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Transcript of Comm Frame
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The Product Market and the Ideas Market:
Commercialization Strategies for Technology Entrepreneurs
by
Joshua S. Gans and Scott Stern*
First Draft: 19th May, 2000
This paper develops a framework to explain observed patterns of start-upcommercialization strategy across different industrial sectors. Our analysisfocuses on two alternative start-up innovator commercialization strategies: (a)independent commercialization resulting in competition with more establishedfirms (as observed in, say, the disk drive industry) and (b) cooperativecommercialization through contracting with more established firms (perhapsthrough strategic alliances, licenses, or outright acquisition as observed in thepharmaceutical industry). These different paths have very different implicationsboth in terms of the practical management issues associated with implementationand in terms of their predictions about the role of innovation in enhancingproduct market competition. While contracting in the market for ideas reinforcesthe market power of established firms, independent entry results in a more
competitive product market environment. The analysis is organized around twofundamental environmental drivers of commercialization strategy: the strengthof start-up knowledge assets (e.g., their intellectual property) and the scope ofestablished-firm complementary assets. This allows us to characterize fourdistinct commercialization environments. For each of these environments, weare able to identify start-up strategy, incumbent strategy, the incentives to investin a reputation, and, perhaps most importantly, the relationship betweentechnological and market leadership.
DRAFT ONLY: PRELIMINARY AND VERYINCOMPLETE
* Melbourne Business School, University of Melbourne, and NBER and Sloan School of Management,MIT, respectively. Contact author: Scott Stern, Sloan School of Management, MIT, Cambridge, MA,02142. E-mail: [email protected]. The latest version of this paper is available at:
www.mbs.unimelb.edu.au/jgans/research.htm.
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1. Introduction
Over the past two decades, there has been a dramatic increase in the level of
investment in start-up innovation. Start-up innovations are the technologies and
inventions with potential commercial application developed by small, young and/or
entrepreneurial firms. Because of their youth and small size, start-up innovators usually
have little experience in the markets for which their innovations are most appropriate, and
they have at most two or three technologies that are at the stage of potential market
introduction at any one time. For many of these firms, their single most important
management challenge is how to translate these promising technologies into a stream of
economic returns accruing to the firm=s investors and employees. In other words, the
main problem is not so much invention but successful commercialization.
In some cases, technologies that show themselves to be intrinsically superior at a
technical level are, for one reason or another, unsuccessful in the marketplace. For
example, in the development and marketing of typewriter keyboards, a number of designs
(most notably the Dvorak keyboard design) have been promoted as being intrinsically
superior to the so-called QWERTY keyboard (named after the first six letters on the top
row of the typewriter) but have met very little success in the marketplace (David, 1986).
From the perspective of inventors such as Dvorak, the advantages accruing to the
established producers of typewriters using the QWERTY system swamped the benefits of
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the proposed design and so precluded successful commercialization of this promising
technology.1
In other cases, the start-up=s technology is successful in the marketplace but the
lion=s share of the profits accrue to firms other than the start-up innovator. Whether
through outright imitation or improvement upon the core ideas inherent in the start-up
technology, the history of high-technology markets is littered with examples where initial
start-up innovators are unable to successfully appropriate the returns on innovation
(Teece, 1986). To take but one dramatic example, the intermittent windshield wiper was
developed by the independent inventor Robert Kearns; shortly after showing his design to
Ford Motor company, Ford introduced their own intermittent windshield wiper based on
a design and technology close to that of Kearns. For over twenty-five years, Ford (and
the rest of the auto industry which adopted and then build on the Ford design through
cross-licensing agreements and the like) did not pay Kearnss firm any royalties on his
innovation; it was not until 1990 (and after extraordinary personal perseverance on the
part of Kearns in pursuing patent litigation against Ford and other auto manufacturers)
was he able to extract even a portion of the economic returns due to his technological
innovation through (Seabrook, 1994).
In each of these cases, a promising start-up invention was not followed up with
successful commercialization by the initial innovator. Together, these cases raise key
strategic questions for start-up innovators:
Was the failure of the Dvorak design or the inability to appropriate returnson the intermittent windshield wiper inevitable, or might an alternative
1 In this specific case, David (1986) highlights the specific role by the process of technologystandardization and the specific role played by network externalities in helping to explaining the very low
diffusion rate of typewriter designs such as Dvorak.
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commercialization strategy produced a more favorable outcome for theinnovator?
What is the right commercialization strategy for a given invention?
To address these questions, it is useful to examine strategies employed by technology
entrepreneurs who in fact have successfully profited from their ideas. Of key interest
here is that this examination does not lead to a simple statement of best practice; instead,
different (successful) technology entrepreneurs employ extremely different
commercialization strategies. On the one hand, there are a number of (extremely well-
known) cases where successful commercialization by a start-up involves the restructuring
of established market structure and patterns of market power. For example, when Sun
Microsystems entered the workstation market as a start-up innovator, it was mostly
discounted by more established firms such as Digital, IBM, and Apollo Systems.
However, Sun translated its overall technological vision (the network is the computer)
into a concrete series of technological, organizational, and market positioning choices
which allowed Sun to emerge as the dominant firm within its core market within five
years after its founding. On the other hand, some of the most recent spectacular financial
successes by technology entrepreneurs have been earned not by direct entry but through
integration into the value chain constructed by established industry players. For example,
in the field of interconnection technology, companies such as American Internet
Corporation and Growth Networks developed technology and positioned themselves for
acquisition by the market leader, Cisco Systems; in the case of the 20-month-old Growth
Networks, the $355 million acquisition secured an extraordinary return for the firms
stakeholders -- at the time of the acquisition, Cisco paid more than $1 million per
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employee in order to integrate this firms technology and technology development team
into its Internet routing business.
The main goal of this paper is to provide a framework for understanding the
fundamental drivers of these differences in commercialization strategy by start-up
innovators. Our analysis is organized around the contrast between two alternative
commercialization principles: competition and contracting. Under a competition
approach, profiting from technological success involves direct entry into the product
market and posing a challenge to established sources of market power; in other words,
the start-up innovator uses their technological leadership to construct a new value
proposition for the industry. In contrast, under a contracting strategy, successful
commercialization involves working with established firms to integrate the start-up
innovators technology and ideas into the existing value proposition in the industry.
Simply put, the key strategic commercialization choice facing start-up innovators is
between the product market and the ideas market.
The remainder of this paper first describes these two principles of
commercialization in more detail; we highlight both the types of industries and
competitive environments where we tend to see one strategy or the other and, from a
more theoretical perspective, the benefits and costs associated with each approach. We
then turn to the development of our commercialization strategy framework. In addition
to providing a way of understanding the differences in commercialization strategy across
different environments, the framework provides a guide as to the elements of strategy
appropriate for particular competitive environments and some guidance for public policy,
particularly in the areas of antitrust and intellectual property.
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2. Profiting From Innovation: The Product Market versus theIdeas Market
For many technology-based start-ups, reaching the commercialization stage is the
first opportunity to truly define a firms strategy and positioning. Prior to the irreversible
strategic choices related to commercialization, the start-up innovator is often able to have
multiple strategic visions coexist among the firms managers and within the organization
more generally; indeed, technology entrepreneurs often exploit this ambiguity to attract
initial investors and employees, each of whom has a different vision of the opportunities
afforded by the new organization. However, the process of choosing how to bring a new
technology to the market forces a companys managers to confront a set of concrete
choices about how to translate their technological vision into sustainable competitive
advantage. By successfully implementing these strategic decisions, the organization
begins to reflect areas of competence necessary for success within a given strategy.2
One view of competition attributed to Joseph Schumpeter sees innovation-
based entry as the principal means of the eroding incumbent market power. Indeed,
Schumpeters main concern was that innovation might become beyond the reach of the
smaller firm. This is because the increasing internal financial resources required to bring
those products to final consumers could only be feasibly undertaken by larger incumbents
who have little incentive to create products that cannabalize their existing sunk assets.
Hence, competition would fall away along with previous patterns of technological
dynamism.
2 Of course, the relationship between organizational definition and firm strategy is more iterative than the
perspective provided here. However, particularly for start-up innovators, the commercialization process isthe first instance in which concrete strategic decisions are made and are then reflected in the organziations
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In recent times, however, there is renewed interest in the process by which
smaller research-oriented firms pursue innovative activity. In particular, the
Schumpeterian view widespread in the economics literature3 that small firms will
commercialize their innovations by competing with incumbents in the product market has
been challenged anecdotally, empirically and theoretically. Anecdotally, there are many
examples of firms where small, research-oriented start-ups never enter the product market
directly. Instead, they choose to commercialize their innovations by contracting by
means of licensing, partnerships or acquisition with product market incumbents. Such
cooperative commercialization strategies are commonplace in among biotechnology start-
ups.
Empirically, there appears to be heterogeneity in commercialization patterns
across industries. Figure 1 depicts the proportion of small firm innovations that chose
cooperative rather than competitive commercialization paths by industry group.4 The
pattern confirms the anecdotal evidence regarding cooperation used in biotechnology
versus more competitive strategies in among smaller electronics firms. This heterogeneity
is substantial; suggesting important industry-specific drivers of commercialization
strategies.
boundaries and structures (Burgelman, 1994). Also, short discussion of dynamic capabilities (Teece, Shuen,and Pisano, 1998).3 See, for example, Gilbert and Newbery (1982) and Reinganum (1989).4 This was based on a sample of over 100 small firms surveyed by Gans, Hsu and Stern (2000).
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Finally, from the perspective of economic theory, there are two reasons why a
cooperative path would result in greater rents being appropriated by small firms than if
they pursued a competitive path. First, by cooperating with product market incumbents,
small start-ups avoid the costly investment in complementary assets required for
successful product market entry. Instead, a cooperative arrangement allows the
innovation to be combined with an incumbents existing complementary assets; thereby,
minimising potential cannabilisation. Second, a cooperative path avoids the dissipation of
monopoly rents that might otherwise occur with product market competition. Generally,
the sum of profits of an incumbent and entrant from competition are lower than the
F i g u r e 1 : P r o b a b i l i t y o f C o o p e r a t i o n b y I n d u s t r i a l S e g m e n t
( f r o m G a n s , H s u a n d S t e r n , 2 0 0 0 )
0
0 .1
0 .2
0 .3
0 .4
0 .5
0 .6
B io te ch no lo gy I nd us tr ia l E qu ip me nt E le ct ro nics I ns t r ume nt s C om pu te r S of tw ar e
I n d u s t r i a l S e g m e n t
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profits the incumbent might earn if it had exclusive access to the innovation. Hence,
choosing a cooperative path preserves industry rents precisely because it subverts the
competitive impact of an innovation.
The broad implication of all this is that the potential for cooperative
commercialization paths to be chosen by small start-ups challenges the Schumpeterian
notions that independent innovation was a force of creative destruction and that
innovation that requires complementary assets for commercialization will become the
exclusive domain of larger, financially-resourced incumbents. When start-ups choose a
cooperative path they explicitly minimise the destructive tendencies for innovative
activity and act to reinforce rather than subvert product market power. Also, in so doing,
the possibility of commercializing innovations through a market for ideas rather than the
product market per se, gives smaller firms an opportunity to appropriate rents from
innovative activity without the need for costly investment in complementary product
market assets. In effect, the ability of small start-ups and incumbents to trade in markets
for ideas is a substitute for product market competition based on innovation.
Consequently, innovation is neither an avenue for increased competition nor is it
necessarily the exclusive domain of less innovative incumbent firms. When cooperation
is possible there will be a lot less destruction but a lot more creation than Schumpeter
envisaged.
From the above discussion, it can be seen that the choice between cooperative and
competitive commercialization paths is both an important phenomenon the patterns of
which differ across industries that gives rise to crucial considerations in the role of
innovation as a competitive force in product markets. Thus, it becomes important to
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consider in detail why some start-ups in some industries tend to follow more cooperative
commercialization paths than those in other industries. Hence, a goal of this paper is to
identify the critical factors that drive this choice and what they mean for the strategies of
entrants and incumbents and overall patterns of technological change at an industry level.
Also, by identifying factors that determine commercialization paths we can also provide a
means of predicting such patterns and informing start-ups and incumbents of important
directions they might commit to as part of their research strategies. Finally, we will then
be able to use these factors to sort among prior perspective that treat some or all of these
factors as fixed.
3. Benefits and Costs of Trading in Ideas Markets
The previous section outlined the broad choice facing start-up innovators as to
whether to commercialize their innovation by competing with established firms in the
product market or contracting with those firms through the ideas market. This choice
depends not so much on the absolute returns it will receive from a cooperative path per se
but on its return relative to a choice of competition. This distinction is important as
transactions in ideas markets take place in the shadow of potential returns by competing
in product markets. That is, competition is both an alternative commercialization path
and potentially the default option for start-up innovators. Consequently, some factors
such as stronger intellectual property rights and a greater competitive advantage to
smaller firms will give the start-up higher returns on either path whereas we seek here
to identify the factors that will cause those firms to favour one commercialization path
over another.
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From this perspective, a competitive choice is really one of choosing to by-pass
ideas markets entirely. That is, a start-up sees value in committing to a product market
presence rather than exploring intermediate trading options for the innovation itself. This
means that we need to consider what the benefits and costs are to start-up firms in
engaging in ideas market trading as opposed to avoiding such trades altogether (at least
given the current stage of development of their innovation).
There are several clear benefits of commercializing innovations through ideas
markets. Essentially, these are the same type of benefits that would arise from non-
integration of the start-up firm in product market activities; allowing it to develop ideas
production as its core competency. First, commercializing through ideas markets means
that costly duplicative investments are avoided. The start-up firm themselves avoids the
costs associated with developing assets for manufacturing, distribution and marketing
that may already exist elsewhere. Established firms that cooperate with the start-up avoid
having to engage in imitative research programs that would become necessary as they
attempt to catch-up with a new entrant. At the very least, a cooperative strategy allows
the incumbent and start-up to use their common advantages to economize on further
development and commercialization costs.
Second, a start-up focused on innovation and that is rewarded only in terms of the
value of that innovation to incumbent firms has high-powered incentives to create
innovations that are of specific value to those firms (Aghion and Tirole, 1994). Hence,
start-up innovations will complement rather than cannibalize an incumbents existing
assets and allow it to be a more effective competitor in product markets. Thus,
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established firms can utilize some important advantages smaller, focused firms possess in
generating ideas. MORE?
Finally, a cooperative path pursued by trading innovations in ideas markets avoids
the dissipation of monopoly rents that might otherwise occur with product market
competition. Generally, the sum of profits of an incumbent and entrant from competition
are lower than the profits the incumbent might earn if it had exclusive access to the
innovation. Hence, choosing a cooperative path preserves industry rents precisely
because it subverts the competitive impact of an innovation. The end result is softer
product market competition and an extension of the incumbents product market
franchise.
Notice that there are distinct benefits to ideas market trading in terms of
increasing industry-wide returns from the innovation. The avoidance of duplicative
investments, the creation of incentives by start-ups minimizing cannibalization and the
softening of product market competition increase or preserve industry profits relative to a
situation where the start-up avoided such contracting. However, while the start-ups
returns are likely to be higher, the more important are each of these benefits, the start-up
will also be concerned with their expected returns from this path as opposed to
competition. In particular, if the process of searching and engaging in negotiations with
incumbent firms was costly or itself weakened a start-up firms potential competitive
position in the product market, the start-up might have an incentive to by-pass such
contracting opportunities.
To see this, we consider some potential frictions that make it difficult to transact
in and maintain ideas markets. First, in order to contract with an incumbent partner, a
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start-up must search for and convince that incumbent of the value of their innovation.
Such search costs must be incurred ex ante, so naturally a start-up will be concerned
about their eventual return. If it is difficult to convince incumbents of the value of an
innovation, rather than incurring the transaction costs associated with doing so, a start-up
may find it more attractive to take their chances in product market competition. Hence, a
start-up may choose a competitive strategy even though ex post there would have been
mutual gains to trade in the idea itself.
Second, there is a more fundamental problem associated with contracting over
ideas: the disclosure problem. The difficulty with selling an idea is that the potential
buyer needs to see the idea and understand it in order to establish their willingness-to-pay
for the idea. However, it is possible that such disclosure may lead to opportunistic
behaviour by the buyer who may expropriate the idea claiming that it was already known.
Arrow (1962) sums up the problem
In the absence of special legal protection, the owner cannot, however, simply sell
information on the open market. Any one purchaser can destroy the monopoly, since he
can reproduce the information at little or no cost. Thus the only effective monopolywould be the use of the information by the original possessor.
He goes on
there is a fundamental paradox in the determination of demand for information; itsvalue for the purchaser is not known until he has the information, but then he has in effectacquired it without cost. Of course, if the seller can retain property rights in the use of the
information, this would be no problem, but given incomplete appropriability, thepotential buyer will base his decision to purchase information on less then optimalcriteria. He may act, for example, on the average value of information in that class as
revealed by past experience. If any particular item of information has differing values fordifferent economic agents, this procedure will lead both to a non-optimal purchase of
information at any given price and also to a non-optimal allocation of the informationpurchased.
At one level, this is just a problem of imperfect property rights. An idea as an asset is not
easy to own and control. It is not easy to exclude users and, moreover, secrecy as a means
of exclusion is given up whenever there is an attempt to trade the idea. The idea seller is
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faced with low prices regardless of whether the idea is revealed prior to trade or not. This
is a problem because of necessary private information:
Idea value: the buyer does not know the true value of the idea (lowering price prior to
revelation).
Idea source: the source of the idea is not ex ante or ex post verifiable (lowering price
after revelation)
If either of these private information problems were eliminated there would be no
disclosure problem. This is because the use of the idea by the buyer must be verifiable. If
this were not the case then only by resolving the idea source problem could the disclosure
problem be solved.
Consequently, the start-up firm may anticipate such expropriation and avoid
contractual negotiations altogether. Hence, the possibility of disclosure problem is a
reason why a market for ideas may not exist. Essentially, it is a problem of a weakness in
the start-ups intellectual property protection over their innovation. An ironclad patent
would give the start-up the ability to exclude the incumbent firm from utilising
innovations that may have been disclosed during negotiations.5
Alternatively, a strong competitive option could, as Anton and Yao (1995)
suggest provide a start-up firm with indirect protection in situations where property rights
are weak. If a start-up could enter product market competition and if the incumbents
profits from monopoly as opposed to competition were large, then failure to reach
agreement could become relatively more costly for the incumbent firm than any returns
5 Example of windshield wiper case described here.
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from expropriation. In effect, the incumbent decides to pay the start-up so as to preserve
monopoly rents rather than for the value of the innovation per se.6
This suggests that there are two factors that will be critical in determining whether
the start-up chooses a cooperative or competitive commercialization path. First, as an
incumbents complementary assets become more important in generating a value from
the innovation, the incumbent and start-up will have an enhanced incentive to reach a
contracting agreement and avoid costly duplication of those assets. This is especially the
case when start-up entry into the product market may lead to a large loss in profits to the
incumbent. The absence of such complementary asset places the incumbent and start-up
on a more equal footing in product market competition making such competition
relatively more attractive from the small firms perspective.
Second, as the start-ups ability to exclude the incumbent from utilizing the
innovation increases, the lower are the costs that it bears in transacting in the market for
ideas. In effect, strong intellectual property protection is the lubricant of a well-
functioning ideas market and creates incentives for start-ups to be concerned about the
industry profits from the innovation that could be achieved through cooperation as
opposed to competition. Without such protection, fear of disclosure may lead to the start-
up pursuing a more secretive path; controlling the innovation through commercialization
stages in order to gain a competitive edge over the incumbent in the product market.
6 Like Rasmusen (1988).
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4. A Framework for Commercialization Environments
In the previous section we explained why commercialization paths of competition
versus cooperation are a choice for start-up firms and how their relative likelihood relates
to the importance of incumbent complementary assets and the strength of intellectual
property protection. In this section, we build upon this insight to suggest that the two
dimensions of incumbent complementary assets and intellectual property protection can
be combined to yield a framework that completely covers patterns of competitive
interaction through innovation over all industries. That is, our framework suggests that
these two dimensions fundamentally guide start-up and incumbent research and
competitive interactions in both ideas and product markets.
To see this more clearly, we ask two questions of the commercialization
environment a start-up may be faced with following the successful generation of a
commercializable innovation:
( Intellectual Property Protection) Can innovation by the start-up preclude
effective development by the incumbent?
(Complementary Asset Availability) Do the incumbents complementary assets
contribute to the value proposition from the new technology?
Notice that there are four possible combinations of yes/no answers to these questions.
Table 1 labels each of the resulting environments and our purpose is to describe each in
turn. In particular, for each we will describe start-up strategies, incumbent strategies, real
world industry examples and the related research literature.
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Table 1: Identifying Commercialization Environments
Do incumbents complementary assetscontribute to the value proposition from the
new technology
No Yes
No
Head-to-HeadCompetition/Attackers
Advantage
InternalDevelopment or
Reputation-BasedIdeas Trading
Can innovation bythe start-up
preclude effectivedevelopment by the
incumbent? Yes
Internal development
or Non-exclusiveLicensing
Ideas
Factory/Contractingor Spot Trading of
Ideas
3.1 Head-to-Head Competition
Consider an environment where start-ups have limited abilities to exclude
imitative development by the incumbent but where incumbents do not possess important
complementary assets that could not be accessed elsewhere. In this environment, the
start-up and incumbent face a level playing field. On the one hand, this frees the start-up
from duplicating previous incumbent investment. On the other, however, it is an
environment where the start-ups technological leadership may be fleeting. Competition in
this type of industry is likely to be intense with incumbents facing constant entry
challenges that destroy the value of existing competencies and where start-ups face
difficulties in appropriating value from their innovations over the longer-term; as they
become incumbents in an environment that does not value incumbency.
In this world, start-ups have an opportunity to capture market leadership by the
effective development of competence destroying technology. That is, attackers have an
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advantage (Foster, 1985). Moreover, there are few opportunities for the start-up to
contract with current market leaders due to the relative salience of a disclosure problem.
Consequently, the most effective start-up strategy is one of stealth. They gain
competitive advantage by choosing niche customers, reconfiguring architectures and not
provoking a competitive response from incumbents until it is too late.
For incumbents, the basis of their competitive advantage is based on products not
competencies. Indeed, each may persist in name only with incumbents benefiting from
research strategies that dismiss their current competencies and instead focus on
technological opportunities that might be occupied by new entrants. A sustainable market
position involves constant reinvention and pre-emption of rivals. When studying similar
environments, Christensen (1997) sent a message to incumbents that they might be
subject to S-curve blind spots (i.e., that fail to not that their current products are
reaching the end of an accelerated growth period and instead assume continued growth).
Consider, for example, Figure 2 that demonstrates the lack of leadership by established
firm in the hard disk drive sector. In response, an effective strategy for the incumbent
involves constant monitoring of new developments and a clearer integration of market
knowledge and technical know-how.
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Figure 2: Leadership of Entrant Firms in the Hard Disk Drive Sector
Source:Christensen (1997), p. 23.
In the end, this is a world of tight integration between research and
commercialization and where market leadership is ultimately determined by
technological leadership. Competition forces firms to undertake high levels of risky R&D
investment in order to survive with established firms falling into competency traps and
becoming subject to the attackers advantage. (e.g., Softbank). On the other hand, start-
ups will invest in seemingly duplicative complementary assets in terms of manufacturing,
marketing etc. as part of establishing a novel value proposition.
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3.2 The Ideas Factory
Standing in complete contrast to head-to-head competition is the ideas factory
environment. In this world, the answer to our two questions is affirmative with start-ups
able to exclude further development of the innovation by the incumbent but where the
incumbent possesses complementary assets the innovation is specialized to.
Consequently, trade in markets for ideas is both feasible and highly desirable so that
start-up firms can specialize in innovation the so-called ideas factory (Pisano) and
contract with incumbents to commercialize the innovation in the product market through
an exclusive licensing arrangement (Gans and Stern, 2000).
Therefore, the key issue for start-ups is no long if they should contract with an
incumbent but when. Moreover, their performance will depend critically on the degree of
bargaining power they command in markets for ideas; that is, their ability to play
incumbents off against one another and prevent work-around technologies from gaining a
product market foothold. In this environment, entering into the product market is both
highly costly and potentially very low in return. Consequently, the threat of competition
does not play a crucial role in bargaining so that start-ups have maximal incentives to
tailor their innovations to incumbents existing asset base; i.e., minimise cannibalization.
For incumbents, start-up technology would not be viewed as a threat as it is in
head-to-head competition. Instead, it is a critical source of improvement to the current
product set. Their sustained market position requires co-opting potential competitors
through the ideas market; indeed, to the point of assisting start-ups with technical and
financial assistance. The primary challenge is to balance internally developed and
externally available technologies in the product development process.
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To see how an ideas factory works consider the intensively studied than the
patent race for human insulin that occurred in the late 1970s (a popular account of this
research is provided in an entertaining book by Hall (1988)). Closely watched at the time
by industry observers and public policy makers, the development of a human insulin
product represented the first commercially-oriented product in the novel field of
biotechnology; as such, innovative investments towards that development goal were
closely watched and the scientific and commercial issues which arose set the context for
debates about the proper use and organization of biotechnology research (for a useful
summary of these debates, see Krimsky (1982)). In the twenty years since the successful
development of insulin by the start-up firm Genentech, the case of human insulin has
been used again and again as an example to motivate different models of technological
competition (for instance, the main case used to explain technological competition and
patent races to business school students is The Race to Develop Human Insulin (Parese
and Brandenberger, 1992)).
Most analysts date the commencement of this case of technological competition
to a research conference hosted by Eli Lilly in May, 1976. As the worlds leading
producer of insulin for diabetics, Lilly arranged the conference to assess whether novel
recombinant DNA tools could be utilized to produce human insulin, providing a quality-
improving substitute to the pork and beef insulin that had been used historically in the
treatment of diabetes. While molecular biologists were extremely excited by the
possibilities of rDNA from a scientific perspective, few analysts or scientists expressed a
belief that there would be important commercial applications in the near future;
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moreover, most of the main researchers were employed by universities, limiting their
incentives and opportunity to explore commercial applications.
The Lilly research meeting, along with continued encouragement by Lilly in the
form of research funding and commitments to license commercializable technology,
provided researchers with new information that financial returns could be realised
through the application of the new scientific tools. As a result, three separate research
teams pursued programs aimed at the expression of the insulin gene (a necessary
condition for commercial exploitation of the rDNA techniques). Two of the teams, based
at the biology/biochemistry departments of Harvard and UC-SF, were essentially
university research labs diverting attention and resources away from purely scientific
projects and towards the commercially relevant human insulin project. The third team
was initiated by Genentech, a start-up biotechnology firm founded by an entrepreneur
(Bob Swanson) and a scientist (Herbert Boyer), which operated outside of the confines of
a university research lab.
According to all accounts of the research, each of these three teams was aware of
the investments by the others and acted to pre-empt the other teams research success.
For example, the UC-SF research team violated NIH rules regarding the use of genetic
materials in their experiments; this type of violation was serious enough so that a leading
researcher speculated that Capitalism sticking its nose in the lab has tainted
interpersonal relationsthe UCSF team was in competition with a group at Harvard
which was known to be working with better source material. (David Martin, quoted in
Wade, 1977, p. 1342). As well, the Harvard team, headed by Walter Gilbert, chose to
discontinue support for a well-regarded graduate student, Forrest Fuller, precisely
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because Fuller was unable to successfully contribute to his assigned portion of the
commercialisation project (see Hall, 1988, pp. 176-178).
Perhaps most telling, Genentech chose to pursue an alternative research strategy
gene synthesis which was more amenable to commercialisation prospects because it
was not subject to burdensome NIH regulations governing the use of genetic materials.
Despite the use of this alternative approach, the possibility of pre-emption was one of the
most important tools used by Genentech management in motivating their researchers. As
recounted by Roberto Crea, one of the principal Genentech scientists, Definitely the
name of Wally Gilbert was in Swansons mouth all the time. That we had to beat
himSwanson used that as a management tool to keep pressure on Goeddel, knowing
that Goeddel was so competitive. (Roberto Crea, quoted in Hall, pp. 219)
Under the threat of pre-emption, each research team pursued human insulin until
August, 1978, at which time Genentech researchers were able to successfully synthesize
the human insulin gene in bacteria, opening the door to the first commercial application
of biotechnology. One day after their experiment was validated, Genentech signed an
exclusive license agreement with Eli Lilly which granted Lilly the manufacturing rights
to Genentechs intellectual property and contracting with Genentech for collaboration on
certain of the scale-up activities for which Genentech would have greater expertise. One
of the distinctive feature of the negotiations around this license is that, despite Lillys
encouragement of the research, Lilly turned out to be an extremely strong negotiator, de-
emphasising Lillys need for the technology (they could continue to use animal insulin)
and discounting claims by Swanson of the viability of the product (Hall, p. 23*).
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The irony of this case is that the realised gains from this research investment came
in the form of a license to the incumbent Eli Lilly. Most prior economic models of
technological competition which evaluate the relative R&D incentives of incumbents and
entrants exclude this possibility by dictating competition in the product market after the
realisation of the innovation. While Lilly did pursue a research program, Lillys main
investments were focused towards encouraging research by independent researchers,
confident that successful innovations could be licensed and that the independent research
teams would be in a relatively weak bargaining power in negotiations.
What is perhaps most interesting about this case is that it is, by all accounts, not
unique for the biotechnology industry. Except for a small number of exceptions,
biotechnology firms either became licensors of their technology to a large established
firm (which retained responsibility for FDA approval procedures, marketing, etc) or
were purchased outright by such a firm through an acquisition. As noted by Orsenigo,
the NBFs, born to exploit commercially their unique skills in the new technologies,
attempted to integrate forward and to acquire capabilities in production but, in most
cases, became specialized suppliers of very specific technical know-how. (Orsenigo,
p.145). Indeed, despite a radical change in the scientific underpinnings of
pharmaceutical research and waves of entry by independent research firms attempting to
exploit these scientific opportunities, there has been little change in the downstream sales
leadership of pharmaceutical products (excluding mergers and acquisitions between
companies) (Henderson and Cockburn, 1996; Gambardella, 199*). Instead of sustained
waves of displacement of incumbents, the set of incumbents has remained relatively
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constant and the incentives for entry for independent firms has been the expectation of
being acquired by one of these incumbent firms.
Thus, the ideas factory paints a picture of a competitive environment focused on
the ideas market. While there may be some competition between start-up firms and
established firms in that market, once an innovation is generated, there are substantial
gains to trade as those firms become complementors. As a consequence, there may well
be frequent changes in technological leadership and the sources of innovation as start-up
firms compete to generate innovations but these changes will not translate into changes in
market leadership (see Table 2 that demonstrates the persistent market leadership of
established pharmaceutical firms). In effect, start-up firms compete with each other for
priority in negotiations with the market leader whose own position is assured by this
process and their existing product market asset base. New technologies reinforce and
build upon this base because the key to maximizing returns in the ideas market depends
on such reinforcement. Indeed, for that reason it is encouraged by established firms.
Table 2: Pharmaceutical Firm Market Leadership
Sales Rank,
1997
Company Date Established Sales Rank,
1973
1 Merck 17th century 2
2 Bristol-MyersSquibb
1887, 1856 9
3 American HomeProducts
1926 6
4 Pfizer 1848 7
5 Abbott Labs 1900 21
6 Eli Lilly 1876 117 Warner Lambert 1852 3
8 Baxter 1931 79
9 Schering-Plough 1851 15
10 SmithKline Beecham 1830 31
Sources: Various corporate web sites; BioWorld 1998; James, 1977.
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3.3 Winner-Take-All Competition
There is no necessary reason why the answers to our two questions should be
correlated; that is, there are shades of grey to these aggressively competitive and mutually
cooperative outcomes. Indeed, one could have a situation where a start-ups innovation is
excludable but also overturns the value of incumbents assets. The formal economics
literature emphasises the potential for a non-integrative outcome by demonstrating the
profitability of widespread licensing once an innovator has established property rights
over an innovation (Arrow, 1962). However, until that point incumbents and start-ups
should compete aggressively to be the first to win control of an innovation either through
a patent (Gilbert and Newbery, 1982; Reinganum, 1989) or the establishment of a
technological standard (Katz and Shapiro, 1987). Thus, incumbents and start-ups are
participants in a winner-take-all race. Consequently, incumbents should view their
innovative activity as partly defensive against the potentially highly incentivized entrant
start-ups (Reinganum, 1989).
So for start-ups, a winner-take-all market is a tremendous opportunity where they
are unconstrained by past investments but have maximal ability to earn returns form an
innovation; if they succeed in the race to patent or in establishing a standard. However, in
this they face an aggressive response from others precisely because returns are so high.
Incumbents with established monopolies will be keen to preserve them. Their competitive
advantage, however, rests on similar terms to start-ups and not on their established
competences. Moreover, the benefits of maintaining their monopoly may be eroded in
part by potential weakness in the bargaining position in markets for ideas as start-ups
have solid alternative options. Indeed, it is only be ceding rents to upstream technology
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partners that incumbents can hope to sustain their market position. But such sustained
presence comes at the cost of profits. Just as it was in dog-eat-dog competition where
incumbents were forced to accelerate cannibalistic R&D investments, an incumbents
profit base is eroded by the need to pay dearly for cannibalistic innovations in the market
for ideas.
EXAMPLES: RETAILING? STANDARDS WARS
This competitive environment is potentially very intense but also the industry
rents accruing to successful innovation are higher. Where the rents go depends much less
on becoming the market leader per se but developing the winning technology. That is the
source of bargaining power over the value chain and, indeed, gives technological
providers an opportunity to use this power to buy the benefits of incumbency.
3.4 Reputation-Based Ideas Trading
When a start-ups innovation is not excludable but incumbents possess key
complementary assets, while there is a large incentive to trade in ideas, ideas markets
themselves are difficult to establish and maintain. In a head-to-head competitive world,
the incentive for trade is not there; making competition the feasible commercialization
path. Firms there are driven towards secrecy while keenly monitoring for technological
opportunity. When there is a value to incumbency, incumbents themselves drive the
potential value of ideas trading. However, unless they manage short-term temptations to
expropriate rents from start-ups, incumbents will be forced to rely in in-house research
capabilities with consequent low powered incentives on researchers (Aghion and
Tirole, 1994). In this scenario, the rate of innovative activity will be diminished.
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A more favourable outcome is possible if incumbents can develop a reputation for
rewarding start-ups for successful innovation even though they might be able to imitate
an idea relatively easily. That reputation encourages start-up entry in an otherwise
incomplete contracting world and, moreover, encourages a closer working relationship
between start-ups and incumbent firms. Incumbent firms that succeed in establishing
relational research contracts (Baker, Gibbons and Murphy, 2000) will be able to generate
a greater rate of product innovation than their competitors. This provides those
incumbents with an opportunity to move beyond the highly integrated structures in dog-
eat-dog competition and use a virtual ideas factory model to sustain market leadership.
Symantec Corporation practices this type of strategy. It has established a
reputation for acquisition of entrepreneurial start-ups at a reasonable price and also the
sensitive integration of those firms into its larger organization. Consequently, software
developers have come to see Symantec as a potential partner in development rather than a
competitor.
USER-BASED INNOVATION MODEL
This environment will be characterized by far less market and technological
stability than other structures. In most cases, the lions share of innovation is the result of
internal development. Nonetheless, a substantial opportunity exists for incumbents to
encourage external innovation by providing rewards and incentives through relational
contracting despite the lack of property rights and potential for expropriation and hold-up
of start-up researchers.
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5. Empirical Evidence
The main argument of the previous section was that the dimensions of intellectual
property protection and the importance of incumbent complementary assets allow us to
characterize alternative commercialization environments facing start-up innovators. In
particular, for each combination of answers to our guiding questions, we can identify the
profitability of cooperative as opposed to competitive commercialization strategies and
how this alters the strategic positions of incumbents and start-ups in both product and
ideas markets.
Of particular interest is the start-ups choice of cooperation over competition. As
noted earlier, this choice is critical in determining whether the locus of technological
competition is ideas or product markets and whether the Schumpeterian gale of creative
destruction actually blows or not. If start-ups pursue cooperative commercialization
strategies, incumbent market power is likely to be reinforced rather than challenged by
start-up innovation.
Gans, Hsu and Stern (2000) provide an empirical examination of the choice of
commercialization strategy and, in particular, how that choice relates to intellectual
property protection and the importance of specialized complementary assets. Table 3
reports their principal findings arising from their survey of start-up firms that have
successfully generated a commercially viable innovation over a range of industry
segments. Notice that, as predicted in Section 3, cooperation is more likely to be chosen
over cooperation when intellectual property protection is strong and complementary
assets are important.
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Table 3: Proportion Choosing Cooperation
Entrants Cost of Acquiring Necessary Complementary Assets
Relatively Low Relatively High
Nopatents
14% 31%
NumberofPatentsAssociatedwiththeProject
Atleastonepatent
35% 56%
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Conclusion
TO BE DONE ...
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