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Making Waves: The Interplay between Market Incentives and Capabilities in the Evolution of Industries Timothy Bresnahan, Shane Greenstein, Rebecca Henderson Outline The Schumpeterian puzzle Illustrating Alignment Before a Wave

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Making Waves: The Interplay between Market Incentives and Capabilities in the Evolution of Industries

Timothy Bresnahan, Shane Greenstein,

Rebecca Henderson


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Outline

  • The Schumpeterian puzzle

  • Illustrating AlignmentBefore a Wave

  • Re-Alignment of Sunk OrganizationInitial Contact with Entrant/Wave

  • Scope DiseconomiesInconsistent Alignment to Two Large Opportunities


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The Schumpeterian Puzzle

Performance

Maturity

What determines the timing & effect

of a “Schumpeterian Wave”?

Discontinuity

Takeoff

Ferment

Time



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What Do These Organizations Have In Common?

  • Levi Strauss

  • Kodak

  • SSIH/ASUAG

  • Zenith

  • Syntex

  • Kidder Peabody

  • Firestone

  • Kuhn Loeb

  • Bausch & Lomb

  • Ciba-Geigy

  • Oxford Health

  • Sears

  • Timex

  • Nestlé

  • Philips

  • U.S.Steel

  • Polaroid

  • IBM


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Japanese Beer Market: Kirin & Asahi Share 1971-2001

60

Kirin’s share of market

40

%

20

Asahi’s share of market

Higuchi commits to dry beer

1971

1975

1980

1985

1990

1995

2000

Source: Timothy James, Resource development in firms: New product development and organizational change in the Japanese brewing industry, University of Washington, 1992: table 5.8. Nikko Weekly.


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Tires Shipped By Construction Type: 1961-1989

80

radial

60

%

40

belted bias

bias

20

1961

1965

1970

1975

1980

1985

Sources: Rubber Manufacturers Association, “Tire Shipments by Construction,” Tire Industry Facts (Akron, Ohio, 1990); Firestone Tire & Rubber Company, “Sales Forecasts,” Corporate Archives (Akron, Ohio, 1980).

Citation: Sull, Donald. “The Dynamics of Standing Still: Firestone Tire & Rubber and the Radial Revolution,” Business History Review, 1999, pp. 430-464.


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But incumbents sometimes (often?) survive Schumpeterian waves successfully…

  • Corning Glass in Glass

  • NCR in Cash registers

  • Mergenthaler Linotype in typesetting

  • Intel in microprocessors

  • GE in Medical imaging

  • Kodak & digital imaging


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Several outstanding puzzles: waves successfully…

  • (mkt) We need to explain the odd event that an entrant (sometimes) challenges an established and entrenched incumbent.

  • (org) We need to explain the odd event that a highly successful organization (sometimes) becomes unsuccessful.

  • (org and mkt) We need to explain the odd event that an innovative entrant (sometimes) doesn’t cooperate with or sell innovation to an established incumbent.


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Market focused explanations waves successfully…

  • Incumbents & entrants have different incentives to invest in “radical” or “breakthrough” inventions

    • Arrow (1962), Gilbert & Newberry (1982), Reinganum (1983), Henderson (1993)

    • Aghion et al (2001), Grossman & Helpman (1991), Caballero & Jaffe (1993), Segerstrom & Zolnierek (1999)

    • Cassiman & Ueda (2002), Stein (1997a)

  • But these explanations cannot explain why incumbents cannot “simply duplicate entrant behavior” once uncertainty is resolved


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Organizationally focused explanations waves successfully…

  • Incumbent firms cannot duplicate the incentives of the market

    • Anton & Yao (1995), Hellman (2002)

  • Constraints on information lead firms to fund projects that are “similar” to their existing portfolios

    • Stein (1997b), Stein (2002)

  • But this stream of explanation cannot explain why incumbents appear to have so much difficulty executing “radical” projects once they have made the decision to do so


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Our key contention: waves successfully…

  • One cannot understand the timing & effects of Schumpetarian waves without an integrated theory of markets and organizations…

  • … that incorporates a theory of “diseconomies of organizational (proximate?) scope”


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Diseconomies of organizational scope waves successfully…

  • Organizations find it extremely difficult to do “two things at once”

    • When the two things are sufficiently close to teach other in organizational and product market space

  • A problem in

    • Cognition?

      • Rotemberg & Saloner (1994, 1995) Van den Steen (2005), Wernerfelt (2003)

    • Agency?

      • Kaplan & Henderson, 2006, Lamont (1997), Shin & Stulz (1996), Scharfstein & Stein (2000)

    • Limited attention?


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Two Firms waves successfully…

  • IBM in the 1970s

    • Dominant in enterprise computing

    • Fabulous strategic marketing

    • Re-invented outsider’s inventions within its platform

    • Strategy of continued dominance of enterprise computing with its changing technical basis

    • The PC

  • Microsoft in the 1990s

    • Dominant in infrastructure software for PC

    • Fabulous strategic marketing

    • Embedded outsider’s inventions in its platform

    • Strategy of continued dominance of ubiquitous computing

    • The widely-used Internet


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Towards a framework: Three Concepts waves successfully…

  • Alignment

    • Between strategic capabilities and market opportunity

  • Sunkness and Slow Adjustment

    • To Realign

  • Scope Diseconomies

    • …from attempting alignment to inconsistent market opportunities


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Outline waves successfully…

  • The Schumpeterian puzzle

  • Illustrating AlignmentBefore a Wave

  • Re-Alignment of Sunk OrganizationInitial Contact with Entrant/Wave

  • Scope DiseconomiesInconsistent Alignment to Two Large Opportunities


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Before a Wave -- the questions waves successfully…

  • IBM did not enter the PC business early, though the PC is important in commercial data processing. Costly! By delaying, they faced a thriving open systems model. Why?

  • Microsoft decided against the Internet as a platform for electronic commerce and e-content, though the ‘net triggered those mass markets. Costly! By waiting, they faced entrants who “are smart, aggressive, and have a big lead.” Why?

  • Many entrepreneurs entered the PC industry, despite IBM’s impressive reputation as a “strong second.” Why?

  • Internet entrepreneurs entered the PC industry with new infrastructural technologies despite Microsoft’s impressive reputation as a “strong second” and rapacious partner. Why?


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Towards an integrated framework (1) waves successfully…Alignment to Existing Opportunity

  • Incumbent firms invest in physical (etc) assets that support their dominant position

  • They also invest in organizational assets that are aligned with the market

    • Distribution systems? Production?

      • Stein (1997a), Sutton (1991)

    • Managerial vision?

      • Rotemberg & Saloner (1994, 1995),

    • Employees with similar prior beliefs?

      • Van den Steen (2005)


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Alignment at IBM waves successfully…

  • Core strategy: Build on the overwhelming success of the system 360:

    • Use proprietary standards and keep upgrades “in the family”

    • Knowledge of existing customers & their needs is paramount

  • Create aligned organizational assets

    • Constant technology & market scanning

    • Products can be slow but they must be really reliable

    • Centralized (slow) decision making – “sales guides technology”

  • IBM was aware that this structure had costs

    • Disastrous experience with the 4300


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Alignment at Microsoft waves successfully…

  • Core strategy: Control components that cannot easily be commoditized with proprietary standards, force open standards on complementors

  • Create aligned organizational assets:

    • Outstanding ability to:

      • Aggregate a wide range of user concerns

      • Coordinate large-scale product development

      • Coordinate development at complementors

    • Become a highly skilled “second mover”

      • Decentralize authority for current product lines

      • Retain strong central control over potential new initiatives


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Alignment Matters for Assessment & Action waves successfully…

  • “Wave possibilities” are typically not labeled – they often come clouded with huge amounts of uncertainty

  • Prior investments will lead entrants and incumbents to make different assessments of potential “waves”, at least until the uncertainty is resolved.

  • Incumbents – knowing that they cannot do everything and that many markets are relatively unattractive – will invest in only a subset of opportunities.

  • In general, it is rational for the incumbent to continue to invest in the existing platform, at least until uncertainty resolved

  • Entrants will make different investments (they have incentives to avoid the incumbent)

  • Not that one is right and one is wrong.

  • But these dynamics may (often) lead to a divergence between incumbent and entrant experience, learning.


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Assessment (and entrants) at IBM waves successfully…

  • Both IBM and the early PC industry early saw the PC as irrelevant to corporate business data processing.

    • Hobbyist customers

    • Product not even remotely competitive to the mainframe

    • No existing computer firm enters in the early stages

  • Entrants

    • could avoid IBM (and DEC…) easily.

    • open systems / low entry costs


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Assessments (and entrants) at Microsoft waves successfully…

  • Microsoft was focused – hard – on the launch of Windows 95

  • Anticipated that widespread distribution of online software with Windows 95 would lead to mass market for applications -- electronic commerce, entertainment, other online applications

  • But believed diffusion would be slow (waiting for broadband) and that a closed, proprietary architecture would be more profitable for e-commerce and e-content. (AOL example)

  • Entrants

    • open systems / low entry costs

    • Windows 95 transition lag for MSFT

    • Building first mover advantage in new infrastructure components


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Outline waves successfully…

  • The Schumpeterian puzzle

  • Illustrating AlignmentBefore a Wave

  • Re-Alignment of Sunk OrganizationInitial Contact with Entrant/Wave

  • Scope DiseconomiesInconsistent Alignment to Two Large Opportunities


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Early stage responses waves successfully…

  • Both firms try a “firm within a firm”

  • Both then move away from this model and reintegrate the unit into the mainstream

  • Why did IBM's initial foray into PCs succeed?

    • While the business then faltered…

  • Why did Microsoft's initial forays into internet E-commerce and E-content fail?

    • While the business then succeeded…


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IBM responds: the strategic rationale waves successfully…

  • Lots of buzz

  • Some users were beginning to bring the PC to work – perhaps to people inside IBM’s customers

  • PCs as an “intelligent terminal” threaten peripheral revenues

  • IBM’s traditional strengths in distribution and service may be an advantage

  • “We’ve been trying to do a “small” computer for years!”

  • The nightmare scenario: if PCs are allowed to evolve, customers may accept standards created by firms outside IBM


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IBM responds: organizational form waves successfully…

  • IBM’s unit in Boca Raton is allowed to:

    • Make a major investment

    • Use a quite different organizational & business model

      • “Act like an entrant”

      • Open systems

      • Report directly to the CEO

  • Why?

    • The 4300 experience is still fresh in many minds

    • Extensive history of separate divisions attacking niche markets

    • Social mechanism in place: “wild ducks”

    • PC not seen as a threat to the core business


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Microsoft responds: waves successfully…

  • Microsoft is slow: IBM wins the first mass market for the PC, but Microsoft does not win the first mass market for the browser

  • Not because of a lack of information – presentation to the senior team in April 1994

  • Appears to have believed that:

    • Internet applications will not be profitable (Mosaic is a university generated product, after all)

    • Internet applications are not strategically valuable

    • Standards for PC-Internet connections will be decided by Microsoft and the firm’s 100 million users

  • Senior management presses for the addition of Internet “plumbing” into Windows 95.


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Microsoft responds – part 2 waves successfully…

  • Netscape’s share takes off, and the firm begins to make $$

    • Begins to encourage third party developers to build applications on the Netscape browser

    • Expands into networking products

    • Begins to mimic the functionality of proprietary on-line services

  • Gates responds with the “Internet Tidal Wave” – May 1995

  • Announces new strategy in August 1995: skunkworks, then Internet Platform & Tools Division

    • Open Systems

    • Vertically Disintegrated at first

    • Protected by senior management

  • Why?

    • Avoid distracting attention from Windows 95

    • No advanced development work already present inside the firm


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Re-Alignment is Incomplete: Baggage waves successfully…

  • Both IBM PC and MSFT ‘net acted like open systems…but entrepreneurs have a healthy suspicion of "strong second"

  • IBM got many deals with leading PC firms (microprocessor, programming tools, spreadsheet, disk drive.)

    • IBM didn’t get deals with some key partners (OS, word processor) but replaced those.

    • SET a standard

  • MSFT got only half a deal with Sun (Java) and got no deal with Netscape (browser.)

    • MSFT was compelled to compete head to head with browser.

    • “Given the positive spiral that Netscape is experiencing what could possibly slow them down?” – Wm. Gates.

    • LOSING a standards race


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But existing assets are also a strength waves successfully…

  • IBM

    • Strong brand name, credibility, leads to extraordinarily rapid diffusion

  • Microsoft

    • Internet Platform & Tools Division builds to 4500 people, allowing very rapid improvements in browser quality and features


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Outline waves successfully…

  • The Schumpeterian puzzle

  • Illustrating AlignmentBefore a Wave

  • Re-Alignment of Sunk OrganizationInitial Contact with Entrant/Wave

  • Scope DiseconomiesInconsistent Alignment to Two Large Opportunities


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Diseconomies of (organizational) scope waves successfully…

  • Once the threat is recognized, market theory suggests that incumbent will respond aggressively

  • Exciting the existing market probably doesn’t make sense

  • Key question – can the incumbent do both? Why cannot the incumbent “simply duplicate the entrant”?

  • Scope Diseconomies

    • Serious conflicts in org design (not just in resource allocation)

    • Or in strategic priorities

    • Shared assets (reputation, marketing channel..)


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Diseconomies of scope at IBM waves successfully…

  • As the PC unfolds, the core organization begins to suspect that The failure to use IBM’s existing organizational competence is hurting performance!

  • The PC group attempts to make internal suppliers behave like external suppliers – won’t cover many costs –

    • Those PC guys are only successful because they are not paying their share of overhead costs…

  • The PC-jr fails

    • But IBM doesn’t make mistakes

    • It’s because they didn’t use follow standard procedure to understand the market

  • Quality problems in hard drives

    • It’s because they violated company norms for having second sources for key components


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Diseconomies of scope at IBM: (2) waves successfully…

  • The PC begins to be viewed as a threat to the core business

    • Problems with the division threaten years of careful image building, particularly IBM’s reputation for reliability

    • All the attention given to the PC interferes with the marketing strategy to the traditional customer base

    • Serious channel conflict starts to arise

    • PC revenues are not contributing to sales commissions

    • PCs are suspected of flowing through “grey” channels


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Diseconomies of scope at IBM: (3) waves successfully…

  • In January 1985, 3 years after selling the first IBM PC, the National Distribution Division gains control over retail sales

  • Conventional reporting structure put in place

  • 200 top executives moved from Florida to Armonk

  • A political fight?

  • A genuine perception that these changes will benefit the PC business?


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Diseconomies of scope at IBM: (4) waves successfully…

  • By the mid 1980s, the mainframe business is booming

  • The PC division attempts to act like a good corporate citizen

    • Products released only after internal consultation and deliberation

    • Technically reliable products that are both late and more expensive

    • No independent manager who can e.g. make direct deals with Microsoft

  • The division reverts to IBM’s historical stress on proprietary products

    • 1988 rolls out the “micro-channel” architecture

    • Announces that the AT286 -- the then best selling product – will be discontinued


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Diseconomies of scope at Microsoft waves successfully…

  • The Strength (and costs) of Windows 95 make a dramatic response difficult

    • Employees have invested heavily in bringing Windows 95 to market

    • Launch was extraordinarily successful – what crisis?

    • The success of Windows 95 predicated on moving existing customers from Windows 3.0 – who needs a cross platform browser?

      • In the short term, IE available for all PCs

    • Attempts to force distributors and assemblers to carry IE are by partners and threatens to complicate transition to Windows 95


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Diseconomies of scope at Microsoft (2) waves successfully…

  • Microsoft begins to follow standard operating practices:

    • Invests heavily in browser technology

    • Signals to developers that mass market has still not taken off, IE is a credible contender

    • Attempts to use proprietary standards

  • The independent browser group – IPTD – begins to develop its own APIs

    • Serious conflicts with the Windows group

    • Dispute consumes massive amounts of top management time


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Diseconomies of scope at Microsoft (3) waves successfully…

  • Browser unit control moved to the OS (Windows) unit

    • “Open Internet” inconsistent with Proprietary Windows

    • Windows’ control of PC distribution will be a source of strength


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Diseconomies of scope at Microsoft (4) waves successfully…

  • Leveraging distribution channel requires supporting ISPs using open strategy – particularly AOL

    • AOL requests the lifting of the “first screen restriction”

    • Very significant conflict with MSN – Microsoft’s proprietary service

    • Conflict resolved in favor of AOL – many MSN employees leave

  • As Netscape threat recedes, MS refocuses on the OS, reneges on many commitments to make IE truly “cross platform”

    • Many IE employees leave

    • MS leaves open opportunities in search, retail hosting, social networking…


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Shaping outcomes: waves successfully…The critical role of legacy market assets

  • IBM had complete control of enterprise computing channel

    • Attempted bundle – IBM PC with Mainframe network standards

    • Market: so what?

  • Microsoft had complete control of PC channel

    • Attempted bundle – distribution only of MS browser with new PC

    • Market: No Netscape Standard, no Open Standard


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Conclusions & Implications waves successfully…


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Implications waves successfully…

  • Waves are more likely when:

    • The structure of the market and the new technological opportunity is such that there are significant incentives for incumbents & entrants to make different investments

    • Or, there is major uncertainty, so that differences in assessment play a major role in shaping investment patterns for incumbent vs. entrant

    • Scope diseconomies between “old” and “new” organizations within the incumbent are particularly costly

    • Realignment costs are high

    • Historical market position is difficult to leverage into the new market


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Conclusions, further work waves successfully…

  • One cannot understand waves without an integrated theory of markets and organizations

    • Alignment, costs of realignment, scope diseconomies

    • Need theory of investments in organizational capability, in which market position (inter alia) shapes investment

  • Organizational scope diseconomies

    • Not just resource allocation

    • Fundamental conflict over core assets (distribution, reputation)

    • Can’t be aligned to two distinct strategic imperatives

  • “Waves” play a significant role in modern economies – particularly with accelerating pace of change – this is an important challenge


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Caveats waves successfully…

  • Our theory does not rely on a strong form of rationality, although consistent with it. One could get similar implications from a theory of selection

  • Our theory does not allow us to predict the resolution of a particular episode

    • Sometimes incumbents will “win” – sometimes “entrants” – our claim is simply that resolution is a function of the interplay between market and organizational forces

  • Generality – all our concepts have realizations in computing, but we have not looked elsewhere


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