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MANAGERIAL AND DECISION ECONOMICS
Manage. Decis. Econ. 29: 489–502 (2008)
Published online in Wiley InterScience
(www.interscience.wiley.com) DOI: 10.1002/mde.1413
Building Micro-foundations for the
Routines, Capabilities, and
Performance Links
Peter Abell
a
, Teppo Felin
b
, and Nicolai Foss
c,
*
a
London School of Economics, London, UK
b
Marriott School of Management, Brigham Young University, Provo, UT, USA
c
Copenhagen Business School, Center for Strategic Management and Globalization,
Porcelainshaven 24, Frederiksberg, Denmark
Micro-foundations have become an important emerging theme in strategic management. This
paper addresses micro-foundations in two related ways. First, we argue that the kind of macro
(or ‘collectivist’) explanation that is presently utilized in the capabilities view in strategic
management}which implies a neglect of micro-foundations}is incomplete. There are no
mechanisms that work solely on the macro-level, directly connecting routines and capabilities
to firm-level outcomes. While routines and capabilities are useful shorthand for complicated
patterns of individual action and interaction, ultimately they are best understood at the micro-
level. Second, we provide a formal model that shows precisely why macro-explanation is
incomplete and which exemplifies how explicit micro-foundations may be built for notions of
routines and capabilities and how these impact firm performance. Copyright #2008 John
Wiley & Sons, Ltd.
INTRODUCTION
Micro-foundations have become an important
emerging theme in strategic management. Scholars
increasingly realize that understanding such issues
as value appropriation (Coff, 1999; Barney, 2001;
Lippman and Rumelt, 2003a), resource value
(Lippman and Rumelt, 2003b; Foss and Foss,
2005), strategy implementation (Barney, 2001),
factor market dynamics (Makadok and Barney,
2001), inertia (Kaplan and Henderson, 2005), and
firm-level heterogeneity (Gavetti, 2005; Felin and
Hesterly, 2007) requires that substantial attention
be paid to explanatory mechanisms that are
located at the ‘micro-level,’ that is, the level of
individual action and (strategic) interaction. It
seems that strategic management is now embark-
ing on a micro-foundations project somewhat
similar to similar projects in (macro)economics
(Leijonhufvud, 1968; Lucas, 1977) and rational
choice sociology (Elster, 1989; Coleman, 1990;
Abell, 2003a, b).
This paper contributes to the emerging micro-
foundations project theoretically and methodolo-
gically. Specifically, we address the emphasis
placed upon routines and capabilities as key
constructs in much of strategic management
research and question the present emphasis on
collective and macro constructs. A central argu-
ment in much work in strategic management is
that routines or capabilities are fundamental units
of analysis, and that organizations should be
*Correspondence to: Copenhagen Business School, Center for
Strategic Management and Globalization, Porcelainshaven 24,
Frederiksberg, Denmark. E-mail: njf.smg@cbs.dk
Copyright #2008 John Wiley & Sons, Ltd.
conceptualized as repositories of routines and
capabilities (e.g., Nelson and Winter, 1982; Kogut
and Zander, 1992). It is, furthermore, asserted in
this stream of research that routines and capabil-
ities cause firm-level outcomes, such as financial
performance, innovation, and the boundaries of
the firm (e.g., Nelson and Winter, 1982; Kogut and
Zander, 1992; Teece et al., 1997; Eisenhardt and
Martin, 2000; Winter, 2003). Thus, it is argued
that explaining firm-level outcomes should take
place in terms of other firm-level variables.
Two explanatory gaps}of which we shall
primarily concentrate on the second one}stand
out in this research stream. First, there is little
recognition of the need to explain the origins (or
emergence) of routines and capabilities (except
perhaps in terms of other routines and capabil-
ities). Second, exactly how routines and capabil-
ities are related to firm-level outcomes, such as
performance, is seldom elaborated (cf. Argote and
Ingram, 2000, p. 156). Thus, crucial explanatory
theoretical mechanisms are left unexplored and
implicit.
We argue that gaps related to underlying micro-
foundations cannot be bypassed, they need to be
explicated, and that in addressing these gaps one
must involve the level of individual action and
interaction. The specific gap and associated
problem is that the macro (or ‘collectivist’) mode
of explanation that currently dominates large parts
of the strategic management literature, and which
asserts a causal relation running directly from
routines and capabilities to firm-level outcomes, is
incomplete. To be sure, firm-level concepts such as
routines and capabilities may be (indeed, are)
relevant to the explanation of firm-level outcomes.
However, they are relevant because they are useful
shorthand for complicated repetitive patterns of
individual action and coordinated interaction.
Thus, the micro-level (i.e. individual action and
interaction) ultimately replaces the macro-level
(i.e. the postulated direct link between routines/
capabilities and performance) in the explanation
of how routines/capabilities and performance are
linked.
To clarify this argument, we develop a formal
model that details the importance of the micro-
level in explaining firm-level outcomes. The argu-
ments, and the accompanying modelling effort,
explain how micro-foundations can be built for
capabilities and how they are linked to firm-level
outcomes. Thus, the paper is offered as one way
of furthering the received capabilities view in
strategic management (cf. Zollo and Winter,
2002). Specifically, we argue that the nature of
routines is to internalize externalities. This argu-
ment harmonizes with the emphasis in the
literature on routines as coordinating devices
(Nelson and Winter, 1982, Chapter 5). However,
because of asymmetric information routines only
imperfectly internalize externalities. This second-
best argument harmonizes with the emphasis in
the literature which suggests that routines are
often not optimal (Nelson and Winter, 1982).
However, we diverge from the literature, first, by
explicitly modelling the micro-foundations of
how routines impact performance; second, by
embedding our arguments in a conventional
production function framework; and third, by
modelling production externalities as giving rise to
prisoner’s dilemma situations rather than to
coordination problems. Finally, we link routines
and capabilities in a simple manner by arguing
that a firm can be described as possessing the
capability to realize a routine to the degree that it
can repeatedly internalize such externalities (i.e.
realize synergies).
ANALYTICAL LEVELS IN STRATEGIC
MANAGEMENT
Many phenomena of interest in the strategic
management field, such as financial performance,
diversification patterns, vertical integration, com-
petitive rivalry, etc., are placed on a level of
analysis that is above that of the individual. In
fact, explananda (i.e. the dependent variables) in
strategic management are usually placed at the
level of the firm. However, the explanans (i.e. the
independent variables and the mechanisms that
link them to the dependent variables) may involve
other levels of analysis as well, such as the dyadic
level, the industry level, or the level of individuals.
Any theoretical and empirical effort to explain
phenomena in strategic management then has to
make a choice that concerns the level(s) at which
explanation takes place (Dansereau et al., 1999). A
classic distinction in social science research is
between the collective and the individual level
(Lazarsfeld and Menzel, 1970; Coleman, 1990,
pp. 3–5), which in the context of organizational
theory and strategic management corresponds to a
P. ABELL ET AL.490
Copyright #2008 John Wiley & Sons, Ltd. Manage. Decis. Econ. 29: 489–502 (2008)
DOI: 10.1002/mde
distinction between ‘macro’ and ‘micro.’ We argue
that strategic management research has too often
located not only the explanandum (which is
entirely legitimate) on the collective or macro-
level, but also all of the explanans (which is often
problematic).
A General Model of Social Science Explanation
In order to clarify notions of ‘micro’/‘individual
level,’ and ‘macro’/‘collective level’, as well as
examine the relations between these notions and
levels, consider Figure 1 which builds on the
framework popularized by James Coleman (1990).
This framework organizes much of our discussion
and modelling effort.
The Figure makes a distinction between the
macro-level and the micro-level. For example, it
may be that the macro-level is organizational
whilst the micro-level is that of individuals. As
shown, there are links between macro–macro
(arrow 4) and macro–micro (arrow 1), micro–
micro (arrow 2), and micro–macro (arrow 3).
1
The
Figure also makes a distinction, perhaps
more implicit, between what is to be explained
(i.e. the explanandum) and its explanation (i.e. the
explanans). In social science, the aim usually is to
explain either a macro-level phenomenon (located
in the upper right hand corner of Figure 1), such as
a firm-level outcome, or a link between macro-
phenomena, as indicated by arrow 4. An example
of the latter may be an observed correlation
between the routines and the performance of firms
in a population. To explain and understand a
particular phenomenon (such as overall firm
performance) the analyst makes use of theoretical
mechanisms that are consistent with the arrows.
Note that the arrows in Figure 1 are, from a
theoretical perspective, empty boxes. They may be
filled with different theoretical mechanisms,
entirely dependent on theory development on the
part of the analyst. (Our later modelling effort is
an example of development of such concrete
theoretical content.)
Macro-Explanation in Strategic Management
At first inspection, the framework depicted in
Figure 1 would seem to formally allow for
explanation that takes place solely in terms of
arrow 4, that is, explanatory accounts that are
wholly located on the macro-level. However,
whether arrow 4 explanation is deemed legitimate
depends on (ontological) criteria related to an
understanding of how the social world works
(Ma
¨ki, 2001). Specifically, there are no conceivable
causal mechanisms in the social world that operate
solely on the macro-level. There are no macro-level
entities on the social domain that somehow possess
capacities or dispositions to act (Cartwright, 1989)
that make them capable of directly producing
macro-level outcomes, and there are no processes
of interaction between macro-entities that take
place on this level. In short, there is no macro-level
causal mechanism that can be theoretically repre-
sented in terms of arrow 4.
2
However, arrow 4 explanation is not necessarily
entirely ruled out. First, arrow 4 may be taken as no
more than a representation of a correlation between
macro-variables in need of further explanation of
the micro-level. This is entirely unproblematic.
Second, arrow 4 may be used as convenient
shorthand. ‘Convenient shorthand’ here means that
we can make use of arrow 4 explanations when we
are convinced that they can be reduced to micro-
mechanisms, but performing this reduction would
not add anything in the explanatory context (cf.
Stinchcombe, 1991). For example, there is no
problem in asserting and showing that organiza-
tional culture perhaps is correlated with organiza-
tional performance. More generally, arrow 4
explanation may be legitimate when the relation-
ship does not appear to be particularly puzzling,
for example, because we have a good grasp of the
underlying micro-mechanism (Abell, 2003b,
p. 261).
3
Be that as it may, it certainly is the case
that several examples of arrow 4 ‘explanation’ can
be found, such as the arguments that routines are a
direct cause of firm-level adaptation (Nelson and
Winter, 1982), ‘combinative capabilities’ cause firm-
level innovativeness (Kogut and Zander, 1992), and
••
••
1
2
3
4
Individual
of Individual action
Conditions
action
Social
outcomes
”Social
facts”(e.g.,
institutions)
”macro”
”micro”
Figure 1. A general model of social science explanation.
MICRO-FOUNDATIONS FOR THE ROUTINES 491
Copyright #2008 John Wiley & Sons, Ltd. Manage. Decis. Econ. 29: 489–502 (2008)
DOI: 10.1002/mde
different ‘absorptive capacities’ cause differences in
how well firms learn from partner firms in inter-
organizational relations (Lane and Lubatkin, 1998).
It was briefly suggested above that macro-
explanation may be warranted under certain
conditions. However, it would be hard to argue
that these conditions are always met in strategic
management research; in fact, it is rarely so. Thus,
strategic management scholars do not have the-
ories of why routines and capabilities impact firm
performance that involve the micro-level, that is,
at the level of individual action and interaction.
Second, there is much reason to think that
micro-level considerations add substantially to
macro-level understanding. For example, a micro-
perspective suggests that macro-level heterogeneity
can be an epiphenomenon of individual level self-
selection. Further reasons why micro-foundations
are in fact critical are given in the following.
Why Micro-Foundations Are Critical
We take the position}associated with
‘methodological individualism’}that the explana-
tion of firm-level (macro) phenomena in strategic
management must ultimately be grounded in
explanatory mechanisms that involve individual
action and interaction (cf. Hayek, 1952; Ullmann-
Margalit, 1977; Elster, 1989; Coleman, 1990;
Boudon, 1998). We also take it that the ultimate
aim of scientific endeavour in the field of strategic
management should be to identify and theorize the
causal mechanisms}the ‘cogs and wheels’ (Elster,
1989, p. 3)}that produce the observed associa-
tions between events (Cowan and Rizzo, 1996;
Hedstrom and Swedberg, 1998).
4
Combining methodological individualism with
an emphasis on causal mechanisms implies that
strategic management should fundamentally be
concerned about how intentional human action
and interaction causally produce strategic phe-
nomena. It is implicit in this view that explanatory
black boxes be avoided (Boudon, 1998). Admit-
tedly, black boxes may sometimes be justified in
terms of explanatory parsimony (Hedstro
¨mand
Swedberg, 1998, p. 12; also see Coleman, 1990, p.
16), as indeed happens in much of arrow 4-type
explanation. Strategic management scholars know
(or should know) that when they speak of a firm
appropriating a revenue stream, this is shorthand
for a complicated underlying process of bargaining
between numerous individual resource owners and
other stakeholders (Coff, 1999; Lippman and
Rumelt, 2003a, b). In a related vein, to say that
a firm has a certain capability is essentially
shorthand for a complex set of underlying
individual actions and interactions, and associated
characteristics or skills which make the realization
of these capabilities possible. Because scholars
may not always want to make explicit reference to
complicated underlying patterns of actions, they
often prefer to make use of explanatory shorthand
in the form of collective concepts. This is
completely legitimate. However, a fundamental
methodological (and ultimately theoretical and
managerial) problem in contemporary strategic
management research is that it seems to be too
often forgotten that explanation in strategic
management should nevertheless have a micro-
foundation.
Before proceeding to our modelling effort, we
delineate, building on Coleman’s (1990, pp. 3–4)
insight, perhaps the most persuasive reason for
why micro-foundations are critical for strategic
management. That is, perhaps the most critical
problem with macro-level explanation is that there
are likely to be many alternative lower-level
explanations of macro-level behaviour which
cannot be rejected with macro-analysis alone.
Even if a large sample can be constructed on the
basis of macro-units of analysis, a problem of
alternative explanations may persist. As indicated
above, alternative explanations at lower levels are
readily apparent in, notably, the capabilities view,
which seeks the explanation of differential firm
performance in firm-level heterogeneity, that is,
heterogeneous routines and capabilities. However,
heterogeneity may be located at the individual
level, notably when individuals self-select into
particular firms.
An argument for the importance of under-
standing micro-foundations lies in the fundamen-
tal mandate of strategic management: to enable
managers to gain and sustain competitive advan-
tage. To achieve this, managerial intervention is
required, which inevitably has to take place with
an eye toward the micro-level.
5
Coleman (1990, p.
3) convincingly argues that explanations that
involve the micro-level have the properties of
being more stable, fundamental, and general than
macro-level explanations:
An explanation based on internal analysis [i.e.
micro-foundations] of system [organization]
P. ABELL ET AL.492
Copyright #2008 John Wiley & Sons, Ltd. Manage. Decis. Econ. 29: 489–502 (2008)
DOI: 10.1002/mde
behaviour in terms of action and orientations of
lower-level units is likely to be more stable and
general than explanation which remains at the
system level. Since the system’s behaviour is in
fact resultant of the actions of its component
parts, knowledge of how the actions of these
parts combine to produce systematic behaviour
can be expected to give greater predictability
than will statistical relations of surface char-
acteristics of the system.
To the extent that strategic management is
concerned not just with explaining past perfor-
mance but also with being prescriptive, Coleman’s
point raises an important concern: the ability to
predict is a condition for putting forward pre-
scriptions. Micro-foundations are therefore an
important part of strategic management as a
prescriptive enterprise.
ROUTINES AND CAPABILITIES
The seminal and in many ways founding contribu-
tion to the capabilities view is Nelson and Winter
(1982). Their conceptualizations and insights have
been fundamental to the way subsequent work on
routines and capabilities has developed (Foss,
2003; Becker, 2004), not the least in strategic
management (e.g., Teece et al., 1997; Dosi et al.,
2000; Eisenhardt and Martin, 2000).
6
In this
section, we look at routines, first, as dependent
variables (i.e. as explananda), and, second, as
independent variables (i.e. part of the explanans).
We argue that in both cases the extant literature
has a problem with missing micro-foundations.
Explaining Routines
Nelson and Winter begin their analysis of routines
from the notion of skill (Nelson and Winter 1982,
Chapter 4), which they define as ‘... a capability
for a smooth sequence of coordinated behavior
that is ordinarily effective relative to its objectives,
given the context in which it normally occurs’
(1982, p. 73).
7
There are a number of reasons why
the skill metaphor is attractive to Nelson and
Winter (see Foss, 2003), but the one that is of
interest in the present context is that the notion of
skills is used to establish a link between individual
action and organizational routines, even if that
link is merely metaphorical. Routines are con-
ceptualized by Nelson and Winter (1982, p. 124) as
the ‘skills of an organization’ and as ‘a repetitive
pattern of activity in an entire organization’ (1982,
p. 97). Routines refer to repetitive interaction that
is somehow patterned, typically (but not necessa-
rily) in the form of fixed sequences of individual
actions where the specific sequence and the
contents thereof are organization-specific (i.e. firm
A may do things in a different order than firm B)
(Cohen et al., 1996; Dosi et al., 1999; Becker,
2004).
While Nelson and Winter spend considerable
time on developing the notion of a routine, they
are less forthcoming about the notion of cap-
ability, which is loosely defined as ‘associated with’
‘individual members’ repertoires ... particular
collections of specialized plant and equipment ...
[and]... the ability to operate that plant and
equipment’ (Nelson and Winter, 1982, p. 103).
Unfortunately, they do not clarify how routines
and capabilities are related, and much the same
may be said of the subsequent literature that has
taken its cues from Nelson and Winter.
8
Because
of this lack of clarity with respect to the capability
construct, we shall primarily make reference to the
less ambiguous routines construct, but later
suggest a specific interpretation of what a cap-
ability may entail.
Neither Nelson and Winter, nor subsequent
writers in strategic management, have (to our
knowledge) offered a rigorous analysis of why and
how actions taken by different individuals in an
organizational setting should come to mesh into
orderly and repetitive (reproducible) sequences
(employee A doing Xafter employee B has done
Y, etc.), that is, routines. It is arguable that the
reason for our understanding of routines being
incomplete in this manner is the lack of an explicit
starting point in individual action and interaction.
Specifically, it is necessary to examine the actions
that an individual can take (e.g., routine action or
non-routine action) and the payoffs associated
with these actions before it is possible to ascertain
whether the actions individually taken will con-
stitute a routine.
Consider the left-hand side of the diagram
depicted in Figure 2, which is concerned with the
explanation of routines (i.e. routines as explanan-
dum). In terms of the diagram, arrows 1–3 are not
given theoretical content in extant work on
routines. Instead, routines at time t
1
are explained
MICRO-FOUNDATIONS FOR THE ROUTINES 493
Copyright #2008 John Wiley & Sons, Ltd. Manage. Decis. Econ. 29: 489–502 (2008)
DOI: 10.1002/mde
directly in terms of routines at t
0
. For example,
Nelson and Winter (1982) argue that routines
change through the operation of other routines
(‘dynamic routines’). This is an explanation in
terms of arrow 4. A similar neglect of the micro-
level arises in connection with explanation that
involves routines, not as explananda, but as part of
the explanans.
Explaining by Means of Routines
Among the reasons why routines have proved
attractive to strategic management scholars is that
they are seen as representing the outcomes at a
given time of a firm’s knowledge development path
(e.g., Teece et al., 1997; Eisenhardt and Martin,
2000). They are therefore relevant to the under-
standing of such important knowledge-based
phenomena as heterogeneity, competitive advan-
tage, inertia, diversification patterns, and patterns
of innovation. However, as Argote and Ingram
(2000, p. 156) lamented, to the extent that there
has been progress in studying knowledge as the
foundation of competitive advantage, ‘... it has
been at the level of identifying consistencies in
organizations’ knowledge development paths and
almost never at the level of human interactions
that are the primary source of knowledge and
knowledge transfer.’ In other words, explanations
of (for example) competitive advantage that
involve notions of routines in the explanans
typically reason directly from these to competitive
advantage. In terms of the right-hand side of
Figure 2, this amounts to explanation using arrow
4(a). Again, however, arrows 1(a), 2(a) and 3(a)
are not given theoretical content.
Understanding the firm-level consequences of
actions being routinized}for example, why a
certain routine may be a source of superior
performance}requires taking a starting point in
individual action and interaction: the routine may
be associated with a high-productivity equilibrium
(Leibenstein, 1987), for example, because it leads
to superior coordination of actions (Camerer and
Knez, 1996) (sans incentive conflicts) or because it
leads to agents choosing actions that overcome
latent prisoner’s dilemma situations. Thus, the
causal links from routines to firm-level outcomes
are never direct (arrow 4a in Figure 1); rather, they
involve individual skills, motivations, and actions.
Unfortunately, these individual level considera-
tions have been consistently blackboxed in the
received capabilities view.
9
The following section is
an attempt to open up this black box.
EXPLAINING THE LINKS BETWEEN
ROUTINES, CAPABILITIES, AND
PERFORMANCE
Conceptualizing Routines and Capabilities
As noted, the relation between the core constructs
of routines and capabilities is far from clear in the
literature, and definitions of these constructs tend
to be vague. We suggest the following simple
definition of routines and capabilities and how
they relate: A firm can be described as possessing
the capability to realise a routine to the degree that
it can repeatedly internalise a pattern of individual
level external productivity effects.
10
This definition seems to capture important parts
of what many scholars}not only Nelson and
Winter}imply by routines and capabilities (e.g.,
Cyert and March, 1963, pp. 120–133).
11
Notably,
there is more to a routine than merely sequentially
• •
•
•
•
•
•
Macro antece-
dents for routines Routines
Firm-level
outcomes
1
31a 3a
2a
2
Not described and
clrified in extant clrified in extant
literature on routines
Not described and
literature on routines
44a
Figure 2. Explaining routines and explaining by means of routines.
P. ABELL ET AL.494
Copyright #2008 John Wiley & Sons, Ltd. Manage. Decis. Econ. 29: 489–502 (2008)
DOI: 10.1002/mde
organizing the productive effort of a number of
independent productive agents. Their efforts are
interdependent (as manifested in external produc-
tivity effects), and these interdependent efforts can
be repeated (Cohen et al., 1996). Also note the
cross-level nature of this definition referring, as it
does, to both a firm (collective level) and
individuals.
One might ask why the routine should not be
attributed to the (collective action of) individuals
rather than to the organization (thus obviating the
need for an awkward cross-level conceptualiza-
tion). The reason for taking this route is that the
literature appears to make it a requirement of
routines that they are replicable by mechanisms
operating at the organizational level (Nelson and
Winter, 1982, p. 117; Cohen et al., 1996).
12
To put
it somewhat differently, routines are deemed to be
institutionalized to the extent that they are not
overly sensitive to the turnover of employee and
management turnover (and perhaps depreciation
of substitutable capital assets) in realizing the
capability (Nelson and Winter, 1982). This feature
must, of course, be a matter of degree and it is
difficult to precisely characterize it.
Firms as Averaging Mechanisms
The way we propose to address these issues is by
conceiving a firm as an averaging mechanism. This
notion may be exemplified in terms of a principal-
agent setting with one principal and a number of
agents that cooperate in a team (as in Alchian and
Demsetz, 1982). Information is asymmetric in the
specific sense that the principal cannot observe
individual efforts and outputs. He can only
observe the team’s output; however, basing the
remuneration of individual team members on team
output introduces a prisoner’s dilemma problem.
Resorting to some kind of monitoring is therefore
necessary. Although he cannot observe individual
effort, the principal/manager can, based on var-
ious signals, form an estimate of the average of
input productivities and therefore an estimate of
output, given the average. Moreover, we assume
that managers can implement this average and that
the means to such implementation is a routine.
13
The average mechanism conception implies that
firms (i.e. management) do(es) not have the
information to internalize the full micro-complex-
ity of external effects, which is why resorting to
some averaging procedure is necessary. This
conception is consistent with the notion that
routines assist in coordinating dispersed, tacit
knowledge (Kogut and Zander, 1992; Cohen
et al., 1996; Dosi et al., 1999), that is, knowledge
that cannot be fully centralized in the management
team. Routines, whilst conferring potentially high
financial performance, may not be optimal (Nel-
son and Winter, 1982, p. 126).
14
Finally, the
averaging procedure harmonizes with the key idea
in the literature that an important function of
firms is to simplify the micro-complexity of inter-
individual external productivity effects by means
of routines and standard operating procedures (cf.
Cyert and March, 1963).
15
Fundamental Notions
The following modelling exercise gives some
substance to the explanatory skeleton represented
by the diagram in Figure 1. Specifically, Figure 3,
which is simply an application of the Coleman
diagram in Figure 1 to the present model,
introduces some of the notation and terminology
used here.
The basic analytical procedure is as follows. N
individuals exerting certain skills at a certain level
of motivation, X, could}in the absence of
externalities in production}operate indepen-
dently producing an aggregate output Y
indep.
.
Under standard assumptions about production
costs (which we shall leave implicit for the sake of
clarity), there is in this case nothing to be gained
from routinization. In order to provide a rationale
for routines, we introduce production externalities
as a network (i.e. a di-graph). Optimal output,
Y
dep:;now requires micro-level internalization of
these effects. Consistent with the theory of the firm
literature (e.g., Alchian and Demsetz, 1972;
••
••
1
2
3
4
Individual
action
X
YR,Z
1a
Figure 3. Explaining the routines/performance link.
MICRO-FOUNDATIONS FOR THE ROUTINES 495
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DOI: 10.1002/mde
Holmstro
¨m, 1982; Grossman and Hart, 1986) we
assume that it is beyond the individuals, acting
independently, to achieve such internalization.
In this context, the firm (i.e. management) may
be seen as a mechanism for attending to the
external effects when the output is Y
dep
. Because of
asymmetrical information, not all external effects
can be (efficiently) internalized; hence, the
notion that only average external effects are
internalized. The application of a routine results
in an output level that lies somewhere in the
interval, ]Y
indep.
,Y
dep:[.
16
In the following, routine impact on firm
performance is defined as the explanandum, that
is, we primarily look at the right-hand side of the
diagram in Figure 2 (and black-boxing the left-
hand side). If a firm is conceived as a repository of
routines, they are not necessarily independent of
one another, as, reflected in notions of routine
hierarchies (Nelson and Winter, 1982; Winter,
2003). The capability to realize one routine may
depend upon the capacity to realize other routines
(i.e. inter-routine synergies). For the sake of
expository convenience, however, we abstract
away from such interdependence and deal with
independent routines.
Individual Level Considerations
To introduce individual level considerations, let
the productive output of individual i¼ð1;2;...;
NÞin the routine be Y
i
. Further, let the exogenous
individual (micro)-level variable be X(i.e. the
bottom node to the left in Figure 2). To ease
presentation, X
i
represents an interactive (choice)
variable of individual i’s motivation and skills (i.e.
‘motivated skill’). More specifically, we can
represent an individual level (arrow 2) production
function as a simplified Cobb–Douglas function:
Yi¼b0Xb1
iri;ð1Þ
where r
i
represent stochastic factors. In logs, this
becomes
log Yi¼log b0þb1log Xiþlog ri;ð2Þ
r
i
has the usual stochastic interpretation (i.e.
normally distributed with mean zero, uniform
variance, and zero co-variance among the resi-
duals) across the Nindividuals. b
0
is the total
factor productivity of the routine. Again, to avoid
notational complexities we have suppressed other
productive factors (notably capital) which may be
regarded as embodied in b
0
.
Aggregating Up
Under standard assumptions about the value
(benefits) of Yand the cost of motivated skill (X)
to each individual, the optimal levels of Y
i
,i¼
1;2;...;i;...;N;are easily definable in terms of
equalizing costs and benefits at the margin. Then
the total output, Y
indep.
, is given by
Yindep:¼SiYi;ð3Þ
where ‘indep.’ stands for independent individual
maximization. Thus, the firm-level outcome is
reached by simple addition (i.e. arrow 3 in Figure
2). However, the notion of routines implies more
than Equation (3). In order to better capture the
meaning and implications of routines, assume now
that the individual production functions poten-
tially take the form
Y
i¼b0ðXiSkaikXkÞb1ei;ð4Þ
where e
i
represent stochastic factors. In logs, this
becomes
log Y
i¼log b0þb1log Xiþb1log SkðaikXkÞ
þlog ei;ð5Þ
where k¼1;2;...;N;k=i:e
i
has the usual
stochastic interpretation across the Nindividuals.
a
ik
is the weighting of the external effect of
individual k’s motivated skill (X
k
) upon individual
i’s output performance (i.e. ‘Hawthorne effects’).
In other words, a
ik
represents externalities in
production. In this context, the notion of
‘institutionalization’ can be interpreted to refer to
the extent to which the effects represented by a
ik
can be maintained in the face of turnover; for
example, strong institutionalization implies that
a
ik
is rather invariant to personnel turnover.
It is convenient to interpret the matrix, A,of
binary coefficients a
ik
across the Nactors as a
network, or more formally, a di-graph, R¼ðN;AÞ;
where Nrepresents, the nodes and Athe arcs. In
fact, given our earlier remarks about the institu-
tionalized capacity of routines it may be useful to
regard the graph Ras running across institutiona-
lized positions rather than specific individuals.
This conceptualization links capability and rou-
tines: the more an organization has institutiona-
lized such positions, the better its capability of
repeatedly realizing the routine.
17
It is as if the
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DOI: 10.1002/mde
organization has a ready blueprint for organiza-
tional design (including task allocation) and HRM
policy that it can efficiently and repeatedly
implement in the face of even substantial personnel
turnover (cf. Nelson and Winter, 1982).
The significance of Ais that it marks the
potential for collective action in the following
sense: to the degree each individual, k, sets her
level of motivated skill at X
k
, taking account of,
not only her own output Y
k
, but also the impact
she has on the other individuals in R, the value of
Ydep:¼SiY
ið6Þ
will be optimal. In general,
Ydep:>Yindep:ð7Þ
if, for at least one pair iand k,aik >0;and
individuals take account of their impact on other
individuals in R.
PRODUCTION IN ROUTINES
If, as before, we assume conventional individual
cost functions in X, it is intuitive that the
individual level production functions (i.e. Equa-
tion (4)) establish an N-person prisoner’s dilemma.
Thus, the (Pareto) optimum is achieved when all
players internalize their external effects in setting
their respective Xvalues (Holmstro
¨m, 1982). Each
has, however, an incentive to free ride and then Y
(indep) will be realized, supporting the (sub-
optimal) N-person Nash equilibrium.
18
The firm
tries to prevent this problem by institutionalizing a
routine.
19
We now allow both parameters in equations of
the form (4) to vary across routines j. Assume,
without any loss of generalization, that they take,
respectively, the simple linear forms
log b0j¼c01Zjþlog u0j;ð8Þ
b1j¼c11Rjþu1j;ð9Þ
where again the uterms are both stochastic with
the standard interpretation. Z
j
and R
j
are variables
which vary across routines, but not across
individuals within a routine. These are firm-level
variables that impact/moderate the relation be-
tween individual-level motivated skill and indivi-
dual output performance. Thus, Z
j
measures the
variation in total factor productivity across
routines (that is, effects in output that are not
caused by inputs of motivated skill), while R
j
is a
measure of the extent to which the routine
internalizes externalities. (We will return to this
below.) By making these stochastic functions we
signal that arrow 1 in Figure 3 is empirical rather
than definitional.
20
Introducing variation across jand combining (2)
with (8) and (9) we obtain an expression for
individual i’s productivity in routine j:
log Yij ¼c01Zjþc11 Rjlog Xij þlog u0j
þu1jlog Xij þlog rij :ð10Þ
Note the dependence of the ‘error’ on the value of
Xwhich in the context of empirical estimation
would call for special treatment.
Variables Zand Rare under the control of the
firm (i.e. in practice management). Zis any
variable, like size influencing economies of scale,
which impacts total factor productivity. With
respect to Z(our concern here), management has
at its disposal three basic mechanisms for deter-
mining the aggregate input, X(i.e. motivated
skill)}namely, firstly, an incentive system; second,
monitoring and direct supervision; and, third, the
creation and maintenance of firm-level cultural
norms.
It is reasonable to assume that management
does not possess the detailed information on
inputs (X) and the strength of the external effects
(a
ikj
) in order to design individual-specific incen-
tive contracts which would optimally internalize
these effects. Management could offer a collective
incentive contract (e.g., profit or gain sharing), but
this is open to free-riding (Alchian and Demsetz,
1972). Indeed, we assume, in the first place, that
individual coordination cannot be achieved, thus
necessitating management (i.e. the firm). Manage-
ment will, of course, expend resources on super-
vision and monitoring, but once again the details
of complex routines will fall beyond their grasp.
Given the potential failure of sharp incentives and
monitoring, the establishment of norms (i.e.
corporate culture) may provide a partial solution
(cf. Miller, 1992). More generally, we conjecture
that management can only be the recipients of
noisy signals about the potential of the routine.
In light of this earlier analysis let,
Rj¼1=NðN1ÞSiSkaikj Xik:ð11Þ
That is to say, R
j
is the mean value of the
institutionalized external effects in routine j.
MICRO-FOUNDATIONS FOR THE ROUTINES 497
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DOI: 10.1002/mde
So (10) becomes
log Yij ¼c01Zjþc11 ð1=NðN1ÞSiSkaijkXkj Þlog Xij
þlog u0jþu1jlog Xij þlogrij :ð12Þ
The firm by averaging over the external effects
institutionalizes the production functions across
routines:
Yij ¼Zc01
jðXijÞcð1=NðN1ÞSiSkaikjXkj Þ
11 u0jrijXijuij :ð13Þ
With an averaging assumption the total output
will be Y(mean) for any j, where
Y
dep:>Ymean >Yindep::ð14Þ
Notice that the collective/macro-level variables, Z
j
and R
j
, enter the explanation of the routines-
performance link, not through arrow 4 in Figure 2,
but by moderating the relationship between the
exogenous individual-level variable and perfor-
mance (c
11
; arrow 2), or directly by influencing Y
ij
(i.e. c
01
Z
j
; arrow 1a).
Although the purpose of this paper is rather
general, pointing to the necessity of a micro-
foundational model in any theory of routines,
there are some possible empirical tests of our
particular model. First, insofar as firm perfor-
mance is attributable to institutionalized routines,
then collective incentives are likely to be absent.
Second, payment by results is also likely to prove
ineffective. Third, for routines to be effective they
will probably need to be complemented by strong
norms. (We return to empirical issues in the
Concluding Discussion.)
Collectivist Explanation is Incomplete
Armed with the above analysis, we can now
examine somewhat more rigorously the claim
made earlier that collectivist explanations are, in
the present context, not tenable. Specifically, we
can ask whether it would ever prove sensible to
explain the capabilities-performance link only in
terms of arrow 4.
Assume (2), introducing variation across j,is
changed to
log Yij ¼log b0jþlog rij :ð15Þ
This is equivalent to saying that all the individual-
level exogenous variables, embodied in r
ij
, bear a
random relationship to individual performance;
there is no generalizable impact on performance of
any micro-level variables. This is of course highly
unlikely, but this is the only meaning we can attach
to the idea whereby arrow 4 can constitute a sui
generis form of explanation (Abell, 2003b).
Given this change, (10) also undergoes change,
namely to
log Yij ¼c01Zjþlog rij þlog m0j:ð16Þ
But (16) is depicted as arrow 1a in Figure 3. Given
(6), arrow 4 in Figure 3 is a transitive closure of
arrows 1a and 3.
Thus, the above demonstrates that we can use
collective level, arrow 4 explanations at best as
shorthand or ‘reduced form’ explanation. Arrow 4
must always be either a conjunction of mechan-
isms indicated by arrows 1–3 or/and arrows 1a
and 3. Thus, in explaining collective-level phenom-
ena, reference must be made to the level of the
individual. A further interpretation is that indivi-
dual-level/micro-explanation replaces collective-
level/macro-explanation.
CONCLUDING DISCUSSION
Towards Micro-foundations
The field of strategic management seems to be
increasingly aware of the need to embark upon a
micro-foundations project. There is clearly an
increasing need to build individual-level founda-
tions for firm-level phenomena, such as hetero-
geneity, inertia, and superior financial performance.
However, the perhaps dominant approach to firm-
level heterogeneity in strategic management, the
capabilities-based view, has seen virtually no
attempts to build explicit micro-foundations. As a
result, it is unclear how crucial collective or macro-
level constructs, such as routines and capabilities,
impact firm-level performance (and it is unclear
how they emerge from individual action and
interaction). This is unsatisfactory from the point
of view of theory building in strategic management
theory, because crucial underlying mechanisms
remain unspecified. Similarly, the ‘reduced form’
approach of work on routines and capabilities also
means that applied work will suffer from a great
deal of indeterminacy in the sense that multiple,
potentially rival stories on the micro-level can
explain a macro-correlation.
Finally, we are worried that the absence of
micro-foundations in the capabilities view may
contribute to a disappearing mandate for strategic
management. In other words, the possibility of
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DOI: 10.1002/mde
strategic action may become obscured by putting
for too much emphasis on firm-level constructs,
such as routines and capabilities. It seems critical
for both organizational scholars and managers to
be able to impute action to individual rather than
collective variables. And, if routines and capabil-
ities indeed are meaningful variables then both
strategic management scholars and managers
should take an interest in the micro-level mechan-
isms through which they exert their influence on
firm performance. Performance improvements
may come about not just through selecting new
routines and capabilities (as in Nelson and Winter,
1982), but also through changing or influencing
the micro-mechanisms through which routines
work their influence on performance.
The main argument in this paper has, accord-
ingly, been that micro-foundations must be built,
and a simple formal model has been offered as an
example of how micro-foundations may be built
for the case of understanding how routines impact
performance. In terms of the theories that strategic
management research draws upon, an implication
of this work is that routines can be meaningfully
interpreted within a standard production function
framework (in contrast, Nelson and Winter, 1982,
are strongly critical of this framework), and that
key insights from the economic theory of the firm
(Alchian and Demsetz, 1972; Holmstro
¨m, 1982)
on firms as vehicles for internalizing externalities
may have a significant bearing on the under-
standing of the nature of routines. A theoretical
contribution that emerges from the latter con-
ceptualization is the notion we have proposed of
firms as averaging mechanisms.
Limitations and Future Work
The aim of this research has been to make a
fundamental methodological point, that collecti-
vist or macro-explanation is incomplete, and to
indicate that it is possible to build micro-founda-
tions for how routines and capabilities impact
performance. Because of this overall focus, a
number of specific points have (deliberately) not
been developed. For example, we have refrained
from directly discussing the micro-foundations of
routines themselves, and have taken routines to be
rather deus ex machina like. The present approach
may therefore strike some readers as not going
sufficiently far in the direction of micro-founda-
tions. Ultimately, a satisfactory treatment should
explain both the emergence of routines and their
impact on performance (i.e. the whole of Figure 2).
One reason is that how routines impact perfor-
mance may be related to which routines are
allowed to emerge and such a feedback loop may
be a crucial part of the dynamics of routines
(Nelson and Winter, 1982).
Another limitation resides in our focus on
prisoner’s dilemma games. The usual treatments
of routines tend to see them as solving coordina-
tion rather than cooperation problems (Nelson
and Winter, 1982). However, recent work has
suggested that resolving incentive problems (i.e.
problems of cooperation) may be an important
part of what routines accomplish (Gavetti, 2005;
Kaplan and Henderson, 2005). Our model illus-
trates exactly this feature of routines. Obviously,
however, such a treatment leaves out a host of
other possible aspects of routines (for catalogues
of these, see Levitt and March, 1988; Becker,
2004). For example, routines may contribute to
shaping cognition in a firm. This aspect is left out
of consideration in the present treatment. Simi-
larly, we remain agnostic on the issue of whether
(or to which extent) routines are emergent or
designed entities (cf. Dosi et al., 1999).
Developing a clear picture of what routines
accomplish arguably requires discussing one thing
at a time. Still, it should be noted that although the
reasoning in this paper draws on ideas from
economics, it is consistent with a broad set of
behaviours. In particular, the arguments and
modelling effort in this paper are not tied to
rational choice theory; learning and adaptive
behaviours are entirely consistent with the model.
Given the various, strikingly broad, definitions of
routines (routines as truces, memory etc), of course
the conceptualization and definition utilized by a
particular scholar will influence how the routine-
performance link is explained. For example, those
who take a more cognitive approach to routines
and capabilities (e.g., Levitt and March, 1988) have
suggested an alternative explanation of the routine-
performance link, along with implications for
micro-foundations (though these remain implied).
21
We welcome such work. In order to make a micro-
foundations project viable in such a relatively
diverse field as strategic management, alternative
micro-foundations should be tried out.
Finally, although the main purposes of this
research are methodological and theoretical in
nature, the issue of how to make micro-foundations
MICRO-FOUNDATIONS FOR THE ROUTINES 499
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DOI: 10.1002/mde
testable and accountable to observed performance
facts must be briefly raised. Recall the definition of
a ‘capability’ (to realize a routine) in this paper as
the ability to repeatedly internalize a pattern of
individual-level external productivity effects. Thus,
metaphorically the firm possesses a ‘blueprint’
which can carry the firm, without a drop in
performance, despite turnover (in all the functions
that are connected to the routine) (cf. Nelson and
Winter, 1982). Testing this idea, while linking it to
the level of individuals, may involve starting from a
certain sampling frame of firms and search for
stable interaction patterns amongst personnel
(perhaps across functions) through turnover. The
resulting set of independent variables must then be
related to some measure of sustained performance
as the dependent variable. Organizations without
routines would need to search and exhibit a
dislocation in interaction patterns.
NOTES
1. Hedstro
¨m and Swedberg (1996, pp. 296–298) refer
to arrow 1–3 as ‘situational,’ ‘individual action,’ and
‘transformational’ mechanisms, respectively. Hodg-
son and Knudsen (2004, Section 7) call arrow
‘downwards causation.’
2. Note that this point does not concern whether the
explanandum can be placed on the macro level.
Many (most) explananda in social science are placed
at this level (Coleman, 1990, p. 2)}notably, most of
the phenomena that the strategic management field
seeks to explain.
3. Moreover, it can be argued that for pragmatic
reasons it is often times justified to do research as if
arrow 4 causation existed. Thus, Stinchcombe (1991,
pp. 379–380) argues that ‘[w]here there is rich
information on variations at the collective or
structural level, while individual-level reasoning (a)
has no substantial independent empirical support and
(b) adds no new predictions at the structural level that
can be independently verified, theorizing at the level
of [individual level] mechanisms is a waste of time.’
4. For an elaboration of mechanism-based explanation
for a management audience, see Felin and Foss
(2006). There is a huge literature in the theory of
science on the nature and role of mechanisms in
explanation. The interested reader may consult
Cartwright (1989), Bunge (1997), Glennan (1996),
and Machamer et al. (2000).
5. For example, a correlation between collective
culture and collective outcomes inherently tells the
manager very little of what should be done to
change culture. Similarly, it makes little sense to
argue that managers can directly intervene on the
level of, for example, capabilities. Perhaps, however,
managers can influence capabilities, for example, by
hiring key employees (in which case the micro-level
is directly involved) or by changing overall recruit-
ment policies, reward systems, etc., all of which
involves the micro-level.
6. Note that there is a fundamental difference in terms
of levels of analysis between Nelson and Winter
(1982) and later writers in strategic management:
Nelson and Winter were interested in building
(evolutionary) theories that would be rival to the
dominant neoclassical approach with respect to
explaining and predicting outcomes at the level of
the industry (i.e. evolutionary price theory) and the
level of the economy (i.e. evolutionary growth
theory). Routines and capabilities were parts of this
analytical enterprise, but the aim was not to explain
them per se. This also explains why in Nelson and
Winter’s treatment, quite a lot is packed into the
notion of organization routine, including a variety
of behaviours (e.g., heuristics and strategies),
organizational processes and arrangements, cogni-
tive issues (e.g., ‘organizational memories’), and
incentives (‘truces’). The reason for this all-inclu-
siveness arguably is that ‘routine’ is a catch-all
concept for those collective-level aspects of an
organization that may contribute to the relative
rigidity of firm-level behaviour that is so important
in evolutionary theory. In contrast, strategic man-
agement is mainly interested in explaining and
predicting competitive advantage, that is, a phe-
nomenon that is placed on a level of analysis below
that of the industry (or the economy), namely the
level of the firm.
7. In their discussion of routines, Cohen et al. (1996)
echo this definition almost verbatim when they
define a routine as ‘... an executable capability for
repeated performance in some context that has been
learned by an organization in response to selective
pressures’ (Cohen et al., 1996, p. 683).
8. It has been suggested, however, that there is a
hierarchy in firms involving routines, capabilities
and dynamic capabilities and that routines, repre-
senting ‘static’ sequences of actions, are somehow at
the bottom of this hierarchy (e.g., Teece et al., 1997;
Winter, 2003).
9. For example, Nelson and Winter (1982, p. 107)
assume that routines represent organizational truces.
10. It is possible to conceive of units of analysis (e.g.,
groups) lying between the firm and the individual–
and, thus there are group externalities– but we
abstract from this complexity as group-level phe-
nomena also invite reduction to the individual level.
We use the term ‘productivity effect’ to cover all
possible functions.
11. However, some scholars pack much more into these
notions, see, e.g., Levitt and March (1988) for an
extremely expansive definition of routines.
12. Of course, this might be a surrogate for a manage-
ment group.
13. This assumption is a very strong simplification and
therefore also a significant limitation of the analysis.
Essentially we work with a n-person PD game, but
solve the game by dictatorial fiat, introducing an
P. ABELL ET AL.500
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DOI: 10.1002/mde
exogenous routine which captures the extent to
which the firm internalizes externalities. In the
present analysis, the routine is not the explicit result
of individual action and interaction. A full analysis
would also require incorporating the left-hand side
of the diagram in Figure 2. However, considerations
of space prevent such an analysis (for an attempt to
model routine emergence, see Dosi et al., 1999).
14. A pertinent question is why a routine, if it is
relatively easily replicable, is best coordinated in an
organization rather than by markets or by multi-
lateral or distributed bilateral bargaining (Coase,
1937). The preliminary answer is that the efficiency
losses introduced by averaging in organization
procedures are less than those associated with these
alternative mechanisms. We leave the exploration of
this for treatment elsewhere.
15. One could go on to study productivity losses by
introducing averaging under different assumptions
about the distribution of these effects across the
individuals/positions in the routine. For instance, if
they are distributed normally then averaging will
not introduce significant distortions; however if they
were to follow a power distribution (which they may
well if the structure of external effects contains hubs)
then the average will not capture the impact of the
effect very well.
16. Thus, it is assumed that the routine will always
improve output relative to the prisoner’s dilemma
output (i.e. the minimum output), but will never be
able to reach the first-best output level (the level that
could be reached if information was symmetric).
17. Thus, Rsolves (sub-optimally) a repeated game with
turnover of actors. Note that individual incentives
will not do this in a repeated or one-shot situation.
Repeated game equilibria require a stable popula-
tion of players for folk theorems to apply.
18. This is akin to the familiar team production problem
(Alchian and Demsetz, 1972; Holmstro
¨m, 1982).
19. This may be taken as an interpretation of Nelson
and Winter’s (1982, pp. 107–112) notion of routines-
as-truces.
20. We here deviate slightly from the Coleman diagram;
R
j
impacts the coefficient relating the micro-level
variables Xand Yrather than the value of Xitself,
which appears to be Coleman’s intention. This is
captured in Figure 3 where the arrow 2 in this
instance is drawn into arrow 3 rather than into X.It
does seem sensible to allow macro-variables to
modify the impact of micro-motivational variables.
21. Indeed, much work on routines, particularly in
economics, apply simulation methods (e.g.,
Marengo, 1996; Hodgson and Knudsen, 2004;
Gavetti, 2005).
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DOI: 10.1002/mde
