Making Waves: The Interplay between Market Incentives and Capabilities in the Evolution of Industries Timothy Bresnahan, Shane Greenstein, Rebecca Henderson.

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

Re-Alignment of Sunk OrganizationInitial Contact with Entrant/Wave

Scope DiseconomiesInconsistent Alignment to Two Large Opportunities

The Schumpeterian Puzzle

Performance

Time

Ferment

Takeoff

Maturity

DiscontinuityWhat determines the timing & effect

of a “Schumpeterian Wave”?

“Waves” often displace incumbent firms

Cumulate share of sales of photolithographic alignment equipment, 1962-1986, by generation Contact Proximity Scanner S&R (1) S&R (2)

Cobilt 44 <1

Kasper 17 8 7

Canon 67 21 9

P-Elmer 78 10 <1

GCA 55 12

Nikon 70

Total 61 75 99+ 81 82+

IBM Corporate Strategy

MIT Sloan School of Management | IBM Confidential © 2005 IBM Corporation

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



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.

Japanese Beer Market: Kirin & Asahi Share 1971-2001

1971 1975 1980 1985 1990 1995 2000

20

40

60

%

Kirin’s share of market

Asahi’s share of market

Higuchi commits to dry beer



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.

Tires Shipped By Construction Type: 1961-1989

1961 1965 1970 1975 1980 1985

20

40

60

80

%

belted bias

radial

bias

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

Outline


Before a Wave



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

Outline


Before a Wave



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

Outline


Before a Wave



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


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?


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


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


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 Timothy Bresnahan, Shane Greenstein, Rebecca Henderson.

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