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Negotiating for the Market

Joshua Gans NBER Summer Institute July 2010

Creation without Destruction

Creation without Destruction
• Competition: Technological entrepreneurship can displace product market incumbents • Entrepeneurship implies creative destruction

Creation without Destruction
• Competition: Technological entrepreneurship can displace product market incumbents • Entrepeneurship implies creative destruction • Cooperation: Technological entrepreneurship may reinforce existing market power • Entrepreneurship leads to creation but no destruction

Creation without Destruction
• Competition: Technological entrepreneurship can displace product market incumbents • Entrepeneurship implies creative destruction • Cooperation: Technological entrepreneurship may reinforce existing market power • Entrepreneurship leads to creation but no destruction Key insight: Competition vs cooperation is not a given but a choice ... the result of negotiations between start-ups and incumbents.

Broad research agenda

Broad research agenda
• Builds on research program with Scott Stern (MIT) and David Hsu (Wharton) ...

Broad research agenda
• Builds on research program with Scott Stern (MIT) and David Hsu (Wharton) ... • Goal: use insights from bargaining theory to understand the commercialisation choices of entrepreneurial start-ups and the impact of these on the rate of innovation

Broad research agenda
• Builds on research program with Scott Stern (MIT) and David Hsu (Wharton) ... • Goal: use insights from bargaining theory to understand the commercialisation choices of entrepreneurial start-ups and the impact of these on the rate of innovation • This paper ... • What are the ‘dynamic’ drivers of competitive versus cooperative commercialisation? • Under Schumpeterian competition, when is cooperative commercialisation desirable?

Broad research agenda
• Builds on research program with Scott Stern (MIT) and David Hsu (Wharton) ... • Goal: use insights from bargaining theory to understand the commercialisation choices of entrepreneurial start-ups and the impact of these on the rate of innovation • This paper ... • What are the ‘dynamic’ drivers of competitive versus cooperative commercialisation? • Under Schumpeterian competition, when is cooperative commercialisation desirable? • Answering each requires a dynamic model and an environment where competition for the market is more important than competition in the market.

Dynamic drivers of commercialisation choice

Dynamic drivers of commercialisation choice
• Static rationale for cooperative commercialisation is compelling • Save duplicating complementary assets (Teece, 1986) • Prevent rent dissipation (Gans & Stern, 2000)

Dynamic drivers of commercialisation choice
• Static rationale for cooperative commercialisation is compelling • Save duplicating complementary assets (Teece, 1986) • Prevent rent dissipation (Gans & Stern, 2000) • But competition is often observed • Arora and Gambardella (2009)

Dynamic drivers of commercialisation choice
• Static rationale for cooperative commercialisation is compelling • Save duplicating complementary assets (Teece, 1986) • Prevent rent dissipation (Gans & Stern, 2000) • But competition is often observed • Arora and Gambardella (2009) • Competition can be partly explained by imperfections in ideas markets • Theory: Arora, Anton & Yao • Examples: Apple, Google, Genzyme, Intuit, Facebook ... • Strong IP encourages cooperation: Gans, Hsu & Stern (2002); Arora & Ceccagnoli (2005) • Less IP uncertainty encourages cooperation: Gans, Hsu & Stern (2008)

Dynamic drivers of commercialisation choice
• Static rationale for cooperative commercialisation is compelling • Save duplicating complementary assets (Teece, 1986) • Prevent rent dissipation (Gans & Stern, 2000) • But competition is often observed • Arora and Gambardella (2009) • Competition can be partly explained by imperfections in ideas markets • Theory: Arora, Anton & Yao • Examples: Apple, Google, Genzyme, Intuit, Facebook ... • Strong IP encourages cooperation: Gans, Hsu & Stern (2002); Arora & Ceccagnoli (2005) • Less IP uncertainty encourages cooperation: Gans, Hsu & Stern (2008) • But individual studies of start-up choice over commercialisation suggest a dynamic concern for creation and capture of future innovative rents • EMI (CT Scanner); Nucleon, Ecton and Palm

Antitrust and cooperative commercialisation

Antitrust and cooperative commercialisation
• Two schools • ‘Hands off’: When there is competition for the market, there are no competitive gains from intervention. Better not to disrupt innovation. (Gilbert, Schmalensee, Evans, etc) • ‘Vigilance’: In dynamic environments, it pays to be vigilant in promotion competition so as not to lose future innovative potential

Antitrust and cooperative commercialisation
• Two schools • ‘Hands off’: When there is competition for the market, there are no competitive gains from intervention. Better not to disrupt innovation. (Gilbert, Schmalensee, Evans, etc) • ‘Vigilance’: In dynamic environments, it pays to be vigilant in promotion competition so as not to lose future innovative potential • Recent FTC/DOJ Draft Merger Guidelines • “… effect is most likely to occur if at least one of the merging firms has capabilities that are likely to lead it to develop new products in the future that would capture substantial revenues from the other merging firm. The Agencies therefore also consider whether a merger will diminish innovation competition by combining two of a very small number of firms with the strongest capabilities to successfully innovate in a specific direction.”

Starting point

Starting point
• Segal & Whinston (2007) model of dynamic technological competition • SW apply to antitrust practices • SW consider entrants as competing and displacing incumbents -- ongoing change

Starting point
• Segal & Whinston (2007) model of dynamic technological competition • SW apply to antitrust practices • SW consider entrants as competing and displacing incumbents -- ongoing change • Here, modifications • Remove static competition effects to focus on dynamics in Schumpeterian, ‘winner-take-all’ or ‘for the market’ competition. • Incorporate ideas markets • Model dynamic capabilities (firms may not be long-lived)

Firms & Innovations

Firms & Innovations
• Discrete time, infinite horizon with common discount factor, δ

Firms & Innovations
• Discrete time, infinite horizon with common discount factor, δ • Innovations are sequential • Innovation yields new product of higher quality than previous generation

Firms & Innovations
• Discrete time, infinite horizon with common discount factor, δ • Innovations are sequential • Innovation yields new product of higher quality than previous generation • Incumbent (I) • There is a single producer of the new product who can earn per period monopoly rents, Π, until displaced.

Firms & Innovations
• Discrete time, infinite horizon with common discount factor, δ • Innovations are sequential • Innovation yields new product of higher quality than previous generation • Incumbent (I) • There is a single producer of the new product who can earn per period monopoly rents, Π, until displaced. • Ideas are scarce • For each product generation only one firm conducts R&D • Innovation leader drawn from pool of firms including the current incumbent (O’Donoghue, Scotchmer and Thisse, 1998) • I can be the innovation leader and prolong incumbency • Otherwise, label leader as ‘entrant’ or E.

Innovation Rate

Innovation Rate
• Paper: assume that an innovation leader generates an innovation immediately

Innovation Rate
• Paper: assume that an innovation leader generates an innovation immediately • Here: for welfare focus on situations where we believe that incumbents innovate less intensively than start-ups • Cannabilisation (Arrow, 1962) • Low powered incentives (Aghion and Tirole, 1994)

Innovation Rate
• Paper: assume that an innovation leader generates an innovation immediately • Here: for welfare focus on situations where we believe that incumbents innovate less intensively than start-ups • Cannabilisation (Arrow, 1962) • Low powered incentives (Aghion and Tirole, 1994) • Key implication • In welfare judgments, want policies that will encourage start-up rather than incumbent innovation

Timeline

t-1

t

t+1

Timeline

t-1

t

t+1

Selection

Timeline

t-1

t

t+1

Selection

Production

Timeline

t-1

t

t+1

Selection

Production

Innovation

Timeline

t-1

t

t+1

Selection

Production

Innovation

Negotiations

Timeline

t-1

t

t+1

Selection
Innovation leader chosen

Production

Innovation

Negotiations

Timeline

t-1

t

t+1

Selection
Innovation leader chosen

Production

Innovation

Negotiations

Capabilities Acquired

Timeline

t-1

t

t+1

Selection
Innovation leader chosen

Production

Innovation

Negotiations
Commercialisation choice

Capabilities Acquired

Negotiations

Negotiations

Entrant Innovates

Negotiations

Competition

Entrant Innovates

Negotiations

Competition

I loses monopoly profits

Entrant Innovates

Negotiations

Competition

I loses monopoly profits

E becomes I (earns Π)

Entrant Innovates

Negotiations

Competition

I loses monopoly profits

E becomes I (earns Π)

Entrant Innovates

Cooperation

Negotiations

Competition

I loses monopoly profits

E becomes I (earns Π)

Entrant Innovates
I retains monopoly profits

Cooperation

Negotiations

Competition

I loses monopoly profits

E becomes I (earns Π)

Entrant Innovates
I retains monopoly profits

Cooperation

E remains E (earns τ)

Selection: Dynamic Capabilities

Selection: Dynamic Capabilities Prior Activity

Selection: Dynamic Capabilities Prior Activity
Production Only

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example
I not an innovation leader

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example
I not an innovation leader E as innovation leader

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example
I not an innovation leader E as innovation leader Merger or I as innovation leader

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example
I not an innovation leader E as innovation leader Merger or I as innovation leader

Probability of becoming Leader

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example
I not an innovation leader E as innovation leader Merger or I as innovation leader

Probability of becoming Leader

σ p ∈[0,1]

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example
I not an innovation leader E as innovation leader Merger or I as innovation leader

Probability of becoming Leader

σ p ∈[0,1]

σ i ∈[0,1]

Selection: Dynamic Capabilities Prior Activity
Production Only Innovation Only Production & Innovation

Example
I not an innovation leader E as innovation leader Merger or I as innovation leader

Probability of becoming Leader

σ p ∈[0,1]

σ i ∈[0,1]
σ ip ≥ max{σ p , σ i }

Continuation payoffs

Continuation payoffs
I Innovation Leader

Continuation payoffs
I Innovation Leader

Continuation payoffs
I Innovation Leader

E Innovation Leader

Continuation payoffs
I Innovation Leader

E Innovation Leader

Continuation payoffs
I Innovation Leader

E Innovation Leader

Continuation payoffs
I Innovation Leader

E Innovation Leader

I NonInnovator

Continuation payoffs
I Innovation Leader

E Innovation Leader

I NonInnovator

Continuation payoffs
I Innovation Leader

E Innovation Leader

I NonInnovator

Continuation payoffs
I Innovation Leader

E Innovation Leader

I NonInnovator

Cooperation

Continuation payoffs
I Innovation Leader

E Innovation Leader

I NonInnovator

Cooperation

Competition

Gains from Trade (Licensing)

Cooperation

Competition

Gains from Trade (Licensing)

+

Cooperation

Competition

Gains from Trade (Licensing)

+

+

Cooperation

Competition

Gains from Trade (Licensing)

+

>

+

Cooperation

Competition

Gains from Trade (Licensing)

Π − τ + δσ pVI + δ (1 − σ p )v I + τ + δσ i v E ≥ Π + δσ p v E + δσ iVI + δ (1 − σ i )v I

Gains from Trade (Licensing)

(σ p − σ i ) VI − v E − v I ≥ 0

(

)

Gains from Trade (Licensing)

(σ p − σ i )(σ ip − σ i − σ p ) ≥ 0

Gains from Trade (Licensing)

(σ p − σ i )(σ ip − σ i − σ p ) ≥ 0

Caveat: if incumbents innovate at a slower rate, both will have an interest in choosing a commercialisation mode that maximises the probability that the incumbent is the innovation leader

Licensing Equilibrium Outcomes
σ ip
Competition Licensing
VI < v I + v E

σp

Licensing

Competition
σi

VI ≥ v I + v E

σ ip

Licensing Equilibrium Outcomes
σ ip
Competition Licensing
VI < v I + v E

σp

Licensing

Does high σi drive competition?

Competition
σi

VI ≥ v I + v E

σ ip

Gains from Trade (Acquisition)

Gains from Trade (Acquisition)
Π − τ + σ ipδV + (1 − σ ip )δVI + τ   
i I Joint Payoff from Cooperation i I

≥ σ pδVE + Π + σ iδV + (1 − σ i )δVI    
Joint Payoff from Competition

Gains from Trade (Acquisition)

(σ ip − σ i )δ (VI − v I ) ≥ σ pδ v E

Gains from Trade (Acquisition)

(σ ip − σ i )δ (VI − v I ) ≥ σ pδ v E

1 − σ ip > 1 − σ i − σ p

Gains from Trade (Acquisition)

(σ ip − σ i )δ (VI − v I ) ≥ σ pδ v E

1 − σ ip > 1 − σ i − σ p

implies positive externality on potential entrants

Acquisition Equilibrium Outcomes
σ ip

Competition
σp

VIi < v II + v EE V +V

Acquisition
Does high σi drive competition?
VIi ≥ v II + v EE V +V

σi

σ ip

Welfare

Welfare
• Acquisition never socially desirable

Welfare
• Acquisition never socially desirable • Significant: commentators suggest that Schumpeterian competition implies loose merger policy

Welfare
• Acquisition never socially desirable • Significant: commentators suggest that Schumpeterian competition implies loose merger policy • Here: merger consolidates capabilities to become next lead innovator in incumbent’s hands (removes entrant capabilities) -- with reduced innovation incentives.

Welfare
• Acquisition never socially desirable • Significant: commentators suggest that Schumpeterian competition implies loose merger policy • Here: merger consolidates capabilities to become next lead innovator in incumbent’s hands (removes entrant capabilities) -- with reduced innovation incentives. • Merger delays the forces of creative destruction

Alternative Contracting Possibilities

Alternative Contracting Possibilities
• Restructuring and spin-outs • If incumbent innovation leader has lower chance of persisting, may prefer to spinout innovative element prior to innovation and production • No gains from trade from licensing

Alternative Contracting Possibilities
• Restructuring and spin-outs • If incumbent innovation leader has lower chance of persisting, may prefer to spinout innovative element prior to innovation and production • No gains from trade from licensing • Delayed negotiation • If incumbent innovation leader has a higher chance of persisting, want to minimise risk and delay licensing until after innovation leader is revealed or to renegotiate a prior agreement upon the resolution of uncertainty • However, this may, in reality, represent considerable cost in terms of delayed commercialisation

Alternative Contracting Possibilities
• Restructuring and spin-outs • If incumbent innovation leader has lower chance of persisting, may prefer to spinout innovative element prior to innovation and production • No gains from trade from licensing • Delayed negotiation • If incumbent innovation leader has a higher chance of persisting, want to minimise risk and delay licensing until after innovation leader is revealed or to renegotiate a prior agreement upon the resolution of uncertainty • However, this may, in reality, represent considerable cost in terms of delayed commercialisation • Entrant participation in production • Wakeman (2008): one third of biotech start-up deals involve collaboration in marketing, sales, clinical trials etc • Increases domain for cooperation but causes firms to favour licensing over acquisition

Conclusions

Conclusions
• Even in the absence of static rationales, dynamic considerations can drive commercialisation choices

Conclusions
• Even in the absence of static rationales, dynamic considerations can drive commercialisation choices • Need to look at relative capabilities • Capabilities here are based on experience • Empirically, examine commercialisation choice based on start-up experience in R&D variables and incumbent experience in products and production

Conclusions
• Even in the absence of static rationales, dynamic considerations can drive commercialisation choices • Need to look at relative capabilities • Capabilities here are based on experience • Empirically, examine commercialisation choice based on start-up experience in R&D variables and incumbent experience in products and production • Private commercialisation choice aimed at slowing down forces of creative destruction • Will cooperate if can reduce future innovation incentives • But competition may also generate this outcome • Difficult to find blanket policies against licensing (may want it to be compulsory!) but acquisition is always welfare reducing