COMPETING IN THE AGE OF DIGITAL CONVERGENCE

Edited by

David B. Yoffie

HARVARD BUSINESS SCHOOL PRESS Boston, Massachusetts

Copyright © 1997 by the President and Fellows of Harvard College

All rights reserved

Printed in the United States of America

01 009998 543

Library of Congress Cataloging-in-Publication Data

Competing in the age of digital convergence / edited by David B.

Yoffie,

p. ern.

Includes index.

ISBN 0-87584-726-9 (alk. paper)

1. Computer industry. 2. Microelectronics industry.

3. Telecommunication equipment industry. 4. Information technology. 5. Competition. I. Yoffie, David B.

HD9696.C62C63 1997

338.4'7004-dc20

96-10890 CIP

The paper used in this publication meets the requirements of the American National Standard for Permanence of Paper for Printed Library Materials Z39.49-1984

CONTENTS

Preface and Acknowledgments

CHAPTER 1 INTRODUCTION

CHESS and Competing in the Age of Digital Convergence David B. Yoffie

CHAPTER 2

THE COMPUTER INDUSTRY The First Half-Century Alfred D. Chandler, Jr.

CHAPTER 3 SUN WARS

Competition within a Modular Cluster, 1985-1990 Carliss Y. Baldwin and Kim B. Clark

CHAPTER 4

WINNERS AND LOSERS

Industry Structure in the Converging World of Telecommunications, Computing, and Entertainment

David J. Collis, P. William Bane, and Stephen P. Bradley

CHAPTERS

WHAT DOES INDUSTRY CONVERGENCE MEAN! Shane Greenstein and Tarun Khanna

vii

1

37

123

159

201

CHAPTER 6

CREATING VALUE AND SETTING STANDARDS

The Lessons of Consumer Electronics for Personal Digital Assistants Anita M. McGahan, Leslie L. Vadasz, and David B. Yoffie

CHAPTER 7

LARGER FIRMS' DEMAND FOR COMPUTER PRODUCTS AND SERVICES

Competing Market Models, Inertia, and Enabling Strategic Change Timothy F. Bresnahan and Garth Saloner

CHAPTER 8

PATENT SCOPE AND EMERGING INDUSTRIES Biotechnology, Software, and Beyond

Josh Lerner and Robert P. Merges

CHAPTER 9

ALLIANCE CLUSTERS IN MULTIMEDIA Safety Net or Entanglement?

Benjamin Gomes-Casseres and Dorothy Leonard-Barton

CHAPTER 10

BEYOND THE WATERFALL Software Development at Microsoft

Michael A. Cusumano and Stanley A. Smith

CHAPTER 11 MANAGING CHAOS

System-Focused Product Development

in the Computer and Multimedia Environment Marco Iansiti

Index

About the Contributors

227

265

301

325

371

413

445

459

CHAPTER 1

INTRODUCTION CHESS and Competing in the Age of Digital Convergence

David B. Yoffie

Separating hype from reality seems almost impossible when talking about digital convergence. Droves of start-ups are pouring into the information superhighway, best-selling books are being written about "being digital;" politicians are proclaiming the age of new electronic democracy, and multibillion-dollar deals are inked almost daily in the name of digital convergence. But how much substance is behind the hype? Are we on the verge of a true technological revolution that will reshape the global economy? What should companies and managers do to prepare for such a turbulent world?

There is something real to the excitement over digital convergence.

If only a small portion of the convergence-related R&D pays off, our lives could be materially altered by the turn of the century. In the consumer segment of the market, for example, firms are undertaking huge investments in video-on-demand, interactive television, on-line services, and new forms of digital entertainment content; in education, companies are exploring ways to use multimedia technology to enhance studentstudent learning, teacher-teacher sharing, and continuous learning; and in business, enhancements to corporate networks, and the Internet are creating opportunities for new channels of distribution, new methods of

1

2 Introduction: CHESS and Competing in the Age of Digital Convergence

communication (e.g., personal videoconferencing), and new vehicles for delivering real-time corporate information. Some products and technologies, such as personal digital assistants, are designed to cut across segments, potentially serving as personal communicators for business while also acting as personal organizers for the home. While some firms are making big investments to enhance the personal computer as a generalpurpose device that will equally serve the home, business, and education, others are proclaiming the death of the modern PC with the emergence of a ubiquitous multimedia network and cheap Internet access devices.

Our challenge in this volume is to say something meaningful about such trends, even though the technology and the market seem to change almost daily. Our solution has been to focus our research on how companies have managed previous paradigm shifts in the world of electronics and information technology. While it is too early to predict the winners and losers in the battle for the information superhighway, there is a great deal we can learn about the forthcoming battle from more than forty years of consumer electronics experience, thirty years of mainframe and minicomputer experience, and almost twenty years of experience with the microprocessor revolution.

We start with a functional definition of digital convergence and an overview of its key drivers. Merriam- Webster's Collegiate Dictionary defines convergence as a movement toward a point or the coming together to unite in a common interest or focus. Likewise, we define convergence as the unification of functions-the coming together of previously distinct products that employ digital technologies. The telephone and the computer, for example, both utilize digital technologies, but historically they have served completely different markets with entirely different functions. The process of digital convergence implies that a computer begins to incorporate the functionality of a communicating device, and the telephone takes on the functionality of a computer.

Our primary interest is understanding the consequences of convergence. The argument is that mastering digital convergence does not require a magical new set of technologies. Too many companies have sought, and failed, to master digital convergence with a big technological breakthrough or grand acquisition. Instead, I suggest, success will emerge by adopting a strategy that I summarize in the acronym CHESS, which stands for creative combinations, horizontal solutions, externalities and standards, scale and bundling, and new production techniques, called system-focused development.

A CHESS strategy means rethinking many traditional approaches to convergence. The entertainment business and telecommunications

Introduction: CHESS and Competing in the Age of Digital Convergence 3

industries, for example, have focused their strategies on huge infrastructure investments or big bets that will reorganize the hardware and software industries. But the lesson we have learned from the computer industry is that success is more likely to emerge from creative combinations that build on complementary technologies. Moreover, mastering all aspects of digital technology appears to be beyond the capabilities of most firms. Even the world's largest electronics giants, from NEC and Fujitsu to IBM and AT&T, have failed in their efforts to internalize digital convergence through extensive vertical integration. The most successful strategies have emerged from companies adopting horizontal solutions, such as Microsoft in software and Intel in silicon.

Digital convergence further requires an appreciation for externalities and the art of creating standards. The growing importance of networks, especially of the Internet, means that no single firm or group of firms can capture all of the value embodied in the network. Some firms have discovered that Trojan horse strategies can set de facto standards, while others embrace and enhance open standards. Ironically, the firms best positioned to influence the emerging global standards may be the existing incumbents, not the start-ups who are pioneering these efforts. Today's dominant firms have the advantages of scale economies and the ability to bundle complementary technologies. However, incumbents can sustain their advantages only if they are willing and able to aggressively cannibalize their historic market positions.

Finally, CHESS means changing the basic organization of production. New business processes must emerge to handle the turbulence and uncertainty associated with next-generation technologies. Our research found that successful internal processes for the converging world will have to reflect at least two potentially conflicting imperatives: first, they have to be highly flexible and adaptive; and second, they must be very time-sensitive. Microsoft's synch-and-stabilize approach and Silicon Graphics' system-focused product development strategy are models to be emulated.

DIGITAL CONVERGENCE

The topic of convergence has been around for decades. Forecasters have long predicted the coming of a digital age in which semiconductors, computing, communications, and other forms of electronics would converge into overlapping industries. In its simplest form, convergence means the uniting of the functions of the computer, the telephone, and the television

4 Introduction: CHESS and Qnnpeting in the Age of Digital Convergence

set. Taken literally, the unification of functions could produce a massive reorganization of a trillion dollars in global business.

One of the corporate pioneers in evangelizing digital convergence was Japan's NEC Corporation. In 1977 the company first adopted "C&C' (Computers and Communications) as their corporate slogan and rallying cry (see figure 1-1).

NEC management foresaw many of the basic drivers pointing to convergence:

As digital technology finds its rightful place in communications, communications technology will inevitably converge with computer functions, and communications networks will become capable of more effective transmission of information. With distributed processing systems linking a group of processing units, the computer will become highly systemized and inseparable from communications!

The center ofNEes vision was semiconductor technology. Moving up the diagonal in figure 1-1, the progression from vacuum tubes to transistors to very-large-scale integrated (VLSI) circuits would drive computers toward distributed processing and communications toward digital networks. As computers became more powerful and ubiquitous, and communications became capable of handling rich data that could be digitized, such as facsimile and video, convergence would become a reality.

After NEC proclaimed the coming of digital convergence, many companies adopted similar slogans. For example, John Sculley, while chairman of Apple Computer in the early 1990s, displayed an alternative vision for information-based digital industries. Rather than focus on the underlying technology drivers from a provider's perspective, Sculley pictured convergence from the customer's perspective. In Sculley's view, telecommunications, office equipment, consumer electronics, media, and computers were separate and distinct industries through the 1990s, offering different services with different methods of delivery. But as the computer became an "information appliance," businesses would move to take advantage of emerging digital technologies, such as CD-ROMs and virtual reality, and industry boundaries would blur (see figure 1-2).

Conceptually, NEC, Apple, and many other firms have been delivering the same message; the development of key digital technologies allows companies to create new functionality and extend product features into new arenas. The problem has been predicting the appropriate time frame and the course of digital convergence. As figure 1-2 suggests, boundaries between industries are not collapsing but blurring at the edges. And while

Introduction: CHESS and Competing in the Age of Digital Convergence 5

FIGURE I-I

NEC's 1977 VISION OF CoMPUTERS AND CoMMUNICATION

20001

~

Q '

',::21

1990 ~ '~I' .

III El

1980 ~

i 1970 ~

<.5

1960 -

1950

1960

1970 Communications

1980

1990

2000

SOURCE: Adapted from NEC Corporation, The First 80 Years (Tokyo: NEC Corp., 1984), p. 82, © Koji Kobayashi, NEC Corporation. Reprinted with permission.

NEC's original diagram assumed convergence in the mid -1980s, later depictions moved the end point to the mid-1990s, and still later pictures show convergence at the turn of the century.

The uncertainty over time frames and industry boundaries is partly a function of different combinations of technologies progressing at different rates. Believing in long-run convergence should never imply a unilinear path. Some industries will converge before others, and some technologies will mature faster than others. Moreover, the mass acceptance of convergence requires content as well as infrastructure. Just as

6 Introduction: CHESS and Competing in the Age of Digital Convergence

FIGURE 1-2

JOHN SCULLEY'S VISION FOR DIGITAL CONVERGENCE

Info Industry, 2001: Fusion Powered

t DISTRIBUTION

,.--------,

INTERNATIONAL, LONG-DISTANCE, AND LOCAL TELEPHONE SERVICES

INFO ON DEMAND

TELECOM

CABLE NETWORKS AND OPERATORS

"FIBER TO THE HOME" DlGITALDBE

"NATIONAL DATA HIGHWAY"

INFO VENDORS

MEDIA AND PUBLISHING

TELEPHONES

VIDEO

CONFERENCING PUBLIC KIOSKS

VOICE AND/ GUI AND OS VIRnlAL REALITY

VIDEO E-MAIL COMPUTERS ,

I CD-ROM

PCN AND DIGITAL PERSONAL COMPUTERS A

CELLULAR \ V1DEOGAME

"INFORMA nON CARTRIDGES

HDTV APPLIANCES" ~~~~<,J~~ENT \DANDVIDEODISC

"r-LANS AND EDUCATION FILM, TV,ANDVlDEO

i _PIMPC',------- j

~i~~ CONSUMER RECORDS AND

ELECTRONICS

2-WAYTV

COPIER PRINTER

i SCANNER FAX

CUSTOM PUBLISHING NEWSPAPERS

NEWSLETTERS

MAGAZINES AND JOllRNALS BOOKS

OFFICE EQUIPMENT

.-- Container/Medium ~ Transport - Translate - Transform - Presents- Content/Message__'

SOLTRCE, Adapted from a presentation by John Sculley at Harvard University, Program on Information Resources Policy, 199 L

the computer industry required killer applications to drive demand, much of the substantive content for business and consumers has yet to be delivered.

The Drivers of Digital Convergence

The premise of this book is that we are closing in on digital convergence as we approach the twenty-first century, and three driving forces are accelerating these trends: semiconductor, software, and digital communications technologies; government deregulation; and managerial creativity. The inexorable expansion of computing power from the microprocessor, the inevitable decline in the price of bandwidth, and

Introduction: CHESS and Competing in the Age of Digital Convergence 7

creative combinations of technologies and content will increasingly lead to new products and services with overlapping functionality.'

Most of the underlying technology and governmental drivers of this convergence are well understood. The place to begin is Moore's Law, named after Intel Corporation's chairman, Gordon Moore. In the 1960s, as a manager at Fairchild Semiconductor, Moore made a prediction that the power and capacity of integrated circuits would double approximately every eighteen months. Remarkably, Moore's Law has held true for thirty years. While the doubling cycle is now stretching out to almost two years, the basic principle remains: the price of computing power is becoming so cheap that it is virtually free. With only one chip costing a few hundred dollars, a product can perform most of the functions of a multimilliondollar mainframe computer of fifteen years ago. Within the next ten years, microprocessors will have one hundred million transistors and will be capable of processing billions of instructions every second!

The declining cost of microprocessor power and the declining cost for memory and storage have enabled computers to become pervasive. Once the sole responsibility of the information technologist in a glass house, computers became ubiquitous on the corporate desktop and reached into thirty to forty million homes around the world. According to one estimate, 35 percent of American homes had computers by the end of 1994.' And America was not unique. Computers are spreading to the home throughout the world. Microsoft, for example, projected that 65 percent of the one million computers sold in Korea in 1994 went to the horne.'

By making computing power cheap and ubiquitous, computers have already begun to envelop adjacent businesses, ranging from calculators to answering machines, and from electronic games to faxes. As semiconductors and related software become more powerful and cost less, they allow computers to take over a growing range of functions in the home and the office. In fact, computer and semiconductor technologies have an imperial nature: each new generation of chip grabs more functionality from related products, and each new generation of computer utilizes chip and software technology to conquer new businesses. For example, multimedia, once the sole domain of electronic games, has become part of the computer domain: 22 percent of all computers shipped in the world in 1994 had multimedia capabilities, up from only 1 percent two years earlier,"

Progress in communications has lagged somewhat behind the computer revolution. However, a combination of government deregulation

8 Introduction: CHESS and Competing in the Age of Digital Convergence

and new transmission and software technologies is beginning to dramatically reduce the cost of delivering information. Traditionally, communications depended upon copper wires, called twisted pair, as conduits of information. These copper wires' limited capacity to move information (i.e., limited bandwidth) raised the costs of telecommunication services; in addition, complicated regulatory schemes around the world forced telecommunication vendors to cross-subsidize different forms of service for various customers. The dramatic reduction in costs for telecommunication services began with a global process of deregulation, which gained considerable momentum with the breakup of AT&T in the United States in 1984. As communications around the world move from monopoly provider to competitive service, prices will ultimately decline.

But just as important as deregulation is the advent of new technologies that undermine many of the traditional cost/price relationships in telecommunications and may accelerate the trends of deregulation. First, the explosion in wireless technology created the opportunity for anywhere, anytime communications. Second, coaxial cable, historically used for cable television, as well as the growing installation of fiber-optic cable, exploded the amount of bandwidth available to transmit voice, video, and data. While traditional phone lines could carry up to six million bits per second, fiber will ultimately carry more than one billion bits per second. The third technology driver is software compression, which can provide order-of-magnitude growth in bandwidth within each of these channels -copper, wireless, coaxial, or fiber. As communications companies lay fiber-optic cable and introduce software compression techniques, and as government regulatory barriers melt away the prohibitions that prevent phone and cable TV companies from meeting in the marketplace, the price of bandwidth should become as cheap as computing power. Once we can transmit all types of data, from anywhere to anyplace, at very low cost, the possibilities become virtually endless for the real-time linking of computers and communications.

Yet technology and deregulation alone will not lead to digital convergence. Computing and communication costs have been declining for decades, but the promise of digital convergence did not materialize in the 1970s, 1980s, or early 1990s. Much of the technological progress in computers, communications, and consumer electronics took place within established industry boundaries rather than across boundaries. A PC on every desk and in every home, high-bandwidth communications, or five hundred-channel television sets in every corner will not, by themselves, change the way we work, play, or organize our lives. We need creative business and home solutions to drive the market for converging technologies.

Introduction: CHESS and Competing in the Age of Digital Convergence 9

Thus the third driving force required for digital convergence is managerial creativity. Many of the early efforts by corporations to facilitate convergence relied on conventional views of technology, which stated that hardware firms needed software expertise, computer firms required communications capabilities, or communications firms needed to learn how to make computers. Like Says's Law, managers assumed that once they assembled the capabilities, "converged products" would emerge and supply would create its own demand. Yet most firms that followed this conventional approach lost spectacular sums of money in the name of digital convergence. The biggest failures have include the biggest names: IBM, with its failed acquisition of Rolrn: AT&T, with its failed acquisition of NCR; and Matsushita's and Sony's disastrous acquisitions of MCA and Columbia Pictures, respectively.

Despite the large number of failures, activity to bring about convergence through brute force continues on a large scale. The most obvious indicator of this activity is the mergers, acquisitions, and alliance deals among communications, information, and entertainment companies. Collis, Bane, and Bradley catalog 508 multimedia alliances prior to 1993. Since that time, activity has increased. In 1994, for example, KMPG Peat Marwick reported that a record $27.8 billion was spent on multimedia acquisitions, and another $22 billion in the first half of 1995.7 A partial analysis of investments and acquisitions made in the name of building capabilities for convergence during 1993, 1994, and the first half of 1995 suggests that more than $96 billion has been committed to projects in anticipation of convergence. As table 1-1 illustrates, the largest investments were made by telecommunications and entertainment companies. Almost half of these investments have been related to infrastructure and have been made by local telephone companies. Finally, while the computer companies have not been prominent among the largest deal makers to date, they have been investing aggressively in new product categories, such as personal digital assistants (PDAs),s PC videoconferencing," and interactive television, that require substantial investments in R&D, manufacturing, and marketing. At the other end of the spectrum, start-up firms have been exploding onto the scene, looking to capitalize on technological discontinuities. Successful start-ups have focused on niche markets where established players have been too slow to respond, too tied to an existing customer base, or too committed to a single technological path.

Through the mid-1990s, start-ups have provided most of the managerial creativity for driving digital convergence. Perhaps the most powerful and widely cited example of this creativity is the Internet. Its history

10 Introduction: CHESS and Competing in the Age of Digital Convergence

INVESTMENTS IN MULTIMEDIA CAPABILITIES, 1993-1995 (IN MILLION DOLLARS)

Year

Company

Amount Details

Capital

Ameritech 4,400 expansion project to bring switched
interactive video to homes budgeted
AT&T 5 to Ziff-Davis for Interchange spent
1994 PacTe!, Bell 300 with CAA to develop multimedia
Atlantic, NYNEX programs budgeted
1994 Ameritech, 500 with Disney develop
Bell South, SBC multimedia programming budgeted
Bell Atlan tic 11,000 build broadband networks budgeted
Bell Atlantic 1,500 wire 8.5 million customers for video budgeted
1993 Bell South 300 22.5% stake in Prime Cable of
Austin, TX spent
MCI 2,000 13.5% stake in News Corp. over 4 years budgeted
1994 Microsoft 55 investment in Mobile
Telecommunications Technologies spent
Corp.
Microsoft 10 with SBC Communications to test
interactive services in Texas underway
1994 NYNEX 1,200 investment in Viacom spent
NYNEX 2,000 per year investment to upgrade
network budgeted
Pacific Telesis 16,000 create fiber-optic/coaxial network for
interactive video in CA, NV budgeted
Prodigy 1,000 investment ofIBM and Sears
since 1984 spent
1993 SBC 680 purchase two suburban cable
Communications companies spent
SBC 1,000 over 4 years to add multimedia
Communications capabilities budgeted
TCI Technology 125 20% stake in Microsoft Network spent
1993 US West 2,500 25% stake in Time Warner spent
US West 10,000 500,000 per year over 20 years to
upgrade network capacity budgeted
1994 US West 1,200 purchase two cable systems in Atlanta spent
Consortium of 600 to build trans-European network with
European railways Global Telesystems group budgeted
1995 Veba 1,300 10% of British Telecom budgeted
1994 Viacom 10,000 acquisition of Paramount spent
1995 Disney 19,000 acquisition of Cap Cities! ABC budgeted
1995 Time Warner 8,000 acquisition of Turner Broadcasting budgeted
1995 MCI 2,000 13.5% stake in News Corporation budgeted
Total Investment $96,675 SOURCES: Various issues of The Economist; Broadcasting & Cable; and Media Week.