386 • Chapter 11 • Sustaining Competitive Advantage
technologies succeeded because they had higher B–C than did their predecessors. In the popular book, The Innovator’s Dilemma, Clay Christensen identified a special class of products that offer much higher B–C than their predecessors, but do so not through incremental improvements but with entirely new technologies that drastically lower C.20 In the spirit of Schumpeter, Christensen calls these disruptive technologies. Examples include computer workstations (replacing more powerful mainframes), ink jet printers (replacing higher visual-resolution laser printers), electronic mail (replacing more personal “snail mail” and the telephone), and downloadable MP3 recordings (replacing higher audio-resolution compact discs). Not all low C technologies are disruptive. Backers of the Segway human transporter thought for a brief moment that it would replace the automobile for urban commuting. Most commuters thought the B was too low, and so the Segway was relegated to niche status.
The concept of the innovator’s dilemma raises a fundamental question about sustainability: Are large firms doomed to be less innovative than smaller rivals? Economists have identified four factors that weigh on this question: (1) the productivity effect, (2) the sunk cost effect, (3) the replacement effect, and (4) the efficiency effect.
The Productivity Effect
Suppose that a large firm and five small firms all pursue the same research objective. The first firm to succeed obtains a patent and enjoys sustained profits. To make for a level playing field, suppose that the total size of the research effort of the small firms equals the total research effort of the large firm. Will the large firm win the race? The answer depends in part on whether the large firm will be more productive at research, or what we call the productivity effect.
The large firm may have the advantage of scope economies. For example, a large pharmaceutical company could maintain a biostatistics department that services all of its research activities. But these scope economies can be defeated by the sheer statistical power of the innovative process. In this example, innovation is a winner-take-all activity rewarded by a patent. Economists call this type of competition patent racing. Statistical analysis shows that if there are no scope economies, then the winner of the patent race is most likely to be one of the five small firms each pursuing an independent research agenda. This is because the large firm may not explore all possible research directions, which handicaps its effort to be the first innovator. The large firm could counter this by dividing its efforts among five smaller internal research labs. But this tactic only works if the internal labs are truly independent. If lab managers are influenced by a common corporate research philosophy, or if they mimic each other’s strategies, then the research efforts will be correlated and one of the five independent firms will be more likely to win the race.
The incentive and bureaucratic effects of vertically integrated firms also weigh on large firms seeking to motivate internal research labs. It is very difficult for large firms to provide a financial incentive for innovation that rivals the potential rewards earned by the innovative entrepreneur. Countering this, Jeremy Stein observes that investors in R&D firms often have little direct understanding of the underlying science and cannot easily evaluate research progress. 21 However, this may work to the benefit of the firms because the investors do not meddle in research decisions. The managers of small R&D firms are usually also their founders. This may work against the firms because the managers/founders might overstate the success of ongoing research rather than see the plug pulled on their projects and, therefore, on their firms. In contrast, allocation of R&D in large firms is conducted by scientists (often with the title of vice president
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for research). They oversee the funding of numerous projects. If one project is faltering, they can reallocate funds to another without fear of losing their jobs. In this way, larger firms may do a better job of allocating research dollars.
The Sunk Cost Effect
The sunk cost effect has to do with the asymmetry between a firm that has already made a commitment to a particular technology or product concept and one that is planning such a commitment. The sunk cost effect arises because a firm that has already committed to a particular technology has invested in resources and organizational capabilities that are likely to be specific to that technology and are thus less valuable if the firm switches to another technology. For an established firm, the costs associated with these investments are sunk and thus should be ignored when the firm considers whether to switch to a new technology. Ignoring these sunk costs creates an inertia that favors sticking with the current technology. By contrast, a firm that has not yet committed to a technology can compare the costs of all of the alternative technologies under consideration and is thus not biased in favor of one technology over another.
The Replacement Effect
Who stands to gain more from an innovation: a profit-maximizing monopolist or a new entrant? The Nobel Prize–winning economist Kenneth Arrow considered the incentives for adopting a process innovation that would lower the average variable costs of production.22 The innovation is drastic: once it is adopted, producers using the older technology will not be viable competitors. Arrow compared two different scenarios: (1) the opportunity to develop the innovation is available to a firm that currently monopolizes the market using the old technology, and (2) the opportunity to develop the innovation is available to a potential entrant who, if it adopts the innovation, will become the monopolist. Under which scenario, Arrow asked, is the willingness-to-pay to develop the innovation greatest?
Arrow concluded that assuming equal innovative capabilities, an entrant would be willing to spend more than the monopolist to develop the cost-reducing innovation. The intuition behind Arrow’s insight is this: a successful innovation for a new entrant leads to it becoming a low cost monopolist; a successful innovation by the established firm maintains its monopoly, albeit at lower cost. So the entrant gets the full benefit of being a low cost monopolist while the incumbent monopolist gets the partial benefit of increasing its monopoly profits further. Thus, the entrant has greater incentive to innovate. Put another way, through innovation an entrant can replace the monopolist, but the monopolist can only replace itself. For this reason, this phenomenon is called the replacement effect.23
The Efficiency Effect
If an incumbent monopolist anticipates that potential entrants may also have an opportunity to develop the innovation, then the efficiency effect comes into play. To understand the efficiency effect, compare the following: (1) the loss in profits when a monopolist becomes one of two competitors in a duopoly, and (2) the profits of a duopolist. Most oligopoly models, including the Cournot model discussed in Chapter 5, suggest that (1) is larger than (2). In other words, a monopolist usually has more to lose from another firm’s entry than that firm has to gain from entering the market. The reason is that the entrant not only takes business from the monopolist, but also