the domain of losses, but, since utility functions only consider final outcomes, utility functions do not differ with reference point.

3. Near the reference point, in prospect theory, a unit change for outcomes framed as losses influences value much more than a unit change for outcomes framed as gains.

▪ Three main contributions:

1. Loss aversion.

2. Diminishing sensibility.

3. Decision weights.

▪ Diminishing sensitivity—the further from the reference point, the less perception of difference for small amounts. Not only money but also time, positive vs negative, temperature, weight, distance, etc. this is maybe a natural cognitive behavior because one does not confront things far from one’s reference point frequently.

▪ Expected value: probability times outcome. Utility theory—what matters is the utility of the outcome, not the outcome itself vs Prospect theory—the weight of the probability; reference point is the status quo. Far from the reference point—underweighted; close to the reference point—over weighted (Holmes et al., 2011).

▪ The pain of losses is much higher than the pleasure of gains (about 2.25 times).

▪ If the probability is close to the midpoint, the choice is usually based on the outcome. If the probability is close to the endpoint, the choice is usually based on the probability.

▪ Prospect theory differs from BToF particularly in relation to choices near the reference point. Firms with performance near the reference point should face even more mixed gambles than firms further from the reference point. In contrast, the BToF predicts relatively little risk-taking for firms near the reference point.

▪ Risk-taking behavior is affected by prior gain and losses. The presentation format of the alternatives also matters. Hence, generalizing about risk-taking preferences is difficult. General tendencies can be reversed by a simple reframing of options. Challenges the isolation effect. Silver-lining principle—we experience gain separately from loss and prefer to segregate gains (Thaler & Johnson, 1990; Wong & Kwong, 2005 when analyzing performance valuations).

▪ One wants information to be framed in a positive way, with small numbers in things one is good at and large numbers in things one is weak at (Wong & Kwong, 2005).

▪ Prospect theory predicts behavior for inexperienced consumers. Consumers with high market experience, however, behave largely in accordance with expected utility predictions. Via previous market interaction and arbitrage opportunities, they learn to treat goods leaving their endowment (i.e. reference point; from where one frames gains and/or losses) as an opportunity cost rather than a loss. Willingness to accept is higher than to pay. Loss aversion creates endowment (i.e. status quo; omission) (List, 2004).

Issues and Directions for Future Research:

▪ Comes from experimental results where a particular reference point is imposed. Therefore, it does not offer a sophisticated explanation for the determination of the reference point. A diversity of factors determine the reference point (Tversky & Kahneman, 1981).

▪ Almost all strategy interpretations of prospect theory only consider the value function without addressing the other components of the theory.

▪ Predictions of prospect theory depend strongly on a variety of assumptions that the management literature has ignored (Bromiley, 2008).

▪ Whether corporate behavior patterns actually reflect organizational rather than psychological effects remains an open issue.

▪ Four areas of concern regarding the use of prospect theory (Holmes et al., 2011):

1. Most of the studies use only a couple of constructs proposed by the theory instead of using the whole theory.

2. Predictions made by these studies are inconsistent with the theory.

3. Since the use of the theory is not coherent, it is difficult to compare results across studies.

4. Studies use the theory to explain high-level phenomena, while it is an individual-level theory.

The main suggestions for future research are threefold:

1. Studies should derive the hypotheses directly from the two central components of the theory (value function and probability weighting function).

2. Studies should have clearly identified the aspects of the theory being analyzed.

3. There should be more valid and consistent measurement of the constructs.

▪ Other theories should be incorporated into organizational aspirations research, such as legitimacy theory, psychological goal-setting theory, institutional theory, and research on competitive dynamics. Also, there should be proper measurement of aspirations (or goals), considering different levels of analysis (Shinkle, 2012).

Sociology:

S1: Institutional theory – Uses this content and references as source of inspiration:

DiMaggio, P. & Powell, W. 1983. The iron cage revisited: institutionalized isomorphism and collective rationality in organizational fields. ASR, 48: 147-160.

Meyer, J. & Rowan, B. 1977. Institutionalized organizations: formal structure as myth and ceremony. AJS, 83: 340-363.

North. 1990. Institutions, institutional change and economic performance. Ch 1. (more latter)

Maguire & Hardy. 2009. Discourse and deinstitutionalization: The decline of DDT. AMJ, 52: 148-178.

Jonsson, S., Greve, H. & Fujiwara-Greve, T. 2009. Undeserved loss: The spread of legitimacy loss to innocent organizations in response to reported corporate deviance. ASQ, 54: 195-228.

Suddaby, R., Elsbach, K., Greenwood, R., Meyer, J. & Zilber, T. 2010. Organizations and their institutional environments – bringing meanings, values, and culture back in: Introduction to the special research forum. AMJ, 53: 1234-1240.

Delmestri, G. & Greenwood, R. 2016. How Cinderella became a queen: Theorizing radical status change. ASQ, 61: 507-550.

Dalpiaz, Rindova & Ravasi. 2016. Combing logics to transform organizational agency: Blending industry and art at Alessi. ASQ, 61: 347-392.

Yan, S., Ferraro, F. & Almoandoz, J. 2019. The rise of socially responsible investment funds: The paradoxical role of the financial logic. ASQ, 64: 466-501.

Durand, R., Hawn, O. & Ioannou, I. 2019. Willing and able: a general model of organizational responses to normative pressures. AMR, 44: 299-320.

S2: Power and Resource Dependence – Uses this content and references as source of inspiration:

Pfeffer, J. 1981. Power in organizations: Ch 1, 4 & 9. – Overview, clasic

Emerson, R. 1962. Power-dependence relations. ASR, 27: 31-41.

French & Raven. 1968. The bases of social power. In Cartwright & Zander Group Dynamics. New York: Harper & Row. – two classics on power dependence, deals with power and interdependence on

Pfeffer & Salancik 1978. The external control of organizations. Ch 1, 3-5 & 10

Casciaro, T., & Piskorski, M.J. (2005). Power imbalance, mutual dependence, and constraint,

absorption: A close look at resource dependence theory. Administrative Science Quarterly, 50(2), 167–199. – only ones that extended, and took them all the way to the 2005, summarize kucal,d and haudreitchs

Oliver, C. & Holzinger, I. 2008. The effectiveness of strategic political management: A dynamic capabilities framework. AMR, 33: 496-520. – a little bit a good bit of including clarificing the political monubering

Wry. T., Cobb, J., Aldrich, H. 2013. More than a metaphor. Academy of Management Annals, 7: 441-488. –

Sutton, T., Devine, R., Lamont, B. & Holmes, R.M. Resource dependence, uncertainty, and the allocation of corporate political contributions across multiple jurisdictions. Working paper under 4th review at AMJ. – extend resource depended theory

Economics:

E1: Agency theory – Uses this essay and references as source of inspiration:

Fama, Jensen, Jensen & Meckling 1976

Fama 1980

Fama & Jensen 1983

Demsetz 1983

Eisenhardt 1989

Davis et al. 1997

Hitt, Arregle and Holmes, 2021 – agency theory will use stakeholder theory as critical complement due to multifaceted principal (many stakeholders)

Barney (2018) and Hitt, Arregle and Holmes, 2021, consider the shareholder as the only residual claimant is inconsistent and does not work on the current situation of the world. Generate value to other stakeholders is necessary to create firm’s value and profits for shareholders. Stakeholder theory became critical complement on agency theory. All stakeholders can be considered principals in different ways and with different claimants.

An agency relationship mainly involves two actors, the principal, and the agent. The two engage mostly to achieve some service, including transferring some authority in making decisions to the agent. One of the notable agency relations is the one that exists between an employer and an employee. Agency theory in management attempts to explain this relationship between the principal and the agent. It also tries to explain the delegation of control and prevent misalignments of goals between the agent and the principal. The theory explains how to establish a relationship where one party regulates the activities of the other, and another party completes and styles the required decisions on the principal’s behalf (Jensen and Meckling, 1976). Agency has been noted as a universal principle and not just a theory belonging to the firm. It focuses on the main model of making the agent produce maximum gains for the principal and not for itself.

According to the theory, there arise three main issues that give a chance to a concern. The issues include the problems encountered by the principal, the agent, by policing procedures and initiatives (Jensen & Meckling, 1976). The principal’s problem is concerned with inspiring the agent to perform to accomplish the principal’s goals. The principal uses motivational tools that agree with his goals. The agent faces the problem of deciding to perform in the interest of the principal, his interest, or concuss between the two in case do not concur. Besides, monitoring the agent’s actions is seen as a source of agency cost. With the costs come other costs, including bonding costs borne by the agent and wealth loss borne by the agent’s actions. Jensen and Meckling (1976) identify that both parties resolve the issues found in corporate welfare. The administration of the organization may also affect the director’s monitoring behavior.

On the other hand, agency theory recommends that outside authority mechanisms can dissuade managers from acting resourcefully. With the assistance of cognitive evaluation theory, the argument comes in that powerful expectations imposed by external authorities can influence the feelings of the top manager. The impingement may lead to the autonomy of the manager’s feelings. It may also lead to an effect on the intrinsic motivation of the crowd. The autonomy eventually leads to financial fraud committed by the manager (Shi, Connelly, & Hoskisson, 2017). External pressures forced on managers further decrease the likelihood of ethical dangers. Besides, the theory outlines the concept where the manager takes for himself possible risks. This results in potential outcomes and extreme loss (Sanders & Hambrick, 2007). The main financial options of the manager may lead to high levels of investment or extreme corporate performance, which includes big gains and big losses for the organization.

In addition, Nyberg, Fulmer, Gerhart, & Carpenter (2010) point out that agency theory suggests that the manager’s damage may happen in case of a divergence between the interests of owners and managers. They establish the importance of agent compensation and equity ownership as possible solutions to the problem. On theorizing executive compensation for agents, micro-foundations are mainly used as behavioral agency theory. The microfoundations focus on the agent performance and notes that the welfares of shareholders and their agents are expected to be affiliated if directors are driven to achieve to the best of their capabilities (Pepper & Gore, 2015). With this arises the incentive alignment mechanism as a way to monitor and control agency costs.

However, the agency theory contains some shortfalls. The agency’s model’s unsophisticated conceptualization of the struggle with interest inherent in the relationship between employer and employee proves insufficient to handle the complications and inconsistencies surrounding the uses of accountancy data. They are mainly experienced in assessing and regulating employee accomplishment (Ogden, 1993). Besides, the ownership arrangements found in the venture capitalist-entrepreneur relationships appear to be important (Arthurs & Busenitz, 2003). Agency theory does not clearly explain the behavior of individuals in the relationship. The theory uses assumptions of agents being self-centered, boundedly rational, and diverse from leaders in their ideas and taking risks; thus, it is narrow in its assumptions. Agency theory focuses on self-interested and opportunistic human behavior. Thus, the theory tends to ignore a broader range of human motives further to explain their behaviors and the outcome of those behaviors.

Besides, the theory may be used in the future in some ways. According to Bosse & Phillips, 2016), the theory draws attention to various behaviors of managers and authorities that create losses for the community. This may, in turn, initiate a problem between the principal and the agent that happens when the welfares of the principal and the agent conflict. However, when agency theory is utilized to the maximum, it may result in corporate governance, which restores the policies that guide the agent and the principal’s interests. It helps in understanding the associations between agents and principals. Agency theory helps the agent represent the principal in various organizational activities with the principal’s best interest without regard for self-interest. In the organization’s structure, this may be helpful as it leads to obedience, respect, and quality operations. The theory can also be used to resolve issues in the relationship. The most common relationship is found between the shareholders as principals and executives in an organization as agent.

E2: Transaction costs economics

5. Transaction Cost Economics (TCE)

Argote, L. (2015). A Behavioral Theory of the Firm. Journal of Management Inquiry, 24(3), 321–321. https://doi.org/10.1177/1056492615572538

Argyres, N. S., & Zenger, T. R. (2012). Capabilities, transaction costs, and firm boundaries. Organization Science, 23(6), 1643–1657. https://doi.org/10.1287/orsc.1110.0736

Asmussen, C. G., Foss, K., Foss, N. J., & Klein, P. G. (2021). Economizing and strategizing: How coalitions and transaction costs shape value creation and appropriation. Strategic Management Journal, 42(2), 413–434. https://doi.org/10.1002/smj.3227

Coase, R. H. (1937). The Nature of the Firm. Economica, 4(16), 386–405. https://doi.org/10.1111/j.1468-0335.1937.tb00002.x

Cuypers, I. R. P., Hennart, J. F., Silverman, B. S., & Ertug, G. (2021). Transaction cost theory: Past progress, current challenges, and suggestions for the future. Academy of Management Annals, 15(1), 111–150. https://doi.org/10.5465/annals.2019.0051

David, R. J., & Han, S.-K. (2004). A systematic assessment of the empirical support for transaction cost economics. Strategic Management Journal, 25(1), 39–58. https://doi.org/10.1002/smj.359

Geyskens, I., Steenkamp, J. B. E. M., & Kumar, N. (2006). Make, buy, or ally: A transaction cost theory meta-analysis. Academy of Management Journal, 49(3), 519–543. https://doi.org/10.5465/AMJ.2006.21794670

Greve, H. R., & Argote, L. (2015). Behavioral Theories of Organization. International Encyclopedia of the Social & Behavioral Sciences, 481–486. https://doi.org/10.1016/B978-0-08-097086-8.73121-7

Sestu, M. C., & Majocchi, A. (2020). Family Firms and the Choice Between Wholly Owned Subsidiaries and Joint Ventures: A Transaction Costs Perspective. Entrepreneurship Theory and Practice, 44(2), 211–232. https://doi.org/10.1177/1042258718797925

Weber, L., & Mayer, K. (2014). Transaction cost economics and the cognitive perspective: Investigating the sources and governance of interpretive uncertainty. Academy of Management Review, 39(3), 344–363. https://doi.org/10.5465/amr.2011.0463

Williamson, O. E. (1975). Markets and Hierarchies: Analysis and Antitrust Implications: A Study in the Economics of Internal Organization. Free Press.

Williamson, O. E. (1981). The Economics of Organization: The Transaction Cost Approach on JSTOR. American Journal of Sociology, 87(3), 548–577. https://www.jstor.org/stable/2778934?seq=24#metadata_info_tab_contents

Williamson, O. E. (1985). The Economic Institutions of Capitalism. Free Press. https://papers.ssrn.com/abstract=1496720

Williamson, O. E. (1991). Comparative Economic Organization: The Analysis of Discrete Structural Alternatives. Administrative Science Quarterly, 36(2), 269. https://doi.org/10.2307/2393356

Zenger, T. R., Felin, T., & Bigelow, L. (2011). Theories of the Firm–Market Boundary. Academy of Management Annals, 5(1), 89–133. https://doi.org/10.5465/19416520.2011.590301

QUESTION 1B

Use these three studies:

1 – Organizational learning:

https://www.emerald.com/insight/content/doi/10.1108/MD-09-2019-1319/full/html

OR the pdf attached: Q1B1 – ahn2020

2 – Institutional theory:

https://journals.aom.org/doi/10.5465/amj.2016.0575

OR the pdf attached: Q1B2 – jeong2018

3 – Agency theory:

https://onlinelibrary.wiley.com/doi/10.1002/smj.2560

OR

the pdf attached: Q1B3 – Shi-2017-External-corporate-governance-and-f

QUESTION 2

Must read this paper:

https://doi.org/10.1111/j.1467-6486.2007.00732.x

OR the pdf attached: Q2 – Zander-2007-Do-you-see-what-i-mean-an-entrepren

to be able to answer the question and use citations from it. Answer each part of the question on the proper letter (a,b,c,d)

Strategic Management Journal
Strat. Mgmt. J., 38: 1268 – 1286 (2017

)

Published online EarlyView 27 October 2016 in Wiley Online Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2560
Received 18 September 2015; Final revision received 20 April 2016

EXTERNAL CORPORATE GOVERNANCE AND
FINANCIAL FRAUD: COGNITIVE EVALUATION
THEORY INSIGHTS ON AGENCY THEORY
PRESCRIPTIONS

WEI SHI,
1* BRIAN L. CONNELLY,2 and ROBERT E. HOSKISSON3

1 Kelley School of Business, Indiana University, Indianapolis, Indiana, U.S.A.
2 Raymond J. Harbert College of Business, Auburn University, Auburn, Alabama,
U.S.A.
3 Jesse H. Jones Graduate School of Business, Rice University, Houston, Texas,
U.S.A.

Research summary: Agency theory suggests that external governance mechanisms (e.g., activist
owners, the market for corporate control, securities analysts) can deter managers from acting
opportunistically. Using cognitive evaluation theory, we argue that powerful expectations imposed
by external governance can impinge on top managers’ feelings of autonomy and crowd out their
intrinsic motivation, potentially leading to financial fraud. Our findings indicate that external
pressure from activist owners, the market for corporate control, and securities analysts increases
managers’ likelihood of financial fraud. Our study considers external governance from a top
manager’s perspective and questions one of agency theory’s foundational tenets: that external
pressure imposed on managers reduces the potential for moral hazard.

Managerial summary: Many of us are familiar with stories about top managers “cooking the
books” in one way or another. As a result, companies and regulatory bodies often implement
strict controls to try to prevent financial fraud. However, cognitive evaluation theory describes
how those external controls could actually have the opposite of their intended effect because
they rob managers of their intrinsic motivation for behaving appropriately. We find this to be the
case. When top managers face more stringent external control mechanisms, in the form of activist
shareholders, the threat of a takeover, or zealous securities analysts, they are actually more likely
to engage in financial misbehavior.

Copyright © 2016 John Wiley & Sons, Ltd.

INTRODUCTION

Strategy scholars and policymakers have devoted
renewed attention in recent years to “external”
mechanisms of corporate governance, such as the
monitoring and control by stakeholders who are
not inside the organization. For example, a recent
review of this literature seeks to “bring external

Keywords: External governance mechanism; Financial
fraud; Ownership; Takeover defenses; Securities analysts
*Correspondence to: Wei Shi. 801 W. Michigan St, BS 4020,
Kelley School of Business-Indianapolis, Indianapolis, IN 46202,
phone: 317-274-0939. E-mail: ws7@iu.edu

Copyright © 2016 John Wiley & Sons, Ltd.

corporate governance into the corporate governance
puzzle” more fully (Aguilera et al., 2015). Gov-
ernance research has yielded important insights
about these external governance mechanisms (Cof-
fee, 2006), but few have considered their potentially
adverse ramifications. Toward this end, we incorpo-
rate a behavioral perspective of managers into our
understanding of external governance to highlight
how the expectations imposed by external gover-
nance could impose on managers’ motivation, and
we thus uncover the potential harm such governance
mechanisms might introduce.

Recent developments in agency theory research
relax the theory’s assumption of purely economic

External Corporate Governance and Financial Fraud 1269

agents (Wiseman and Gomez-Mejia, 1998). For
example, behavioral agency theory reevaluates
predictions in view of more realistic assumptions
about agent behavior, with particular emphasis
on internal governance (Pepper and Gore, 2015).
Researchers have incorporated prospect theory
(Martin, Gomez-Mejia, and Wiseman, 2013) and
equity theory (Pepper, Gosling, and Gore, 2015)
into agency theory predictions about how compen-
sation structures influence managerial behavior.
We build on the notion of overlaying cognitive
biases onto agency theory prescriptions and extend
this approach to external governance mechanisms.
In particular, we inquire into how agents feel
about external monitoring and control and what
this means for their intrinsic motivation to behave
ethically.

Cognitive evaluation theory (Boal and Cum-
mings, 1981; Deci, 1971, 1975) is particularly
informative in this regard because it explains how
external controls can actually be counterproductive.
The fundamental tenet of cognitive evaluation the-
ory is that intrinsically motivated behavior is a func-
tion of a person’s need to feel self-determining in
his or her decisions (Phillips and Lord, 1981). The
theory asserts that external monitoring and controls
“crowd out” an individual’s motivation to behave
in ways the controls are designed to ensure (Frey
and Jegen, 2001). In our context, this would sug-
gest that pressure from external governance lessens
managers’ feelings of autonomy, thereby decreas-
ing their intrinsic motivation to behave in ways that
the governance mechanisms are supposed to safe-
guard against (Deci and Ryan, 2000). In this study,
we ask whether external governance weakens man-
agers’ intrinsic motivation to act in the interest of
shareholders and behave appropriately in the con-
text of financial reporting.

Managerial financial fraud (e.g., inappropriately
booking revenue, improperly valuing assets, not
disclosing material information) is a phenomenon
that is drawing extensive industry and regula-
tory attention (Eaglesham and Rapoport, 2015). In
fact, in 2014 alone, the Securities and Exchange
Commission (SEC) announced 93 investigations
against publicly traded companies for alleged finan-
cial misconduct. As a result, governance scholars
are acutely interested in how to predict and prevent
the occurrence of financial fraud.

Agency theory

suggests that internal governance reduces informa-
tion asymmetry between those inside and outside
the firm, and consequently, decreases the likelihood

of fraud (Dalton et al., 2007). We, however, sug-
gest and find that pressure from external governance
may impose hidden agency costs as managers shift
their locus of causality outward and lose their intrin-
sic motivation to ethically report their respective
firm’s performance, thus resulting in a greater like-
lihood of financial fraud.

Our study introduces a key behavioral consider-
ation into agency theory’s predictions about exter-
nal governance, uncovering some counterintuitive
relationships. For instance, we found that the “high-
est quality” principals (Higgins and Gulati, 2006)
are positively associated with the likelihood of
fraud. Conversely, organizational provisions that
many thought would lead to managerial entrench-
ment, such as poison pills and golden parachutes
(Bebchuk, Cohen, and Ferrell, 2009), actually bear
a negative association with the likelihood of finan-
cial fraud.

THEORETICAL DEVELOPMENT

Agency theory

Recent agency theory formulations focus on how
agents behave in boundedly rational ways (Wise-
man and Gomez-Mejia, 1998). The behavioral
agency model (BAM) was developed largely to
overcome criticisms regarding static assumptions
about executives’ risk preferences (Wiseman and
Gomez-Mejia, 1998). Empirical research on behav-
ioral agency theory to date has focused mainly
on behavioral risk propensities and internal gov-
ernance using prospect theory arguments (Chris-
man and Patel, 2012). For instance, this line of
study re-examines compensation risk, highlight-
ing the importance of individual problem framing
to explain how risk influences executive behavior
(Larraza-Kintana et al., 2007; Martin et al., 2013).

Following this model, we extend agency the-
ory by applying behavioral considerations to three
forms of external governance (we define external
as being those forms of governance that operate
without full access to the firm’s inside informa-
tion). Within agency theory, one form of external
governance is a firm’s owners, which serve as a
market-based governance mechanism (Baysinger,
Kosnik, and Turk, 1991). From an agency per-
spective, managers are also subject to the market
for corporate control, which researchers sometimes
describe as a governance mechanism of last resort

Copyright © 2016 John Wiley & Sons, Ltd. Strat. Mgmt. J., 38: 1268 – 1286 (2017)
DOI: 10.1002/smj

1270 W. Shi, B. L. Connelly, and R. E. Hoskisson

(Jensen and Ruback, 1983). More recently, agency
theory scholars have begun to investigate rating
agencies (i.e., securities analysts) as another form of
external governance (Chen, Harford, and Lin, 2015;
Wiersema and Zhang, 2011). There are other exter-
nal forces that act on firms beyond the three men-
tioned here (e.g., legal institutions, social activists),
but we limit our investigation to these three because
they are the most central and influential forms of
external governance within the agency framework.

We also add to agency theory by considering a
key cognitive bias that challenges the theory’s eco-
nomic assumptions. Specifically, we theorize about
how to incorporate trade-offs between intrinsic and
extrinsic motivation into agency theory models (c.f.
Boivie, Graffin, and Pollock, 2012; Pepper and
Gore, 2015). We use cognitive evaluation theory
(Deci and Ryan, 1985) to explain how external gov-
ernance mechanisms introduce high expectations on
managers who serve as an extrinsic motivational
force, which could crowd out intrinsic motivation,
so that the combined effect is actually the oppo-
site of what was intended with respect to preventing
fraudulent behavior.

Cognitive evaluation theory

The concepts underlying cognitive evaluation the-
ory emerged from the study of how external pres-
sure affects internal motivation to do what is right.
Some described this in terms of a “crowding-out
effect,” wherein excessive external rewards and
punishments can subvert intrinsic motivation to
behave ethically (Bertelli, 2006; Georgellis, Iossa,
and Tabvuma, 2011). Originators of the theory pred-
icated their ideas on the assumption that individuals
have innate needs for autonomy and competence
(Ryan and Deci, 2000). Autonomy concerns “the
experience of acting with a sense of choice, volition
and self-determination” and competence is about
“the belief that one has the ability to influence
important outcomes” (Stone, Deci, and Ryan, 2009:
77). The level of autonomy and competence that
individuals perceive they have is a powerful deter-
minant of their intrinsic motivation (Deci and Ryan,
2012; Gagne and Deci, 2005).

In the cognitive evaluation theory framework,
when external mechanisms of control impinge on
an individual’s sense of autonomy and control, it
could thereby decrease his or her internal motiva-
tion to behave in ways that the external controls
were supposed to ensure (Osterloh, Frost, and Frey,

2002). Consistent with these ideas, a number of
studies in management support the notion that exter-
nal consequences could potentially reduce individu-
als’ motivation to behave in ways that are consistent
with their responsibilities to the firm (e.g., Barkema,
1995; Jacquart and Armstrong, 2013). For example,
Osterloh and Frey (2000) argued that high lev-
els of extrinsic motivators can curtail employees’
intrinsic motivation to engage in organizational cit-
izenship behavior, thus hindering them from trans-
ferring tacit knowledge. Similarly, Sundaramurthy
and Lewis (2003) contended that top managers
oftentimes perceive external controls as coercive,
reducing their desire to put forth effort. Our study
builds on these ideas to develop specific hypotheses
about how some of the most commonly investigated
mechanisms of external corporate governance affect
the likelihood of managerial financial fraud.

HYPOTHESES

Financial fraud

Financial fraud occurs when managers take actions
that deceive investors or other key stakeholders
(Gande and Lewis, 2009; Shi, Connelly, and
Sanders, 2016). It often involves corruption, lying
about facts, failure to disclose material infor-
mation, falsifying information about the firm’s
performance, or covering up systematic problems
(Baucus and Near, 1991). There may be benefits to
financial fraud that motivate managers to engage in
such actions, such as the appearance of improved
performance or increases in contingent compensa-
tion. However, financial fraud harms investors, and
especially, those who hold the firm’s stock over
long periods.

As a result, external stakeholders attempt to cur-
tail executive misbehavior in the form of finan-
cial fraud by increasing their levels of monitoring
and control (Davidoff, 2013). Standard economic
approaches, including agency theory, consider the
relative costs and benefits of fraud to determine
the extrinsic motivation necessary to ensure that
individuals will not engage in such scandalous
behavior (Becker, 1976). Working within these the-
oretical frames, a large body of empirical work
has found external governance mechanisms that
focus on monitoring and disciplining managers for
misbehavior can reduce the likelihood of financial
fraud (Beasley et al., 2000; Chen et al., 2006). Few,

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External Corporate Governance and Financial Fraud 1271

however, have considered the psychological impact
of these external corporate controls.

Mechanisms of external governance

The first external governance mechanism we con-
sider is the firm’s owners (Brav et al., 2008;
Hoskisson, Castleton, and Withers, 2009).
Researchers examining shareholder influence
on firm outcomes focus largely on institutional
investors, such as mutual funds, hedge funds,
pension funds, banks, insurance companies, and
endowments (Goranova, Dharwadkar, and Bran-
des, 2010). One type of investor resides at the
extreme with respect to his or her ability to monitor
and control: the dedicated institutional investor
(Bushee, 1998, 2004). Porter (1992) described
dedicated owners as being those who maintain
large, long-term holdings concentrated in a small
number of firms. These owners have incentive
to monitor executive behavior and are able to
understand rich and complex information about
firms in which they invest (Higgins and Gulati,
2006). As such, they introduce high expectations
on managers because they are closely attuned to
managerial performance.

Dedicated institutional investors have a unique
variety of tools at their disposal to control man-
agers and demand results, which makes them an
unusually potent force of external governance
(Connelly et al., 2010a; Goranova and Ryan, 2014).
By definition, dedicated institutional investors own
substantial portions of firms in their portfolios.
Thus, they are endowed with immense power over
top managers because their exit would almost cer-
tainly be followed by a sizeable drop in the firm’s
stock price (Bushee, 2004). Under the threat of exit,
this class of investors can demand that managers
offer consistently high performance maintained
over time (Koh, 2007; Maffett, 2012). Dedicated
institutional investors also affect managerial
expectations by exercising voice-based governance
(Filatotchev and Toms, 2006; Goranova and Ryan,
2014). Dedicated owners frequently undertake
shareholder resolutions, launch proxy contests,
and initiate media campaigns to coerce managers
(Wahal and McConnell, 2000). This group of
owners is particularly adept at leading activism
activities among shareholders (Gaspar, Massa,
and Matos, 2005). They often support activist
shareholders who push managers to maximize

performance, which can give rise to excess pressure
faced by managers (Martin, 2011).

Traditional agency theory predicts that a higher
level of dedicated institutional ownership should
be associated with a reduced likelihood of moral
hazard (Sharma, 2004). One of the main reasons
is that managers should be fearful of the neg-
ative repercussions of being caught, which they
might know is more likely to occur when the firm
has high levels of dedicated institutional owner-
ship. Information asymmetry between principals
and agents should be lower for dedicated owners
as compared to other types of owners (Weiss and
Beckerman, 1995). This is because dedicated own-
ers have extensive resources to devote to moni-
toring managerial behavior, and given the nature
of their holdings, are motivated to monitor man-
agers carefully (Connelly et al., 2010a). Close mon-
itoring and low levels of information asymmetry
should constrain self-serving managerial manipu-
lations of financial information by increasing the
risk of detection (Hadani, Goranova, and Khan,
2011). In other words, agency theory highlights
the notion that dedicated investors could heighten
managerial concerns about being caught for wrong-
doing, thus mitigating the likelihood of financial
fraud.

Incorporating cognitive evaluation theory, on
the other hand, uncovers a hidden problem with
this agency theory prediction by accounting for
how CEOs might feel about the external expec-
tations that come with high levels of dedicated
ownership. As one observer noted: “The perception
that activism creates greater value for all share-
holders has won the sympathy and support of
major institutional investors that traditionally have
remained passive when it comes to engaging with
the companies in their portfolios” (Duffy, 2015).
The heavy hand of dedicated institutional investors
could prompt managers to shift from an internal
to an external locus of causality, making them
potentially less concerned with doing business
honestly than they are with outward perceptions of
compliance (Osterloh and Frey, 2004). This shift
in managers’ locus of causality helps explain why
traditional agency theory predictions about external
governance may not apply, and in fact, we expect
to see results that are more consistent with steward-
ship arguments with a focus on intrinsic motivation
(Arthurs and Busenitz, 2003; Sundaramurthy and
Lewis, 2003).

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1272 W. Shi, B. L. Connelly, and R. E. Hoskisson

In the cognitive evaluation theory framework,
external intervention could crowd out managers’
intrinsic motivation to act ethically. This is espe-
cially so, given that such monitoring is often
focused on continually positive financial returns,
so managers may become more likely to compro-
mise their ideals by engaging in financial fraud that
appears to meet dedicated owners’ persistent exter-
nal expectations, even though managers know it
is wrong. Argyris (1964) was one of the first to
recognize the potential for this phenomenon when
he noticed that strict governance has a paradoxical
effect: It leads to continuously expanding control,
but at the same time, reduces managerial loyalty.
When dedicated institutional ownership is high, top
managers, subject to unrelenting external expec-
tations from dedicated institutional investors and
activists, may feel compelled to make financial
reporting decisions not from their own beliefs, but
merely to satisfy the expectations of the firm’s own-
ers. Therefore, we suggest the following hypothesis:

Hypothesis 1: A firm’s level of dedicated institu-
tional ownership is positively associated with the
likelihood of financial fraud.

Another commonly considered form of exter-
nal governance is the market for corporate con-
trol (Jensen and Ruback, 1983). The market for
corporate control imposes external pressure on
managers to deliver consistently positive financial
earnings reports because, if they do not, other
management teams may attempt to gain control
of the company (Hitt et al., 1996). It is diffi-
cult to directly measure the extent to which this
governance mechanism is at work because it is
an unobservable force until it is activated (i.e.,
until the poor performing firm is acquired). How-
ever, we can view the extent to which executives
are exposed to the market for corporate control
by looking at the firm’s takeover defense provi-
sions (Humphery-Jenner, 2014). Although takeover
defenses are internal, researchers often use them as
a means of examining the extent to which managers
are subject to the external governance of the mar-
ket for corporate control (Humphery-Jenner, 2014;
Kabir, Cantrijn, and Jeunink, 1997).

Common takeover defenses include supermajori-
ties, staggered board appointments, poison pills,
and golden parachutes. Kini, Kracaw, and Mian
(2004) argued that the disciplinary function of the

market for corporate control is largely ineffective
when firms have takeover defenses such as these.
As a result, external expectations to perform that
arise from the market for corporate control are likely
to be less dogged when managers enjoy more and
better takeover protections. In contrast, managers
experience greater pressure and higher expectations
from the market for corporate control when their
company has fewer, or weak, takeover defenses
(Mahoney, Sundaramurthy, and Mahoney, 1997).

Traditional agency theory predicts that a higher
level of takeover defenses (and thus, an ineffec-
tive market for corporate control) should be asso-
ciated with a greater likelihood of moral hazard
(McGurn, 2002). Agency theorists would argue that
these types of provisions give rise to managerial
entrenchment and increase agency costs (Bebchuk
et al., 2009; Gompers, Ishii, and Metrick, 2003). As
a result, though managers generally want takeover
defenses, most existing studies focus on how they
can be bad for shareholders (Mahoney et al., 1997;
Sundaramurthy, Mahoney, and Mahoney, 1997).
From a purely economic view of the agent, takeover
defenses can reduce or even eliminate the poten-
tially negative outcomes associated with commit-
ting financial fraud. If they are less concerned about
the consequences of being caught, managers may
be more likely to inflate numbers or adjust financial
reports to garner private benefits.

Cognitive evaluation theory, on the other hand,
offers a different perspective. Top managers of firms
with strong takeover defense protection may not be
overly concerned about employment safety, even
if their companies fail to meet external perfor-
mance expectations, and thereby, become takeover
targets. Put differently, top managers are more
likely to make decisions that reflect their own
values and beliefs when the company has ample
takeover defenses in place. In the absence of those
provisions, though, failing to meet performance
expectations would increase top managers’ employ-
ment risk (Kacperczyk, 2009). Without takeover
defenses, the threat of a takeover could alter the
risk propensity of top managers, potentially lead-
ing them to make short-term financial reporting
decisions. Takeover defense provisions protect top
managers from the external pressure of the mar-
ket for corporate control, affording managers an
extra measure of decision autonomy and allow-
ing them to think about the long term when
reporting their performance (Wang, Zhao, and He,
forthcoming).

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External Corporate Governance and Financial Fraud 1273

The imposing presence of external expectations
from the market for corporate control could crowd
out managers’ intrinsic motivation to behave
ethically, and vice versa, removing those external
expectations could activate managers’ intrinsic
sense of duty to do what is right (Kanfer, 1990),
as is consistent with stewardship theory (Sundara-
murthy and Lewis, 2003). In fact, being vulnerable
to the market for corporate control may be par-
ticularly salient to the problem of financial fraud.
Financial fraud encompasses a range of actions
that are almost universally harmful to shareholders
and generally have one thing in common: failure to
disclose material financial information. Takeover
defenses could make managers more willing to
disclose critical information simply because they
know it is the right thing to do. Stated formally,

Hypothesis 2: The number of a firm’s takeover
defense provisions is negatively associated with
the likelihood of financial fraud.

Researchers in management, law, finance, and
accounting have, through the years, explored how
the expectations of external financial markets via
rating agencies influence firm behaviors (Ben-
ner and Ranganathan, 2012; Chen et al., 2015).
Securities analysts raise questions with top man-
agers about firm performance and strategies dur-
ing conference calls and distribute information to
investors through reports and media outlets (Lang,
Lins, and Miller, 2004). These reports generally
include forecasts of the firm’s expected future stock
price and the analysts’ recommendations about
whether to “buy,” “hold,” or “sell” the firm’s stock
(Bradshaw, 2004; Schipper, 1991).

This line of research has shown that analysts
play an important role in shaping the expectations
imposed on managers to undertake actions (Gen-
try and Shen, 2013). One way analysts impose
pressure on managers is via their effects on stock
price (Zuckerman, 2000). This occurs even when
analysts make recommendations based on stock
repurchase plans that could have vague or inde-
terminate stock price effects (Zhu and Westphal,
2011). Positive or negative recommendations have
implications for stock purchase behavior and help
determine the value of a firm’s stock. As a result,
there is a growing body of evidence that managers
are highly attentive to analysts’ recommendations
and the resultant changes in stock price (Martin,

2011; Rao and Sivakumar, 1999). For example,
one study shows that firms covered by a large
number of financial analysts have less innovative
activity because financial analysts impose pressure
to deliver consistently positive short-term financial
results (He and Tian, 2013).

External expectations from financial analysts
may come in two forms. First, sell recommen-
dations reduce a firm’s stock price, and there-
fore, impose external pressure on managers to take
action so that the firm’s performance bounces back
(Stickel, 1995). Second, buy recommendations also
introduce external pressure because managers are
likely to feel the burden of high earnings expecta-
tions when analysts are recommending their stock
to capital markets (Barsky, 2008; Mishina et al.,
2010). In contrast to buy and sell recommendations,
a hold recommendation should result in sharehold-
ers devoting less attention to firms, so this represents
the lowest level of external pressure from analysts,
and in fact, most recommendations are hold.

Agency theory envisions securities analysts col-
lectively as an external governance mechanism,
keeping managers in check by reducing information
asymmetry between principals and agents (Jensen
and Meckling, 1976). Seeking to gain investor fol-
lowing, analysts are concerned with obtaining the
most comprehensive information they can get about
publicly traded firms and issuing insightful rec-
ommendations to shareholders (Womack, 1996).
Investors pay close heed to analysts’ recommenda-
tions, lending particularly close attention to those
firms to whom the analysts recommend attention
(Beunza and Garud, 2007; Brown, Wei, and Wer-
mers, 2013). Thus, in the agency framework, we
should expect external expectations that arise from
security analysts’ recommendations to be nega-
tively associated with financial fraud.

Again, cognitive evaluation theory introduces
a different perspective on securities analysts’
ratings. Some scholars have found that high
performance expectations can actually lead to
fraudulent behavior owing to the increased pres-
sure leaders feel because of those expectations
(Schweitzer, Ordóñez, and Douma, 2004). This
may be particularly true of analysts’ ratings
because missing analyst forecasts can precipitate
drops in stock price, reduced managerial com-
pensation (Chen et al., 2015), or even dismissal
(Wiersema and Zhang, 2011). In this sense, “sell”
recommendations can impose great pressure on
managers. Similarly, when analysts recommend

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DOI: 10.1002/smj

1274 W. Shi, B. L. Connelly, and R. E. Hoskisson

“buy” it also introduces pressure on managers,
wherein top managers are compelled to meet high
expectations. Research suggests that this pressure
may be accentuated by stock market overreaction
to these analysts’ recommendations (Brown et al.,
2013). When external pressure from analysts is
high, it could lead top managers to make decisions
that violate their codes of conduct but help achieve
tangible objectives (e.g., meeting analyst expec-
tations or turning around company performance)
(Hirsch and Pozner, 2005). Stated differently,
external pressure from analysts could introduce
high performance expectations on managers,
making them less concerned with doing the right
thing than they are with outward perceptions of
compliance. As a result, we expect this external
governance mechanism could have an adverse
effect on managerial behavior, as follows:

Hypothesis 3: Pressure from security analysts’
recommendations is positively associated with
the likelihood of financial fraud.

METHODS

Sample

We tested our hypotheses on a longitudinal data set
covering the years 1999 – 2012. The sample used in
this study starts with all firms in the in the S&P
1500 index during our sampling window as well
as a few other large public firms included in the
Investor Responsibility Research Center (IRRC).
The dependent variable data are from the SEC
Accounting and Auditing Enforcement Releases
(AAERs). Data on institutional ownership, takeover
defense provisions, and securities analysts are from
Thomson Reuters Institutional (13F) Holdings, the
IRRC, and Thomson Reuters IBES, respectively.
Financial data are from Compustat and the Center
for Research in Security Prices (CRSP). We col-
lected top manager compensation and governance
data from ExecuComp and Risk Metrics.

Dependent variable

The dependent variable of our study is commit-
ment of financial fraud. Since 1982, the SEC has
issued AAERs during or at the conclusion of an
investigation against a company, an auditor, or an

individual for alleged accounting or auditing mis-
conduct (Dechow et al., 2011). The SEC takes
enforcement actions against firms that it identifies
as having violated the financial reporting require-
ments of the Securities Exchange Act of 1934.
Given budget constraints, the SEC chooses firms
for enforcement action when there is strong evi-
dence of accounting manipulation. In general, firms
that the SEC selects have already admitted restating
earnings or having unusually large write-offs (e.g.,
Enron and Xerox) (Dechow et al., 2011).

To identify fraud commitment years accurately,
we read each AAER entry to identify the years when
financial fraud actually occurred and matched them
to our independent and control variables based on
fraud commitment years. We identified a total num-
ber of 265 cases of fraud commitment firm years
for our sample firms. The primary advantage of
our chosen operationalization is that firms selected
for SEC enforcement are almost certainly guilty
of fraudulent financial reporting (i.e., Type I error
is low) (Dechow et al., 2011). Fraud commitment
receives a value of 1 if a firm commits financial
fraud in a year and is later detected by the SEC, and
0 otherwise.

Independent variables

Our first independent variable is Dedicated insti-
tutional ownership. We followed Bushee (2001)
to identify dedicated institutional investors among
all the institutional investors reported in Thomson
Reuter Institutional (13F) Holdings. This approach
relies on a factor and cluster analysis to classify
institutional investors into different types. The clas-
sification is based on portfolio turnover, momen-
tum trading strategies, and portfolio diversification
strategies (Bushee, 2001). We identified dedicated
institutional investors, which are low on all three
factors, for each sample firm and calculated their
average holdings across four quarters for each year.
Dedicated institutional ownership is the ratio of
total shares held by dedicated institutional investors
to total shares outstanding (Connelly et al., 2010b).

Our second independent variable is takeover
defenses. We measured the number of Takeover
defense provisions as the sum of the following six
indicator variables: (1) staggered board, (2) limita-
tion on amending bylaws, (3) limitation on amend-
ing the charter, (4) supermajority to approve a
merger, (5) golden parachute, and (6) poison pill.
Findings by Bebchuk et al. (2009) suggest these six

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DOI: 10.1002/smj

External Corporate Governance and Financial Fraud 1275

takeover defense provisions play the most important
role in shielding managers from the market for cor-
porate control and are of greatest relevance to man-
agerial entrenchment. Because the IRRC published
takeover defense provision data every other year
until 2004, we followed existing work by Bebchuk
et al. (2009) and replaced the four years in our sam-
pling window that did not have IRRC coverage with
data from immediately subsequent years.

The third independent variable is Analysts’
recommendation pressure. We measured this as the
sum of the average percent of sell recommendations
and the average percent of buy recommendations
issued by securities analysts across different
quarters for each year. We focus on sell and buy
recommendations because these two types of
recommendations have important implications
on the trading behavior of individual investors
and fund managers (Stickel, 1995). Sell recom-
mendations suggest that rated stocks are likely to
underperform relative to the market or its previous
performance whereas buy recommendations sug-
gest that rated stocks are likely to outperform the
market within the next 6 – 12 months. As we argue,
sell and buy recommendations introduce power-
ful external earnings expectations on managers,
while hold recommendations present the least
pressure.

Control variables for fraud commitment

Our chosen method of analysis, bivariate probit
models, mandates that we develop separate models
with fraud commitment as one dependent variable
and fraud detection as a different dependent variable
(Wang, 2013; Wang, Winton, and Yu, 2010). We
follow Wang’s (2013) guidelines for control vari-
ables that could increase the likelihood of fraud
commitment.

First, we control for a range of firm-level char-
acteristics. We control for Firm performance using
return on assets (ROA). We also control for Firm
size using the natural logarithm of total assets. The
fraud literature suggests that managers of firms with
high levels of External financing need are more
likely to commit fraud than managers of firms with
lower need (Teoh, Welch, and Wong, 1998). We
follow Demirguc-Kunt and Maksimovic (1998) to
measure this as a firm’s asset growth rate in excess
of the maximum internally financeable growth rate:
asset growth rate — ROA/(1-ROA). We control for

Firm leverage using the ratio of total short- and
long-term debt to total assets.

We also control for three variables related to
firm risk-taking activities that are associated with
fraud commitment (Wang, 2013). These are Capital
expenditure intensity, measured as capital expen-
diture divided by total sales revenues; R&D inten-
sity, measured as R&D expenditure divided by total
sales revenues; and Acquisition intensity, measured
as total annual acquisition expenditure divided by
total sales revenues.

We control for a number of executive charac-
teristics as well. We control for Top management
team (TMT) equity ownership, measured as the total
percent of equity ownership held by all the top
executives reported in ExecuComp. We control for
TMT option pay, measured as the ratio of total
TMT option pay value to total TMT pay. We con-
trol for Board independence, measured as the total
number of independent outside directions divided
by board size, and for the percent of Directors
appointed by CEOs, measured as the ratio of direc-
tors appointed by CEOs to board size. We control
for Outside directors’ ownership, measured as the
ratio of shares held by outside directors to total
shares outstanding, and for CEO duality, which
receives a value of 1 if a CEO is also Board Chair.
We control for Analysts’ coverage, measured as the
number of analysts covering a firm. Last, we control
for the Post-SOX period, which is 1 for years after
(and including) 2002, and 0 otherwise because gov-
ernance reforms triggered by the Sarbanes-Oxley
Act (SOX) may deter managers from committing
financial fraud.

Control variables for fraud detection

Fraud detection describes when firms commit fraud
and the SEC catches them for doing so. To model
the likelihood of fraud detection we include some
control variables that overlap with the control vari-
ables used to model the likelihood of fraud com-
mitment. Control variables used in both the fraud
commitment (P(F)) and fraud detection (P(D|F)) are
possible indicators not only that a firm will com-
mit fraud, but also that it will be caught. When we
include a control in both fraud commitment and
fraud detection models, we operationalize the vari-
able the same in both models.

However, our models for the likelihood of
fraud detection contain some unique control vari-
ables that we do not use in our models of fraud

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DOI: 10.1002/smj

1276 W. Shi, B. L. Connelly, and R. E. Hoskisson

commitment. For instance, the SEC could be more
likely to select for investigation firms that operate
in industries where securities lawsuits are common,
so we control for Abnormal industry litigation.
To measure this, we calculate industry litigation
intensity, measured as the natural logarithm of the
total market value of all litigated firms in an indus-
try year (using two-digit SIC codes). Abnormal
industry litigation is the annual deviation from the
average litigation intensity in an industry. We also
control for Abnormal ROA, which can flag a firm
as a potential problem, using the residual from the
regression: ROA1 = 𝛼0 + 𝛼1ROA0 + 𝛼2ROA- 1 + 𝜀.
Similarly, we control for Annual stock returns
because the SEC may target for enforcement firms
with sharp changes in stock returns. For the same
reason, we control for Abnormal return volatility,
measured as the demeaned standard deviation of
monthly stock returns in a year, and Abnormal stock
turnover, measured as the natural logarithm of the
demeaned monthly turnover in a year. Last, we
include a measure of total Institutional ownership
in our fraud detection models because research
shows that institutional investors could play a role
in discovering fraud (Dyck, Morse, and Zingales,
2010).

METHODS AND RESULTS

Table 1 summarizes the descriptive statistics,
including means, standard deviations, and cor-
relations of variables used in this study. Table 2
presents the results of bivariate probit models. P(F)
models the likelihood of fraud commitment, and
P(D|F) models the likelihood of fraud detection
given fraud commitment.

Analysis

Corporate fraud is a rare event. Given the low rate
of occurrence within our population of firms, exam-
ining the data using hazard models or conditional
logistic regressions with matched pairs could be
appropriate (Carberry and King, 2012). Yet, there
are two latent processes associated with corporate
fraud: firms that engage in fraud (i.e., fraud com-
mitment) and those that the SEC actually catches
in the act of fraud (i.e., fraud detection). We are
interested in the former, but can only observe the
latter. Traditional methods are limited to examining
the observable firms that have been caught in the act

of fraud, ignoring firms that have committed fraud
but have not (or not yet) been caught. The under-
lying assumption is that firms that are cheating and
getting away with it are comparatively much fewer
than those that cheat and are caught, but this may
not be an accurate assumption.

We attempt to address this problem methodologi-
cally by using bivariate probit regressions with par-
tial observability, following the works of Wang et al.
(2010) and Wang (2013). Bivariate probit regres-
sions model fraud detection and fraud commitment
simultaneously, thus mitigating biases caused by
the presence within our sample of firms that have
engaged in fraud but have not yet been detected.
This is an important distinction because our theory
describes why firms might actually engage in finan-
cial fraud, not whether the SEC catches them in the
act. Of course, neither the traditional methods nor
our bivariate probit models account for the possi-
bility that firms may have had an SEC enforcement
action against them when, in fact, they did nothing
wrong. However, given the extensive nature SEC
investigations and the burden of proof they must
overcome, we expect it is a safe assumption that
there are few, if any, firms that are innocent victims
of the SEC enforcement.

To explain how bivariate probit models work, let
F∗

i
represent firm i’s propensity to commit fraud,

and D∗
i

represent the firm’s likelihood of being
detected conditional on fraud being committed. The
reduced form model is then:

F∗
i
= xF,i𝛽F + ui, (1)

D∗
i
= xD,i𝛽D + vi, (2)

where xF,i is a row vector with variables that
explain the propensity for firm i to commit fraud,
and xD,i is a second-row vector with variables
that explain the firm’s likelihood of getting caught
conditional on fraud commitment. The variables ui
and vi are zero-mean disturbances with a bivariate
normal distribution and variances normalized to
unity because we cannot estimate the variances.
The correlation between ui and vi is 𝜌 (Wang,
2013).

To model fraud commitment, we transform F∗
i

into a binary variable Fi, where Fi = 1 if F
∗
i
>

0, and Fi = 0 otherwise. To model fraud detection
conditional on fraud commitment, we transform D∗

i
into a binary variable in the same way. We cannot
observe all the realizations of F∗

i
and D∗

i
, but note

Copyright © 2016 John Wiley & Sons, Ltd. Strat. Mgmt. J., 38: 1268 – 1286 (2017)
DOI: 10.1002/smj

External Corporate Governance and Financial Fraud 1277

T
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so
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Copyright © 2016 John Wiley & Sons, Ltd. Strat. Mgmt. J., 38: 1268 – 1286 (2017)
DOI: 10.1002/smj

1278 W. Shi, B. L. Connelly, and R. E. Hoskisson

Table 2. Bivariate probit models with fraud commitment and detection as dependent variables

Variables Model 1 Model 2 Model 3

P(F) P(D|F) P(F) P(D|F) P(F) P(D|F)

Constant −2.949 −5.231 −2.664 −4.979 −3.119 −4.994
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000)

ROA 0.664 −0.967 −0.719
(0.415) (0.383) (0.587)

External financing need 0.032 0.027 0.044
(0.041) (0.263) (0.009)

Firm leverage 0.201 0.302 0.157
(0.478) (0.373) (0.532)

TMT ownership −1.415 −1.525 −1.420
(0.003) (0.002) (0.000)

TMT option pay 0.510 0.525 0.450
(0.165) (0.048) (0.127)

Board independence −0.883 −1.415 −0.566
(0.106) (0.068) (0.302)

CEO appointed directors 0.991 1.023 1.007
(0.000) (0.000) (0.000)

Outside director ownership −6.024 −6.778 −5.767
(0.020) (0.087) (0.027)

CEO duality 0.010 0.061 0.096
(0.916) (0.688) (0.307)

Post-SOX −0.479 −0.612 −0.541
(0.003) (0.000) (0.018)

Firm size 0.000 0.464 −0.014 0.380 −0.036 0.455
(0.999) (0.020) (0.814) (0.001) (0.697) (0.095)

Capital expenditure ratio −1.910 2.033 −1.999 −0.117 −2.748 3.900
(0.004) (0.533) (0.013) (0.941) (0.003) (0.371)

R&D intensity 0.236 0.412 −1.327 3.780 −0.694 1.272
(0.801) (0.831) (0.161) (0.151) (0.603) (0.805)

Acquisition intensity −1.098 13.311 −0.469 6.337 −1.238 13.464
(0.181) (0.202) (0.575) (0.217) (0.394) (0.571)

Analysts’ coverage −0.189 −0.443 −0.122 −0.700 −0.046 −0.407
(0.015) (0.110) (0.097) (0.007) (0.876) (0.616)

Institutional ownership 0.806 2.267 2.121
(0.376) (0.013) (0.255)

Abnormal industry litigation 0.293 0.425 0.334
(0.052) (0.010) (0.059)

Abnormal ROA −1.008 2.926 0.938
(0.608) (0.379) (0.816)

Annual stock returns 0.440 0.296 0.500
(0.210) (0.060) (0.354)

Abnormal return volatility 0.233 0.817 0.911
(0.912) (0.668) (0.801)

Abnormal stock turnover 0.315 0.496 0.302
(0.030) (0.001) (0.279)

Dedicated ownership 1.913
(0.026)

Takeover defense −0.202 0.397
(0.008) (0.107)

Analysts’ pressure 1.056 −1.587
(0.005) (0.247)

Observations 15, 845 15, 032 14, 729
Chi-squared 2, 180 285.6 2, 433
Log-likelihood −986.3 −854 −793.1

P-values in parentheses. Standard errors clustered by two-digit SIC codes. We do not control for dedicated ownership P(D|F) in Model
1 because dedicated ownership is included in total institutional ownership.

Copyright © 2016 John Wiley & Sons, Ltd. Strat. Mgmt. J., 38: 1268 – 1286 (2017)
DOI: 10.1002/smj

External Corporate Governance and Financial Fraud 1279

that
Zi = Fi × Di, (3)

where Zi = 1if firm i has committed fraud and
been detected, and Zi = 0 otherwise. With Φ as
the bivariate standard normal cumulative distribu-
tion function, the empirical model for estimating
Zi is

P
(
Zi = 1

)
= P

(
FiDi = 1

)
= P

(
Fi = 1, Di = 1

)

= F

(
xF,ibF, xD,ibD, 𝜌

)
(4)

P
(
Zi = 0

)
= P

(
FiDi = 0

)
= P

(
Fi = 0, Di = 0

)

+ P
(
Fi = 1, Di = 0

)
= 1 − F

(
xF,ibF, xD,ibD, 𝜌

)
.

(5)

Poirier (1980) and Feinstein (1990) suggest that
the conditions for full identification of the model
parameters have two requirements. First, xF,i and
xD,i must not include the same variables. As noted
in the variable section, we mainly follow Wang
(2013) to identify key variables that influence the
propensity of fraud commitment and the likeli-
hood of fraud detection. The second requirement
is that predictor variables need to exhibit sub-
stantial variation in the sample. As a result, the
model can be identified more easily if xF,i and
xD,i include continuous instead of indicator vari-
ables (Wang, 2013). This explains why we did not
include industry dummy variables and year dummy
variables in our bivariate probit models because
inclusion of too many dummies without sufficient
variation can lead to estimation failure. Given that
we cannot include industry fixed-effects in regres-
sions, we cluster standard errors by two-digit SIC
codes to address potential correlations among resid-
uals of firms in the same industry (Khanna, Kim,
and Lu, 2015). We then estimate bivariate pro-
bit models using the maximum-likelihood method,
as follows:

L
(
𝛽F, 𝛽D, 𝜌

)
=

∑

z

i=1

log(P

(
Zi = 1)

)

+
∑

zi=0
log(P

(
Zi = 0)

)
=

N∑

i=1

{
zi log

[
Φ
(
xF,i𝛽F,

xD,i𝛽D, 𝜌
)]
+
(
1 − zi

)
log

[
1−Φ

(
xF,i𝛽F, xD,i𝛽D, 𝜌

)]}
.

(6)

Results

P(F) in Model 1 of Table 2 introduces the first inde-
pendent variable, dedicated institutional ownership.
The coefficient estimate of dedicated investors is
positive (𝛽 = 1.913, p = 0.026), lending support to
Hypothesis 1, which suggests a positive relationship
between the level of dedicated institutional own-
ership and the likelihood of committing financial
fraud. In terms of economic significance, when ded-
icated institutional ownership increases from mean
(0.045) to mean plus one standard deviation (0.112),
holding all other variables at their means, the per-
centage increase in the likelihood of firms’ commit-
ting financial fraud is 36%. In P(D|F) in Model 1,
the coefficient estimate of institutional ownership is
positive but statistically not significant, suggesting
that institutional ownership may not influence fraud
detection.

Hypothesis 2 states that takeover defenses are
negatively associated with the likelihood of com-
mitting financial fraud. The estimated coefficient
for takeover defense provisions in P(F) of Model 2
is negative and is associated with a p-value of 0.008
(𝛽 = -0.202, p = 0.008), consistent with Hypothe-
sis 2. In terms of economic impact, when the
number of takeover defense provisions increases
from zero to one, holding all other variables at
their means, the percentage decrease in the likeli-
hood of firms’ committing financial fraud is 37%.
In P(D|F) in Model 2, the coefficient estimate of
takeover defense is statistically not significant, indi-
cating that takeover defense provisions may not
bear a relationship with the likelihood of fraud
detection.

Hypothesis 3 states that earnings pressure from
analysts’ recommendations is positively associ-
ated with the likelihood of committing financial
fraud. The estimated coefficient for this inde-
pendent variable in P(F) of Model 3 is posi-
tive and is associated with a p-value of 0.005
(𝛽 = 1.056, p = 0.005), supporting Hypothesis 3. In
terms of economic magnitude, when analysts’ pres-
sure increases from mean (0.560) to mean plus one
standard deviation (0.785), holding all other vari-
ables at their means, the percentage increase in the
likelihood of firms’ committing financial fraud is
82%. In P(D|F) in Model 2, the coefficient esti-
mate of analysts’ pressure is statistically not sig-
nificant, indicating that analysts’ pressure may not
bear a relationship with the likelihood of fraud
detection.

Copyright © 2016 John Wiley & Sons, Ltd. Strat. Mgmt. J., 38: 1268 – 1286 (2017)
DOI: 10.1002/smj

1280 W. Shi, B. L. Connelly, and R. E. Hoskisson

Additional analyses

In our main study and analysis, we theorize that
and test whether external monitoring and pressure
from dedicated investors, the market for corporate
control, and financial analysts result in higher lev-
els of financial fraud. One could make additional
related arguments, though, that a moderate amount
of external pressure may be necessary and dis-
courage top managers from committing financial
fraud, even if too much external pressure exacer-
bates fraud. Therefore, in supplementary analyses,
we test whether there were curvilinear relationships
between our independent variables and dependent
variable. However, we failed to find statistical sup-
port for such relationships. Results for this analysis
and other unreported results are available from the
authors on request.

Also, as described in our theory and methods,
we examine external pressure from analysts’ rec-
ommendations in terms of both buy and sell recom-
mendations. To investigate this further in a post-hoc
manner, we subsequently considered the individual
relationships between buy/sell recommendations
and fraud commitment. We found that the coef-
ficient estimate of the percent of buy recommen-
dations is positive and is statistically significant,
whereas the coefficient estimate of the percent of
sell recommendations is positive but statistically not
significant. This suggests that high earnings expec-
tations from positive analysts’ recommendations
appear to exert a stronger influence on top man-
agers’ motivation to commit financial fraud com-
pared to the pressure managers feel from having
to turn around performance in the face of negative
recommendations.

As described in the analysis section above, our
chosen methodology is a unique approach to inves-
tigating the likelihood of fraud. Therefore, we con-
firm our results using an alternative method based
on a matched-pair sample (Arthaud-Day et al.,
2006; Cumming, Leung, and Rui, 2015; Gomulya
and Boeker, 2014; O’Connor et al., 2006). For each
fraud firm, we found a control firm that is most sim-
ilar to fraud firm in terms of firm size (log assets)
and Tobin’s q and belongs to the same Fama and
French 12 industry classification (Fama and French,
1997). We require that control firms have never been
charged with fraud. To analyze the matched-pair
sample, we used conditional logistic regressions,
which recognize the conditional nature of the prob-
abilities that matched-pair samples create (Manski

and Lerman, 1977). Conditional logistic regressions
control for time-invariant paired fixed-effects, but
cannot address potential biases caused by fraud that
has been committed but not detected. In unreported
results, we find support for our three hypotheses.

Supplementary study

The analyses above suffer from some limitations
common to studies of archival data. For example,
our control variables cannot account for all possible
alternative explanations and the control variables
we include could overlap with the explained vari-
ance of our predictors, thus changing what it is our
predictors are actually measuring (Audia, Locke,
and Smith, 2000). Another problem with archival
studies of market data is that we cannot actually
measure people’s thoughts, but rather are limited to
viewing outcomes. This may be important because
our theory deals with intrinsic motivation, and with
archival analyses, we make inferences about how
managers are motivated based on how we see them
behaving.

Therefore, we develop a supplementary study, the
details of which we provide in Appendix S1, to
observe managerial decision making directly in a
more controlled environment (Priem, Walters, and
Li, 2011). We used a policy-capturing approach in a
survey-based study with strengths, and limitations,
that are complementary to our prior analyses. In
short, we ask executives to imagine they are the
CEO of a small but publicly traded company. The
company received a sale a few days into Q1 of
the current fiscal year, but it would help the CEO
if he or she could book it in Q4 of the prior
year, which is when most of the work for the sale
actually occurred anyway. Results are presented in
Table 3.

We analyze the data using hierarchical linear
modeling to account for both within-person and
between-person variance (Spence and Keeping,
2010). The dependent variable is Managers’ reac-
tion, which is how they would actually report the
sale. For each scenario, participants select their
response on a seven-point Likert scale to the state-
ment “Based solely on the information provided
here, I might consider reporting the sale in Q4 of
the prior year.” Answers range from “strongly dis-
agree” to “strongly agree.” We inform respondents
that they should report the sale in Q1, but report-
ing it in Q4 would engender both personal benefits
and risk to the firm. In other words, indicating they

Copyright © 2016 John Wiley & Sons, Ltd. Strat. Mgmt. J., 38: 1268 – 1286 (2017)
DOI: 10.1002/smj

External Corporate Governance and Financial Fraud 1281

Table 3. Hierarchical regression of intent to commit
fraud

Model 1 Model 2
Variables Controls Main effects

Experience −0.071 −0.071
[0.031] [0.031]

Gender −0.658 −0.658
[0.326] [0.326]

Locus of causality 0.131 0.131
[0.839] [0.839]

CEO power −0.050 −0.050
[0.281] [0.275]

Shareholder pressure 0.086
[0.064]

Takeover defense −0.077
[0.097]

Analysts’ pressure 0.121
[0.009]

Race (dummy variables) Included Included
Education (dummy variables) Included Included
Raised place (dummy variables) Included Included
Constant 4.802 4.802

[3.231] [3.231]
Chi-squared 17.63 30.65
Log-likelihood −722.8 −722.9

N = 456. P-values based on Huber-White robust errors reported in
brackets.

would report the sale in Q4 is equivalent to intent to
commit fraud.

Model 1 in Table 3 shows the effects of the
control variables. Model 2 in Table 3 shows our
supplementary study’s measurement of the main
effects advanced in Hypotheses 1 through 3, with
the dependent variable being intent to commit fraud.
Consistent with the results from our main study, the
coefficient estimate of pressure from shareholders
is positive (𝛽 = 0.086, p = 0.064), consistent with
Hypothesis 1. Also in Model 2, the coefficient esti-
mate of takeover defenses is negative (𝛽 = -0.077,
p = 0.097), consistent with Hypothesis 2. The drop
in significance level may be due to the small number
of observations used in this study. The coefficient
estimate of analysts’ pressure is positive (𝛽 = 0.121,
p = 0.009), supporting Hypothesis 3.

DISCUSSION

In this study, we extend agency theory by examin-
ing external mechanisms of corporate governance
in view of managerial cognitions. We find empirical
support for the notion that external governance can

dampen managers’ intrinsic motivation to act in the
interest of shareholders, increasing their likelihood
of financial fraud. Each of the three external gov-
ernance mechanisms under investigation — activist
shareholders, the market for corporate control,
and rating agencies — provides unique explanatory
value in the context of financial fraud, and each runs
counter to traditional agency predictions.

Key contributions

Our results hold the potential for contributing to
the literature in several ways. Foremost, behav-
ioral agency theory incorporates cognitive biases
into agency theory assumptions about internal
governance (Martin et al., 2013; Wiseman and
Gomez-Mejia, 1998), but this stream of research
devotes less attention to external governance.
Our study adds to the academic community’s
understanding of agency theory by introducing a
key behavioral consideration into agency theory’s
predictions about external governance. In so doing,
our study questions the utility of external gover-
nance mechanisms for reigning in the potential for
moral hazard, in our case, in the form of managerial
financial fraud. Whereas the governance literature
has prescribed (over the long years of research in
corporate governance) several alignment mech-
anisms that policymakers expect to work most
of the time, our study shows that some of these
mechanisms may not work as expected.

Our study also potentially provides new insights
into the consequences of investor activism.
Agency theory suggests that dedicated institutional
investors, who are well known for their activist
approach to ownership (Goranova and Ryan, 2014),
can mitigate agency problems because they have
incentive to monitor managers and the ability to
bring about change due to the size of their holdings
(Shleifer and Vishny, 1997). Existing studies
lend empirical support to the notion that dedicated
investors can be conducive to mitigating managerial
risk aversion and encouraging managers to make
decisions that create long-term value for the firm
(Bushee, 1998; Connelly et al., 2010b; Hoskisson
et al., 2002). However, researchers have devoted
little attention to possible trade-offs of the powerful
expectations imposed on managers via the external
pressure of dedicated investors. Our results show
that an ownership structure laden with dedicated
investors can have unanticipated consequences
in the form of diminished intrinsic motivation,

Copyright © 2016 John Wiley & Sons, Ltd. Strat. Mgmt. J., 38: 1268 – 1286 (2017)
DOI: 10.1002/smj

1282 W. Shi, B. L. Connelly, and R. E. Hoskisson

resulting in higher instances of managerial finan-
cial fraud. There is an ongoing policy debate about
the effects of activist shareholders (Benoit and
Hoffman, 2015; Gandel, 2015). Our study informs
this debate by showing that powerful shareholders
could perhaps be hurting more than helping as
they magnify the Wall Street “expectations game,”
and consequently, managers could abandon their
own beliefs in order to satisfy the expectations of
shareholders (Martin, 2011).

Our findings may also contribute to research
on takeover defenses. Existing studies generally
suggest that the market perceives takeover defense
provisions negatively because they result in reduced
firm value (Gompers et al., 2003; Mahoney and
Mahoney, 1993; Sundaramurthy et al., 1997).
Research shows that managerial entrenchment
brought on by takeover defenses can cushion man-
agers’ exposure to the market for corporate control.
Our study, however, adds that such protection
can provide a positive effect wherein managers
maintain higher levels of intrinsic motivation,
akin to stewardship theory, as opposed to being
motivated mainly by extrinsic factors, which are
central to agency theory (Sundaramurthy and
Lewis, 2003). Future research might tease out
even further this juxtaposition of the principles
and assumptions underlying cognitive evaluation
theory, and relatedly, stewardship theory versus
those that underlie agency theory.

We also contribute to a nascent stream of
literature that explores the benefits of takeover
defense provisions. For instance, Danielson and
Karpoff (2006) find that firms that have adopted
poison pills witness modest operating performance
improvement over time. Similarly, findings by
Kacperczyk (2009) and Wang et al. (forthcoming)
suggest that an exogenous increase in takeover
protection leads managers to focus on strategic
decisions that can increase shareholders’ long-term
interests. Our results suggest that the benefits of
takeover defense provisions extend beyond issues
of performance as they discourage managers from
engaging in financial fraud, which is detrimental to
the interests of shareholders and other stakeholders.
Relatedly, researchers might also consider how
different kinds of corporate governance provisions
operate in different ways, such as those that prevent
actions that could lead to a takeover versus those
that take effect only if a takeover occurs.

Last, our study illustrates the power that secu-
rities analysts wield. Although analysts play an

important role as information intermediaries that
can help reduce information asymmetry between
investors and companies, their recommendations
introduce powerful expectations on managers to
perform, which could influence their financial
reporting decisions. While much of the research
on rating agencies focuses on how investors react
to analysts’ recommendations, our study builds on
the more limited amount of research (Gentry and
Shen, 2013; Zhu and Westphal, 2011) that explores
how managers react, and behave differently in
response, to analysts’ recommendations. Our study
has focused on one type of external rating agen-
cies (i.e., financial analysts), but future research
might explore how other external rating agencies
(e.g., journalists) shape managers’ performance
expectations, and thereby, influence managerial
motivations to engage in financial fraud (Shani and
Westphal, 2016; Westphal and Deephouse, 2011).

The focus of our study is on how performance
expectations from external governance mechanisms
crowd out top managers’ intrinsic motivation, lead-
ing to higher instances of financial fraud. Future
research might consider whether and how this gen-
eralizes to managerial misconduct. Further, schol-
ars could extend this research by considering how
cognitive evaluation theory applies to internal gov-
ernance devices, such as boards of directors and top
manager compensation designs. Similarly, scholars
might also examine whether internal and external
governance devices are complements or substitutes.
It could be, for example, that dedicated institutional
investors substitute for vigilant boards because both
introduce strong expectations on managers. If this
is the case, then the monitoring role of vigilant
boards could become less important when dedi-
cated investors are present. Conversely, one could
make an argument that dedicated investors comple-
ment vigilant boards. In this case, the two work
together to inflict such weighty expectations that
managers reach a tipping point where they feel they
have to resort to fraud so that they do not let every-
body down.

CONCLUSION

In sum, our findings suggest that policymakers may
face a paradox in regulating corporate governance.
Imposing strict external monitoring and control can
decrease top managers’ intrinsic motivation and
reduce their focus on internal values, potentially

Copyright © 2016 John Wiley & Sons, Ltd. Strat. Mgmt. J., 38: 1268 – 1286 (2017)
DOI: 10.1002/smj

External Corporate Governance and Financial Fraud 1283

leading them to commit financial fraud. However,
granting top managers too much freedom from
external performance pressure could result in some
managers extracting personal gains at the expense
of shareholders. Perhaps managers can “earn the
right” to autonomy over time as they demonstrate
that they consistently act in the best interest of
shareholders, despite who may or may not be
looking over their shoulders.

ACKNOWLEDGEMENTS

Guidance and comments provided by SMJ Editor
Will Mitchell and two anonymous SMJ reviewers
have significantly improved this article.

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SUPPORTING INFORMATION

Additional supporting information may be found
in the online version of this article:

Appendix S1. Policy capturing study.

Copyright © 2016 John Wiley & Sons, Ltd. Strat. Mgmt. J., 38: 1268 – 1286 (2017)
DOI: 10.1002/smj

Do You See What I Mean? An Entrepreneurship
Perspective on the Nature and Boundaries of the Firm

Ivo Zander
Uppsala University

abstract In answering the questions ‘why does the firm exist?’ and ‘what determines its
boundaries?’, established theories of the firm have focused on boundary choice in a context of
relatively easily identified and evaluated alternatives. This paper starts by asking the kindred
question ‘why does the firm come into existence?’, shifting attention to the circumstances and
choices surrounding new firm formation and the exploitation of new and untried business
ideas. It proceeds to delineate an entrepreneurship perspective on the nature and boundaries
of the firm, where boundary decisions are driven by the difficulty of implementing new,
subjective means–ends frameworks in sometimes very unreceptive markets. A set of
propositions developing the concepts of cognitive incongruence and cognitive incompleteness
suggests that activities are internalized when other market participants are unable to accept or
understand the entrepreneur’s subjectively perceived means–ends framework. In conclusion,
the paper supports the development of theory that explains choice of modes of action based on
subjective world views and the emerging notion of a distinctive entrepreneurship-based theory
of the firm.

INTRODUCTION

The theory of the firm has generated a vigorous stream of research on the existence,
boundaries, and internal organization of the firm. Significant contributions have been
made on the basis of various forms of transaction costs and the nature of principal–agent
relationships. More recently, evolutionary theory, the resource-based view, as well as
knowledge-based theories have all suggested alternative conceptions of the nature and
boundaries of the firm. With few exceptions, existing theories have been concerned with
boundary decisions in a context of established firms and relatively easily identified and
evaluated alternatives. Boundary decisions have been framed as a choice between arm’s
length contracts and internal organization under stable or slowly changing technolo-
gical conditions, whether the determining factors be transaction costs (Coase, 1937;

Address for reprints: Ivo Zander, Uppsala University, Box 513, 751 20 Uppsala, Sweden (Ivo.Zander@
fek.uu.se).

© Blackwell Publishing Ltd 2007

. Published by Blackwell Publishing, 9600 Garsington Road, Oxford, OX4 2DQ, UK
and 350 Main Street, Malden, MA 02148, USA.

Journal of Management Studies 44:7 November 2007
0022-2380

Williamson, 1985, 1991),[1] the costs of coordinating diverse production skills (Conner
and Prahalad, 1996), or the ability to effectively combine and recombine related sets of
knowledge (Kogut and Zander, 1992).

Because of their preoccupation with already established firms, existing approaches to
the theory of the firm have diverted attention from the analytically interesting period
surrounding new firm formation. This is unfortunate, because new firm formation
encompasses particular conditions and processes that appear to have a direct bearing on
the choice between markets and internal organization. Specifically, the founding of new
firms takes place in a context of changing technological conditions, sometimes extreme
ambiguity, and incomplete or slowly emerging markets for materials, products and
services. Under these conditions, general resistance to the logic and consequences of new
ideas can become a critical obstacle to the development of new ventures. New firm
formation also involves the presence of individuals or entrepreneurs whose personal
convictions and subjective opinions play a central role in the recombination and reor-
ganization of existing resources and exchange relationships.

The central thesis of this paper is that the problems associated with the introduction
of new and untried business ideas in unreceptive markets represent a critical and
currently overlooked element in determining why markets are sometimes superseded by
internal organization. Drawing upon insights from Austrian economics, cognition
theory, and entrepreneurship research, the paper formalizes a set of propositions on how
subjective means–ends frameworks and cognitive incongruence and cognitive incom-
pleteness among market participants influence the entrepreneur’s decision to carry out
activities within firm boundaries. Generally, the propositions suggest that internalization
is the result of the inability of other market participants to either accept or understand the
entrepreneur’s subjectively perceived means–ends framework, which to his or her mind
spells out the preferred or ‘best way’ of implementing the entrepreneurial idea in the
marketplace.

The paper makes two contributions to the existing literature and academic debate.
First, it responds to the call for further investigations of modes of action or organizational
alternatives in the entrepreneurship literature (Shane and Venkataraman, 2000; Venka-
taraman, 1997), particularly with respect to theory that connects the discovery of oppor-
tunities and the formation of firm boundaries (Bruyat and Julien, 2001; Busenitz et al.,
2003). Specifically, it develops the concept of a subjective means–ends framework, and
differentiates between cognitive incongruence and cognitive incompleteness as concep-
tually distinct sources of inefficient markets and the lack of intersubjective agreement
(Dew et al., 2004). The formalized propositions are primarily concerned with new firm
formation and the introduction of new combinations, as opposed to mere imitation of
ideas and business concepts which have already been pioneered and proven by others.
However, it is suggested that the fundamental mechanisms may also extend into later
stages of firm growth, whenever new business initiatives are taken and existing markets
are deemed inadequate to promote the development of a particular business idea.

Second, by focusing on the period of new firm formation, the paper addresses a void
in the existing theory of the firm and probes the universal relevance and boundary
conditions of existing theories. Building on the original insights by Silver (1984) and
Langlois (1988, 1992a), it offers theoretical formalizations to support the emerging

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© Blackwell Publishing Ltd 2007

notion of an entrepreneurship-based theory of the firm (Alvarez and Barney, 2004; Dew
et al., 2004; Foss, 1994, 1997; Foss and Klein, 2005; Witt, 1999). The theory is consistent
with those contributions that question the universal relevance of moral hazard as an
explanation for the establishment of firm boundaries (Conner and Prahalad, 1996;
Kogut and Zander, 1992; see also Coase, 2000), yet offers a different and distinctive
interpretation of the mechanisms determining firm boundaries. Although it will not be
attempted to compare and evaluate competing theories of the firm at length, the con-
cluding discussion contrasts the different perspectives and reflects upon their possible
co-existence in explaining the formation of firm boundaries.

The paper is structured into three main sections. The first section delineates the
fundamentals of entrepreneurship and describes how the entrepreneur discovers new
business opportunities and translates this discovery into a subjective means–ends frame-
work. The section that follows focuses in on boundary decisions, identifies cognitive
incongruence and cognitive incompleteness as two conceptually distinct drivers of firm
boundaries, and formulates a set of propositions on how they influence the entrepre-
neur’s choice between markets and internal organization. While focusing on the forma-
tion of firm boundaries in the context of new combinations, it also reflects upon
boundary decisions in the maturing firm. The third and final section contains a summary
and conclusions, including reflections on the distinctive properties and complementari-
ties of entrepreneurship-based and alternative theories of the firm.

ENTREPRENEURSHIP AND THE DISCOVERY OF NEW BUSINESS
OPPORTUNITIES

An entrepreneurship perspective on the nature and boundaries of the firm rests on two
fundamental assumptions about the nature of business activity: profit-seeking individuals
and asymmetrically dispersed knowledge across economic actors. It embraces continu-
ous change and the existence of genuine uncertainty in the introduction and exploitation
of new business ideas, fundamentally disputing equilibrium approaches to the function-
ing of the economic system (Mathews, 2006).

The quest for profit or wealth plays an important motivational role in the entrepre-
neur’s pursuit of new business opportunities (Baumol, 1990, 1993). It may be that
enterprising individuals ultimately aim at goals other than profit alone, such as social
respectability, power, personal freedom, or securing an outlet for creativity (e.g. Rey-
nolds and White, 1997), but earning and protecting profits still play an important role in
reaching these ultimate goals. Moreover, the quest for profit takes place in a context
where time is of the essence. In the eyes of the entrepreneur, ‘windows of opportunity’
are open only during limited periods of time, and being the first to exploit an opportunity
is perceived to be associated with significant first-mover advantages.

Asymmetrically dispersed knowledge implies differentiated sets of information and
knowledge held by individual decision-makers (Hayek, 1937, 1948; Menger, 1981;
Mises, 1949), which in the business context causes variation in the ability to identify and
assimilate new information and events. Individual decision-makers tend to notice infor-
mation that relates to and can be integrated with what they already know, and the value
attributed to new information and events depends on prior knowledge of the market for

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resources and customer needs (Shane, 2000; Witt, 1992).[2] As a result, a ‘given’ oppor-
tunity is not recognized by all potential entrepreneurs, and the same opportunity may be
interpreted differently depending on the individual. Strictly speaking, opportunities
become real in the creative mind of the entrepreneur, as he or she uses observations and
impressions from the external environment to activate unobserved or latent combina-
tions of resources and customer demand.

Asymmetrically dispersed knowledge is accompanied by incomplete information
about the variables that affect market conditions, and unanticipated change caused by
the plans developed and implemented by other market participants. It means that in
some areas the individual’s knowledge is scant, negligible or lacking and consequently
subject to guesswork or incomplete estimation. In this context of genuine uncertainty, the
entrepreneur, like any individual, will act on the basis of what he or she thinks rather
than objective information supplied through existing market relationships or signalled
through market prices (Kirzner, 1997). The pursuit of a new business opportunity is
partly an act of faith, which by definition involves incomplete perception of current and
future states of the world and the role of any prospective business therein.

The unpredictability of market conditions is reinforced by the imaginative or creative
element in entrepreneurial decision making. The creative element contains the unex-
pected and perhaps surprising association between observations and sets of data, or even
speculation and dreams about possible attributes and events of the future. Shackle (1973,
p. 39) suggests that:

. . . what individuals, thinking individuals, do springs from their thoughts, and those
thoughts are not regular continuations and outgrowths of their immediate past but are
subject to sudden mutations, even originations, as new suggestions are noted and
interpreted by the individual in the course of deciding his actions.

In subsequent work, Shackle (1979) develops the proposition that entrepreneurial
action involves choice and commitment based on feelings, anticipation and an element
of surprise, which puts within reach a good state of mind.

The creative element in entrepreneurial decision making lies partly in the discovery of
new business opportunities through recombination or analogical reasoning (Ward,
2004), and partly in the ingenuity and resourcefulness which may be shown in the
process of reorganizing or creating new market structures and relationships (Amabile,
1997; Whiting, 1988). Similar to the consequences of asymmetrically dispersed knowl-
edge and incomplete information, the imaginative or creative element of entrepreneur-
ship sustains market disequilibrium and denies any objective certainty with respect to
future developments of markets and states of the world.

Asymmetrically dispersed knowledge and the creative element in entrepreneurial
decision making represent a double-edged sword. On the one hand, it permits the
entrepreneur to discover and pursue a particular business opportunity, expecting that the
uniqueness of insight can be turned into sizable profits. On the other hand, it tends to
create problems because other individuals and firms affected by and needed in the
exploitation process are unlikely to see and understand the logic of the new idea, or to
share the same expectations, and as a result may resist or even actively oppose it. In the

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words of Schumpeter (1961, p. 87), this resistance manifests itself first in the groups
threatened by the innovation, then in the difficulty in finding the necessary cooperation,
and finally in the difficulty in winning over customers. As will be discussed presently,
resistance and opposition play an important and critical role in the entrepreneur’s
decisions concerning where to draw the boundaries of the firm.

The Discovery and Exploitation of New Business Opportunities

In the entrepreneurial process that results in the founding of a firm, the entrepreneur can
be defined as someone who discovers or ‘sees’ a new business opportunity. This requires
alertness to hitherto unnoticed business opportunities, be it in arbitrage and trading or in
business schemes that involve some form of in-house processing (Kirzner, 1973, 1979,
1985; Schumpeter, 1942, 1961). Kirzner (1985, p. 56) suggests that seeing involves
perceiving the ‘unfolding of the tapestry of the future in the sense of seeing a preordained
flow of events’, and that it comprises ‘ways by which the human agent can, by imagi-
native, bold leaps of faith, and determination, in fact create the future for which his
present acts are designed’. Although there have been relatively few investigations of the
opportunity-recognition process (Gaglio, 1997; Ucbasaran et al., 2001), there is some
evidence that the ability to see a business opportunity may vary systematically among
individuals (McCline et al., 2000).

Apart from alertness and the conception of a future-oriented vision, the perception of
a new business opportunity involves elements of evaluation and further development,
which may occur sequentially but perhaps more often simultaneously or in an interactive
process (Ardichvili et al., 2003; Herron and Sapienza, 1992; Long and McMullan, 1984).
In the process of evaluating and developing a new entrepreneurial idea, rough concepts
are transformed into an increasingly elaborate and explicit notion of how markets are
going to be served and resources must be deployed, redeployed, or created. Eventually,
but far from always, the evaluation and development process may result in articulation
of the entrepreneurial idea in the form of a feasibility study or more or less full-fledged
business plan.

In order to exploit the identified business opportunity, the entrepreneur must act upon
his or her judgment, perhaps with a degree of confidence which to an outsider appears
unwarranted. In the words of Knight (1964, pp. 269–70), acting upon judgment is
responsible for a system or organization under which the confident and venturesome
‘assume the risk’ or ‘insure’ the doubtful by guaranteeing the latter a specified income in
return for an assignment of the actual results. In the case of the trading or pure
entrepreneur, this means committing to the purchase of a certain product for resale at a
later point in time. For the entrepreneur involved in more complex business schemes, it
also becomes a matter of actively mobilizing resources and labour to perform the
necessary work.

Recent developments in the entrepreneurship literature suggest that the decision to act
upon identified business opportunities depends on the entrepreneur’s unique prior
knowledge, experience, and social networks. According to intentions-based models
(Krueger, 2000; Krueger et al., 2000), the active pursuit of a new business opportunity is
preceded of the forming of an intention, the strength of which depends on what the

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© Blackwell Publishing Ltd 2007

entrepreneur perceives as desirable and feasible. In the model suggested by Krueger
(2000), as in parts of the theoretical antecedents (Ajzen, 1987; Ajzen and Fishbein, 1980;
Ajzen and Madden, 1986), the entrepreneur is likely to respond to opportunities when
believing himself/herself to be in possession of the required personal resources and also
of the requisite support from the extended social network.

The entrepreneur’s opportunity to act is perceived to be temporally constrained, as the
passing of time involves changing perceptions of profit opportunities and is seen to open
the way for pre-emptive action by other market participants. The entrepreneur considers
it necessary to act swiftly and to maintain flexibility to respond to unanticipated change,
lest much of the first-mover advantage and profit potential be lost to others. Whenever
the entrepreneur can draw sufficiently upon existing markets and resources, he or she
will do so in order to speed up the implementation of the entrepreneurial idea (Bird,
1988). Efforts will then focus on those aspects of the entrepreneurial idea that prove
particularly difficult to develop and implement. Typically, as will be further elaborated
upon below, these aspects challenge conventional beliefs and ways of doing things and
require substantial adjustments by other market participants.

The Subjective Means–Ends Framework

The exploitation of a new business opportunity involves the creation of a subjective
means–ends framework, which represents a more or less detailed or coherent scenario of
the unfolding of future market events. This subjective means–ends framework could be
described as a schema or knowledge structure (Fiske and Taylor, 1991; Markus and
Zajonc, 1985; Walsh, 1995),[3] a cognitive structure that represents perceived knowledge
about a future state of the world, including specific attributes, the relationships between
those attributes, and the events and sequences of events that lead up to its realization.
The entrepreneur’s means–ends framework involves a largely unarticulated estimation
of the probabilities of the emergence of particular attributes, events, or sequences of
events ( perhaps only in terms of expectations that ‘this is likely to happen’ or ‘this is
unlikely to happen’), beliefs about change that can be brought about by the entrepre-
neur’s own actions, and a hierarchy of events in terms of their perceived importance for
the successful implementation of the entrepreneurial idea. Parts of the framework,
particularly those related to activities and conditions which have to be actively created
rather than those which only require modest reconfigurations of already existing market
relationships and resources, are only ascertainable within wide limits and are subject to
substantial guesswork depending on the beliefs of the individual. These aspects will be
more fully revealed through the further development and exploitation of the new busi-
ness opportunity.

Particularly in the case of new combinations, the subjective means–ends framework
may involve only a hazy picture of the future state and the sequences of events that may
lead to its realization. As an illustration, Baldwin (1951, p. 77) reiterates King C.
Gillette’s conception of the safety razor: ‘As I stood there with my razor in my hand, my
eyes resting on it as lightly as a bird settling down on its nest – the Gillette razor was born.
I saw it all in a moment, and in that same moment many unvoiced questions were
asked and answered more with the rapidity of a dream than by the slow process of

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reasoning . . .’. In the correspondence preceding the foundation of the firm, co-founder
William E. Nickerson wrote: ‘I am confident that I have grasped the situation and can
guarantee, as far as such a thing can be guaranteed, a successful outcome. Your knowl-
edge of my long experience with inventions and machine building will, perhaps, cause
you to attach considerable weight to my opinion in this matter’ (Baldwin, p. 82; emphasis
added).

However, it would be erroneous to conclude that the subjective means–ends frame-
work is based on pure intuition. For example, Passer (1949) illustrates how the inventive
genius of Thomas A. Edison coincided with meticulous market analyses in the process of
substituting incandescent light for gas illumination in New York City. In 1878, Edison
noted: ‘I started my usual course of collecting every kind of data about gas; bought all the
transactions of the gas engineering societies, etc., all the back volumes of the gas journals.
Having obtained all the data and investigated gas-jet distribution in New York by actual
observation, I made up my mind that the problem of the subdivision of electric current
could be solved and made commercial.’ Additional efforts included canvassing the
district to obtain information on the number of gas jets burning at each hour up to three
in the morning, a house-to-house survey which provided complete data on exactly how
many jets were in each building, the average hours of burning, and the cost of this light
to the consumer (Edison collected some 24 books containing gas-light bills of consumers
in the district). Eventually, Edison was able to calculate the variable and overhead cost
component of the gas which sold for $2.25 per 1000 cubic feet, and was confident that
he could get one-half of the lighting business in the district by setting the price of
electric-light equivalent to gas at $1.50.

The establishment of a subjective means–ends framework, particularly when the
entrepreneur believes the business opportunity has few comparable precedents, is sus-
ceptible to cognitive biases. Overconfidence may lead the entrepreneur to an over-
optimistic assessment of the validity of means–ends framework and his or her own
capability to influence attributes and events in the desired direction (Busenitz and
Barney, 1997). Specifically, when rough probabilities are assigned to the future occur-
rence of desirable attributes, events, or sequences of events, they tend to be overesti-
mated. Because of the planning fallacy associated with future-oriented visions, the
entrepreneur is also likely to disregard risks and to overestimate how much can be
accomplished in a given period of time (Baron, 1998; Kahneman and Lovallo, 1993). As
a consequence, the entrepreneur will often expect earlier and more substantial profits
than actually turns out to be the case.

As the entrepreneur converts the discovery of a new business opportunity into prac-
tical action, he or she identifies a seemingly most suitable, or ‘right’, way to proceed given
prior knowledge and particular circumstances. The entrepreneur formulates and
executes plans that are neither random nor predetermined, and their correctness will
only be proven as future events unfold. As the entrepreneur over time gains access to new
information, the subjective means–ends framework tends to become more complex,
although the uniqueness of the situation and the absence of comparable cases may not
necessarily make it more cognitively compact or accurate (Fiske and Taylor, 1991). The
means–ends framework will undergo change as the entrepreneur learns more about
external conditions and the entrepreneurial idea itself, but critical underlying assump-

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tions about attributes, events, or sequences of events will remain intact, lest the pursuit of
the entrepreneurial idea be abandoned. Strong prior beliefs concerning the subjective
means–ends framework may even lead to the denial of mixed or contradictory evidence.

Given the subjectivity of the means–ends framework and a possibly over-optimistic
entrepreneur, it is not difficult to understand why the entrepreneur is often seen as
irrational. The fact that the entrepreneur sees a new business opportunity, correctly or
incorrectly, implies the discovery and exploitation of something which has hitherto gone
unnoticed or been neglected by others. Unable to see the future state or to perceive the
means to get there, bystanders often have difficulty in relating to the logic underlying the
entrepreneurial idea. They may also have considerably different opinions about the true
risks involved or the likelihood that certain attributes, events, or sequences of events will
materialize. As specified in the following section, this has important implications for the
establishment of firm boundaries.

AN ENTREPRENEURSHIP PERSPECTIVE ON THE NATURE AND
BOUNDARIES OF THE FIRM

With the fundamental elements of the discovery and exploitation of new business oppor-
tunities in place, it is possible to probe more fully into the link between the entrepreneur
and the establishment and boundaries of a business firm, or the question why there are
‘islands of conscious power in this ocean of unconscious co-operation like lumps of butter
coagulating in a pail of buttermilk’ (Coase, 1937, p. 388, quoting D. H. Robertson). The
critical factor is that the entrepreneur, particularly in the introduction of new combina-
tions (Schumpeter, 1961),[4] attempts to impose a subjective and largely unknown
means–ends framework on the market and must find and activate resources to achieve
the desired ends (Aldrich, 1999; Aldrich and Fiol, 1994; Stinchcombe, 1965). In the
establishment of the firm, the entrepreneur thereby fulfils the function of creator, orga-
nizer and market-maker in one, albeit often with the help of other individuals and
organizations (Schoonhoven and Romanelli, 2001).

In pursuit of the entrepreneurial idea, the entrepreneur is preoccupied with imposing
the subjective means–ends framework on the market and with finding various means of
eliminating any forces that may erode the profit potential. He or she acts in what may be
characterized as a hurry, since expected returns are perceived to be under constant
threat of discovery and exploitation by others. In other words, the entrepreneur cannot
sit back and wait for markets to develop and converge, and may indeed start the
entrepreneurial venture without reference to available information. The aim of preserv-
ing the profit potential sometimes impels the entrepreneur to counteract unfavourable
bargaining positions vis-à-vis suppliers of critical materials and equipment, as has been
demonstrated both theoretically and empirically ( Joskow, 1991; Williamson, 1985,
1991). However, concerns about unfavourable bargaining positions may initially be
secondary to a larger and perhaps more problematic undertaking – that of convincing
other market participants of the value and correctness of the means–ends framework
(Aldrich and Fiol, 1994; Lounsbury and Glynn, 2001).

Fundamentally, the entrepreneur’s subjective perception of profit opportunities
implies that existing markets for materials, equipment, and labour have not been able to

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converge to produce the intended product or service offering. Specifically, markets may
have failed to produce the desired functionality, timing (supplying the product or service
at the right time and place), or paths of upgrading that fulfil the perceived needs of
customers. The inability of existing markets to converge suggests that the entrepreneur
must activate and co-ordinate resources beyond established market relationships. He or
she must become involved in the reconfiguration of ongoing business activities and
occasionally in the establishment of new ones. In the words of Schumpeter (1961, p. 89),
the entrepreneur thereby ‘leads the means of production into new channels’. Some
materials, equipment, or services may be readily available in the market, requiring little
adaptation in terms of functionality, timing, or paths of upgrading, while others will
require modification along one or several dimensions to fit the perceived means–ends
framework. Likewise, some skills may be available in existing labour markets, while
others may require development and special training to support the new undertaking.

Explaining the Boundaries of the Firm

In response to institutional expectations and tradition, the entrepreneur in pursuit of a
new business opportunity registers a legal entity and proceeds to develop and coordinate
its activities and resources. With respect to utilizing existing markets for materials,
equipment, or services (including logistics and distribution), the entrepreneur may be
confronted with two typical situations. In the first, existing materials, equipment, or
services are adequate to fulfil the requirements of the entrepreneur’s subjectively per-
ceived means–ends framework, or can be adapted to fit these requirements with limited
effort. This situation typically results in external contracting for the required inputs,
because it speeds up the implementation of the entrepreneurial idea and maintains the
entrepreneur’s flexibility to respond to unforeseen and changing circumstances. From
the suppliers’ point of view, sales are effectuated in the course of already established
operations and carry little risk apart from the credit that may be extended to the
entrepreneur.[5]

The other situation requires a higher degree of change with regard to existing mate-
rials, equipment, or services, and sometimes the initiation of new activities and market
relationships. In this case, the ability to understand and share the entrepreneur’s means–
ends framework becomes much more critical. From the entrepreneur’s point of view,
introducing actual change in existing activities and market relationships is critical for the
successful implementation of the new entrepreneurial idea. Among potential suppliers of
materials, equipment, or services, becoming involved in the entrepreneurial idea prom-
ises profits from gaining first-mover advantages in a market of new products and services
that is yet to develop. Simultaneously, new-investment decisions require closer scrutiny
and evaluation of the idea’s true market potential, and the forming of an opinion about
the probability of overall or partial success of the entrepreneur’s undertaking.[6]

The conflicts which may arise in this situation have two conceptually different but
similar origins: (1) cognitive incongruence, or disagreement concerning the entrepre-
neur’s means–ends framework or the probabilities assigned by the entrepreneur to the
future occurrence of individual attributes, events, or sequences of events; and (2) cogni-
tive incompleteness, the perceived but in critical respects incomplete understanding of

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the entrepreneur’s means–ends framework. As further specified below, both cognitive
incongruence and cognitive incompleteness tend to push the entrepreneur towards the
internalization of activities to secure the preferred way of implementing the entrepre-
neurial idea in the marketplace.

Cognitive incongruence. Potential suppliers of materials, equipment, or services will be
reluctant to invest in a new business proposition when they disagree with the correctness
of the entrepreneur’s means–ends framework. Different opinions may be expressed in
the form of alternative means–ends frameworks, which may or may not be linked to
successful outcomes, or as different probabilities of critical attributes, events, or
sequences of events. Specifically, market participants may have different views on the
overall viability of the entrepreneur’s means–ends framework, or the possibility that
critical technical or market-related problems can be satisfactorily resolved.

When there is disagreement about the entrepreneur’s means–ends framework, market
exchange will be discouraged by the lack of support from other market participants and
by the entrepreneur’s perceived costs of having to explain, persuade, or negotiate with
potential contractual counterparts (Foss, 1993; Langlois, 1988, 1992a, 1992b; Langlois
and Robertson, 1989, 1995; Silver, 1984). While these costs may be subsumed under the
general concept of transaction costs, it is notable that explanation and persuasion aim at
altering rather than accepting perceived uncertainty and that they in the eyes of the
entrepreneur comprise lost revenues due to delayed introduction of the new business idea
(Alvarez and Barney, 2004). In some cases, different opinions about the fundamental
aspects of the means–ends framework may be so entrenched that any form of persuasion
or negotiation will prove futile. In the words of Aldrich (1999, p. 81), entrepreneurs with
business plans outside current expectations ‘may find no one who accepts what they
propose to do’. In order to pursue the entrepreneurial idea, the entrepreneur will be
compelled to internalize those activities where disagreements prove particularly acute
and difficult to resolve.

The case of King C. Gillette and the development of the safety razor illustrates the
point. In order to launch the new product, Gillette needed access to thin sheets of steel
of sufficient quality to withstand repeated usage. However, established steel-makers
unanimously remained sceptical about the potential for producing a quality blade out of
sheet steel. Baldwin (1951, p. 78) writes: ‘. . . during this period from 1895–1901 Gillette
experimented persistently with the key problem of trying to make a blade from sheet steel
that would harden and temper suitably for taking a keen edge. In pursuing this idea,
Gillette visited “every cutler and machine shop in Boston and some in New York and
Newark . . . Even [the Massachusetts Institute of ] Technology experimented and failed
absolutely.” Those who knew most about steel and most about razors were the most
discouraging, for they unanimously told him that it was not possible to put a keen edge
on sheet steel.’ Ultimately, the industrial manufacturing process had to be worked out
in-house.

In cases of less severe disagreements, potential suppliers of materials, equipment, or
services may be in accord with the basic aspects of the entrepreneur’s means–ends
framework, but assign different probabilities to the overall success of the entrepreneurial
idea or the likelihood that problems related to certain attributes, events, or sequences of

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events can be overcome. This situation may exist when market participants apply an
outside view on the new venture, involving an assessment of the entrepreneurial idea
against what are believed to be prior, similar cases, or a comparative assessment that
results in ambiguity avoidance (Fox and Tversky, 1991; Kahneman and Lovallo, 1993).
Where disagreements are modest or not overly fundamental, the entrepreneur’s choice
between using existing markets and resorting to internalization is determined by the
perceived costs of persuasion and negotiation, constrained by limited resources and the
perceived threat of pre-emptive actions by other market participants. These costs are
associated with direct expenditures and personal efforts, but also with delayed and what
is perceived as impaired implementation of the entrepreneurial idea ( perhaps more
correctly put, delayed and impaired implementation reduces the income stream of the
new venture). They may be considered at the outset or become apparent as the entre-
preneurial idea is launched and tested in the marketplace.

Cognitive incongruence is very difficult to resolve even through the use of contingent
contracts, because potential suppliers and supporters of the entrepreneurial idea must
ultimately commit to investments that involve genuine risk and face the very real
possibility of a potentially insolvent entrepreneur. In contrast to interactions between
established firms, potential business partners find little security in the form of accumu-
lated resources that can be reallocated by the entrepreneur and used for selective
reputation-saving efforts. Cognitive incongruence is also difficult if not impossible to
insure away since entrepreneurial undertakings are typically unique events with rela-
tively few, if any, precedents or comparable cases (Busenitz and Barney, 1997; Knight,
1964).

Generally, cognitive incongruence suggests that the entrepreneur internalizes activi-
ties when other market participants understand but to a significant extent disagree with
the subjectively perceived means–ends framework:

Proposition 1a: In the introduction of new combinations, the entrepreneur internalizes
activities when potential suppliers of materials, equipment, or services have different
opinions about the correctness of the entrepreneur’s means–ends framework.

Proposition 1b: In the introduction of new combinations, the entrepreneur internalizes
activities when potential suppliers of materials, equipment, or services have different
opinions about critical attributes, events, or sequences of events that are part of the
entrepreneur’s means–ends framework.

These two propositions must allow for a certain amount of variation or random factors
influencing the formation of firm boundaries. As the entrepreneur follows and imple-
ments a subjective means–ends framework, resource and time constraints prevent exten-
sive search for potential suppliers of materials, equipment, or services. Moreover,
boundary decisions may reflect the entrepreneur’s personal preferences regarding orga-
nizational size (sometimes entrepreneurs do internalize activities for which appropriate
markets already exist), the perceived need for control and exact implementation of the
entrepreneurial idea, as well as cash constraints ( Jacobides and Winter, 2007, this issue).
In short, boundary decisions may be subject to ‘errors’ which are offset by particular

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strengths in other aspects of the entrepreneurial idea, and any explanation for observed
organizational boundaries should allow for considerable variation in expected outcomes
(Burton, 2001).

Cognitive incompleteness. While cognitive incongruence occurs when the fundamental pre-
mises of the entrepreneur’s means–ends framework have been understood but then
rejected, cognitive incompleteness is the result of the incomplete or only partial under-
standing of the overall logic of the means–ends framework (or inability to recognize the
entrepreneur’s ability to influence events in his or her favour). The sources of incomplete
understanding may be limited cognitive ability to grasp new business ideas that deviate
from existing and established practices, and/or the entrepreneur’s inability to articulate
and communicate complex and partly intuitively understood business propositions. In
the early stages of implementing the novel entrepreneurial idea, it may also be very
difficult to articulate and accurately describe requisite and frequently changing product
or service attributes or interfaces.

Sometimes, incomplete understanding of the entrepreneur’s undertaking may not be
accompanied by the establishment of any alternative means–ends frameworks at all, but
result in outright rejection of the entrepreneurial idea. To illustrate, Murphy (1966, p.
173, quoting Jerome, 1860) describes the local townsfolk’s limited appreciation of Eli
Terry’s experimentation with large-volume clock manufacturing and distribution tech-
niques in the early 19th century, and summarizes their reactions:

The foolish man, they said, had begun to make two hundred clocks; one said, he never
would live long enough to finish them; another remarked, that if he did he never
would, nor could possibly, sell so many, and ridiculed the very idea.

Alternatively, potential suppliers of materials, equipment, or services may for various
reasons show interest in and support for an entrepreneurial idea, but lack sufficiently
detailed and in-depth understanding of critical attributes, events, or sequences of events
of the underlying means–ends framework. Specifically, suppliers may differ in their
perception of requisite product or service functionality and quality, the timing of invest-
ments or accuracy in product and service delivery (creating costs of not having the
requisite capabilities when they are needed), or the paths of upgrading products and
services (Foss, 2001). An overheard discussion between a Russian entrepreneur selling
bottle caps in the local market and a group of fellow businesspeople may illustrate the
point. Responding to the question why the firm did not deal with the quality problems
encountered with a Chinese manufacturing partner and instead decided to start in-house
manufacturing, the answer was: ‘We tried to, but they didn’t have a clue what we were
talking about.’ As in the case of cognitive incongruence, the insufficient understanding of
the entrepreneur’s subjective means–ends framework may be evident at the outset, or
more typically become apparent as the entrepreneurial idea is launched and imple-
mented in the marketplace.

When other market participants, despite the best of intentions, are unable to supply
what the entrepreneur believes are the right products or services at the right time, their
limited outlook will be perceived as a threat to the implementation of the entrepreneurial

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idea. Under such circumstances, the entrepreneur may resort to explanation or nego-
tiation (aimed, for example, at reaching agreement on minimum standards of supplied
materials or services), but the perceived costs will ultimately reach a point where activities
are internalized and coordinated within firm boundaries. Paradoxically, cognitive
incompleteness may therefore result in a situation where intersubjective ‘agreement’ is
not necessarily supportive of market exchange (Dew et al., 2004).

Proposition 2: In the introduction of new combinations, the entrepreneur internalizes
activities when potential suppliers of materials, equipment, or services have an in-
complete understanding of the entrepreneur’s means–ends framework or critical
attributes, events, or sequences of events of that framework.

While the entrepreneur may resort to explanation, persuasion, or negotiation to
implement the entrepreneurial idea, the level of effort is limited by the entrepreneur’s
alternative use of time and the perceived need to get the entrepreneurial venture off the
ground before profits are eroded by competition. Moreover, because the entrepreneur
tends to move about in limited geographic areas (Zander, 2004), it is unlikely that he or
she will be able to survey the entire set of possible suppliers and supporters of the
entrepreneurial idea. Negotiation implies unwanted alterations to the entrepreneur’s
original means–ends framework, and may ultimately reach a point where the entrepre-
neur perceives that critical elements of the entrepreneurial idea have become compro-
mised and too hollowed-out for its effective implementation. When the entrepreneur
internalizes activities that are particularly non-transparent or challenge conventional
beliefs in the marketplace, the firm thus becomes a substitute for shared understandings
and knowledge of the future (Loasby, 1990).[7]

It is notable that lack of support for the entrepreneurial idea and the perceived costs
of explanation, persuasion, and negotiation are not necessarily a reflection of moral
hazard, but the outcome of different opinions or understandings of the entrepreneur’s
means–ends framework (Hodgson, 2004). Other market participants may be considered
as self-interest seeking when following their own convictions, but this does not necessarily
imply the stronger form that involves self-interest seeking with guile (Williamson, 1996).
As firms emerge and evolve they may thus be seen as reflections of different opinions and as
such play a central role in technological and economic processes. When challenging
conventional beliefs and ways of doing things, the entrepreneur and his or her firm are
precursors of what will eventually become established views in the normal course of
competition. Indeed, Hayek (1948, p. 106) describes the essence of the competitive
process as the formation of opinion and spreading of information, which creates the unity
of the economic system which is presupposed when we think of it as one market.

Overcoming the Market Coordination Problem

The entrepreneur’s decision to internalize activities for which there is little agreement or
understanding among other market participants is accompanied by an active involve-
ment in the coordination of activities and resources. Employees will be hired and tasks
organized and interconnected in ways which are believed will best support the realization

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of the subjective means–ends framework. Likewise, tangible and intangible resources
will be acquired, reconfigured and recombined to produce the intended output. In the
process of coordinating activities and resources, the entrepreneur initially uses central-
ized decision making and directing as a substitute for market coordination. As explained
by Knight (1964, p. 269):

. . . the organization of industry depends on the fundamental fact that the intelligence
of one person can be made to direct in a general way the routine manual and mental
operations of others . . . men differ in their powers of effective control over other men
as well as in intellectual capacity to decide what should be done.

Centralized decision making and directing allows the entrepreneur to take a shortcut
in the formation of agreement and shared understanding concerning new business ideas.
While the question ‘could it often be more productive to let someone else make the
decision?’ has been answered in the negative (Cheung, 1983), the answer in an entre-
preneurial view of the firm is more affirmative.[8] The entrepreneur’s active involvement
in coordination and directing is an essential and highly visible aspect of the start-up
period, although with some qualifications it is found also in the maturing and ultimately
established enterprise (Evans, 1942; Jenks, 1949).

Hiring decisions reflect the ambition to contract individuals who, in contrast to the
small number of people whose convictions deny access to other firms’ employees and
resources, are willing to contribute to the implementation of the entrepreneurial idea. In
the early growth phase, the entrepreneur may typically be looking for people who can
grasp and identify with the entrepreneurial idea, have the skills needed to accomplish
some immediate tasks, and are willing to accept still undefined positions in future projects
(Aldrich, 1999; Burton, 2001). However, many prospective employees, particularly in a
newly established firm, will lack a comprehensive understanding of the entrepreneurial
idea and the specific tasks they are expected to perform (indeed, this may be seen as one
of the factors that prevent employees from assuming the entrepreneurial role themselves).
Hence, the entrepreneur will initially attend to and be actively involved in allocating
tasks and clarifying interconnections among employees, often beyond what can be
explicitly expressed in the original employment contract.[9]

Employment contracts, as opposed to transactional agreements that involve short-
term and highly specified exchange of labour for compensation, yield unparalleled
flexibility to redesign and adjust operations in the flux of time and competition (Langlois,
2003). They give the entrepreneur the right within reasonable limits to swiftly change the
nature of tasks, making it possible to reorganize activities and resources without prior
consideration or renegotiation of contractual terms (Conner and Prahalad, 1996; Foss,
1996a; Simon, 1951). Indeed, the entrepreneur’s general resistance to formalizing role
assignments or job titles in the early phases of developing a business can be seen as a
reflection of the anticipated need to adapt operations to changing circumstances and
business conditions.

It has been suggested elsewhere that employment does not allow the entrepreneur fully
to control the activities of others, and that there is little difference between directing
employees and independent consultants or even representatives of other firms (Alchian

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and Demsetz, 1972). It is not argued here that employment gives or even should give the
entrepreneur absolute control or power, but submitted that the signing of an employ-
ment contract generally involves an implicit acknowledgement of the entrepreneur’s
superior ability to see and act upon profitable business opportunities, and of his or her
right to exert authority across a relatively wide range of tasks which may be activated in
the course of developing the entrepreneurial idea (Rideout, 1996). Arm’s length contracts
with external parties, which may of course vary in detail and the implicit understandings
of rights to exercise discretionary power (Collins, 2003), are based on the fundamental
assumption that authority may not to be exercised except for those instances explicitly
and unambiguously stipulated in contractual terms.

There are reasons to believe that labelling or recognition of being employed by a firm
has a demarcating effect on individual role perceptions, one of which involves acknowl-
edgement of the founding entrepreneur’s authority in business decisions. At a funda-
mental level, boundary-identifying conditions such as a firm name, an office and mailing
address, or identifying symbols distinguish work done as a firm member from individual
activities outside boundary conditions (Katz and Gartner, 1988). Reflecting this distinc-
tion, role identification has been found to be minimal, or at least less committing, in
short-term enactments such as temporary employment (Ashforth, 2001). Some recent
empirical work supports the assumption that salaried employees are more likely to
indicate stronger organizational identification, and suggests that the stronger the indi-
vidual’s organizational identification the higher the likelihood of cooperative behaviour
(Dukerich et al., 2002).

Apart from the directing of employee activities, the entrepreneur is likely to be
involved in hands-on teaching (Mintzberg and Waters, 1982), the communication of the
means–ends framework, or even the cultural paradigm of the entrepreneurial idea
(Schein, 1983), using persuasiveness, patience, and persistence to implement a model of
conduct, understanding, and commitment to the business venture (Witt, 1998). These
activities support the formation of an overall understanding of the means–ends frame-
work among newly appointed firm members, which will guide the interpretation of new
information and events and produce actions that are consistent with the perceived future
state of the world. By thus communicating the subjective means–ends framework to firm
members, the entrepreneur lays the foundation for further interaction and socialization
among employees (Witt, 2001), which as the firm matures reinforces shared understand-
ings and models of behaviour (Stinchcombe, 1965; for a review of the literature on
organizational knowledge structures, see Walsh, 1995). Eventually, the firm develops the
routines and higher-order organizing principles that make it distinctive in the market-
place (Kogut and Zander, 1992), but these routines and organizing principles originate
in the perceptions and active directing of the entrepreneur.

When market coordination problems are associated with cognitive incompleteness,
internalization and directing allows the entrepreneur to compensate for initially incom-
plete understandings of the entrepreneurial idea.[10] But internalization also has an effect
on the individual’s ability to discard or change existing cognitive structures, as entering
a new organizational context comes with the explicit or implicit recognition that new
ways of thinking and acting may be required. This gives the entrepreneur an opportunity
to change ingrained and taken-for-granted understandings and models of behaviour.[11]

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A casual illustration would be the often expressed intentions to ‘learn the new job’ and
‘get to know how things are done around here’ whenever individuals change employ-
ment and enter a new work environment. The co-location of activities under the direct
auspices of the entrepreneur allows for more frequent interaction and rapid iterations in
the process of establishing desired cognitive structures and models of behaviour. Yet,
although co-location typically coincides with activities that are carried out within the
firm, it is technically possible also in the context of organizationally separate entities and
individuals. The benefits of internalization are therefore tightly connected to the demar-
cating effects employment has on individual role perceptions and the openness towards
changing established cognitive structures and models of behaviour.

Boundary Decisions in the Maturing Firm

It has been suggested that the entrepreneur’s subjectively perceived means–ends frame-
work has a significant influence on boundary decisions when firms are created to exploit
new combinations. However, the fundamental mechanisms are likely to persist in later
stages of firm growth as well, whenever existing markets and market relationships are
deemed inadequate to promote the development of a particular business idea, or, in a
more general sense, when attempts are made to significantly change the firm’s operations
and strategy.

The traditional and most extensively discussed explanation for vertical integration
concerns avoidance of unfavourable bargaining positions or ‘bottlenecks’, and is inti-
mately associated with asset specificity and the threat of opportunistic behaviour. The
alternative view, which has been promoted in this paper, is based on the existence of
cognitive incongruence and cognitive incompleteness among market participants, and
the entrepreneur’s perceived costs of explanation, persuasion, and negotiation in the
process of implementing a specific entrepreneurial idea. This view does not assume or
depend critically on the existence of moral hazard or opportunistic behaviour, but
derives from asymmetrically dispersed knowledge, competing or incomplete means–ends
frameworks among market participants, and the constrains imposed by the entrepre-
neur’s perceived need to act swiftly upon new business opportunities.

The proposition that difficulties in responding to or understanding subjective means–
ends frameworks remain influential even after the firm’s early formation period finds
support in observations that specifically refer to the inability of market participants to
produce certain materials, equipment, or services. In his study of the growth of American
enterprises, Chandler (1977) emphasizes the importance of administrative coordination
to supplant market exchanges. Although avoidance of unfavourable bargaining positions
as well as pre-emptive competitive moves are part of the Chandler’s analytical frame-
work, the mental or physical inability to perform required tasks appears in many
instances to play an equally important role. Concerning the integration of upstream
activities, Chandler (1977, p. 487) notes that: ‘. . . marketers went into manufacturing
only on those relatively rare occasions when processors were unable to provide the goods
at the price, quality and quantity desired.’ Brown (1989, p. 533) makes a similar obser-
vation concerning William Britain’s 19th century involvement in the toy-soldier business
– because uniform details and colours were found to be important buyer selection

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criteria, the company ‘. . . made its own paints in order to ensure evenness of quality and
accuracy of colour.’ Other examples are found in the distribution and manufacturing of
American dry goods at the turn of the century and trawler ownership among Aberdeen
fish-merchants (Evans, 1957; Loasby, 1976).

In terms of downstream investments, Chandler (1977, p. 486) finds that: ‘. . . where
the mass marketers were unable to provide the services needed to distribute the goods in
the volume in which they could be produced, the enterprise became large.’ Specifically,
mass marketers were found reluctant to make what they perceived as risky investments.
Likewise, C.E.L. Brown and Walter Boveri of Brown Boveri found that the sale of
equipment in the infant electrotechnical industry was blocked by scepticism concerning
the use of electricity and certain legal problems surrounding water rights. To solve this
problem, their company set up a separate division, purchased concessions, made the
necessary installations, supervised operations, and once the concept had proven itself in
the market eventually sold the operations to cities, municipalities and private investors
(Ziegler, 1937).

While obviously open to alternative interpretations, these observations are suggestive
of the persistent consequences of divergent means–ends frameworks across entrepre-
neurs and other market participants. If taken literally, the inability of market participants
to produce certain materials, equipment, or services can and sometimes should be
interpreted as the persistent lack of understanding the tasks that the entrepreneur
perceives necessary to exploit and grow a particular entrepreneurial idea. Reluctance to
commit to risky investments may be attributed to different perceptions of the non-
measurable risks associated with the introduction of new products or services, and may
not primarily or necessarily involve consideration of the risks of opportunistic behaviour
among prospective contractual partners. The essential, but unproven, proposition is that
the problem is one of cognitive incongruence and cognitive incompleteness, not of strong
bilateral dependency and the lack of credible commitments (Williamson, 1996).

SUMMARY AND CONCLUSIONS

This paper started from the assumption that firms come into existence on the basis of
profit seeking individuals, asymmetrically dispersed knowledge, and the subjective
means–ends frameworks that ‘seeing’ entrepreneurs establish to exploit new business
opportunities. A set of propositions addressing the effects of cognitive incongruence and
cognitive incompleteness on the exploitation of new combinations has suggested that
decisions concerning firm boundaries are driven by the inability of other market partici-
pants to either accept or understand the entrepreneur’s perceived means–ends frame-
work. The extended discussion has elaborated upon how the decision to internalize
resources and activities allows the entrepreneur to overcome or alleviate the associated
problems of market coordination.

The conceptual development and formalized propositions contribute to the advance-
ment of theory that explains choice among modes of action or organizational arrange-
ments in the entrepreneurship literature (Busenitz et al., 2003), detailing the subjective
means–ends framework and identifying cognitive incongruence and cognitive incom-
pleteness as conceptually distinct drivers of firm boundaries. In the case of cognitive

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incompleteness, one paradoxical conclusion is that intersubjective agreement is not
necessarily supportive of market exchange (Dew et al., 2004). In a broader sense, the
paper’s focus on new firm formation and the introduction of new combinations resonates
and supports recent calls for establishing a distinctive domain of entrepreneurship
research, addressing and explaining the ‘why, when, and hows’ of discovering and
organizing the exploitation of future goods and services (Shane and Venkataraman,
2000).

By focusing on the conditions and processes surrounding new firm formation, the
paper supports the emerging notion of a distinctive entrepreneurship-based theory of the
firm (Alvarez and Barney, 2004; Dew et al., 2004; Foss, 1994, 1997; Foss and Klein,
2005; Witt, 1999). In contrast to established theories, which have been preoccupied with
established business entities and relatively stable markets, the entrepreneurship perspec-
tive explores the context and consequences of new and creative insights, subjectively
perceived means–ends frameworks, and time constraints in the pursuit of new business
opportunities. It is a start, and several related issues such as the entrepreneur’s use of
in-between forms of market coordination or the profit consequences of using different
coordinating mechanisms in the exploitation of new opportunities await more focused
and extensive treatment in future work.

While sharing the assumption of bounded rationality and uncertainty with the trans-
action cost view, the entrepreneurship-based theory suggests a more parsimonious expla-
nation for firm boundaries by rejecting strong forms of self-interest seeking as a universal
problem in the coordination of markets. In this respect, it concurs with suggestions that
the significance of moral-hazard problems in different business situations may currently
be overstated (Casadesus-Masanell and Spulber, 2000; Coase, 2000; Conner and Pra-
halad, 1996; Freeland, 2000; Kogut and Zander, 1992). A different interpretation would
be that whereas the transaction cost view emphasizes one particular behavioural assump-
tion (that individuals are given to opportunism), the entrepreneurship perspective
emphasizes other behavioural traits – the individual’s tendency and ability to construct
and act upon subjective means–ends frameworks, to identify with organizations, and to
enact the environment from a particular organizational or firm perspective. In this
context, the perceptions and expectations of individuals entering employment are critical
for understanding how internalization can overcome problems of market coordination.

The entrepreneurship perspective coincides with the view that firms exist because they
know how to perform certain things well (Kogut and Zander, 1992), but it does not
reduce boundary decisions to a question of knowledge fluidity and routines for knowl-
edge recombination. To overcome the barriers associated with cognitive incongruence
and cognitive incompleteness, the entrepreneur initially uses centralized decision making
and communication to coordinate resources and activities to meet the perceived require-
ments of the subjective means–ends framework. The directing of activities and alter-
ations of pre-existing cognitive structures will be followed by learnt and increasingly
elaborate routines that define the exchange and recombination of knowledge among firm
members, but the formation of these routines should be recognized as a consequence of
the entrepreneur’s initial efforts to introduce cohesion in partially unreceptive markets.

While it is beyond the scope of the present paper to comment extensively upon
operationalization and measurement issues, the conceptual development and the

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formalization of propositions concerning boundary decisions is a first step towards
empirical tests. Empirical studies that probe the relationship between cognitive incongru-
ence, cognitive incompleteness and boundary decisions could draw particularly upon
work on the measurement and comparison of cognitive maps (Eden et al., 1992;
Langfield-Smith and Wirth, 1992; Markóczy and Goldberg, 1995; Wang, 1996).
Although direct observation of cognitive structures is inherently difficult, measurement
difficulties are shared with other approaches to the theory of the firm, and at least selective
aspects of the proposed causal mechanisms could be effectively addressed in experimental
settings. Additional insights could be gained from qualitative sources and content analysis
of actual statements concerning boundary decisions by practicing entrepreneurs.

As a closing reflection, the parallel existence of conflicting views on the nature and
boundaries of the firm is reflective of a dynamic and still elusive phenomenon (Afuah,
2001; Langlois, 1992a, 2003; Langlois and Robertson, 1989). The present paper has
suggested cognitive incongruence and cognitive incompleteness as critical determinants
of boundary decisions in the exploitation of new combinations, adding that their influ-
ence may also extend into later stages of firm growth. Yet, it must be emphasized that it
does not purport to replace any existing theories of the firm, assuming that other
considerations and explanations may gain in importance as new combinations prove
themselves in the marketplace, markets for materials, equipment, or services become
more generally recognized and understood, and specialist suppliers increasingly provide
viable alternatives to internally coordinated activities and resources (Alvarez and Barney,
2005). A perhaps bolder proposition would be that decisions concerning firm boundaries
routinely reflect a mix of different considerations and decision logics, the full implications
of which are yet to be addressed in further conceptual and empirical work.

Returning to the core arguments of the paper, the primary ambition has been to detail
the consequences of an entrepreneurship perspective on the nature and boundaries of
the firm, and to contribute to the building of theoretical foundations of the domain of
entrepreneurship research. The focus on new firm formation, new combinations, and
subjective world views concurrently offers a reference point for assessing the universal
relevance of established theories of the firm. Although general acceptance of the
co-existence of competing theories is perhaps unlikely to emerge anytime soon, discus-
sions that probe the boundaries and general explanatory power of current and new
theoretical approaches should become a more prominent element in the debate on the
nature and boundaries of the firm in the years to come.

NOTES

[1] Also, Casson (1982), Grossman and Hart (1986), and Milgrom and Roberts (1992).
[2] As suggested by Baron (1998), entrepreneurs may also disregard large parts of the information available

from past experiences, instead focusing on their enthusiastic visions of the future.
[3] Related concepts, which involve the articulation of causality, include cognitive maps or cause maps

(Eden, 1992; Eden et al., 1992).
[4] These new combinations largely correspond to the technological discontinuities and radical innova-

tions discussed by Tushman and Anderson (1986) and Henderson and Clark (1990).
[5] The context is that of multiple suppliers with diversified sales who add an insignificant buyer to their

existing customer base. To the extent existing markets are skewed or imperfect, for example due to the
existence of patents or firms with dominant positions that have been historically determined, the

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entrepreneur will need to take these factors into account when estimating the potential success of the
new business venture. In the long term, the entrepreneur may be able to act strategically to mitigate the
effects of imperfect markets, for example by attempting substitution or forging coalitions with other
firms.

[6] The problem may be re-framed as one of suppliers contemplating investments that are characterized
by high degrees of asset specificity and thus subject to the risks of opportunistic behaviour. The
situation initially (and in the absence of additional assumptions also in the long run) will be one of
balanced bilateral dependence, and outcomes sensitive to any credible commitments the parties may
be able to make. Yet, as argued by others (e.g. Alvarez and Barney, 2005), transaction cost theory is yet
to address decision outcomes under conditions of genuine uncertainty. It will be maintained in the
following that decisions concerning firm boundaries can be explained without evoking assumptions
about opportunistic behaviour.

[7] Although in some cases explanation, persuasion and negotiation increase the risk of imitation (Alvarez
and Barney, 2004), the extent to which other actors can use the information opportunistically should
not be overestimated. The inclination and ability of others to act upon the received information
depends on a set of factors that affect the feasibility or desirability to engage in imitative behaviour
(Krueger, 2000). For example, external parties may not be in possession or control of the skills or
personal networks of the entrepreneur, and sometimes patents effectively prevent outright imitation.
Other limiting factors include preconceived notions of the potential scope of the existing business
(similar to the notion of core strategic areas; Burgelman, 1983), reputational effects (imitation may
damage the ability to conduct business with other parties and create bad-will among customers), or the
relative size of the new venture compared to already established businesses. Clearly, the possibility of
opportunistic behaviour remains a factor to be considered in explaining new business ideas to others,
the point is that it is not the only or necessarily overriding consideration in all cases.

[8] Foss (2001) makes the same point from a property rights perspective.
[9] It is beyond the scope of this paper to investigate why some individuals are willing to bet on the

uncertain future of new ventures or why they decide to take up employment rather than work
independently or start their own firm. Answers may be found in the entrepreneur’s charismatic
leadership, rational utility-maximizing behaviour (Simon, 1951), differences in the inclination to act
upon insight or judgment (Knight, 1964), a clearing process which separates those who inspire from
those who get inspired (Witt, 1998, 1999), or even the suggestion that firms offer an arena for social
belonging which conveniently combines with monetary rewards (thereby connecting the extra-
economic with the economic; Foss, 1996b).

[10] Along the same lines, Alvarez and Barney (2004, p. 628) note: ‘The craftsman “knows more than he
can tell” . . . and thus cannot simply explain to the apprentice all that must be known to create valuable
works of art. However, to the extent the apprentices are willing to subject themselves to the direction
of the craftsman, over time they can begin to learn the skills necessary to create great works of art.’

[11] The entrepreneur’s relative advantage in changing taken-for-granted understandings and models of
behaviour includes both cases of acquired firms (although factors such as the degree of hostility in the
take-over process may complicate matters) and newly employed individuals. It is temporally con-
strained, as over time learning on the job and socialization tend to solidify new cognitive structures.

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Performance feedback and
organizational learning: the role of

regulatory

focus

Shinhye Ahn

Graduate School of Business, Seoul National University, Seoul, Korea

Cecile K. Cho
Korea University Business School, Seoul, Korea, and

Theresa S. Cho
Graduate School of Business, Seoul National University, Seoul, Korea

Abstract

Purpose – This study investigates how a firm’s regulatory focus (i.e. promotion and prevention foci) affects
growth- and efficiency-oriented strategic change, highlighting the role of organizational-level regulatory focus
as a cognitive frame within which to interpret performance feedback and its subsequent effects on strategic
decisions.
Design/methodology/approach – The authors collected longitudinal data on 98 S&P 500 manufacturing
firms for a seven-year period. The panel data, which includes texts from the firms’ 10-K filings, were then
analyzed using a feasible generalized least squares (FGLS) regression estimator to test the authors’ hypotheses.
Findings – A firm’s strategic change orientation is affected by its regulatory focus and performance feedback:
a promotion focus increases the magnitude of growth-oriented strategic change, while a prevention focus
favors efficiency-oriented strategic change. Furthermore, both foci moderate the effect of performance
feedback on the strategic change orientation: under negative performance feedback, a promotion (prevention)
focus increases (decreases) the magnitude of growth-oriented strategic change relative to that of efficiency-
oriented change. The findings provide robust evidence that regulatory focus can influence how organizations
learn from feedback and formulate strategic change.
Research limitations/implications – The authors’ examination of regulatory focus and organizational
learning process relied on large manufacturing firms in the USA. However, learning process could be quite
different in small and/or young firms. Future work should expand to a wider range of organizational types,
such as nascent entrepreneurial ventures. In addition, the authors’ measurement of regulatory focus using
corporate text has inherent weakness and could be supplemented with alternative research methods, such as
surveys, interviews or experiments. All in all, however, the findings of this study offer a novel behavioral
perspective while demonstrating that a regulatory focus is an important antecedent of organizational learning.
Practical implications – This study highlights the importance of motivational characteristics of the top
managers in the process of organizational learning from performance feedback. Furthermore, recruitment of a
new top manager should be aligned with the organizational context, values and goals. In addition, corporate
governance systems such as managerial compensation schemes need to be carefully designed so as to
maximize organizational resilience, especially in the context of performance downturn or environmental
change. Establishing a constructive organizational culture so that strategic decisions are not overly swayed by
the performance outcomes would also be crucial to the organizational learning process.
Social implications – This study highlights the importance of understanding the motivational orientations
of top managers in organizational learning. In terms of managerial compensation, for instance, an optimal
incentive system should reflect the desired performance output by encouraging managerial behavior that
corresponds to its objective. Furthermore, motivational orientation of new recruits should be considered in the
context of the composition of the top management team members in order to achieve “optimal fit.” In addition,
this study suggests that top executives’ regulatory focus can be a key factor for organizations in balancing
goals of different value orientations.
Originality/value – The findings of this study demonstrated that a firm-level regulatory focus has a
significant effect on organizational learning and strategic change following performance feedback. The
authors hope this study provides an impetus for future discussions on the microcognitive mechanisms of

Organizational
learning and
regulatory

focus

This research has received funding from Institute of Management Research at Seoul National University
and Korea University Business School Research Grant.

The current issue and full text archive of this journal is available on Emerald Insight at:

https://www.emerald.com/insight/0025-1747.htm

Received 30 September 2019
Revised 2 May 2020

2 June 2020
Accepted 3 June 2020

Management Decision
© Emerald Publishing Limited

0025-1747
DOI 10.1108/

MD

-09-2019-1319

https://doi.org/10.1108/MD-09-2019-1319

organizational learning by exploring the relations between organizations’ regulatory foci, performance
feedback and strategic change orientations.

Keywords Regulatory focus, Cognitive frame, Performance feedback, Strategic change, Organizational

learning

Paper type Research paper

Introduction
The behavioral theory of the firm suggests that organizations learn through formalized,
structured processes that continuously and incrementally adjust organizational routines
and strategic decisions based on feedback on prior performance (Cyert and March, 1963).
Cyert and March (1963) proposed that organizations compare their performance levels
against their aspirations as the minimal level of “satisficing” or the threshold between
success and failure (Greve, 2003). When a firm’s performance falls short of its aspirations,
it initiates a problemistic search, which increases its risk tolerance (Cyert and March,
1963). In contrast, when performance exceeds its aspirations, the firm becomes more risk-
averse (Cyert and March, 1963). This performance feedback model (Cyert and March, 1963;
Greve, 2003) has provided a growing body of research with a powerful framework through
which to explain the associations between organizational learning and various corporate
strategic decisions, including allocation patterns of managerial attention (Hu et al., 2017),
organizational change (Greve, 1998), acquisition activities (Miller and Chen, 2004),
corporate divestitures (Shimizu, 2007), research and development investment (Lim and
McCann, 2014), new market entrance (Shapira, 2017), foreign direct investment (Xie et al.,
2019), cooperative behavior toward competitors (Makarevich, 2018), bribery expenses (Xu
et al., 2019) and fraudulent actions, such as misrepresenting financial information (Harris
and Bromiley, 2007).

However, despite the growing body of literature on the performance feedback model, the
cognitive-level microprocesses involved in organizational learning remain relatively
underexplored. An organization is an open system in which learning occurs not in
isolation, but through its continuous interactions with various internal and external
environments (Scott and Davis, 2015; Thompson, 2017). As such, scholars have increasingly
been interested in the environmental factors that may either amplify or constrain the effect of
performance feedback on organizational change. For example, firm size (Audia and Greve,
2006), organizational success and failure experiences (Desai, 2008), executive compensation
(Lim and McCann, 2014), outside experience of managers and the independence of boards
(Choi et al., 2019), organizational structure (Joseph et al., 2016) and business group affiliation
(Vissa et al., 2010) have been found to alter the outcomes of organizational performance
feedback learning.

Currently, this literature focuses on mostly how archival measures based on the firm-level
affect organizational learning, largely ignoring how cognitive elements can stimulate such
learning. This paucity of research is surprising, given that behavioral theory of the firm
(Cyert and March, 1963) posits that organizations learn through sociocognitive mechanisms
in decision-making processes. This lack of research on the cognitive aspects of organizational
learning was also highlighted by Posen et al. (2018), who suggested that research on
performance feedback and problemistic searches needs to incorporate such aspects in order
to better understand the processual issues in organizational learning.

In this study, we address these gaps in the literature. In particular, we explore the role of
regulatory focus at the firm level as a crucial determinant of the cognitive frame used in the
performance feedback learning process. Regulatory focus, in general, is defined as an
individual’s tendency to self-regulate his/her own behavior through promotion and/or
prevention focus (Higgins, 1998). Specifically, we argue that a firm’s regulatory focus serves

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as a crucial determinant of its strategic change orientation. Furthermore, we posit that the
interplay between the firm’s focus and its performance feedback affects the firm members’
perceptions and interpretation of the feedback. This leads to a shift in the firm’s strategic
change orientation that diverges from the outcomes predicted by the behavioral theory of the
firm. Hence, we examine two research questions: (1) How does a firm’s regulatory focus directly
affect its strategic change orientation? (2) How does performance feedback affect the interplay
between a firm’s regulatory focus (as a cognitive frame) and its strategic change orientation?
We test our idea empirically using longitudinal data on 98 US manufacturing firms for the
period 2011–2017. The results support our prediction, in general.

In summary, this study adds to the organizational learning literature (Cyert and March,
1963; Greve, 2003) by showing that, in addition to archival measures (e.g. financial
performance or slack), organizational learning is governed by how the members of the firm
perceive and interpret their environmental contexts, based on their cognitive orientations. By
clarifying the role of regulatory focus in the relation between performance feedback and
strategic change, we hope to provide novel insights that expand our understanding of this
role beyond that currently documented in the literature (Gamache et al., 2015; Jiang et al., 2019;
Rhee and Fiss, 2014).

Theory and hypotheses
Strategic change as a response to organizational regulatory focus
Organizational scholars have devoted much attention to drivers of strategic change. As such,
various firm characteristics have been found to stimulate such change, including firm size
(Audia and Greve, 2006), age (Hannan and Freeman, 1984), successful and unsuccessful prior
performance (Audia et al., 2000; Greve, 1998) and external media portrayal of the firm (Bednar
et al., 2013). In particular, given that the strategic change process entails much risk and
uncertainty (Carpenter, 2000; Zhang and Rajagopalan, 2010), scholars have become
increasingly interested in its underlying cognitive mechanisms. As Gioia and Chittipeddi
(1991) note, a strategic change involves “the creation of instability in members’ ways of
understanding the organization” (p. 434) and, hence, is inevitably influenced by how these
members make sense of the world.

As a result, management scholars are increasingly focusing on the cognitive antecedents
of strategic change. For instance, studies have identified executives’ entrepreneurial
orientation (Cho and Hambrick, 2006), personality (Herrmann and Nadkarni, 2014) and
motivational characteristics (Jiang et al., 2019) as predictors of strategic change. However,
despite this growing recognition of the importance of such cognitive antecedents, we still lack
a comprehensive understanding of the organizational cognition involved in strategic change.
In fact, many of the micro-level processes of strategic change remain underexplored, with
intermediate-level processes conceptualized as a “black box in the middle.” This lack of
research is surprising, given that strategic change, which entails substantial uncertainty and
risk of failure, is closely linked to how organizational members perceive, interpret and make
sense of their environment.

We contend that a firm’s implementation of strategic change is driven by organizational
cognition and, in particular, by its regulatory focus (Gamache et al., 2015; Higgins, 1997, 1998;
Jiang et al., 2019; Rhee and Fiss, 2014; Weber and Bauman, 2019). Although this theory
originated as an individual-level construct, it is increasingly being applied to teams and
organizations (Brockner et al., 2004; Gamache et al., 2015; Johnson et al., 2015). Our premise is
consistent with the view that a firm’s collective cognitive orientation can be gauged by
assessing that of its top management team. To this end, we briefly describe regulatory focus
theory, including recent studies based on this theory, and then explain how we use it to
conceptualize the cognitive dimension of organizational learning.

Organizational
learning and
regulatory
focus

Regulatory focus and individual cognition
Regulatory focus theory posits that individuals pursue their goals through distinctive modes
of self-regulation, represented by promotion focus and prevention focus (Higgins, 1997, 1998).
Although numerous psychological theories (e.g. approach-avoidance theory, expectancy-
valence theory and emotional and evaluative sensitivity theories) have been derived from the
hedonic principle of “approaching pleasure and avoiding pain,” it remains unclear which end
states individuals pursue and what strategies they employ to reach such end states (Higgins,
1997, 1998). Regulatory focus theory proposes two distinctive ways of approaching types of
desired end states, based on how individuals perceive and pursue their goals: promotion and
prevention focus. Scholars have suggested both biological (Gomez et al., 2013; Higgins, 1997)
and environmental factors (F€orster et al., 1998; Higgins, 2000) as constituents of individual
regulatory focus. Thus, a regulatory focus may be conceptualized as comprising two
dimensions of psychological elements: chronic individual dispositions (e.g. narcissism and
core self-evaluations) and situational and context-dependent emotions (e.g. positive and
negative moods) (Gamache et al., 2015).

Promotion- and prevention-focused individuals self-regulate their emotions, cognition and
behavior through different mechanisms. Following Brockner et al. (2004), promotion- and
prevention-focused self-regulations differ along three major dimensions: (1) the underlying
motives of behavior, (2) the goals individuals try to attain and (3) the types of salient
performance cues or outcomes that sensitize them. First, promotion-focused individuals are
motivated by growth and advancement needs, whereas those focused on prevention are
motivated by security and safety needs (Higgins, 1997). Thus, the most prominent goals of
promotion-focused people are those related to capturing opportunities that align with their
aspirations by maximizing gains, minimizing nongains, ensuring hits and minimizing “errors
of omission” (missing out on an opportunity). These attributes drive such individuals to
initiate actions in response to an opportunity for gain, value speed and quantity over
accuracy and quality and tolerate experimentation and risk-taking if this means moving
closer to their ideals and aspirations (Higgins and Spiegel, 2004). Thus, individuals with
promotion focus are sensitive to positive stimuli in the environment (Higgins, 1997).

In contrast, prevention-focused individuals tend to focus on their ought selves (fulfilling
their designated responsibilities), minimizing losses and maximizing nonlosses and
preventing “errors of commission” (investing too many resources unnecessarily, owing to
a misjudgment), with heavier weight given to negative stimuli (Higgins, 1997). These
attributes gear their behavior toward vigilance. As such, they make careful and systematic
decisions, emphasize accuracy and quality over quantity and create a sense of security by
adhering to rules and conventional routines (Higgins and Spiegel, 2004). To summarize, in the
same context, their divergent motivations and preferences mean that promotion- and
prevention-focused individuals interpret the environmental stimuli differently and, thus,
make different choices.

Regulatory focus and organizational cognition
Organization research offers much evidence that regulatory focus can be applied to
understanding firm-level cognition and behavior. In their review article, Johnson et al. (2015)
suggest that regulatory focus theory can be considered “a multilevel construct” that operates
on individuals and at the team and organizational levels (Johnson and Wallace, 2011). Here,
teams and organizations are conceptualized as assuming a promotion or prevention focus,
offering a distinct way of characterizing their respective goals (Johnson et al., 2015; Rietzschel,
2011). Regulatory focus has been described as a collective cognitive orientation that exerts a
direct influence on the formation of group and organizational norms with respect to strategic
thinking (Levine et al., 2000). This distinct orientation has been found to affect firm

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performance related to innovation (Beersma et al., 2013), creativity (Sacramento et al., 2013)
and strategic change (Downs et al., 2006). For instance, a collective regulatory focus has been
shown to manifest in organizational change when the focus of the top executives trickles
down to employees (Downs et al., 2006). In a macro-organizational context, the collective
cognition of the top management team can take on a distinctly promotion or prevention
orientation, affecting how a firm identifies its goals (Wallace et al., 2010) and the manner in
which these goals are pursued, including its perception of risk and its acquisition decisions
(Gamache et al., 2015).

We predict that the distinctive characteristics of firm-level promotion and prevention foci
lead to variations in firms’ orientations toward strategic change. The basic premise of our
theoretical framework is that organizational-level cognition is, in general, an amalgamation of
individual cognitions, aggregated through various processes (Fiske and Taylor, 1991; Walsh,
1995). Thus, in the context of regulatory focus, we contend that a promotion focus shifts a
firm’s strategic change orientation toward growth rather than efficiency. Conversely, we
speculate that a prevention focus leads to an orientation toward efficiency rather than
growth.

The dichotomized strategic change orientation of growth versus efficiency is drawn from
two divergent mechanisms of strategic change (Gordon et al., 2000, p. 912). Revolutionary
strategic change, on the one hand, creates systematic reconfiguration in organizational design
and brings discontinuous and fast-paced changes in firms’ strategies (Gordon et al., 2000,
p. 912; Lant et al., 1992; Tushman and Romanelli, 1985). On the other hand, evolutionary
strategic change induces the incremental adaptation and refinement of a firm’s current
strategy toward consistency and convergence (Gordon et al., 2000, p. 912; Pettigrew, 1987). In
this research, we draw on these previous theoretical perspectives on strategic change (Gordon
et al., 2000; Tushman and Romanelli, 1985) and refer to them as growth or efficiency orientation.

First, growth-oriented strategic changes (e.g. increased R&D investment and advertising
expenditures) necessitate that a firm explores novel domains and confronts future
uncertainty. In particular, R&D investment entails substantial risk because it has a longer
payoff horizon and significant sunk costs (Lee and O’Neill, 2003). Moreover, because R&D
projects usually require external equity and specialized human capital, they increase the risk
of diluting incumbent members’ control of the firm (Carney, 2005; Sirmon and Hitt, 2003). In
contrast, efficiency-oriented strategic change (e.g. reducing nonproduction overheads and
inventory levels; see Haleblian and Finkelstein (1993)) occurs when the firm seeks to exploit
familiar domains and reaffirm its learning curve, as dictated by previous routines. Cost
inefficiencies, such as increases in operative and administrative expenses and excessive
inventory levels (Haleblian and Finkelstein, 1993), arise when a firm deviates substantially
from its previous strategic options. Conversely, organizational efficiency is best achieved
when organizations follow prior routines based on repetitive trial-and-error processes
(Argyris and Sch€on, 1997) and make incremental adjustments to their heuristics and
standard operating procedures (Bingham et al., 2007).

Thus, we expect a firm’s promotion focus to facilitate a strategic change oriented toward
growth, but to hamper that oriented toward efficiency. In contrast, we expect a prevention
focus to favor efficiency over growth. Prior research on regulatory focus suggests that a
promotion focus is associated with experimentation and a global and explorative search,
whereas a prevention focus is associated with a localized and exploitative search. In their
experimental studies, Pham and Chang (2010) found that promotion-focused consumers
conduct searches that are more global and consider larger choice sets when making dinner
selections from a restaurant’s menu, as compared with their prevention-focused counterparts.
This finding is consistent with those of prior related studies (F€orster and Higgins, 2005;
Lee et al., 2010; Semin et al., 2005). In addition, Ahmadi et al. (2017) found that promotion-
focused individuals pursue higher levels of exploration related to technological change.

Organizational
learning and
regulatory
focus

This increased scope of search and higher intensity of exploration associated with a
promotion focus leads to a greater desire to increase the chance of success by exhausting all
alternatives (Higgins, 1998). In contrast, the primary concern of prevention-focused
individuals is reducing errors of commission by examining all options in detail (Pham and
Chang, 2010). Thus, we suggest that promotion-focused organizations, with their inclination
for exploration and experimentation, adopt a strategic orientation of growth, rather than
efficiency. In contrast, we expect that prevention-focused organizations emphasize efficiency
over growth. Combining these ideas, we propose the following hypotheses.

H1. Firms with a promotion focus undertake greater growth-oriented strategic change
relative to efficiency-oriented strategic change.

H2. Firms with a prevention focus undertake greater efficiency-oriented strategic change
relative to growth-oriented strategic change.

Regulatory focus and strategic change: the role of performance feedback
Although we predict that a firm’s regulatory focus will have a direct effect on the extent of
strategic change, this effect may be moderated by its performance feedback. A basic premise
of the behavioral theory of the firm (Cyert and March, 1963) is that above-aspiration
performance leads to risk aversion and below-aspiration performance leads to risk-taking
behavior, at the firm level. The argument is based on the following assumptions. First, top
decision-makers focus primarily on a prior level of aspiration, defined as “the smallest
outcome that would be deemed satisfactory by the decision-maker” (Schneider, 1992, p. 1053).
Thus, an organization’s aspiration is derived from its own past performance history and the
performance levels of other comparable organizations within an industry (Cyert and March,
1963; Greve, 2003). Second, decision-makers interpret their organizational performance based
on their aspirations. Thus, the firm’s performance is considered successful when it exceeds
the aspirations, but is a failure when it falls below these aspirations. Finally, the firm’s
performance relative to its aspirations determines its search activities and risk-taking
behavior. Those in a failure state take more risks than those in a success state do, because the
desire to overcome failure is greater than the desire to maintain success.

However, as noted by Posen et al. (2018), critics of the performance feedback model point
out its highly mechanistic prediction on organizational behavior. Indeed, diverse alternative
predictors other than performance feedback can account for a firm’s problemistic search and
strategic change. Examples include the escalation of commitment theory (e.g. Sleesman et al.,
2012; Staw, 1976), threat rigidity theory (e.g. Staw et al., 1981) and shifting-focus model of
decision-making (e.g. March and Shapira, 1987, 1992). In this light, organizational scholars
have attempted to identify environmental factors that can amplify or attenuate the effects of
performance feedback on organizational change. For instance, Audia and Greve (2006) found
that firm size significantly moderates the relationship between performance feedback and
business expansion in the Japanese shipbuilding industry. Desai (2008) found that operating
experience, corporate legitimacy and firm age are boundary conditions for organizational
performance feedback learning in the US railroad industry. Other moderators include the
structure of executive compensation (Lim and McCann, 2014), outside experience of
managers and independence of the boards (Choi et al., 2019), business group affiliation (Vissa
et al., 2010), time horizon of strategic decisions (Lehman et al., 2011), level of internal resources
(Kuusela et al., 2017), organizational structure (Joseph et al., 2016) and a firm’s status and
category distinctiveness (Kim and Rhee, 2017).

Nonetheless, the extant literature has focused mainly on the archival measures, such as
organizational resources and financial performance, as the boundary condition, with few
studies examining the micro- and cognitive-level factors in the organizational learning process.
Although a few works have examined how cognitive attributes (e.g. self-enhancement,

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narcissism and internal and external referent orientation) alter the process of learning from
performance feedback (e.g. Audia and Brion, 2007; Jordan and Audia, 2012; Short and Palmer,
2003), we still know relatively little about how the sociocognitive attributes of an organization
influence its performance feedback learning. Posen et al. (2018) highlighted this paucity of
research by stating that “a research agenda premised on a more central role for cognition in
the theory and the need for greater emphasis on a process perspective of problemistic search
is needed” (p. 208).

In this study, we answer the call of Posen et al. (2018) and contend that an organization’s
cognitive frame (how the organization perceives, interprets and makes sense of its
environmental change) significantly alters how it responds to its performance feedback. In
particular, we suggest that a firm should employ its regulatory focus as a cognitive frame,
such that a motivational mindset oriented toward either seeking pleasure (i.e. promotion
focus) or avoiding pain (i.e. prevention focus) becomes a fundamental part of its strategic
change orientation.

Organizations with different cognitive frames perceive and interpret the environment
differently. Research on cognitive frames, which form the unique perceptions and
interpretations of a context (Gioia and Thomas, 1996), is increasing among organizational
theorists, particularly in relation to positive and negative framing (e.g. Dutton and Jackson,
1987; Ocasio, 1995), temporal framing (e.g. Nadkarni et al., 2018) and emotional ambivalence
framing (e.g. Gilbert, 2006; Plambeck and Weber, 2009). Promotion and prevention framing
are also the subject of a growing number of organization studies (e.g. Cacioppo et al., 1997;
Higgins, 1997; Weber and Bauman, 2019; Weber and Mayer, 2011), based mainly on the
Carnegie School’s tenet that how we frame a problem guides our search and matching
processes, which causes significant variation in individuals’ risk-taking behavior. Indeed, a
firm’s performance is not viewed as a success until its members subjectively interpret and
make sense of the event as positive. As such, we predict that how an organization responds to
performance feedback is shaped significantly by how it uniquely interprets and makes sense
of its prior performance.

First, we predict that under positive performance feedback, a firm’s regulatory focus will
not play a significant role in its strategic decisions; in fact, the firm is more likely to maintain
its status quo (e.g. Greve, 2003; Iyer and Miller, 2008). Positive performance feedback that
surpasses the aspiration level signals to the firm that its current course of strategic actions
has been effective. Under a positive signal, the firm reduces its exploration of novel domains
by, for example, reducing its R&D and advertising expenses. Moreover, such organizations
would not feel it necessary to venture into new areas with high risk, because the net gain from
incremental exploitation and adhering to the status quo is greater than that from exploration
and adventuring into unknown domains. In fact, experimenting would jeopardize its current
advantages that stem from the status quo.

This logic holds even when we analyze regulatory foci separately. On the one hand, for
promotion-focused organizations, positive performance feedback suggests that adhering to the
prior course of strategic action will best guarantee a continued flow of positive stimuli, which is
a strong source of motivation. On the other hand, for prevention-focused organizations,
receiving positive performance feedback implies that negative stimuli will be best avoided by
maintaining their previous routines and heuristics related to implementing strategic change.
Therefore, we expect that both promotion- and prevention-focused organizations respond to
positive performance feedback by reducing the magnitude of their strategic change and
becoming strategically inactive. Thus, we suggest the following hypotheses.

H3. Under positive performance feedback, firms with a promotion focus maintain the
status quo with less strategic change, regardless of whether they are growth- or
efficiency-oriented.

Organizational
learning and
regulatory
focus

H4. Under positive performance feedback, firms with a prevention focus maintain the
status quo with less strategic change, regardless of whether they are growth- or
efficiency-oriented.

The behavioral theory perspective suggests that when performance falls short of the firm’s
aspirations, it initiates a problemistic search, which increases the level of strategic change
(Cyert and March, 1963; Greve, 2003). In this study, we propose that this organizational search
to find solutions to the negative performance feedback differs substantially by regulatory
focus. Traditionally, the previous research has highlighted the search as a fundamental
process of organizational learning (Cyert and March, 1963; Levitt and March, 1988; March
and Simon, 1958). This search is an organic problem-solving process through which
organizations “recombine,” “relocate” and “manipulate” existing knowledge and “create” new
knowledge (March and Simon, 1958; Katila and Chen, 2008, p. 593). Firms use the search to
approach their aspirations, specifically, by solving impending problems or using slack
resources in novel ways (Cyert and March, 1963; Greve, 2003).

Managers are boundedly rational and are overloaded with more information than they can
fully perceive or interpret (March and Simon, 1958). Thus, the domain of the search in which
the managers allocate their limited cognitive resources becomes a critical issue. While
previous research differentiates between local and distant searches (e.g. March, 1991; Martin
and Mitchell, 1998; Stuart and Podolny, 1996), we extend this stream of research by
distinguishing between two additional types of search: (1) a global search, in which the search
terrain spans distant, broad and inexperienced domains with the goal of exploring novel
knowledge; and (2) a local search, in which the search terrains are local, narrow and
experienced while striving to leverage previously developed knowledge.

In organizations, a search domain depends on its organizational-level cognition. As Li et al.
(2013) remarked, a search is a “controlled and proactive process of attending to, examining,
and evaluating new knowledge and information” (p. 893). For promotion-focused
organizations, negative performance feedback prompts a problemistic search that is more
global in scope, because these organizations hope to encounter a positive stimulus by
increasing their exploration, confronting uncertainty and attempting novel domains. Hence,
we predict that global search activities result in a firm’s strategic change being oriented more
toward growth than efficiency. In contrast, prevention-focused organizations under negative
performance feedback focus their behavior more toward safety and stability, rather than
exploration and experimentation, owing to their fear of encountering even greater losses
relative to the status quo (Higgins, 1997). Thus, we predict that prevention-focused
organizations initiate searches that are more local in scope, resulting in a firm’s strategic
change being oriented more toward efficiency than growth.

Therefore, we propose two hypotheses on the relation between regulatory focus and
strategic change under negative performance feedback. Specifically, we contend that a
promotion focus is positively associated with strategic change oriented toward growth rather
than efficiency. In other words, a firm with a promotion focus is more likely to concentrate its
efforts on growth and expansion when performance feedback is subpar. In contrast, under
negative performance feedback, a prevention focus is positively associated with strategic
change oriented toward efficiency rather than growth. In other words, a firm with a
prevention focus is more likely to focus on streamlining operations, minimizing overhead
costs and so forth, when performance feedback is below its aspirational level. We thus offer
the following two hypotheses.

H5. Under negative performance feedback, firms with a promotion focus will undertake
greater growth-oriented strategic change, relative to efficiency-oriented strategic
change.

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H6. Under negative performance feedback, firms with a prevention focus will undertake
greater efficiency-oriented strategic change, relative to growth-oriented strategic
change.

Methods
Data selection
We collected data on US manufacturing firms listed on the S&P 500 in 2017. The Standard
Industrial Classification (SIC) codes of the sample firms ranged from 2,000 to 3,999, which
means our sample is comparable with those of prior studies on organizational learning (e.g.
Chen and Miller, 2007; Lim and McCann, 2014; Miller and Chen, 2004).

The data cover the period 2011–2017 and are taken from three databases: COMPUSTAT,
EXECUCOMP and Securities and Exchange Commission (SEC) EDGAR. Firms with any
missing data were omitted from the sample. The final sample comprised 98 firms with 447
firm-year observations.

Dependent variables
Growth-oriented relative to efficiency-oriented strategic change. Based on prior related research
(Bednar et al., 2013; Jiang et al., 2019; Zhang and Rajagopalan, 2010), we measure a firm’s
strategic change orientation as the change in its resource allocation patterns in key strategic
dimensions representing growth and efficiency. Growth-oriented strategic change is
measured in terms of advertising intensity (advertising/sales) and R&D intensity (R&D/
sales). Efficiency-oriented strategic change is calculated using nonproduction overheads
(selling, general and administrative [SGA] expenses/sales) and inventory levels (inventory/
sales). All variables are obtained from COMPUSTAT.

We derive our measures as follows. First, for each ratio, we calculate the difference
between the focal year and the previous year to capture the variation in a firm’s resource
allocation over time. Next, we subtract the median value of the relevant ratio within each two-
digit industry to adjust for primary industry effects. Following the operationalization used in
prior studies (Bednar et al., 2013; Jiang et al., 2019; Zhang and Rajagopalan, 2010), we
standardize the absolute values of the industry-adjusted differences within the sample such
that the mean is 0 and the standard deviation is 1. Then, we add the two standardized ratios
for each strategic change dimension and use the index as our composite measure of strategic
change. This reflects the extent to which firms’ strategies were fixed or changed over time in
the respective domains. Thus, a lack of change in this measure represents a degree of
persistence in the firms’ strategies (Bednar et al., 2013). For the index of efficiency-oriented
strategic change, we multiply the result by �1, reflecting that an increase in nonproduction
overheads and inventory levels represents organizational inefficiency (Haleblian and
Finkelstein, 1993). The Pearson correlation coefficient between the two strategic change
orientation indices is �0.2730 (p < 0.01), indicating that the growth and efficiency orientations are inversely correlated.

We wish to determine how much of the firm-level strategic change can be accounted for by
the trade-off between growth and efficiency. Thus, for each firm, we divide the change in
growth-oriented change by the sum of growth- and efficiency-oriented change. Because the
averages of the standardized values are highly skewed toward 0, we add the value 2 and take
the natural logarithm of the result.

Independent variables
Organizational regulatory focus: promotion focus and prevention focus. To capture the
strength of the promotion and prevention foci at the firm level, we perform a text analysis of
the management discussion and analysis (MD&A) section (item 7) in the firms’ 10-K filings.

Organizational
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focus

This section and other corporate documents (including annual reports) are widely used to
measure managerial and organizational cognition (e.g. Cho and Hambrick, 2006; Hu et al.,
2018; Kaplan, 2008). We use text analysis software called Linguistic Inquiry and Word Count
2015 (LIWC 2015; Pennebaker et al., 2015) to assess the lexicons in the MD&A section of 10-K
filings in order to measure the percentages of promotion and prevention words that appear in
each document. The dictionaries for promotion and prevention words, 27 and 25, respectively,
were developed by Gamache et al. (2015). Table 1 lists these lexicons, along with examples of
their usage in the sample firms’ 10-K MD&A sections. The 10-K filings were collected for each
year from the EDGAR database provided by the US SEC.

Positive and negative performance feedback. Organizational performance feedback is
operationalized using the method of Audia and Greve (2006) and Gaba and Joseph (2013).
Here, we calculate the difference between a firm’s performance and its organizational
aspirations in a given year. The aspirations are calculated as the weighted sum of the firm’s
historical and social aspirations. We measure firm performance using return on assets (ROA),
because this is the major accounting-based proxy for firm profitability within the
manufacturing industry; see Lim and McCann (2014) and Miller and Chen (2004). The
historical aspiration of each firm in a given year is the weighted average of performance and
the historical aspiration of the previous year; the social aspiration is the mean performance of
all firms in the manufacturing industry in a given year, excluding that of the focal firm (Audia
and Greve, 2006; Mezias et al., 2002). The total aspiration of each firm in a given year is a
weighted sum of its historical and social aspirations (Audia and Greve, 2006). Eqns (1)–(3)
describe how we operationalize these measures, where HA denotes historical aspiration, P is
performance, SA is social aspiration, A denotes total aspiration, α and β are weights and the
subscripts i and t indicate a firm and a period (year), respectively.

HAi;t ¼ αPi;t−1 þ ð1 � αÞHAi;t−1 (1)

SAi;t ¼
X
j≠i

Pj;t

,
ðN � 1Þ (2)

Ai;t ¼ βSAi;t−1 þ ð1 � βÞHAi;t−1 (3)
The weights used to measure the historical and total aspirations, α and β, were determined
following the approach of Gaba and Joseph (2013). Here, each weight increases from 0.1 to 1 in
increments of 0.1. We run OLS regressions for each model, predicting the strategic change

Dimensions Key words Examples from sample firms’ MD&A

Promotion words
(27 key words)

Accomplish, Achieve, Advancement,
Aspiration, Aspire, Attain, Desire, Earn,
Expand, Gain, Grow, Hope, Hoping, Ideal,
Improve, Increase, Momentum, Obtain,
Optimistic, Progress, Promoting,
Promotion, Speed, Swift, Toward,
Velocity, Wish

(1) AbbVie Inc. MD&A in 2015 10-K
“In addition, AbbVie expects to achieve
operating margin improvements while
continuing to invest in its pipeline in
support of opportunities in oncology,
HCV, and immunology, as well as
continued investment in key products.”

Prevention words
(25 key words)

Accuracy, Afraid, Anxious, Avoid,
Careful, Conservative, Defend, Duty,
Escape, Escaping, Evade, Fail, Fear, Loss,
Obligation, Ought, Pain, Prevent, Protect,
Responsible, Risk, Safety, Security,
Threat, Vigilance

(2) Boeing Co. MD&A in 2016 10-K
“During the second quarter of 2015 and
of 2014, we recorded reach-forward
losses of $835 million and $425 million on
the USAF KC-46A Tanker contract.”

Table 1.
Regulatory focus
words (Gamache
et al., 2015)

MD

using different weights, and choose those that yield the highest explanatory power (R2). The
results indicate that the highest explanatory power is given by 0.1 for both αand β. Consistent
with Audia and Greve (2006), we create separate variables for positive and negative
performance feedback using a spline specification. This lets us examine the differential
effects of the variables on the dependent variable, depending on whether their values are
above or below 0. Positive performance feedback is equal to performance minus total
aspiration when the value is above 0 and is 0 otherwise. Similarly, negative performance
feedback is equal to performance minus total aspiration when the value is below 0 and is
0 otherwise. All raw data were gathered from the COMPUSTAT database.

Control variables
We consider several control variables at the firm, CEO and industry levels that might also
affect strategic change. Because a firm’s size might increase its risk-taking behavior (Wright
et al., 2007), we measure firm size as the log of total assets. Organizational slack has been
identified by prior studies as affecting firms’ risk-taking behavior (e.g. Chen and Miller, 2007).
Thus, we measure organizational financial slack as the current ratio, calculated by dividing
current assets by current liabilities. We also include the return on investment (ROI) and
market-to-book ratio (MTB) to control for the effects of firm performance. Following prior
studies that employ text analyses in their research methods, we include the total number of
words in the MD&A section of a 10-K filing as a control in our model (e.g. Cho and Hambrick,
2006; Yadav et al., 2007). Previous studies have suggested that CEO tenure affects executives’
strategic choices (e.g. Hambrick and Fukutomi, 1991; Simsek, 2007). As such, we measure
CEO tenure as the fiscal data year minus the year in which a CEO joined the firm and add 1.
The joining years are taken from EXECUCOMP, company websites and media reports
(including the CEOs’ biographies). Based on the information provided by EXECUCOMP, we
also include CEO age and gender (1 5 female CEO, 0 5 male CEO) as controls. Given that
CEO turnover affects risk-taking behavior (Westphal and Fredrickson, 2001), we include a
dummy variable in our model that captures CEO turnover, based on the executive data in the
EXECUCOMP database. Here, CEO duality takes the value 1 if the CEO is the chairperson of
the board and 0 otherwise. We include multiple CEO compensation variables to account for
the possibility that the firm’s risk-taking behavior might be affected by CEO incentives (e.g.
Sanders and Hambrick, 2007). We measure CEO total current compensation as the natural log
of the sum of his/her cash-based pay (salary) and bonus. We measure CEO stock option pay as
the natural log of the proportion of CEO stock option grants in CEO stock option awards, each
of which is measured using the FAS-123R valuation (e.g. Sanders and Hambrick, 2007).
Although Black–Scholes valuations (Black and Scholes, 1973) are more widely used, we had
to use FAS-123R valuations because these were the only data provided by the EXECUCOMP
database for our sample period. We measured CEO restricted stock holdings as the natural log
of the total market value of the restricted shares held by the executive at the end of the fiscal
year. For all compensation data, we add 2 to avoid values of 0 before taking the natural logs.
All compensation data were collected from the EXECUCOMP database. Given that
managerial discretion is positively associated with strategic change (Hambrick and
Abrahamson, 1995; Chen et al., 2015), we include managerial discretion as a control
variable, based on an index comprising three variables: capital intensity, product
differentiability and market munificence. Each measure is based on annual data at the
two-digit SIC industry level, following the operationalization of Chen et al. (2015).

Analysis
We use a feasible generalized least squares (FGLS) regression estimator to test our
hypotheses, consistent with several prior studies on the linkage between performance

Organizational
learning and
regulatory
focus

feedback and risk-taking behavior (e.g. Desai, 2008; Labianca et al., 2009). We employ a
likelihood ratio (LR) test and a Wooldridge test (Wooldridge, 2010) to detect
heteroscedasticity and autocorrelation, detecting significant heteroscedasticity in our data.
We corrected for this data characteristic using a corresponding option in Stata 15. In addition,
we include year fixed effects and industry fixed effects (in two-digit SIC codes) in our models
to control for unobserved heterogeneity effects between periods and industry sectors. All
variables included in the interactions are mean-centered to mitigate any potential
multicollinearity problem (Aiken et al., 1991).

Results
The descriptive statistics and pairwise correlations for all variables are shown in Tables 2
and 3. Because some of the bivariate correlations between the variables are significant, we
tested the variance inflation factor (VIF) to check for potential multicollinearity. The mean
VIF was 1.30 and the maximum VIF was 1.78 for the independent variable “negative
performance feedback.” Thus, in all our models, every variable had a VIF well below 10,
which is the widely accepted cutoff value. Thus, no multicollinearity exists among our
research variables.

Effects of organizational regulatory focus and performance feedback on strategic change
orientation
Table 4 reports the results of the FGLS regression analyses that test the effects of
organizational regulatory focus and performance feedback on strategic change orientation.
Model 1 represents the baseline model and includes only the control variables. Model 2 tests
the effects of promotion and prevention focus. Model 3 adds positive and negative
performance feedback as controls in the model, and Model 4 investigates the interaction
effects of organizational regulatory focus and performance feedback on strategic change
orientation.

Variable Mean Std. Dev Min Max

Growth-oriented relative to efficiency-oriented strategic
change (growth stg. change)

0.851 0.878 �5.07 4.039

Firm size 4.094 0.523 1.58 5.523
Financial slack 2.185 1.307 0.089 9.592
ROI (return on investment) 0.135 0.139 �2.094 0.557
MTB (market-to-book ratio) 3699.165 44417.71 �210000 1020000
CEO age 55.1 10.099 38 77
CEO tenure 18.958 11.921 1 45
CEO gender 0.043 0.203 0

1

CEO turnover 0.029 0.167 0 1
CEO duality 0.421 0.494 0 1
CEO total current compensation (TCC) 6.942 0.932 �6.908 9.004
CEO stock option pay �2.046 1.61 �8.664 7.905
CEO restricted stock holdings 6.283 3.721 0.693 12.283
Managerial discretion 0 0.462 �0.688 1.955
Total number of words in MD&A 14854.65 6585.531 1.24 66440
Positive performance feedback (PosPF) 0.026 0.04 0 0.292
Negative performance feedback (NegPF) �0.019 0.054 �0.648 0
Organizational promotion focus (ProF) 1.108 0.371 0.28 2.62
Organizational prevention focus (PreF) 0.466 0.169 0 1.13

Table 2.
Descriptive statistics of
research variables

MD

V
a
ri
a
b
le
s

1
2

3
4

5
6

7
8

9
1
0

1
1

1
2

1
3

1
4

1
5

1
6

1
7

1
8

1
9

1
G
ro
w
th

st
g
.

ch
a
n
g
e

1

2

F
ir
m

si
ze

�0
.2
4
7
*

1
3

F
in
a
n
ci
a
l
sl
a
ck

0
.0
5

4

�0
.3
1
6
*

1
4

R
O
I

0
.0
3

2

0
.0
5
7

0
.0
1
7

1
5

M
T
B

0
.0
2

8

0
.0
7
9

�0
.0
3
3

0
.0
9
3
*

1
6

C
E
O
a
g
e

�0
.0
2
8

0
.0
5
1

0
.0
9
9
*

�

0
.0
4

4

�

0
.0
2
3

1
7

C
E
O
te
n
u
re

�

0
.0
3
5

�0
.0
4
5

�0
.0
5
9

0
.0
3

�0
.0
0
1

�0
.5
9
6
*

1
8

C
E
O
g
en
d
er

�0
.1
1
6
*

0
.1
4
4
*

�0
.1
6
8
*

�

0
.0
0
5

0
.0
0
6

0
.0
3
9

0
.0
4
4

1
9

C
E
O
tu
rn
o
v
er

�0
.0
2
7

0
.0
0
9

0
.0
1
3

�0
.0
2
8

�0
.0
1
2

�0
.0
4
3

0
.0
2
9

0
.1
1
4
*

1
1
0

C
E
O
d
u
a
li
ty

�0
.0
8
4

0
.1
4
4
*

�

0
.0
6

9

0
.0
5
6

�0
.0
3
1

0
.1
4
7
*

�0
.0
5
9

0
.1
2
8
*

�0
.0
0
3

1
1
1

C
E
O
T
C
C

�0
.0
9
7
*

0
.3
2
0
*

�

0
.0
2
6

0
.1
1
7
*

0
.0
2
6

0
.1
0
5
*

�0
.1
2
6
*

�0
.0
2
8

�0
.0
8
6
*

0
.1
7
1
*

1
1
2
C
E
O

st
o
ck

o
p
ti
o
n

p
a
y

0
.1
0
5
*

�0
.1
2
0
*

�0
.0
5
1

�0
.0
2
6

0
.0
5

0
.1
4
1
*

�0
.1
7
4
*

0
.1
5
1
*

�0
.0
1
8

�0
.0
5
5

�0
.1
4
4
*

1

1
3

C
E
O
re
st
ri
ct
ed

st
o
ck

h
o
ld
in
g
s

�0
.0
7
1

0
.1
0
3
*

�

0
.0
2
5

�0
.0
3
3

0
.0
1
9

0
.0
2

�0
.0
7
3

�0
.0
6
4

0
.0
7
9
0
.0
6
0
.0
2

0
.0
4
8

1

1
4
M
a
n
a
g
er
ia
l

d
is
cr
et
io
n

�

0
.2
1
7
*

0
.2
5
2
*

�0
.1
0
1
*

0
.0
1
5

0
0
.1
3
3
*

�0
.1
0
7
*

�0
.0
8
8
*

0
.0
4

0
.0
4
6

0
.2
1
4
*

�0
.1
0
0
*

0
.0
0
9
1

1
5

T
o
ta
l
n
u
m
b
er

o
f

w
o
rd
s
in

M
D
&
A

�0
.0
1
3

0
.4
0
8
*

�0
.2
0
3
*

0
.0
1
1

0
.0
6
2

0
.0
5
3

0
.0
0
5

0
.2
0
4
*

�0
.0
4
6

0
.0
1
6

0
.1
8
3
*

0
.0
1
9
0
.0
3

0
.0

9
8

*

1

1
6
P
o
si
ti
v
e

p
er
fo
rm

a
n
ce

fe
ed
b
a
ck

0
.0
7
7

�0
.1
8
7
*

0
.2
9
9
*

0
.5
5
8
*

0
.0
9
9
*

0
.0
9
0
*

0
.0
0
8

�0
.0
8
6
*
�0
.0
2
6
�0
.0
1
8
0
.0
2
9
�0
.0
4
3

�0
.0
2
9

0
.0
3
5

�0
.0
8
5
*

1

1
7
N
eg
a
ti
v
e

p
er
fo
rm
a
n
ce
fe
ed
b
a
ck

0
.0
0
2

0
.2
2
6
*

0
.1
3
2
*

0
.6
6
4
*

0
.0
1
4

0
.0
3
5

�0
.0
2
2

�0
.0
1
5

�0
.0
1
2
0
.0
9
3
*

0
.3
7
1
*

�0
.2
6
9
*

�0
.0
6
3

0
.0
2
0
.0
4
4

0
.2
2
9
*

1

1
8
P
ro
m
o
ti
o
n
fo
cu
s

0
.2
0
5
*

�0
.1
0
6
*

0
0
.2
4
7
*

�0
.0
2
4

0
.0
6

�0
.0
7
4

�0
.0
4
6
0
.0
4
0
.0
2
5

�0
.0
3
4

�0
.1
4
0
*

�0
.1
1
7
*

�0
.0
7
4

�0
.1
3
7
*

0
.2
1
7
*

0
.2
3
6
*

1
1
9
P
re
v
en
ti
o
n
fo
cu
s

�0
.0
5
9

0
.1
2
1
*

�0
.1
9
2
*

�0
.0
6
1

0
.0
2
3
�0
.1
0
6
*
0
.1
4
1
*
0
.0
2

0
.0
0
7

�0
.0
4
7

0
.0
6
8

�0
.0
1
3

0
.0
9
4
*

0
.0
7
6

0
.2
5
4
*

�0
.0
8
5
*
0
.0
0
2

�0
.2
1
6
*

1

N
o
te
(s
):
*
sh
o
w
s
si
g
n
if
ic
a
n
ce

a
t
th
e
0
.0
5
le
v
el

Table 3.
Pairwise correlations
of research variables

Organizational
learning and
regulatory
focus

V
a
ri
a
b
le
s

M
o
d
el
1

M
o
d
el
2

M
o
d
el
3

M
o
d
el
4

F
ir
m
si
ze

�0
.2
1
4
*
*
*
(0
.0
3
0
2
)

�0
.1
6
7
*
*
*
(0
.0
3
4
0
)

�0
.1
7
3
*
*
*
(0
.0
3
5
3
)

�0
.1
4
4
*
*
*
(0
.0
3
6
1
)

F
in
a
n
ci
a
l
sl
a
ck

�0
.0
5
7
7
*
*
*
(0
.0
1
1
5
)

�0
.0
4
9
3
*
*
*
(0
.0
1
2
2
)

�0
.0

4
4
7

*
*
*
(0
.0
1
3
8
)

�0
.0
2
8
9
*
*
(0
.0
1
3
8
)

R
O
I

0
.1
8
3
(0
.1
1
9
)

0
.1
8
0
(0
.1
1
0
)

0
.2
8
1
*
(0
.1
4
5
)

0
.8
8
6
*
*
(0
.3
6
6
)

M
T
B

2
.2
5
e-
0
7
*
(1
.3
0
e-
0
7
)

2
.3
5
e-
0
7
*
*
(1
.1
1
e-
0
7
)

2
.4
7
e-
0
7
*
*
(1
.2
0
e-
0
7
)

2
.6
7
e-
0
7
*
*
(1
.1
4
e-
0
7
)

C
E
O
a
g
e

0
.0
0
8
8
7
*
*
*
(0
.0
0
2
1
3
)

0
.0
0
9
7
6
*
*
*
(0
.0
0
2
2
4
)

0
.0
0
9
7
7
*
*
*
(0
.0
0
2
2
1
)

0
.0
0
9
4
4
*
*
*
(0
.0
0
2
1
4
)

C
E
O
te
n
u
re

�2
.0
0
e-
0
5
(6
.5
3
e-
0
5
)

4
.3
2
e-
0
5
(6
.9
5
e-
0
5
)

4
.4
0
e-
0
5
(6
.8
9
e-
0
5
)

8
.8
7
e-
0
5
(6
.6
7
e-
0
5
)

C
E
O
g
en
d
er

�0
.4
3
1
*
*
*
(0
.1
0
2
)

�0
.3
3
7
*
*
*
(0
.1
0
2
)

�0
.3
3
4
*
*
*
(0
.1
0
1
)

�0
.3
8
3
*
*
*
(0
.1
0
1
)

C
E
O
tu
rn
o
v
er

0
.0
9
5
7
(0
.0
6
0
7
)

0
.1
0
0
(0
.0
6
5
7
)

0
.1
0
6
*
(0
.0
6
4
5
)

0
.1
0
1
(0
.0
6
7
3
)

C
E
O
d
u
a
li
ty

�0
.1
7
2
*
*
*
(0
.0
2
7
4
)

�0
.1
7
3
*
*
*
(0
.0
2
8
3
)

�0
.1
7
1
*
*
*
(0
.0
2
8
4
)

�0
.1
5
7
*
*
*
(0
.0
2
9
8
)

C
E
O
T
C
C

�0
.0
5
8
3
*
(0
.0
3
1
7
)

�0
.0
3
3
4
(0
.0
3
3
5
)

�0
.0
3
4
7
(0
.0
3
4
6
)

�0
.0
2
4
4
(0
.0
3
3
4
)

C
E
O
st
o
ck

o
p
ti
o
n
p
a
y

0
.0
6
1
9
*
*
*
(0
.0
1
0
5
)

0
.0
6
9
3
*
*
*
(0
.0
1
1
7
)

0
.0
6
7
1
*
*
*
(0
.0
1
1
6
)

0
.0
6
7
0
*
*
*
(0
.0
1
1
6
)

C
E
O
re
st
ri
ct
ed
st
o
ck
h
o
ld
in
g
s

�0
.0
1
9
7
*
*
*
(0
.0
0
3
8
2
)

�0
.0
1
3
3
*
*
*
(0
.0
0
3
8
3
)

�0
.0
1
3
5
*
*
*
(0
.0
0
3
8
4
)

�0
.0
1
2
8
*
*
*
(0
.0
0
3
8
9
)

M
a
n
a
g
er
ia
l
d
is
cr
et
io
n

0
.0
3
7
6
(0
.0
5
6
9
)

0
.0
0
5
5
9
(0
.0
6
0
7
)

0
.0
0
1
6
0
(0
.0
6
1
7
)

0
.0
2
9
2
(0
.0
5
4
9
)

T
o
ta
l
n
u
m
b
er

o
f
w
o
rd
s

1
.4
7
e-
0
5
*
*
*
(3
.0
8
e-
0
6
)

1
.3
3
e-
0
5
*
*
*
(3
.0
8
e-
0
6
)

1
.3
0
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Table 4.
FGLS regressions
predicting growth-
oriented strategic
change

MD

Hypotheses 1 and 2 test the relation between firm-level regulatory focus and growth-oriented
strategic change. Specifically, Hypothesis 1 posits that a promotion focus leads to greater
strategic change oriented toward growth rather than efficiency. Hypothesis 2 suggests that a
prevention focus leads to lower strategic change oriented toward growth rather than
efficiency. The results show that a promotion focus is significantly and positively associated
with growth-oriented strategic change (β 5 0.219, p < 0.01 in Model 2 of Table 4). However, a prevention focus is not significantly associated with such an orientation (β 5 �0.00136, n.s., in Model 2 of Table 4). Thus, Hypothesis 1 is supported, but Hypothesis 2 is not.

Hypotheses 3–6 examine the interplay between organizational regulatory focus and
strategic change, with organizational performance feedback as a moderator. First,
Hypotheses 3 and 4 stated that promotion and prevention foci, respectively, lead to firms
maintaining the status quo under positive performance feedback, regardless of their strategic
change orientation. In our analyses, both hypotheses are supported. Specifically, the
interaction effect of a promotion focus and positive feedback on growth-oriented strategic
change is insignificant (β 5 �0.633, n.s., in Model 4 of Table 4). Similarly, the interaction effect
of a prevention focus and positive feedback on growth-oriented strategic change is also
insignificant (β 5 �2.130, n.s., in Model 4 of Table 4).

Hypothesis 5 predicted that a promotion focus is positively associated with a growth-
oriented strategic change, particularly when the performance feedback is negative. Our
results support this hypothesis, showing a significant and positive result (β 5 3.233, p < 0.01, in Model 4 of Table 4). Hypothesis 6 states that a prevention focus is negatively associated with growth-oriented strategic change, particularly when performance feedback is negative. This hypothesis is supported because the interaction effect of a prevention focus and negative performance feedback on growth-oriented strategic change is significant and negative (β 5 �8.006, p < 0.01, in Model 4 of Table 4).

Discussion
The primary goal of this study was to examine the effects of organizational regulatory focus
on strategic change. Our study provides robust evidence to suggest that regulatory focus
impacts how organizations learn from feedback and subsequently undertake strategic
change. Moreover, it allows us to look “inside the blackbox” and refine the interplay between
individual-level learning and strategic formulation. Overall, our results indicate that
promotion focus encourages an organization to orient its strategic change toward growth, but
less toward efficiency. Furthermore, we found that under positive performance feedback,
both promotion and prevention foci increase the tendency of the organization to adhere to the
status quo. Under a negative performance feedback, however, firms with a promotion focus
tend to pursue more growth-oriented strategic changes, while reducing efficiency-oriented
changes. In contrast, firms with a prevention focus tend to pursue more efficiency-oriented
strategic changes, rather than growth-oriented. In other words, under negative performance
feedback, a regulatory focus functions as a cognitive frame that magnifies its underlying
tendencies. In sum, we showed in this study how firms’ strategic responses to performance
feedback can diverge from the conventional behavioral theory expectations. By delineating
regulatory focus as an important driver of the organizational learning process, we offered a
novel perspective on how organization-level psychological characteristics interact with
performance feedback leading to strategic changes.

In addition, the findings of our study provide the following practical and social
implications for managers. First, this study highlights the importance of understanding the
motivational orientations of top managers in organizational learning. In fact, our study
indicates that certain motivational characteristics need to be redressed or “incentivized” in
organizations (Wowak and Hambrick, 2010) in order for managers to learn effectively from

Organizational
learning and
regulatory
focus

performance feedback. For example, if a firm’s objective is to achieve growth, it would be
critical to promote and facilitate the top managers’ promotion focus by designing an incentive
system to reflect this priority. It is duly noted that an individual manager has both promotion
and prevention foci, which operate in tandem (Higgins, 1997). An optimal incentive system
should reflect the strategically desired (growth or efficiency) performance output by
encouraging managerial behavior that corresponds to its objective. Furthermore, when new
executives are recruited into the top management team, his/her underlying motivational
orientation, that is, regulatory focus, should be considered in the context of the composition of
the incumbent team members (e.g. Chen et al., 2018) in order to achieve “optimal fit” (Higgins,
2000). After all, regulatory focus of top managers functions as a cognitive frame that filters
information perceived in the environment and dictates the orientation of strategic change. We
invite future scholars to take deeper interest in the interrelationship among top managers’
regulatory focus, corporate governance mechanisms and organizational decision-making.

Second, our study suggests that top executives’ regulatory focus can be a key factor for
organizations in balancing goals of different value orientations – for instance, a conflict
between the growth goal, which encourages experimentation and exploration with longer
time horizons, and the efficiency goal, which prioritizes immediate and stabilized profits via
exploitation with shorter time horizons. Striking the optimal balance between growth and
efficiency orientations in strategic change is critical for firms’ survival and performance. For
example, the past failure of Nokia indicates that pursuing efficiency strategy amid
heightened industrial competition for innovation can hinder organizational flexibility and
innovativeness, which may eventually lead to losing corporate competitive advantage
(McCray et al., 2011). In contrast, efficiency strategies of Toyota Motors and Japan Air Lines
pursued in the late 2000s during the global economic downturn proved successful, which
ultimately led to the firms’ resilient performance (Liker and Franz, 2011). As these anecdotal
evidences indicate, strategic orientations need to be adapted continuously in accordance with
the environmental conditions. In this light, organizational regulatory focus would play a
significant role in firms’ strategic adaptation.

Our study suffers from a number of limitations. First, we examined the role of regulatory
foci in organizational learning processes of large manufacturing firms in the USA. However,
the process could be quite different in small and/or young firms. Future research should test
our ideas with different samples of firms, such as nascent entrepreneurial ventures. Second,
we assessed the regulatory focus of organizations using a content analysis of their 10-K
filings. Although an increasing number of studies have employed text analyses to measure
regulatory focus (e.g. Gamache et al., 2015; Rhee and Fiss, 2014; Stam et al., 2016), this method
is prone to issues of construct validity. Employing alternative research methods, such as
surveys, interviews or experiments, to measure an organization’s regulatory focus and
triangulating the results would add validity to our findings.

To conclude, while scholars have examined a variety of drivers of organizational learning
and strategic change, the psychological and cognitive underpinnings in such processes have
remained underexplored. In this study, we bridge this gap by exploring the interlinkages
between organizations’ regulatory focus, performance feedback and strategic change
orientation. We hope this study provides an impetus for opening up future discussions on the
microcognitive mechanisms of organizational learning and change.

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Organizations, Vol. 2, pp. 10-23.

Corresponding author
Cecile K. Cho can be contacted at: cecilecho@korea.ac.kr

For instructions on how to order reprints of this article, please visit our website:
www.emeraldgrouppublishing.com/licensing/reprints.htm
Or contact us for further details: permissions@emeraldinsight.com

MD

mailto:cecilecho@korea.ac.kr

• Performance feedback and organizational learning: the role of regulatory focus

Introduction
Theory and hypotheses
Strategic change as a response to organizational regulatory focus
Regulatory focus and individual cognition
Regulatory focus and organizational cognition
Regulatory focus and strategic change: the role of performance feedback
Methods
Data selection
Dependent variables
Independent variables
Control variables
Analysis
Results
Effects of organizational regulatory focus and performance feedback on strategic change orientation
Discussion
References
Further reading

Ann

.

Rev. Sociol. 1988. 14:319-40
Copyright © 1988 by Annual Reviews Inc. All rights reserved

ORGANIZATIONAL LEARNING

Barbara Levitt and James G. March

Department of Sociology and Graduate School of Business, Stanford University,
Stanford California 94305

Abstract

This paper reviews the literature on organizational learning. Organizational
learning is viewed as routine-based, history-dependent, and target-oriented.
Organizations are seen as learning by encoding inferences from history into
routines that guide behavior. Within this perspective on organizational learn­
ing, topics covered include how organizations learn from direct experience,
how organizations learn from the experience of others, and how organizations
develop conceptual frameworks or paradigms for interpreting that experience.
The section on organizational memory discusses how organizations encode,
store, and retrieve the lessons of history despite the turnover of personnel and
the passage of time. Organizational learning is further complicated by the
ecological structure of the simultaneously adapting behavior of other orga­
nizations, and by an endogenously changing environment. The final section
discusses the limitations as well as the possibilities of organizational learning
as a form of intelligence.

INTRODUCTION

Theories of organizational learning can be distinguished from theories of
analysis and choice which emphasize anticipatory calculation and intention
(Machina 1987), from theories of conflict and bargaining which emphasize
strategic action, power, and exchange (Pfeffer 1981), and from theories of
variation and selection which emphasize differential birth and survival rates of
invariant forms (Hannan & Freeman 1977). Although the actual behavioral
processes and mechanisms of learning are sufficiently intertwined with
choice, bargaining, and selection to make such theoretical distinctions artifi­
cial at times, ideas about organizational learning are distinct from, and framed
by, ideas about the other processes (Grandori 1987, Scott 1987).

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320 LEVITI & MARCH

Our interpretation of organizational learning builds on three classical
observations drawn from behavioral studies of organizations. The first is that
behavior in an organization is based on routines (eyert & March 1963, Nelson
& Winter 1982). Action stems from a logic of appropriateness or legitimacy
more than from a logic of consequentiality· or intention. It involves matching
procedures to situations more than it does calculating choices. The second
observation is that organizational actions are history-dependent (Lindblom
1959, Steinbruner 1974). Routines are based on interpretations of the past
more than anticipations of the future. They adapt to experience incrementally
in response to feedback about outcomes. The third observation is that orga­
nizations are oriented to targets (Simon 1955, Siegel 1957). Their behavior
depends on the relation between the outcomes they observe and the aspira­
tions they have for those outcomes. Sharper distinctions are made between
success and failure than among gradations of either.

Within such a framework, organizations are seen as learning by encoding
inferences from history into routines that guide behavior. The generic term
“routines” includes the fonns, rules, procedures, conventions, strategies, and
technologies around which organizations are constructed and through which
they operate. It also includes the structure of beliefs, frameworks, paradigms,
codes, cultures, and knowledge that buttress, elaborate, and contradict the
fonnal routines. Routines are independent of the individual actors who ex­
ecute them and are capable of surviving considerable turnover in individual
actors.

The experiential lessons of history are captured by routines in a way that
makes the lessons, but not the history, accessible to organizations and organi­
zational members who have not themselves experienced the history. Routines
are transmitted through socialization, education, imitation, professionaliza­
tion, personnel movement, mergers, and acquisitions. They are recorded in a
collective memory that is often coherent but is sometimes jumbled, that often
endures but is sometimes lost. They change as a result of experience within a
community of other learning organizations. These changes depend on in­
terpretations of history, particularly on the evaluation of outcomes in tenns of
targets.

In the remainder of the present paper we examine such processes of
organizational leaming. The perspective is narrower than that used by some
(Starbuck 1976, Hedberg 1981, Fiol & Lyles 1985) and differs conceptually
from that used by others. In partiCUlar, both the emphasis on routines and the
emphasis on ecologies of learning distinguish the present formulation from
treatments that deal primarily with individual leaming within single organiza­
tions (March & Olsen 1975, Argyris & SchOn 1978) and place this paper
closer to the traditions of behavioral theories of organizational decision­
making (Winter 1986, House & Singh 1987), and to population level theories
of organizational change (Carroll 1984, Astley 1985).

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ORGANIZATIONAL LEARNING 321

LEARNING FROM DIRECT EXPERIENCE

Routines and beliefs change in response to direct organizational experience
through two major mechanisms. The first is trial-and-error experimentation.
The likelihood that a routine will be used is increased when it is associated
with success in meeting a target, decreased when it is associated with failure
(Cyert & March 1963). The underlying process by which this occurs is left
largely unspecified. The second mechanism is organizational search. An
organization draws from a pool of alternative routines, adopting better ones
when they are discovered. Since the rate of discovery is a function both of the
richness of the pool and of the intensity and direction of search, it depends on
the history of success and failure of the organization (Radner 1975).

Learning by Doing

The purest example of learning from direct experience is found in the effects
of cumulated production and user experience on productivity in manufactur­
ing (Dutton et al 1984). Research on aircraft production, first in the 1930s
(Wright 1936) and subsequently during World War II (Asher 1956), indicated
that direct labor costs in producing airframes declined with the cumulated
number of airframes produced. If Ci is the direct labor cost of the ith airframe
produced, and a is a constant, then the empirical results are approximated by:
Cn = C1n-a. This equation, similar in spirit and form to learning curves in
individuals and animals, has been shown to fit production costs (in constant
dollars) reasonably well in a relatively large number of products, firms, and
nations (Yelle 1979). Much of the early research involved only simple
graphical techniques, but more elaborate analyses have largely confirmed the
original results (Rapping 1965). Estimates of the learning rate, however, vary
substantially across industries, products, and time (Dutton & Thomas 1984).

Empirical plots of experience curves have been buttressed by three kinds of
analytical elaborations. First, there have been attempts to decompose experi­
ence curves into several intercorrelated causes and to assess their separate
contributions to the observed improvements in manufacturing costs. Although
it has been argued that important elements of the improvements come through
feedback from customers who use the products, particularly where those
products are complex (Rosenberg 1982), most of the research on experience
curves has emphasized the direct effects of cumulative experience on produc­
tion skills. Most studies indicate that the effects due to cumulative production
are greater than those due to changes in the current scale of production,
transformation of the technology, increases in the experience of individual
production workers, or the passage of time (Preston & Keachie 1964, Hollan­
der 1965, Argote et al 1987); but there is evidence that the latter effects are
also involved (Dutton & Thomas 1984, 1985). Second, there have been
attempts to use experience curves as a basis for pricing strategies. These

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322 LEVITI & MARCH

efforts have led to some well-publicized successes but also to some failures
attributable to an inadequate specification of the basic model, particularly as it
relates to the sharing of experience across organizations (Day & Montgomery
1983, Dutton & Freedman 1985). Third, there have been attempts to define
models that not only predict the general log-linear result but also accommo­
date some of the small but theoretically interesting departures from that curve
(Muth 1986). These efforts are, for the most part, variations on themes of
trial-and-error learning or organizational search.

Competency Traps

In simple discussions of experiential learning based on trial-and-error learning
or organizational search, organizations are described as gradually adopting
those routines, procedures, or strategies that lead to favorable outcomes; but
the routines themselves are treated as fixed. In fact, of course, routines are
transformed at the same time as the organization learns which of them to
pursue, and discrimination among alternative routines is affected by their
transformations (March 1981, Burgelman 1988).

The dynamics are exemplified by cases in which each routine is itself a
collection of routines, and learning takes place at several nested levels. In
such multilevel learning, organizations learn simultaneously both to dis­
criminate among routines and to refine the routines by learning within them.
A familiar contemporary example is the way in which organizations learn to
use some software systems rather than others and simultaneously learn to
refine their skills on the systems that they use. As a result of such learning,
efficiency with any particular procedure increases with use, and differences in
success with different procedures reflect not only differences in the perfor­
mance potentials of the procedures but also an organization’s current com­
petences with them.

Multilevel learning typically leads to specialization. By improving com­
petencies within frequently used procedures, it increases the frequency with
which those procedures result in successful outcomes and thereby increases
their use. Provided this process leads the organization both to improve the
efficiency and to increase the use of the procedure with the highest potential,
specialization is advantageous. However, a competency trap can occur when
favorable performance with an inferior procedure leads an organization to
accumulate more experience with it, thus keeping experience with a superior
procedure inadequate to make it rewarding to use. Such traps are well-known
both in their new technology version (Cooper & Schendel 1976) and in their
new procedures version (Zucker 1977).

Competency traps are particularly likely to lead to maladaptive specializa­
tion if newer routines are better than older,ones. One case is the sequential
exposure to new procedures in a developing technology (Barley 1988). Later

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ORGANIZATIONAL LEARNING 323

procedures are improvements, but learning organizations have problems in
overcoming the competences they have developed with earlier ones (Whetten
1987). The likelihood of such persistence in inferior procedures is sensitive to
the magnitude of the difference between the potentials of the alternatives. The
status quo is unlikely to be stable if the differences in potential between
existing routines and new ones are substantial (Stinchcombe 1986). The
likelihood of falling into a competency trap is also sensitive to learning rates.
Fast learning among alternative routines tends to increase the risks of mala­
daptive specialization, while fast learning within a new routine tends to
decrease the risks (Herriott et al 1985).

The broader social and evolutionary implications of competency traps are
considerable. In effect, learning produces increasing returns to experience
(thus typically to scale) and leads an organization, industry, or society to
persist in using a set of procedures or technologies that may be far from
optimal (Arthur 1984). Familiar examples are the standard typewriter key­
board and the use of the internal combustion gasoline engine to power motor
vehicles. Since they convert almost chance actions based on small differences
into stable arrangements, competency traps result in organizational histories
for which broad functional or efficiency explanations are often inadequate.

INTERPRETATION OF EXPERIENCE

The lessons of experience are drawn from a relatively small number of
observations in a complex, changing ecology of learning organizations. What
has happened is not always obvious, and the causality of events is difficult to
untangle. What an organization should expect to achieve, and thus the
difference between success and failure, is not always clear. Nevertheless,
people in organizations form interpretations of events and come to classify
outcomes as good or bad (Thompson 1967).

Certain properties of this interpretation of experience stem from features of
individual inference and judgment. As has frequently been observed, in­
dividual human beings are not perfect statisticians (Kahneman et al 1982).
They make systematic errors in recording the events of history and in making
inferences from them. They overestimate the probabil�ty of events that actual­
ly occur and of events that are available to attention because of their recency
or saliency. They

·
are insensitive to sample size. They tend to overattribute

events to the intentional actions of individuals. They use simple linear and
functional rules, associate causality with spatial and temporal contiguity, and
assume that big effects must have big causes. These attributes of individuals
as historians are important to the present topic because they lead to systematic
biases in interpretation, but they are reviewed in several previous publications
(Slovic et al 1977, Einhorn & Hogarth 1986, Starbuck & Milliken 1988) and
are not discussed here.

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324 LEVITT & MARCH

Stories, Paradigms, and Frames

Organizations devote considerable energy to developing collective un­
derstandings of history. These interpretations of experience depend on the
frames within which events are comprehended (Daft & Weick 1984). They
are translated into, and developed through, story lines that come to be
broadly, but not universally, shared (Clark 1972, Martin et al 1985). This
structure of meaning is normally suppressed as a conscious concern, but
learning occurs within it. As a result, some of the more powerful phenomena
in organizational change surround the transformation of givens, the redefini­
tion of events, alternatives, and concepts through consciousness raising,
culture building, double-loop learning, or paradigm shifts (Argyris & Schon
1978, Brown 1978, Beyer 1981).

It is imaginable that organizations will come to discard ineffective in­
terpretive frames in the very long run, but the difficulties in using history to
discriminate intelligently among alternative paradigms are profound. Where
there are multiple, hierarchically arranged levels of simultaneous learning, the
interactions among them are complex, and it is difficult to evaluate higher
order alternatives on the basis of experience. Alternative frames are flexible
enough to allow change in operational routines without affecting organiza­
tional mythology (Meyer & Rowan 1977, Krieger 1979), and organizational
participants collude in support of interpretations that sustain the myths (Tirole
1986). As a result, stories, paradigms, and beliefs are conserved in the face of
considerable potential disconfirmation (Sproull 1981); and what is learned
appears to be influenced less by history than by the frames applied to that
history (Fischoff 1975, Pettigrew 1985).

Although frameworks for interpreting experience within organizations are
generally resistant to experience-indeed, may enact that experience (Weick
1979)-they are vulnerable to paradigm peddling and paradigm politics.
Ambiguity sustains the efforts of theorists and therapists to promote their
favorite frameworks, and the process by which interpretations are developed
makes it relatively easy for conflicts of interest within an organization to
spawn conflicting interpretations. For example, leaders of organizations are
inclined to accept paradigms that attribute organizational successes to their
own actions and organizational failures to the actions of others or to external
forces, but opposition groups in an organization are likely to have the
converse principle for attributing causality (Miller & Ross 1975). Similarly,
advocates of a particular policy, but not their opponents, are likely to interpret
failures less as a symptom that the policy is incorrect than as an indication
that it has not been pursued vigorously enough (Ross & Staw 1986). As a
result, disagreements over the meaning of history are possible, and different
groups develop alternative stories that interpret the same experience quite dif­
ferently.

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The Ambiguity of Success

ORGANIZATIONAL LEARNING 325

Both trial-and-error learning and incremental search depend on the evaluation
of outcomes as successes or failures. There is a structural bias toward
post-decision disappointment in ordinary decision-making (Harrison & March
1984), but individual decisionmakers often seem to be able to reinterpret their
objectives or the outcomes in such a way as to make themselves successful
even when the shortfall seems quite large (Staw & Ross 1978).

The process is similar in organizational learning, particularly where the
leadership is stable and the organization is tightly integrated (Ross & Staw
1986). But where such conditions do not hold, there are often differences
stemming from the political nature of an organization. Goals are ambiguous,
and commitment to them is confounded by their relation to personal and
subgroup objectives (Moore & Gates 1986). Conflict and decision advocacy
within putatively rational decision processes lead to inflated expectations and
problems of implementation and thus to disappointments (Olsen 1976,
Sproull et al 1978). Different groups in an organization often have different

targets and evaluate the same outcome differently. Simple euphoria is con­
strained by the presence of individuals and groups who opposed the direction
being pursued, or who at least feel no need to accept responsibility for it
(Brunsson 1985). New organizational leaders are inclined to define previous
outcomes more negatively than are the leaders who preceded them (Hedberg
1981). As a result, evaluations of outcomes are likely to be more negative or
more mixed in organizations than they are in individuals.

Organizational success is ordinarily defined in terms of the relation be­
tween performance outcomes and targets. Targets, however, change over
time in two ways. First, the indicators of success are modified. Accounting
definitions change (Burchell et al 1985); social and policy indicators are
redefined (MacRae 1985). Second, levels of aspiration with respect to any
particular indicator change. The most common assumption is that a target is a
function of some kind of moving average of past achievement, the gap
between past achievement and past targets, or the rate of change of either
(Cyert & March 1963, Lant 1987).

Superstitious Learning
Superstitious learning occurs when the subjective experience of learning is
compelling, but the connections between actions and outcomes are mis­
specified. Numerous opportunities exist for such misunderstandings in learn­
ing from experience in organizations. For example, it is easy for technicians
to develop superstitious perceptions of a new technology from their experi­
ence with it (Barley 1988). Cases of superstition that are of particular interest
to students of organizations are those that stem from special features of life in
hierarchical organizations. For example, the promotion of managers on the

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326 LEVITI & MARCH

basis of performance produces self-confidence among top executives that is
partly superstitious, leading them to overestimate the extent to which they can
control the risks their organizations face (March & Shapira 1987).

Superstitious learning often involves situations in which subjective evalua­
tions of success are insensitive to the actions taken. During very good times,
or when post-outcome euphoria reinterprets outcomes positively, or when
targets are low, only exceptionally inappropriate routines will lead an organ­
ization to experience failure. In like manner, during very bad times, or when
post -outcome pessimism reinterprets outcomes negatively, or when targets
are high, no routine will lead to success. Evaluations that are insensitive to
actions can also result from adaptive aspirations. Targets that adapt very
rapidly will be close to the current performance level. This makes being above
or below the target an almost chance event. Very slow adaptation, on the
other hand, is likely to keep an organization either successful for long periods
of time or unsuccessful for long periods of time. A similar result is realized if
targets adapt to the performance of other organizations. For example, if each
firm in an industry sets its target equal to the average performance of firms in
that industry, some firms are likely to be persistently above the target and
others persistently below (Levinthal & March 1981, Herriott et al 1985).

Each of these situations produces superstitious learning. In an organization
that is invariantly successful, routines that are followed are associated with
success and are reinforced; other routines are inhibited. The organization
becomes committed to a particular set of routines, but the routines to which it
becomes committed are determined more by early (relatively arbitrary) ac­
tions than by information gained from the learning situation (Nystrom &
Starbuck 1984). Alternatively, if failure is experienced regardless of the
particular routi�e that is used, routines are changed frequently in a fruitless
search for some that work. In both cases, the subjective feeling of learning is
powerful, but it is misleading.

ORGANIZATIONAL MEMORY

Organizational learning depends on features of individual memories (Hastie et
al 1984, Johnson & Hasher 1987), but our present concern is with organiza­
tional aspects of memory. Routine-based conceptions of learning presume
that the lessons of experience are maintained and accumulated within routines
despite the turnover of personnel and the passage of time. Rules, procedures,
technologies, beliefs, and cultures are conserved through systems of
socialization and control. They are retrieved through mechanisms of attention
within a memory structure. Such organizational instruments not only record
history but shape its future path, and the details of that path depend signifi­
cantly on the processes by which the memory is maintained and consulted. An

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ORGANIZATIONAL LEARNING 327

accounting system, whether viewed as the product of design or the residue of
historical development, affects the recording and creation of history by an
organization (Johnson & Kaplan 1987, Rf/lvik 1987). The ways in which
military routines are changed, maintained, and consulted contribute to the
likelihood and orchestration of military engagement (Levy 1986).

Recording of Experience

Inferences drawn from experience are recorded in documents, accounts, files,
standard operating procedures, and rule books; in the social and physical
geography of organizational structures and relationships; in standards of good
professional practice; in the culture of organizational stories; and in shared
perceptions of “the way things are done around here.” Relatively little is
known about the details by which organizational experience is accumulated
into a structure of routines, but it is clearly a process that yields different kinds
of routines in different situations and is only partly successful in imposing
internal consistency on organizational memories.

Not everything is recorded. The transformation of experience into routines
and the recording of those routines involve costs. The costs are sensitive to
information technology, and a common observation is that modem computer­
based technology encourages the automation of routines by substantially
reducing the costs of recording them. Even so, a good deal of experience is
unrecorded simply because the costs are too great. Organizations also often
make distinction between outcomes that will be considered relevant for future
actions and outcomes that will not. The distinction may be implicit, as for
example when comparisons between projected and realized returns from
capital investment projects are ignored (Hligg 1979). It may be explicit, as for
example when exceptions to the rules are declared not to be precedents for the
future. By creating a set of actions that are not precedents, an organization
gives routines both short-term flexibility and long-term stability (Powell
1986).

Organizations vary in the emphasis placed on formal routines. Craft-based
€Irganizations rely more heavily on tacit knowledge than do bureaucracies
(Becker 1982). Organizations facing complex uncertainties rely on informally
shared understandings more than do organizations dealing with simpler, more
stable environments (Ouchi 1980). There is also variation within organiza­
tions. Higher level managers rely more on ambiguous information (relative to
formal rules) than do lower level managers (Daft & Lengel 1984).

Experiential knowledge, whether in tacit form or in formal rules, is re­
corded in an organizational memory. That memory is orderly, but it exhibits
inconsistencies and ambiguities. Some of the contradictions are a conse­
quence of inherent complications in maintaining consistency in inferences
drawn sequentially from a changing experience. Some, however, reflect

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328 LEVIIT & MARCH

differences in experience, the confusions of history, and conflicting in­
terpretations of that history. These latter inconsistencies are likely to be
organized into deviant memories, maintained by subcultures, subgroups, and
subunits (Martin et al 1985). With a change in the fortunes of the dominant
coalition, the deviant memories become more salient to action (Martin &
Siehl 1983).

Conservation of Experience

Unless the implications of experience can be transferred from those who
experienced it to those who did not, the lessons of history are likely to be lost
through turnover of personnel. Written rules, oral transitions, and systems of
formal and informal apprenticeships implicitly instruct new individuals in the
lessons of history. Under many circumstances, the transfer of tradition is
relatively straightforward and organizational experience is substantially con­
served. For example, most police officers are socialized successfully to
actions and beliefs recognizable as acceptable police behavior, even in cases
where those actions and beliefs are substantially different from those that were
originally instrumental in leading an individual to seek the career (Van
Maanen 1973).

Under other circumstances, however, organizational experience is not
conserved. Knowledge disappears from an organization’s active memory
(Neustadt & May 1986). Routines are not conserved because of limits on the
time or legitimacy of the socializing agents, as for example in deviant
subgroups or when the number of new members is large (Sproull et al 1978);
b�cause of conflict with other normative orders, as for example with new
organization members who are also members of well-organized professions
(Hall 1968); or’because of the weaknesses of organizational control, as for
example in implementation across geographic or cultural distances (Brytting
1986).

Retrieval of Experience

Even within a consistent and accepted set of routines, only part of an
organization’s memory is likely to be evoked at a particular time, or in a
particular part of the organization. Some parts of organizational memory are
more available for retrieval than others. Availability is associated with the
frequency of use of a routine, the recency of its use, and its organizational
proximity. Recently used and frequently used routines are more easily evoked
than those that have been used infrequently. Thus, organizations have diffi­
culty retrieving relatively old, unused knowledge or skills (Argote et alI987).
In cases where routines are nested within more general routines, the repetitive
use of lower level routines tends to make them more accessible than the more
general routine to which they are related (Merton 1940). The effects

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ORGANIZATIONAL LEARNING 329

of proximity stem from the ways the accumulation of history is linked to
regularized responsibility. The routines that record lessons of experience are
organized around organizational responsibilities and are retrieved more easily
when actions are taken through regular channels than when they occur outside
those channels (Olsen 1983). At the same time, organizational structures
create advocates for routines. Policies are converted into responsibilities that
encourage rule zealotry (Mazmanian & Nienaber 1979).

Availability is also partly a matter of the direct costs of finding and using
what is stored in memory. Particularly where there are large numbers of
routines bearing on relatively specific actions, modem information technolo­
gy has reduced those costs and made the routinization of relatively complex
organizational behavior economically feasible, for example in the preparation
of reports or presentations, the scheduling of production or logistical support,
the design of structures or engineering systems, or the analysis of financial
statements (Smith & Green 1980). Such automation of the recovery of
routines makes retrieval more reliable. Reliability is, however, a mixed
blessing. It standardizes retrieval and thus typically underestimates the con­
flict of interest and ambiguity about preferences in an organization. Expert
systems of the standard type have difficulty capturing the unpredictable
richness, erratic redundancy, and casual validity checking of traditional re­
trieval procedures, and they reduce or eliminate the fortuitous experimenta­
tion of unreliable retrieval (Simon 1971, Wildavsky 1983). As a result, they
are likely to make learning more difficult for the organization.

LEARNING FROM THE EXPERIENCE OF OTHERS

Organizations capture the experience of other organizations through the trans­
fer of encoded experience in the form of technologies, codes, procedures, or
similar routines (Dutton & Starbuck 1978). This diffusion of experience and
routines from other organizations within a community of organizations com­
plicates theories of routine-based learning. It suggests that understanding the
relation between experiential learning and routines, strategies, or technologies
in organizations will require attention to organizational networks (Hakansson
1987) as well as to the experience of the individual organization. At the same
time, it makes the derivation of competitive strategies (e.g. pricing strategies)
more complex than it would otherwise be (Hilke & Nelson 1987).

Mechanisms for Diffusion

The standard literature on the epidemiology of disease or information distin­
guishes three broad processes of diffusion. The first is diffusion involving a
single source broadcasting a disease to a popUlation of potential, but not
necessarily equally vulnerable, victims. Organizational examples include

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330 LEVITI & MARCH

rules promulgated by governmental agencies, trade associations, professional
associations, and unions (Scott 1985). The second process is diffusion involv­
ing the spread of a disease through contact between a member of the popula­
tion who is infected and one who is not, sometimes mediated by a host carrier.
Organizational examples include routines diffused by contacts among orga­
nizations, by consultants, and by the movement of personnel (Biggart 1977).
The third process is two-stage diffusion involving the spread of a disease
within a small group by contagion and then by broadcast from them to the
remainder of a population. Organizational examples include routines com­
municated through formal and informal educational institutions, through
experts, and through trade and popular publications (Heimer 1985a). In the
organizational literature, these three processes have been labeled coercive,
mimetic, and normative (DiMaggio & Powell 1983). All three are involved in
a comprehensive system of information diffusion (Imai et al 1985).

Dynamics of Diffusion

The possibilities for learning from the experience of others, as well as some of
the difficulties, can be illustrated by looking at the diffusion of innovations
among organizations. We consider here only some issues that are particularly
important for organizational learning. For more general reviews of the litera­
ture, see Rogers & Shoemaker (1971) and Kimberly (1981).

Although it is not easy to untangle the effects of imitation from other effects
that lead to differences in the time of adoption, studies of the spread of new
technologies among organizations seem to indicate that diffusion through
imitation is less significant than is variation in the match between the technol­
ogy and the organization (Mansfield 1968), especially as that match is
discovered and molded through learning (Kay 1979). Imitation, on the other
hand, has been credited with contributing substantially to diffusion of city
manager plans among American cities (Knoke 1982) and multidivisional
organizational structures among American firms (Fligstein 1985). Studies of
the adoption of ‘ civil service reform by cities in the United States (Tolbert &
Zucker 1983) and of high technology weaponry by air forces (Eyre et al 1987)
both show patterns in which features of the match between the procedures and
the adopting organizations are more significant for explaining early adoptions
than they are for explaining later ones, which seem better interpreted as due to
imitation. The latter result is also supported by a study of the adoption of
accounting conventions by firms (Mezias 1987).

The underlying ideas in the literature on the sociology of institutionaliza­
tion are less epidemiological than they are functional, but the diffusion of
practices and forms is one of the central mechanisms considered (Zucker
1987). Pressure on organizations to demonstrate that they are acting on
collectively valued purposes in collectively valued ways leads them to copy
ideas and practices from each other. The particular professions, policies,

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ORGANIZATIONAL LEARNING 33 1

programs, laws, and public opinion that are created in the process of produc­
ing and marketing goods and services become powerful institutionalized

myths that are adopted by organizations to legitimate themselves and ensure

public support (Meyer & Rowan 1977, Zucker 1977). The process diffuses
forms and procedures and thereby tends to diffuse organizational power
structures as well (Fligstein 1987).

The dynamics of imitation depend not only on the advantages that come to
an organization as it profits from the experience of others, but also on the

gains or losses that accrue to those organizations from which the routines or

beliefs are drawn (DiMaggio & Powell 1983). In many (but not all) situations
involving considerations of technical efficiency, diffusion of experience has
negative consequences for organizations that are copied. This situation is

typified by the case of technical secrets, where sharing leads to loss of

competitive position. In many (but not all) situations involving considerations
of legitimacy, diffusion of experience has positive consequences for organiza­
tions that are copied. This situation is typified by the case of accounting

practices, where sharing leads to greater legitimacy for all concerned.
The critical factor for the dynamics is less whether the functional impetus is

a concern for efficiency or legitimacy than whether the feedback effects are
positive or negative (Wiewel & Hunter 1985). Where concerns for technical
efficiency are associated with positive effects of sharing, as for example in
many symbiotic relations within an industry, the process will unfold in ways

similar to the process of institutionalization. Where concerns for legitimacy
are associated with negative effects of sharings as for example in cases of

diffusion where mimicking by other organizations of lower status reduces the

lead organization’s status, the process will unfold in ways similar to the

spread of secrets.

ECOLOGIES OF LEARNING

Organizations are collections of subunits learning in an environment that
consists largely of other collections of learning subunits (Cangelosi & Dill
1965). The ecological structure is a complication in two senses. First, it
complicates learning. Because of the simultaneously adapting behavior of

other organizations, a routine may produce different outcomes: at different

times, or different routines may produce the same outcome at different times.
Second, an ecology of learners complicates the systematic comprehension and

modeling of learning processes. Environments change endogenously, and
even relatively simple conceptions of learning become complex.

Learning in a World of Learners

Ecologies of learning include various types of interactions among learners,
but the classical type is a collection of competitors. Competitors are linked

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partly through the diffusion of experience, and understanding learning within
competitive communities of organizations involves seeing how experience,
particularly secrets, are shared (Sitkin 1986), and how organizational actors
come to trust one another, or not (Zucker 1986). Competitors are also linked
through the effects of their actions on each other. One organization’s action is
another organization’s outcome. As a result, even if learning by an individual
organization were entirely internal and direct, it could be comprehended only
by specifying the competitive structure.

Suppose competitors learn how to allocate resources to alternative tech­
nologies (strategies, procedures) in a world in which the return received by
each competitor from the several technologies is a joint consequence of the
potentials of the technologies, the changing competences of the several
competitors within the technologies, and the allocations of effort by the
several competitors among the technologies (Khandwalla 1981). In a situation
of this type, it has been shown that there are strong ecological effects (Herriott
et aI1985). The learning outcomes depend on the number of competitors, the
rates at which they learn from their own experience, the rates at which they
adjust their targets, the extent to which they learn from the experience of
others, and the differences in the potentials of the technologies. There is a
tendency for organizations to specialize and for faster learners to specialize in
inferior technologies.

Learning to Learn

Learning itself can be viewed as one of the technologies within which
organizations develop competence through use and among which they choose
on the basis of experience. The general (nonecological) expectation is that
learning procedures will become common when they lead to favorable out­
comes and that organizations will become effective at learning when they use
learning routines frequently. The ecological question is whether there are
properties of the relations among interacting organizations that lead some of
them to learn to learn and others not to do so.

In competitive situations, small differences in competence at learning will
tend to accumulate through the competency multiplier, driving slower learn­
ers to other procedures. If some organizations are powerful enough to create
their own environments, weaker organizations will learn to adapt to the
dominant ones, that is they will learn to learn (Heimer 1985b). By the sarne
token, powerful organizations, by virtue of their ability to ignore competition,
will be less inclined to learn from experience and less competent at doing so
(Engwall 1976). The circumstances under which these learning disabilities
produce a disadvantage, rather than an advantage, are more complicated to
specify than might appear, but there is some chance that a powerful organiza­
tion will become incapable of coping with an environment that cannot be
arbitrarily enacted (Hannan & Freeman 1984).

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ORGANIZATIONAL LEARNING 333

LEARNING AS A FORM OF INTELLIGENCE

Organizational learning from experience is not only a useful perspective from
which to describe organizational change; it is also an important instrument of
organizational intelligence. The speculation that learning can improve the
performance, and thus the intelligence, of organizations is confirmed by
numerous studies of learning by doing, by case observations, and by theoreti­
cal analyses. Since we have defined learning as a process rather than as an
outcome, the observation that learning is beneficial to organizations is not
empty. It has become commonplace to emphasize learning in the design of
organizations, to argue that some important improvements in organizational
intelligence can be achieved by giving organizations capabilities to learn
quickly and precisely (Starbuck & Dutton 1973, Duncan & Weiss 1979). As
we have seen, however, the complications in using organizational learning as
a fonn of intelligence are not trivial.

Nor are those problems due exclusively to avoidable individual and organi­
zational inadequacies. There are structural difficulties in learning from experi­
ence. The past is not a perfect predictor of the future, and the experimental
designs generated by ordinary life are far from ideal for causal inference
(Brehmer 1980). Making organizational learning effective as a tool for com­
prehending history involves confronting several problems in the structure of
organizational experience: (a) The paucity of experience problem: Learning
from experience in organizations is compromised by the fact that nature
provides inadequate experience relative to the complexities and instabilities of
history, particularly when the environment is changing rapidly or involves
many dangers or opportunities each of which is very unlikely. (b) The
redundancy of experience problem: Ordinary learning tends to lead to stability
in routines, to extinguish the experimentation that is required to make a
learning process effective. (c) The complexity of experience problem: Organi­
zational environments involve complicated causal systems, as well as in­
teractions among learning organizations. The various parts of the ecology fit
together to produce learning outcomes that are hard to interpret.

Improving the Structure oj Experience

The problems of paucity, redundancy, and complexity in experience cannot
be eliminated, but they can be ameliorated. One response to the paucity of
experience is the augmentation of direct experience through the diffusion of
routines. Diffusion increases the amount of experience from which an organ­
ization draws and reduces vulnerability to local optima. However, the sharing
of experience through diffusion can lead to remarkably incomplete or flawed
understandings. For example, if the experiences that are combined are not
independent, the advantages of sharing are attenuated, and organizations are
prone to exaggerate the experience base of the encoded information. Indeed,

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334 LEVITI & MARCH

part of what each organization learns from others is likely to be an echo of its
own previous knowledge (Anderson 1848).

Patience is a virtue. There is considerable evidence that organizations often
change through a sequence of small, frequent changes and inferences formed
from experience with them (Zald 1970). Since frequent changes accentuate
the sample size problem by modifying a situation before it can be com­
prehended, such behavior is likely to lead to random drift rather than improve­
ment (Lounamaa & March 1987). Reducing the frequency or magnitude of
change, therefore, is often an aid to comprehension, though the benefits of
added information about one situation are purchased at a cost of reduction in
information about others (Levinthal & Yao 1988).

The sample size problem is particularly acute in learning from low proba­
bility, high consequence events. Not only is the number of occurrences small,
but the organizational, political, and legal significance of the events, if they
occur, often muddies the making of inferences about them with conflict over
formal responsibility, accountability, and liability. One strategy for moderat­
ing the effects of these problems is to supplement history by creating hypothe­
tical histories of events that might have occurred (Tamuz 1987). Such histor­
ies draw on a richer, less politically polarized set of interpretations, but they
introduce error inherent in their hypothetical nature.

Difficulties in overcoming the redundancy of experience and assuring
adequate variety of experience is a familiar theme for students of organiza­
tional change (Tushman & Romanelli 1985). Organizational slack facilitates
unintentional innovation (March 1981), and success provides self-confidence
in managers that leads to risk-taking (March & Shapira 1987); but in most
other ways success is the enemy of experimentation (Maidique & Zirger
1985). Thus, concern for increasing experimentation in organizations focuses
attention on mechanisms that produce variations in the failure rate, preferably
independent of the performance level. One mechanism is noise in the
measurement of performance. Random error or confusion in performance
measurement produces arbitrary experiences of failure without a change in
(real) performance (Hedberg & JOnsson 1978). A second mechanism is
aspiration level adjustment. An aspiration level that tracks past performance
(but not too closely) produces a failure rate-thus a level of search and risk
taking-that is relatively constant regardless of the absolute level of perform­
ance (March 1988).

A second source of experimentation in learning comes from imperfect
routine-maintenance-failures of memory, socialization, or control. In­
complete socialization of new organizational members leads to experimenta­
tion, as do errors in execution of routines or failures of implementation
(Pressman & Wildavsky 1973). Although it seems axiomatic that most new
ideas are bad ones (Hall 1976), the ideology of management and managerial

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ORGANIZATIONAL LEARNING 335

experience combine to make managers a source of experimentation. Leaders
are exhorted to introduce change; they are supposed to make a difference
(MacCrimmon & Wehrung 1986). At the same time, individuals who have
been successful in the past are systematically more likely to reach top level
positions in organizations than are individuals who have not. Their experience
gives them an exaggerated confidence in the chances of success from ex­
perimentation and risk taking (March & Shapira 1987).

Overcoming the worst effects of complexity in experience involves improv­
ing the experimental design of natural experience. In particular, it involves
making large changes rather than small ones and avoiding multiple simulta­
neous changes (Miller & Friesen 1982, Lounamaa & March 1987). From this
point of view, the standard version of incrementalism with its emphasis on
frequent, multiple, small changes cannot be, in general, a good learning
strategy, particularly since it also violates the patience imperative discussed
above (Starbuck 1983). Nor, as we have suggested earlier, is it obvious that
fast, precise learning is guaranteed to produce superior performance. Learn­
ing that is somewhat slow and somewhat imprecise often provides an advan­
ta�e (Levin thai & March 1981, Herriott et al 1985).

The Intelligence of Learning

The concept of intelligence is ambiguous when action and learning occur
simultaneously at several nested levels of a system (March 1987). For ex­
ample, since experimentation often benefits those who copy successes more
than it does the experimenting organization, managerial illusions of control,
risk taking, and playful experimentation may be more intelligent from the
point of view of a community of organizations than from the point of view of
organizations that experiment. Although legal arrangements, such as patent
laws, attempt to reserve certain benefits of experimentation to those organiza­
tions that incur the costs, these complications seem, in general, not to be
resolved by explicit contraets but through sets of evolved practices that
implicitly balance the concerns of the several levels (March 1981). The issues
involved are closely related to similar issues that arise in variation and
selection models (Holland 1975, Gould 1982).

Even within a single organization, there are severe limitations to organiza­
tional learning as an instrument of intelligence. Learning does not always lead
to intelligent behavior. The same processes that yield experiential wisdom
produce superstitious learning, competency traps, and erroneous inferences.
Problems in learning from experience stem partly from inadequacies of
human cognitive habits, partly from features of organization, partly from
characteristics of the structure of experience. There are strategies for
ameliorating some of those problems, but ordinary organizational practices do
not always generate behavior that conforms to such strategies.

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336 LEVIIT & MARCH

The pessimism of such a description must, however, be qualified by two
caveats. First, there is adequate evidence that the lessons of history as
encoded in routines are an important basis for the intelligence of organiza­
tions. Despite the problems, organizations learn. Second, learning needs to be
compared with other serious alternatives, not with an ideal of perfection.
Processes of choice, bargaining, and selection also make mistakes. If we
calibrate the imperfections of learning by the imperfections of its com­
petititors, it is possible to see a role for routine-based, history-dependent,
target-oriented organizational learning. To be effective, however, the design
of learning organizations must recognize the difficulties of the process and in
particular the extent to which intelligence in learning is often frustrated, and
the extent to which the comprehension of history may involve slow rather than
fast adaptation, imprecise rather than precise responses to experience, and
abrupt rather than incremental changes.

ACKNOWLEDGMENTS

This research has been supported by grants from the Spencer Foundation, the
Stanford Graduate School of Business, and the Hoover Institution. We are
grateful for the comments of Robert A. Burgelman, lohan P. Olsen, W.
Richard Scott, and William H. Starbuck.

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