Lecture 6

Incentives, Firms and Innovation

Outline• Resources and Capabilities: examples

• The <value added> of recent theories

• Firms in developing countries•• Firms and institutions

Resources and Capabilities: examples

Appraising ResourcesRESOURCE CHARACTERISTICS INDICATORS

Financial Borrowing capacity Debt/ Equity ratioInternal funds/ generation Credit rating

Tangible Net cash flowResources Physical Plant and equipment: Market value of

size, location, technology fixed assets.flexibility. Scale of plantsLand and buildings. Alternatives for fixedRaw materials. assets

Technology Patents, copyrights, know how No. of patents owned.R&D facilities. Royalty income

Intangible Technical and scientific R&D expenditure.Resources employees R&D staff

Reputation Brands. Customer loyalty. Company Brand equity. Productreputation (with suppliers, customers, price premium.government) Recognition.

Human Training, experience, adaptability, Employee qualifications,Resources commitment and loyability of customers pay rates, turnover.4

What a firm Has...

What a firm has to work with:

its assets, including its people and the value of its brand name

Resources represent inputs into a firm’s production process...

such as capital equipment, skills of employees, brand names, finances and talented managers

Resources

Tangible ResourcesFinancial*Physical*Human Resources*Organizational*

Intangible ResourcesTechnological*Innovation*

Reputation*

Capabilities

What a firm Does...Capabilities represent:

the firm’s capacity or ability to integrate individual firm resources to achieve a desired objective.

Capabilities develop over time as a result of complex interactions that take advantage of the interrelationships between a firm’s tangible and intangible resources that are based on the development, transmission and exchange or sharing of information and knowledge as carried out by the firm's employees.

Capabilities become important when they are combined in unique combinations which create core competencies which have strategic value and can lead to competitive advantage.

The <value added> of recent theories

Early contributions

• Edith Penrose 1959: – Although firms may control similar ressource

bundles, the services they can derive from resources may be very different.

– Services change through experiential learning.

– They rest on tacit knowledge.

Firms-Innovation• The extreme proliferation of labels/taxonomies,

– ”the knowledge-based view,”– ”competence perspective,” – ”core competencies,” – ”capabilities approach,” – ”dynamic capabilities approach,”

• ”competence-based competition,”

– ”the resource-based view,” – ”the evolutionary theory of the firm”

Firms-Incentives

Evolution of the firm in a broader context [routines vs. the selection process]

Evolutionary theory

Emphasis on internal resources

Resource-based theories

Information asymmetries, incentives

Positive agency theory

Existence and limits of firmsTransaction cost economics

Market structure [influence of sectoral factors]

Industrial organization

Central objectiveTheory

Empirical justification• Inter-industry variation in returns significantly lower than

intra-industry variation• For example, business level and corporation specific factors

accounted for 37% and industry factors for only 16% of the variation in returns in Rumelt 1991, SMJ.

• Thus, i.e., factors internal to firms more important than the environment.

• The increasing specialization in knowledge production [strategic alliences designed to exchange knowledge in technological fields like ICT and biotechnology]

• The importance of in-house integration capacity

• ICT is improving understanding and increasing complexity

• Creative destruction in organizational [not technological] practises

Evolutio-nary theory of the firm

Dynamic capabilities

Knowledge-based

Competence-based

To be practical, we are interested in this intersection of four areas of research

Background

• Why the rise of capabilities approaches –particularly ”dynamic capabilities” approaches –during the last decade?

• Knowledge economy background: Increasing importance of innovation, knowledge assets account for an increasing part of value added, ”innovation driven competition,” [Lecture 3]

• A reaction against the neoclassical theory of production (Lecture 2]

• The Resources Based approach is the <managerial perspective> in this area of research with a static quality in its analysis.

• Other theories focus primarily on internal factors.

Knowledge and Routines• Knowledge:

– Knowledge forms: – 1) private, – 2) distributed, – 3) shared, and– 4) common. – Firms are seen as systems of distributed knowledge –

”Only APPLE as a firm knows how to produce the iPod.”

– Given the stock of knowledge , how is coordination achieved?

• That brings us to Routines; ways to:– Embed the firm’s knowledge. – Coordinate dispersed knowledge.

Firms respond to pressure and change: Routines

• “... an executable capability for repeated performance in some context that has been learned by an organization in response to selective pressures” (Cohen et al. 1996).

• Capabilities, competencies, etc. may be characterized likewise.

• Change also take place through”dynamic routines.”

A basic vocabularyFrom an evolutionary point of view, the firm is aprofit-seeking entity whose primary activities are to build (through organizational learningprocesses) and exploit commercially valuable knowledge assets.

These assets co-determine the firm’s productive opportunity set and are applied in production through the operation of routines.

Dynamic Capabilities

• Examples of dynamic capabilities: – Product development routines (e.g., Toyota). – Superior ability to absorp external knowledge and

integrate it – e.g., alliance and aquisition routines (e.g., some biotech firms).

– ”Patching” – reshuffling of corporate resources in response to changing demands (Dell’s ability to constantly segment operating businesses to match demands).

Knowledge and economic organization

• We will consider these recent attempts to turn ideas into a full theory of the firm in the sense of a theory that addresses the following aspects of knowledge development:– Existence -- why aren’t all knowledge transactions

mediated over the market?– Boundaries -- what explains the firm/market

boundary?– organization -- what explains the firms formal

and informal structure?

• Understanding the demand aspects of why resources are ”valuable.”

• The creation and dynamics of resources (”dynamic capabilities”).

• Organizing resources, organization as a source of competitive advantage.

• Which resources to create? • Protecting resources through entry

deterrence, understanding the context of competition.

• System effects between resources.• Understanding firm heterogeneity and its

dynamics.• Understanding how value sharing

impacts on value creation.

A theory on knowledge development provides hypotheses on the following questions:

Key Ideas

• A theory of firm level specialization based on knowwledge constraints.

• Firms should be seen as heterogeneous agents of largely tacit knowledge assets (e.g., ”capabilities”).

• They underlie competitive advantages and innovative performance (”dynamic capabilities”).

• Economic organization shaped by attempts to capture rents from such assets (including economizing with the costs of building, protecting and leveraging them).

Market selection as an evolutionary processes

• Processes which generate variation in the pool of characteristics in a population

• Processes which restrict and guide possiblepatterns of variation in behaviour

• Processes which change the relative frequency of different entities within the population

• Processes which determine the rate at which the above three processes change

• Processes which determine the overall directionof evolutionary change

Source: Metcalfe, J.S. (1998), Evolutionary Economics and Creative Destruction, London, p. 23

Firms in developing countries

Learning and Productivity in the Assimilation of Process Industry Technology

Activities Affecting the Productivity of Capital and Labour Accumulated via Process

Industry Investment Projects

(a) Project implementation (b) Start-up and subsequent operation

Specification of product & process Technology

Procurement of inputs for selected Technology

Project Integration and completion

Initial Commissioning and Start-up performance improvement

Subsequent incremental product/process innovation

Investment in training and experience-Acquisition

Operations and maintenance

+ +

(1) Firm-level capability creation (“Learning-by-Spending”)

Design, engineering and project management

+ + + + +

Acquisition and/or Development of Technology for New Major Investment Projects

(3) Cumulative Mobilisation of Learned Capabilities

Execution of: Project implementation Design/Engineering Technology Development

ASSIMILATION OF TECHNOLOGY EMBODIED IN PROJECT CAPITAL

(2) Learning-by-doing

Experience Experience Experience Experience Experience Experience

THE LEARNING HIERARCHY IN TECHNOLOGY FOLLOWERS

BASIC OPERATINGSKILLS AND

CAPABILITIES

DESIGN ANDENGINEERING

R&D

Present, Often Strongand Regularly Upgraded

Occasionally Present (Rarely in TNCs)Scale Limited. Depleted by Crisis

Capabilities Limited, When Present Often Limited Technology Development Role

Usually Present, Often Focus ofIntensive Training Efforts, Selected Key Skills Sometimes

Weak

Large Domestic

Large TNC

TECHNOLOGY USE AND OPERATION

TECHNOLOGYACQUISITION AND

ASSIMILATION

TECHNOLOGYUPGRADING

REVERSE ENGNRG

INNOVATIVE CAPABILITY ACCUMULATION IN THE MALAYSIAN ELECTRONICS INDUSTRY

Proportions of Firms Mastering Different Capability Levels

Capability Levels Mastered

TNC Sub-

sidiaries

All Local Firms

Local Linkage Firms

Local Independent

firms

(26) (27) (14) (13) Routine Operation 100% 100% 100% 100%

Basic Innovation 100% 100% 100% 100%

Intermediate Innovation 85% 85% 86% 86%

Advanced Innovation 31% 37% 43% 31

Research-Based Innovation 8% 0 0 0

Norlela Ariffin: DPhil Thesis

INNOVATIVE CAPABILITY ACCUMULATION IN THE MALAYSIAN ELECTRONICS INDUSTRY

Times Required to Master Different Capability Levels

Capability Levels Mastered TNC Sub-

sidiaries

Local Linkage Firms

Local Independent

firms

(n = 26) (n = 14) (n = 13) Years Years Years

Routine Operation (From entry) 3.8 2.9 3.4

Intermediate Innovation (From RO) 9.0 5.5 7.0

Advanced Innovation (From RO) 15 8.8 7.0

Research-Based Innovation (From RO) 20 - -

Norlela Ariffin: DPhil Thesis

Technology Strategies in Developing CountriesRole in Markets The Technology Dimension

1 Passive importer (pull) Assembly skills, basic production capabilitiesCheap Labor assembly Mature ProductsDependent on buyers for distribution

2 Active sales of capacity Incremental process changes for quality and speedQuality and cost-based Reverse engineering of productsForeign buyer dependent

3 Advanced production sales Full production skillsMarketing department establis Process innovationOverseas marketing started Product design capabilityOwn designs marketed

4 Product marketing (push) R&D for products and processes begunSell direct to retailers Product innovation capabilitiesand distributors overseas Build up product rangeStart own-brand sales

5 Own-brand (push) Competitive R&D capabilitiesMarket directly to customers R&D linked to market needsIndependent distribution channels, Advanced product/process innovationdirect advertisingIn-house research

Sources: Marketing stages derived from Wörtzel and Wörtzel (1981): Technology stages derived from Hobday (1995a)

A checklist of Technology Strategy in latecomer Firms

Product Structure Size B usiness Strategy Technology strategy Selection, Specialization & Embodiment Sources of Technology Capability Building International Conformance Innovation Networks R &D Investment R &D Organization M anufacturing Strategy Links with Corporate/Technology Strategy Location Capacity Practices Process Training Likely T rajectory Technology Characterization Product Obsolescence Process Obsolescence Firm Trajectory Strategic Technological Challenges

Firms and institutions

CUSTOMERS INDUSTRY LINKAGE OTHER KNOWLEDGE SOURCES

Policy and Incentive Systems Financial and Funding SystemsLegal Frameworks Organisational Structures

INSTITUTIONAL CONTEXT

Foreign Technology

Sources

Metrology and Standards

Knowledge Linkage, Transfer andDevelopment Organisations

Export

Domestic

Large TNC

Large Domestic

SME

Start-Ups

ResearchInstitutes

Universities

VocationalTraining

The Innovation Development System: A Framework

The linkage structure of NIS’sAn NIS consists of institutions,

– that formulate policy goals and co-ordinate (govt. agencies)

– that finance and fund R & D(science funds, special loan programmes, etc)

– that act as bridge between decision making and fund redistribution: research councils and associations

– that are responsible for knowledge creation: private R&D labs, universities

– That forster diffusion: technology transfer and diffusion, promotion of technology-based firms, human resource mobility

Facts:– The degree of complexity of modern

technology requires a) specialisiation AND b) cross-disciplinary cooperation

– Technology becomes more science based (science based patents increased from 17000 in 1987 to >50000 1994)

– Labour is the most powerful transmission mechanism of “tacit knowledge”

Policy instruments for “high growth and innovativeness” goal:

• Different depending on – industrial structure, – degree of development of knowledge

creation institutions– given strength of science technology

linkages

BASIC SYSTEM CONCEPTS(see Edquist, for overview)

1. ‘National’ Systems (Freeman, Nelson, Lundvall, etc.)

2. ‘Sectoral’/Technology Systems (Carlsson, Malerba, etc.)

3. ‘Regional’ Systems (Cooke & Morgan, ‘Milieux’, etc)

4. ‘Cluster’ Systems (Saxenian, Schmitz, Bell and Albu, etc.)

System Scope - What is ‘in’ the system? What is ‘Outside’?

1. Scale - relative to…………

2. Internal Structure - relative importance of actors/activities

3. Internal ‘Coherence’ - (relative) strength of links

4. External Links - ‘openness’ to inputs, collaboration- ‘Active/Passive’ learning

IMPORTANT SYSTEM CHARACTERISTICS

KEY ANALYTICAL ISSUES FOR POLICY

Origins, Evolution and Change in System Characteristics

Differing Characteristics : Effectiveness at Different ‘Stages’

Rates of Change in Key Characteristics

Responsiveness of Rate to Policy (What Policy? Whose Policy?)

A first analytical step: the specialisation pattern of a NIS

• Where lies the intellectual and technological strength of a nation?

• How does knowledge generation change in reaction to new policies, technological innovation, etc. ?

� Revealed Technological Advantage (RTA)– Science: e.g. France, Germany and Italy are specialised

in chemistry, physics, mathematics; USA wide spread– Engineering: e.g. Austria, Netherlands, Nordic

countries, UK specialisation in clinical medicine;

Emerging Specialisation Patterns: Patenting

The increasing importance of technology markets

A case study in our list of readings [Cohen, at al.]

• Comparison of appropriability conditions and spillovers between Japan and the US

• Puzzle to explain: higher R&D spending in Japan but difficult to protect rents

• A NOTE: the creation of secure assets in new technological knowledge has been one of the main characteristics of the US technological innovation in the 19th century [NBER, 10966]

Readings…• An overview of theories: Galende• The evolutionary perspective and dynamic

capabilities: Nelson, Teece• Firm level analysis: large firms in advanced

countries (Pavitt), technoloogy followers (Forbes) [additional reading: Hobday]

• NIS: Cohen