Bocconi Duke Seminar Industry Life Cycles

1. Bocconi Duke Seminar Industry Life Cycles Ulya Tsolmon, Duke University Luis Rios, Duke University October 18, 2010

2. Central tension • Industry structure arises from industry and temporal patterns of founding and selection, • Rather than from firm capabilities or other firm-level factors

3. Three main determinants of industry structure • Production scale economies (Jovanovic and MacDonald 1994) • Marketing and distribution economies (Knox 1963, Chandler 1990, Klepper and Simons 2000) • Technological change and associated returns (Dasgupta and Stiglitz 1980, Nelson and Winter 1982, Jovanovic and MacDonald 1994, Klepper 1996, Klepper and Simons 2000) • Closely related theories: neoclassical economics (equilibrium); IO; population ecology (age dependence, density, birth, entry, exit)

4. Why industry structure is best explained by industry and temporal patterns of founding and selection • Technological change and innovation drives industry evolution (Gort and Klepper 1982, Jovanovic and MacDonald 1994) • Patterns are well-established and explained across industries for birth; shakeout; oligopoly (Klepper 1996) • Establishment of dominant design (Utterback and Abernathy 1975) • Timing of entry: advantages of early entry (lower hazards, higher profitability, more productive R&D) • Number of firms in an industry; level of innovation, type of innovation • Recognizes heterogeneity on firm resources and capabilities, costs of expansion, different types of entrants and incumbents, different hazard rates for entrants • Geographic agglomeration (Klepper 2002)

5. Central tension • Industry structure arises from industry and temporal patterns of founding and selection, • Rather than from firm capabilities or other firm-level factors

6. Central tension • Industry structure arises from industry and temporal patterns of founding and selection, • (Jovanovic and MacDonald, 1994, Utterback and Suarez, 1993) • Rather than from firm capabilities or other firm-level factors • (Klepper, Gort, Simons, Helfat, Lieberman, 1982-present)

7. Both camps rooted in the same evolutionary tradition • Both approaches model industry structure as the result of changing selection pressures and firm survival • But they diverge on the issue of whether the determinants of fit are exogenous or endogenous

8. Both camps rooted in the same evolutionary tradition • Both approaches model industry structure as the result of changing selection pressures and firm survival • But they diverge on the issue of whether the determinants of fit/survival are exogenous or endogenous

9. There is something depressing about thinking that survival is exogenously and stochastically determined... • “The key property of whatever [key] invention(s) preceded the shakeout is that it increased the optimal scale of any firm that implemented it” • “firms that [implemented] early were rewarded…others joined a mass exodus” • (Jovanovi and MacDonald, 1994)

10. But in rapidly changing industries the dominant design is only known a posteriori • So, though it is tempting to propose in retrospect that those firms which chose the wining design were somehow endowed with “capabilities”… • …in the rush to enter after new technologies emerge, most firms have only a crude understanding of the technology, and are experimenting in ill-defined markets (Mueller and Tilton, 1969)

11. Helfat (2002) frames the debate well: • “In Jovanovic’s model, firms learn about their cost efficiency subsequent to entry, but have no information about their pre-entry costs (and hence, resources and capabilities) other than the distribution of costs for all possible entrants”

12. Helfat (2002) frames the debate well: • “In Jovanovic’s model, firms learn about their cost efficiency subsequent to entry, but have no information about their pre-entry costs (and hence, resources and capabilities) other than the distribution of costs for all possible entrants” • “our analysis strongly suggests that firms possess pre-entry knowledge about their resources and capabilities, which in turn affects both entry decisions and subsequent success of entry”

13. We have three possibilities for any given population of firms: • H1 The degree of firms’ understanding, k, of their own capabilities, tends to be normally distributed around  = k = fully accurate knowledge (e.g. a few grossly over/under estimate their capabilities, but most cluster around “pretty good self-awareness”) • H2 The distribution of k tends to be negatively skewed • H3 The distribution of k tends to be positively skewed

14. This makes it highly unlikely that capabilities shape industry structure: • Under H1 There would on average be little impact on the industry structure from k, since just as many firms would overestimate their capabilities and fail in unsuitable markets as those that would underestimate their capabilities and avoid entrance altogether. Only for those that fall within a range where they underestimate but not enough to deter entry would we see any relation between known capabilities and industry structure (and they would likely receive supernormal returns) • (call this level of knowledge k*<k ). • Clearly, under H2 and H3 the problems under H1 would be magnified.

15. Another way of saying this is that capabilities may be important for firms seeking to outperform the market average, but not for shaping the market • Allowing the possibility that many capabilities can change and develop post-entry makes it even harder to pin down the contribution of capabilities to shaping the industry. • How can we separate those market survivors who had better luck, but then developed capabilities from those whose capabilities helped them survive?

16. Even if we could get comfortable with the self-knowledge issue*, there is the problem of interactions with the industry • Assume that the firms in the population that we care about have the optimal level of knowledge k* at t0. In order for industry structure to arise from firm capabilities, successful entrants would have to somehow predict the capabilities needed in atn where the industry has changed! • (because if our firms don’t survive, their impact will be insignificant) • *and ignore for now the ever evolving list of new “capabilities” defined, which no manager can be expected to keep up with, much less asses for her firm

17. Fundamentally, the issue is about causality and bias There are too many assumptions necessary in order to claim that industry structure arises from firm-level factors, such as capabilities. All we observe are industries shaped partly by the outcome of firm entry and survival, but we have almost no information on firms that don’t enter, and the ones that fail only shape the industry in the short run. This generates many compelling but misleading narratives of the survivors, who account for only 5% of any industry. And given the very slight proportion of firms that survive, it is hard to argue that capabilities shape the industry. It is more likely that much entry is motivated by more mundane cyclical ecological processes (i.e. for many victims of shakeouts, capabilities are orthogonal to their entry decision, otherwise we run into a tautological definition of capabilities that ascribes “missing capabilities” to actors).

18. Why firm-level factors are insufficient for explaining the industry structure • Firm-level factors are: size, age, capabilities, core competencies and complementary assets • No consistency in explanations, very industry-specific; hard to make predictions or see patterns across industries—“application of theories by context” (Carroll et al 1996) • Prior resources and capabilities: in semiconductor industry prior history impeded innovation and de novo firms were more successful than de alio; in the auto industry “spin-offs” were more successful than de alio or de novo firms (Klepper 2002), also in disk-drive industry incumbents succumbed to new entrants (Christensen 1993).

19. Why firm-level factors are insufficient for explaining the industry structure, cont. • Capabilities—which ones are “core” and “complementary”—hard to tell if they are going to be relevant a priori entrance: in auto industry the authors (Carroll et al 1996) thought that engine was “core”, but it turned out that production experience was the more important capability. There are too many variations of which capabilities are relevant and when. • The assumption of learning of their capabilities upon entry (Jovanovic 1982) may not be as strong an assumption after all. • Founder effect (Klepper 2002): classification of different types of entrants was not very accurate—companies with founders that spent only a little time in parent company classified as “spinoffs” and attributed the success of spinoffs to the extensive experience these people got from working for the parent company that go imprinted on their new ventures.

20. Why firm-level factors are insufficient for explaining the industry structure, cont. • Diversifying entrants using their resources to enter a different industry (Helfat and Lieberman 2002): • Why firms decide to engage the resources that are used elsewhere: how are they “freed up” or are they able to “replicate” capabilities and resources? • The timing of entry explained in terms of resource match. Under what conditions established firms would enter markets with dissimilar resource requirements?

21. Critiques of industry and temporal patterns of founding and selection as determinants of industry structure • Time paths may not be followed—there are examples of industries that do not follow the general time paths (Sleeper 1998) • longer cycles--the pattern is yet to be seen • Survival is the measure of performance, rather than market share and profitability • profitability at each stage of ILC • Studied firms that are innovation-intensive • only need to see major innovations and establishment of dominant design • First mover (dis)advantages; second-mover advantage: • Jovanovic and Klepper’s models do not exclude the possibility of later entrants developing high-tech capabilities and doing better than some earlier entrants that fail to evolve to be high-tech

22. Critiques of industry and temporal patterns of founding and selection as determinants of industry structure, cont. • Alternative explanation of the hazard patterns in 4 industries (Klepper 2002): • No compelling reasons to think that these are firm-level differences; most likely another type of industry-level pattern of selection to be yet identified • Various assumptions in economic models, such as costless imitation and free entry: • Trade-off between integrating all complexities and parsimony; looking at one mechanism at a time • Not incompatible, can be integrated in the models if one wishes to study the effect of firms’ previous experiences on entry

23. Directions for future research to address the challenges presented by the Prop 1. • Multi-industry studies; use of other research methods, for example, enrich the data with other sources of data • Study industries that do not exhibit the traditional time paths • One-industry studies of less innovative industries • Explore interesting industry conditions, for example, under what industry conditions firms diversify with dissimilar resources? When and why multiple “loops” in industry time paths may occur?