The Battle for Your Strategic Soul: Knight vs. Coase

Back in the 1930s, an up-and-coming 26-year-old named Ronald Coase took on and largely vanquished the theory of one of his mentors, an older economist named Frank Knight. Coase went on to win a Nobel while Knight faded into near obscurity.

It’s time for a rematch.

As our economy grows more complex, senior managers find themselves having to navigate under increasing uncertainty. Knight had a lot to say about the subject of uncertainty. His ideas are gaining more relevance to strategy every day.

Knight is best known for pointing out that risk and uncertainty are not the same. Because of Coase, though, he is virtually unknown for his theory of the firm — that is, the economic theory that explains why firms exist in the first place. Knight’s thesis was that entrepreneurs are better at peering into uncertainty. This does not mean they are better at statistics. Rather, they have a knack for identifying what kinds of things might happen. Call it “vision.” This skill cannot be observed or measured, Knight argued, and therefore cannot be contracted out. The rest of us are okay with working for entrepreneurs as long as they help us deal with uncertainty. In return, we offer them the upside by way of the firm’s profits.

Knight’s view was rooted in uncertainty. In contrast, Coase’s view was rooted in efficiency. Firms exist, Coase argued, because if everyone freelanced, the costs of contracting and supervising workers would be prohibitive. It’s better for the firm to internalize some of those activities. Coase’s theory was based on measurable efficiency and Knight’s was based on the more abstract concept of uncertainty. No wonder Coase’s theory took hold.

Coase was the intellectual forebear of such strategy consulting mainstays as the Porter model and value chain analysis. These models cast strategy as a decision of what assets and activities to incorporate within the firm and what to leave out. They all shared a common worldview: it is not prediction that matters but position and capability.

Which brings us to today. Coase-influenced strategy has reached its logical conclusion. Not even capabilities and position can take center stage anymore. These, after all, still carry some uncertainty. Instead, they have been supplanted by sure-thing efficiency initiatives: offshoring, six-sigma, cost cutting, etc. We have tried to travel as far from uncertainty as possible, and yet, somehow, it still manages to catch up to us.

As an investor, I see a lot of CEOs standing at the edge of the uncertainty frontier. Coase and efficiency have brought them this far, but that set of sure-thing initiatives cannot provide what their companies really need: revenue growth. That now requires innovation, prediction, and seeing past the fog created by our increasingly complex business environment.

Knight’s view implied that uncertainty was the whole point of strategy — the reason firms exist in the first place. If his view had won out over Coase’s, strategy would look different today. It is time to bring Knight’s ideas back. Strategy adds value when it understands and exploits uncertainty better than the competition. That makes uncertainty the source of a competitive advantage. Knight and Coase would no doubt do battle over that statement. But I think we would have a different champion today.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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