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Value Creation In Innovation Ecosystems: How The Structure Of Technological Interdependence Affects Firm Performance In New Technology Generations

Value creation in innovation ecosystems: how the structure of technological interdependence affects firm performance in new technology generations

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  Strategic Management Journal Strat. Mgmt. J. ,  31 : 306–333 (2010)Published online EarlyView in Wiley InterScience (www.interscience.wiley.com) DOI: 10.1002/smj.821  Received 6 May 2008 ;  Final revision received 12 October 2009 VALUE CREATION IN INNOVATION ECOSYSTEMS:HOW THE STRUCTURE OF TECHNOLOGICALINTERDEPENDENCE AFFECTS FIRM PERFORMANCEIN NEW TECHNOLOGY GENERATIONS RON ADNER 1 * and RAHUL KAPOOR 2 1 Tuck School of Business, Dartmouth College, Hanover, New Hampshire, U.S.A. 2 TheWhartonSchool,UniversityofPennsylvania,Philadelphia,Pennsylvania,U.S.A. The success of an innovating firm often depends on the efforts of other innovators in its environ-ment. How do the challenges faced by external innovators affect the focal firm’s outcomes? Toaddress this question we first characterize the external environment according to the structure of interdependence. We follow the flow of inputs and outputs in the ecosystem to distinguish betweenupstream components that are bundled by the focal firm, and downstream complements that arebundled by the firm’s customers. We hypothesize that the effects of external innovation challengesdepend not only on their magnitude, but also on their location in the ecosystem relative to the focal firm. We identify a key asymmetry that results from the location of challenges relative toa focal firm—greater upstream innovation challenges in components enhance the benefits that accrue to technology leaders, while greater downstream innovation challenges in complementserode these benefits. We further propose that the effectiveness of vertical integration as a strat-egy to manage ecosystem interdependence increases over the course of the technology life cycle.We explore these arguments in the context of the global semiconductor lithography equipment industry from its emergence in 1962 to 2005 across nine distinct technology generations. We find strong empirical support for our framework.  Copyright  ©  2009 John Wiley & Sons, Ltd. INTRODUCTION A firm’s competitive advantage depends on itsability to create more value than its rivals (Porter,1985; Brandenburger and Stuart, 1996). Greatervalue creation, in turn, depends on the firms’ability to innovate successfully. To capture thereturns from innovation, many firms strive to betechnology leaders in their industry by being firstto introduce new innovations to the market. Agiven innovation, however, often does not standalone; rather, it depends on accompanying changes Keywords: technological change; first mover advantage;business ecosystem; vertical integration; complements;semiconductor lithography *Correspondence to: Ron Adner, Tuck School of Business, Dart-mouth College, Strategy and Management, 100 Tuck Hall,Hanover, NH 03755, U.S.A. E-mail: [email protected] in the firm’s environment for its own success.These external changes, which require innovationon the part of other actors, embed the focal firmwithin an ecosystem of interdependent innovations(Adner, 2006).Consider, for example, Airbus’s monumentalinvestment in pioneering the super-jumbo passen-ger aircraft with its A380 offer. Airbus, as the focalfirm, faces substantial challenges in designing andmanufacturing the core airframe of the airplane.Beyond this internal challenge, it also relies ona host of suppliers for subassemblies and com-ponents. Some of these suppliers are themselvesconfronted with significant innovation challengesto deliver components that meet Airbus’s require-ments (e.g., engine, navigation system), while oth-ers will not need to innovate at all (e.g., carpet-ing). Receiving these various components, Airbus Copyright  ©  2009 John Wiley & Sons, Ltd.  Value Creation in Innovation Ecosystems  307 faces the additional challenge of integrating thesecomponents with the airframe in order to delivera functioning aircraft to its airline customers. Inorder for the aircraft to be used productively byairlines, however, a number of other actors inthe environment, outside of Airbus’s direct supplychain, confront additional innovation challengesas well. Complementors such as airports need toinvest and develop new infrastructure to accommo-date the oversized aircraft, regulators need to spec-ify new safety procedures, and training simulatormanufacturers need to develop new simulators onwhich aircraft crews can be trained. The A380innovation ecosystem thus comprises not only Air-bus as the core innovator, but also its upstreamsuppliers, and its downstream buyers and comple-mentors. The key point is that it is not enoughto consider whether and how Airbus will success-fully resolve its internal innovation challenges; inorder for the A380 offer to create value, all of theother ecosystem partners need to resolve their owninnovation challenges as well.Understanding firm performance in such ‘inno-vation ecosystems’ requires a change in the wayin which the strategy and the innovation litera-tures have traditionally linked industry dynamicsto firm performance. Most obviously, it requires anapproach that is explicit not only about the inno-vation challenges that are faced by the focal firm(Cooper and Schendel, 1976; Tushman and Ander-son, 1986; Henderson and Clark, 1990; Chris-tensen, 1997), but one that is also explicit aboutthe nature of innovation challenges confronted bythe external partners. In addition, it requires anapproach that extends beyond the focus on howdifferent actors will bargain over value capture(Porter, 1980; Teece, 1986; Brandenburger andStuart, 1996; Brandenburger and Nalebuff, 1997)to include an explicit consideration of the innova-tion challenges that different actors will need toovercome in order for value to be created in thefirst place.The current paper presents an approach to ana-lyzing the dynamics of value creation that focuseson the role of innovation challenges in a firm’secosystem as potential bottlenecks to value cre-ation. We show that no less important than the magnitude  of innovation challenges in the ecosys-tem is the  location  of these challenges. We presenta simple structure for locating challenges relativeto the focal firm according to the flow of activi-ties within the ecosystem and draw key distinctionsbetween challenges that need to be confronted bythe focal firm, its upstream suppliers, and its down-stream complementors.Specifically, the current paper identifies asym-metries that arise from the positions of differentcounterparties relative to the focal firm. We showthat a firm’s ability to create value is impactedin very different ways depending on whether itis its upstream or downstream partners that faceinnovation challenges The impact of high externalinnovation challenges on the focal firm depends onwhether the challenges are confronted by suppliers,which affects the components that the firm needs tointegrate in order to offer a complete product to itscustomers, or by complementors, in which case thefirm can offer its complete product to the customer,but the customer cannot utilize it to its full poten-tial. We link these asymmetries in value creationto their impact on value capture and competitiveadvantage. To our knowledge this is the first paperin the management literature to explicitly postulateor test the asymmetric effects of components andcomplements.We use this ecosystem lens to consider two inter-related questions. First, how the structure of tech-nological interdependence—the location of chal-lenges relative to the focal firm—affects the ben-efit that accrues to technology leaders (i.e., firmsthat pioneer the introduction of new technologygenerations). Second, how the effectiveness of ver-tical integration as a strategy for managing tech-nological interdependence changes over the courseof a technology’s life cycle.The first mover advantage literature has iden-tified important considerations under which tech-nology leaders gain or lose from early entry intonew markets. Both the applied and scholarly lit-eratures are replete with studies, prescriptions,and caveats regarding the merits of pioneeringopportunities (Lieberman and Montgomery, 1988;Mitchell, 1991; Golder and Tellis, 1993; Chris-tensen, Su´arez, and Utterback, 1998). Consistentwith strong arguments for and against the benefitsof leading in the introduction of new innovations,the empirical findings have been decidedly mixed,with some studies reporting significant pioneer-ing advantages while others report disadvantagesand non-effects (Kerin, Varadarajan, and Peter-son,1992; VanderWerf and Mahon, 1997).The debates over the advantage accorded totechnology leaders have tended to overlook the Copyright  ©  2009 John Wiley & Sons, Ltd.  Strat. Mgmt. J. ,  31 : 306–333 (2010)DOI: 10.1002/smj  308  R. Adner and R. Kapoor  nature of the technology challenges that lead-ers and their ecosystems must overcome. In sodoing, they have neglected a key contingency.The current paper moves beyond the literature’straditional analysis of firms’ positions relative totheir rivals. We explicitly consider the innovationchallenges that reside in the firm’s environmentand need to be confronted by external partners if the focal innovation is to succeed in the market.We develop a simple framework for characteriz-ing the technological uncertainty associated withexternal innovation challenges. We argue that thelocation of challenges impacts the steepness of firms’ learning curves, their rate of progress alongthese curves, and the extent of spillovers to rivals.We predict that challenges in components increasethe performance advantage attributable to tech-nology leaders, while challenges in complementsdecrease this advantage. 1 In so doing, we revealhow the structure and sequence of value creationaffects the outcomes of competition for value cap-ture.We then consider firms’ vertical integration of key components as a strategy to manage thisinterdependence. We integrate arguments fromthe research literatures on technology life cycles(Rosenberg, 1976; Sahal, 1981; Dosi, 1982) andtransaction cost economics (Williamson, 1985),and suggest that while technological challengestend to decrease as technologies mature, con-tractual challenges need not dissipate over time.Because vertical integration mitigates contractualhazards but not necessarily technological chal-lenges, we posit that the shifting balance of tech-nological and contractual uncertainty will act toincrease the benefit from vertical integration overthe course of the technology life cycle. Hence, ver-tical integration is likely to be more effective aftera technology has reached a stage of maturity, ratherthan during its emergence.We test these arguments in the context of the global semiconductor lithography equipmentindustry from its emergence in 1962 to 2005,a period during which the industry transitionedthrough nine distinct technology generations.While focal innovators faced significant challengesin each of these generational transitions, the extent 1 Note that our focus is  not   in specifying whether technologyleaders will have a competitive advantage. Rather, our focus ison specifying whether competitive advantage from technologyleadership is enhanced or eroded by the magnitude and locationof external innovation challenges. to which suppliers and complementors faced inno-vation challenges varied across these generations,providing us with an ideal setting in which to testthe impact of ecosystem challenges on technologyleaders. We construct a unique dataset to test ourarguments. The data include a novel measure of ecosystem challenges for each of the nine tech-nology generations, as well as information aboutevery firm that ever sold lithography equipmentfor mainstream applications in the semiconductorindustry.Our study makes a number of contributions.First, it introduces a structured approach for ana-lyzing technology interdependence. This approachoffers a new perspective for understanding inno-vators’ outcomes during periods of technologicalchange by focusing not only on the internal chal-lenges faced by the focal firms (Tushman andAnderson, 1986; Henderson and Clark, 1990) butalso on the external challenges faced by partnersin the ecosystem. By using an ecosystem lensto examine the benefits of technology leadership,we expand the scope of inquiry beyond its tradi-tional focus on direct competitors to identify theunderpinning mechanisms by which uncertainty incomponents and complements exercise opposingeffects on the performance of technology leadersand laggards (Lieberman and Montgomery, 1998).By disaggregating the external environment intoupstream and downstream constituents, we showthat the location of challenges matters no lessthan their magnitude, and offer a finer-grainedview of the interaction between organizations andtheir environments (Dess and Beard, 1984) andits implication for the dynamics of value creation(Brandenburger and Stuart, 1996; Adner and Zem-sky, 2006). By linking the flow of activities amongexchange partners to the distribution of innova-tion challenges across the ecosystem, we shedlight on a key mechanism of joint value creationand contribute to the emerging research literatureon ecosystem strategy (Moore, 1996; Iansiti andLevien, 2004; Adner, 2006). To the best of ourknowledge, the current study is the first to opera-tionalize the environment in this way. Finally, byexplicitly considering the changing benefits of ver-tical integration over the course of the technologylife cycle we contribute toward an understand-ing of how firms’ boundary choices affect theirperformance outcomes over time (Stigler, 1951;Argyres and Bigelow, 2007; Novak and Stern,2008). Copyright  ©  2009 John Wiley & Sons, Ltd.  Strat. Mgmt. J. ,  31 : 306–333 (2010)DOI: 10.1002/smj  Value Creation in Innovation Ecosystems  309 AN ECOSYSTEM PERSPECTIVE The ecosystem construct, as a way of makinginterdependencies more explicit, has gained promi-nence in both business strategy (Moore, 1996; Ian-siti and Levien, 2004; Adner, 2006) and practice(e.g., Intel Corporation, 2004; SAP Corporation,2006). These approaches have focused on under-standing coordination among partners in exchangenetworks that are characterized by simultaneouscooperation and competition (Brandenburger andNalebuff, 1997; Afuah, 2000). Studies in this veinexplore the challenges that arise when incentivesacross the ecosystem are not aligned (Casadesus-Masanell and Yoffie, 2007), the role of estab-lished relationships with ecosystem partners inshaping firms’ motivations to compete for differentmarket segments (Christensen and Rosenbloom,1995), and the activities that focal firms undertaketo induce exchange partners to favor their spe-cific technology platforms (Gawer and Cusumano,2002).Notice, however, that these studies are primarilyconcerned with strategic interactions among firms,extending the focus on value capture from thecontext of bilateral partnerships (Teece, 1986) andindustries (Porter, 1980) to the context of ecosys-tems (Jacobides, Knudsen, and Augier, 2006;Pisano and Teece, 2007). Thus, while the strategyliterature has explored the role of co-specialization,bargaining power, and relationships betweenexchange partners in shaping firms’ value capture,it has tended to assume away the question of howvalue is created in the first place.Notice too, that while these research studies areclearly sensitive to the presence of different rolesand actors along the value chain (i.e., drawingclear distinctions between suppliers, complemen-tors, and buyers), the specific value chain positionof a counterparty relative to the focal firm has hadno impact on the resulting analysis;—that is, theimpact of an exchange partner with high bargain-ing power on the focal firm’s ability to capturevalue is exactly the same regardless of whetherthe counter party is positioned as a complementor,a buyer, or a supplier.Indeed, although the very imagery of a valuechain (at the level of both firms and indus-tries) suggests interdependencies characterized asan ordered arrangement of activities, the literaturehas largely neglected the impact of the relativelocations of activities along the chain. This has leftthe field in the odd position of highlighting theimportance of complements, complementors, andcomplementary assets, (e.g., Teece, 1986; Milgromand Roberts, 1990), claiming qualitatively distinctstatus for the role of complementors and suppli-ers, but unable to use its definition of these con-structs 2 to distinguish between complements (e.g.,software for hardware) and components (e.g., pro-cessors for computers) because improvements ineither increase the attractiveness of the focal offer.We depart from this literature by explicitly link-ing the dynamics of value creation and their impli-cations for value capture to the structure of inter-dependence in a firm’s ecosystem. The perspectivethat we propose and test in this study exploits therelative location of activities within the ecosys-tem to distinguish among the different roles playedby various actors in the firm’s environment. Weidentify roles according to the location in whichactivities are bundled in the ecosystem by follow-ing the flow of inputs and outputs of firms, anduse this as the basic framework for our analysis.Figure 1 shows the schema of our approach. Theoutputs of upstream suppliers serve as inputs tothe focal actor. We refer to such inputs, whichare bundled by the focal actor into its product,as components. The focal actor’s product servesas an input to its customer. A customer may alsoneed to bundle other offers alongside the focalactor’s product in order to utilize it. We refer tosuch offers, which are bundled downstream by thecustomer, as complements. Thus, components andcomplements are defined according to where ele-ments are bundled in the flow of activities relative Supplier 2Complementor 1Supplier 1Complementor 2Focal firmCustomer Components  Complements Figure 1. Generic schema of an ecosystem 2 For example, ‘The defining characteristic of these groups of complements is that if the levels of any subset of the activitiesare increased, then the marginal return to increases in any or allof the remaining activities rises’ (Milgrom and Roberts, 1990:514). Copyright  ©  2009 John Wiley & Sons, Ltd.  Strat. Mgmt. J. ,  31 : 306–333 (2010)DOI: 10.1002/smj  310  R. Adner and R. Kapoor  to the position of the focal product, not accord-ing to whether they are produced by a given firmor outsourced to another. For example, althoughHewlett Packard produces both personal comput-ers and printers, they remain separate offers thatare brought together by the customer: the printeris a complement to the computer independentlyof whether it is offered by Hewlett Packard orCannon. In the figure, as in our study, we exam-ine only first-tier components and complements;clearly, this structure can be extended forwardand backward along the activity chain to includehigher-tiered actors (e.g., suppliers’ suppliers; cus-tomers’ customers). In the following section, weapply this approach in the context of innova-tions. Innovation and the structureof interdependence The majority of studies in the innovation liter-ature have sought to characterize the magnitudeand nature of the internal innovation challengesconfronted by focal innovators. 3 The magnitude of innovation challenges can be characterized by theextent to which they require changes to the cur-rent approach to problem solving. The nature of achallenge can be rooted in discovery, design, anddevelopment (Tushman and Anderson, 1986; Hen-derson and Clark, 1990); in integrating externalcomponents into firms’ internal designs (Takeishi,2002; Brusoni, Prencipe, and Pavitt, 2001); or inscaling up the production and delivery of the iden-tified solution (Argote, 1999; Hatch and Mowery,1998).The success of an individual innovation, how-ever, is often dependent on the success of otherinnovations in the firm’s external environment.Hughes’s (1983) rich description of the emergenceof the electrical power network highlights theobstacles raised when some technological elementsof an ecosystem lag behind others in resolving theirchallenges. He attributes the decline of direct cur-rent (DC) generation technologies to bottlenecks 3 Exceptions are Afuah’s studies (Afuah and Bahram, 1995;Afuah, 2000), which have explored how firm performance isimpacted when partners face technology challenges. These stud-ies focus on the overall level of innovation challenges that part-ners must confront. In contrast, our study explicitly considers theimpact of variations in both the level and the location of chal-lenges within the ecosystem. In so doing, we are able to uncovernew insights regarding the asymmetric impact of upstream anddownstream uncertainty on innovators’ outcomes. in the development of distribution technology forthe DC network. Conversely, Henderson’s (1995)study of the semiconductor lithography industry(the same industry we examine in this paper) high-lights the role that suppliers, customers, and com-plementors played in offsetting bottlenecks in opti-cal lithography technology, thereby extending thedominance of optical lithography over nonopticalapproaches. However, while the existence of exter-nal innovation dependencies in such systems of innovation has been well documented in the liter-ature, it has been undertheorized.The existence of bottlenecks in an ecosystem isevidence that challenges are distributed unevenlyacross ecosystem roles. While challenges in anylocation within the ecosystem will constrain thefocal firm’s ability to create value with its prod-uct, challenges located in different positions con-strain its value creation and value capture inqualitatively different ways. Specifically, whereasupstream component challenges limit value cre-ation by constraining the focal firm’s ability toproduce its product, downstream complement chal-lenges limit value creation by constraining thecustomer’s ability to derive full benefit from con-suming the focal firm’s product.Figure 2 illustrates these distinctions. In theupper left hand quadrant, external component chal-lenges and complement challenges are low, and theprimary constraint on the focal firm is managingits own internal innovation challenges. An exam-ple might be DuPont developing a new plastic.The innovation literature has largely focused on themanagement of challenges in this quadrant. Theseinternal challenges are an issue in all quadrants inFigure 2. In the other three quadrants, however, inaddition to these internal challenges, external chal-lenges also need to be overcome. In the upper right External complement challengesLowLowInternal innovationchallengesInternal challenges +external constrainton consumption    E  x   t  e  r  n  a   l  c  o  m  p  o  n  e  n   t  c   h  a   l   l  e  n  g  e  s HighInternal challenges +external constrainton productionInternal challenges +external constraintson production andconsumptionHigh Figure 2. A framework for understanding the effect of ecosystem challenges on innovators Copyright  ©  2009 John Wiley & Sons, Ltd.  Strat. Mgmt. J. ,  31 : 306–333 (2010)DOI: 10.1002/smj