Incentive Structures, Capability Inﬂuences, and Innovation
and knowledge that mediate between inputs andoutputs (Rosenberg, 1972). Managers perceivenew process technology as a means of increasingproductivity and ﬂexibility, reducing cycle times,and improving quality (Adler, 1988; Stalk, 1988).Technology scholars state that process technol-ogy innovation is crucial to competitiveness (e.g.,Ettlie, 1988). Although process innovations do notnecessarily require fundamental changes in productdesign, they often necessitate the development of new manufacturing skill sets and the integration of new manufacturing equipment. When the changesin these skill sets are signiﬁcant, they drasticallyaffect the cost and/or value of the output.At least three research streams examine therelationship between ﬁrm size and the amountof a ﬁrm’s innovation activity. The ﬁrst streamrelates ﬁrm size and market power to the incen-tive to invest in innovation activities. This work suggests that large ﬁrms typically are better ableto control the resources necessary to direct tech-nical change, or to develop barriers that allowthem to appropriate the gains from innovation rel-ative to small ﬁrms (e.g., Schumpeter, 1942). Assuch, large ﬁrms, on average, will have greaterincentives to invest in R&D and, in turn, willbe more likely to innovate as compared to smallﬁrms. Focusing on the risky nature of R&D invest-ment, Galbraith (1952) extended this basic rea-soning by arguing that ﬁrms may reduce theirexposure to risky investments in innovation activ-ity by spreading investment across a large numberof projects. If large ﬁrms can spread their invest-ment over a larger number of R&D projects thansmall ﬁrms can, large ﬁrms may be able to investmore resources in innovation for a given risk leveland, in turn, generate larger amounts of innovationactivity than their smaller rivals.Subsequent work reﬁned these arguments byexamining how various product- and factor-marketimperfections affect the relationship between ﬁrmsize and innovation activity. For instance, if cap-ital market imperfections exist, large ﬁrms maysecure ﬁnancing for risky R&D investments moreefﬁciently than small ﬁrms by leveraging internalcapital markets (e.g., Armour and Teece, 1981).Similarly, if imperfections exist in the market fortechnological knowledge, large, and presumablymore diversiﬁed, ﬁrms may be better positioned
occur at the instant a change is introduced to the world or to amore local environment.
to exploit innovations through internal applicationrather than external licensing (e.g., Teece, 1982),relative to their smaller, and more focused, rivals.Other work argues that scale economies in R&Dactivities directly favor large ﬁrms and/or thatcomplementarities between R&D, manufacturing,and other downstream activities favor large ﬁrms(Teece, 1986). The results from this work how-ever, are extremely fragile. Given this fragility,Teece states that, ‘A large but unsatisfactory liter-ature exists in industrial organization on the rela-tionship between market structure and innovation,and between ﬁrm size and innovation, but boththe theoretical and empirical literature are almostcompletely silent on interﬁrm and intraﬁrm orga-nizational issues. When these issues have beenaddressed, it is without much of a theoretical foun-dation (Teece, 1992:2).A second body of work, couched within theframework of patent races, explores the trade-offsestablished ﬁrms (incumbents) and entrant ﬁrmsface when considering investments in innovation.The ﬁrst of these arguments states that when mech-anisms such as the patent system, brand identi-ﬁcation, spatial location, or capacity expansion,effectively protect the economic beneﬁts of aninnovation, established ﬁrms alone stand to reapthe beneﬁts of monopoly power once the inno-vation is introduced. As such, established ﬁrmswill have greater incentives to invest in innova-tion than entrants (Gilbert and Newberry, 1982).A second argument conditions the ﬁrst by pointingout that even when mechanisms exist to protect theeconomic rents generated from innovation, uncer-tainty in the invention process, and in subsequentdemand, may diminish established ﬁrms’ incen-tives to innovate (Reinganum, 1983). For example,established ﬁrms have lower incentives to investin innovation than entrants when there is uncer-tainty about whether an innovation will cannibalizea portion of the established ﬁrms’ rents (e.g., Rein-ganum, 1983). This work assumes that establishedand entrant ﬁrms have relatively homogeneous,research capabilities. Yet, few empirical studiestest these competing arguments. Indeed, the onlyempirical article we were able to identify providesa case study that describes how Xerox’s failureto invest in research and development to coun-teract Canon’s challenge in the early 1980s wasdue, in part, to Xerox’s unwillingness to cannibal-ize revenues from its plain paper copier business(Bresnahan, 1985).
2008 John Wiley & Sons, Ltd.
Strat. Mgmt. J.
: 711–735 (2009)DOI: 10.1002/smj