Pisano (1990)
Abstract
Theory: Sources of transaction costs
1) Small-numbers-bargaining hazards
2) Appropriability concerns
Subject: Established firms' choices between in-house and external sources of R&D
when technological change shifts the locus of R&D expertise from established enterprise to new entrants,
and established firms face a make-or-buy decision for R&D projects
+ Contingency on the R&D procurement decision
Sample:
92 biotechnology R&D projects
that major pharmaceutical companies have sponsored either in-house or through external contractual arrangements
Result:
1) Small-numbers-bargaining hazards: Small-numbers-bargaining problems -> Internalize R&D
2) Appropriability concerns: Firm's R&D experience / Dependence on the pharmaceutical business / National origin -> Decision
* Introduction
Literature
A: In-house R&D VS B: Contractual arrangements (Licenses, R&D agreements, and Joint ventures)
A - Mowery 1983
A vs B: von Hippel 1982; Bozeman and Link 1983; Pavitt 1986
Background
Broad and: rapid changes in the core technologies ("Creative destruction") -> R&D procurement decisions
The past application of transaction cost
1) Production and supply activities: Monteverde and Teece, 1982a, 1982b; Stuckey, 1983; Masten, 1984; Walker and Weber, 1984; Balakrishnan and Wernerfelt, 1986; Joskow, 1987
2) Marketing: Anderson and Schmittlein, 1984
Technology?
R&D = Hierarchy > Markets: Williamson (1975), Teece and Armour (1977), Teece (1988)
The best location for R&D
Examine with the project-level data
Not with Individual components and subassemblies (Monteverde and Teece, 1982a; Masten, 1984; Walker and Weber, 1984 )
Potential sources of transaction costs
Engineering intensity and design specialization (Monteverde and Teece, 1982a, 1982b; Masten, 1984)
Technological uncertainty (Walker and Weber, 1984; Balakrishnan and Wernerfelt, 1986)
Co-location of specialized assets (Joskow, 1987)
This paper
1) small numbers-bargaining hazards stemming from specialized R&D capabilities (Previous: intermediate product markets)
2) appropriability problems arising from competition in product markets. (Schumpeter, 1975; Arrow, 1962; Teece 1986, 1988)
Topic: The decisions of establihse pharmaceutical companies to develop new biotechnology-based pharmaceutical products through in-house R&D versus through contractual arrangements with outside firms
Biotechnology in pharmaceutical firms: the relatively dramatic changes in the technological environment
Start-up firms in the biotechnology industry have chosen to commercialize the technologies Shan (1989)
Competitive position -> Decision whether to commercialize its technologies on its own or through a cooperative arrangement with a partner
The determinants of cooperative commercialization strategies
# Speed: Red-Queen competition
Current
The R&D procurement behavior of large established firms already capable of commercializing the technology
1) The transactional difficulties of R&D contracts
2) How these difficulties affect established firms' R&D procurement
* Technological changes and the boundaries of the firm
Technological changes
"Competence-destroying" technological change (Tushman and Anderson, 1986)
The locus of technical expertise: Industry incumbent -> Newly formed ventures and firms from other industries
"Creative destruction" Schumpeter (1975)
+ "Revolutionary" technological change (Abernathy and Clark, 1985) which weakens or destroys established firms' advantages in R&D and production has little or no effect on their relative advantage in distribution and marketing -> differences in distinctive competences
A competitive clash (X), Opportunities for beneficial trade (O)
Background
The emergence of biotechnology during the late 1970s for the pharmaceutical industry
: Biotechnology as a competence-destroying technology
Most of the early commercial biotechnology R&D
: by new ventures that formed in the United States between 1976 and 1982 and
: not by the established pharmaceutical firms (Office of Technology Assessment, 1984)
Duality
Biotechnology was competence destroying on the R&D end, it was competence preserving at the commercialization end.
Must all go through the same clinical tests and regulatory approval process and are sold through the same distribution channels as traditional drug
Established pharmaceutical companies with years of commercial experience and existing organizational capabilities in these "downstream" functions (bringing new drugs from the laboratory to the market)
Economies of functional or vertical specialization
Efficiency: In-house vertical integration < Procure the services from a new biotechnology firm
Counterexample
However, established pharmaceutical companies undertook biotechnology R&D projects internally
Established pharmaceutical firms were conducting slightly less than half (47 percent) of their biotechnology R&D projects in-house.
Factors that have affected the extent and direction of backward integration into biotechnology R&D by individual pharmaceutical companies and,
How transaction costs may have impeded markets for biotechnology R&D.
- Transaction-cost theory
Why institutional structures other than markets are necessary for the efficient governance of economic activity
Markets > Hierarchies: Economies of specialization and the administrative and incentive limits (Williamson, 1985; Grossman and Hart, 1986)
Hierarchies > Markets: Special circumstances (e.g., Williamson, 1975, 1985; Klein, Crawford, and Alchian, 1978; Teece, 1982)
ex. 1 Uncertainty (when the contingencies affecting the execution of the agreement are complex and difficult for the trading partners to understand, predict, or articulate) and 2 Transaction-specific assets
1 When unexpected contingencies occur -> Renegotiation
1 + 2 A hazardous situation with Small-numbers-bargaining problem (Williamson, 1975): limited exchange alternatives
: when a firm invests in assets that are costly to transfer to alternative transactions or uses
: Limit the firm's ability to switch partners, make it vulnerable to opportunistic recontracting
Repeatedly entering into contractual agreements that involve uncertainty and transaction-specific asset
-> An incentive for vertical integration
Eliminates the ex-post bargaining problems that might arise with an outside partner and thus improves incentives to commit specialized capital.
Governance economies > The incremental economic costs (due to additional administrative burdens, incentive distortions, and losses in production efficiency that occur when a firm's in-house capabilities are inferior to those of outside sources Williamson, 1985; Grossman and Hart, 1986)
Transaction cost theory
R&D boundary choices that occur in the wake of technological changes
Structural -> Opportunities for trade between firm
Why firms may vertically integrate despite the benefits of trading with external parties
- Transaction costs in markets for biotechnology R&D
Sequential adaption
The uncertainties of R&D pervades and can only be resolved sequentially as the project progresses (Nelson and Winter, 1977)
Futile to attempt to lock-in the terms of trade at the outset, generally agree to renegotiate the contract instead.
Recurrent transaction and hazards
Repeated rounds of negotiation during a single project
Start-up costs of vertical integration make it desirable only for recurring transactions and not for one-time exchanges
Two types of contractual hazards that may lead to vertical integration:
1) small-numbers bargaining
2) appropriability problems.
1) Small-numbers bargaining
Reimbursement of R&D costs, distribution of property rights, and completion dates
The sponsor's options for transferring the project to an alternative supplier
-> transaction-specificity of investments and the opportunism of the R&D supplier
Tacit knowledge
Media cannot capture the tacit dimensions of the relevant technological know-how (Teece, 1976)
-> Transferring a project from one R&D partner to another will involve some losses in progress
The magnitude of these losses will depend on whether the new R&D partner has some experience or capabilities in the same product application area
Alternative supplier
1) if a sponsor has alternative suppliers with relevant R&D experience, it can better preserve the value of its original R&D investment in the event that the agreement with the initial contractor is terminated
2) If the sponsor cannot find alternative partners with experience, the R&D funding provided to the original contractor is a transaction-specific investment
Logic
The degree to which the know-how being procured is specialized to the supplier
-> A pharmaceutical company's ability to find alternative partners during a project
Even with future projects
Once a technological paradigm is established, one generation of product development provides the starting point for subsequent efforts (Nelson and Winter, 1977; Dosi, 1982; Tushman and Anderson, 1986).
Investments in durable assets that are specialized to the product market (such as distribution capabilities or reputation) are a source of "quasi-rents" (Monteverde and Teece, 1982b) and leave the pharmaceutical company vulnerable to rent extraction in negotiating agreements for future projects.
When alternatives are possible
When alternative partners are available, partner switching is a credible action
R&D contracts generally allow the sponsor to retain or share with the contractor the rights to the technology
The sponsor generally gets to keep for share with the contractor) technical data, materials, and other descriptive artifacts (a valuable starting point for an experienced supplier)
Hypothesis 1
the costs of market governance for a biotechnology R&D project are related to the number of R&D suppliers with R&D programs in the same product application area
Hypothesis 1: A pharmaceutical company will be more likely to internalize R&D in those biotechnology product areas in which R&D capabilities are concentrated in fewer R&D suppliers.
2) Appropriability problems
The firm not only has an interest in gaining access to both the specific and more general know-how but also in restricting rivals from using i
Conditions
1) When a project is done internally, the R&D organization can be prohibited -(by fiat) from transferring know-how to competitors.
2) When the project is sponsored externally, however, the restriction must be incorporated into the contractual agreement.
Problems in the contraction
Problems arise in specifying all the relevant intellectual property right
+ The uncertain scope and efficacy of biotechnology patents (Cooper, 1987).
Hypothesis 2
An inability either to define or enforce intellectual property rights creates a hazard of expropriation
The number of rivals with an interest in commercializing applications of the technology
Highly competitive therapeutic markets provide an incentive for the pharmaceutical firm to internalize the development of technology
Hypothesis 2: A pharmaceutical company will be more likely to internalize R&D in those biotechnology product markets in which it faces greater competition from other established pharmaceutical companies.
- Other factors affecting R&D procurement decisions
A fundamental axiom of TCE: the boundaries of the firm are determined by the trade-off between the transaction costs of using the market and the organizational costs of using hierarchies. Coase (1937)
Economics: Factors that make the firm less efficient at either performing or governing certain activities internal
BTOF: Bounded rationality prevents firms from making optimal adjustments to environmental changes (internal organizational factor)
Historical factors_1
A firm's historical pattern of R&D procurement should affect its R&D procurement decisions in the new technological regime
First, according to a behavioral perspective of the firm, historical patterns of R&D procurement reflect deeply engrained repertoires (Simon, 1947), search rules (Cyert and March, 1963), operating procedures (Allison, 1971), and routines (Nelson and Winter, 1982).
Historical factors_2
The second way historical R&D procurement patterns affect current R&D procurement decisions is through their effect on the relative organizational costs of using either markets or hierarchies for R&D
Firms lacking experience with R&D contracting are likely to be less able to search for and select R&D partners and to absorb technologies from external sources (Westney, 1986).
Hypothesis 3: A pharmaceutical firm that tended to use in-house R&D for its traditional pharmaceutical products will have a greater propensity to internalize R&D for biotechnology-based products.
R&D experience in the relevant technology.
Previous research on technological innovation suggests that when the technical advance is cumulative (e.g., Nelson and Winter, 1977) a firm's efficiency in performing a particular type of R&D project depends on its prior experience with similar R&D projects.
Coase's (1937) original formulation of the problem, this R&D experience reduces the costs of internalizing new R&D projects
Hypothesis 4: A pharmaceutical firm will be more likely to undertake a biotechnology R&D project in-house when it has accumulated more in-house R&D experience in the relevant area of biotechnology.
Focus.
Decisions to expand the R&D boundaries of the firm into a new technological field are generally made at the highest levels of the corporation
One factor is the size of the pharmaceutical business relative to other businesses managed by the corporation
Hypothesis 5: A firm with a higher percentage of its business in pharmaceuticals will be more likely to internalize biotechnology- pharmaceutical R&D projects.
Firm size.
Previous research suggests that firm size affects organizational behavior (Scherer, 1980; Miles, 1980) in general and organizational boundary decisions in particular
Anderson and Schmittlein (1984) found that in the electronics industry, the likelihood that a firm will use an internal sales force (rather than independent representatives) increases with firm size
1-1) when expanding R&D boundaries involves fixed costs (such as new equipment and laboratory facilities), larger firms may have scale-economy advantages.
1-2) have more resources to invest in the development of internal capabilities.
2) increasing size adds complexity to the administrative process, size can have a negative effect on R&D performance
Transaction-cost theorists, beginning with Coase + Clark, Chew, and Fujimoto (1987) suggested that firms can reduce the complexity of managing projects and improve project performance by using suppliers for some development tasks.
National origin.
A firm's national-geographic origin may influence its R&D boundary choices by affecting its relative costs of undertaking R&D
# When, as in the case of biotechnology, there are national-regional differences in technological expertise, firms from one country may find it more costly to pursue R&D themselves than to purchase R&D from firms in another country better endowed with the relevant personnel and scientific expertise # My own interest
* Method
Sample_firm
R&D project-level procurement decisions
A list of the world's top 50 pharmaceutical companies in 1982 (Scrip World Pharmaceutical News in 1982)
The largest pharmaceutical firms -> Established positions in pharmaceutical markets
The largest pharmaceutical firms -> Firms that had at least some interest in commercializing biotechnology-based products
-> Modeling backward vertical integration
The largest pharmaceutical firms -> Firms which accounted for a very significant share of the world's total efforts to commercialize new pharmaceutical products
Sample_project
1) Paine Webber's 1986 Biotechnology Fact Book
2) A database compiled by a California biotechnology firm (Drawn from public primary sources)
Prior to human clinical trials
Total
94 R&D projects across 30 of the sample firms
2 excluded for hypothesis 1
Unobserved heterogeneity -> sampling method
Mij: 1 internal, 0 external (1986)
SUPPLIERSj: the number of new biotechnology firms working in each market
RIVALSj: the number of established companies in the same area
HISTORY: Number of own R&D projects in development (1982) / All R&D products in development (1982)
EXPERIENCEij: Number of completed R&D projects by firm i in biotechnology category j
FOCUSj: the percentage of each firm's total sales attributable to its pharmaceutical business
SALES, SALES^2, log(SALES) (Firm size): pharmaceutical sales
NATION: (1) American-based, (2) European-based, or (3) Japanese-based
Mij ~ log(SUPPLIERSj) + log(RIVALSj) + EXPERIENCEij + SALES + SALES^2 + NATION
# Multicolinaerity: SUPPLIERSj & RIVALSj
# Mij as DV or IV?
* Results and discussion
H1 (supplier): O
H2 (rival): X
H3 (history): X (internalization cost)
H4 (experience): O (Technical capabilities -> Boundary decisions) # Longitudinal analysis
# JAM JAM
H5 (focus): O (Radical core technology change (Changes of the technology regime) -> Alter strategic importance of technology)
H6 (size): X
H7 (nation): O # Japan externalize #VOC
* Conclusion
How the structure of competition between new entrants and established firms may evolve in the wake of technological change.
# Not direct
Economies of functional or vertical specialization