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

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 AlignmentBefore a Wave • Re-Alignment of Sunk OrganizationInitial Contact with Entrant/Wave • Scope DiseconomiesInconsistent Alignment to Two Large Opportunities

The Schumpeterian Puzzle Performance Maturity What determines the timing & effect of a “Schumpeterian Wave”? Discontinuity Takeoff Ferment Time

“Waves” often displace incumbent firms

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

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.

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.

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

Several outstanding puzzles: • (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.

Market focused explanations • 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

Organizationally focused explanations • 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

Our key contention: • 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”

Diseconomies of organizational scope • 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?

Two Firms • 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

Towards a framework: Three Concepts • Alignment • Between strategic capabilities and market opportunity • Sunkness and Slow Adjustment • To Realign • Scope Diseconomies • …from attempting alignment to inconsistent market opportunities

Before a Wave -- the questions • 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?

Towards an integrated framework (1)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)

Alignment at IBM • 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

Alignment at Microsoft • 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

Alignment Matters for Assessment & Action • “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.

Assessment (and entrants) at IBM • 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

Assessments (and entrants) at Microsoft • 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

Early stage responses • 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…

IBM responds: the strategic rationale • 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

IBM responds: organizational form • 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

Microsoft responds: • 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.

Microsoft responds – part 2 • 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

Re-Alignment is Incomplete: Baggage • 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

But existing assets are also a strength • 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

Diseconomies of (organizational) scope • 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..)

Diseconomies of scope at IBM • 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

Diseconomies of scope at IBM: (2) • 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

Diseconomies of scope at IBM: (3) • 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?

Diseconomies of scope at IBM: (4) • 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

Diseconomies of scope at Microsoft • 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

Diseconomies of scope at Microsoft (2) • 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

Diseconomies of scope at Microsoft (3) • 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

Diseconomies of scope at Microsoft (4) • 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…

Shaping outcomes: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

Conclusions & Implications

Implications • 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

Conclusions, further work • 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

Caveats • 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

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