Lecture 5 in-class notes

INNOVATION, ENTRY AND INDUSTRIAL DYNAMICS

Three approaches for how industries change + evolve:

  • Industry dynamics

    • Simplest & oldest. Very used nowadays

  • Industry life cycle

    • More complex

  • Evolution of industries & sectoral systems

    • MUCH more complex. Focus on evolution, not so mechanic but more complex with feedback, etc.

1 - INDUSTRY DYNAMICS, ENTRY AND EXIT

Industry dynamics focuses on 3 aspects:

  1. Entry of new firms

  2. Exit of existing firms

  3. Firm’s growth

In a QUANTITATIVE way!! How many new firms enter, in which way, how many existing firms exit and in which way, and what is the rate of growth of existing firms. Extremely used way!! Because nowadays, we have enormously large databases!! With census and research and everything. So we have lots of detailed stats that we can use. The problem is that each country does it in a different way.

1.1 - 5 STYLIZED FACTS

(Global study)

  1. Entry and exit are common

    • Around 15-20% enter and exit the industry each year

  2. Entry and exit are mostly by small firms

    • (smaller than those in the market)

  3. Entry and exit are correlated

    • Revolving door concept:

      • If you’re an entrant, you’re usually a small inexperienced firm (liability of newness), with the wrong products, the wrong managerial system, etc.

      • It is highly probable that, after some years, a good part of entrants exit, due to their above-mentioned characteristics

  4. Exit commonly occurs quite soon

    • After 2 years = common exit

    • After 4 years = more chances to survive in industry

    • After 7 years = much lower chances of exiting

  5. The new firms that survive grow

    • If you’re able to survive, you’ll grow fast

1.2 - INNOVATION & INDUSTRY DYNAMICS - WHAT DO WE KNOW?

  • Persistent differences in innovativeness & technological capabilities among new firms

    • This is why some new firms are great innovators, and some aren’t

  • There is the “Core” and “Fringe” of innovators (see image below)

    • Fringe: the firms that enter and exit, that are subject to the revolving door

    • Core: part of the industry that is rather stable, with persistent innovators.

  • Differences across sectors & technologies

1.3 - ENTRY

THE ROLE OF ENTRY IN MICROECONOMICS (discussion)

Why do they enter?

  • Opportunity of profit!

    • As long as there is opportunity of profit, firms will enter until there is no longer any opportunity.

      Why?

    • If price is greater than marginal cost, firms know that they can profit

  • In perfect competition market:

    • All firms are the same, cannot distinguish them!!!

    • So why are there profits if there is perfect competition?

      • Shock in demand,

      • Shock in supply,

      • Change in technology that reduces the cost,

    • Bref, there is some shock that abruptly increases demand or reduces the cost. This makes the price go over the marginal cost

    • Therefore, firms get profit (over regular compensation), even though they are in a perfect competition.

  • If profits increase:

    • Outsiders will want to enter

    • Of course, there are no barriers to entry in a perfect competition, so they enter

    • This will cause the price to reduce

    • And then the market goes back to equilibrium! Until a new shock takes place eventually. This is the basic role of entry in microeconomics.

SIMPLIFIED:

  • ++ demand = price ++ = extra profit == ++ entries == ++ supply == -- price

  • New technology = -- production cost == extra profit == ++ entries == ++ supply == -- price

  • THE ENTRY IS A RE-EQUILIBRATING FORCE!!!

    • Entry re-equilibrates the market.

    • It’s off equilibrium because SOMETHING happened, which gives signals to firms outside, who flock in with no barriers to entry, and the market returns to equilibrium.

    • Price goes back to be == to marginal cost, and we’re all happy

WHAT DO WE KNOW ABOUT ENTRY?

  • Does entry have an equilibrating function?

  • Does entry eliminate over-profits/extra profits?

    • No (for both)

  • Through empirical analysis, one can see that, particularly in med-high tech sectors… (P. Geroski)

    • Entrants introduce innovations & new strategies, organizational forms and approachs

    • There are differences among entrants in terms of capabilities

      • (opposed to the theory of perfect competition. IRL entrants are different than incumbents)

WHAT FACTORS AFFECT ENTRY?

  • The industry yields high profits

  • You perceive / expect that demand will grow

    • Room for new entrants because demand is / is expected to grow

  • Low barriers to entry (capital requirements, etc.)

  • In order to be active you don’t need high-skill specialized labor!

  • Consumers have a low switch in cost!

    • If you enter with a new product, you expect that consumers will move to your product (they’re not locked in to a certain product and are able to move to you)

  • Availability to financial resources

  • Level of regulation in the industry (high = difficult, low = easy entry)

  • Scientific and technological opportunities (SCH I)

1.4 - NEW INNOVATIVE FIRMS

THEIR KEY ROLE

  • New innovative firms: firms that enter a technology/sector for the first time with an innovation.

How to measure that?

  • With patents. New innovative firms are firms that patent for the first time in a specific technology. They can be called TECHNOLOGICAL ENTRANTS

  • Calculate the share of technological entrants on total innovators

  • SCH I industries > technological entrants than SCH II industries

  • Keep in mind that patents do not measure all the innovations !

(example)

What is the difference between total amount of new patenting firms and REAL new patenting firms.

  • Total amount new patenting firms = REAL + those who have patented before, but in a different technology

  • REAL new patenting firms = those who have NEVER EVER patented before, in any technology

  • You see big difference in new innovators/patentors between then and now

  • Why is the share of patents so different of that of the firms?

    • Because the new entrants are usually ones that only do ONE patent, while there are persistent innovators (big firms), that patent a lot.

    • Aka smaller nominator, bigger denominator = smaller fraction

MAIN OBSTACLES TO INNOVATION

  • No economies of scale, if innovation has to be produced at large scale

  • Troubles regarding organizational aspect (if you need to hire lots of people)

    • But you could license your organization to another firm.

  • Lack of strong relationship with suppliers (think of specialized suppliers)

  • Less access to specialists in the field (not inserted to networks)

  • Lack of reputation, need to build one up (depends on market)

  • Lack of financial availability

1.5 - EXIT

Three basic forms of exit:

  1. Relocation & restructuring:

    • Part of the dynamic process

    • Involves modification of firms’ products + processes

    • E.g. close a plant in USA and open in Italy instead

  2. Business closure

    • Voluntary liquidation or bankruptcy

  3. Mergers and acquisitions

    • Transfer of ownership, but production capacity remains within the industry.

    • Often take place to seize growth opportunities

TWO MODES OF EXIT

  1. Revolving door

    • Liability of newness, small new firms

  2. Schumpeterian Gale of creative destruction

    • More evenly distributed - can be small, large, new or old firms

1.6 - FIRMS’ GROWTH

In general, there are two theories to explain the growth of firms:

  1. Persistence of growth

    • Once you start growing, you’ll continue to do so

  2. Random walk

    • Today you could grow, but tomorrow there may be uncertainty.

Dosi et al. (2019);

Found positive autocorrelation in firms’ growth rates. But…

  • There is heterogeneity in autocorrelation coefficients…

    • Effect: maybe the company Is delulu and thinks they’re growing faster/slower than they actually are.

  • Larger values of autocorrelation are for the leaders in industries such as semiconductors, computer, etc.

2 - SPIN-OFFS

2.1 - TYPES OF ENTRANTS (KLEPPER 2001)

  • Start-up: a new firm that enters an industry

  • Spinoff: an independent start-up that comes from an existing firm within the same industry.

    • Therefore entrepreneurs who open a spinoff have previous experience in the industry

    • They are intra-industry spinoffs

    • New firm, independent, from an ex-employee of an existing firm FROM SAME INDUSTRY.

Other types of spinoffs

  • Corporate spinoffs: a spinoffs started by a corporation

  • Academic spinoffs

2.2 - SPINOFFS

  • Present in all industries

  • In some industries more numerous (example ICT in US)

  • Possess technology, operations and market knowledge

  • Can do product & process innovations

  • Enter in the growth & mature stages of an industry’s life cycle

Advantage:

  • You don’t have the liability of newness! You know the industry, you know the product, etc.! You have experience since you come from the industry

4 STYLIZED FACTS

  1. Spinoffs have better performance than other de novo entrants

    • Because they have experience and knowledge

  2. The relation between the age of parents and their spinoff generation rate has an inverted U-shape (see graph below)

    • At the beginning, the firm is new and there aren’t many employees in the first place for anyone to spin off.

    • Increase of age = + employees = + spinoffs

    • But it goes back down. why?

      • Market saturation. More mature market, so there is less incentive to create something new.

      • Company could become less innovative, more routinized.

      • Employee loyalty = if you’ve been an employee for long, you tend to be more loyal

      • Loss of employees and knowledge.

  3. High-performing parents have higher spinoff generation rates

  4. High-performing parents generate high-performing spinoffs

    • Is this due to the company or the people spinning off?

    • Both. A highly dynamic organization of the firm + a highly performing human capital = ideas flow

What do these stylized facts tell us?

  • Spinoffs usually come from successful firms

  • Spinoffs are more rare when the firm is very young or old

  • Spinoffs are associated to organizational changes

MOTIVATIONS BEHIND AN INNOVATIVE SPINOFF

Situation: I’m an employee at Apple and get a great idea. Why would I want to leave and create my own firm, rather than to stay, share my idea and get promoted?? A lot of companies stimulate intrapreneurship!!

  • Cannibalization

    • If you create a new firm, you can take market shares from the parent company!!

    • E.g. my product may take customers away from Apple

  • In very large companies, the company MAY be less receptive to ideas of a new employee

    • Non-receptive, non-attentive organizational culture

  • I want to profit fully from my idea, rather than just getting a small promotion!!

    • This is called the Principal Agent. Let’s say I hate my manager. Why would I share my great idea and profits with her, when she’s not even nice to me??

    • Not good communication, I keep my idea secret and leave.

  • Different views, cognitive frames, perceptions, etc.

    • I want my idea to be exactly the way I imagine it!! But the company may want to make changes to it that I won’t agree on.

  • What I want to make is out of the scope of the firm!

  • Different expectations

POSSIBLE REASONS FOR A SPINOFF (discussion)

  1. Agency Theory:

    • Information asymmetry - inventor does not want to share idea and leaves

  2. Cannibalization:

    • Management rejects idea because it may cannibalize an existing product of the firm

    • (information sharing present)

  3. Disagreement:

    • Disagreement regarding importance of idea.

    • (information sharing present)

  4. Learning in Rigid Organizations:

    • The inventor learned and developed the necessary skills within the company, then moves out since the firm is rigid

3 - INDUSTRY LIFE CYCLE

Same variables we saw, PLUS…

  • Whether I have product and process innovation

  • What kind of competition there is between entrants and incumbents

  • The concentration of the industry

Pros: richer framework. Cons: not easily available information

3.1 - “STANDARD” LIFE CYCLE REPRESENTATION

  1. Start/emergence

    • Radical product innovation, which generates other products, and new firms enter

  2. Growth

    • A product that becomes dominant!

    • Firms try to do process innovation, and over time there is the exit of established firms

  3. Maturity

    • Increase in concentration and capital intensity.

  4. Discontinuity in technology, markets or industrial actors

For a radical innovation, specifically:

  1. Start/emergence

    • Uncertainty about preferences and techniques

    • Variety of products

    • Low barrier to entry/turnover in leadership

  2. Growth

    • Uncertainty is in resolution

    • -- variety, ++ efficiency

    • Shakeout, barriers ot entry

  3. Maturity

    • No uncertainty

    • -- level of innovation

    • ++ concentration, stable market shares

  4. Discontinuity in technology, markets or industrial actors

3.2 - UNCERTAINTY + DOMINANT DESIGN (ABERNATHY & UTTERBACK, 1978)

  • When a new industry emerges, there is a lot of uncertainty in both technology and demand.

  • As a consequence, firms try different solutions (product variants) that have different technological requirements and satisfy different demand needs.

  • The incentives to invest in process innovations are low because they need to be tailored to the specific product variant, whose demand is highly uncertain.

  • At a certain point, a dominant design – a successful product configuration – emerges

  • Once a dominant design emerges, uncertainty is reduced.

  • It is now convenient to invest in process R&D, because it is not very risky to tailor the new production processes to the dominant design.

  • Instead, it is very risky to keep engaging in product innovation, because these innovations will be discarded if not compatible with the dominant design.

  • Then, why there is a shakeout?

    • Because only firms that are good in doing process innovations related to the dominant design will be able to survive.

3.3 - INNOVATION + INDUSTRY LIFE CYCLE (KLEPPER, 1996)

  • There is a standard product and there are distinctive products, which are the result of product R&D.

  • Process R&D lowers the average cost of the standard products.

  • There are potential entrants with distinctive competences.

  • Entrants are randomly endowed with innovative expertise which cannot be modified.

  • New entrants: information on their expertise prior to entry, and on the number of incumbents.

  • Distinctive competences influence the success of product R&D. Firms with successful product innovations grow.

  • Last period product innovations are incorporated into the standard product

Only winning products have the incentive of introducing process innovation, because the costs will be able to be repaid with the profits made

  • Incentive for firms that have a large market share to move to process innovations: this lowers costs and prices

  • The decrease in prices provokes the exit of the less innovative firms

  • Therefore, over time in the industry there is a decrease in the number of entering firms and an increase in concentration

  • There is also a reduction in product diversity related to the appearance of a dominant design

Key results of model:

  • The first result is that if firms grow over time, process R&D will increase in importance and product R&D will decline.

  • Do firms grow over time? Yes, because firms that enter early have more incentives to invest in production capacity. These incentives in fact depend on past quantities.

  • Why is there a shakeout?

  • The number of firms will start decreasing, because firms that are not big enough shrink more and more, and eventually exit

  • In this model the emergence of a dominant design and the decline in production costs are endogenous to the model.

3.4 - ALTERNATIVE LIFE CYCLE PATTERNS

  • In some industries, you could have process innovation before product innovation (reverse life-cycle)

  • Specialization can take place very early on. A firm can be specialized since the beginning!

  • Joining product and process innovations together (e.g. new drug)

  • No process innovation in some industries

  • Relevance of several segments & specialization in submarkets== leaders in each market (not much concentration, but have firms that are specialized in each segment).

  • In some industries (most popular being; mainframes and semiconductors), you need the big guys (IBM, AT&T, etc.)

    • Concentration exists at the beginning!

4 - INDUSTRY EVOLUTION

Aspects:

  • The origin of new industries

  • The transformation of products and technologies

  • The development and change in firms’ competences

  • The change in firms’ boundaries

  • The rise and development of networks of firms

  • The role of institutions

Sectoral systems are a good starting point for looking at industry evolution

4.1 - TRIGGER EVENT OF A NEW INDUSTRY

The initial even of a new industry

  1. RADICAL PRODUCT INNOVATION

    • Auto

  2. SCIENTIFIC OR TECHNOLOGICAL DISCOVERY

    • Recombinant DNA & biotechnology

    • Nanotechnology

    • Substantial technological and market uncertainty

  3. UNMET USER NEEDS

    • Users can be consumers, professionals or firms.

    • E.g.;

      • Clean dirty dishes and the dish-washing machine industry

      • Enthusiast kayaker and the specialized sport equipment industry

      • Academics and probe microscopy

    • The user is the inventor. Technological and demand uncertainty; role of user community

  4. MISSION ORIENTED GRAND CHALLENGES

    • US Office of scientific research and development (OSRD), the need to treat infections and the Penicillin industry

    • Extensive partnership between the public sector and the private sector

(Agarwal, Moeen and Shah, 2017)

4.2 - INCUBATION STAGE

Period between the introduction of a discontinuous change & the first instance of commercialization

  • Average between 26-28 years of the industry

  • Heterogeneous actors = active using diverse knowledge bases

  • Continuous attempts to reduce technological & demand uncertainty

  • Lots of experimentation

  • Knowledge sharing through formal & informal interactions

  • Incubation stage shapes industry structure & firm strategy in the stages of commercialization

4.3 - COEVOLUTION OF KNOWLEDGE, TECHNOLOGY, FIRMS AND USERS

  • Coevolutionary processes affect the evolution of an industry

  • Example;

    • Technology affects firms’ capabilities & strategies, but at the same time firms affect technological change

  • The same coevolutionary process takes place between firms, technology and demand

  • Feedback very important!!

(Nelson, 1994)

4.4 - EVOLUTION OF SECTORAL SYSTEMS

4.4.1 - EMERGENCE OF NEW TECHNOLOGIES

The evolution of pharmaceuticals-biotech

  • From random screening => science driven search

  • Before biotech revolution, science was not as important and NBF (new biotech firms) were not present

  • Now: dynamic interaction between large pharma, uni labs, NBFs and VCs

Other example: internet

4.4.2 - TECHNOLOGICAL & MARKET DISCONTINUITIES. DISRUPTIVE/COMPETENCE DESTROYING INNOVATIONS

Music industry

  • Analog

    • Gramaphone

    • Cassette

  • Digital compact disk

  • Internet

    • MP3

    • iTunes

    • Spotify

(Co-existence of SCH I and II)

4.4.3 - RELATED INDUSTRIES AND VALUE NETWORKS

Computers

Computer hardware:

  • Mainframe

  • Mini

  • PC

  • Workstations

Demand:

  • Mainframe: large firms

  • Mini: research labs, etc.

  • PCs: individuals