A Resource-based Theory of the Firm-
Knowledge Versus Opportunism
Kathleen R. Conner C. K. Prahalad
University of Michigan Business School, University of Michigan, Ann Arbor, M/48109
Abstract
This paper develops a resource-based ktiowledge-based
theory of the firm. Its thesis is that the organizational mode
through which individuals cooperate affects the knowledge
they apply to business activity. We focus on the polar cases of
organization within a firm as compared to market contract-
ing. There will be a difference in the knowledge that is
brought to bear, and hence in joint productivity, under the
two options. Thus, as compared to opportunism-based, trans-
action-cost theory, we advance a separate (yet complemen-
tary) answer to the question: why do firms exist? Our aim is
to develop an empirically relevant and complementary theory
of why firms are formed: a theory based on irreducible
knowledge differences between individuals rather than the
threat of purposeful cheating or withholding of information.
We assume limited cognitive abilities on the part of individu-
als (bounded rationality), and assume that opportunistic be-
havior will not occur. The latter allows us to determine
whether resource-based theory has independent force, as
compared to the opportunism-based, transaction-cost ap-
proach. The paper predicts choice of organizational mode,
identifying whether firm organization or market contracting
will result in the more valuable knowledge being applied to
business activity. The resource-based predictions of organiza-
tional mode are compared and contrasted with correspond-
ing opportunism-based, transaction-cost ones. A principal
point is that knowledge-based considerations can outweigh
opportunism-related ones. The paper also establishes the
relation of a theory of the firm to a theory of performance
differences between competing firms.
(Theory of the Firm; Strategy; Resource-based; Transac-
tion Costs)
This paper develops a resource-based theory of the
firm. Its thesis is that the organizational mode through
which individuals cooperate affects the knowledge they
apply to business activity. For example, Y and Z might
face a choice between working together as employees
in a firm or completing the same task as independent
contractors. There will be a difference in the knowl-
edge that is brought to bear, and hence in their joint
productivity, under the two options. This conclusion
depends on the straightforward assumption that Y and
Z each possess experience, insights, or skills that are to
some extent different from those of the other. Tacit
knowledge, which can be learned only through per-
sonal experience (Polanyi 1962, Nelson and Winter
1982, Nonaka 1994), is an example of know-how that
is difficult to transfer ex ante. The difference in the
knowledge that is brought to bear, once anticipated,
affects the choice of organizational mode itself. Thus,
as compared to opportunism-based, transaction-cost
theory, we advance a separate (yet complementary)
answer to the question: why do firms exist?
As the literature makes increasingly clear, a knowl-
edge-based view is the essence of the resource-based
perspective. The central theme emerging in the strate-
gic management resource-based literature is that pri-
vately held knowledge is a basic source of advantage in
competition. The resource-based view generally ad-
dresses performance differences between firms using
asymmetries in knowledge (and in associated compe-
tencies or capabilities; see, e.g., Amit and Schoemaker
1993, Barney 1991, Chen 1996, Henderson and
Cockburn 1994, Peteraf 1993, Prahalad and Hamel
1990, Robins and Wiersema 1995, Schoemaker and
Amit 1994, Winter 1995). A resource-based theory of
the firm thus entails a knowledge-based perspective.^
Using the standard established by Coase (1937), a
theory of the firm generally addresses two issues: why
firms exist, and what determines their scale and scope
(Holmstrom and Tirole 1989). Of the two, the reason
for the firm’s existence is logically prior and is the
primary subject of this paper. In the literature, it is
tantamount to asking why a firm exists instead of the
alternative of market contracting between the same
individuals.
Since received theory concentrates centrally (and
virtually universally) on the effect of opportunistic be-
havior (see, e.g., Alchian and Demsetz 1972; Williamson
1975, 1985a; Klein et al., 1978; Grossman and Hart
1986; Kreps 1990; Milgrom and Roberts 1990), we stay
away from opportunism in order to determine whether
1047-7039/96/0705/0477/$01.25
Copyright ' 1996. Institute for Operations Research
and the Management Sciences ORGANIZATION SCIENCE/VOI. 7, No. 5, September-October 1996 477

KATHLEEN R. CONNER AND C. K. PRAHALAD A Resource-based Theory of the Firm
a resource-based theory of the firm has independent
force. We do not claim, however, that resource-based
theory constitutes the exclusive explanation of firms.
Rather, the approach presented here accepts the valid-
ity and, indeed, the remarkable intellectual achieve-
ment of the opportunism-based view in explaining
some of the motivation for firm organization.^ Our aim
is to identify additional, equally valid, empirically rele-
vant causes. In particular, we argue that firms can exist
because of knowledge-based transaction costs that are
independent of the opportunistic considerations ex-
plored by Williamson. Recognition of knowledge-based
transaction costs leads, we believe, to a fuller realiza-
tion of Coase’s (19^7) original insights as to the reasons
for firm organization.
We focus on basic choices: firm organization versus
market contracting. We thus concentrate on polar or-
ganizational modes rather than complex or "hybrid"
arrangements, such as joint ventures, alliances, or com-
plicated corporate structures. Although the latter may
be of great practical and scholarly interest, analysis of
them is facilitated by studying the polar modes, since
the more complicated structures can be seen as permu-
tations of the polar ones. A joint venture, for example,
may consist of blending aspects of firm organization
and market contracting, while a geographically ex-
tended corporate structure, in contrast, may attempt to
gain the basic advantages of firm organization repeat-
edly, through linking multiple layers or units. The polar
cases are "basic particles" from which more elaborate
arrangements are constructed. In addition, in this study
we are concerned with human, rather than physical,
capital. We also are concerned with joint production
between cooperating individuals, rather than simple
exchange of discrete, separable products.^ The analysis
is presented, for simplicity, in terms of the choices of
natural persons. However, it also applies to organiza-
tional entities, such as firms or organizational subunits,
considering operating as one unit versus transacting
autonomously.’’
Section 1 motivates the study by asking: why should
strategic management and organizational scholars be
interested in primary development of a theory of the
firm? We contend that a theory of performance differ-
ences between firms requires, as an essential compo-
nent, a theory of when advantage can be gained by
organizing activify within a company instead of through
arms-length markets. A logical nexus exists, therefore,
between a theory of performance differences between
firms and a theory of the firm itself, in that the former
necessarily incorporates the latter.
Section 2 identifies key concepts used in this study.
These concern the nature of firm organization and
individual behavior. We define the firm in a way con-
sistent with Coase (1937), Simon (1951), Williamson
(1975, 1985a), and Milgrom and Roberts (1988, 1990),
among others. Firms are distinguished from markets
based on an authority (employer-employee) relation-
ship in the former, as compared to autonomous parties
contracting in the latter. As to individual behavior, we
assume bounded rationality (Simon 1957). This has an
important corollary: cognitive limitations prohibit indi-
viduals from possessing identical stocks of knowledge.
Individuals additionally are taken to behave truthfully.
This insures that we avoid opportunism-related reasons
for the firm, allowing us to focus on other, knowledge-
based considerations. In contrast to Williamson (1985a),
we maintain that truthful behavior does not rule out
market contracting frictions that can give rise to firm
organization.
Section 3 presents a resource-based theory of the
existence of the firm. Organizational mode affects the
knowledge applied to business activity in two ways.
These are (1) how the parties’ existing knowledge is
blended and used, and (2) how new learning or devel-
opments occurring during the course of the work are
taken into account. We call these, respectively, the
"knowledge-substitution" and "flexibility" effects of or-
ganizational mode. As to knowledge-substitution, an
employee sometimes acts according to the manager’s
direction rather than in conformity with what the em-.
ployee otherwise would do. The manager’s wisdom in
such situations is substituted for the employee’s.^ If the
employee cannot absorb the manager’s wisdom before
the employee profitably can apply it, the employee may
opt to be directed by the manager and hence to be
employed in a firm. In contrast, under market contract-
ing, each person uses its own judgment to decide the
specific responsibilities and duties that it will agree to
carry out.^ Indeed, the very notion of an autonomous
market contractor means that the individual "retains
the right or power of self-government" (Merriam-
Webster’s, 1994), or put differently, "works for itself."
An individual will favor knowledge-substitution and
hence, all else equal, a firm when the manager’s
understanding (present or future) is believed to be of
superior value compared to corresponding elements of
the employee’s.
The flexibility effect concerns the cost of altering an
individual’s responsibilities or duties on an ongoing
basis, in order to respond to new learning or other
developments arising during the course of the work.
478 ORGANIZATION SCIENCE/VOI. 7, No. 5, September-October 1996