mckenna technological innovation

7/27/2019 McKENNA Technological Innovation

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Capturing Value from Technological InnovationIntegration, Strategic Partnering, and LicensingDecisionsDAVID]. TEECE School of Business AdministrationUniivrsiti/ of California

Berkeley, California 94720

The competitive potential embedded in new technology is nalways captured by the innovator. Follower firms, customersand suppliers are often the principal beneficiaries. When in-novating firms lose to followers or imitators, the reason isoften the failure of the innovator to build or access competi-tive capacity in activities, such as manufacturing, which arecomplementary to the innovation. This paper analyzes themake-or-buy decision with respect to these capacities in dif-ferent competitive environments, including that of rapid technological change and easy imitation. Often it is pointless forfirms to invest in R&D unless they are also willing to investin the development of certain complementary capacities, athome or abroad.I t is commonly recognized that firmsresponsible for technological break-throughs and for technological enhance-ment of existing products and processesare often unable to commercialize theproduct so that the product concept ulti-mately fails. Myriads of would-be innova-tors have discovered that technical

success is necessary but not sufficient foestablishing economic utility and commcial acceptance. A less commonly recognized but equally important phenomenois the firm that is first to commercialize new product concept but fails to extracteconomic value from the innovation, ev


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nd is the source of economic rents (prof-to competitors. The phenomenon un-

and has obviousfor the dynamic efficiency ofas well as for the distribu-

of income, domestically and interna-in the international context, it

for economicfor commercial policy, and for

I offer a framework that may shed lightn the factors that determine who wins

the firm that is first toor those that follow. The followermay or may not be imitators. The

for explainingof the profits from innovation

to the innovator compared to the1), and for explaining a

of interfirm activities such as joint

Imitatorsand other"Followers"

Figure 1: The benefits from innovation, some-times referred to as economic rents, are di-vided among innovator, imitators, suppliers,and customers. A normative framework devel-

distribution arrangem ents, and technolog-ical licensing.The Phenomenon

The EMI Scanner is a classic case of alosing innovation [Martin 1984]. By theearly '70s, the UK firm. Electrical MusicalIndustries (EMI) Ltd., was producing avariety of products including phono-graphic records, movies, and advancedelectronics. EMI had developed high reso-lution TVs in the '30s, pioneered airborneradar during World War II, and developedth e UK's first all solid-state computers in1952.

In the late '60s Godfrey Houndsfield,an EMI senior research engineer, engagedin research on pattern recognition, whichresulted in his displaying a scan of a pig'sbrain. Subsequent clinical work estab-lished that computerized axiai tomogra-phy (CAT) was viable for generatingcross-sectional "views" of the humanbody; this was the greatest advance inradiology since the discovery of X-rays in1895.

The US was the major market for theproduct. However, EMI was UK basedand lacked a marketing capability or pres-ence in medical electronics in the UnitedStates. Because the scanner was a com-plex product, it required an organizationthat had service and training capacity aswell as marketing ability. EMI's competi-tors, such as Siemens and GH, had theseassets.

A m arket for CAT scanners rapidlyemerged after EMI displayed advancedprototypes in Chicago in November 1972.By 1975, EMI had an order backlog of 55


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TEECEprojected by investors, and stock analystsbegan to think of EMI as shaping up fora success of the magnitude of Xerox's inthe previous decade.

By the mid-'70s imitators had emerged,most notably GE with faster scanners tai-lored more closely to the needs of themedical profession and supported in thefield by experienced marketing and ser-vice personnel. Simultaneously, healthcare regulations in the United States im-posed a requirement that hospitals obtaincertificates of need before purchasinghigh priced items like scanners. EMI wasforced to sell its scanner business and inApril of 1980 announced a sale to GE. Atthat time EMI indicated that it had lost26 million on the business. Meanwhile,GE's operations were believed to be quiteprofitable. Subsequently, GE and Johnson& Johnson each paid EMI $100 million indamages for patent infringement.

Other examples of losing innovators areRC Cola, Bowmar, Xerox, and de Havil-land. RC Cola, a small beverage company,was the first to introduce cola in a canand the first to introduce diet cola. BothCoca Cola and Pepsi followed almost im-mediately, depriving RC of any significantadvantage from its innovation. Bowmar,which introduced the pocket calculator,was not able to withstand competitionfrom Texas Instruments, Hewlett Packard,and others and went out of business. Xe-rox failed to succeed with its entry intothe office computer business, eventhough Apple succeeded with the Mac-intosh, which contained many of Xerox's

Innovator Imitalor-Follower1 Pilkington (Float Glass)

G.D. Searle (NulraSweel) DuponI (Tellon)

3 RC Cota (diel cd a)-EMI Iscannerl- Bowmar (pockel calculator) XeroK CStar") DeHavilland {Comel)

IBM (persor^l compute Ualsushila

[VHS video recordefs) Seiko (quartz watch)

Kodak IJnstaniphotography)

- r^orthrup (F20) DEC (personal compuie

Figure 2: There is lore, but little analytics,explain when and why innovators lose outimitators and followers. Xerox, for instanchas been first to commercialize key computechnologies developed in its Pare facility;however, in several instances it has failed recover its investment, while competitors,such as Apple, have done fabulously well derivative technology.jet was introduced into the commerciaairline business two years or so beforeBoeing introduced the 707, but throughan unfortunate series of events, de Haland failed to capitalize on its substantearly advantage.Capturing the Rent Stream fromInnovation: Basic Building Blocks

In order to develop a coherent framework within which to explain the distrbution of outcomes illustrated in Figurthree fundamentai building blocks musfirst be described: the appropriability rgime, complementary assets, and thedominant design paradigm.Regimes of Appropriability

The term regime of appropriability refeto aspects of the commercial environ-ment, excluding firm and market struc-ture, that govern an innovator's ability


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however, only if a firm can put its

The degree to which knowledge is tacit

Empirical research by Levin, Klevorick,

results show considerable collinearityamong certain mechanisms of appropria-bility. They conclude that "at the expenseof some oversimplification, the data sug-gest that the mechanism of appropriationmay reduce to two dimensions: one asso-ciated with the use of patents, the otherwith lead time and learning-curve advan-tages. For process innovations, secrecy isclosely connected with exploiting leadtime and learning advantages. For prod-uct innovation, sales and service effortsWho wins from innovation?are part of the package" [p. 18]. Thesefindings are tentative and must be inter-preted with care. They do, however, indi-cate that methods of appropriability varymarkedly across industries and probablywithin industries as well.The property rights environment withinwhich a firm operates can thus be classi-fied according to the nature of the tech-nology and the efficacy of the legalsystem to assign and protect intellectualproperty. While a gross simplification, adichotomy can be drawn between prod-ucts for which the appropriability regimeis "tight" (technology is relatively easy toprotect) and those for which it is "weak"(technology is almost impossible to pro-tect). An example of the former is the for-mula for Coca Cola syrup; an example ofthe latter is the Simplex algorithm inlinear programming.The Dominant Design Paradigm

Thomas Kuhn's seminal work [1970]


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TEECEas applied to scientific development isbroader than that of a theory. In fact, aparadigm is a Cestalt that embodies a setof scientific assumptions and beliefs aboutcertain classes of phenomenon. Kuhnsuggests that there are two stages in theevolutionary development of a givenbranch of a science: the preparadigmaticstage, when there is no single generallyaccepted conceptual treatment of the phe-nomenon in a field of study, and the par-adigmatic stage, which begins when abody of theory appears to have passedthe canons of scientific acceptability. Theemergence of a dominant paradigm sig-nals scientific maturity, and the accept-ance of agreed upon standards by whichwhat Kuhn calls "normal" scientific re-search can proceed. These standards re-main in force unless or until the para-digm is overturned. Revolutionary scienceis what overturns normal science, aswhen the Copernicus theories of astron-omy overturned Ptolemy's in the 17thcentury.

Abernathy and Utterback [1978] andDosi [1982] have provided a treatment ofthe technological evolution of an industrywhich appears to parallel Kuhnian no-tions of scientific evolution. In the earlystages of industry development, productdesigns are fluid, manufacturing pro-cesses are loosely and adaptively organ-ized, and generalized capital is used inproduction. Competition among firmsmanifests itself in competition among de-sign s, which are markedly different fromeach other. This might be called the

or a narrow class of designs begins toemerge as the more promising. Such adesign must be able to meet a whole sof user needs in a relatively completefashion. The Model T Ford, the IBM 36and the Douglas DC-3 are examples ofdominant designs in the automobile, cputer, and aircraft industries.

Once a dominant design emerges, copetition shifts to price and away from sign. Competitive success then shifts t

Expectations of 100 millionyear in scanner sales by EMwere projected.whole new set of variables. Scale andlearning become much more importantand specialized capital is deployed ascompeting firms seek to lower unit cosby exploiting economies of scale andlearning. Reduced uncertainty over prouct design provides an opportunity toamortize specialized long-livedinvestments.

Innovation is not necessarily haltedonce the dominant design emerges; asClarke 11985] points out, it can occurlower down in the design hierarchy. Foinstance, a "V" cylinder configurationemerged in automobile engine blocks ding the 1930s with the emergence of theFord V-8 engine. Niches were quicklyfound for it. Moreover, once the producdesign stabilizes, there is likely to be asurge of process innovation as producerattempt to lower production costs for th


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INNOVATION

preparadigmatic design phase paradtgmalc design phaseFigure 3: When new technologies are commer-cialized, process innovation often foltowsproduct innovation. As the rate of product in-novation slows, designs in the marketplacetend to become more standardized, providingthe opportunity for large-scale production andthe deployment of specialized assets. The na-ture of competition and the requirements formarketplace success shift dramatically as themarket evolves from its early preparadigmaticphase (with competition based on featuresand product performance) to its post paradig-matic phase (with competition based more onprice).seems more suited to mass marketswhere consumer tastes are relatively ho-mogeneous. It appears less characteristicof small niche markets where the absenceof scale and learning economies attachesmuch less of a penalty to multiple de-signs. In these instances, generalizedequipment will be employed in production.

The existence of a dominant designwatershed is of great significance to thedistribution of rents between innovatorand follower. The innovator may havebeen responsible for the fundamental sci-entific breakthroughs as well as the basicdesign of the new product. However, ifimitation is relatively easy, imitators mayenter the fray, modifying the product inimportant ways, yet relying on the funda-

stops, and a dominant design emerges,the innovator might well end up at a dis-advantage. Hence, when imitation is pos-sible, and when it occurs coupled withdesign modification before a dominantdesign emerges, a follower's modifiedproduct has a good chance of beinganointed as the industry standard.Complementary Assets

Let the unit of analysis be innovation.An innovation consists of certain techni-cal knowledge about how to do thingsbetter. Assume that the know-how inquestion is partly codified and partlytacit. In order for such know-how to gen-erate a rent stream, it must be sold orused in the market.

In almost all cases, the successful com-mercialization of an innovation requiresthat the know-how in question be utilizedin conjunction with such services as mar-keting, competitive manufacturing, andafter-sales support. These services areoften obtained from complementary as-sets that are specialized. For example, thecommercialization of a new drug is likelyto require the dissemination of informa-tion over a specialized information chan-nel. In some cases, as when the innova-tion is systemic, the complementary as-sets may be other parts of a system. Forinstance, computer hardware typically re-quires the development of specializedsoftware, both for the operating systemand for applications. Fven when an inno-vation is autonomous, the services of cer-tain complementary assets will be neededfor successful commercialization (Figure 4).

Whether the assets required for least


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CoreTechnologicalKnow-HowIn Innovation ComplementarvTechnologies

Figure 4: In order to innovate, firms needcomplementary assets and technologies to sup-port the commercialization of some core tech-nology. These assets typically includemanufacturing, distribution, and sales andservice. They may already reside in-house. Ifnot, they are conceivably available throughmerger, acquisition, or contract. The key con-sideration is the terms upon which they areavailable to the innovator.important in the development presentedbelow. Complementary assets can be ge-neric, specialized, or cospecialized.

Generic assets are general purpose as-sets that do not need to be tailored to theinnovation. Specialized assets are thoseon which the innovation depends, tai-lored to that innovation. Cospecializedassets are those for which there is a bilat-eral dependence. For instance, specializedrepair facilities are needed to supportMazda's rotary engine. These assets arecospecialized because of the mutual de-pendence of the innovation and the repairfacility. Container shipping required asimilar deployment of cospecialized assetsin specially designed ships and terminals.However, the dependence of trucking on

trucks can convert from containers to flatbeds at low cost. An example of a genericasset would be the manufacturing facili-ties needed to make running shoes. Gen-eralized equipment can be used exceptfor the mold for the sole.Implications for Profitability

These three concepts can now be re-lated in a way that will shed light on theimitation process and the distribution ofrents between innovator and follower. Inthose few instances where the innovatorhas ironclad patent or copyright protec-tion, or where trade secrets effectivelydeny imitators access to the product, theinnovator is almost assured of capturingthe lion's share of available profits forsome period of time. Even if the innova-tor does not have the desirable comple-mentary assets, ironclad protection ofintellectual property will afford it time toobtain them. If these assets are generic, acontractual relationship may suffice; theinnovator may simply license its technol-ogy. Specialized R&D firms are viable insuch an environment. Universal Oil Prod-ucts, an R&D firm developing refiningprocesses for the petroleum industry, wassuch an innovator. If, however, theneeded complementary assets are special-ized or cospecialized, contractual relation-ships are exposed to hazards, becauseone or both parties will have to commitcapital to certain irreversible investments,which will be valueless if the relationshipbetween innovator and licensee breaksdown. Accordingly, the innovator maywant to integrate by owning the special-ized and cospecialized assets. Fortu-


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INNOVATIONinnovator to build or acquire those com-plementary assets without competingVk'ith innovators for their control.

Competition from imitators is thusmuted in tight appropriability regimes,which sometimes characterizes the petro-chemical industry. In this industry, theprotection offered by patents is fairly eas-ily enforced. A factor that helps the licen-sor is that most petrochemical processes

RC Cola was the first tointroduce cola in a can andthe first to introduce dietcola.are designed around a specific variety ofcatalysts that can be kept proprietary. Anagreement not to analyze the catalyst canbe extracted from licensees, affording ex-tra protection. Even if such requirementsare violated by licensees, the innovator isstill well positioned: the most importantproperties of a catalyst are related to itsphysical structure, and the process forgenerating this structure cannot be de-duced from structural analysis alone.Every reaction technology a company ac-quires is thus accompanied by an ongoingdependence on the innovating companyfor the catalyst appropriate to the plantdesign. Failure to comply with the licens-ing contract can result in a cutoff in thesupply of the catalyst and possibly infacility closure.

Similarly, if an innovator comes to mar-ket in the preparadigmatic phase with a

design right. The best initial design con-cepts often turn out to be hopelesslywrong, but if the innovator possesses animpenetrable thicket of patents, or simplyhas technology that is difficult to copy,then the market may well afford the inno-vator the time necessary to find the rightdesign.

However, tight appropriability is the ex-ception rather than the rule. Most innova-tors must formulate and implement com-plex business strategies to keep imitatorsat bay. The nature of the strategic chal-lenge will vary according to whether theindustry is in the paradigmatic or prepar-adigmatic phase.

In the preparadigmatic phase, the inno-vator, with little or no intellectual prop-erty protection available for its technolo-gy, must be careful to let the basic designfloat until the design seems likely to be-come the industry standard. In some in-dustries this may be difficult as littleopportunity exists for product modifica-tion. In microelectronics, for example, de-signs become locked in when thecircuitry is cho sen . Produ ct modificationis limited to debugging and softwarechanges. An innovator must begin the de-sign process anew if the product does notfit the market well. To some extent, newdesigns are dictated by the need to meetcertain compatibility standards so that thenew hardware can interface with existingapplications software. In one sense,therefore, design for the microprocessorindustry today is relatively straightfor-ward: deliver greater power and speedwhile meeting the industry standards of


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TEECEallow the introduction of entirely newfamilies of microprocessors that will de-fine a new industry and software stand-ard. Then basic design parameters areless defined and can float until marketacceptance is apparent.

The early history of the automobile in-dustry an industry characterized by aweak ap propriability regime exempli-fies the importance of selecting the rightdesign in the preparadigmatic stages.None of the early steam cars survivedwhen the closed-body, internal combus-tion engine automobile emerged as thedominant design. The steam car, never-theless, had virtues, such as reliability,that the internal combustion engine autosof that time did not.

The British fiasco with the Comet I isalso instructive. De Havilland had pickedan early design with significant flaws. Byracing on to production, the innovatorsuffered an irreversible loss of reputationthat seemed to prevent it from convertingto what subsequently became thedominant design.

In general, innovators in weak appro-priability regimes need to be intimatelyconnected with the market so that de-signs are based on user needs. Whenmultiple parallel and sequential prototyp-ing is feasible, it has clear advantages.Usually, it is too costly. Developmentcosts for a large commercial aircraft canexceed one billion dollars; variations onone theme are all that is possible.

Hence, the probability that the firstfirm to commercialize a new product de-sign will enter the paradigmatic phase

the cost of prototyping and the moretightly coupled the firm is to the market.The firm's relationsh ip to the m arket is afunction of organizational design and canbe influenced by managerial choices. Thecost of prototyping is embedded in thetechnology and cannot be greatly influ-enced by managerial decisions. Hence, inindustries with large developmental andprototyping costs where choices areirreversible and where innovation of theproduct concept is easy the innovatorwould be unlikely to emerge as a winnerat the end of the preparadigmatic stage ifthe appropriability regime is weak.

In the preparadigmatic phase, comple-mentary assets do not loom large. Rivalryis focused on trying to identify the designthat will dominate the industry. Produc-tion volumes are low, and little can begained from deploying specialized assetssince scale economies are unavailable andprice is not a principle competitive factor.However, as the leading design or designsare revealed by the market, volumes in-crease and firms gear up for mass pro-duction by acquiring specialized toolingand equipment, and possibly specializeddistribution as well. Since these invest-ments are irreversible, they are likely toproceed with caution. Islands of assetspecificity will thus begin to form in a seaof generalized assets.

However, as the terms of competitionbegin to change and prices become in-creasingly unimportant, complementaryassets become critical. Since the coretechnology is easy to imitate, commercialsuccess depends on the terms under


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INNOVATIONAt this point, specialized and cospecial-

ized assets become critically important.Generalized assets, almost by definition,are always available in an industry, andeven if they are not, they do not involvesignificant irreversibilities. Even if there isinsufficient capacity, additional capacitycan be put in place with little risk. Spe-cialized assets, on the other hand, involvesignificant irreversibilities and cannot beeasily accessed by contract. Recontractinghazards abound when dedicated assetsthat do not have alternative uses are sup-ported entirely by contractual arrange-ment [Williamson 1975, 1981, 1985, Teece1980, 1982, 1985]. O w ners of cospecial-ized assets, such as distribution channelsor specialized manufacturing capacity, areclearly advantageously positioned relativeto an innovator. Indeed, when they holdan airtight monopoly over specialized as-sets, and the innovator is in a regime ofweak appropriability, they could com-mand all of the rents to the innovation.Even without a monopoly, specialized as-sets are often not as easy to replicate asthe technology. For instance, the technol-ogy in cardiac pacemakers was easy toimitate; competitive success was deter-mined by who controlled the specializedmarketing. A similar situation exists inthe US for personal computers:There are a huge number of computer manu-facturers, companies that make peripherals(e.g., printers, hard disk drives, floppy diskdrives), and software companies. They are alltrying to get marketing distributors becausethey cannot afford to call on all of the UScompanies directly. They need to go throughretai! distribution channels, such as Business-land, in order to reach the marketplace. The

their products. The point of distribution iswhere the profit and the power are in themarketplace today [Norman 1986, p. 438].Channel Selection Issues

Access to complementary assets is criti-cal if the innovator is to avoid handingover the lion's share of the profits to imi-tators or to the owners of specialized andcospecialized complementary assets.What controls should the imitator estab-lish over these critical assets?

Many channels can be employed. Atone extreme, the innovator could inte-grate into all of the necessary comple-mentary assets, an option that is probably

Patents do not work inpractice as they do in theory.unnecessary and prohibitively expensive.The assets and competencies needed maybe numerous, even for quite simple tech-nologies. To produce a personal com-puter, for instance, a company needsexpertise in semiconductor technology,display technology, disk-drive technology,networking technology, keyboard technol-ogy, and several others. No company, noteven IBM, has kept pace in all of theseareas by itself.

At the other extreme, from handling alltechnologies internally the innovatorcould attempt to access these assetsthrough contractual relationships (for ex-ample, component supply contracts, fabri-cation contracts, and distributioncontracts). In many instances, contractsmay suffice, although they expose the in-


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TEECEthese two extremes are a myriad of inter-mediate forms and channels. I will ana-lyze the properties of two extremes andalso describe a mixture.Cdntractual ModesThe advantages of a contractual solu-tion whereby the innovator contractswith independent suppliers, manufactur-ers or distributors are obvious. The in-novator will not have to make the capitalexpenditures needed to build or buy theassets. This reduces risks as well as cashrequirements. Also, contractual relation-ships can bring added credibility to theinnovator, especially if the innovator isunknown and the contractual partner isestablished and viable. Indeed, arms-length contracting which embodies morethan a simple buy-sell agreement is be-coming so common and is so multifacetedthat the term strategic partnering hasbeen devised to describe it. Even largecompanies such as IBM are now engagingin it. For IBM, partnering buys access tonew technologies enabling the companyto learn things they couldn't have learnedwithout many years of trial and error.IBM's arrangement to use Microsoft's MS-DOS operating system software on theIBM PC facilitated the timely introductionof IBM's personal computer into the mar-ket. Had IBM developed its own operat-ing system, it would probably havemissed the market window.

Smaller, less integrated companies areotten eager to sign on with establishedcompanies because of the name recogni-tion and reputation spillovers. Eor in-stance. Cipher Data Products contracted

drive, which is likely to become the in-dustry standard. Cipher management recognizes that one of the biggest advan-tages to dealing with IBM is that, onceyou've created a product that meets thehigh quality standards necessary to sellinto the IBM world, you can sell into anyarena. Similarly, IBM's contract with Mi-crosoft meant instant credibility to Micro-soft [McKenna 1985, p. 94].

it is important to recognize that stra-tegic partnering, which is currently veryfashionable, exposes the innovator to cer-tain hazards, particularly when the inno-vator is trying to use contracts to accessspecial capabilities. Eirst, it may be diffi-cult to induce suppliers to make costly ir-reversible commitments which depend fortheir success on the success of the inno-vation. To expect sup pliers , manufactur-ers, and distributors to do so is to expectthem to take risks along with the innova-tor. For the innovator, this poses prob-lems similar to those associated withattracting venture capital. The innovatorlYiust persuade its prospective partnerthat the risk is a good one. The situationis open to opportunistic abuses on bothsides. The innovator has incentives tooverstate the value of the innovation,while the supplier has incentives to "runwith the technology" should the innova-tion be a success.

Instances of both parties making irre-versible capital commitments neverthelessexist. Apple's LaserWriter a high reso-lution laser printer which produces neartypeset quality text graphics is a casein point. Apple persuaded Canon to par-


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INNOVATIONits copiers, but only after Apple con-tracted to pay for a certain number ofcopier engines and cases. In short, Appleaccepted a good deal of the financial riskin order to induce Canon to assist in thedevelopment and production of the Laser-writer. The arrangement appears to havebeen prudent, yet there were clearly haz-ards for both sides. It is difficult to write,execute, and enforce complex develop-ment contracts, particularly when the de-sign of the new product is still floating,which it often is, even after commerciali-zation. Apple was exposed to the riskthat its co-innovator Canon would fail todeliver, and Canon was exposed to therisk that the Apple design and marketingeffort would not succeed. Still, Apple's al-ternatives may have been rather limited,in that it did not have the technology togo it alone.

The current euphoria over strategicpartnering may be partially misplaced. Itsadvantages are being stressed (for exam-ple, by McKenna [1985]) without a bal-anced presentation of costs and risks.These have been described by Williamson[1975, 1985]. Briefly, there is the risk thatthe partner will not perform according tothe innovator's perception of what thecontract requires; there is the added dan-ger that the partner may imitate the inno-vator's technology and attempt tocompete with the innovator. The dangeris particularly acute if the provider of thecomplementary asset is uniquely situatedwith respect to that asset and also canabsorb and imitate the technology. Con-tractual or partnering strategies are un-

in competitive supply. Because alterna-tives exist, failure of the partner to per-form according to the contract is notparticularly damaging on the innovator.Integration ModesAn alternative organizational arrange-ment is for the firm to provide the neces-sary complementary assets internally.This in-house approach facilitates greatercontrol, but it is costly in terms of mana-gerial and financial resources.

There are clear advantages to integra-tion when assets are in fixed supply overthe relevant time pe riod . To avoid a spec -ulative price run-up, the assets in ques-tion must be acquired by the innovatorbefore their connection with the innova-tion is public knowledge. If the value ofthe complementary asset to the innovatorleaks out, the owner of a critical comple-mentarity could extract a portion of therent stream that the innovation was ex-pected to generate. Such bottleneck situa-tions are not uncommon, particularly indistribution.

However, an innovator may not havethe time or the money to acquire or buildthe complementary assets it would like tocontrol. Particularly when imitation iseasy, timing becomes critical. Innovators,therefore, need to rank complementaryassets as to their importance. If the com-plementary assets are critical, ownershipis warranted, although if the firm is cashconstrained, a minority equity posihonmay well be a sensible trade-off. If thecomplementary asset in question is tech-nology, this calculus needs to be revisedin terms of the desired equity position.


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Figure 5: When making R&D and commer-cialization decisions, managers must identify,preferably ahead of time, the complementaryassets the innovation will need for successfulcommercialization. Contractual alternativeswill make strategic sense if the complemen-tary assets are not specialized, or if the inno-vators' position regarding its intellectualproperty is ironclad, or for assets which arenot critical, or for assets in which the innova-tor does not have or cannot obtain the neces-sary financial resources, or for assets in whichimitators are in any case already irrevocablybetter positioned. Otherwise, the integration(in-house) alternative ought to be preferred.with hazards, as integration tends to de-stroy incentives and cultures, particularlywhen a deep hierarchy is involved.

When imitation is easy, building orbuying specialized complementary assetsmust be considered in light of the movesof competitors. Building loses its point ifone's imitators can do it faster. Figure 5

building or buying {mixed modes and in-termediate solutions are ignored in orderto simplify the analysis.)

If the innovator is a large enterprisethat controls many of the relevant comple-mentary assets, integration is not likely tobe the issue it might be for a smallercompany. However, in industries experi-encing rapid technological change, nosingle company is likely to have the fullrange of expertise needed to bring ad-vanced products to market in a timelyand cost-effective fashion. In such indus-tries, integration is an issue for large aswell as small firms.Mixed Modes

Organizational reality rarely affords thepossibility of choice among pure forms ofeconomic organization. Integration andcontract are, accordingly, rarely seenwithout some accommodation to eachother. The reality of business is thatmixed modes involving the blending ofelements of integration and contract are rather common. Still, in examiningsuch intermediate forms, it is instructiveto bear in mind the simple economics ofpure forms.

Sometimes mixed modes representtransitional phases. For instance, becausecomputer and telecommunication technol-ogies are converging, firms in each indus-try are discovering that they need thetechnical capabilities of the other. This in-terdependence requires the collaborationof those who design different parts of thesystem; intense cross-boundary coordina-tion and information flows must be sup-


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INNOVATIONdifficulties can be anticipated since theselection of common technical protocolsamong the parties will often be followedby investments in specialized hardwareand software. There is little doubt thatthis was a key part of IBM's motivation inpurchasing 15 percent of PBX manufac-turer Rolm in 1983 and exp and ing thatposition to 100 percent in 1984. IBM'sstake in Intel, which began with a 12 per-cent purchase in 1982, is most probablynot a transitional phase leading to 100percent purchase, because both compa-nies realized that the two corporatecultures are not very compatible.

An example of how profoundly chang-ing technology can affect the boundariesof the firm and the identity of the firmat the nexus of contracts needed to de-velop and manufacture complex products can be found in the jet fighter busi-ness. Avionics now constitutes about onethird of the cost of a fighter, up fromabo ut 15 percent a decade ago (Figure 6).Avionics is expected to be even more im-portant in the future, both in terms ofcost and in terms of performance. Given

the fairly widespread diffusion of air-frame and propulsion technology, thesuperiority of fighters today and in thefuture will depend primarily upon the so-phistication and capability of the aircraft'selectronics. Indeed, in the future, com-puter manufacturers like AT&T and IBMmay become prime contractors for ad-vanced weapons systems, including fight-ers. In a related way, VHSIC technologyis regarded as a key factor in reestablish-ing what the US sees as a necessary de-gree of operational supremacy for itsforces against the numerical superiority ofthe Soviet Union and the Warsaw Pact. Itwill be an essential ingredient of new air-craft programs such as the USAF's ATFadvanced tactical fighter, the US Navy'sVFMX air superiority fighter, and the USArm y's LHX light battlefield helicopter,not to mention extensive upgrading ofcurrent equipment such as the F-15 andF-16 fighters and AH-64 helicopter [jane'sAl! the World's Aircraft 1983-84, p. 24].

Of particular relevance here is theUSAF's advanced tactical fighter (ATF).While it is still too early to discuss

19BO1975 1975-199O 1990-5000

Figure 6: The trend in fighter plane subsystem costs has been away from air vehicle and propul-


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TEECEelectronics definitively, according to jane's[1983-84, p. 26], a number of technologi-cal areas can be identified that will be re-quired in the ATF, including the integra-tion of flight and propulsion control sys-tems, fly-by-wire, and integration of cock-pit displays, probably with a voicecommand system to enhance the HOTAS(hands on throttle and stick). Advancedheads-up display and VHSIC technologywill also be critical.

In order to compete in the advancedfighter market in the future, prime con-tractors will have to be on the leadingedge with respect to avionics technology.A manufacturer that fails to develop oracquire such technology must expect tobe shut out of a growing portion of themarket.

Airframe companies without considera-ble in-house electronics capability willprobably not be able to contract with elec-tronics companies for the requisite sub-systems. Because avionics is becomingthe core technology that dictates otherelements of design, it will not be enoughfor airframe companies to contract withboth avionics and propulsion companies.Indeed, the leading fighter manufacturers such as General Dynamics andMcDonnell Douglas have developed in-house avionics capabilities. Were thesecompanies to fail to build a substantial in-house capability, it might be impossible,in the future, for them to design competi-tive fighter planes using avionicssubcontractors.

The reason is that complex trade-offsoften exist between avionics and air-

air vehicle and propulsion. Moreover,much of the avionics of a fighter plane isspecific to that aircraft. In the absence ofin-house avionics capabilities, jet fightermanufacturers would be unable, withoutextremely close collaboration with avion-ics' subcontractors, to formulate and im-plement new fighter plane concepts.Moreover, the kind of collaboration re-quired would require deep dependence oa kind very likely to lead to contractualvulnerabilities.Conclusion

Clearly, the boundaries of an innovatinfirm are an important strategic variable,particularly when intellectual propertyprotection is weak, as with microelectronics. The control of complementary assetsparticularly when they are specialized orcospecialized, helps establish who winsand who loses from innovation. Imitatorcan do better than innovators if they arebetter positioned on cost and quality wirespect to critical complementary assets,such as manufacturing.

There are important implications forcorporate strategy. Except in unusual circumstances, innovating firms must em-phasize the development of cost-competitive capabilities in the activitiesdownstream from R&D if they are toprofit from investment in R&D. Beingfirst to market is no longer a guarantee ocommercial success, particularly if toachieve early market entry the innovatinfirm engages in risky contracts with manufacturers, distributors, and developers ocomplementary technologies.For public policy, a related set of impli


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INNOVATIONpolicies to assist R&D is increasingly wideof the mark. Except in special circum-stances, national prowess in research anddevelopment is neither necessary nor suf-ficient to ensure that the innovator (ratherthan followers) captures the greater shareof the profits available from innovation.Public policy towards science and technol-ogy must recognize how important thetechnological infrastructure (particularlyeducation at all levels and manufacturing)is to the ability of domestically-basedfirms to build the requisite competitivecapacities needed to capture value frominnovation.Acknowledgments

I thank Raphael Amit, Harvey Brooks,Therese Flaherty, Richard Gilbert,Heather Haveman, Mel Horwitch, GaryPisano, Richard Rumelt, RaymondVernon, and Sidney Winter for helpfuldiscussions relating to the subject matterof this paper. A related treatment of theissues in this paper was published inResearch Policy 1986, Vol. 15, No. 6.ReferencesAb erna thy, W. J. and Utterb ack, J. M. 1978,"Pat terns of indust r ia l innovat ion ," Technol-

ogy Review, Vol, 80, No. 7 (Janu.uy/July),p p . 40-47.

Clarke, Kim B. 1985, "The interaction of de-s ign h ierarchies and market concepts intechnological evolution," Research Policy, Vol.14, No. 5 (October) , pp . 235-251.Dosi, G. 1982, "Technological paradigms andtechnological trajectories," Research Policy,Vol. 11, N o. 3 (lun e), p p . 147-162.

Jane's All the World's Aircraft 1983-84, McGraw-Hill, New York.Kuhn, T. 1970, The Structur e of Scientific Revolu-

tions, Universi ty of Chicago Press, Chicago,Illinois.

unp ubl is hed ma nusc r ip t , Yale Univers i ty ,Martin, Michael 1984, Managing TechnologicalInnovation and Enterpreneurship, Reston Pub-lishing Company, Reston, Virginia.

McKenna, R. 1985, "Market posit ioning inhigh technology," California Management Re-vieiv. Vol. 27, No. 3 (Spring), pp. 82-108.

Norman, D. A. 1986, " Impact of en t repreneur-sh ip and innovat ions on the d is t r ibu t ion ofper sona l compu ter s , " i n The Positiz'e Su mStrategy, eds. R. Landau and N. Rosenberg ,Nat ional Academy Press , Washington , DC,p p . 4 3 7 ^ 3 9 .

Teece, D. J. 1980, "Economics of scope and thescope of the en terpr ise ," journal of EconomicBehavior and Organization, Vol. 1, No. 3,p p . 223-247.Teece, D. J. 1981, "T he m arke t for kn ow -ho wand the efficient international transfer oftechnology," Annals of the American Academyof Political and Social Science, Vol. 458(November) , pp . 81-96 .

Teece, D. J. 1982, "Towards an economic the-ory of the mult iproduct f irm," journal of Eco-nomic Behanior and Organization, Vol. 3, No. 1,pp . 39 -63 .

Teece, D. J. 1985, "Multinational enterprise,in ternal governance, and indust r ia l o rgani -za t ion , " American Economic Review, Vol. 75,N o. 2 (May), pp. 233-238.Williamson, O. E. 1975, Markets and Hierar-

chies, The Free Press, New York.W ill iamson, O . E. 1981, "Th e mod ern corpo ra-t ion : Orig ins , evolu t ion , a t t r ibu tes ," journal

of Economic Literature, Vol. 19, No. 4 (Decem-ber), pp. 1537-1568.Williamson, O. H. 1985, The Economic Institu-

tions of C apitalism, The Free Press , NewYork.


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