TECHNOLOGICAL INNOVATION AND TECHNOLOGY STRATEGY

INTRODUCTION
Introduction
Technological innovation has become an important part of the process by which companies
in many industries generate competitive advantage, making it a crucial part of firm strategy.
In recent years, many companies have increased their level of technological innovation to
produce a greater variety of new products, and to introduce those new products to market
faster. In many industries, the share of sales and profits accounted for by products introduced
in the past five years has been growing rapidly. In fact, some companies, like 3M, now
generate 40 per- cent of their sales from products that did not exist five years ago.
Companies have also increased their level of technological innovation in response to
competition. The reduction of costs and the improvement in quality of products made in
lower wage countries, like China and India, have posed a major challenge for firms in
developed countries, like the United States and Germany. Many firms from developed
countries have responded to this challenge by introducing new products at a faster pace to
stay ahead of imitators, and by using technological innovation to reduce their own production
costs.6
Technological innovation has also increased as more companies that once pro- duced
commodity products now seek to differentiate their offerings from those of competitors. The
desire of more companies to offer differentiated products has short- ened the product life
cycle and has increased the importance of investments in new product and process
development.7
Furthermore, technological innovation has increased as companies have turned intellectual
property into a marketable asset. In recent years, the licensing of tech- nology to other
companies has become an important revenue stream for many com- panies, with some, like
IBM, adopting the approach that all of its intellectual property is potentially for sale. This
marks a major change from only a couple of decades ago when intellectual property was used
only as an input into a company’s product or service.
In addition, there has been significant growth recently in the formation of high- technology
start-ups that use funding by venture capitalists and business angels (individuals who invest
their own money in start-up companies, usually by taking an equity stake in them) to
introduce high-technology products and compete with established firms. As a result,
technological innovation has also been increasing because of entrepreneurs, including those
who create spin-off companies, using tech- nology developed at major corporations and
universities.
This emphasis on technological innovation as a way to generate or preserve competitive
advantage has led to an increased need for managers and entrepre- neurs who can develop
strategies to successfully manage this activity. While com- panies can, and do, introduce new
products, improve production processes, and target new markets without strategies or plans,
companies are better at these activities if they develop, and execute, an effective strategy to
undertake them.8 By combining an understanding of markets and technological evolution
with an understanding of firm organization and capabilities in a deliberate and organized
manner, managers and entrepreneurs can generate value by developing technol- ogy products
and services that better meet customer needs, and can become better at capturing that value.
The increased need for managers and entrepreneurs to develop strategies for technological
innovation, in turn, has led to an increased demand for business school courses in the
management of technological innovation, and for strategic

WHAT IS TECHNOLOGICAL INNOVATION?

The previous vignette illustrates the importance of understanding technology strat- egy by
highlighting many of the important issues that companies face and that are the subject matter
of this text. But before we get into a discussion of what technology strategy is, and how to
develop it effectively, we need to lay a little ground work. We have to define technological
innovation and explain how firms use it to achieve their objectives. After all, strategy is just
an approach to achieving a particular goal, mak- ing technology strategy nothing more than
an approach to using technological inno- vation to achieve a goal.
So our first step is to define technological innovation. That is best done by decomposing the
phrase into its two parts, the concepts of technology and innovation.
Defining Technology
While there has been a tendency for the popular media to use the word technology as
shorthand for information technology, technology is much broader than just informa- tion
technology. It is the application of tools, materials, processes, and techniques to human
activity.
Certainly, information technology—the use of zeros and ones in digital form on computers—
is an important technology, but there are many other important tech- ologies as well.
Biologically based technologies, such as those used to create new drugs or to clean up
pollution, are also important. Similarly, mechanically based technologies, such as those that
make pumps or valves, matter. New materials, such as those in new ceramic composites, are
valuable too.
Defining Innovation
The next important definition is that of innovation—the process of using knowledge to solve
a problem. Innovation is different from invention, which is the discovery of a new idea,
because it involves more than just coming up with an idea about how to
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What Is Technological Innovation?
Introduction
use knowledge to solve a problem. For example, during the Renaissance, inventors came up
with the ideas for parachutes, fountain pens, mechanical calculators, and ball bearings.
However, these ideas did not become innovations until much later because they were not
technically feasible and could not be implemented at the time that the ideas were
discovered.9
Defining Technological Innovation
So what is technological innovation? Simply put, it is the use of knowledge to apply tools,
materials, processes, and techniques to come up with new solutions to prob- lems.10 Some
innovations, like Michael Dell’s approach to selling computers—selling personal computers
assembled from standard components direct to customers11— were not technological
innovations because the knowledge used to solve a problem did not involve new technology
(tools, materials, processes, and techniques), but, instead, involved new ways of organizing a
business. However, other innovations, like genetic engineering, were technological
innovations because the knowledge used to solve problems involved new tools, materials,
processes, and techniques.
Technological innovation can be planned or accidental. Sometimes the use of technical
knowledge to solve problems is purposeful. For instance, many companies invest in research
and development with the goal of coming up with an innovative new product or process that
will give them an advantage over their competitors.
However, other times technological innovation isn’t the result of a deliberate attempt to solve
a particular problem. For example, Pfizer was not looking for a solu- tion to the problem of
erectile dysfunction when it came up with Viagra. The solution to this problem was merely a
side effect discovered in tests of the drug for its intended purpose of treating angina in cardiac
patients. Similarly, Alexander Fleming discovered penicillin because a spore of mold
contaminated a sample of bacteria that he was using, and inhibited its growth.
This definition of technological innovation has three important implications for
understanding technology strategy. First, technological innova- tion doesn’t have to be
profitable. Companies can, and do, come up with solutions to problems that they can’t make
any money exploiting. So a big part of technology strategy is coming up with ways to make
money from technological innovation (and another big part of technology strategy is keeping
that money, rather than letting competitors take it).
So when this text discusses technology, we aren’t talking just about information technology.
Rather, we are talking about a host of technologies, including, but not limited to, new
microorganisms, new mechanical devices, new materials, and a vari- ety of other products
and processes. So, when you see the word technology or the phrase technological innovation,
do not just think of the Internet and computer soft- ware, think of processes like nano-
fabrication (the process of making things less than one micrometer in size) and products like
fuel cells, ceramic composites, new drugs, or heart valves.
The use of technology is more prevalent in some industries than in others. Figure 1 shows the
industries that the U.S. government defines as technology- intensive. Clearly, these industries
are the ones in which an understanding of technology strategy is important to entrepreneurs
and managers. A technological innovation involves the application of knowledge to solve a
problem and need not work nor result in something of commercial value.
Second, there are many different kinds of technological innovations. They can come from
any kind of technical knowledge, from knowledge of computer science to knowl- edge of
biology to knowledge of new materials. Moreover, technological innovation can take the
form of solutions to a variety of different kinds of problems, from speeding production to
introducing new products that meet customer needs to facilitating distri- bution. The
development of a new material for making aircraft lighter or a new way to produce biodiesel
are just as much technological innovations as Windows Vista.
Third, there is not a direct, one-to-one, relationship between technological change and new
products or processes. Some new technologies may lead to only one, or even no, new
products or processes, while others might make possible a very large number of them. Take,
for example, the case of radio frequency identification (RFID) technology. This technology
has led to the creation of ExxonMobil’s speed- pass, the E-ZPass highway toll collection
system, a system for inventory tracking in libraries, a way to identify the parts and
components in computer and automobile manufacturing, a method to record quality problems
in disk drive manufacturing, and a way to track products shipped from manufacturers to
retailers.13
Why Technological Innovation Is Important
Technological innovation is an important source of value creation. The application of
knowledge to human activity allows for the more efficient production of existing products
and services (that is, production that takes less money or effort) and allows for the creation of
products and services that meet needs that were not previously satisfied.14 For example,
technological innovation allows us to provide burn victims with artificial skin, and makes the
cost of heating our homes cheaper.
Because of the importance of technological innovation to value creation, techno- logical
change has tremendous economic impact. Economists have shown that much of the growth in
gross domestic product comes from the use of technology to make more productive use of
labor and capital.
Technological innovation is also important because it has a profound effect on the creation of
wealth for individual entrepreneurs and corporate shareholders. New technology makes
possible the formation and rapid growth of companies like Google and Microsoft that were
not around four decades ago, and attributes to the death of leading companies of a previous
era, such as Digital Equipment Corporation. In fact, researchers have shown that much of the
wealth creation by entrepreneurs is accounted for by the creation of products and services
based on technological innovation.
Technological innovation is also important because it has a major impact on our lives. For
instance, the way in which we look for information has been dramatically altered by Internet
search, how we get around was forever changed by the airplane and the automobile, and life
expectancy has been greatly lengthened by medical diagnostics and treatments.
Not all of the impact of technological innovation is good. Research has shown that the rapid
and constant technological progression that we have experienced in recent years causes social
isolation, increased time pressure, the constant need to multitask, the inability to disconnect
from work, and other adverse consequences. As Figure 3 illustrates, somewhat humorously,
many people have found the loss of privacy and control that technological innovation has
generated sometimes out- weighs the benefits of the opportunities that technological change
has created.
Designing an effective technology strategy entails the creation of new technol- ogy products
and processes that provide benefit to your firm while minimizing the adverse effects of
technological change on your customers and society at large. Many companies have run into
trouble when they have made use of technology to achieve a competitive advantage and that
technology has had adverse consequences. For example, the efforts of retailers T.J. Maxx and
Marshalls to gain competitive advan- tage by using information technology to gather
customer information that could be used for targeted marketing led to a loss of customer
information to identity thieves who could perpetuate fraud against tens of millions of people,
alienating large num- bers of their customers
Sometimes, process development—the anticipation and resolution of problems that arise in
the production of a product—is more important than product development as a source of
competitive advantage for high-technology firms.
Key Points
• Technologicalinnovationistheuseoftechnicalknowledgetocomeupwith solutions to problems.
• Technologicalinnovationisimportanttoentrepreneursandmanagersbecause it provides a
mechanism to create and preserve competitive advantage.
WHY TECHNOLOGY STRATEGY?
While the previous section of this chapter discussed the importance of technological
innovation to companies and outlined some basic forms that technological innova- tion can
take, it did not say anything about why companies need to develop a strat- egy to manage
innovation. However, many observers believe that companies can, and should, develop
technology strategies. A technology strategy is the approach that a firm takes to obtaining and
using technology to achieve a new competitive advantage, or to defend an existing
technology-oriented competitive advantage against erosion.
Technology strategy is different from overall business strategy in several impor- tant ways:
1. Technology strategy has to deal much more with issues of uncertainty than gen- eral
business strategy because technological change is highly uncertain. A very small portion of
new technology ideas result in new products or processes.
2. Technology strategy involves the use of intellectual property management to cap- ture
financial returns to a much greater degree than general business strategy.
3. Technology strategy involves the creation of new products and services that are sometimes
new to the world, which demand different mechanisms for assessing market needs and
designing products than is the case with general business strategy.
4. Technological change occurs in ways that influence the design of effective strategies and
create business dynamics that are different from those that exist when new technology is not
important.
5. Organisations faced with a great deal of technical change need to be structured, manage
human resources, and design business models in ways that are different from organisations
that are not faced with technical change.
6. Making decisions about technology projects requires the use of different decision-making
tools than is the case with non-technology projects.
7. Technological change opens up opportunities for new, high growth businesses in ways not
possible in other settings.
8. High-technology businesses face many strategic issues, like standards and increasing
returns, that are much rarer with low technology businesses.
In short, technology strategy differs from general business strategies in enough ways to make
a text (and a course) focused on it useful to students
Purpose of the Text
This text will provide you with analytical tools that will help you to become a successful
technology strategist. Using these tools will require you to understand a variety of things,
including the sources of opportunity for technological innovation and how to identify them;
the assessment of customer needs; the product develop- ment process; technology evolution;
new product adoption and diffusion; increasing returns, network effects, and technical
standards; trade secrets, trademarks, copy- rights, patents, and other types of intellectual
property protection; firm capabilities and competitive advantage; management of the
innovation process; and organiza- tional form and structure.
Approach to Technology Strategy
Four observations about the approach to technology strategy taken in this text are important
to make. First, this text is inherently interdisciplinary. Technological inno- vation is a general
management problem whose solution requires an understanding of psychology, economics,
strategy, finance, organization behavior, and marketing. Therefore, the concepts that are
discussed are drawn from a wide variety of fields, including economics, psychology,
sociology, strategic management, finance, and operations management.
Second, this text discusses technology strategy in all types of businesses in all kinds of
industries, from aerospace to environmental consulting to motor vehicles. This means that the
issues that are discussed, and the examples that are given, are not limited to those industries
commonly thought of as “high tech,” like computer software. As a result, the focus is on
issues that transcend industries, like the man- agement of intellectual property and the use of
incentives to motivate people to come up with and implement new ideas.
Third, the text discusses technology strategy in service businesses as well as manufacturing
businesses. Technology strategy for services is different from technol- ogy strategy for
products because services are intangible and cannot be examined before customers purchase
them and are inseparable—they are used in the same place that they are produced.19 As a
result, innovation in services involves greater joint activity between companies and their
customers, has goals that are more diffi- cult to measure, is more difficult to standardize, and
involves outputs that cannot be maintained in inventory.

Coverage of service businesses is important because technological innovation is not

something that only manufacturing firms undertake. In fact, research and development
(R&D) spending in services now accounts for 30 percent of total R&D expenditures.
Moreover, services are a growing part of the economies of most devel- oped countries. In the
United States, for instance, services now account for 68 percent of the gross domestic
product. Furthermore, in some industries, like biotechnol- ogy and software, technological
innovation in services is central to competitive advantage.
Fourth, this text examines technology strategy in the context in which it occurs.
Technological innovation does not occur in a vacuum, but, instead, is affected by the
environment in which it occurs. Therefore, it considers the effects of the industrial,
geographic, political, regulatory, cultural, competitive, and economic context when
discussing different aspects of technology strategy.
Technology Strategy in Start-ups and Large, Established Firms
While technological innovations are often developed and exploited by large, estab- lished
corporations, sometimes people start new companies to create and exploit these innovations.
This discussion takes a different perspective. It looks at technology strategy issues from the
perspective of both the small, new firm and the large, established one. For many aspects of
technology strategy, this only means clarifying that the strategy is the same for all firms,
whether they are large and established or small and new. For example, the demand for
technical standards to permit different companies to link their components together is true
regardless of whether an industry is com- posed primarily of large, established firms, or
small, new ones.
However, for other aspects of technology strategy, this means discussing two approaches to
the same issue. For instance, the way in which large, established com- panies with deep
pockets protect their intellectual property is not the same as that used by cash-poor small,
young businesses.
Where aspects of technology strategy are different for large, established firms and small, new
companies, the text specifically identifies and discusses those differ- ences
Key Points
• Technology strategy is the approach that firms take to obtaining and using tech- nology to
achieve a new competitive advantage or to defend an existing com- petitive advantage against
erosion.
• Technology-strategy helps companies in many industries to perform better.
• Technologystrategyinvolvesavarietyofissues, which can be categorized as those related to
understanding technical change, meeting the needs of customers, capturing the value created
from innovation, and implementing a technology strategy.
KEY TERMS
Appropriate: To capture the returns from investment in innovation and keep them from going
to competitors. Cost per Unit: The amount of money that a company
needs to spend to create one of a product.
Technological Innovation: The use application of tools, materials, processes, and techniques
to come up with new solutions to problems.
Technology: The application of tools, materials, processes, and techniques.
Technology Strategy: The approach of firms to obtain- ing and using technology to achieve a
new competi- tive advantage or to defend an existing competitive advantage against
imitation.

Earning a return on investment: mechanisms for ensuring that value is captured from
innovation
INTRODUCTION
Capturing Value from Innovation
Companies often use technological innovation to enhance their competitive position relative
to their rivals.4 Doing this successfully requires capturing the returns to their investment in
innovation because innovating cannot provide a competitive advan- tage if other companies
derive the benefits from it. Take, for example, the case of Palm Computing. Although the
company developed an innovative personal digital assistant that customers valued a lot, the
company created no barriers to imitation. As a result, competitors copied many of Palm’s
valuable innovations and stole many of its customers.5
So how can you deter imitation of your innovative new products and services? While you can
sometimes use the legal mechanisms, often these mechanisms are not available or not very
effective, and you need to take other approaches, such as exploiting the lead time advantages
discussed in the opening vignette.
This chapter focuses on the nonlegal ways that companies appropriate the returns to
investment in innovation. The first section identifies several key mecha- nisms that you can
use to capture the profits from innovation, including controlling resources, obtaining
architectural control, developing a brand name reputation, moving up the learning curve,
being a first mover, and taking advantage of economies of scale. The second section brings
together the intellectual property issues with the issues discussed earlier in this chapter to
present a model of when to be an imitator, and focus on the control of complementary assets,
and when to be an innovator, and focus on the introduction of new products.
APPROPRIABILITY MECHANISMS
Developing an innovative new product or service often requires you to invest in R&D, which
is costly. This investment makes sense if you can appropriate, or cap- ture, the financial
returns from it.6 However, if you cannot capture those returns, then the investment in
innovation makes little sense at all.
While you can block imitation and thus appropriate the returns to innovation by using the
legal mechanisms, you will often need to use nonlegal barriers to imi- tation. First, legal
barriers to imitation cannot be obtained for many products and services. Take for example,
the case of a superior snowboard binding design. You will be unable to patent that design
unless you can prove that it is novel and nonob- vious, and even then, the patent office might
deny your patent application or refuse to give you broad and enforceable claims. You also
will be unable to protect the design as a trade secret because it could be easily identified
through reverse engi- neering. Therefore, to capture the returns to your investment in
developing this new design, you would need some type of nonlegal barrier to imitation.
Second, most nonlegal barriers to imitation are more effective at deterring inno- vation than
legal barriers.7 As Table 1 shows, managers in high-technology indus- tries believe that
patents deter imitation a little more than a third of the time; whereas complementary assets in
manufacturing and marketing block imitation over 43 percent of the time, and lead time does
so approximately half of the time
Third, legal and nonlegal barriers are not mutually exclusive. You can combine the two
simultaneously, as would occur if you developed a trade secret and moved up the learning
curve, or sequentially, as would occur if you used a patent to protect your new product until
you had established a brand name.
Fourth, the degree of protection provided by legal mechanisms in certain techni- cal areas,
such as genetics and Internet business methods, are uncertain. Changing legislation and
unresolved legal issues can make relying on legal mechanisms to deter imitation in these
areas risky. You might invest heavily in obtaining patent pro- tection only to find that it
doesn’t have the effect that you thought that it would have because legislation or court
decisions subsequently limited the strength of that protection.
Fifth, technological change itself has weakened the value of the legal barriers to imitation in
many high-technology industries. For instance, the creation of technol- ogy to facilitate the
exchange of video and audio content on the Internet, such as that used by video-sharing Web
sites or peer-to-peer music networks, makes the enforce- ment of copyrights on video and
audio content much more difficult. By dramatically increasing the number of people who
violate copyrights, and dramatically reducing the average size of each violation, these
technological changes have essentially reduced the value of lawsuits as a deterrent to
imitation. Violators know that the odds they will get caught and sued is very small.
Because you cannot rely only on legal barriers to imitation, you need to learn how to employ
nonlegal mechanisms to protect your innovations, including controlling key resources,
creating a brand name reputation, establishing architectural control, exploiting of economies
of scale, moving up the learning curve, and exploiting first mover advantages.
Controlling Key Resources
One way to deter imitation and appropriate the returns to your investment in inno- vation is
by obtaining control over the key resources needed to create and sell your product or service.
These key resources will vary across industries and can include such things as manufacturing
facilities (e.g., a billion-dollar semiconduc- tor fab), distribution channels (e.g., shelf space in
a supermarket),9 key inputs (e.g., part of the communication spectrum),10 and the patents,
copyrights, trademarks, and trade secrets. For example, if you run an oil company, you might
want to purchase, or sign long-term contracts with, all of the low-cost sources of oil. This
would create a barrier to imitation by insuring that you had a lower cost of oil than your
competi- tors.11 Similarly, if you run a biotechnology company, you might want to buy the
patents necessary to produce the drug that you are developing from the university where it
was invented to make sure that your competitors cannot get access to this resource.
The use of resource control as a barrier to imitation does not require the key resources to be
natural resources, or even physical resources.12 They could easily be human resources. While
you can’t buy up all of the key human resources needed to create and distribute your product,
you can still obtain control over those resources through contracting. For example, if you run
a biotechnology company, you could sign long-term employment contracts with all of the top
genetic engineers in the world so that you had control over their talent, which is a rare
resource in drug development.13
Controlling resources is most effective at deterring imitation when the key resource is rare
and also a rival good, which keeps it from being used by two com- panies simultaneously.14
If the resource meets these two conditions, you can deter imitation by gaining control over
just a few sources of supply. For example, you can deter imitation in cellular communications
by licensing part of the radio. Establishing a Reputation
A second way that you can appropriate the returns to your investment in innovation is by
developing a reputation for satisfying customers.16 When value of a new prod- uct’s
attributes is unknown, customers often look to the reputation of the seller as an indication of
that value.17 As a result, companies with stronger brand names can attract customers to their
new products more easily than companies with weaker reputations. For example, when IBM
developed its first personal computer, it was able to attract business customers much more
easily than its competitors because of its reputation as a leading computer manufacturer.18
In addition, by creating a strong brand name, you can generate the perception in the minds of
customers that your product or service is better than those offered by your competitors. This
mitigates the tendency for your customers to shift to competi- tors’ products or services, even
if they can obtain those products or services at a lower price. For instance, Apple Computer
has sought to convince customers that its products are better than those of its competitors by
stressing its brand and its reputa- tion for design excellence.
Furthermore, you can use a brand name to cross-sell products into new mar- kets. If your
brand becomes known for something in one area, such as value or excellent engineering, you
can leverage that customer perception in other markets. For example, Microsoft has used its
brand name to sell video games.19 Even though Microsoft had no proven ability in making
video games when it first introduced those games, its brand name led consumers to believe
that its video games would be very good.
Of course, the effectiveness of using reputation to capture the returns to invest- ment in
innovation varies greatly across industries. Reputation matters more in industries that serve
consumers than industries that serve businesses because busi- nesses are less likely to be
swayed by perceptions than by the economics of a transac- tion. Moreover, among industries
that serve consumers, brand names are most effective in industries, such as fashion, in which
customer behavior is more heavily influenced by perceptions, and in industries in which
advertising is more important in affecting buying decisions.
Developing a brand name is expensive. To build one, you have to invest in advertising, which
provides information to customers about the qualities of your new product or service and
persuades them that these qualities make the product or service better than those offered by
competitors. Because the price of develop- ing and running a radio, television, or print
advertisement tends to be fixed, regardless of how many units you produce, advertising is
subject to considerable economies of scale. Therefore, advertising is very expensive on a per
unit basis if you produce and sell very few units of a product, but falls as your volume
increases.
Moreover, it takes a long time to build a reputation though advertising. The nature of the
human mind is such that it can only process a certain amount of infor- mation at a time,
whether that information comes from advertising or some other source. As a result, people do
not absorb much from an ad each time they see it. For advertising to be truly effective,
repeated messages need to be sent over a long period of time. This means that you have to
invest in advertising for a while before you can see any benefits from it.
Obtaining Architectural Control
A third way that you can deter imitation and appropriate the returns to your investment in
innovation is by developing architectural control, or control over the operation and
compatibility of a product or service. Architectural control allows you to determine what
products and services work with your own, making it possible to bias compatibility toward
your own products. Moreover, it allows you to manage the type and pace of improvements to
your technology to ensure that improvements benefit you and not your competitors. For
example, Microsoft has been able to influence the development of computer software to favor
its prod- ucts at the expense of its competitors’ products because it has architectural control
over the dominant interface between computer hardware and software, the Windows
operating system.22
Architectural control also permits you to maximize your profits from the sale of older
versions of products before the introduction of newer ones. Microsoft’s archi- tectural control
in personal computer operating systems allows it to time the intro- duction of new
generations of operating system software to maximize customer upgrades and minimize the
cannibalization of its sales.
When companies have architectural control, they are generally very successful at bundling.
Bundling allows companies to combine old products of known value to customers with new
products of unknown value to increase the odds that customers will adopt the new products.
When a company has architectural control, the effectiveness of a bundling strategy is
enhanced because the old product that is part of the bundle is not only known, it is also
critical to customers. For example, Microsoft used its architec- tural control over the
Windows operating system to push its Web browser for- ward at the expense of Netscape’s
Navigator. By bundling its Web browser with its operating system, Microsoft essentially
forced computer manufacturers to adopt its Web browser as the one that they would offer on
the computers that they sold.23
Exploiting Economies of Scale
Another way to deter imitation and appropriate the returns to your investment in innovation is
by exploiting economies of scale, the reduction in unit costs that occurs as production volume
increases. When economies of scale exist, larger firms have a lower cost of production than
smaller firms, which allows them to deter imitation by keeping their prices low. For example,
the capital intensity of the semiconductor business means that Intel, which is larger than other
firms in the industry, can produce new generations of semiconductors at much lower unit
costs than its competitors.
Larger firms can also deter imitation by investing in so much capacity that entry into the
industry by other firms would be unprofitable. Because volume pro- duction reduces costs
dramatically, new entrants have to enter on a large scale to match the cost structure of
existing competitors. This means that their entry will create a large amount of excess
capacity, dragging down prices, and reducing prof- its.24 Faced with the prospect that entry
will be unprofitable, imitators often choose not to enter.
For example, Monsanto is the world’s largest producer of glycophosate, the active ingredient
in herbicides, like Roundup. Because the production of glycophos- phate requires high levels
of capital investment, production is subject to scale economies. By operating at a very large
scale, Monsanto has driven production costs so low that it is cheaper for companies to source
glycophosate from Monsanto than to produce it on their own, which keeps other companies
from entering the gly- cophosphate business.25
In general, economies of scale provide more of a barrier to imitation for large, established
firms than for small, new ones. The advantages of scale economies go to those companies
that have more scale, which tend not to be the new ones. While new companies can
sometimes be created at a larger size than established competitors, most of the time, the cost,
risk, and difficulty of creating a new company on a large scale means that new companies
usually are smaller than established companies in the businesses that they enter.
Moving Up the Learning Curve
You can deter imitation and appropriate the returns to your investment in innovation by
moving up the learning curve. (A learning curve is a graphical depiction of how well
someone does at something as a function of the number of times that they have done it.26)
Moving up the learning curve helps you to deter imitation for two reasons. First, as Figure 3
indicates, by doing more of something than your competi- tors, you become better at it than
them. (You produce more output at a lower input cost.27) As a result, your competitors
cannot produce a new product with the same efficiency as you, and so choose not to copy
what you are doing.
For example, as semiconductor firms produce more semiconductors, they learn how to solve
problems that lead to poor yields. As a result, their production yields— the proportion of
products that meet performance standards—improve with the vol- ume produced. Because of
the capital intensity and complexity of the process of making semiconductors, the advantage
that innovators have in increasing produc- tion yields makes copying their efforts
uneconomical, making the learning curve an important barrier to imitation in this industry.
Second, as you gain experience making and selling a product, you learn how to create
features that your competitors cannot match. The inability of your competitors to match your
product deters imitation because customers do not find their alterna- tives as appealing as
yours. For example, many consumer electronics firms have learned how to make their
products smaller and more robust to wear-and-tear through the process of producing and
selling the devices. Other companies have been unsuccessful at copying these products
because their lack of experience keeps them from providing similar features. Your ability to
use the learning curve to deter imitation depends on your ability to learn from experience. If
your organization has a lot of employee turnover; poor mechanisms for capturing learning; an
inability to access information that already has been learned; or has poor mechanisms for
transferring knowledge internally, then it will be poor at learning from experience. As a
result, your organization will be unable to use the learning curve to appropriate the returns to
innovation.29
In addition, you can only use the learning curve to appropriate the returns to innovation if
learning is proprietary. If what you have learned seeps out to other companies in your
industry, then your competitors will know whatever you know, equalizing their performance
with yours, even if they have less experience. For instance, many early Internet clothing start-
ups were unable to generate learning curve advantages because later start-ups learned what
those entrants had figured out about how to get people to buy clothing online simply by
observing the efforts of the early entrants. The learning curve is more effective at deterring
imitation in some industries than in others because more of the knowledge that provides value
in those industries is tacit. For example, much of the knowledge about how to make aircraft is
tacit, and held in the brains of aerospace engineers, while most of the knowledge about com-
puter networking is codified in books, articles, and patents.31 As a result, the learning curve
is a stronger deterrent to imitation in aerospace than in computer networking.
As you have probably already figured out, the learning curve is a much better mechanism to
appropriate the returns to investment in innovation for established companies than for new
ones. By definition, any learning curve advantages that exist go to the companies that have
produced more of a product. Therefore, estab- lished companies, which have been operating
in an industry longer than new com- panies, tend to have the learning curve advantages. The
only exception to this occurs when all of the learning resides in the head of individuals, as
might be the case in, say, IT consulting. In that industry, if all of the experienced employees
quit an established consulting company to start their own, the new company might end up
higher on the learning curve than the old one because it would have the more experienced
consultants.
Exploiting a First Mover Advantage (Lead Time)
A sixth way that you can deter imitation and appropriate the returns to your invest- ment in
innovation is by exploiting a first mover advantage, or the advantage that accrues to a
company from being the first to enter a market. Several studies have shown that first movers
often are able to obtain a higher market share32 and earn higher profits than later entrants.33
First Mover Advantages
Being a first mover can help you to appropriate the returns to investment in innova- tion in
several ways. First, by moving early, you are more likely to obtain control over key
resources. For instance, you can acquire assets that are in limited supply,34 such as the most
attractive physical locations, the best distribution channels, or the least expensive sources of
raw materials and other inputs.35 In addition, you can work to reduce your costs of
production by moving up the learning curve unfettered by competition before other firms can
reap the benefits of learning.36 Furthermore, you can tip the industry toward your product
before competitors can catch up, as Apple appears to have done in the music download
business with its early introduc- tion of the iPod.37
Second, by moving first, you can target the best customers in a market. By selling your
products to the innovators and early adopters, you will leave only potential customers who
are negatively disposed to adopting new products, making it hard for imitators to sell their
products successfully.38 Moreover, as a first mover, when you first enter a market, you will
have a monopoly on promoting your products. Therefore, you can advertise without
customers hearing competing messages,39 making your advertising more effective.
Third, as a first mover, you can exploit switching costs, or the cost to customers of changing
suppliers. While moving first doesn’t guarantee that you can create switching costs, it is a
necessary condition. If you are a late mover, then someone else will have the opportunity to
create switching costs that create obstacles for cus- tomers to change from its products to
yours.
Switching costs can take a variety of different forms. Sometimes, they take the form of the
additional expense necessary to purchase a replacement product. These costs can be
particularly high when products are bundled and other products must also be changed if
suppliers are replaced. For example, for a long time, customers were deterred from switching
from Apple to Microsoft as a supplier of graphics soft- ware because changing to Windows-
based software also required changing com- puter hardware.
Other times, switching costs exist because it is costly for customers to learn a new system.
For example, many hospitals use particular intravenous solution deliv- ery systems because
nurses have learned to use those systems, and it is too costly for the hospitals to retrain them
to use different systems. For instance, Amazon.com is the default choice for most customers
who buy books online. Customers switch suppliers only when Amazon.com fails to satisfy
their needs.48 As a result, Amazon.com has to spend less money to keep its customers than
its competitors have to spend to woo them away.
Late Mover Advantages
Despite the advantages listed previously, moving first is not always a good strategy. As Table
2 shows, many late movers have been more successful than early movers. For instance,
Google was a late entrant in Internet search but has done better than Lycos, the first mover.
Similarly, many other first movers have been less successful than their late moving
competitors, including Netscape in the Web browser busi- ness,49 VisiCalc in the spreadsheet
business,50 and Apple in the PDA market.51 In fact, one study showed that first movers have
a high—47 percent—failure rate and achieve only about 10 percent market share.52
Why are late movers sometimes more successful than first movers? The answer is that being
a late mover provides several advantages to companies. First, as a late mover, you benefit
from the ability to free ride on the investments that the first mover makes in creating supply
infrastructure and distribution channels.53 For instance, when DEKA Research developed its
IBOT wheelchair, it had to create its own ball bearings because no company could supply it
with the ones it needed.54 By the time later movers had entered the industry, however, other
com- panies had figured out how to provide these ball bearings, reducing the cost of sourcing
supply.
Second, as a late mover, you can design products that correct the mistakes that the first mover
has made in meeting customer needs.55 First movers often face cus- tomers who do not know
what features they want in new products or services, or what they will pay for them, while
later movers face customers that are better edu- cated about the product category.56 The
lower uncertainty about customer prefer- ences faced by later movers allows them to design
products that better fit customer needs.57
Third, as a late mover, you can leapfrog ahead of the first mover’s technology.58 Often, first
movers cannot adapt to changing supply or demand conditions, and are unable to develop
products based on a new generation of technology because they are locked into earlier
product designs or process technologies.59 As a result, later movers can often develop better
products and production processes than first movers. For example, later movers in personal
computers benefited from the changes in customer preferences to which Osborne Computer,
the industry pio- neer, could not respond because it had already committed to a particular
techno- logical approach that was incompatible with these changes.
Fourth, as a late mover, you can benefit from the investments in R&D that the first mover has
made. Because knowledge spills over from the first mover to later movers, the cost of
innovation is higher than the cost of imitation. As a result, first movers spend more money
than later movers to develop comparable new prod- ucts.61 Therefore, you may be better off
entering a market late, particularly if the technology underlying a new product is costly to
develop and inexpensive to imitate.
Fifth, as a later mover, your entry into the market is often better timed to take advantage of
the development of complementary technology than the first mover’s entry, which sometimes
occurs before the complementary technology has had a chance to develop. For example, to
have hydrogen fuel cell vehicles, someone first needs to figure out how to store compressed
hydrogen in pressurized tanks at fueling stations. A first mover that enters the market before
this refueling problem is resolved would face very slow adoption of its vehicles, and might be
worse off than a later mover that enters after the problem had been solved.
First Mover or Late Mover?
So how do you know if you should be a first mover or a late mover? The answer depends on
your industry. The following dimensions of industry affect this choice:
• First,youarebetteroffbeingafirstmoverinindustriesinwhichproductsand services are
expensive, cannot be valued easily prior to purchase, are durable, and are infrequently
purchased.63 In these industries, once customers have adopted a product, they are not likely
to repurchase it very soon. As a result, first movers are likely to remove the best customers
from the market before later movers have a chance to sell to them.
• Second,youarebetteroffbeingafirstmoverinadvertising-intensiveindus- tries, and industries in
which customers learn very little or very slowly about new products.64 In these industries, it
is very difficult to persuade customers to switch from the first mover’s product to the later
mover’s version. As a result, first movers face a much lower cost to attract customers than
later movers.
• Third,youarebetteroffbeingafirstmoverinindustriesinwhichproducts require distributors to
hold large stocks, additional parts, or complementary products to satisfy the needs of end
users.65 In these industries, later movers often find it difficult to obtain access to distribution
channels because the dis- tributors lack the space to handle the later mover’s product in
addition to the first mover’s.
• Fourth, you are better off being a first mover in industries where network externalities exist.
In these industries, the first mover has the opportunity to build an installed base and tip the
market to its product before later movers have a chance to compete.
Fifth, in industries in which patents are more effective.67 In these industries, first movers
have the chance to develop pioneering patents that later movers cannot get around.
• Sixth, in industries in which scale economies are very large.68 In these industries, moving
first will allow you to grow large and drive your costs down before your competitors can
introduce an alternative product.
Key Points
• Companies need to determination to appropriate the returns to investment-in innovation.
• Non legal mechanisms—controlling key resources, exploiting economies-of scale, moving
up the learning curve, being a first mover, building a brand name reputation, and establishing
architectural control—help companies to do this.
• Non legal barriers to imitation are valuable because legal and non legal barriers are not
mutually exclusive, and legal barriers cannot always be obtained, are of uncertain value in
some fields, are less effective than nonlegal barriers in most industries, and because
technological change has weakened their value in some industries.
• Controlling key resources is most effective when resources are revival goods.
• By exploiting economies of scale, companies can reduce their costs below their
competitors’, and make entry by other firms unprofitable.
• By moving up the learning curve, companies become more efficient at-making products and
develop product features that competitors cannot match.
• Learningcurveadvantagesexistonlyiflearningisproprietaryandfirmsare good at learning.
• By building a reputation, companies can attract customers more easily and keep them from
shifting suppliers; however, brand names are more effective at appropriating the returns to
investment in innovation in industries that serve consumers, particularly those that are
strongly affected by perception.
• Architecturalcontrolallowsfirmstolimitcompatibilityoftheirproductsto companies that are not
a competitive threat, to bias compatibility to their own products, and to control the type and
pace of product improvement.
• Beingafirstmoveroffersavarietyofadvantagesanddisadvantagestofirms; whether it is better to
be a first mover or a later mover depends on which indus- try you are in.
TEECE’S MODEL
Many companies do not succeed with efforts to introduce innovative products because their
competitors imitate those products and offer their versions at a lower cost, taking customers
(and profits) away from the innovators.69 This means that you need to figure out when you
are better off being an innovator and developing new products, and when you are better off
being an imitator and letting your competitors develop them. David Teece, a professor at the
Haas School of Business at the University of California at Berkeley, has developed a model
that you can use to make this decision. The model is based on the idea that imitators are more
successful than innovators when innovations are easy to imitate, a dominant design has

Teece’s Model
Capturing Value from Innovation
When using Teece’s model, decision makers first need to determine if the industry is one in
which patents or trade secrets are effective, then determine if convergence on a dominant
design has occurred, and then if the value chain assets are specialized or generic.
emerged in an industry, and imitators control the key complementary assets in the industry.
We need to define complementary assets to explain Teece’s model. Complementary assets are
upstream or downstream assets that are used to develop, produce, or distribute an innovative
new product or service.70 For example, Merck’s pharmaceutical sales force, which numbers
in the thousands and can reach most doc- tors in the world; Sony’s specialized facilities for
producing high-definition televi- sions; and Bristol Myers Squibb’s process of conducting
drug clinical trials and obtaining FDA approval are all complementary assets because they are
all used along with the innovations themselves to generate and capture value from innovating.
Difficult to Imitate
Innovators usually do not lose out to imitators in industries in which imitation of new
products and services is difficult. Therefore, the first step in applying Teece’s model is to
determine how difficult it is to imitate new products and services in your industry. To do this,
you want to look at the effectiveness of patents and trade secrets in your industry (perhaps by
examining data which shows patent effectiveness in different industries). In industries in
which patents or trade secrets are very effective at deter- ring imitation, being an innovator is
a good idea. The barriers to imitation afforded by patents or trade secrets will allow you to
keep your competitors from copying your new products, adjust the design of your new
products if market feedback suggests that such changes are necessary,71 and build or contract
for the complementary assets needed to exploit the innovations.72 For example, being an
innovator is a good idea in biotechnology because companies can exploit the effectiveness of
drug patents to compete successfully with imitators.

Easy to Imitate, No Dominant Design

However, your strategy needs to be different in industries in which innovations are easy to
imitate. This is the case in industries like consumer electronics, in which patents are very easy
to get around. Here your decision of whether or not to be an innovator depends a lot on
whether or not your industry has converged on a domi- nant design.73 (Remember that a
dominant design is a common form that all prod- ucts or services in an industry take).
If your industry has not yet converged on a dominant design, then it is hard to say whether or
not you should be an innovator. The success of innovators in industries in which imitation is
easy, but no dominant design exists, depends largely on what prod- uct designs are favored by
different niche markets, and what design ultimately becomes dominant. If you come up with
a design that appeals to a valuable niche market, or better yet, a design that ultimately
becomes dominant, then your company can capture the returns to innovation through lead
time or first mover advantages.74 For example, in the computer industry, Sun Microsystems
succeeded as an innovator by developing a product that appealed to the niche market of
computers for network servers in the period before the industry converged on a dominant
design.
Easy to Imitate, Dominant Design
The story is very different if your industry has already converged on a dominant design, but
new products are easily imitated. Under these conditions, you need to control com-
plementary assets in marketing and manufacturing to be successful. Once a dominant design
is in place, companies make products that are very similar to one another. Consequently,
success goes to the firms that control manufacturing and marketing assets because they can
produce products at a lower cost.75
To succeed in industries in which the imitation of new products and services is easy, and
convergence on a dominant design has occurred, innovators need to gain control over
complementary assets quickly. Typically, this requires contracting for manufacturing and
marketing assets because building these assets from scratch usu- ally takes too long, and
because contracting minimizes the cost and risk of capital investment.76 For instance, when
they first began, cellular telephone companies con- tracted with traditional
telecommunications companies to gain access to the tele- phone companies’ switching
networks.77
The success of this strategy depends on whether the complementary assets are generic or
specialized. Complementary assets are generic if they do not need to be modified to fit the
innovation, and specialized if they need to be modified. If the complementary assets are
generic, then an innovator can obtain access to the needed complementary assets through
contracting.78 However, if the complementary assets are specialized, then contracting will
not work. Specialized assets cannot be rede- ployed cheaply to other uses. Therefore, any
investment that a company undertakes to modify a specialized complementary asset to work
with another company’s inno- vation is vulnerable to the second company’s opportunistic
actions to strike a better deal by exploiting the first company’s dependence. This threat of
opportunistic action deters firms from contracting. As a result, when complementary assets
are specialized, companies usually have to own them to use them.
exploit an innovation, new products and services are easy to imitate, and conver- gence on a
dominant design has already occurred, it is better to be an imitator than an innovator. For
example, being an imitator is a better strategy than being an inno- vator in the auto industry in
which patents tend to be relatively ineffective, the dom- inant design of the internal
combustion engine exists, and complementary assets in manufacturing are highly specialized.
In short, being an innovator or an imitator depends on industry conditions. Table 4
summarizes the different conditions under which firms will be more successful if they are
innovators and the conditions under which they will be more successful if they are imitators.
BE AN IMITATOR BE AN INNOVATOR
Patents and trade secrets are not effective. Patents and trade secrets are effective. A dominant
design exists. A dominant design does not exist. Complementary assets are important and
specialised Complementary assets are unimportant and generic
Innovators do not always capture the returns to innovation; these returns some- times go to
imitators who control complementary assets in manufacturing and marketing.
• In industries in which products and services are difficult to imitate, innovators tend to be
successful.
• Inindustriesinwhichnewproductsandservicesareeasytoimitateand dominant designs have not
yet been established, innovators’ success depends on their ability to make their technologies
the dominant designs.
• Inindustriesinwhichnewproductsandservicesareeasytoimitateand dominant designs have
been established, innovators’ success depends on control of complementary assets.
• If complementary assets are generic, then innovators can contract for them.
• If complementary assets are specialised, then contracting is undermined by
problems of opportunistic renegotiation.
• When innovators do not control specialised complementary-assets, intellectual
property protection is weak, and a dominant design exists, being an imitator is a better
strategy than being an innovator.
KEY TERMS
Appropriate: To capture the financial returns from investment in innovation.
Architectural Control: Control over the operation and compatibility of a product or service.
Codified: Written down in drawings or words. Complementary Assets: The assets that are
used in conjunction with an innovative new product or service to capture value.
Economies of Scale: A situation in which unit costs decline as production volume increases.
First Mover Advantage: The advantage that accrues toor service to capture value that do not
need to be modified to fit the innovation.
Learning Curve: A graphical depiction of how well someone does at something as a function
of the number of times that they have done it.
Rival Good: A good that cannot be used by two companies simultaneously.
Specialised Complementary Assets: The assets that
are used in conjunction with an innovative new product or service to capture value that need
to be modified to fit the innovation.
Switching Costs: The cost to customers of changing suppliers.
Understanding Value Creation Strategies in High- Technology Industries The purpose of this
exercise is to develop an understanding of what strategies are effective and ineffective at
capturing value from innovation in a high-technology industry. Pick a company. Using the
information in this chapter on mechanisms to appropriate the returns to investment in
innovation, as well as information on patents, trade secrets, copyrights, and trade- marks,
identify all of the mechanisms that the firm uses to deter imitation. Explain why they use
these mechanisms and not others. Next, indicate whether these barriers to imitation are likely
to change in the future. Explain why or why not. Then, specify whether the barriers to
imitation would be different if the firm were small and new or if it were large and established,
and explain why or why not.
2. Learning Curve This exercise is designed to help you understand the learning curve. (The
learning curve measures the relationship between the cumulative amount produced and the
cost of producing that product.) First, calculate the cumulative number of gigabytes of
DRAM produced by Intel by the end of each year. Next, calculate the cost per gigabyte in
each year. Then, calculate the natural log of the cumulative number of gigabytes of DRAM
produced in each year and the natural log of the cost per giga- byte in each year. Next create a
scatter plot of the natural log of the cost per gigabyte against the natural log of the cumulative
number of gigabytes produced. Does the scatter plot show evidence of a learning curve? Why
or why not? What does this scatter plot tell you about Intel’s ability to appropriate the returns
to its investment in innovation in DRAM? Does Intel have a learning curve advantage?
First Mover Advantage The purpose of this exercise is to help you understand when being a
first mover is an advantage, and when it is not.
explain why being a first mover was an advantage. For the first mover that did not remain a
market leader, explain why being a first mover was not an advantage.

The importance of technical standards and collaboration in high tech industries

INTRODUCTION
Because many industries converge on technical standards, understanding their role in
business is important to the accurate formulation of technology strategy. For instance, you
need to understand how technical standards affect customer adoption of new products. You
may need to fight a standard-setting battle. And you certainly will need to adopt strategies
that are appropriate to the outcome of the standard-setting process to make your business
successful.
This chapter discusses the creation and exploitation of technical standards. The first section
defines a technical standard, and explains how standards develop, why they aren’t always the
best technology, and how their formation relates to customer adoption. The second section
examines standard-setting battles. It explains how to win a standards battle, and what to do if
you lose one. It also explains why technical
Technical Standards
standards shift the locus of competition from firms to systems of firms and identifies the way
that the shift affects strategy. The final section compares open and closed technical standards
and explains how technology strategy differs depending on the openness of the industry
standard.
TECHNICAL STANDARD
There is the concept of a dominant design, or form of a product on which all producers
converge. A related, but broader, concept is that of technical standards, which are
specifications to ensure that different components of the same system are compatible For
example, the electrical plug is designed to specifications that ensure that it will work in all
electrical outlets.
Technical standards are important in a wide variety of industries, from comput- ers to
transportation to telecommunications, because they permit independent com- panies to
produce different components for the same product. They exist when components made by
one company need to be used with components made by another because companies cannot
ensure that components made by others will be compatible, unless they are made to conform
to a standard. For instance, in comput- ers, technical standards permit hardware, printers,
software, memory chips, and peripheral devices that are produced by different companies to
all work together.3 As Figure 2 highlights, technical standards in measurement are
particularly important.
Technical standards are particularly important to start-up firms. While large, established
companies can make all of the components in a product and avoid prob- lems with the lack of
established technical standards, start-ups usually lack the capi- tal to do this. Because start-
ups usually cannot produce all of the components in a product, they need technical standards
to ensure that their products are compatible with complementary products.
The Development of Technical Standards and Dominant Designs
Research has shown that technical standards and dominant designs develop in a variety of
ways. Sometimes, chance occurrence leads them to emerge. For example, some researchers
argue that the all-steel body in automobiles emerged as a domi- nant design just because
aluminum was relatively costly in comparison to steel in the 1920s.4
The emergence of a technical standard or dominant design also depends, at least in part, on
the nature of technology. Some technical solutions are better than others, and the best
technical solution sometimes emerges.5 For example, nylon and poly- ester emerged as the
dominant designs in synthetic fiber because they have the chemical composition to produce
long fibers, which is useful in making fabric.6 Similarly, suspension-preheating became the
dominant design in cement manufac- ture because it was the most fuel-efficient alternative.7
Sometimes governments impose technical standards and dominant designs.8 For example, the
European Union adopted the GSM wireless telephony standard to ensure that people in all the
countries of the Union had compatible mobile phones.
Other times, the government does not impose a technical standard or a domi- nant design, but
influences its adoption nonetheless. Typically, this happens when the government serves as an
early adopter of a product and creates a large installed base—the number of users of a
product at a point in time—for a particular variant.9 For example, the U.S. government could
make a particular type of fuel cell vehicle the technical standard by purchasing those vehicles
for the military, postal service, and other government agencies.
Governments often get involved in setting technical standards or dominant designs when
companies have little incentive to adopt a new technology. Take, for example, the case of
high-definition television. Broadcasters have little incentive to switch to the new technology
because it is unlikely that the audience for televi- sion, and hence advertising revenues, will
increase as a result.10 And television users do not want to adopt the new technology until the
price of high-definition televisions comes close to that of traditional televisions, and
programs are pro- duced in high definition. Because the market has no mechanism to spur a
shift to high-definition television, government mandate is the only way to put the new
technology in place.11
Industry trade associations or standard-setting organizations sometimes create technical
standards and dominant designs, usually through votes of committee mem- bers that are
selected by their employers to represent them on working groups. For example, an
international organization called the International Telecommunication Union.
Companies sometimes cooperate with other firms to create a technical stan- dard or dominant
design.14 The logic of this approach is that if companies cooper- ate with others to jointly
develop a common standard, they will attract customers more quickly. If the cooperating
companies are large enough, other companies will often go along with their approach, and the
common standard will be adopted. For instance, Philips and Sony worked together to develop
a standard for compact disk technology that was favorable to both of them; the size of the two
companies led other companies to go along, rather than pursue a rival standard, and
convinced the music labels to provide content that adhered to the Philips-Sony standard.
However, many firms, even large firms, fail at strategic efforts to make their tech- nology the
industry standard, as occurred when IBM backed a standard for local area networking, but
lost out to Ethernet. This raises the question: Is investing in efforts to establish and control a
technical standard worthwhile? Given the significant chance that you will fail at this effort,
investing a lot of money in trying to do so might not be a good strategy. You might be better
off simply accepting the evolution of a technical standard and adopting a strategy that best
fits it.
Not Always the Best Technology
As you can probably tell from the description of the different ways that technical standards
develop, the technology that becomes the industry standard is not always the “best”
technology from the perspective of functionality.17 Often, it is technically inferior to the
other alternatives available.
The “best” technology doesn’t always become the industry standard for many reasons,
including government mandate, the strategic actions of firms, agreement by standard-setting
bodies, or social support for a particular alternative.19 For example, in automobiles, the
internal combustion engine emerged as the dominant design, rather than the electric battery
engine, which many observers thought was techni- cally superior, in part because the electric
battery engine needed recharging, which made it less popular for touring, a major social use
of the automobile at the begin- ning of the twentieth century.20
Nevertheless, the most common way that industries converge on technically inferior
alternatives is through the natural workings of the market.21 If a technology achieves a large
installed base, later adopters will tend to choose this technology even if it is inferior to
alternatives that emerge later.
The QWERTY typewriter keyboard (named for the order of letters on the top line) is a good
example. The QWERTY keyboard was designed initially to slow typ- ing, which was
important with the jamming-prone typewriters of the 1880s. Once this technical problem was
resolved, however, typing performance could be enhanced by the adoption of different
keyboard designs. In fact, one of these key- boards, patented by Dvorak and Dealey in 1932,
was so good that the costs of retrain- ing typists to use it could be amortized in 10 days. Yet,
despite the performance advantages of the alternative keyboard designs, they have never been
adopted in large numbers because the installed base of QWERTY keyboards has always been
too large to make widespread switching possible.
Technical Standards and Customer Adoption
The emergence of a technical standard is important to attract customers in large vol- ume.
Customers are risk averse and do not want to adopt products that might be abandoned or
discontinued because the products are incompatible with a technology that becomes the
industry standard.23 As a result, customers are often slow to adopt new products until a
technical standard is in place.24 For instance, adoption of high- definition DVDs has been
slow because their producers have been unable to agree upon a common standard, with two
groups battling over competing Blu-ray and HD-DVD alternatives.
Technical standards are particularly important to the customer adoption deci- sion when
products are systemic. Because systemic products are composed of com- ponents that need to
be used with other components, having a common standard is important in ensuring that
components produced by different companies can be used together. For example, the
adoption of digital cameras did not take off until technical standards for the different camera
components had been established because these cameras are made up of an image gathering
device, a processing device, a storage device, and a reproduction device, all of which are
produced by dif- ferent companies.
Technical standards also enhance customer adoption by making many prod- ucts more
functional.25 For example, imagine how difficult it would be to use a telephone if the people
you wanted to call had a telephone that operated on a dif- ferent technical standard from
yours. You wouldn’t be able to speak to them. And if there were multiple telephone standards,
you would probably get pretty frustrated because ou would only be able to call a small
portion of the people that you wanted to reach.
Standardisation also enhances customer adoption because it facilitates the creation of
complementary products.26 The existence of a technical standard permits companies to make
products that work with those developed by other companies, increasing the number of
products available to customers. Take Web sites, for example. Because all Web sites are
created in accordance with a common technical standard, consumers have Web sites that are
produced by millions, if not billions, of entities when they browse on their computers. The
greater availability of Web sites makes Web surfing a more useful, and enjoyable, activity.
Key Points
• In some industries, products must conform-to technical standard-or specifications that
ensure that different components are compatible.
• Standards are of particular importance to start-up firms, which generally cannot produce all
of the components needed to make a product.
• Technical standards develop because of chance occurrence, because one tech- nology is
superior to others, because the installed base of one technology is far ahead of the installed
base of others, because companies take strategic action, because industry trade associations or
standard-setting bodies establish them, and because governments mandate them.
• Industriessometimesconvergeonstandardsthataretechnicallyinferiorto other alternatives.
• Technicalstandardsinfluencecustomeradoptionbecausecustomersdesire compatibility,
particularly for systemic products.
STANDARDS BATTLES
Where technical standards exist, your company will have a tremendous advantage and the
potential to earn high profits if your proprietary technology is the industry standard. There are
several reasons why. Products that conform to the technical stan- dard can be sold at a
premium given their greater value to customers. These higher prices create higher profit
margins and give you the opportunity to generate out- sized financial returns. Moreover, if
your technology becomes the industry standard, your suppliers will have to adhere to it,
giving you leverage over them, and allowing you to capture a large portion of industry
profits. Furthermore, your competitors will have to adopt your technology, which puts them
at a competitive disadvantage.
Because gaining control over a standard is valuable to companies, battles for technical
standards have long been a part of technology strategy. In the nineteenth century, for instance,
railroads fought over whether the technical standard for rail- way gauges should be 4 feet 8.5
inches wide or 5 feet wide; and in the 1940s, CBS and NBC fought over the technical
standard for color televisions
How to Win a Standards Battle
So what can you do to win a standards battle? First, you can gain the support of the producers
of complementary products. If all other things are equal, one technical standard will be
preferred to another if more complementary products are available for that standard. Why?
Because the availability of complementary products makes a given product more valuable to
customers.
In the high-definition DVD war, for example, the Blu-ray faction, led by Sony, and the HD-
DVD faction, led by Toshiba, are each working to gain the support of the movie studios,
which provide content for their version of the high definition DVD player (see Figure 3).
Each faction offers different advantages to those comple- mentors, which it stresses to
convince them to support its standard. Blu-ray offers greater recording capacity and
protection against illegal copying, while HD-DVD offers a manufacturing process that
requires few changes from conventional DVDs
Second, you can make your product backward compatible so that it works with a previous
generation of products. (If products are not backward compatible, they won’t work with
previous generations of technology, as is the case with MP3 players and CDs.) For example,
the backers of both competing standards for high- definition DVDs, Blu-ray, and HD-DVD,
have made their products compatible with standard DVD players.30 Backward compatibility
helps you win a standards battle by facilitating customer adoption of your new product. As
was mentioned earlier in the chapter, customers often do not adopt a new technology product
because they are afraid that the product will be useless if the new technology does not
become the industry standard. By making your product backward compatible, you reduce the
cost to customers of choosing the wrong technology—they can always use it with the
previous generation of technology—and enhance their will- ingness to buy your new product.
However, making a new product backward compatible is expensive, and there- fore, not
always worthwhile. It also reduces the incentive for the producers of com- plementary
products to make their products unique. If complementary products are not unique to your
product, then customers will derive less benefit from switching to your new product, and will
be less likely to do so.31
Furthermore, making your product backward compatible might undermine its unique
advantages over other products on the market. For instance, Intel made its 486 processor
using complex instruction set computer (CISC) architecture as opposed to reduced instruction
set computer (RISC) architecture so that it would be backward compatible with earlier
generations of personal computers. While this approach made its customers more comfortable
adopting the new processor, it also meant that Intel could not take advantage of the greater
scalability, faster product development time, and better performance of the RISC processor.32
As a result, the 486 processor offered less of an advantage over rival processors than it could
have.
Third, you can manage customer and competitor expectations.33 Customers are influenced
not just by reality but by their perceptions about products, their installed base, and the
availability of complementary products. Because a small advantage in the early life of a
market can lead customers to tip to a particular product, you can often win a standards battle
by changing customer perceptions through the manage- ment of information.
You can manage customer expectations by making pronouncements about the size of your
installed base. Because potential customers favor products with larger installed base,
companies frequently try to convince customers that they have a larger market share than
their competitors. For example, in the early 1990s, Sega and Nintendo each claimed they
controlled over 60 percent of the video game market, knowing that future customer adoptions
would go dispro- portionately to the product that customers perceived as dominant.
You can also manage customer and competitor expectations by making prod- uct
preannouncements, or announcements of product release dates before the actual release
occurs. Preannouncements help to manage expectations in several ways:
• First,theyhelpconvincecompetitorsthattheyaresofarbehindtheannouncing firm that they
should not launch a competing product.35 For example, Sony widely publicized its
investment in the development of the PlayStation video game product to convince other
companies not to launch competing products.36
• Second,theyleadcustomerstobelievethattheannouncingcompany’sproduct will be better than
its competitors’, which causes them to delay their purchase of competing products and wait
for the announcing company’s product to be released.37
• Third,theysignalthattheannouncer’sproductwillbeonthemarketbefore competitors’ products,
and so will become the industry standard because of its greater installed base.38 For example,
the preannouncement of the DIVX standard slowed the rate of adoption of DVD technology,
enhancing the prob- ability that DIVX would become the industry standard in digital video
recorders.39
• Fourth,theysignaltheannouncer’sintentionstosuppliersordistributorswith whom it would like
to form agreements40 and encourages other companies to produce complementary
products.41 For example, Microsoft used product pre- announcements to signal that it would
successfully enter the Web browser and video game businesses as a way to encourage
suppliers and distributors to work with it.42
However, preannouncements are not without costs. They provide information to competitors,
who might respond strategically by accelerating their development of competing products.
Moreover, they motivate customers to delay purchases of your company’s product until the
newer, and presumably better, versions have been released.43 Furthermore,
preannouncements are anticompetitive and can provoke antitrust action if your firm is large
and has a dominant market posi- tion.44 Finally, preannouncing, which can involve making
statements that do not come true, undermines the trust that your customers have in the
statements that you make.45
Despite these costs, preannouncements are a very common part of technology strategy in
industries in which customers are biased toward the adoption of products with the largest
installed base. For instance, one research study showed that software firms engage in
preannouncements almost half the time that they release products.46
A final way that companies manage customer expectations is through criticism of their
competitors’ technology.47 By criticizing your competitors’ products, you can convince
customers not to adopt their products and to adopt yours instead. Perhaps the most famous
example of an effort to criticize competitors’ products was Thomas Edison’s electrocution of
a dog, using his rival, George Westinghouse’s, electrical standard. Edison’s goal was to
persuade customers that his electricity standard was superior to Westinghouse’s, and his
gruesome act did just that.

Technical Standards
While all of the tactics described previously will help you to win a standards bat- tle,
companies cannot always predict or control the emergence of a standard, as the earlier part of
the chapter explained. Therefore, your strategy should hedge against the loss of a standards
battle. For example, you will be better off if you can make your technology work equally well
with multiple standards so that your firm will not be greatly disadvantaged if one standard
emerges rather than another.
What If You Lose?
Suppose you fight and lose a standards battle. What options are open to you?48 If the
industry only has room for one standard, then you might have to exit the market. Quitting will
be the best choice if your company would be at too much of a competi- tive disadvantage to
serve that market effectively.49 This is what Circuit City was forced to do when it lost the
digital video recorder standards battle.
Another option is to give up the fight, conform to the standard, and try to com- pete on some
other dimension, like cost, service, or features. This is what Amdahl and Hitachi did when
they lost the mainframe computer standards battle to IBM. The advantage of this strategy is
that it gives you the chance to come up with a new technology in the future that leapfrogs the
standard holder’s technology. For exam- ple, Apple first conformed to the MP3 player
standard and then, having come up with a better design, introduced a new standard with the
iPod.
However, pulling off this strategy isn’t easy. You will need to change your tech- nology to
conform to the industry standard and will have to abandon all of the capi- tal, reputation, and
learning that you have invested in it.50 As a result, your company may suffer significant
losses. For example, Rockwell and Lucent were badly dam- aged in their loss to 3Com in the
battle over the 56K modem standard.
If your industry doesn’t have an all-or-nothing standard, then you face a dif- ferent strategic
choice. Do you conform to the technical standards that have emerged, or do you try to sell
products that don’t conform to industry standards (see Figure 4)?
You might not conform to the standard and focus on a niche where you can use your
technology to meet the needs of a market segment better than the alternatives that conform to
the technical standard.51 For example, Apple Computer was able to survive for many years
without conforming to the PC standard by providing com- puters tailored to the needs of the
desktop publishing segment of the personal computer market (graphics-oriented
applications). Ultimately, however, it had to conform to the Intel standard.
Moreover, adhering to the technical standard will hinder your ability to differen- tiate your
products from those of your competitors. The aspects of your technology that conform to the
industry standard cannot be a source of competitive advantage because they must be the same
as those offered by your competitors. If you can’t be the low-cost producer, then customers
will have no reason to select your product. For example, many personal computer
manufacturers who adopted the Wintel standard lost out to Dell and Compaq because all of
the companies that adhered to the PC standard offered virtually identical products, and Dell
and Compaq were the low- cost producers.52
On the other hand, by conforming to industry standards, you will have many more customers
to target. And you will find selling your products to be easier because customers prefer
products that conform to the standard.53
Moreover, it is often difficult to focus on a niche over a long period of time because your
competitors will have the advantage of scale economies. This is why Apple finally gave in
and adopted the industry standard, letting its machines run Windows software. Over time it
became difficult for Apple to support a different standard than Microsoft because the latter’s
much larger installed base (1 billion versus 30 million) meant that it took Microsoft only
eight weeks to break even on the $1 billion cost of developing a new operating system, as
opposed to four years for Apple. Apple also could not benefit from the creation of
complementary software for its operating system because software developers needed to
write separate software for the Macintosh, and had less incentive to write for the small
installed base. Therefore, Apple earned lower profits than Microsoft on its operating system,
and had a less desirable product in terms of software availability.
Furthermore, customers put pressure on companies to adopt the dominant industry standard if
they cannot continue to offer the advantages that make differen- tiation valuable. For
instance, Sun was pushed to abandon its more powerful and more expensive microchips, and
adopt the Intel standard, when the company could not provide its network server customers
enough benefits to offset the lack of com- patibility and higher cost of its chips.55
Given the pros and cons of conforming to the industry standard, should you do it, or should
you focus on a niche? The answer to this question depends on the stage of the product life
cycle. If your market is young, and most of the customers are inno- vators or early adopters,
then you should differentiate your product from existing technical standards. At this point in
the life cycle, so little of the market has adopted the technology that convergence on a single
standard is unlikely, especially if you can offer a viable alternative. Given the advantages of
not adhering to the standard described previously, the balance falls in favor of differentiating
your product.
However, if the market is already mature, and most of the users are from the early or late
majority, then you should make your product compatible with existing technical standards. At
this point in the life cycle, so much of the market has adopted the technology that
convergence on a single standard is quite likely. Given the advantages of adhering to the
standard described previously, the balance falls in favor of conforming Defending a
Technology Standard
If your proprietary technology becomes an industry standard, then you’ll want to defend this
privileged position against the efforts of other firms to dislodge you. So how should you do
that? The answer lies in making it difficult for customers to switch to the products and
services offered by your competitors. For example, Microsoft has made it difficult for
customers to switch to competitive products by maintaining a very wide range of products
that work with the Windows operating system, even though some of those products are not
very profitable for the company. Until recently, the range of software that was compatible
with Windows locked many users into this system because there were one or two programs
that they used—niche software for games or hobbies or custom software for their industry—
that did not work with the Apple OS X operating system. Consequently, they could not switch
over to Apple computers despite the latter’s better design, superior operating sys- tem, and
lower susceptibility to viruses.
To increase your customers’ switching costs and reduce their likelihood of changing
suppliers, you can do the following:
• Makeyourproductsmoreattractivetocustomersthancompetitors’products by making the
products more functional, by adding features, or by making peripheral components available.
• Signlong-termcontractswiththeproducersofcomplementaryproductsorser- vices to ensure the
availability of complements, which enhances the value to customers of the products that you
provide.
• Makefuturegenerationsofyourproductbackwardcompatiblewithprevious generations so that
customers can easily upgrade their products (as Microsoft has done with multiple generations
of Windows software).
• Makeyourproductsorservicesincompatiblewiththealternativesofferedby your competitors.58
For example, AOL refused to allow its instant messaging service to connect to those provided
by other companies, which gave customers an incentive to remain in the AOL network.59
Technical Standards and Competition Between Systems
Technical standards often change the nature of competition from that between firms to that
between systems. When more than one technical standard exists in an industry, some products
are designed to be compatible with other products, and together they make up a technical
system. Other products, designed not to be compatible with those products, but designed to
be compatible with each other, make up a different techni- cal system. The groups of
companies that work together on the first system compete with the groups of companies that
work together on the second system. For instance, not all MP3 players are compatible with all
compression formats, creating several different MP3 systems. Thus, competition in this
business occurs at the level of the system, with Apple’s iPod/iTune system competing against
other systems that provide music players and Web sites for downloading music.
When multiple different technical systems compete in an industry, you need to decide
whether to make your products conform to all, or only some, of them. For example, until very
recently, the Apple and Microsoft computer operating systems were not compatible, so the
providers of applications software had to decide whether to offer two versions of their
products or just align with one of the systems.
If you chose to conform to only one technical standard, then you need to decide which system
is the best for your company to join. Moreover, you will have to design your products to be
compatible with the other products in that system, while making them incompatible with
products outside of the system.
Key Points
• Companiesoftenbattletocontroltechnicalstandardsbygainingthesupportof complementary
products, having a killer application, making their products backward compatible, and
managing customer and competitor expectations.
• Ifyouloseastandardsbattle,youcanexitthemarket,conformtothestandard and compete on
another dimension, or focus on a niche and meet its needs without conforming to the
standard.
• Ifyourtechnologybecomestheindustrystandard,thenyouneedtodefendit against the efforts of
other firms to dislodge it by keeping customer switching costs high.
• Technicalstandardsoftenleadtocompetitionbetweensystemsofcompanies, rather than between
individual organizations.
Open Versus Closed Standards
Companies need to decide whether to create an open standard—a standard for which
specifications are known by other companies—or a closed standard—a sys- tem for which
those specifications are not known.
There are many advantages to having an open standard. First, an open standard will make it
easier for other companies to understand how your products work and, therefore, how to
build complementary products.60 For example, JVC’s decision to establish an open standard
encouraged movie studios to provide more video content on VHS than on Betamax, and led
the video recorder market to tip to the VHS standard.61
In fact, by attracting the providers of complementary products, an open standard can create a
positive feedback loop that benefits a company. The more complemen- tary products that are
available for a product, the more customers are interested in buying it; and the more
customers that are interested in buying a product, the more companies are interested in
providing complementary products for it.
Take, for example, the case of the open-source software provider Linux, which provides
software that any user can license for free in return for licensing any addi- tions that they
make to the software at no charge. As Figure 5 shows, the more people that used Linux
software, the more software applications were created for it; and the more software
applications that were created for Linux, the more people used it.62
Second, open standards encourage other companies, which might develop supe- rior
alternatives, to adopt your technology, mitigating the threat of competition.63 For example,
Sun Microsystems brought out minicomputers that used the UNIX operating system and
adopted an open approach to its software, publishing its spec- ifications and interface
protocols.64 This open system made it possible for other com- panies to write software for
Sun’s platform, which reduced their incentive to develop their own alternatives.65
Third, open standards allow you to generate a large installed base very quickly by attracting
more users than a single company can support.66 For example, Microsoft generated a much
larger installed base for its DOS operating system than Apple did for
While an open standard benefits companies, it also has risks. By opening up your technology
to other companies, you run the risk of losing control over your technology and,
consequently, sales.68 For example, Palm used open-source coding for its PDAs to increase
adoption and to encourage the development of a technical standard. However, this approach
made Palm vulnerable to competitors who could produce the PDA hardware at a lower cost
than Palm.
By using an open standard, you also incur the risk that licensees might change your
technology in a way that makes it unnecessary for them to pay you royalties. Thus, you might
make less money off of your technology than if you had created a closed standard and never
licensed it to others. For example, AMD was able to get out of paying royalties on Intel’s K5
microprocessors after having made modifica- tions to Intel’s initial technology, undermining
Intel’s revenue stream from that technology.69
Furthermore, an open standard demonstrates to your competitors how your technology works,
making it easier for them to imitate it. Because your competitors will be more likely to
leapfrog your technology if they can imitate it, having an open standard could undermine
your competitive advantage.
Two different types of open standards exist, each of which creates different opportunities and
problems for managers and entrepreneurs. Some open standards are proprietary, like
Microsoft Windows. The standard is open because Microsoft shares information about the
operating system so that other companies can provide complementary products. However, the
Windows standard is owned and controlled by Microsoft. Other open standards are
nonproprietary, like the Linux operating sys- tem, which is not owned or controlled by a
single company.
Proprietary and nonproprietary open standards both have their advantages and disadvantages.
Nonproprietary open standards benefit companies by making their products better for
customers. First, they are neutral, which means that customers
More Users
More More Contributors Applications
More Developers
don’t have to accept the strategic direction of the owner of the standard, or its power over the
development of their products. Second, they do not require customers to pay royalties, thus
lowering costs. Third, they are easier to use and customize because more information about
them is provided to users.
However, nonproprietary open standards create several strategic problems for providers.
First, they do not allow companies to control quality or the development of the standard in a
way that benefits their products, as Microsoft has done with the Windows operating
system.71 Second, they do not provide strong incentives for com- panies to support their
customers.72 Third, they open up markets to competition, which can undermine a provider’s
competitive position, as occurred when computer operating systems switched from IBM to
Unix.
Opensystemsarevaluablebecausetheyfacilitatethecreationofcomplemen- tary products, create
a positive feedback effect, permit the rapid creation of a large installed base, and discourage
other companies from competing against your technology.
• Opensystemsriskthelossofcontrolovertechnology,whichcouldleadtoa decline in sales.
• Twotypesofopensystemsexist;some,liketheMicrosoftoperatingsystem,are proprietary, while
others, like the Linux operating system, are nonproprietary.
• Nonproprietaryopenstandardshavetheadvantageofbeingmoreattractiveto customers; they are
neutral, don’t require royalty payments, and are easier for customers to use.
• Proprietaryopenstandardshelpcompaniesbyreducingcompetition,bygiving them control over
the development of technology, and by providing a strong incentive to support the system
KEY TERMS
Backward Compatibility: Making a product or service work with previous generations of
products or services.
Installed Base: The number of users of a product at a
Open Standard: standard whose specifications are known by other companies.
Preannouncements: The announcements of product release dates before the actual release
occurs.
Technical Standards: The specifications that are necessary to make sure that the components
of a technical system are compatible with each other.
PUTTING IDEAS INTO PRACTICE
1. Identifying Technical Standards The purpose of this exercise is to identify all of the
technical stan- dards that affect a laptop computer. Begin by mak- ing a list of all of the
components of a laptop computer with wireless capability. Then, identify if there is a
technical standard that governs each of these components. (If you know the name of the
specific technical standard, that’s great. Write it.
2. How Standards Emerge Identify three technical standards. Investigate how those standards
came into existence. (They don’t all have to have come into existence the same way.) Explain
why the mechanisms that you identified accounted for the emergence of the standards

Collaboration in high tech industries

CONTRACTUAL AND VERTICALLY INTEGRATED MODES OF DOING BUSINESS
As a technology entrepreneur or manager, you need to think about whether your company’s
value chain will be vertically integrated or contractual. Vertically inte- grated means that your
company owns all of the parts of the value chain (e.g., sup- ply, manufacturing, marketing,
distribution, etc. . .), while contractual means that your company signs agreements with
independent firms to provide part of the value chain, as occurs with licensing, joint ventures,
strategic alliances, contract manufac- turing, and outsourcing.
Vertically integrated and contractual modes of doing business each have advan- tages and
disadvantages. While vertical integration gives you greater control, it also imposes greater
coordination costs and demands the smooth utilization of assets across stages of the value
chain.5 Contracting reduces costs but exposes you to the risks that come from having limited
control over the activities of your contracting partners.
When choosing whether to use a vertically integrated or contractual mode of business, you
need to look at the advantages and disadvantages of each. For exam- ple, you might compare
the costs and benefits of licensing technology from another firm with acquiring that company
to obtain its technology.
Although the balance between vertical integration and contracting varies by industry,
companies in almost all industries use both modes for the different parts of the value chain,
from product development to production to distribution. As a result, competitors in the same
industry often choose very different modes of doing busi- ness, making the way that a
company configures its value chain an important aspect of technology strategy. For instance,
Intel conducts most of its research outside the organization by funding university researchers;
IBM does most of its research in- house. This difference leads the two companies to compete,
at least in part, on the basis of which approach to research is more effective in making
different kinds of semiconductors.6
304
Discrete and Systemic Technologies
Collaboration Strategies
So how should you determine what the governance structure of your business should be? It
should depend, in large part, on two dimensions of your core technol- ogy: discreteness and
tacitness. Contractual modes of exploitation are more effec- tive when technologies are
discrete (like a drug), than when technologies are part of a system (like computer software)
because discrete technologies can be used alone, while systemic technologies need to be used
with complementary technologies (see Figure 1). When technologies are part of a system, the
development of products and services requires coordination of the different components of
the system so that complementary changes can be made to them. Vertical integration
facilitates this coordination because it allows a single firm to decide how to make these
changes, rather than requiring different companies to come to an agreement that satisfies all
sides.
If the value from the joint sale of the different components that make up a sys- temic product
is evenly distributed across the components, you sometimes can exploit a systemic
technology through a contractual approach. However, if the value generated from the joint
sale of the components is unevenly distributed, you usually cannot. The companies that own
the components from which most of the value is created will have a strong incentive to
exploit the technology, while the companies that own the other components will not. For
example, when Microsoft initially sought to enter the video game business, it tried to
convince personal computer man- ufacturers, like Dell, to make consoles to run its software.
However, because video game consoles are typically sold at cost, while profit is made from
selling the games themselves, Dell and other computer makers had little interest in working
with Microsoft to develop video games.7
Vertical integration is particularly important if a technology is systemic and tech- nical
standards have not been established.8 For example, 30 years ago, the companies that
produced applications software also produced systems software because techni- cal standards
ensuring the compatibility of applications and system software did not
Verticalintegrationoccurswhenacompanyownsallpartsofthevaluechain; contracting occurs
when a company signs an agreement with an independent firm to provide part of the value
chain.
KEY POINTS
• Contractualformsofdoingbusinessarecomposedofstrategicalliances,tech- nology licensing,
outsourcing, contract manufacturing, and joint ventures.
• Thenatureoftechnologyaffectsthechoicebetweenverticalintegrationand contracting because
systemic technologies and tacit knowledge are best exploited through vertically integrated
companies.
ALLIANCES, LICENSING, JOINT VENTURES, CONTRACT MANUFACTURING, AND
OUTSOURCING
If you decide to use a contractual form of governance, then you have a number of more
specific choices to make: You have to decide whether to use strategic alliances, licensing,
joint ventures, contract manufacturing, or outsourcing.
Strategic Alliances
A strategic alliance is a relationship between two firms to work together to achieve a common
business goal. It can be formal and specified in a written contract or informal and the result of
an unwritten agreement. When alliances are made between firms at different stages of the
value chain, they are called vertical alliances. For example, Millennium Pharmaceuticals has
a strategic alliance with Bayer Pharmaceuticals in which Millennium develops promising
drug targets and Bayer obtains FDA approval for them, and manufactures and markets the
drugs.18 When alliances are made between firms at the same stage in the value chain, they
are called horizontal alliances. The part- nership between Kodak and Hewlett-Packard to
develop photographic printers is an example of a horizontal alliance.
Advantages and Disadvantages of Strategic Alliances
So what makes strategic alliances so popular? They offer eight advantages to tech- nology
firms:
• First,strategicalliancespermitcompaniestospecializeinthecapabilitiesinwhich they have a
comparative advantage. For example, the skills needed to develop drugs are very different
from those needed to manufacture them because research and development, which seeks to
show the efficacy of drugs, is quasi-academic, and manufacturing, which seeks to produce
replications that meet regulatory stan- dards, is production-oriented. To manufacture drugs,
companies need to hire peo- ple with different skills and attitudes from the ones that they
need to develop those drugs. Consequently, many biotechnology firms form strategic
alliances with pharmaceutical firms and focus on their comparative advantage in R&D, while
the
pharmaceutical firms concentrate on their comparative advantage in obtaining
regulatory approval, manufacturing, and marketing.20
• Second,strategicalliancesreducetheexpenseofbuildingthebusiness’svalue
chain by making it possible to use another company’s assets at marginal cost. This cost
reduction is particularly important to start-up firms, which lack cash flow from existing
activities and so face a high cost of capital. (Because lending money to, or buying shares in,
new businesses is riskier than lending money to, or buying shares in, established companies,
new companies must pay a
risk premium—a higher interest rate on a loan or more shares in an equity investment—to
obtain the same amount of money from financial markets as established firms.21) For
instance, Imax Inc., a small company in Ohio that is developing fuel cells for the army, has
formed an alliance with W. L. Gore & Associates to avoid incurring the cost of creating its
own the fuel cell membrane from scratch.22
• Third,strategicalliancesallowcompaniestodevelopnewcompetitiveadvan- tages, such as
economies of scale from increased production volume, lead time from the use of other
companies’ assets, and improvement on the learning curve by sourcing knowledge from other
firms.23 For example, Sony partnered with Samsung to make flat-panel television sets to
move up the learning curve in liquid crystal display technology,24 while Cisco partnered with
Microsoft to develop a new networking product in 18 months, instead of the four years it
would have taken to do it alone.25
• Fourth,strategicalliancesallowcompaniestolearncapabilitiesoutsideoftheir current areas of
technical and market expertise.26 For example, many of the pharmaceutical firms formed
alliances with biotechnology companies after the genetic engineering revolution so that their
R&D units would learn how to con- duct drug development using genetic engineering and
genomics.
• Fifth,strategicalliancesallowcompaniestoinvestigatenewtechnologiesand markets at
relatively low cost because the magnitude of the investment needed to investigate a new
technology or market through a strategic alliance is less than the magnitude of the investment
needed to do so independently.
• Sixth,strategicalliancesprovidecompanieswithrealoptionsthatallowthemto investigate
possible acquisition targets. By forming strategic alliances with other companies, you can
make small investments that allow you to gather information about their cultures and
capabilities, which permits you to make more informed selection of acquisition targets, to
more accurately value those targets, and to better estimate the costs of merging them into
your organization.
• Seventh,strategicalliancesallowcompaniestoincreasetheirprofitsbyreduc- ing price
competition that dissipates the economic rents from providing a product or service.31 Of
course, you have to be very careful if you do this in the United States. Regulators see the
formation of strategic alliances to reinforce market power as anticompetitive behavior that is
prohibited by antitrust laws.
• Eighth,strategicalliancesareusefulinsettingstandardsinanindustry,which encourages customer
adoption of products and the provision of complementary products by other firms. For
example, General Motors and Toyota have formed an alliance to set standards for fuel cell
and electric vehicles in the hopes that it will encourage customer adoption of such vehicles.32
However, strategic alliances also have three significant drawbacks:
• First,alliancestomanufacture,market,anddistributeproductskeepcompanies from developing
capabilities in these areas.33 For example, Microsoft lacks capa- bilities in procurement,
manufacturing, and distribution because the company has traditionally concentrated on the
development of computer software, and has formed strategic alliances with other companies
to produce the hardware on which its software runs. Because these capabilities are necessary
to offer devices that integrate computer hardware and software, Microsoft has had trou- ble
entering the video game business and lost billions of dollars in its initial foray into the
production of the Xbox.34
• Second,strategicalliancesexposecompaniestotheriskoflossofproprietary knowledge. Because
you must transfer knowledge to your alliance partners to make your alliances work, you
expose your company to the risk that your counterparts will take knowledge that you did not
intend to transfer, and increase the likelihood that your proprietary knowledge will diffuse to
other firms.35
• Third,whentwolargecompaniesdecidetoworktogether,itraisesconcerns that the alliance will
reduce competition, raise prices, and hurt customers, lead- ing to regulatory scrutiny that can
increase costs significantly.
Joint Ventures
A joint venture is legal partnership between two firms to own equity in a third firm formed by
the two partners. For example, 3Com and the Chinese firm Huawei have formed a joint
venture company named H-3C to produce Ethernet switches and IP routers.3
First, jointventureshelpcompaniestolearnnewcapabilitiesthatenhancetheir performance or are
necessary to exploit new technologies or to enter new mar- kets. For instance, Samsung
formed a joint venture with Sony to make flat-panel televisions to learn how to make better
displays than the versions it used in cell phones and computer monitors.38
• Second,jointventureshelpcompaniestoimprovetheirefficiencybyallowing companies to
concentrate on common activities in a joint venture, minimizing the duplication of activities,
and increasing scale economies. They also permit companies to exploit synergies in their
operations, as occurs when the manufac- turing operations of one company are combined
with the marketing activities of another.39
• Third,jointventuresallowcompaniestopoolresourcestoundertakeactivities that they cannot
afford to undertake alone.40 For example, Advanced Micro Devices established a joint
venture with United Microelectronics Corporation to create a 300 mm wafer semiconductor
fabrication facility because the high cost of establishing a semiconductor foundry (now
averaging $2.5 billion) makes producing microprocessors in a dedicated facility too costly for
companies with less than several billion dollars of annual revenue.41
However, joint ventures also have some important drawbacks:
• First,thecreationofjointventuresexposesyoutocounterpartsthatusethejoint venture as a
window on your technology or capabilities, or as a place to test and cherry-pick talent or to
dump poor-performing employees.
• Second,thesuccessofjointventuresdependsonthewillingnessofbothparties to make large
investments in mechanisms to coordinate the organizational structures, cultures, and
strategies of the parent organizations, which raises the cost of operating joint ventures.
An important special case of joint ventures in technology-intensive industries is the joint
research organization, or a joint venture established for the purposes of conducting research.
For example, the Semiconductor Research Corporation, a joint effort of the major
semiconductor firms, finances precommercialization research on semiconductors and related
technology, largely at academic institutions.
Joint research organizations are becoming increasingly common because rising technical
complexity requires companies to work with counterparts with comple- mentary expertise to
develop new technologies.43 In the United States, interest in these organizations has risen
since the passage of the National Cooperative Research Act of 1984, which exempts joint
R&D efforts from antitrust barriers as long as that activity is not in restraint of trade.
Like other kinds of joint ventures, joint research organizations are not all success- ful. The
most effective ones focus on research that extends the technical capabilities of the firms
supporting them, and where controls are in place to keep the parent com- panies from
appropriating their counterparts’ proprietary knowledge.44
Licensing
Licensing is an arrangement under which one organization permits another to use its
technology in return for the payment of a fee. Sometimes companies are the licensors of
technology to other businesses, as was the case when Intel licensed its instruction set for
producing microprocessors in personal computers to AMD.45 Other times, universities,
government laboratories, and nonprofit organizations are the licensors to companies, as was
the case when Michigan State University licensed
Licensing is an important part of technology strategy, particularly to the start-up companies
that have based their entire business model on it. For example, the initial business model of
biotechnology firm Abgenix involved licensing the company’s genetically engineered mouse
to pharmaceutical and biotechnology companies that had identified specific disease targets to
treat with antibodies.
Even some very large companies generate a significant portion of their revenue from
technology licensing. For example, at IBM, royalties from licensing account for 20 percent of
net income, while at Texas Instruments they account for more than 55 percent. As a result,
many high-technology companies, like Microsoft, have established business units to license
their technology to other firms.50
Often firms license to others technology that they are longer using, or that is no longer central
to their business. For example, Lockheed Martin converted idle patents on flight simulators
into an equity investment in a start-up video game com- pany, and Microsoft licensed some of
its unused patents to Toshiba.51 Boeing licensed laser technology and factory automation
tools that do not apply to the aerospace business to firms in other industries,52 while General
Electric licensed out a microor- ganism that digests oil spills to the major oil companies,53
and Monsanto licensed genes that it has developed to other companies to produce crop
seeds.54
Companies also have used technology licensing to grow their businesses. By licensing in
technology from other organizations, these companies have moved into more lucrative lines
of business. For example, tiny Haloid Corporation licensed Chester Carlsson’s xerography
patents and transformed a small printing business into the multinational corporation Xerox;
and Suhas Patil licensed a single MIT semi- conductor gate array patent to create the billion-
dollar semiconductor company Cirrus Logic.
Advantages and Disadvantages of Licensing
Licensing is a valuable tool of technology strategy. It can provide a mechanism to earn a
financial return on a technology that your company has developed, even if your company
lacks the capabilities or resources to develop or manufacture new products or services that
use the technology, or wants to avoid the costly and difficult process of creating
manufacturing and marketing capabilities.
The returns that you can earn from licensing your technology can be quite high because
licensing allows you to transfer technology to other firms and avoid creating duplicative
assets that lower the returns of all companies in the industry. Combined with the much lower
financial or human resource expenditures that it demands, this means that licensing can
generate very high profit margins.55 For example, IBM esti- mates that it would have to have
an extra $20 billion in sales every year to earn the same net income as the $1 billion it earns
from royalties on licensing its technology.56
Licensing also facilitates rapid market penetration. By transferring technology to other
companies that already have manufacturing or marketing assets in place, you can get your
technology to market more quickly. For instance, Sony licensed its com- pact disk technology
to 30 manufacturers to get that technology into products quickly.57 (The ability to achieve
rapid market penetration is very important to firms in industries subject to increasing returns.)
Licensing allows you to manage risk in technology development by treating new technologies
as real options. By obtaining the right, but not the obligation, to make use of a technology
invented by a university, supplier, or customer only if that entity
Licensing helps you to avoid intellectual property disputes. When other firms hold key
patents that limit your freedom to operate in a particular technology area, you can mitigate
the threat of patent litigation by licensing the other firms’ patents. You can also obtain
additional protection of your own intellectual property by licens- ing it to other firms,
particularly those with deep pockets that can enforce the patents against infringement,
because your licensees can be made responsible for defending your intellectual property.
On the other hand, licensing has drawbacks that you need to understand. Much like strategic
alliances, licensing hinders capability development because other firms develop,
manufacture, market, and distribute products using your technology, deny- ing you the
opportunity to learn how to do these things. If these activities add a lot of value to the base
technology, or if they permit the creation of strong competitive advantages through trade
secrecy, patenting, specialized manufacturing, or learning curves, you may be worse off than
if you created these capabilities. In fact, many firms have chosen to develop, manufacture,
and market their own products even when they initially lacked the capabilities to do so,
because the long-term benefits of capability development exceeded the short-term benefits of
greater revenue from licensing. For instance, Abgenix, a biotechnology company that had
originally devel- oped and licensed the genetic mouse, ultimately expanded into the
production of its own drugs to ensure that the company generated capabilities in late-stage
drug development and regulatory approval.
In addition, you will likely generate lower total profits by licensing a technology than from
producing a product or service based on the technology because most of the value generated
by new products comes from the development, manufacture, and mar- keting of the products
than from the technology itself.59 For example, Xerox licensed the technology for the
Ethernet to Bob Metcalfe who founded 3Com, earning a small licens- ing fee, rather than the
billions of dollars that 3Com made off of the invention.
Furthermore, by licensing your technology to another company, you might cre- ate a
competitor that you otherwise would not have. For example, Intel licensed its microprocessor
technology patents to AMD in the early 1980s to win a contract with IBM as the supplier of
microprocessors for the IBM personal computer because IBM insisted on having a second
source supplier.60 This licensing agreement strengthened AMD, which was, at the time, a
young semiconductor company, and helped it to grow into a large and formidable competitor
Exclusive licenses have the advantage of providing licensees with a greater incen- tive to
expend effort and money to get a product or service based on the licensed technology to
market. In contrast, nonexclusive licensees have an incentive to free ride because they can
benefit from the efforts of other licensees to develop the technology without incurring the
costs.
However, exclusive licensing is riskier than nonexclusive licensing. With exclu- sive
licensing, you will earn no return if you are poor at choosing licensees and select one that is
unable to get the technology to market; with nonexclusive licens- ing, you are diversified
across the talents of different licensees. The risk of a licensee shelving a technology
(licensing a technology without intention to develop it just to keep others from licensing it) is
also greater with exclusive licensing than with nonexclusive licensing because a single
nonexclusive licensee cannot shelve a tech- nology by itself.
Cross–Licensing
When two companies each have patents to technologies necessary to develop a prod- uct,
neither party will invest in the development of that product for fear of a patent infringement
lawsuit. This stalemate can be resolved by cross-licensing, an agree- ment between two
parties to license reciprocally.
To minimize transactions costs, cross-licensing agreements rarely specify indi- vidual patents.
Rather, the firms agree to license patents to all of their existing and future inventions in a
particular field of use for a specified period of time.62 The roy- alty payment on a cross-
licensing agreement is typically calculated by estimating the value of the patent portfolios of
both firms and subtracting one from the other.63 For example, when Sun Microsystems and
Microsoft considered cross-licensing as part of an effort to make their technologies
compatible, the two organizations each valued their own and each other’s patent portfolios to
determine which company would have to pay net royalties to the other.64
Cross-licensing is particularly important in industries like semiconductors and computers, in
which the cost of closing down a factory for even a few days (because of an injunction in a
patent litigation case) can drive a firm into bankruptcy,65 and in which technologies are
cumulative and systemic, and so require the use of patents held by many different
companies.66
When cross-licensing is important, firms often develop large patent portfolios to motivate
competitors to cross-license with them67 because companies prefer to cross- license with
counterparts that have equal-sized patent portfolios to balance the amount of technology each
party needs to give up.68 Moreover, having a lot of patents makes it easier to threaten a
patent infringement countersuit, which encour- ages competitors to cross-license. Therefore,
start-up companies, which usually have a small number of patents, are often at a competitive
disadvantage in industries in which cross-licensing is important because they lack a patent
portfolio large enough to get other firms to cross-license with them.
Outsourcing and Contract Manufacturing
A third contractual mode of doing business is outsourcing, or assigning, some aspect of
operations to another company under contract. All parts of the value chain can be outsourced.
For example, the large pharmaceutical firms, like Merck, out- source research to universities
and nonprofit research institutes,69 and the major auto companies, like Honda and Toyota,
outsource engineering design work to
Outsourcing provides several benefits:
• One,itallowscompaniestospecializeinthepartsofthevaluechainwhere their core capabilities
lie,73 permitting them to move up the learning curve,74 and increasing their production
volume, thereby reaping the benefits of economies of scale. For instance, many
semiconductor firms concentrate on designing semiconductors and outsource manufacturing
to specialist facilities, allowing them to make smaller and faster semiconductors.75
• Two,outsourcingallowscompaniestoexpandtheiroperationswithout investing in additional
plant and equipment or increasing their labor force, which reduces the risk they have to bear
and enhances their flexibility.76 If demand shrinks and they need to reduce their operations,
they can do so more easily than if they produced the product themselves because they have
made no capital investment in increased operations and need only change the terms of their
contracts when they come up for renewal. (This is particularly efficient when demand is
highly variable.77) Moreover, the supplier of the out- sourced service is better able to bear
the risk of demand shrinkage because its capital investment is diversified across multiple
customers, limiting its risk to industry shrinkage, and not to decline in demand for a
particular company’s products.78
• Three, outsourcing allows a company to accelerate the pace at which it begins operations
because the supplier of the outsourced service—be that product design, manufacturing, or
marketing—is already in operation and does not need to scale up.79 For example, research
has shown that automak- ers are able to develop new car models a third of a year faster if
they out- source engineering design to other firms than if they conduct the same work
internally.80
While outsourcing provides the benefits described previously, those benefits come at the
expense of several potential downsides:
• First,outsourcingrisksthelossoftechnologytothefirmprovidingtheproduct because that
company needs to have detailed information about your techno- logy and could use that
information to compete with you. Many consumer elec- tronics companies have confronted
this problem because they have engaged in contract manufacturing with Chinese
manufacturers, who have learned to create competing products from the information provided
by American and Japanese electronics companies.
• Second,outsourcingwillkeepcompaniesfromdevelopingcapabilitiesatthe activities that they
outsource, and the absence of those capabilities could hin- der the company’s performance.81
For instance, 3M discovered that it could not understand its customers’ needs when it
outsourced market research because doing so created too many intermediaries between
product develop- ers and customers, and kept the company from conducting proprietary mar-
ket research.82
• Third,outsourcinginvolveshightransactioncostsbecausefirmsmustwrite contracts to specify
how the activity will be conducted, which they do not have to do if the activity is conducted
in-house.83 When the outsourced activity is complex, the cost of writing these contracts—in
terms of incomplete and unen- forceable agreements—often becomes so high as to deter
companies from engaging in the practice.
The costs and benefits of outsourcing suggest several rules of thumb for you to follow when
considering it. You should contract out only those activities at which significant cost savings
can be achieved, and which are not central to the mission of your company.84 Thus,
outsourcing support services, such as employee benefit services and accounting, or low
value-added activities for which special- ists exist, like product assembly, makes sense;85
outsourcing activities directly linked to the creation of product features that customers value,
that involve tech- nology with which you could develop a competitive advantage, or that
require significant investment over time to build the skills to develop your products, does
not.86
For this reason, many observers believe that Boeing is taking a major risk by outsourcing the
production of sections of the tail, the fuselage, the landing gear, and even the wings, of its
new Dreamliner airplane.87 While outsourcing is saving Boeing billions of dollars, it is also
reducing the company’s ability to produce future generations of aircraft. Consequently,
Boeing may be mortgaging its future by outsourcing.
Key Points
• Strategic alliances are relationships between two firms to work together to achieve a
common goal; they can be vertical (between firms at different stages of the value chain) or
horizontal (between firms at the same stage of the value chain).
Strategic alliances permit the specialization of capabilities, the development of new
capabilities, and the investigation of potential acquisition targets; cre- ate market power; set
standards; and reduce costs; but can hinder the cre- ation of capabilities; raise antitrust issues;
and risk the loss of proprietary knowledge.
• Jointventures,whicharecontractualagreementsbetweentwofirmstocreate and hold equity in a
third firm, help companies to learn new capabilities, improve efficiency, and pool resources,
but can lead to opportunistic action by parent companies and demand costly efforts to blend
organizational structure, culture, and strategy to be effective.
• Licensingisanarrangementinwhichafirmpermitsanothertouseitsintellec- tual property in
return for a fee; it helps firms to enhance financial returns, achieve rapid market penetration,
manage risk, and reduce intellectual property disputes, but can hinder the development of
capabilities, lower profits, and cre- ate competitors.
• Licensingcanbeexclusive(toonlyonelicensee)ornonexclusive(tomultiple licensees); exclusive
licensing gives licensees stronger incentives to develop technology, but raises the risk of
choosing the wrong licensee.
• Cross-licensing,orbilaterallicensing,isimportantinindustriesinwhich patents belonging to
many firms are needed to develop a single product.
• Outsourcing is the assignment of a company’s operations to another firm; when
manufacturing is outsourced, it is called contract manufacturing.
Outsourcingismoresuccessfuliffirmsfocusonnoncoreactivitiesatwhich large savings can be
garnered.
WORK ALONE OR COLLABORATE
Given the advantages and disadvantages of strategic alliances, licensing, joint ventures,
outsourcing, and contract manufacturing, how do you know if you should collaborate or go it
alone? As Figure 7 shows, there are four dimensions that you need to consider in making the
decision: the strategic factors that create the advantages and disadvantages of collaborative
arrangements, the nature of your core technology, the type of firm that you run, and the
industry in which you operate.
First, you need to identify the trade-offs between the different modes of doing business across
the different dimensions discussed earlier in this chapter.
great as to swamp the others and lead you toward one mode of doing business over another
for strategic reasons.
Second, you need to consider the nature of your technology. Based on the dimen- sions
discussed earlier in the chapter, is your technology amenable to contractual forms of doing
business? If it is, is there one contractual mode that is better than another for that technology?
Third, you should consider whether you are operating a small, start-up firm or a large,
established company. The resource and capabilities constraints of new firms often lead them
to make different decisions about business mode than established firms that are exploiting the
same business opportunities. Because start-ups often lack cash, they need to weigh the
demand for money against other factors in deter- mining whether or not to use contractual
forms of business, and cash needs often win out. For example, SmartShopper Electronics, a
start-up that offers a device that allows people to record and print out lists of groceries and
errands, uses contractors to produce the voice-recognition and printing software that goes on
the inside of the product; to design the product and logo; to make, test, and box the
electronics; and to receive the shipments, warehouse the inventory, and fulfill orders.95 An
established company pursuing the same opportunity might do many of these things in house.
Finally, you need to think about your industry because industry characteristics have a large
influence on the effectiveness of contractual modes of doing business. Contractual forms of
business are more important in industries subject to network effects because first mover
advantages are very strong in these industries.96 Licensing permits faster market penetration
than in-house production and distribu- tion, thus allowing a rapid increase in the installed
base, which is so important in net- worked industries. For example, Microsoft was able to
compete with Netscape, which had a year’s lead time on the launch of its browser, by
contracting with online provider AOL to distribute its browser. By licensing out its Web
browser, Microsoft was able to catch up to Netscape before the latter company had an
insurmountable lead in installed base
Markets for Knowledge
Researchers have found that markets for technology face two major problems, which make
contractual modes of doing business more effective in some industries than in others:
disclosure and hold-up. As Nobel Prize–winning economist Kenneth Arrow explained,
markets for technology are undermined by the disclosure paradox: To get buyers to pay for
your new technology, you need to provide them with evidence that it is worth something.
However, the act of showing prospective buyers why a new technology is valuable often
demonstrates how the technology works. And once the buyers know how the technology
works, they have no reason to license it—you just gave it away for free!98
Having an effective patent allows a firm to extricate itself from the disclosure paradox
because the patent protects an innovator against imitation after disclosure. Thus, as Figure 8
shows, in biotechnology, where patents are very effective, con- tractual modes of business,
like strategic alliances and licensing, are very common. At the same time, the cost and
difficulty of drug discovery, regulatory approval, drug manufacture, and pharmaceutical
marketing make the value of specialization very high,99 and avoiding the expense of
duplicating these things valuable.100
Markets for technology are also undermined by hold-up problems. Hold-up occurs when one
party to a contract demands that the agreement be renegotiated in its favor, and the other
party acquiesces because the termination of the agreement would be worse for it than the new
terms of the agreement.
Hold-up is more likely to occur if there are only a few counterparts with whom a company
could contract and if the assets that are needed to use the technology are specialized.
(Specialized assets are assets made specific to a transaction, like a piece of manufacturing
equipment that has to be built and can only be used to produce the
licensor’s product.) If there are small numbers of potential counterparts, then you cannot
easily switch partners if problems arise, giving your counterpart leverage to hold you up.101
If the assets that you need to use the technology are specialized, then you are vulnerable to
your counterpart’s efforts to renegotiate the terms of the agreement in his or her favor because
the financial returns that can be gained from the sec- ond best use of the asset are much less
than those that can be gained from the best use. Consequently, it is rational to accede to your
counterpart’s demands to rene- gotiate the terms of the agreement,102 as long as the new,
worse, terms would still allow you to generate higher returns than those earned from the
second best use of the asset.103 Thus, companies often will not contract for technology if
doing so will require them to invest in specialized assets for fear of being taken advantage of
by opportunistic counterparts, leading markets for these technologies to fail,104 and requiring
firms to own their own manufacturing, marketing, and distribution assets.
Key Points
• Todecidewhetheryoushouldusecontractualorverticallyintegratedmodes of doing business,
you need to consider the industry in which you operate, the nature of your core technology,
the type of firm that you run, and the strategic factors that create the advantages and
disadvantages of collaborative arrangements.
• Thenatureofintellectualpropertyprotection,competitivedynamics,network effects, the nature
of returns, and the rate of change in your industry affect whether you should use contractual
or vertically integrated modes of doing business.
• Thelimitedresourcesandcapabilitiesofnewfirmsoftenleadthemtomakedif- ferent decisions
about business mode than established firms exploiting the same business opportunities.
• Marketstoselltechnologyoftenfailbecauseofdisclosureandhold-up problems.
MAKING CONTRACTUAL ARRANGEMENTS WORK
Research shows that half of all contractual business arrangements fail, often at signif- icant
cost to the parties involved.105 Take, for example, General Motors’s strategic alliance with
Fiat to develop small cars, which had to be undone at the cost of several billion dollars, when
the joint efforts of the companies failed to save either company any money.106
Designing Effective Contractual Arrangements
To design effective contractual organizational arrangements, you should do the following:
1. Know your own firm’s strategy and capabilities at different parts of the value chain and
have a clear picture of how the contractual arrangement that you are considering will help
with that strategy.
2. Assess the match between your business and your prospective counterparts on such
dimensions as technology, skills, resources, strategies, and corporate cul- ture to ensure that
they are complementary.107
3. Conduct due diligence (the verification of the credentials) on your transaction partners to
ensure that they will behave honestly and fairly, and have appropri- ate assets and
capabilities.
4. Keep your partner from acting self-interestedly at your expense by keeping them away
from any information or technology that you do not want to dis- close, creating a team with
the responsibility and authority for managing your relationship with your counterpart, setting
up policies and procedures—such as audits and site visits—to verify that your partners are
adhering to the terms of the contract, establishing routines and structures to facilitate
communication between the two organizations,108 and making reciprocal financial invest-
ments109 that provide “hostages” to deter opportunistic action.110
Contracting Between Large and Small Firms
Many contractual organizational arrangements are created between large, estab- lished firms
and small, start-ups because new firms are very good at developing new products and finding
the initial market niches in which to exploit them, while estab- lished firms are very good at
using manufacturing, marketing, and distribution to capture the mass market.111 However,
these contractual arrangements raise addi- tional management issues. Because large,
established companies are often hierarchi- cal bureaucracies, start-up companies are often
stymied by the inaction of their counterparts and the difficulty of knowing whom to work
with to solve problems.
Moreover, the relationships between the two types of firms are asymmetrical because a single
large, established company will often contract with many small, start-ups, while a small start-
up company will typically contract with one large firm. As a result, the large companies are
more diversified than the small compa- nies, and so are more willing to terminate poor
performing relationships. Take, for example, the reaction of Amylin Pharmaceuticals, a small
biotechnology company, and its partner, Johnson & Johnson, to poor results from a study
testing the drug Symlin that the companies were jointly developing. Amylin, which was
developing
no other drugs at the time, wanted to persist with the project despite the poor results, while
Johnson & Johnson, which had many better performing alternatives, wanted to terminate the
alliance.112
The differences in the portfolios of products also lead to conflict between new and
established firms over decisions to bring new products to market. The estab- lished firms,
which have multiple new product development projects, often want to select the one with the
greatest prospects for success, while the new firms, which usually have only one project,
want theirs to be selected, even if it is not the best. For example, the small biotechnology firm
Tanox ended up in a dispute with its strategic alliance partners, Novartis and Genentech, over
TNX-901, a drug to prevent allergic reactions to foods like peanuts. Tanox wanted to
introduce this drug to the market after researchers had achieved favorable results in clinical
studies. However, Novartis and Genentech decided to move forward with a different drug in
their port- folios, Xolair, and focus it on asthma and hay fever treatments because Xolair
showed more promise than TNX-901, and because asthma and hay fever are more common
than food allergies.113
Finally, established and start-up firm partners also disagree about when to bring new products
to market because established companies often want to delay new product introduction to
reduce cannibalization of their existing products, while new firms, which have no products in
the market yet, want to enter immediately. For instance, the biotechnology company Amylin
and its pharmaceutical partner, Eli Lilly, disagreed about when to introduce the diabetes drug
Exenitide because the drug would postpone the point when diabetics need to take insulin, a
product that Eli Lilly makes significant profits selling.114
Key Points
• Contractualmodesofbusinessoftenfailatahighcost.
• Successatcontractingisenhancedbyknowingyourcompany’sstrategy,formu-
lating a plan, assessing your company’s fit with its collaboration partner, con- ducting due
diligence, and managing the relationship once the contract has been signed.
• Contractualrelationshipsbetweenlargeandsmallfirmsfacetheproblemsof large firm
bureaucracy stymieing action, and asymmetry between the two par- ties, which leads them to
make different decisions about project selection and termination, and the timing of market
entry.
KeY TERMS
Contract Manufacturing: The outsourcing of manufacturing to a company that specializes in
manufacturing on behalf of others.

Contractual: mode of business in which a company signs an agreement with an independent

organization to provide part of the value chain.

Cross-licensing: An agreement between two parties tolicense reciprocally.

Disclosure Paradox: The inability to get others to contract for knowledge unless the
knowledge is dis-closed, combined with the unwillingness for others to pay for knowledge
once it has been disclosed.

Due Diligence: The verification of the credentials of another party.

Exclusive License: license that gives only one party the right to use a technology.

Free Ride: The tendency of one party to let others do the work necessary to receive a benefit.

Hold-up: The tendency of one party to a contractual agreement to take advantage of the
other's vulnerabilities to renegotiate the terms of the agreement.

Horizontal Alliance: partnership between firms at the same stage of the value chain to work
together to achieve a common goal.

Joint Research Organization: A joint venture established to conduct research.

Joint Venture: A legal partnership between two firms to own equity in a third firm formed by
the two
Paruicts
Licensing: form of business, under which one firm permits another to use its technology in
return for the payment of a fee.

Nonexclusive License: license that grants many parties the right to use a technology.

Outsourcing: A mode of business in which a company assigns some aspect of its operations
to another company under contract.

Shelving a Technology: The act of licensing a technology with no intention of developing it

simply to keep others from licensing it.

Strategic Alliance: partnership between two firms to work together to achieve a common
goal.

Vertical Alliance: partnership between firms at the

different stages of the value chain to work together to achieve a common goal.

Vertically Integrated: mode of doing business in which the company owns more than one part
of the value chain.