etmfjl 0920 industry architecture and entry of entrepreneurial startups case of it sector
TRANSCRIPT
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Industry Architecture and Entry of Entrepreneurial Startups:
The Case of the IT Sector
by
Jeffrey L. Funk
Associate Professor
National University of Singapore
7 Engineering Drive 1
Block E3A, 4th Floor
Singapore 129793
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Industry Architecture and Entry of Entrepreneurial Startups:
The Case of the IT Sector
Abstract
This paper uses the literature on industry architecture to examine the tradeoffs involved
with the entry timing of vertically disintegrated entrepreneurial startups. While the
conventional wisdom on entry timing focuses on capabilities and dominant designs, the
literature on industry architecture focuses on capabilities and transaction costs. Falling
transaction costs, through for example the emergence of open standards, can reduce the cost
of entry for vertically disintegrated startups while economies of scale in capabilities can
increase the cost of entry over time. Focusing primarily on transaction costs, this papers
analysis shows that more entrepreneurial startups were founded (and thus entered) after a
relevant open interface standard had been released than were founded before the release.
These results suggest that large numbers of entrepreneurial opportunities still exist after open
interface standards are released, even when these open interface standards are defined as
dominant designs, and that the emergence of these open standards may be an open important
signal for entry by entrepreneurial startups.
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1. Introduction
Understanding where entrepreneurs should look for opportunities remains an important
issue for practitioners and academics. The popular press focuses on final products such as
MP3 players (e.g., i-pod), mobile phones (e., i-phone, Google phone), Internet search (e.g.,
Google), tablet computers (e.g., i-pad) and personal digital assistants. The literature on
entrepreneurship has found that entrepreneurs do better in software than hardware (Audretsch,
1991) or in industries with rapid growth, low capital intensity, small scale, and low
concentration (Bygrave and Zacharakis, 2003; Shane, 2004; Baron and Shane 2005). The
literature on technological management and innovation has found that technological
discontinuities, particularly those that destroy competencies, provide opportunities for new
entrants (Tushman and Anderson, 1986; Anderson and Tushman, 1990; Henderson and Clark,
1990; Christensen, 1997) particularly when firms enter before a dominant design emerges
and defines the necessary capabilities for firms (Utterback, 1994; Suarez and Utterback,
1995).
On the other hand, a growing body of research has concluded that the emergence of
vertical disintegration has challenged incumbents and thus this research implies that vertical
disintegration has led to opportunities for new entrants in a variety of industries (Langlois,
1992; 2003, 2007; Baldwin and Clark, 2000; Arora et al, 2001; Chesbrough, 2003).
Furthermore, these results have led to an increasing interest in so-called industry
architectures, which are an abstract description of the economic agents within an economic
system and represent the degree of vertical (dis)integration in an industry (Jacobides,
Knudsen and Augier, 2006). Changes in industry architecture can come from technological,
institutional, or social changes that impact on the way in which economic agents divide up
work. In particular, reductions in transaction cost can reduce both the costs of having work
done by multiple agents and the importance of integrative capabilities and thus facilitate the
emergence of vertical disintegration (Brusoni and Prencipe, 2001; Jacobides, 2005; Jacobides
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and Winter, 2005). These reductions in transaction costs can come from the emergence of
open standards, modular designs (Langlois, 2003, 2007), and other events such as
governments (or legal systems) requiring the un-bundling of products, restricting a firms
ownership/market share in a market, or approving open standards (Arora et al, 2001;
Kenney, 2003; Steinmueller, 2003) where these events can emerge in either a bottom-up or
top-down process (Jacobides, 2005; Jacobides and Winter, 2005).
In spite of this wide agreement that vertical disintegration is occurring and is somehow
related to entrepreneurial opportunities, however, empirical research has not addressed the
relationship between the emergence of vertical disintegration and entrepreneurial
opportunities nor has it challenged the conventional wisdom on dominant designs. More
specifically: 1) what are the mechanisms by which vertical disintegration emerges and creates
entrepreneurial opportunities; 2) what are the tradeoffs between early and late entry for
vertically disintegrated startups; and 3) under what conditions can firms enter after a
so-called dominant design emerges?
The information technology (IT) sector is an appropriate one to consider these issues.
Vertical disintegration has emerged in almost every type of computer system, open standards
have played a role in the emergence of this vertical disintegration (Langlois, 1992; Ceruzzi,
1998; Baldwin and Clark, 2000), there has been a decline in the number of firms (i.e.,
shakeout) in most of these vertically disintegrated layers (Flamm, 1988; Langlois, 1992;
Steffens, 1994; Hatfield et al, 1999; Campbell-Kelly, 2003), and the number of de novo
entrepreneurial startups has steadily grown.
2. Theoretical Discussion
The most widely used models of technological change in the management and economic
literature are the product life cycle (PLC) and cyclical model of technological change. Both
characterize the evolution of an industry in terms of technological discontinuities, dominant
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designs, and incremental change (Anderson and Tushman, 1990; Tushman and Rosenkopf,
1992). Technological discontinuities can replace existing products and technologies or they
can create entire new product categories (Tushman and Anderson, 1986; Utterback, 1994;
Christensen, 1997). For example, it is generally agreed by the management (Anderson and
Tushman, 1990; Langlois, 1992; Baldwin and Clark, 2001) and other literatures that
mainframe, mini, and personal computers, client server computing, and the Internet represent
technological discontinuities within the IT sector.
The emergence of such a discontinuity is generally defined as the beginning of a
products life cycle. Research on the product life cycle has found that there is typically a large
decline (i.e., a shakeout) in the total number of firms through mergers, acquisitions, and exits
where these shakeouts occur even when the total market for these products continues to grow
rapidly (Gort and Klepper, 1982; Klepper and Grady, 1990; Agarwal and Gort, 1996; Klepper,
1997; Klepper & Simons, 1997). For example, there were large shakeouts in the number of
automobile and television (Klepper and Simons, 1997) and personal computer (Hatfield,
1999) manufacturers in the 1910s, 1950s, and 1980s respectively even though the markets for
these products continued to grow long after the shakeouts had occurred. The conventional
wisdom in the technology management (Teece, 1986; Utterback, 1994; Suarez and Utterback,
1995) and entrepreneurship (Bygrave and Zacharakis, 2003; Shane, 2004; Baron and Shane,
2005) literatures is that the emergence of a dominant design has been a trigger for these
shakeouts because they define a set of necessary capabilities that firms must have in order to
effectively compete,
On the other hand, the literatures on modular design, interface standards, other research
on the product life cycle, and industry architecture imply that the emergence of dominant
designs may not lead to a shakeout in the number of firms and that certain kinds of open
dominant designs may lead to increases in the number of firms and thus the number of
entrepreneurial opportunities. Modular designs are those in which the interfaces that
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determine how the functional components or modules in a product or process design will
interact are specified to enable the substitution of component variations within the design.
Design rules (Baldwin and Clark, 2000) define the interaction between these modules (Ulrich,
1995; Sanchez and Mahoney, 1996; Brusoni and Prencipe, 2001). The term standard or
interface standard (Farrell and Saloner, 1985; Katz and Shapiro, 1985, 1994; Shapiro and
Varian, 1999) is often used to define the way in which these different modules interact when
products from different firms are compatible with the same interface design rules. The greater
the extent to which design rules or interface standards are open, the greater the extent to
which new entrants may challenge vertically integrated incumbents (Langlois, 1992; Langlois
and Robertson, 1992; Baldwin and Clark, 2000; Langlois, 2003, 2007).
Other research on the product life cycle also supports the notion that the emergence of
dominant designs may not lead to a shakeout in the number of firms. Klepper (1996, 1997)
explains a shakeout in the number of product manufacturers in terms of economies of scale in
R&D where R&D can be linked to capabilities and where economies of scale in these
capabilities cause small firms to be acquired or to exit the industry. He also concluded that
the emergence of independent equipment and process technology suppliers reduce the need
for scale in R&D by product manufacturers, creates entrepreneurial opportunities for these
product manufacturers, and thus prevents a shakeout in the number of them. Although his
analysis focused on final manufacturers, as do most analyses of the product life cycle, his
argument is consistent with the notion that vertical disintegration enables new firm entry, in
this case in the final product1.
The framework of industry architectures can probably better address these issues than the
product life cycle model can (Jacobides, Knudsen and Augier, 2006), particularly if some
1 Klepper (1997) also concluded that the existence of sub-markets prevents a shakeout in the number of these final manufacturers since
their existence reduces the advantages of scale in R&D. a more comprehensive analysis could address the number of sub-markets and their
impact on economies of scale in R&D.
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concepts from the product life cycle model (shakeouts and economies of scale in capabilities)
are imported into the framework of industry architectures. According to the literature on
industry architecture, falling transaction costs, through for example the emergence of open
standards, can reduce both the costs of having work done by multiple agents and the
importance of integrative capabilities and thus facilitate the emergence of vertical
disintegration (Brusoni and Prencipe, 2001; Jacobides, 2005; Jacobides and Winter, 2005).
Since previous research implies that incumbents have trouble adapting to these changes in
industry architecture (Storper and Christopherson, 1987; Langlois, 1992; Baldwin and Clark,
2000; Arora et al, 2001; Christensen et al, 2002; Chesbrough, 2003), it is expected that the
emergence of open standards will enable some de novo entrepreneurial startups to become
successful providers of these modules. Thus, de novo startups will be more successful in
providing modules that involve open standards than in providing modules that do not involve
open standards. This leads to Hypothesis 1:
Hypothesis 1: de novo entrepreneurial startups are more represented among suppliers of
modules that involve open interface standards than in those that do not,
But when should these firms enter a market (i.e., become suppliers of a specific module)
and what are the relative tradeoffs between entering early or late? Kleppers (1996, 1997)
theory of economies of scale in R&D for product and process capabilities recommends early
entry. Early entrants can begin doing R&D, selling products, and developing the relevant
capabilities. Later entrants will be at a disadvantage in terms of these economies of scale in
capabilities and thus may incur higher R&D costs as a percent of sales than do an earlier
entrant. On the other hand, the literature on industry architecture suggests that reductions in
transaction costs, through for example the emergence of open design rules and open standards,
can facilitate the entry of vertically disintegrated suppliers. Assuming these open standards do
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eventually emerge, early entrants may incur higher entry costs than do later entrants because
initially few system suppliers have set open design rules, because open standards have not yet
been defined for these design rules, and because when these open standards do emerge the
early entrants may not notice, they may be unable to adapt, or they may incur high costs in
their attempts to adapt to the open standards and the capabilities that are associated with them.
Furthermore, if these open standards are defined by designs that can be classified as dominant
designs, firm that enter after a dominant design emerges may incur lower entry costs than
firms that enter before a dominant design emerges.
Figure 1 summarizes these tradeoffs for a case when an open standard does eventually
emerge for a specific module. As systems providers set open design rules for interfaces and as
standards emerge for these design rules, the transaction costs associated with different firms
supplying different modules and thus the entry costs for a supplier of a specific module
declines. On the other hand, economies of scale for capabilities in a specific module increase
over time thus increasing the cost of entry over time. It should be noted that if open standards
are later replaced by closed ones, this may raise transaction costs and in combination with
economies of scale may raise the costs of new entry (which is not shown in Figure 1).
Assuming that economies of scale in R&D increases as characterized by Klepper (1996),
this paper focuses on the falling transaction costs from the emergence of open design rules
and interface standards and whether these falling transaction costs enable new firms to enter
even after an open standard is defined. In particular, since existing firms are often slow to
adapt to the emergence of open standards and to the changes in industry and inter-firm
architecture that are brought about by these open standards (Storper and Christopherson,
1987; Langlois, 1992; Baldwin and Clark, 2000; Arora et al, 2001; Christensen et al, 2002;
Chesbrough, 2003, the emergence of open standards may enable some de novo
entrepreneurial startups to enter (and perhaps be founded) and succeed even after an open
standard has emerged. This leads to the following hypothesis:
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Hypothesis 2: more de novo entrepreneurial startups are founded after open standards
emerge than before they emerge
3. Methodology
This paper uses the literature on the IT sector to define the technological discontinuities,
the modules for each discontinuity, the emergence of design rules, interface standards, and
other factors that impacted on falling transaction costs, the classification of the design rules
and standards as either open or closed, and the dates of release for open standards. The
relevant literature includes academic papers and books from the management, economic, and
historical fields, practitioner-oriented accounts, and encyclopedic histories. The emergence of
open standards for a specific interface refers to the year in which the open interface standard
is released (e.g., the release of the IBM PC in 1981). Although the emergence of an interface
standard typically follows the emergence of the discontinuity, in some cases the emergence of
standards may precede the emergence of the discontinuity (e.g., UNIX emerged before the
first workstation was introduced in 1980) particularly when the standards and vertical
disintegration emerged in a bottom-up process (Jacobides, 2005).
The sample of firms was taken from Datamation magazine and includes those that were
ranked at least once in the Datamation 50 or Datamation 100. Datamation magazine used
sales data from annual reports to annually (in a June issue) rank the top 50 IT firms in the
North American market in terms of IT revenues between 1975 and 1996, the top 100 IT firms
between 1979 to 1994, and for most years broke down each firms revenues into multiple IT
categories (e.g., mainframe versus mini-computers, peripherals and software) and
summarized the firms annual activities in a half page description. Focusing on the most
successful firms in an industry can be problematic due to so-called sampling on the
dependent variable. One reason why this is not a major problem with this papers database is
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that this database is large enough to represent the entire set of firms in the IT sector. Second,
the representativeness of this sample was checked by testing Hypothesis 2 for the most
successful firms in the IT sector; these are defined as those firms that were ranked by
Datamation in the top 25 IT firms at least twice. Third, the paper is testing whether a majority
of successful firms were founded after open standards emerged, and not whether firms should
enter after an open standard has emerged. This last point is addressed in the discussion
section.
This paper used the Datamations firm descriptions, breakdowns in firm revenues, and
other sources (see footnote #2) to classify each firm for each year in terms of one
technological discontinuity and its associated system (e.g., mainframe, mini-, and personal
computers and client-server systems) and one vertically disintegrated layer (e.g., computer
design, peripherals, software) within these technological discontinuities/systems. More than
80% of the de novo firms in the Datamation 100 were classified each year in the same layer
and system/discontinuity2. The same sources (in particular the Internet) were also used to
classify each firm as either de novo or de alio and to identify the firms founding date. This
paper focuses on de novo firms and their founding date because this data was easier to obtain
than was data on entry date into the relevant vertically disintegrated layers by de novo or de
alio firms. Since firms have to be founded before they can release products, this analysis will
underestimate the extent to which successful firms have entered a market after the emergence
of open interface standards.
Firms were classified as de novo firms if they were founded to enter the IT sector and as
de alio firms if they entered the IT sector from another sector. Partly to prevent double
2 For those few firms whose classifications did change at least once, short historical descriptions were constructed from the firm
descriptions in the Datamation magazines and other sources such as the Computer Industry Almanac (Juliussen et al, 1987), the Internet, and
historical accounts of software (Steinmueller, 1996; Campbell-Kelly, 2003), local area networks (von Burg, 2001), hard disks (Christensen,
1993), and printers (Dorfman, 1987) in order to more accurately classify them.
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counting within a specific vertically disintegrated layer, for the small number of mergers and
acquisitions (
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Table 2 also summarizes the relevant standards for these discontinuities and Figure 2
roughly summarizes the changes in vertical disintegration that were brought about by the
emergence of these standards. As discussed in the subsequent sub-sections, open standards
emerged for the interfaces between computers and peripherals, operating systems (OSs) and
application software, and computers and some services (e.g., remote services). Key events
related to the emergence of these open interface standards include the release of IBMs
System/360 in 1964, of 16-bit mini-computers in 1970, of TCP/IP (transmission control
protocol/ internet protocol) specifications for the Internet in the late 1970s, of the IBM PC in
1981, and of the Ethernet for local area networks (LAN) in the early 1980s, plus IBMs
announcement of software unbundling in 1969 and partial agreements on UNIX in the mid-
to late-1970s On the other hand, open standards did not emerge for the interfaces between the
OS (operating system) and CPU (central processing unit) for mainframe and mini computers
and only initially for personal computers (PCs). Furthermore, they did not emerge between
application software from different systems/discontinuities and instead experience in dealing
with these non-standard interfaces became a barrier to entry for new suppliers of system
integration services (discussed in more detail in sub-section 4.4).
Hypothesis 1 can be tested by looking at the ratio of de novo to total number of firms in
Table 3 or the total number of de novo firms in the vertically disintegrated layers. Comparing
the different software layers shown in Table 3, the proportion of de novo to total number of
firms is greater in those layers for which open standards did emerge than for layers for which
they did not emerge (systems integration in column labeled application software). Hypothesis
1 was tested using hypothesis testing for the difference between two binomial proportions
(Mitra, 1993, p. 119). The smaller proportion of de novo to total number of firms in systems
integration software (10 of 24) than in other software (35 of 39 is significant at the 0.001
level.
Furthermore, a lack of open standards for the interfaces between the OS and CPU for
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computers made it difficult for independent providers of OSs and CPUs, much less de novo
ones, to emerge. For OSs, only one firm (Microsoft) had any level of success before 2000.
For CPUs, although the Datamation rankings do not include semiconductor suppliers, the
literature on the computer industry primarily emphasizes one firm, Intel (Flamm, 1988,
Langlois, 1992; Ceruzzi, 1998). A much smaller number of de novo firms in these layers than
in the other layers shown in Table 3 provide further confirmation of Hypothesis 1.
Excluding those layers (i.e., systems integration) for which open standards did not emerge,
Table 4 shows the number of de novo firms that were ranked at least once in the Datamation
100 and that were founded before and after open standards emerged for specific vertically
disintegrated layers. Although a small number of firms are represented twice in Table 4
because a few of them are classified into different layers/discontinuities in different years, the
total number of firms shown in Table 4 (150) is less than the total number of firms in Table 1
(170) since firms classified as systems integrators or classified as other are eliminated from
Table 4.
Hypothesis 2 is addressed using Table 4. Sixty five percent (97 of 150) of the de novo
firms were founded after an open standard was released. Hypothesis 2 was first tested using
hypothesis testing for the difference between two binomial proportions (Mitra, 1993, p.
119). The larger proportion of de novo to total number of firms founded before (97 of 150)
than after (523 of 150) open standards emerged is significant at the 0.001 level. Furthermore,
a similar proportion (13 of 21) of the of the most successful firms (those spending more than
two years in the top 25 IT firms) were established after these open standards were released
(See Table 4). These results suggest that large numbers of entrepreneurial opportunities still
exist after open interface standards are released, even when these open interface standards are
defined as dominant designs, and that the emergence of these open standards may be an open
important signal for entry by entrepreneurial startups.
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4.1 Mainframe computers
Open standards emerged for some modules and their interfaces but not for others in
mainframe computers. The first key event was the release of IBMs System/360 in 1964. In
order to reduce the rising software costs of computers, IBM designed the System/360 to be a
modular system in which software and also peripherals (such as storage devices and printers)
could be mixed and matched with any computer in the family of System/360 computers
(Fisher et al, 1983; Flamm, 1988; Pugh, 1995; Ceruzzi, 1998). Although IBM did not intend
for its customers to purchase peripherals from other manufacturers, the release of the IBM
System/360 inadvertently made this possible as the design rules that defined the interface
between computers and peripherals became open to the public thus reducing the transaction
costs associated with other firms selling peripherals to users of IBMs System/360.
Furthermore, although other computer manufacturers had already opened their design
rules in order to facilitate their use of externally available peripherals, IBMs large share of
the mainframe computer market caused its design rules to become industry standards and the
IBM System/360 to become a so-called dominant design for mainframe computers (Fisher et
al, 1983; Dorfman, 1987; Flamm, 1988; Tushman and Rosenkopf, 1992; Baldwin and Clark,
2000). This increased the potential size of the market for independent suppliers of peripherals
and in combination with the falling transaction costs associated with the emergence of a
single standard facilitated the founding of many new firms (Fisher et al, 1983; Flamm, 1988;
Baldwin and Clark, 2000). As shown in Table 4, four of the 9 de novo mainframe peripheral
suppliers in the Datamation 100 were founded after the IBM System/360 was released.
As for application software, IBM opened the interface between its OS and application
software in 1969 under pressure from the U.S. government. Until then IBM made its large
library of application software available for free to all customers that leased IBMs
System/360 computers (Flamm, 1988; Baldwin and Clark, 2000). It was only after the U.S.
Justice Department started an anti-trust case against IBM that IBM un-bundled its hardware
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and application software in 1969 thus making IBMs interface between hardware and
software an open industry standard in 1969 (Steinmueller, 1996; Campbell-Kelly, 2003). As
with peripherals, this reduced the transaction costs associated with other firms selling
application software to users of IBMs System/360 and thus facilitated the founding of many
new firms (Campbell-Kelly, 2003). As shown in Table 4, seven of the twelve de novo
mainframe software firms in the Datamation 100 were founded after IBM announced the
unbundling of its software and hardware.
Open standards did not emerge for other modules and their interfaces in mainframe
computers. None of the mainframe computer manufacturers opened the design rules that
defined the interface between their CPUs and OSs and instead they designed their own CPUs
and OSs. A lack of open design rules, much less open interface standards, prevented
reductions in both the transaction costs associated with different firms designing these
modules and the importance of integrative capabilities from occurring. Mainframe computer
suppliers competed in these integrative capabilities and both IBMs high share and economies
of scale in capabilities (Fisher et al, 1983, Flamm, 1988; Ceruzzi, 1998; Klepper, 1997)
reduced the chances of entry by new computer manufacturers and caused IBM to have the
highest market value in the IT sector until the 1990s (Baldwin and Clark, 2000). Nevertheless,
1 of 2 de novo mainframe computer suppliers was founded after the release of IBMs
System/360.
From the standpoint of users, not all of them could afford mainframe computers. The
emergence of other open standards provided opportunities for firms to provide so-called
remote services to users that could not afford mainframe computers. Through the emergence
of open standards, users were able access these remote services on dumb terminals that were
attached to telephone lines through modems. The key event that enabled the emergence of
open standards for the interfaces modems and telephone lines was the DC Circuit Court of
Appeals decision for Hush-a-Phone in 1956 (Brock, 1981; Cortada, 2004). The Court ruled
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that third parties could attach devices to AT&Ts telephone system. As shown in Table 4, all
of the de novo firms involved with remote services were formed after the first standards for
connecting modems to telephone lines were first established in the late 1950s (Cortada,
2004).
4.2 Mini-computers
Open standards also emerged to some extent for mini-computers. A key event for
mini-computers was DECs release of a 16-bit mini-computer in 1970, which many observers
(Flamm, 1988; Rifkin and Harrar, 1988; Ceruzzi, 1998) including management scholars
(Anderson and Tushman, 1990) consider a dominant design for mini-computers. The success
of IBMs System/360 had defined word lengths with multiplies of 8-bits (now considered one
byte) as an industry standard. Although many suppliers of peripherals and application
software were already selling to users or manufacturers of mini-computers, the introduction
of 16-bit machines increased the compatibility between mini-computers and between them
and mainframe computers (Ceruzzi, 1998) and thus further reduced the transaction costs
associated with different firms providing mini-computers, peripherals, and applications
software, some in the form of so-called value-added resellers (VARs), which combined these
modules for specific industry applications (Rifkin and Harrar, 1988; Ceruzzi, 1998).
Furthermore, these reductions in transaction costs also reduced the importance of integrative
capabilities and enabled vertically disintegrated mini-computer suppliers to dominate the
market (Flamm, 1988; Rifkin and Harrar, 1988). As shown in Table 4, a little more than half
(19 of 36) of the de novo suppliers of mini-computer-related products were founded after
DECs 16-bit mini-computer emerged as a dominant design in 1970 and defined an open
standard between peripherals, computers, operating systems, and application software.
4.3 Personal Computers (PCs)
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Open standards also emerged to some extent in PCs. As documented in a great deal of
detail elsewhere, perhaps best by Langlois (1992), the design rules for the IBM PC became
the standards for these interfaces. IBM intentionally opened the design rules for the interface
between most of the key components such as the microprocessor, OS, application software,
and the so-called BIOS software, which was IBMs only proprietary part of the PC, in order
to attract outside suppliers. Unfortunately for IBM, other firms were able to re-engineer the
BIOS software and other interface design rules and offer so-called IBM compatible
computers that relied on many of the exact same components (e.g., microprocessor, OS, and
peripherals) that were used in the IBM PC. For example, Compaq, and Dell were founded
after the release of the IBM PC and used the externally available OSs, microprocessors,
peripherals, and application software to become successful suppliers of PCs. In other words,
the release of the IBM PC inadvertently reduced both the transaction costs associated with
different firms supplying different modules and the importance of capabilities in multiple
modules and of those associated with integrating them.
However, as shown in Table 4, a smaller proportion of de novo firms were founded after
the release of the IBM PC (14 of 33) than were founded before its release (19 of 33). One
reason for this smaller proportion than in the other discontinuities/systems is the increases
transaction costs that came from the closing of some interface standards. Although the
interface standards that define the interaction between the CPU, OS, and application software
were relatively open when IBM first released its PC in 1981 (and thus I define them as open
for the analysis done for Hypothesis 1 with the data in Table 3), most observers argue that
Microsoft gradually increased its control over these interface standards in the late 1980s and
early 1990s and this control increased the transaction costs associated with different firms
supplying the OS and application software and thus reduced the number of entrepreneurial
opportunities for application software providers (Ceruzzi, 1998; Campbell-Kelly, 2003). For
example, initially successful software from WordPerfect (word processing), Lotus
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(spreadsheet), and Borland (database) was largely replaced by software from Microsoft in the
1990s (Campbell-Kelly, 2003) and only two PC application software providers, Adobe and
Novell, remained in the top 50 software firms by 2002 (Cusumano, 2004).
4.4 Client-Server Computing
Unlike the other discontinuities, client-server systems did not emerge through a top-down
process in which a relatively complete computer system was introduced at a single point of
time. Instead it emerged through multiple bottom-up processes (Jacobides, 2005) that
involved the parallel introduction of open standards for workstations (UNIX), the Internet
(TCP/IP), and LANs (Ethernet) before Microsofts Windows 3.0 marked the official
beginning of client-server computing in the early 1990s (Ceruzzi, 1998; Moore, 1999; Brock,
2003; Campbell-Kelly, 2003). UNIX was gradually improved and revised following its
release by AT&T in 1970 where 1978 is defined as the emergence of the open standard for
UNIX because variations began to emerge after 1978. The TCP/IP standard for the Internet
was established in the late 1970s (Abbate, 1999) and the first version of the Ethernet standard
for LANs was released in 1980 (von Burg, 2001) where the emergence of these open
standards gradually reduced the transaction costs associated with different firms supplying
these modules.
As shown in Table 4, more de novo were founded after the release of these open standards
than were founded before their release (19 of 33). Seven of the ten LAN/router suppliers from
the Datamation 100 were founded after the LAN standard was released in 1980 and the
Internet standards were released in the late 1970s. For workstations, all 12 of these firms
eventually used UNIX or another externally available OS and also externally available
microprocessors in their workstations3 and 9 of 12 were founded after the version of UNIX
3 Although a standard also emerged for workstation microprocessors in the form of Suns SPARC (Scalable Processor Architecture), which
is a RISC-(Reduced Instruction Set Computing) based microprocessor (Garud and Kumaraswamy, 1993; Khazam and Mowery, 1998;
Sorensen, 2003), since the literature on the computer industry focuses more on UNIX than RISC or SPARC (Abbate, 1999; Ceruzzi, 1998;
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that is common to all subsequent versions was released in 1978.
For system software, all of the firms classified as suppliers of system software started as
suppliers of software for mainframe, mini-, and personal computers and merely upgraded
their software for client-server systems after Microsoft successfully introduced Windows 3.0
in the early 1990s. They were able to do this because the users of client-server systems
already used mainframe, mini-, and personal computers and thus demanded backward
compatibility with these computers as they upgraded their systems to client-server systems
(Flamm, 1988, Ceruzzi, 1998). Therefore, the relevant dates for when open standards
emerged for system software suppliers are when open standards were established for
mainframe, mini-, and personal computer software. Eight of the system software suppliers
were initially suppliers for mainframes including Oracle, SAS, and JD Edwards and all eight
of them were founded after IBM announced unbundling in 1969. SAP and System Software
Associates were initially suppliers for mini-computers and Sybase was initially a supplier for
PCs. Both SAP and System Software Associates were founded after the release of 16-bit
mini-computers and Sybase was founded three years after the release of the IBM PC.
An alternative way to analyze system software would be to consider the interface for which
the emergence of an open standard would have reduced the transaction costs associated with
new entrants providing system software. Since users demanded backward compatibility with
their existing systems, the relevant interface is between the software for previous (i.e.,
mainframe, mini-, and PC software) and client-server systems (i.e., system software).
However, open standards for these interfaces have never emerged (Besen and Farrell, 1994;
Shapiro and Varian, 1999; van Everdingen et al, 2000) partly since incumbent suppliers of
software did not want such an open standard to emerge and instead used control over their
Campbell-Kelly, 2003), this paper uses the release of the first version of UNIX as the date for the release of the open standard (i.e., dominant
design) for workstations.
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20
proprietary design rules to upgrade customers from existing software (for mainframe, mini, or
personal computers) to the system software for client-server systems (Moore, 1999; Shapiro
and Varian, 1999).
The last vertically disintegrated layer to consider is system integration, for which open
standards have never emerged. Although this layer is included in this sub-section on
client-server systems, it is probably more accurate to include this layer as a separate
sub-section since it has existed since the early days of main- frame computers. Firms in this
layer initially provided contract software for sophisticated users such as the military and other
government agencies and this contract software gradually became more complex and
proprietary as the complexity of computer systems has increased. Now called systems
integrators, the early providers of these services successfully resisted the emergence of open
standards between different computer systems and between software for these different
computer systems (cited in the previous paragraphs) and have used their proprietary systems
to increase the switching costs for users (Shapiro and Varian, 1999; van Everdingen et al,
2000). These switching costs have increased the transactions costs associated with new
entrants providing systems integration services. The result is that de novo firms are
represented less among systems integrators than other providers of software (see earlier
discussion of Hypothesis 1) and none of the firms defined as a systems integrator in the
Datamation 100 (either de alio or de novo) were founded after 1982 and more than half of
these firms were founded before 1970. Many of the de alio system integrators in the
Datamation lists came from the accounting or general consulting industries. They used their
relationships with IT users in their accounting and general consulting work to build a large
installed base of customers for system integration services and create switching costs to
maintain this installed base.
5. Discussion
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21
This paper uses the literature on industry architecture to challenge the conventional
wisdom on entry timing and re-examine the tradeoffs for vertically disintegrated
entrepreneurial startups. The conventional wisdom is that the emergence of a dominant
design defines a set of necessary capabilities that firms must have in order to effectively
compete, leads to the exit or acquisition of firms that are deficient in these capabilities, and
thus causes a decline, i.e., a shakeout, in the total number of firms, where these shakeouts
occur even when the size of the market continues to grow. This suggests that firms must enter
and be founded before a dominant design emerges.
The literature on industry architecture suggests there is a tradeoff between early entry to
develop capabilities and later entry to benefit from lower transaction costs. For each module
or so-called vertically disintegrated layer, early entrants can begin doing R&D and
developing capabilities. Later entrants will be at a disadvantage in terms of these economies
of scale in capabilities and thus may incur higher R&D costs as a percent of sales than do
earlier entrants. On the other hand, the emergence of open design rules and open standards
can reduce the transaction costs associated with different firms providing these different
modules. The emergence of these externally available modules also reduces the importance
of integrative capabilities and thus increases the advantages of vertically disintegrated firms
vis--vis vertically integrated firms. Furthermore, if the relevant open standards are defined
by designs that can be classified as dominant designs, the emergence of such a dominant
design would also reduce transaction costs and thus facilitate the entry of new firms.
Assuming that economies of scale in R&D increases in the same way for all modules as
characterized by Klepper (1996), this paper focuses on declining transaction costs from the
emergence of open design rules and interface standards and whether these declining
transaction costs enable new firms to enter. Hypothesis 1 addressed whether de novo
entrepreneurial startups are more represented among modules that involve open interface
standards than in those that do not. It was found that the proportion of de novo to total
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22
number of firms, or the number of de novo firms was much larger for those vertically
disintegrated layers in which open standards emerged than for those layers in which they did
not. A lack of open standards for the interfaces between application software from different
systems/discontinuities and for the interfaces between a computers OS and CPU reduced the
number of opportunities for de novo startups in systems integration and in OSs, and CPUs
respectively. The former was tested by comparing the proportion of de novo to total number
of firms in systems integration software (10 of 24) than in other software (36 of 40); the
difference in these proportions is significant at the 0.001 level. The latter was tested by
comparing the small number of independent suppliers of OSs and CPUs with the much larger
numbers of firms in other layers.
After excluding those layers for which open standards did not emerge, the analysis
focused on founding date for new entrants. Since market entry must occur after a firm is
founded, a comparison of when firms were founded and when open standards emerged will
underestimate the extent to which the emergence of open standards reduces transaction costs
and facilitates market entry. This papers analysis found that more de novo firms were
founded after open standards were released (97 of 150) than before they were released (53 of
150) and this is significant at the 0.001 level. These results suggest that entrepreneurial
opportunities still exist after an open interface standard has been established and to some
extent the entrepreneurial opportunities are created by the emergence of the open interface
standards since their emergence reduces transaction and thus entry costs. Furthermore, since
these open standards are often defined by designs that are classified as dominant designs by
the literature on technology management, these results suggest that entrepreneurial
opportunities still exist after a dominant design containing open standards has been
established and to some extent the entrepreneurial opportunities are created by the release of
an open dominant design that reduces the transaction costs associated different firms
supplying different modules.
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23
This papers analysis of multiple modules and interface standards also suggests that
reductions in transaction costs may lead to new firm entry in different ways for different
situations. For example, open standards are needed before some services can be
technologically provided and thus the emergence of open standards may dramatically (as
opposed to gradually) reduce the transaction costs associated with different firms providing
different modules in a very short time. This was probably the case with remote services that
could not be provided before an open interface between computers and telecommunication
systems was defined and a standard for this interface in the form of a modem was released.
Thus, all of the firms that are classified as providers of remote services in Table 4 were
founded after the initial standards for modems were established. More recent examples of
services that could not be provided before open standards were defined are (PC) Internet
content and applications (Abbate, 1999) and mobile Internet content and applications (Funk,
2007).
Second, the emergence of some open standards probably increased the size of the market
for many types of computer peripherals and software and reduced the number of interface
design rules that had to be addressed by suppliers of peripherals and software. For example,
although some firms supplied peripherals to computer manufacturers other than IBM before
the System/360 was released, the release of the System/360 opened up a large new market for
these peripherals and defined a single standard for the interface. To some extent similar things
occurred following IBMs decision to unbundle hardware and software in its mainframe
computer and the release of the 16-bit mini-computers and the IBM PC. Third, the emergence
of open standards makes it easier for firms to supply the final product, computers, using
externally available peripherals, application software, OSs, and CPUs. This was the case with
16-bit mini-computers, the IBM PC, and workstations in that the emergence of externally
available modules reduced the transaction costs associated with new entrants combining these
externally available modules into computers.
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24
The case of Apples i-Phone will hopefully illustrate some of these issues and the problems
with the management literatures characterization of entrepreneurial opportunities and
dominant designs. The conventional wisdom about dominant designs would focus ones
attention on phones and the potential reduction in the number of opportunities for new phone
entrants that the i-Phone might bring. However, this papers analysis would focus ones
attention on how the greater use of open standards in the i-Phone than in other phones has
already enabled thousands of firms to enter the mobile phone industry and become providers
of application software. Furthermore, the emergence externally available modules that the
open standards is bringing might enable other firms to use these same modules to supply
mobile phones in much the same way that the release of the IBM PC inadvertently facilitated
the entry of personal computer manufacturers.
One thing that this paper is not arguing, however, is that firms should be founded after an
open standard has emerged. The real issue is not timing, it is how firms can recognize the
emergence of open design rules and open standards in for example the i-Phone. Economies of
scale in R&D and other functions means that early entry is better than late entry as long as
firms can adapt to changes in interface design rules and standards. However, the large
proportion of de novo firms that were founded after open standards were released suggests
that adapting to changes in design rules and standards is a very large challenge. Future
research should attempt to better understand how early entrants failed (and other firms
succeeded). Did they fail because they did not notice the changes in design rules or the
emergence of standards or because they were unable to adapt to their emergence and to the
new capabilities that were associated with the emergence of these standards?
Future research should also address several limitations in this study. First, a larger sample
of firms would provide a better test of the two hypotheses. Second, testing the hypothesis
with entry date rather than founding data could provide more detailed insights into the impact
of falling transaction costs on entry timing. Third, similar arguments could also be made for
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25
better quantifying the degree of agreements on standards (e.g., there were more versions of
UNIX than in other standards). Fourth, data on economies of scale in for example, R&D
would enable one to further analyze the tradeoffs between economies of scale in R&D and
falling transaction costs. Fifth, data on economies of scale in R&D could be combined with
data on the total number of firms in each module to analyze the impact of economies of scale
in R&D on the total number of firms and thus the number of entrepreneurial opportunities in
each layer.
6. Conclusions
This paper re-characterizes the issue of entry timing using the literature on industry
architecture. Focusing on a specific module, early entrants can benefit from economies of
scale in capabilities while later entrants can benefit from the reductions in entry costs that
occur as open design rules and open standards emerge and that reduce the transaction costs
associated with different firms supplying different modules. Focusing on transaction costs,
this papers analysis found that a larger number of successful de novo firms were founded
after the release of open standards than were founded before their release. These results
suggest that the emergence of open standards can facilitate the entry of new firms and if the
relevant open standards are defined by designs that can be classified as dominant designs the
emergence of such a dominant design would also reduce transaction costs and thus facilitate
the entry of new firms.
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26
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Table 1. Number of De Novo and De Alio Firms in the Datamation Rankings and the Number of New Firms Entering these Rankings (either top 50 or top 100) Each Year
All firms in top 50 All firms in 51-100 Firms New to List Year De Novo De Alio De Novo De Alio De Novo De Alio Total (1)
1975 22 28 NA NA 22 28 50 (2) 1976 21 29 NA NA 3 2 5 1977 22 27 NA NA 0 1 2 1978 21 28 NA NA 1 2 3 1979 19 30 30 19 30 20 51 (2) 1980 17 33 25 23 8 14 22 1981 19 31 26 22 3 4 8 1982 19 31 26 23 6 2 10 1983 20 30 24 24 3 6 10 1984 21 29 30 18 12 3 16 1985 21 29 33 16 9 3 12 1986 23 27 33 17 11 4 15 1987 23 27 36 14 9 4 13 1988 24 26 34 16 5 2 7 1989 25 25 38 12 10 1 11 1990 26 24 34 16 3 2 5 1991 29 21 34 16 11 3 14 1992 28 22 34 15 4 1 5 1993 29 21 37 12 6 0 6 1994 31 19 39 10 13 4 18 1995 31 18 NA NA 1 2 4 1996 31 19 NA NA 0 1 1 Total NA NA NA NA 170 109 288 Notes: (1) Some of the numbers for the de novo and de alio firms to not add up to 50 or to 100 because of a lack of information on some firms. Thus, the differences between the number 50 and the sums of columns 2 and 3 and the sums of columns 4 and 5 are the number of unknown/unclassifiable firms. The same reason accounts for the differences between the total number of new firms to the list in column 8 and the sum of columns 6 and 7. (2) The numbers 50 and 51 reflect the first year of the Datamation 50 and 100 lists respectively and thus there were by definition a large number of firms new to the list in those two years. NA: Not applicable
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32
Table 2. Status of Standards for Discontinuities/Systems in the Information Technology Sector (1950 to 1995)
System Interface Between Name of Standard or Product Defining Standard
Year Established/Released
Open vs. Closed
Computer and Peripherals IBM System/360 1964 Open OS and Application S/W IBMs unbundling of
software and hardware 1969 Open
OS and CPU IBM System/360 1964 Closed
Mainframe Computer
Computer and Remote Services
Various enacted after Hush-a-Phone case
1956 Open
Computer and Peripherals Extensive product documentation by computer firms
1965 Open
OS and Application S/W Open Computer and Value-Added Reseller
16-bit word length (multiple of 8-bits)
1970 Open
Mini- Computer
OS and CPU None NA Closed Computer and Peripherals Open OS and Application S/W Initially
open
Personal Computer (PC)
OS and CPU
IBM PC (later called WINTEL standard)
1981
Closed Computers and Internet TCP/IP 1980 Open Computers and LAN Ethernet 1980 Open Computers and Users Windows 1990 Closed Application S/W from Different Systems/ Discontinuities
None NA Closed
Client- server system
Workstation OS UNIX 1978 Open
Abbreviations: CPU (central processing unit); OS (Operating System); LAN (Local Area Network); S/W (software); NA (Not applicable) Sources: (Rifkin and Harrar, 1983; Flamm, 1988; Langlois, 1992; Steffens, 1994; Pugh and Aspray, 1996; Ceruzzi, 1998; von Burg, 2001; Campbell-Kelly, 2003).
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33
Table 3. Proportion of De Novo to Total Number of Firms
Computers Peripherals Application Software
Operating Systems
Discontinuity
Proportion
All Firms
Proportion
All Firms
Proportion
All Firms
Proportion
All Firms
Mainframe 0.29 7 0.60 15 0.80 15 0 0 Mini 0.67 21 0.50 10 0.83 6 0 0 Personal 0.50 16 0.57 30 1.00 7 1.00 1 Client-Server 1.00
(4) 12 (4) 0.67 (3) 15 (3) 1.00 (1)
0.42 (2) 11 (1) 24 (2)
0 0
Total 0.62 52 0.59 70 0.71 63 1.00 1 (1) system software (2) system integration services (3) LAN/Routers (4) Workstation-related products and services
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34
Table 4. Number of De Novo Firms Founded before the Discontinuity, after the Discontinuity
but before an Open Standard is Released, and after the Open Standard is Released Number of Firms that were Founded System/
Discontinuity
Module/Vertically Disintegrated Layer
Number ofDe Novo Firms Before Standard is
Released After Standard is released
Computer 2 1 1Peripheral 9 5 4
Mainframe Computer
Software 12 5 7Time sharing 3 3Process services 12 12
Remote Services
Terminals 10 10Computer 14 8 6Peripherals 5 2 3Software 5 2 3
Mini- Computer
Value Added Reseller 12 5 7Computer 8 4 4Peripheral 17 11 6
Personal Computer
Software 8 4 4Workstation 12 3 9Local Area Network/Router 10 3
7Client Server Systems
System Software
11 11
Total Number of Firms 150 53 97
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35
Table 5. The Most Successful De Novo Firms* for each Vertically Disintegrated Layer and their Date of Founding System/ Discontinuity
Module/ Vertically Disintegrated Layer
Firm Date of Founding
Years in the Top 25
Computer CDC Amdahl
1957 1970**
1975-1989 1977-81, 83-92
Peripheral
Storage Technology Memorex
1969** 1961
1979-84, 91-92 1975-1980
Software Computer Associates
1974** 1989-1996
Mainframe Computer
Terminals
Mohawk Data Sciences Datapoint
1964** 1969**
1975-1977 1980-1982
Mini- Computers
Computer DEC Data General Prime Tandem
1957 1969 1972** 1974**
1975-1996 1975-1991 1981, 85-86, 88-91 1986-94
Computer Apple Compaq Dell
1977 1982** 1984**
1981-1996 1987-1996 1992-1996
Peripheral Seagate Quantum Conner Peripherals
1978 1980 1986**
1987-1996 1992-1996 1990-1994
Personal Computer
Software Microsoft 1975 1990-1996 Workstaton Sun 1982** 1988-1996 LAN/Router Cisco 1984** 1993-1996
Client Server Systems System
Software Oracle 1977** 1994-1996
*defined as in the top 25 firms in the Datamation ranking for at least two years **established after the relevant standard had been released
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36
Figure 1. Cost Tradeoffs for Timing of Entry/Establishment (1)
Time
Costs
Reductions intransaction costs
Minimum costs of entry/establishment
Increasedeconomies ofscale (includingR&D)
(1) Assumes the eventual emergence of open standards. The emergence of closed standards would increase transaction costs and this case is not shown here.
Figure 2. Evolution of Industry Architecture for IT Sector
1950 1960 1970 1980 1990
MainframeComputers
Mini-Computers
PersonalComputers
(PCs)
Computer Design
User (3)Customization
System360
Peripherals
IBMUnbundling
16-bitword
length
IBM PC
Windows, UNIX, TCP/IP,Ethernet,
S/W: software; App: application; OS: operating system; CPU: central processing unit; VAR: Value-added reseller. (1): Includes PCs and workstations. (2) Mainframe computers and workstations are also used as servers; (3) Includes contract S/W and services; 4) includesfacility management, computer leasing, and remote services such as processing or time-sharing.
User Customization (3)
VARsPeripherals
App S/WPeripherals
OSMicroprocessor
Peripherals Mic
ropr
oces
sor
Syst
ems
Softw
are
and
Syst
ems I
nteg
ratio
nA
pp/ S
/W
OS
Net
-w
orks
Mic
ropr
oces
sor
OS
App
S/W
Clie
nt (1
) Des
ign
Serv
er (2
) Des
ign
Contract S/W, Services (4)
Contract S/W, Services (4)
Peripherals
Computer Design
App S/W
Contract S/W, Services (4)
Application S/WPeripherals
Computer Design
ComputerDesign
Computer Design Computer Design
Computer Design
Client-ServerSystems