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Rational Failure of the Firm:
Transaction Costs Economics and Dynamic Capabilities
Kenshu Kikuzawa
Faculty of Business and Commerce, Keio University, Tokyo,
Abstruct
I begin the following study by reviewing the contrasting trajectories of two (previously)
competitive firms: Kodak and Fujifilm. The former I present as an example of a rationally failed
company; the latter, as a firm which was able to avoid its rival’s fate. I maintain, further, that the
experiences of the two firms do not represent historical accidents, but illuminate essential
characteristics of all organizations. To support this position I draw upon transaction cost
economics, explaining how, theoretically, any organization can fail rationally. This leads next to a
discussion of dynamic capabilities and their indispensability to companies intent on avoiding such
failure. Finally, in order to buttress the validity of my arguments mathematically, I introduce a new
model which incorporates the element of dynamic capabilities into the findings of Riordan and
Williamson.
Keyword：Transaction costs, Dynamic capabilities, Rational failure, Lost profit
2
1. Introduction
In this paper I explain how any organization can fail—not irrationally, but rationally
1
. In
addition, I review a key method by which organizations may avoid such rational failure.
In order to address these theoretical concepts—rational failure and its avoidance—I first focus
in on the specific case of (longtime rivals) Kodak and Fujifilm. For decades both firms were
competitive in the photographic film business. However, with the rapid development of digital
photography in the 1990s, the film industry soon found itself facing extinction. Ultimately, Kodak
would go bankrupt while Fujifilm not only survived but continues to grow in strength today (due
in large part to successful diversification). What accounts for these two markedly different
outcomes? Generally speaking, one could be excused for thinking that Kodak must have acted in
irrational ways, Fujifilm much less so. Indeed, this has been the dominant narrative within
business circles.
However, I reject the conventional wisdom. In fact, I regard it as straightforward that Kodak
failed while behaving rationally whereas Fujifilm succeeded by remaining irrational. I realize the
reader may be incredulous: Is there actually such an event as rational failure? Does this
phenomenon occur in real-life circumstances? The objective of this paper is to explain
theoretically that the phenomenon of rational failure indeed exists; and, further, to present the key
method by which organizations may avoid this potentially ruinous circumstance.
In order to achieve these aims I first briefly review the histories of Kodak and Fujifilm, showing
that the former failed rationally whereas the latter succeeded irrationally. Drawing upon
transaction cost economics I then explain how, theoretically, any organization may experience
3
rational failure. However, it is possible for firms to stay clear of this pitfall; and so I next argue in
support of the concept of dynamic capabilities and its indispensability for avoiding rational failure.
Finally, in order to buttress the validity of my arguments mathematically, I introduce a new model
which incorporates the element of dynamic capabilities into the findings of Riordan and
Williamson.
2. Kodak, Fujifilm, and Conventional Wisdom
2.1 Kodak
Eastman Kodak was founded by George Eastman in 1889 and headquartered in Rochester, New
York. The traditional company was extremely successful and soon came to be referred to
worldwide simply as “Kodak.” The firm was best known for its photographic film products and
cameras and for most of the 20th century maintained a dominant position in the field—at one
point claiming a 90% market share of film sales in the U.S. However, Kodak began to struggle
financially in the late 1990s due to declining sales of photographic film. Many observers have
commented that Kodak failed to rapidly transition to the emerging digital market (ironically,
perhaps, since in 1975 the company invented the core technology that would eventually be used in
all digital cameras).
After 2000, as part of a turnaround strategy, Kodak did begin concentrating on digital
photography and printing (while simultaneously striving to generate revenue through aggressive
patent litigation). And, in a final effort to stave off bankruptcy, the firm attempted to sell off or
license its vast portfolio of patents. However, these moves, in the language of Winter (2003),
4
amounted to little more than “ad hoc problem solving.” By 2011, despite some turnaround
progress, Kodak had depleted its cash reserves; soon after, in January of 2012, the firm filed for
Chapter 11 bankruptcy protection. Yet we should regard Kodak’s final actions as indicative of
management’s attempt to run the firm rationally—that is, on behalf of its many shareholders.
2.2 Fujifilm
In contrast, Fuji Photo Film Co., Ltd. (Fujifilm) was established in Japan in 1934, the new firm
inheriting the photo business of Dainippon Celluloid Co., Ltd. Through sustained efforts the
company soon succeeded in producing photographic film domestically, and by the 1950s Fujifilm
was independently producing a variety of film types: Microfilm, Industrial X-ray film, Color
negative film, and Fujitac (TAC film).
During the 1980s Fujifilm began effectively expanding overseas production, leading it to
become Kodak’s primary and strongest rival. However, the turn of the century witnessed a surge in
the popularity of digital cameras—and a concomitant plunge in the demand for photographic film.
Both firms struggled to adopt to this radically shifting environment. But while circumstances
would eventually undo Kodak, Fujifilm not only endured but began to thrive, and today is stronger
as a company than at any other point in its history.
In order to survive Fujifilm set about boldly reconfiguring its existing technologies (as
opposed to attempting the design of entirely original products “from scratch”), making use of
ample available resources. More specifically, the firm began exploring how photo-related film
technology might be newly applied to other fields. This would eventually lead the firm to enter the
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market for liquid-crystal display panels and, perhaps somewhat surprisingly, women’s cosmetics.
In both areas, however, Fujifilm has successfully engineered a series of innovations resulting in
competitive products, sustained growth, and substantial profits.
2.3 Kodak, Fuji, and Conventional Wisdom
What accounts for the markedly different trajectories of the two companies? The conventional
wisdom remains that, whereas Kodak failed—irrationally—to adapt to rapidly shifting markets,
Fujifilm was able to rationally transform itself into a profitable enterprise. That is, Fujifilm is seen
as rationally seeking out and implementing strategies for survival while Kodak irrationally
followed a business model that ran the company into complete dissolution.
2
However, upon closer inspection we begin to find dissenting voices. For example, in a 2012
interview Rebecca Henderson
3
(a former Kodak-sponsored professor at MIT) commented that
Kodak eventually failed despite senior management being aware of the rapidly shifting landscape
and even taking action so as to adapt to the challenging conditions. In other words, Henderson has
implied that the firm failed rationally.
In contrast, Fujifilm’s CEO Shigetaka Komori (2012) has specifically mentioned that, because
Fujifilm had begun losing its core business (photographic film), securing the company’s survival
necessitated steering it toward greater diversification. Crucially, Komori’s vision was not based on
the principle of profit maximization, but of escaping zero-profit (i.e., making positive profit) in
order to survive the uncertain, fluctuating environment
4
. In this sense, the recovery process he
oversaw was not, strictly speaking, rational.
6
The two brief examples presented above support the claim that Kodak failed rationally whereas
Fujifilm succeeded irrationally. However, it is understandable that the reader may still doubt the
validity of these (related) concepts. In the following sections I therefore explain, theoretically, how
and why rational failure does in fact occur. I then present (again, theoretically) a key method by
which organizations may avoid this potentially ruinous circumstance.
3. The Economics of Rational Failure
3. 1. Transaction Costs Economics
In this section I review transaction cost economics, a model which helps explain why any
organization has the potential to fail rationally. Ronald H. Coase (1936, 1988) and Oliver E.
Williamson (1975, 1985, and 1996), in particular, identified the existence of new costs—namely
“transaction costs”—in the area of economic and commercial activity. While it is true such costs
can be difficult to quantify, it is undeniable that they exist and, moreover, exert considerable
influence on human behavior.
According to Williamson, all human beings behave based on a bounded rationality
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(as
opposed to the hyper-rationality assumed by neoclassical economics). As we are incapable of
perfectly collecting, processing, and then relating all information available to us, we are forced to
try and act rationally within the confines of limited, incomplete information. Moreover, human
beings are opportunistic, and so continuously pursue self-interest, sometimes even though guile
(Williamson, 1975).
If, as assumed by Williamson (1975, 1985, and 1996), every individual—and by extension,
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group—is governed by bounded rationality and opportunism, then, when conducting market
transactions, parties will often try and take advantage of others by bargaining opportunistically in
pursuit of self-interest. Under such circumstances it thus becomes necessary for each party to
carefully appraise counterparts, enter into formal contracts (requiring legal services), and keep
careful watch over one another during the period of execution of the contract (or agreement) that is
eventually decided upon.
As a result, when negotiations are conducted (in our rationally bound world) transaction
costs—which, in a broad sense, involve considerable “futility” (waste) of resources—become
inevitable. Transaction costs may be not entered into accounting expenditures (e.g., they may be
included in off-balance costs); and it is indeed difficult to calculate their actual value for each
specific business deal. Nevertheless, they undoubtedly exist; and, further, every individual has the
ability to grasp (comprehend) their existence. In addition, transaction costs are what cause
discrepancies between individual rationality and social rationality, as well as individual rationality
and social justice. That is, the existence of transaction costs results in a variety of consequences
which may appear rational (acceptable) from the perspective of a particular organization, but
which seem irrational (unjust) from the surrounding society’s point of view.
3.2 Asset Specificity, Static Transaction Costs, and Systems of Governance
According to Williamson (1981, 1996), the degree (amount) of a transaction cost can be
determined by applying three key (conceptual) criteria: (1) uncertainty, (2) frequency, and (3) asset
specificity.
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Thus, if a particular negotiation involves significant uncertainty, transaction costs will
increase due to the possibility for extended bargaining between parties involved. As a result, one
party may eventually opt for acquisition of the other in order to economize on these costs.
However, when transaction frequency is high transaction costs will decrease because each firm
will be able to closely monitor information on the other, thus obviating the need for additional,
specialized expenditure. In this instance it is probable the parties involved will choose to enter into
market transactions; hence, the possibility of acquisition becomes less likely.
However, for Williamson asset specificity (Williamson, 1981) is the most important factor for
analyzing and understanding transactions. The term denotes the existence of a specific kind of
physical asset, human asset, and/or site. In order to conduct business efficiently, firms will make
targeted, specialized, and sizeable fixed investments in connection with a particular transaction
(commitment). As a result, asset specificity may arise in any of three ways: site specificity,
physical asset specificity, or human asset specificity.
For example, any longtime supplier to Toyota Motor Corporation has likely demonstrated an
ability to provide parts to the carmaker consistently, swiftly and inexpensively. In contrast, the
same supplier would almost certainly require more time and be forced to charge higher rates if it
began supplying like parts to Nissan Motors. This would occur because fixed investments had,
over time, been “specialized” for transactions with Toyota, the supplier having equipped itself with
specific machinery and human resources designed to respond to and fulfill Toyota’s exact
demands. Similarly, the supplier will have likely located its plants at particular sites (geographic
locations) allowing it to maximize the efficient (inexpensive) delivery of parts to the carmaker.
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In short, transactions involving such specific facilities, human resources, and sites, are high in
“asset specificity.” When negotiations involve these types of assets, the possibility of one party
trying to outmaneuver (out bargain) the other is high; hence, the possibility for heavy transaction
costs also increases. In this case, in order to economize on such costs, firms tend to integrate or
else draw up long-term contracts between themselves. Similarly, the possibility of acquisition
increases significantly.
According to Williamson, a firm will bear transaction costs not only when engaged in market
activity but also when conducting transactions within its own organization; transaction costs
become unavoidable within the horizontal relationships among employees as well as the vertical
relationships between supervisors and subordinates. Williamson holds that, within firms as well as
the greater marketplace, transaction costs increase as a result of opportunistic behavior. Thus, a
variety of institutions which can economize on transaction costs (i.e., institutions of governance)
become vital to keep in check opportunistic impulses and actions.
Finally, it should be stressed that, for Williamson, transaction costs are most significant for how
they affect the constant, stable, day-to-day operations of organizations. I refer these as “static
transaction costs”.
3.3. Dynamic Transaction Costs
It’s important to remember that, for all firms, realigning strategy and direction (a frequently
necessary process) is likely to result in the accruement of substantial transaction costs; for these
actions will involve the introduction of measures requiring a least some adjustment by regular staff.
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However, within most firms employees are not only intent on maintaining the status quo, they may
aggressively resist attempts to alter it. The costs a firm will have to contend with in this regard
(that is, when carrying out internal change) we may refer to as “dynamic transaction costs”
(though it should be noted that the meaning of the phrase here differs from the concept of
“dynamic transaction costs” as coined by R. Langlois) (2003).
In a world where dynamic transaction costs are the norm this leads to a seemingly
paradoxical phenomenon. For example, suppose there is a firm which independently produces
(through conventional means) most of the parts used in a product it successfully markets. However,
due to a variety of technical innovations in its industry, the firm soon finds that it would be more
profitable to construct the same (or similar) item by substantially outsourcing its production as
well as by acquiring new high-tech manufacturing equipment for use at the firm’s own facilities.
Under these circumstances it would seem inevitable that management would proceed with
the outsourcing and purchasing of new equipment, restructuring the firm accordingly. However,
such steps will demand of employees changes in action and behavior which have become deeply
rooted through established routine (that is, staff will necessarily experience disruption of the status
quo). For example, numerous employees will need to obtain additional skills and know-how in
order to adjust to the firm’s new production methods. Perhaps most importantly, the firm will
likely be forced to dismiss a significant number of staff as part of its reorganization.
Thus, to the extent it is intent on shifting its business model and introducing the more
efficient production methods, the firm will almost certainly be forced to negotiate with employees.
Crucially, management will be aware that this process involves incurring significant transaction
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costs, particularly if the company has been profitable in recent years. In fact, because a significant
number of employees may need to be dismissed (and/or retrained), under asset specific
circumstances the entire process may involve transaction costs which become prohibitive.
Consequently, the firm may actually be unable to introduce the newer, potentially more profitable
technology (equipment) and production methods. That is, based on the principle of transaction
cost economization, it may ultimately find itself unable to adapt to changing conditions.
What should be underscored here is that, under such circumstances (constraints), for the firm
to choose to “remain put”—even within an inefficient status quo—is not necessarily an irrational
choice; rather, it can be regarded as rational behavior, a response to the limited options available.
Thus, asset specificity is indeed a “critical dimension.” A highly specialized firm will often be
unable to shift to more advanced and efficient modes of production (hence, a stronger position in
the market) due to unaffordable transaction costs that will accrue when carrying out such
restructuring.
So far, much scholarship has tried to explain this organizational behavior through references
to (irrational) “inertia,” (irrational) “core rigidities(Leonard-Barton, 1995),” and similar concepts.
However, as explained above, such conduct should not be regarded as irrational (Henderson,
2006). A final key point is that while the behavior in question may not seem rational from the
viewpoint of the larger society within which the firm operates, it will surely appear rational from
the viewpoint of the firm itself. Granted, a firm finding itself in the scenario described may not be
able to survive in the marketplace; but, for the very reasons just outlined, I would refer to its likely
demise by the term “rational failure.”
6
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4. Avoiding Rational Failure: Dynamic Capabilities and Economizing on Lost Profits
4.1 The Principle of Economizing on Transaction Costs (and its Limitations)
How, then, should organizations understand rational failure? And how might firms avoid
falling into this state? As mentioned above, in a world where transaction costs are part of most
negotiations (let alone concrete changes in organizational structure or policy), rational action does
not necessarily correspond to efficient action. What may be regarded as “rationally inefficient”
phenomena appear throughout the economy (and beyond).
In order to avoid falling into such states of rational inefficiency, firms are forced to develop
and employ—before engaging in related conduct—a variety of institutions of governance
designed to economize on transaction costs (just as Williamson explained in his discussion of
transaction cost economics). Because these institutions of governance can obviate the need to
weigh considerable (perhaps prohibitive) transaction costs, they enable institutions to more
rationally opt for efficient courses of action (behavior). That is, by employing institutions of
governance organizations (firms) greatly increase their ability to avoid rational failure.
However, for the firm intent on avoiding this pitfall, the principle of economizing on
transaction costs cannot always be a sure-fire guide to action. When business conditions change
dramatically, becoming uncertain, a firm will need to change in kind if it hopes to survive the
newly unstable environment. However, in order to drastically change course the firm will
necessarily be forced to bear substantial transaction costs with a variety of stakeholders (both
inside and outside its own organization). If the transaction costs are too high, the firm will not
13
change but maintain an inefficient status quo based on the principle of economizing on transaction
costs. In fact, as described above, the firm will maintain the status quo (again, rationally)even if
inefficient from a societal standpoint. In this way the firm will fail to adapt to the changing
business climate and so be unlikely to survive within its industry. In short, it will fail rationally.
Again, for these reasons, the principle of economizing on transaction costs (with its emphasis
on employing institutions of governance) cannot always be an effective guide to action.
Particularly under shifting, uncertain conditions, the principle may be of little use. For a state of
rational failure cannot be remedied simply by economizing. Good governance, by itself, is
unlikely to be sufficient to avoid failing rationally.
4.2 Dynamic Capabilities
However, the firm which possesses dynamic capabilities will likely be able to escape rational
failure, even during unstable market conditions. According to David Teece (2009), one of the
founders of the concept, “dynamic capabilities refer to the (inimitable) capacity firms have to
shape, reshape, configure, and reconfigure the firm’s asset base so as to respond to changing
technologies and markets.” (Teece, 2009 : p.118)
In this sense, dynamic capabilities also relate to how an organization develops or otherwise
acquires ordinary capabilities, then extends and synchronizes them in response to changing market
conditions (Teece, 2011). In short, dynamic capabilities are powerful mechanisms which enable a
firm to expand or modify, in myriad ways, how it sustains its operations (Helfat and Winter, 2011).
As explained below, dynamic capabilities may be divided into three broad categories of abilities
14
that a firm’s senior management must possess in order to maximize success (Teece, 2009, Teece
and Pisao, 1994; Teece et al., 1997):
(1) A firm’s senior management must be able to grasp the competitive landscape and sense
changes, opportunities, as well as threats (i.e., potential shifts in technology, consumer behavior, or
government regulation) which confront the firm’s businesses. This capability is called “sensing.”
(2) Senior management must be able to act upon the aforementioned developments, either by
seizing opportunities or warding off threats. If necessary, management must also be ready to
boldly revise an existing business or even create a new one—not based on the principle of profit
maximization, but on that of positive profit (escaping zero profit). This capability is referred to as
“seizing.”
(3) Finally, in order to sustain profitable growth in the face of shifting markets and new
technologies, senior management must be able to dramatically recombine and reconfigure both
tangible and intangible assets, as well as organizational structures, within the firm. This capability
is known as “transforming.”
In order to successfully employ these dynamic capabilities a firm must also have acquired a
variety of resources, knowledge, technologies, skills, and routines which can then be reconstructed
and reconfigured. In this way, dynamic capabilities may be regarded as a form of
“Meta-capabilities.” Most importantly, to the extent a firm possesses dynamic capabilities, it will
be likely able to avoid falling into a state of rational failure, even under shifting business
conditions (as explained below).
15
4.3 Dynamic Capabilities and the Principle of Economizing on Lost Profits
If a firm possesses dynamic capabilities, then maintaining a “maladjusted” status quo
(operating within an unstable business environment) will necessarily involve the bearing of
substantial “lost profits”
7
(that is, the failure to garner obtainable profits). Yet even under these
conditions the firm will likely be able to remain profitable by reconfiguring existing resources in
response to the fluctuating conditions.
“Lost profits” was originally a legal term which referred to the amount of profits a plaintiff
might lose because of diverted sales, price erosion, and/or increased costs. But here I employ the
term somewhat elastically; I use it to refer to the amount of profits a firm might lose due to
management’s lack of capability (or, incapability).
Firms with dynamic capabilities will usually try to take advantage of existing resources as
aggressively as possible in order to adapt to new market demands, thereby economizing on lost
profits. Yet we must keep in mind that in order to succeed in this regard the firm will also have to
bear some level of dynamic transaction costs (these being necessary for realizing change).
But if, through its dynamic capabilities, a firm is able to “sense” shifts in the business
environment, “seize” upon new opportunities, and in doing so “transform” its existing resources,
the firm may be able to economize on lost profits to a degree greater than the amount it would
incur from any dynamic transaction costs. (Further, such a firm will be aware that failure to adapt
might result, literally, in its demise.) The same firm will thus attempt to shift current operations to
newer modes as soon as possible, reconfiguring existing resources (inside as well as outside the
firm) in order to economize on lost profits, even though it will incur dynamic transaction costs as
16
necessary for realizing these changes. In this way the firm may be able to survive rationally—that
is, avoid falling into a state of rational failure.
However, if a firm does not possess dynamic capabilities then, under similar circumstances, it
is likely to subjectively consider lost profits to be of an amount lower than those dynamic
transaction costs necessary for change (this time, due to an inability to fully comprehend the
changing business environment). The firm may thus try—rationally—to maintain an inferior
status quo as the market continues to shift. However, over time it will find itself incapable of
adapting to the unstable conditions, and so will most likely be unable to survive (thereby failing
rationally).
5. Rational Failure, and Its Avoidance, Among Organizations: A Mathematical Approach
As explained above, if a firm possesses dynamic capabilities it will likely be able to avoid the
pitfall of rational failure. If, however, it does not possess this capacity, the firm will likely
experience such failure when market conditions shift markedly. In order to fully illustrate the
fundamental mechanisms underlying this process it is instructive to turn to mathematics. I have
devised a series of formulas which incorporate the factor of dynamic capabilities into models
earlier developed by Riordan and Williamson (1985). As shown below, the resulting new
paradigm is able to explain mathematically the occurrence, and avoidance, of rational failure
17
among firms:
5.1 Revenue, Cost, and Asset Specificity
Let revenue R be given by R=R(X). R increases with the amount of production X
Production costs C are assumed to be given by the relation
where asset specificity k is assumed to be available at the constant per unit cost of γ. Thus, the
profit expression π corresponding to this statement of revenue and production costs is given by
At a maximum, the decision variables are determined from the zero marginal profit
conditions
18
5.2. Static Transaction Costs and Governance Costs
In terms of procurement there are two kinds of methods; let the superscripts i and m denote
these two. However, because parties are rationally bounded and opportunistic, both methods entail
transaction costs—more specifically, “static transaction costs.” These increase with asset
specificity k. In order to economize on them, a firm will bear governance costs , . Thus,
they increase with asset specificity k. These governance cost expressions are given by
The corresponding profit expressions for the two methods of procurement i, m in the
face of positive governance costs are
When a firm choses the method of procurement i, the maximum number of decision variables
19
determined from the zero marginal profit conditions of the method of procurement i are
When the firm choses the method of procurement m, the maximum number of decision variables
determined from the zero marginal profit conditions of the method of procurement m are
Using this model, in order to show that innovation and success with new products does not
necessarily make a firm profitable, but dynamic capabilities, which reconstruct and reconfigure
resources, will in fact determine success or failure, let the amount of production X be constant.
Under these conditions, the maximum number of decision variables
,
are determined from
the zero marginal profit conditions (3.1) and (3.2)
The left side of each equation (3.1.1) and (3.2.1) is the same. Given that
, the left
20
side is
. Further, in terms of asset specificity, the following relation is assumed
This means that the governance cost of the method of procurement will increase more than
that of the method of procurement (static transaction costs increase) if asset specificity
increases. Therefore, from (3.1.1) and (3.2.1), in terms of optimal asset specificity
，
, the
following relation holds
5.3. Dynamic Transaction Costs, Lost Profits, and Dynamic Capabilities
Let us first assume that a firm has been manufacturing products under procurement method .
However, a variety of innovations have been generated within its industry, altering the business
climate dramatically. So assume, further, that it becomes more efficient for the firm to manufacture
products using procurement method instead of existing method (which the firm can
accomplish by reconstructing or reconfiguring managerial resources within its organization). In
this case, the maximum profit
based on method m will be larger than maximum profit
based on method. (Figure 1)
21
The capabilities which will enable the firm to “sense” the surrounding situation, “seize”
opportunities, and “reconfigure” existing resources, may be seen as dynamic capabilities, as
described above. That is, these are capabilities that can change asset specificity k, allowing the
firm to enact a fundamental transformation in methods: from i to m.
For a firm possessing such dynamic capabilities, maintaining the status quo i means bearing
“lost profits” (Z > 0)—a term which refers to those profits the firm would make by shifting
procurement from method i to method m. In other words, these are profits the firm will lose to the
extent it maintains existing method i. Further, the lost profits will be the difference between the
maximum profit
based on method m, and the maximum profit
based on method.
Therefore, lost profits Z is defined by
＝
If the firm tries to maintain the existing method i—even though the business environment is
Figure 1 Maximum Profits and Optimum Asset Specificity
k
π
22
changing dramatically—it will be unable to obtain these profits (lost profits Z) it would otherwise
have earned by shifting procurement to method m. However, to the extent the firm does not shift, it
can avoid bearing dynamic transaction costs T (being necessary for change) and in this way
benefit. Thus, the firm’s profits is given by
In contrast, if the firm changes asset specificity k through reconfiguring resources based on
dynamic capabilities, enacts a fundamental transformation to its business, and shifts procurement
from the existing method i to the more efficient method m, lost profits Z become real profits for the
firm. Still, the firm will have to bear transaction costs T (being necessary for change). Here, the
profit of the firm is given by
The change in profit that the firm can obtain by shifting procurement from the existing method i
to new method m is calculated by (1.1.1) and (1.2.1). Considering (4), this amount depends on the
difference between lost profits Z and dynamic transaction costs T as follows:
23
The relationship between lost profits Z and dynamic transaction costs T is logically divided into
the following two relations:
(a) When Z is less than or equal to T, I refer to the lost profits as Z to. In this case, the profits
that the firm can obtain through maintaining existing method i will be greater than the
profits that the firm can obtain by shifting procurement to method m. So, in this case,
maintaining the status quo i is rational for the firm.
(b)When Z is more than T, I refer to the lost profits as Z to. In this case, the profits that
the firm can obtain by maintaining existing method i are less than the profits that the firm
can obtain by shifting procurement to method m. So, in this case, shifting procurement to
method m is rational for the firm.
＞
Following upon Figure 1 and (1.1.1) and (1.2.1), these relationships (a) and (b) are illustrated in
Figure 2.
24
5.4 Rational Failure and its Avoidance
If a firm lacks dynamic capabilities, it will undervalue lost profits Z because it will be unable to
sense changes in the business environment, seize opportunities, and transform its organizational
structure. In this case, the firm will misperceive that lost profits the firm will lose by
maintaining the existing method i are less than or equal to the dynamic transaction costs T the firm
would have to bear in shifting to procurement method m.
Thus, under this scenario, the firm will misconstrue that profits , which the firm can
acquire through maintaining existing method i, are greater than profits , which it could
acquire by shifting to method m. In this circumstance, maintaining the status quo i will appear as
Figure 2 Profits, Lost Profits, Transaction Costs
K
＞
T
Π,π
25
rational to the firm (Figure 3).
A firm in this state will thus tend to maintain, rationally, an inferior status quo i based on the
principle of economizing transaction costs. However, the firm will find itself unable to adapt to
shifts in the surrounding business environment. Eventually it will cease to exist—that is, the firm
will fail rationally.
In contrast, if a firm possess dynamic capabilities—enabling it to sense changes in the business
landscape, seize upon opportunities, and transforms its existing resources—the firm will
objectively recognize that lost profits will be larger than dynamic transaction costs.
Figure 3 Rational Failure
K
Π,π
26
In this case, the firm will calculate, correctly, that profits , which the firm can obtain
through maintaining the existing method i, are less than profits , which the firm could obtain
by shifting to method m. Thus, in this instance, shifting to method m is rational for the firm.
This relation is expressed in figure 4. Under these circumstances the firm will shift procurement
from method to method in order to obtain greater profits, even if the change necessitates
bearing transaction costs. Further, in order to enhance profits, the firm will attempt to decrease
asset specificity from
to
(
>
), and shift procurement from method i to m. That is,
the firm will reconfigure resources within its organization based on the principle of economizing
on lost profits (employing dynamic capabilities), thus enacting fundamental transformation
intentionally. Indeed, this organizational behavior may appear slightly curious to an outside
because it depends on “invisible” lost profits and transaction costs. However, by considering these
factors the firm can avoid rational failure and so survive rationally.
27
6. Conclusion
Is there really such a phenomenon as rational failure? Do firms actually experience it, even after
years of successful operation? The objective of this study has been to show, theoretically, that the
phenomenon of rational failure does indeed exist; and, further, to present methods by which any
firm or organization may avoid falling into this state. In order to address and resolve these related
issues I first took up the concrete examples of Kodak and Fuji, explaining—contrary to much
conventional wisdom—how the former failed rationally while the latter succeeded irrationally.
Employing transaction cost economics I then demonstrated, theoretically, that every firm is
capable of falling into a state of rational failure. Next, I showed how, in order to avoid this pitfall, a
firm must possess dynamic capabilities. Finally, in order to illustrate the mechanisms of rational
failure as logically as possible, I developed a mathematical model which integrates the concept of
dynamic capabilities into Riordan and Williamson’s earlier findings. If my arguments are correct,
Figure 4 Avoiding Rational failures
K
Π,π
＞
28
the key to understanding the different trajectories of Kodak and Fujifilm (as well as all other
companies in similar circumstances) lies with dynamic capabilities—that is, whether or not a firm
possesses this powerful capacity which allows for radical reconfiguration (adaptation) in the face
of dramatic changes to the surrounding business and economic environment.
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1
By “rational” or “rationality,” I mean rational decision-making; that is, decision-making which is fully informed,
perfectly logical, and geared toward achieving maximum economic profit. See Simon (1961). By “irrationality,”
I mean that which stands in opposition—in every sense—to rationality.
2
For this explanation of Kodak and Fujifilm, see The Economist (2012).
3
Henderson is now a professor at Harvard University. For Henderson’s complete statement, see her interview
article in Time (Gustin, 2012). Henderson (2006) has acknowledged the existence of rational failure.
4
For this, See Komori (2012).
5
Bounded Rationality was proposed by Herbert A. Simon. According to Simon, bounded rationality is the
framework within which rational choice actually operates—that is, one restricted by limitations on both
knowledge and cognitive capacity.
6
For more on rational failure, see Kikuzawa (2007).
7
It is also possible to make reference to “opportunity costs” instead of “lost profits.”
