Paper to be presented at the Summer Conference 2010

on

"Opening Up Innovation:
Strategy, Organization and Technology"
at
Imperial College London Business School, June 16 - 18, 2010

ORGANIZING FOR ADAPTATION: INNOVATIVE CAPABILITIES, RELATIONAL

STARS, COORDINATION COSTS, AND BOUNDARY CHOICES

Konstantinos Grigoriou
Georgia Institute of Technology
kostas@mgt.gatech.edu
Frank T. Rothaermel
Georgia Institute of Technology
frank.rothaermel@mgt.gatech.edu

Abstract:
Under circumstances of disruptive technological change, incumbent firms often adapt to the changing
environment using exploration alliances to access basic science underlying the new technology. Despite high
asset specificity and uncertain outcomes these governance structures remain popular among incumbents and
persist even after the development of internal innovative capabilities. To resolve the puzzle, we look at the
internal organization of incumbents and identify the origins of their innovative capabilities at the individual
level. We develop a taxonomy of individuals representing different degrees of individual productivity achieved
at varying levels of coordination costs (i.e. relational stars) to emphasize the productive and social aspects of
their skills. Conceptualizing innovation as a process of knowledge production and recombination, we
hypothesize that incumbents are more likely to enter exploration alliances when they lack sustainable knowledge
generation capabilities as reflected on their individuals and that cost economizing considerations operate at the
origins of those capabilities constraining the pure capability logic. We show that incumbents boundary choices
to govern innovative capability development depend on comparative assessments of internal organization,
human resource attributes, capabilities, and coordination costs. Highlighting the role of coordination costs as
a component of innovative capability building efforts, we explicate the relationship between internal skills and
costs by examining them simultaneously as they leverage each other and co-evolve.

JEL - codes: O32, O33, -

 Organizing for Adaptation:
Innovative Capabilities, Relational Stars, Coordination Costs, and Boundary Choices

ABSTRACT
Under circumstances of disruptive technological change, incumbent firms often adapt to the
changing environment using exploration alliances to access basic science underlying the new
technology. Despite high asset specificity and uncertain outcomes these governance structures
remain popular among incumbents and persist even after the development of internal innovative
capabilities. To resolve the puzzle, we look at the internal organization of incumbents and
identify the origins of their innovative capabilities at the individual level. We develop a
taxonomy of individuals representing different degrees of individual productivity achieved at
varying levels of coordination costs (i.e. relational stars) to emphasize the productive and social
aspects of their skills. Conceptualizing innovation as a process of knowledge production and
recombination, we hypothesize that incumbents are more likely to enter exploration alliances
when they lack sustainable knowledge generation capabilities as reflected on their individuals
and that cost economizing considerations operate at the origins of those capabilities constraining
the pure capability logic. We show that incumbents‟ boundary choices to govern innovative
capability development depend on comparative assessments of internal organization, human
resource attributes, capabilities, and coordination costs. Highlighting the role of coordination
costs as a component of innovative capability building efforts, we explicate the relationship
between internal skills and costs by examining them simultaneously as they leverage each other
and co-evolve.

Keywords: Organization of Innovation, Exploration, Internal Knowledge Networks, Micro-

foundations of Capabilities, Coordination Costs, Radical Technological Discontinuities.

INTRODUCTION
Competence-destroying technological change poses significant challenges on an
industry‟s incumbent firms to innovate quickly and adapt to a new technological paradigm
(Tushman & Anderson 1986). To respond, incumbents invest in internal capability development
(Tripsas 1997), human capital (Zucker & Darby 1997), strategic alliances (Rothaermel 2001),
acquisitions of new entrants (Higgins & Rodriguez 2006), or in combinations of those strategies
(Rothaermel & Hess 2007). Among alliances, some serve the purpose of building new
knowledge (exploration alliances) while others exist to exploit existing knowledge (exploitation
alliances) (Koza & Lewin, 1998). A major strategic decision in the process is the choice of the

1
appropriate organizational form among various governance alternatives to develop new
technological capabilities (Nickerson & Zenger 2004). Two different theories have been applied
to explain and predict those boundary choices: transaction cost (TC) theory (Williamson 1975;
1985) and the capabilities-based (CB) view (Kogut & Zander 1992). In this paper, we integrate
these two theories to explain the formation of exploration alliances. We focus on this particular
organizational arrangement for adaptation because we argue that both dominant theories provide
incomplete explanations for its existence if viewed independently.
Incumbents use exploration alliances to rapidly adapt in the changing environment by co-
developing knowledge with their partners. Hence, these organizational forms entail significant
asset specificity and uncertain outcomes. Under those circumstances, the TC logic predicts that
the transaction should not be conducted using the market interface but rather integrated
internally. However, a simple observation of many industries shows that these organizational
arrangements are pretty popular. The CB logic seemingly makes a correct prediction: firms
integrate knowledge which is complementary and similar to their existing knowledge base and
use the market (or hybrid) interface to access dissimilar knowledge assets (Foss & Foss 1999).
However, the CB view fails to explain why firms continue using these governance forms even
after building the necessary internal capabilities. Scholars have argued that TC thinking
overlooks the internal functioning of organizations (Gibbons 1999), neglects the social aspect of
knowledge production (Foss 1996), and underestimates the production costs involved in
qualitative coordination (Langlois & Foss 1999). On the other hand, scholars conclude that CB
logic is still weak as a theory of economic organization because it suffers from lack of agreement
on the microfoundations of capabilities (Felin & Foss 2005) and because it fails to explain how
transaction costs and capabilities combine and co-evolve to determine boundaries (Jacobides &
Winter 2005). To resolve empirical puzzles and theoretical challenges, scholars identified
potential value in an effort to integrate the two competing perspectives (Foss 1996, Madhok
2002, Jacobides & Winter 2005).
We build on this call for integration between TC and CB arguments by making an effort to
predict the formation of exploration alliances by incumbents in the face of radical technological
change based on a combination of capability and cost considerations. First, we identify the micro

2
origins of incumbents‟ internal capabilities by looking at the intrafirm knowledge networks that
emerge through internal individual interaction and collaboration. Since innovation is the outcome
of a process of knowledge production and recombination (Fleming 2001), and as individuals are
the realistic locus of knowledge (Felin & Hesterly 2007), we look for those micro origins at the
individual level and we argue that the necessary individual skills to implement the innovation
process should include both productive and social components. We develop a taxonomy of
individuals (integrators, connectors, and isolates) based on the structure of their ties in the
internal collaboration network and we refer to those individuals as relational stars to emphasize
the social nature of their inherent skills or abilities. In short, integrators collaborate with a large
number of different individuals internally, connectors have fewer collaboration ties but operate
as the linking pins among actors that would otherwise remain unconnected, and isolates have
superior productive skills without engaging in extensive collaborative interactions. We focus on
these three individual roles because they reflect varying degrees of individual productivity
achieved at varying levels of coordination costs and we argue that capability heterogeneity at the
organizational level reflects the underlying human capital heterogeneity at the individual level.
Our umbrella hypothesis is that incumbents are more likely to engage in exploration
alliances when they lack the internal capabilities to innovate in the new paradigm and that
transaction cost economizing operates at the origins of those internal capabilities as a constraint
to pure capability logic. We theorize that cost economizing lies at the heart of capability
development and that eventually incumbents‟ boundary choices are driven by their ability to
attract or internally develop the necessary relational stars. Incumbents with integrators (firm-
specific innovation assets, high recombinative potential, high coordination costs) should be less
likely to enter costly exploration alliances while incumbents with connectors (firm specific
innovation assets, moderate combinative potential, moderate transaction costs) or isolates (non
firm-specific, high productive potential, low combinative potential and coordination costs)
should be more likely to complement their weak internal innovative potential by engaging with
exploration alliances. We test our theoretical framework in a large sample of incumbent
pharmaceutical firms trying to adapt to the biotechnology paradigm and find broad support for

3
our claim that boundary choices depend on a combination of comparative cost and capability
assessments as cost economizing operates at the origins of capabilities.
As a result, we make several important contributions to the literature of organizational
economics and capabilities. First, we are able to identify the individual-level structural
microfoundations of organizational innovative capabilities by looking at the intrafirm knowledge
networks that emerge through individual collaborations. We submit that individual skills
necessary for innovation have productive and social components. Second, we focus on the
internal functioning of firms to restore the neglected coordination and production costs as
important drivers of economic organization. Third, we show that organizations make governance
choices based on comparative assessments of internal organizing, internal capabilities, and
transaction costs. Finally, by documenting the role of cost economizing at the origins of
capabilities as an important capability building mechanism, we are able to explicate the
relationship between internal skills and internal costs and examine them together as they
leverage each other and co-evolve.

THEORY AND HYPOTHESES DEVELOPMENT

Exploration Alliances: An Empirical Puzzle for Transaction Costs and Capabilities
It is well documented that technological change in an industry poses significant
challenges on the industry‟s incumbent firms, which have to take significant strategic actions to
adapt to the changing technological environment. Incumbents survive when they invest in the
new technology to develop internal technological capabilities and when they possess specialized
complementary assets that are necessary for the commercialization of the new technology
(Tripsas 1997). Some incumbents choose to undertake R&D in the new technological paradigm
by acquiring new entrants (Higgins & Rodriguez 2006). Alternatively, incumbents use strategic
alliances to gain access to the emerging technological innovations (Hill & Rothaermel 2003). In
a few words, incumbents have a number of options to survive a discontinuity: invest internally,
ally, or acquire. More recently, scholars have recognized that alliances do not have the same
underlying motivations. Some alliances have the purpose of building new knowledge while
others exist to exploit existing knowledge. The former type has been labeled as exploration

4
alliances and the later as exploitation alliances (Koza & Lewin 1998). Since then, scholars have
used this distinction to understand how firms use these two types of alliances to develop new
products and bring them to the market (Rothaermel & Deeds 2004) and how firms balance these
two types to achieve seemingly conflicting organizational goals (Lavie & Rosenkopf 2006).
We choose to focus our analysis on the phenomenon of exploration alliances as an
adaptation mechanism because it is an empirical puzzle that both TC thinking and CB arguments
fail to explain if viewed independently. TC thinking has its roots in Coase‟s (1937) article
in which he argued that markets and firms are alternative methods of coordinating production
and that firms exist because sometimes the use of the price mechanism is very expensive as a
coordinating device. Williamson (1975; 1985) built on Coase‟s contribution and identified the
conditions under which the costs of using the market exceed those of internal integration and TC
was widely applied to explain boundary choices. These contributions led to the emergence of the
organizational economics paradigm that promised to bring a revolution in organization theory
(Hesterly et al. 1990) by redefining organizations and their boundaries. TC logic fits well to the
problem of incumbent adaptation in the face of radical technological change because:
“…adaptability is the central problem of economic organization” (Williamson, 1991: pg.77) and
economic problems of organization usually emerge after instances of market or technological
change (Barnard 1938, Hayek 1945). In addition, transaction misalignment problems have a
significantly larger negative impact in periods of increased market turbulence (Argyres &
Bigelow 2007).
However, the strategy of some incumbent firms to engage in exploration alliances with
smaller entrants poses a significant theoretical challenge on the TC logic. When firms choose
among structural alternatives based on a comparative cost perspective they usually choose a
hybrid governance form (e.g. alliances) when asset specificity is moderate (Williamson 1991).
The application of this logic to explain exploration alliances is problematic. Exploration alliances
involve significant investments in assets that are highly transaction-specific, outcomes that are
inherently uncertain, incomplete contracts because of bounded rationality, and imperfect
information on the partner‟s underlying abilities. Hence, exploration alliances are a setting where
there is high asset specificity and great potential for opportunism. As a result, we should not

5
observe these transactions taking place in a hybrid governance form. However, a simple
observation of many industries shows that these organizational arrangements are actually pretty
popular. Approaching the problem from a TC standpoint independently from capability
considerations apparently only provides an incomplete answer.
The capabilities-based (knowledge- or resource-based) view of the firm has its roots in
Penrose‟s (1959) work, where she conceptualized firms as bundles of resources and services
drawn from those resources. Building on the resource part of Penrose‟s arguments, scholars
argued that resource heterogeneity lies at the heart of firm performance and competitive
advantage (Wernerfelt 1984, Barney 1986). At the same time, following the “services” part of
Penrose‟s arguments, scholars argued that organizations develop internal capabilities to
effectively manage, coordinate, and deploy their resources, capabilities that change in an
evolutionary manner as organizations learn (Nelson & Winter 1982). Initially, this view was only
aspiring to be a theory of competitive advantage but growing frustration with some of the TC
logic‟s restrictive assumptions (especially the role of opportunism) led some theorists to
conclude that the CB view can also qualify as a theory of the firm. The idea was that firm
existence and boundaries can be explained based on comparative capability considerations and
not based on comparative cost assessments grounding the new theory on underlying knowledge
differences among individuals that are free of opportunism (Kogut & Zander 1992, Conner &
Prahalad 1996).
Applying a CB lens to our setting, incumbents choose the most effective governance
mode based on knowledge efficiency, knowledge flexibility, and knowledge substitution
considerations (Conner & Prahalad 1996, Grant 1996). They integrate knowledge which is
complementary and similar to their existing knowledge base, while they use the market (or
hybrid) interface to access dissimilar knowledge assets (Foss & Foss 1999). Seemingly, the
knowledge based view offers a very good explanation of the phenomenon of exploration
alliances. Incumbent firms faced with a competence-destroying discontinuity have to build
capabilities in the new technological paradigm. However, because the new capabilities are
inconsistent with their existing internal knowledge, capabilities, and routines, they choose to
employ the hybrid governance mode of exploration alliances to adapt. We argue that this view is

6
still incomplete because many questions remain unanswered. The CB view has been unable to
document the origins of capabilities to show that the foundations of capabilities are also
independent from transaction cost considerations (Foss 1999). In addition, it is not clear why
incumbents persist on using exploration alliances as a governance mode even after building the
internal knowledge capabilities that would suggest internal integration (Argyres & Zenger 2008).

Capabilities and Transaction Costs: Shortcomings and the Integration Potential

Following similar empirical puzzles, scholars realized that each theoretical lens has
difficulties in fully explaining observed phenomena of boundary choices. On one hand, the CB
view suggests that firms are better because they create a context where there is effective
knowledge sharing and knowledge flexibility. However, this does not rule out the possibility that
markets can do that too (Foss 1999). Further, the capabilities view has no room for transaction
costs and thus fails to explain how transaction costs and capabilities combine and co-evolve to
determine boundaries (Jacobides & Winter 2005). Finally, lack of understanding on the origins
of capabilities obscures the potential role that past governance decisions may have played in the
formation of capabilities and the reason why firms persist on using specific governance
arrangements even when their capabilities change (Argyres & Zenger 2008). In short, the
capabilities view explains where organizations succeed, but fails to incorporate the possibility
that organizations can fail (Foss 1996).
On the other hand, prior research has also examined the shortcomings of the TC view of
economic organization. TC logic neglects the role of tacit knowledge (Foss 1996), and the social
aspect of knowledge production (Granovetter 1985). and the evolving nature of internal
structures (Langlois & Foss 1999). Perhaps, the most important weakness of transaction cost
theory is the issue of coordination in production, which creates production costs and requires
from different individuals not only incentive alignment but also alignment of knowledge and
expectations (Langlois & Foss 1999). TC thinking overlooks the process of learning under
conditions of bounded rationality and the path dependent process of knowledge building (Foss &
Foss 1999). The economic theory of organization neglects to consider dynamic phenomena like
innovation (Foss 1999) and cannot predict how organizational modes should change as the

7
environment changes (Langlois 1984). Finally, transaction cost theory does not include history
considerations and thus the effects of past decisions on governance modes are not taken into
account (Argyres & Liebeskind 1999).
To resolve some of these respective inherent weaknesses, scholars called for an
integration of the two seemingly conflicting perspectives. Integration would allow the
examination of the co-evolution of capabilities and transaction costs (Jacobides & Winter 2005)
and the role of transaction costs as the origins of capabilities (Foss & Foss 1999). The two
theories are essentially intertwined (Argyres & Zenger 2008) and thus studying them together
will enable researchers to concurrently examine the combination of transaction, coordination,
and production costs (Langlois & Foss 1999). Integration enables the study of transacting as
being itself a capability that can be learned (Mayer & Argyres 2004, Argyres & Mayer 2007). A
promising avenue for both theories is to understand how transactions lead to capabilities and how
capabilities evolve based on different transactions (Argyres & Zenger 2008). Integratios is
important especially for the context of interfirm cooperation where resource sharing has become
a primary driver for interfirm cooperation (Combs & Ketchen 1999). Madhok (2002) proposed a
research approach of aligning resource, transaction, and governance structure attributes and
elaborated on the benefits of such an approach on explaining interfirm collaboration. In sum, he
argued that integration will allow researchers to focus on the two sides of the same coin, namely
both the costs and the opportunities that are involved in interfirm relationships. (Madhok 2002).

Intrafirm Knowledge Networks

We begin by addressing the problem that the TC literature has largely ignored the internal
functioning of organizations (Gibbons 1999). Simon (1991) noted that in order to compare
organizations with markets we need to understand how organizations succeed in coordinating
activities. Failing to do so, results in the unrealistic assumption that firms internally run smoothly
like well-oiled machines (Gibbons 1999). Instead, appreciating the importance of internal
structure may allow closer examination of how informal structures among individuals affect
choices of corporate governance (Baker at al. 2002). A close look at the internal processes
facilitates understanding of the issues of production costs and qualitative coordination which are

8
usually ruled out in TC thinking (Langlois & Foss 1999) and allows us to examine the micro
aspects of internal capability reconfiguration (Lavie 2006a).
Since intraorganizational networks reflect the actual functioning of organizations
(Salancik 1995), we rely on intrafirm knowledge networks that emerge within incumbent firms
in the face of a radical technological change to proxy the process of capability development.
There is evidence that internal investment is the first strategic choice that incumbents make often
leading to good performance outcomes (Tripsas 1997, Rothaermel 2001). In addition, internal
investment facilitates the subsequent boundary choice as incumbents develop the absorptive
capacity necessary to scan potential partners or acquisition targets (Cohen & Levinthal 1990).
These in-house investments eventually lead to the development of an internal knowledge
network, where individuals work together to develop, share, transfer, and recombine their
knowledge in an effort to continuously innovate in the new environment. We rely on those
emerging networks to identify the origins of capabilities and address the fact that one of the
weakest aspects of the capabilities view is that the origins of capabilities are not well defined and
identified (Felin & Foss, 2005).

Relational Stars as the Origins of Capabilities

Innovation is the outcome of a process of knowledge transformation, recombination, and
reconfiguration (Fleming 2001, Galunic & Eisenhardt 2001). These activities are eventually
implemented by individuals as individuals are the realistic locus of knowledge (Felin & Hesterly
2007). Hence, to identify the origins of innovation we ask the question: Who are the individuals
with the necessary productive and social skills to carry the process of innovation by transforming
and recombining knowledge stocks? Blau (1955) was among the first to point that important
individuals in knowledge intensive organizations can be identified if one looks at the patterns of
cooperation. Knowledge workers that employ a central position in the organization‟s internal
network are the most qualified and important actors for their organization‟s success (Blau, 1955).
Individuals serve a dual purpose: produce knowledge by working independently and collaborate
with other individuals to generate knowledge through knowledge combinations. Building on this
observation, we develop a taxonomy of individuals based on the structure of their ties in the

9
internal collaboration network to capture individuals with varying potential for knowledge
production and recombination. We refer to those individuals as relational stars to emphasize the
social nature of their inherent skills or abilities. We identify individuals that follow different
collaboration paths to become internal entrepreneurs (Oliver, 2004).
Integrators are the individuals with an extraordinary number of direct ties. These actors
employ a central position in the intrafirm knowledge networks, reflecting the fact that they
collaborate with many other individuals. These actors are important for the innovation process
for two reasons: first, they are able to source knowledge from many different actors; second, they
are able to use their contacts and status to rapidly diffuse newly acquired knowledge. Their
network position reflects the possession of unique knowledge recombination potential as they are
able to work with many other individuals and explore the possibility of many alternative
knowledge combinations. On the other hand, their position reflects increased coordination costs.
Social interaction and collaboration is costly and integrators bring a significant coordination
burden to their organization. Connectors are the individuals who have a high number of direct
ties but at the same time occupy structural holes (non-redundant ties with unconnected alters) in
the organization‟s network. In other words, most of their collaboration ties are with actors that
are distant from each other in the intrafirm knowledge network. They eventually operate as the
“linking pins” between distant clusters of otherwise unconnected knowledge stocks. These
individuals are important again for two reasons: first, they can combine diverse sources of
knowledge that remain unconnected; second, they can channel newly acquired knowledge
towards distant clusters of knowledge and thus facilitate rapid diffusion of knowledge throughout
the organization. Their position reflects the possession of some unique skills. They have the
cognitive ability to connect distant knowledge pieces and understand diverse sources of
knowledge thus facilitating the innovation process. More importantly, they combine knowledge
stocks without having to incur extraordinary costs of coordination, as their ego-network is very
efficient. Finally, isolates are important not because of their ties but despite the absence of ties.
Isolates are the actors who exhibit exceptional individual productivity but have very few ties
with other actors in the internal knowledge network. As a result, they maintain an acceptable
level of knowledge diversity in the organization, since they develop independent knowledge and

10
remain largely unaffected by the knowledge directions of the larger organization. Hence, they
help their organization avoid competency traps (Levitt & March 1988). In terms of individual
abilities, they can generate new knowledge mostly on their own without collaborating with many
others. However, they cannot engage in a process of knowledge combination since they are
socially unconnected. Hence, these actors provide their organizations with valuable new
knowledge without having to incur any costs of coordination.
We argue that the origins of internal innovation capabilities for incumbents trying to
adapt to a changing environment exist at the skills of their individuals. Hence, knowledge
production heterogeneity at the organizational level reflects the underlying human capital
heterogeneity at the individual level. Incumbents have a capability to innovate internally if they
can attract or develop the individuals with the abilities to generate and recombine knowledge in
the new technological paradigm. We add a social dimension to individual productivity and focus
our analysis on three different types of individuals (integrators, connectors, and isolates). We
choose these types of individuals because they reflect actors with varying degrees of capabilities
to generate new knowledge and different levels of coordination costs involved in the process. In
addition, these types reflect actors with varying abilities to establish the necessary social
mechanisms to positively affect exchange behavior under conditions of network governance
(Jones et al. 1997).

Boundary Choice: Direct and Interaction Effects

Incumbent firms have a significant incentive to choose the appropriate organizational
form to govern capability building in the emerging technological paradigm. This boundary
choice largely depends on the internal mode of organizing which is a window to the firm‟s
internal capabilities and internal transaction costs. To overshadow our hypotheses, we argue that
incumbents are more likely to engage in exploration alliances when they lack the internal
capabilities to innovate in the new paradigm and that transaction cost economizing operates at
the origins of those internal capabilities. Hence, in this paper we consider the choice between
boundary choice and internal organizing as simultaneous (Nickerson & Zenger 2004). From a
capabilities perspective, exploration alliances serve the purpose of collaboratively building new

11
knowledge in the emerging technological paradigm. Hence, we should expect incumbent firms
which do not possess the internal capabilities to innovate to be more likely to enter exploration
alliances. On the other hand, the transaction cost logic suggests that these alliances include high
levels of asset specificity and uncertain outcomes. Consequently, they are really expensive
transactions and we should not observe them occurring in the market as internal integration is
preferred. However, if incumbents can economize internally then they may be able to enter
exploration alliances in order to enhance their weak internal innovation potential. We conclude
that capability considerations drive decisions to engage in exploration alliances and that
transaction cost economizing operates at the origins of those capabilities as a constraint. Having
identified the origins of innovation capabilities at the individual level, we focus on three different
types of individuals which have the necessary skills to effectively implement the innovation
process and incur different costs in their efforts. Our overarching hypothesis becomes that
boundary choices depend on each incumbent‟s effectiveness at developing internally those
individuals. Eventually, when firms consider their boundary choice they start by looking at their
existing resource endowments (Mahoney & Pandian 1992).
Integrators have the extraordinary ability to collaborate with many other individuals
internally and thus they carry great potential as a knowledge recombination mechanism. Among
all those individuals in the industry, some have the extraordinary ability to integrate knowledge
from a very high number of alternative sources - they are star integrators. Hence, incumbents
which possess those individuals have the capability to innovate internally because integrators
provide their organizations with significant knowledge recombinative potential. In addition, they
reflect the organization‟s capability for sustainable innovation because integrators represent a
highly firm-specific asset. This is important because the potential value extracted from alliances
depends on the firm-specificity of those internal assets (Lavie, 2006b). In addition, integrators
are deeply embedded in their organization‟s network and thus they are not easily visible to
outsiders to become an object of interfirm competition or imitation (Gardner, 2005). Further,
there is evidence that individuals whose performance depends on their interactions cannot retain
their high levels of performance when they leave (Groysberg et al. 2008). As a result, integrators
are less likely to leave the organization and thus transfer and disperse their valuable knowledge

12
assets and recombination skills. This results in an incentive alignment between the organization
and those actors. Consequently, incumbents with integrators have a capability of sustainable
innovation because integrators represent a highly firm-specific asset.
However, at the same time these organizations incur higher coordination and transaction
costs internally because social interaction and interpersonal collaboration is costly. Langlois
(1992) refers to those costs that arise in the process of coordinating knowledge as “dynamic
transaction costs”. Felin, Tomsik , and Zenger (2008) argue that any large-scale communal
process of knowledge creation is essentially associated with significant costs and productivity
losses, Gibbons (1999) asserts that organizations are a “mess” mostly because of the burden of
those coordination or production costs, and Lavie (2006a) notes that internal capability
reconfiguration in the face of change involves major costs and risks. As a result, the incentive of
incumbents with integrators to engage in expensive exploratory alliances is significantly reduced
for two reasons: first they have the potential to innovate internally and sustainably at a high
degree; second, they already innovate at a high transaction cost. Consequently,

Hypothesis 1. The greater number of star integrators that incumbent firms

possess, the less likely they are to enter exploration alliances with new entrants.

Connectors have the position and the skills to innovate by connecting distant clusters of
knowledge together. Thus, their ego-network is very efficient as they connect individuals who
would otherwise remain unconnected. They have fewer ties compared to integrators and thus a
reduced portfolio of possible combinations but engage in the equally important activity of
creating novel recombinations. Among all the connectors in a certain industry, some individuals
have the ability to do it at the highest level – they are in turn, star connectors. As a result,
incumbents with those individuals have a certain level of knowledge recombination potential,
although reduced compared to organizations with star integrators. In addition, connectors are
also a firm-specific asset because they exhibit their abilities in a certain organizational
environment which allows them to find opportunities for distant knowledge connections. This
aspect of firm specificity is very important in an environment of prevalent „talent wars‟ (Gardner

13
2002). On the cost side, they also incur lower coordination and knowledge production costs in
the process because connectors are able to efficiently link distant clusters of knowledge and span
structural holes in the firm‟s internal knowledge network. Hence, incumbents with connectors
have an increased incentive to enter exploration alliances to complement their weak internal
innovation potential which is at the same time achieved at moderate levels of cost. Consequently,

Hypothesis 2. The greater number of star connectors that incumbent firms

possess, the more likely they are to enter exploration alliances with new entrants.

Finally, isolates have the unique skills to produce knowledge at the lowest possible cost
of coordination since they generate knowledge without having to collaborate with many other
individuals. Among all the isolates in a certain industry, some are at the top of the productivity
distribution without collaborating with many alters – they are star isolates. Incumbent firms with
star isolates have a capability of knowledge production but not high knowledge recombination
potential. In addition, isolates perform without the help of intrafirm connections. Hence, their
skills and abilities are essentially mobile and incumbents with isolates face the continuous threat
of isolates leaving the organization. There is also an evident problem of incentive misalignment
since isolates may diverge from the knowledge directions of the organization as a whole. As a
result, they have an increased incentive to enter exploration alliances in order to explore for new
knowledge paths to complement their weak internal knowledge production capabilities. The
increased incentive is also enhanced by the fact that isolates innovate at the lowest possible level
of transaction and coordination costs. Consequently,

Hypothesis 3. The greater number of star isolates that incumbent firms possess,
the more likely they are to enter exploration alliances with new entrants.

The three types of individuals that we have identified as the origins of internal innovation
capabilities are not mutually exclusive. Incumbents can – and usually do – have combinations of
star integrators, connectors, and isolates in their internal knowledge networks. Hence, the

14
question becomes: “What is effect on boundary choice of having combinations of these highly
consequential individuals?” However, hypothesizing for the interaction effect among these tree
types of individuals is not an easy theoretical task, since two of the combinations result in rather
ambiguous outcomes.Combining integrators with connectors does not add to the firm-specificity
of those resources, and reflects an increased knowledge recombination potential without having
to incur great additional costs. However, it not clear whether the increased internal innovation
potential would be enough to offset the already high coordination costs, Alternatively, it is not
clear whether incumbents would want to leverage their internal recombinative potential by
exposing it to alternative sources of knowledge or be discouraged to ally by the internal sources
of coordination costs. Similarly, combining integrators with isolates also has ambiguous effects.
Integrators and isolates produce knowledge independently using different skills and the
coordination costs in the process remain largely unaffected. Integrators push for fewer
exploration alliances while isolates push for more exploration alliances and thus their combined
effect is bound to be ambiguous. Consequently, we hypothesize that these two interactions
among individuals will have an ambiguous effect on the propensity of incumbents to engage in
exploration alliances.
On the other hand, the combination of connectors with isolates results in increased firm-
specificity of those resources thus increasing the sustainability of the firm‟s innovation potential.
In addition, this combination significantly increases both knowledge production and
recombination using a complex division labor: isolates produce and connectors link. As a result,
the incumbent firm is able to innovate internally at a rate which is sustainable at an increased
cost of coordination compared to having only connectors or only isolates, since it would
especially hard to develop communication codes between those two roles. Hence, incumbents
with both connectors and isolates in their intrafirm knowledge networks exhibit a superior
internal capability to constantly innovate by linking distant and internally generated alternative
knowledge paths at a higher level of coordination costs. These two influences together reduce the
incentive to engage in costly exploration alliances which usually serve the same purpose of
exposure to new knowledge paths. Consequently,

15
 Hypothesis 4. Connectors complement isolates in the internal innovation process
and increase the internal costs of coordination. As a result, incumbents possessing
both connectors and isolates are less likely to enter exploration alliances.

METHODS
Research Setting and Sample
We test the developed hypotheses in the global pharmaceutical industry. The industry
experienced a radical competence-destroying technological discontinuity with the emergence of
biotechnology (Pisano 2006). Large incumbent pharmaceutical firms faced tremendous pressures
to adapt to the new technological paradigm because their upstream research capabilities were
inconsistent with the new technology. Pharmaceutical incumbents invested in internal research
(Argyres & Liebeskind 2002), in human capital (Zucker & Darby 1997), in exploitation alliances
to exploit their existing complementary assets (Rothaermel 2001), in exploration alliances to
build additional technological capabilities (Rothaermel & Deeds 2004), and in acquisitions of
smaller biotechnology firms (Higgins & Rodriguez 2006). Especially the engagement with
exploration alliances was a phenomenon that could not be fully explained by either capabilities
or transaction cost logic alone. Exploration alliances are costly endeavors vulnerable to
opportunism and uncertainty factors. However, pharmaceutical firms persisted on using those
transactions even after having built extensive internal biotechnology capabilities. Hence, we
submit that this is an excellent setting to test our hypotheses considering the effect of internal
capabilities and coordination costs on the propensity of incumbents to engage in exploration
alliances.
Our sample consists of 106 incumbent pharmaceutical firms worldwide, a sample which
is representative of the global pharmaceutical industry. We characterize those firms as
incumbents as they were active in the pharmaceutical industry focusing on human therapeutics
prior to the emergence of biotechnology. We collected annual data for those firms beginning in
1974 until the end of 1996. The year 1974 closely approximates the beginning of industry
research in biotechnology, one year after the invention of a technique to recombine DNA
developed by Cohen and Boyer in 1973.

16
Dependent Variable
Exploration Alliances. The dependent variable is the incidence of an exploration alliance
between an incumbent pharmaceutical firm and a source of biotechnology knowledge. Data on
the alliance history for every firm in our sample came from the BioScan directory and the ReCap
database, databases that have been successfully used in prior research on alliances and are
considered to be the most comprehensive sources for alliance activities. First, we collected all the
alliances that incumbent firms in our sample entered with various sources of biotechnology
knowledge (smaller entrants, universities, and other institutions). Following a common
procedure in prior research (Koza & Lewin 1998, Rothaermel & Deeds 2004; Lavie &
Rosenkopf 2006) we coded grant, research, and R&D alliances as exploration alliances because
the focus of these alliances is the enhancement of upstream research and basic science
capabilities. To ensure correct coding, we used multiple research assistants who coded
independently the alliances in our sample and the inter-rater reliability was 98%, well above the
recommended 70% (Cohen et al. 2003). The dependent variable is a indicator variable which
takes the value 1 if the incumbent pharmaceutical firm entered at least one exploration alliance
that year.

Intrafirm Knowledge Networks in Biotechnology

To capture the internal capabilities of incumbent firms in the biotechnology paradigm and
identify the relational stars, we developed intrafirm co-inventing networks for each incumbent
firm from 1972 to 1996 based only on their biotech patents. Hence, we were able to proxy the
level of internal collaboration and capability development in biotechnology by looking at the
emerging intrafirm co-inventing networks developing in the context of the new technological
paradigm. The importance of those social networks for the purpose of sourcing biotechnology
knowledge has been well documented in prior research (Liebeskind et al. 1996). To define
biotech patents among all the patents filed by pharmaceutical incumbents, we follow the
definition of biotech patents used by the Patent Technology Monitoring Division (PTMD) of the
U.S. PTO. In addition, we relied on the number of biotechnology patents granted by application
year to come closer to the actual time of the invention as the usual time lag between invention

17
and application is usually no more than 3 months (Darby & Zucker 2006). Despite their
weaknesses, patents have been widely used as an acceptable resource to study topics related to
innovation (Griliches 1990). As a next step, we identified unique individual inventors on these
biotechnology patents using the NBER database inventor file based on a combination of last
name, first name, and middle name after fixing the spelling mistakes which existed in the
database (Hall et al. 2001). The resulting dataset is a file for every firm with unique inventor IDs
associated with patents from 1972 to 1996.
We used UCINET 6 to create the co-inventing networks. The nodes of the network are
individual inventors and a tie between inventors represents a co-patenting event. We considered
knowledge through a tie that is older than five years as out-of-date and thus we developed
networks for every firm using a 5-year rolling window and assigned the resulting values to the
last year of every time window (72-76 values to 1976, 73-77 values to 1977, etc.). For every
inventor, we kept three different measures. First, we retained the size of their ego-networks
(degree centrality) to define integrators; in other words, the number of different inventors with
which each inventor collaborated during each five year time period. Second, we used the
“nbroker” measure from the actors‟ ego networks to define the connectors. This measure
captures the percentage of alters in an actor‟s ego network that are unconnected with each other.
In other words, this measure shows that alters that would otherwise remain unconnected, are now
connected through the presence of a node that plays the role of a bridge between them. Finally,
we kept the number of patents that each inventor has during each five year window to define the
isolates.

Independent Variables
We employ network metrics to propose a taxonomy of biotechnology entrepreneurial scientists
(Oliver, 2004) based on the structure of their collaborations. We constructed the following
independent variables at the inventor level:
Integrators. It is an indicator variable that takes value 1 if the inventor‟s direct ties are one
standard deviation more than the mean ego-network size of all inventors of all firms during the
same five year period and the inventor has more than two patents in the same time window (to

18
avoid one-time inventors). With this variable we capture inventors that are productive and
collaborate with a well above average number of different alters in their firm‟s internal network.
The extensive level of collaboration reflects increased potential for knowledge combinations and
a high cost of coordination.
Connectors. It is a indicator variable that takes value 1 if the inventor has more than two patents
in the current time window (again to avoid one time inventors), a number of ties (degree
centrality) that is above the mean (to have a certain level of connections), and an nbroker
measure one standard deviation above the mean “nbroker” of all inventors in the same time
window. This variable captures inventors who are well connected within their firm‟s network but
at the same time are connected mainly with inventors that would otherwise remain unconnected.
Hence, connectors link distant stocks of knowledge and have the potential for novel knowledge
combinations at reduced coordination costs compared to integrators.
Isolates. It is a indicator variable with value 1 if the inventor has a number of patents one
standard deviation above the mean and at the same time fewer than 5 ties (works alone or at most
with four other inventors). These inventors have significant productive abilities without having
to collaborate with many other individuals. A certain level of connection though (fewer than 5
ties) is required to support the claim that they have the opportunity to somehow affect the
knowledge directions of the organization as a whole. Isolates help their organizations avoid
competency traps, are an excellent source of knowledge production, and manage to operate
under very low levels of coordination costs.
Using these variables at the inventor level we construct variables with the same name at
the firm level, which are count variables capturing the number of integrators, connectors, and
isolates that each firm possesses in each year from 1974 to 1998 (counts from 72-76 go to 1976
at the firm level, counts from 73-77 go to 1977 etc.).

Control Variables
We include a series of different control variables to control for other factors driving exploration
alliance formation. First, we include biotech patents to capture the innovative performance of the
incumbent in the new biotechnology paradigm, its size in the new technology, and its propensity

19
to follow a „make‟ strategy of adaptation to biotechnology. We also control for the number of
non biotech patents to rule out the effect of general innovative performance on alliance
formation. In addition, we include the variable exploitation alliances which captures all the
alliances made by incumbent firms that were manufacturing-, licensing-, development-, or
supply- oriented to capture the effect of other types of alliances. We would expect the coefficient
of this variable to be positive and significant thus illustrating two simultaneous effects: first,
incumbents with exploitation alliances build experience with alliance formation and second,
incumbents may want to complement their commercialization capabilities with increased
upstream research competences. Further, we controll for the number of biotech-related
acquisitions that large incumbent firms made to capture the role of a propensity to use the „buy‟
strategy for rapid adaptation. We also include a ratio of biotech patents divided by total patents
to capture the effect of research focus placed on biotechnology by incumbent firms. Data on
patents are from the NBER database (Hall et al 2001) and data on acquisitions are from the SDC
Platinum database. We use controls for national origin (US and EU), temporal effects (Year
Effects), and main industry of the firm‟s activities to differentiate between focused drug
manufacturer and diversified corporate giants (Pharma). Based on the merging history of each
firm, we controll for horizontal mergers using the indicator variable Merged. Finally, we include
the number of exploration alliances lagged as a right hand variable to make a conservative test
of our hypotheses, remove any remaining endogeneity concerns, and capture any learning or
path-dependence effects on the use of this governance choice by incumbents. This approach also
controls for a potential specification bias (Jacobson 1990).

Estimation Procedure
The dependent variable for this study is the event of an incumbent firm entering an
exploration alliance with an external source of biotechnology knowledge. Hence, we estimated
our models using a logistic regression for panel data. Both fixed- and random- effects
specifications allow for controlling for further unobserved heterogeneity (Greene, 2003). Hence,
we applied a Hausman (1978) specification test, which suggested that differences between
coefficients are not systematic. As a result, we relied on the random-effects logistic regression

20
estimation which while capturing inter-firm heterogeneity also allows us to enter in the
regression time invariant covariates (Hsiao 2003). We believe that by entering the lagged
dependent variable as a right hand side variable, applying a Hausman test, relying on a random
effects logit specification, constructing our independent variables based on 5 past-year rolling
windows and including many relevant control variables, we have been able to address any
endogeneity concerns (Hamilton & Nickerson 2003). In addition, we standardized our
independent variables for better interpretation of the results and created the interaction term for
Hypothesis 4 based on those standardized versions (Cohen et al. 2003). To further support our
causality claims and address any remaining simultaneity concerns we lagged our control
variables for innovative performance, alliances, and acquisitions by one year before entering
them in the regressions. As a robustness check, we also estimated our models using a negative
binomial regression with the number of exploration alliances entered as the dependent variable
and our results were unaffected.

RESULTS
Table 1 depicts the descriptive statistics and bivariate correlation matrix. There are two
elevated correlations in the matrix that need to be addressed. First, the variables integrators and
connectors exhibit a high correlation at the organizational level of analysis. However, it is
important to note that this correlation does not reflect similarities at the individual level. In other
words, individuals that are integrators are generally not the same individuals as the ones that are
connectors. However, a few connectors are also integrators because they manage to connect
many actors and at the same time span structural holes. We submit correlations at the individual
level to support this claim (Table 2). Second, connectors are also correlated with the number of
total inventors. As a network grows in size there are more opportunities for individuals to engage
in knowledge combinations and thus become connectors. To control for this effect, we include in
Models 4-5 the number of inventors that are part of the network thus controlling explicitly for
network size and the results remain robust. Finally, it is important to note that the correlation
between connectors and isolates is very low and well below the 0.70 threshold that is required
for using cross-products to test interaction hypotheses.

21
 Insert Tables 1-2 about here
Table 3 depicts the results for our hypotheses. Model 1 has only control variables and in
Model 2 we add the number of total inventors (or network size) to test the general effect of the
possession of general intellectual human capital on the propensity to enter exploration alliances.
In Model 3, we include the three individual roles which are the independent variables of interest
without including the number of total inventors to show that our results remain robust in
alternative specifications with or without controlling for network size. Model 4 has the three
independent variables controlling for network size to test hypotheses 1-3 and Model 5 includes
all three interactions among individual roles to test hypothesis 4. Table 4 facilitates
interpretation of the results by presenting the odds ratios and factor changes of the variables that
have been found significant drivers of exploration alliance formation in Table 3.
Insert Tables 3-4 about here
The results in Model 2 suggest that the possession of intellectual human capital in the
new biotechnology paradigm has a positive effect on exploration alliance formation (p<0.1). This
result can be interpreted as evidence that incumbents with the appropriate internal human capital
may be able to develop the necessary absorptive capacity to identify promising potential partners
complementing the firm‟s developing internal knowledge base. However, a more interesting
result is that when in Model 4, we include the three different individual roles the positive effect
of intellectual human capital disappears, thus suggesting that we have a case of mediation.
Intellectual human capital affects the boundary choice only through the possession of the three
individual roles identified in this paper. Hypothesis 1 posits that incumbents with integrators are
less likely to enter exploration alliances. We do not find support for H1, although the sign of
integrators remains negative (but not significant) across all different specifications. There are
two possible reasons for this result. We hypothesized that integrators will result in decreased
propensity to explore through alliances because they have the skills to engage in knowledge
combination with their alters and sustain a level of internal innovation achieved at prohibitive
levels of cost since communal knowledge production is costly. From the innovation benefit side,
integrators may not possess an extraordinary innovation potential because their activities involve
mostly local knowledge recombinations with proximate actors thus lacking the potential for great

22
impact. From the cost standpoint, there is evidence that integrators may be able to reduce the
coordination costs of knowledge co-production because their dense networks of connections may
allow them to develop relational contracts and communication codes with their alters (Baker et
al. 2002). As a result, their innovative potential and costs involved are not enough to reduce the
likelihood of their organizations engaging in exploration alliances.
Hypothesis 2 posits that incumbents with connectors are more likely to enter exploration
alliances. We find broad support for hypothesis 2 across all different model specifications
(Models 3-5) since the coefficient for connectors is positive and significant (p<0.05). Incumbents
with connectors have a certain level of knowledge recombination potential (connectors link
distant clusters of knowledge) achieved at low levels of coordination costs (connectors have
fewer ties than integrators). Hence, first the internal costs do not prohibit engagement with
expensive alliances and second, incumbents want to leverage the capabilities of their connectors
by exposing them to additional sources of knowledge to make their connections. Hypothesis 3
posits that incumbents with isolates are also more likely to enter exploration alliances. Models 3-
5 provide broad support for hypothesis 3, as coefficients for isolates are positive and significant
(p<0.01). Incumbents with isolates have high potential for knowledge production (isolates
produce in above average rates) achieved at low or minimum levels of coordination and co-
production costs (isolates have very few or no ties). However, incumbents in this case lack the
knowledge recombination potential to engage in sustainable future innovations. On top of that,
isolates do not depend their performance on their organization and are thus a non firm-specific
asset with an increased likelihood compared to other individual roles to leave the organization.
As a result, incumbents with isolates are more likely to enter exploration alliances to facilitate
their weak internal innovation potential by providing alternative knowledge paths and
opportunities for knowledge co-production to complement their internal knowledge activities.
Model 5 tests our hypothesis 4 about the effects of interaction among individual roles on
the propensity to enter exploration alliances. We hypothesized that two of the three interactions
have theoretically ambiguous effects on the likelihood of exploration alliances. Our results in
Model 5 support the hypothesized ambiguity since coefficients for the first two interactions are
positive but insignificant. On the other hand, we hypothesized that combining connectors and

23
isolates would result in a decreased likelihood for exploration alliances. The results in Model 5
support this hypothesis as the coefficient is negative and significant (p<0.01). The combination
of connectors with isolates reflects increased innovative potential at higher levels of coordination
costs. Consequently, incumbents become less likely to enter exploration alliances.
Finally, we are able to provide some interesting results coming from the control
variables. Incumbents with high innovative performance in the new paradigm (measured by
biotech patents), bio-acquisitions, and a strategic focus on biotechnology (measured by ratio:
biotech divided by total patents) are more likely to enter exploration alliances, a result which
reflects the need to complement internal capabilities with external sources and the effect of
increased absorptive capacity on partner selection. In addition, incumbents with exploitation
alliances are also more likely to enter exploration alliances, a result which reflects a possible
learning effect of using alliances and a propensity to build upstream research capabilities after
exploiting existing commercialization complementary assets. Finally, incumbents with
exploration alliances in the past persist on using these organizational arrangements, a result
which reflects a potential learning or path-dependency effects of using similar organizational
forms as a structure to govern internal capability development.

DISCUSSION
In this paper, we made an effort to meaningfully integrate the two dominant theories
competing for primacy as predictors of economic organization, namely the transaction cost
perspective and the capabilities-based view of the firm. Our purpose was to explain the
organizational arrangements that incumbent firms use under circumstances of competence-
destroying technological change to rapidly adapt to the changing environment. In particular, we
focused our analysis on the phenomenon of exploration alliances between incumbent firms in the
pharmaceutical industry and source of knowledge in the new biotechnology paradigm. These
alliances are a strategic tool that incumbents use to get rapid access to the basic science
underlying the technological discontinuity, involve significant investments of financial and
human capital, and entail a great deal of uncertainty with respect to the outcomes of the process
since knowledge production is an inherently uncertain endeavor. This setting facilitates our

24
research purpose because both dominant theories of economic organization fail to fully explain
the instance of exploration alliances if viewed independently. On one hand, according to the TC
logic these alliances should not be observed because of asset specificity and a threat of
opportunism; rather knowledge development in the new paradigm should be integrated
internally. On the other hand, the CB logic correctly predicts that knowledge which is dissimilar
to the existing knowledge base should be developed externally but fails to explain why such
arrangements persist even after the development of similar internal capabilities.
In this setting, we moved beyond simply showing that both comparative capability and
cost assessments matter for boundary choices. Instead, we achieved real integration between the
two seemingly competing theories by arguing that boundary choices depend on internal
capability assessments and that transaction cost economizing operates at a lower level: at the
origins of those capabilities. In other words, we were able to show that both benefits and costs of
internal capabilities drive boundary decisions by showing that cost economizing is inherently a
component of capability development. Cost considerations define the characteristics of
organizational resources and capabilities, which in turn predict the appropriate boundary choices
for further capability development.
In the process, we made several contributions to the literature. First, we attempted to
open the black box of organizations and look at their internal functioning in order to identify
both the benefits and costs involved in their capabilities. Our starting point was that intrafirm
knowledge networks that emerge through individual collaboration in incumbent firms are a good
proxy for some aspects of their internal organizational processes and structures. Looking at those
internal networks, we theorized on the very important role of qualitative coordination and
collaboration costs thus bringing back to the discussion a certain category of costs (production or
coordination costs), which is largely neglected in the modern theory of economic organization
(Langlois & Foss 1999). Based on our analysis, we agree with Gibbons (1999) that organizations
are actually a „mess‟ but not a „mystery‟. They are a mess because we observe significant
internal heterogeneity in the knowledge production process. Some individuals collaborate with a
huge number of alters, while some others collaborate with only a few or none. In every
organization there are dense clusters of collaboration that vary in size which are sometimes

25
totally unconnected from each other. At the same time these organizations are not a mystery
because internal networks emerge based on a set of certain attributes, of which the most
important are the skills and the interests of the individuals involved. In essence, knowledge
networks emerge around the interests and skills of the participating individuals actors.
Second, we were able to identify some microfoundations of organizational capabilities
that lie at the individual level of analysis. Conceptualizing innovation as a process of knowledge
production and recombination and submitting that individuals are the realistic locus of
knowledge (Felin & Hesterly 2007), we explored for the origins of capabilities by looking at the
productive and social skills of certain individuals as reflected in their positions in the respective
intraorganizational knowledge networks. In particular, we developed a novel taxonomy of
consequential knowledge workers (integrators, connectors, and isolates) and referred to them as
relational stars to illustrate the social aspect of their inherent abilities. We argued in the paper
that individuals in any of the three categories are inherently valuable for the success of the
internal innovation process. Another interesting aspect of these three individual roles is that they
reflect varying degrees of knowledge recombinative potential and coordination costs involved,
thus allowing us to link them with the subsequent organizational boundary choices. Hence, we
asserted that capability heterogeneity at the organizational level is a function of human capital
heterogeneity in terms of individual skills at the individual level. In a recent article, Felin,
Zenger, and Tomsik (2009) provide a roadmap in the search for microfoundations by arguing
that apart from skills there are other important aspects such as incentives, motivation, discretion,
ownership, self-selection, and interest alignment that matter at the individual level of analysis.
Third, we were able to show how firms choose organizational arrangements to govern
capability development based on their internal organizing characteristics and resource attributes.
Hence, we provided an empirical test of the problem solving perspective (Nickerson & Zenger
2004) and the knowledge governance approach (Foss, 2007) by illustrating the simultaneity
between internal organizational procedures and boundary choices in the process of capability
building. Incumbent firms with weak non firm-specific internal capabilities to recombine
knowledge and innovate were more likely to enter uncertain exploration alliances. On the other
hand, incumbents with strong and cost-intensive internal innovation potential were less likely to

26
risk cross-boundary collaboration under the threat of high transaction costs and partner
opportunism.
Fourth, we highlighted the role of costs as a necessary component of capability
development thus diverging from the CB logic‟s absolute focus on the benefit side. In a sense,
we were able to illustrate the fact that coordination costs are at the heart of capability
development. Internal knowledge production costs define the characteristics of organizational
innovative capabilities, which in turn explain the firm‟s boundary decisions, thus providing
evidence for Foss and Foss‟s (1999) conjecture. While on the surface many incumbents in our
sample possessed similar internal capabilities to innovate, a closer look at the origins of their
capabilities enabled us to uncover the cost differences underlying those capabilities which were
critical for the subsequent governance structure decisions. We found that incumbents with
underlying low costs of knowledge production were more likely to afford expensive exploration
alliances while incumbents with similar innovative capabilities but increased production costs
were apparently discouraged.
Fifth, with our research approach we managed to shed some light on the co-evolving
relationship among production costs, transaction costs and capabilities. As a result, we provided
evidence on how costs and skills leverage one another to predict boundary decisions (Madhok
2002). In addition, we believe that our approach reflects the importance of considering historical
governance decisions as predictors of future decisions (Argyres & Liebeskind 2002). Internal
capability development is certainly a path-dependent process and the state of intrafirm
knowledge networks today more than likely reflects the outcome of past boundary decisions. For
example, there is evidence that inter-organizational arrangements ultimately disrupt and
reorganize the internal knowledge networks and the network positions of specific individuals
(Paruchuri 2009). Hence, we submit that past governance decisions may be one reason behind
the observed state of a knowledge network. Consequently, in this paper we provided some
evidence for the role of the co-evolution of skills and transaction costs as drivers of a firm‟s
horizontal scope. Future research should also address the influence of this phenomenon on other
aspects of economic organization such as vertical scope (Jacobides and Winter 2005) or
diversification.

27
 Overall, our answer to the empirical puzzle of exploration alliances between incumbent
pharmaceutical firms and sources of biotechnology knowledge is twofold. First, incumbents
enter exploration alliances despite the high transaction costs involved when they lack the internal
capabilities to innovate sustainably in the new technological paradigm. In this case, such
alliances become a strategic tool for rapid adaptation. On the other hand, these internal
capabilities consist of a potential benefit side and a realized cost side. Potential benefit reflects
the possibilities for firm-specific future knowledge recombinations and the realized cost reflects
the existing production and coordination costs involved in the knowledge production process.
Hence, some incumbents persist on entering such alliances because they innovate internally at a
low realized cost with moderate recombinative potential and thus choose to invest in the benefit
side, while some other incumbents innovate internally at high levels of coordination costs with
high firm-specific recombinative potential which together prevent them from entering costly and
uncertain exploration alliances.

28
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Table 1. Descriptive Statistics and Bivariate Correlation Matrix
Mean S.D. 1 2 3 4 5 6 7 8 9 10 11 12 13
1 Exploration alliances 0.29 0.45
2 Biotech patents 18.47 26.74 0.339
3 Non-biotech patents 50.07 84.63 0.084 0.351
4 Explotation alliances 0.33 0.99 0.383 0.277 -0.017
5 Biotech acquisitions 0.25 1.03 0.250 0.349 0.031 0.164
6 Biotech/total patents 0.42 0.44 0.124 0.169 -0.341 0.108 0.130
7 Inventors 106.48 126.67 0.376 0.831 0.283 0.304 0.382 0.201
8 Firm merged 0.12 0.33 0.193 0.350 0.003 0.156 0.296 0.155 0.405
9 European firm 0.29 0.45 0.021 0.158 0.125 -0.002 0.039 0.092 0.183 0.091
10 US firm 0.33 0.47 0.089 0.182 0.197 0.091 0.126 -0.131 0.045 0.160 -0.454
11 Pharma firm 0.45 0.49 0.014 0.046 -0.367 0.099 0.086 0.349 0.042 0.005 0.030 -0.046
12 Integrators 3.28 9.69 0.169 0.446 0.174 0.101 0.152 0.098 0.577 0.188 0.133 -0.094 0.008
13 Connectors 2.71 5.89 0.282 0.703 0.283 0.195 0.296 0.121 0.783 0.257 0.148 -0.010 -0.003 0.733
14 Isolates 1.88 4.87 0.212 0.472 0.108 0.237 0.175 0.159 0.423 0.204 0.032 0.197 0.116 0.021 0.161
Note: N = 2322 firm-years

Table 2. Descriptive Statistics - Correlation Matrix At the Individual Level

Mean S.D. 1 2 3
1 Integrators 0.030 0.17
2 Connectors 0.025 0.16 0.408
3 Isolates 0.017 0.13 -0.018 -0.021
Note: N = 236,783

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Table 3. Results of Random-Effects Logistic Regression Predicting Exploration Alliance Formation
Model 1 Model 2 Model 3 Model 4 Model 5

Standard Standard Standard Standard Standard

Beta error Beta error Beta error Beta error Beta error
Constant -4.393 *** (0.654) -1.596 *** (0.331) -4.289 *** (0.767) -1.501 *** (0.334) -1.526 *** (0.332)
Year effects *** *** *** *** ***
Firm merged 0.013 (0.222) -0.047 (0.225) 0.002 (0.222) -0.023 (0.226) -0.045 (0.226)
Pharma firm -0.121 (0.212) -0.131 (0.209) -0.160 (0.209) -0.164 (0.208) -0.147 (0.204)
US firm 0.267 (0.251) 0.344 † (0.252) 0.308 (0.252) 0.329 † (0.253) 0.322 † (0.249)
European firm -0.006 (0.250) 0.006 (0.246) 0.019 (0.245) 0.019 (0.244) -0.025 (0.241)
Biotech patents 0.019 *** (0.004) 0.011 * (0.006) 0.009 * (0.005) 0.006 (0.007) 0.009 † (0.007)
Nonbiotech patents 0.001 (0.001) 0.001 (0.001) 0.000 (0.001) 0.000 (0.001) 0.000 (0.001)
Exploitation alliances 0.324 *** (0.077) 0.318 *** (0.077) 0.318 *** (0.076) 0.315 *** (0.076) 0.318 *** (0.076)
Biotech acquisitions 0.191 * (0.089) 0.176 * (0.090) 0.193 * (0.090) 0.187 * (0.091) 0.183 ** (0.090)
Biotech/Total patents 0.328 * (0.198) 0.339 * (0.196) 0.326 * (0.194) 0.330 * (0.193) 0.324 * (0.193)

Lagged exploration
alliances 0.642 *** (0.139) 0.644 *** (0.139) 0.637 *** (0.140) 0.639 *** (0.140) 0.641 *** (0.140)

Total Inventors 0.258 † (0.167) 0.111 (0.183) 0.105 (0.190)

Integrators -0.002 (0.103) -0.009 (0.103) -0.074 (0.129)
Connectors 0.295 * (0.138) 0.268 * (0.145) 0.233 † (0.175)
Isolates 0.230 ** (0.095) 0.227 ** (0.096) 0.278 ** (0.108)
Integrators * Connectors 0.067 (0.064)
Integrators * Isolates 0.210 (0.212)
Connectors * Isolates -0.284 * (0.137)

N 2288 2288 2288 2288 2288

Log likelihood 1029.14 1027.93 1023.47 1023.28 1019.88
Wald χ2 302.22*** 307.15*** 307.73*** 309.51*** 310.42***
df 33 34 36 37 40
Notes: Standard errors are in parentheses; †p < 0.1; *p < 0.05; **p < 0.01; ***p < 0.001

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Table 4 Interpretation of Logit Results
Beta Odds Ratio Factor Change
Exploitation alliances 0.315 *** 1.370 0.370
Biotech acquisitions 0.187 * 1.205 0.205
Biotech/Total patents 0.330 * 1.391 0.391
Connectors 0.268 * 1.307 0.307
Isolates 0.227 ** 1.254 0.254
Connectors * Isolates -0.284 * 0.753 -0.247
*p < 0.05; **p < 0.01; ***p < 0.001

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