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Capturing Value from Technological Innovation: Integration, Strategic Partnenng' and Licensing Decisions DAVID J. TEECE Why, and under what circumstances, is Me recognized technological progressiveness of a nation not sufficient to Capote the benefits stemming from its capabilities in science and technology? This chapter examines why firms and nations can lose ground in the commercialization of ad- vanced technologies at a time when they are the principal sources for major technological innovations of industrial significance; the capacity for scientific and technological innovation may be the last rather than the first advantage that a mature economy loses as it enters its declining phase. The framework developed here helps identify the factors that determine who wins from innovation: The firm Mat is first to market, follower firms, or firms that have related capabilities that the innovator needs. The follower firms may or may not be imitators in the narrow sense of Me term, although dopey sometimes are. The framework helps to explain the share of the profits from innovation accruing to Me innovating firms and nations compared to its followers and suppliers. THE PHENOMENON A classic example of the phenomenon considered in this chapter is Me computerized axial tomographic (CAT) scanner developed by the U.K. Fir Electrical Musical Indusmes (EMI) Ltd. By the early 1970s, EMI This chapter is a revised version of a previously published paper by David J. Teece: "Profiting from Technological Innovation," Research Policy, Vol. 15(1986). No. 6. 65

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66 DAVID J. TEECE was in a variety of product lines, including phonograph records, movies, and advanced electronics. EMI had developed high-resolution televisions in Me 1930s, pioneered a~rbome radar during World War it, and developed He United Kingdom's first aB solid-state computers in 1952. hn He late 1960s, He pattern recognition research of Godfrey N. Houns- field, an EW senior research engineer, resulted in his being able to display a scan of a pig's brain. Subsequent clinical work established that com- puterized axial tomography was viable for generating cross-sect~onal 'views" of He human body, the greatest advance in radiology since He discovery of x rays in iS95. Although EM} was initially successful with its CAT scanner, within 6 years of its introduction into the United States in 1973, the company had lost market leadership and by He eighth year had dropped out of the CAT scanner business. Over companies successfully dominated the market, though they were late entrants, and are still profiting in He busi- ness today. A further example is Hat of the Royal Crown Companies, Inc., a small beverage company Hat was the first to introduce cola in a can and He first to introduce diet cola. Both Coca-Cola and Pepsi-Cola followed almost immediately and deprived Royal Crown of any significant advantage from its innovation. Bowmar Instrument Corporation, which introduced He INNOVATOR WIN LOSE IM ITATOR-FOLLOWER 1 2 Pilkington (Float Glass) IBM (PC) G.D. Searle Matsushita (VHS (NutraSweet) video recorders) DuPont (Tehon) ~ JO ~ waken' _ 4 3 RC Cola (diet cola) Kodak (instant photography) EMI (scanner) Northrup (F20) Bowmar (calculator) DEC (PC) Xerox ("Star ~ DeHavilland (Comet) FIGURE 1 Taxonomy of outcomes from die innovation process.

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CAPTUR1lIG VALUE FROM TECHNOLOGICAL INNOVATION 67 pocket calculator, was not able to withstand competition from Texas In- stnunents, Hewlett-Packard, and others, and went out of business. Xerox Corporation failed to succeed with its entry into the office computer busi- ness, even though Apple Computer, Inc., succeeded with He Macintosh, which contained many of Xerox's key product ideas, such as the mouse and icons. The story of He DeHaviliand Comet has some of die same features. The Comet ~ jet was introduced into the commercial airline business 2 years or so before Boeing introduced the 707, but DeHavilland failed to capitalize on its substantial early advantage. MITS introduced the first personal computer, the Altair, experienced a burst of sales, then slid quietly into oblivion. If Here are innovators who lose, there must be followers (imitators) who win. A classic example is IBM Corporation with its PC, a great success from the time it was introduced in 1981. Neither He architecture nor the components of the IBM PC were considered advanced when introduced; nor was the way He technology was packaged a significant departure from the then-current practice. Yet He IBM PC was fabulously successful and established MS-DOS as He leading operating system for 16-bit PCs. By the end of 1984, IBM had shipped more Han 500,000 PCs and may have irreversibly eclipsed Apple in He PC industry. Figure 1 presents a simplified taxonomy wide examples of the pos- sible outcomes from innovation. Quadrant 1 represents positive outcomes for the innovator. A first-to-market advantage is translated into a sustained competitive advantage Mat either creates a new earnings stream or enhances an existing one. Quadrant 4 and its corollary quadrant 2 are the focus of this paper. PROFITING FROM INNOVATION: BASIC BUILDING BLOCKS To develop a coherent framework within which to explain the distn- bution of outcomes illustrated in Figure 1, three fundamental building blocks must be put in place: the appropriability regime, He dominant design paradigm, and complementary assets. Regimes of Appropriability A regime of appropnability refers to the environmental factors, ex- cluding firm and market structure, that govern an innovator's ability to capture He profits generated by an innovation. The most important di- mensions of such a regime are the nature of the technology and the efficacy of legal mechanisms of protection. It has long been known that patents do not work in practice as they do

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68 DAVID J. TEECE in theory. Rarely, if ever, do patents confer perfect appropnability, al- though they do afford considerable protection on new chemical products and rawer simple mechanical inventions. Many patents can be "invented around" at modest costs. They are especially ineffective at protecting process innovations. Often patents provide little protection, because the legal requirements for upholding their validity or for proving their in- fringement are high. In some industries, particularly where He innovation is embedded in processes, trade secrets are a viable alternative to patents. Protection of made secrets is possible, however, only if a firm can put its product before die public and still keep the underlying technology secret. Usually only chemical formulas and ~ndusmal-commercial processes (for example, cos- mencs and recipes) can be protected as trade seaets after they are placed on He market. The degree to which knowledge is tacit or codified also affects ease of imitation. Codified knowledge is easier to transmit and receive and is therefore more exposed to industrial espionage and the like. Tacit knowl- edge by definition is not articulated, and transfer is hard unless those who possess He know-how in question can demonstrate it to others (Teece, 1981~. Survey research indicates Hat methods of appropnability vary markedly across industries, and probably within industries as well (Levin et al., 19841. The property rights environment within which a firm operates can thus be classified according to the nature of He technology and the efficacy of the legal system to assign and protect intellectual property. Though a gross simplification, a dichotomy can be drawn between environments in which He appropriability regime is "tight" (technology is relatively easy to pro- tect) and "loose" (technology is almost impossible to protect). Examples of die former include the formula for Coca-Cola syrup; an example of He latter is the Simplex algorithm in linear programming. The Dominant Design Paradigm Two stages are commonly recognized in the evolutionary development of a given branch of a science: the pre-paradigmatic stage when there is no single, generally accepted conceptual treatment of die phenomenon in a field of study, and the paradigmatic stage, which begins when a body of theory appears to have passed He canons of scientific acceptability. The emergence of a dominant paradigm signals scientific maturity and He acceptance of agreed-upon '~standards" by which what has been referred to as 'normal" scientific research can proceed. These ``standards" remain in force unless the paradigm is overturned. Revolutionary science is what

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CAPTURING VALUE FROM TECHNOLOGIC~ INNOVATION 69 overturns normal science, as when Me Copernican theories of astronomy overturned those of Ptolemy in the seventeenth century. Abernathy and Utterback (1978), Dosi (1982), and Utterback (in this volume) provide treatment of the technological evolution of an industry in ways that parallel Kuhnian notions of scientific evolution (Kuhn, 1970~. In Me early stages of industrial development, product designs are fluid, manufacturing processes are loosely and adaptively organized, and gen- eralized capital is used in production. Competition among firms manifests itself in competition among designs, which are markedly different from each other. This might be called the pre-paradigmatic stage of an industry. After considerable trial and error in the marketplace, one design or a narrow class of designs begins to emerge as the most promising. Such design must be able to meet a set of user needs in a relatively complete fashion. The Model T Ford, the IBM Systeml360, and Me Douglas DC- 3 are examples of dominant designs in the automobile, computer, and aircraft industries, respectively. Once a dominant design emerges, competition shifts to price and away from design. Competitive success then shifts to a new set of variables. Scale and learning become much more important, and specialized capital is deployed as incumbents seek to lower unit costs through exploiting economies of scale and learning. Reduced uncertainty over product design provides an opportunity to amortize specialized long-lived investments. Innovation is not necessarily halted once the dominant design emerges; as Clarke (1985) points out, it can occur at a lower level in the design hierarchy. For instance, a "v" cylinder configuration emerged in auto- mobile engine blocks during the 1930s with the Ford V-8 engine. Niches were quickly found for it. Moreover, once the product design stabilizes, there is likely to be a surge of process innovation as producers attempt to lower production costs for the new product (see Figure 21. The Abernathy-Utterback framework does not characterize all indus- tries. It seems better suited to mass markets, in which consumer tastes are relatively homogeneous, than to small niche markets where the absence of scale and learning economies attaches a much lower penalty to multiple designs. For these niche markets, generalized equipment will be used in production. The emergence of a dominant design is a watershed that holds great significance for the distribution of profits between innovator and follower. The innovator may have been responsible for the fundamental scientific breakthroughs as well as the basic design of He new product. However, if imitation is relatively easy, imitators may enter He fray, modifying the product in important ways, yet relying on the fundamental designs pi- oneered by the innovator. When the game of musical chairs stops and a

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70 a) / DAVID J. TEECE l 1./ lo Atom I, - \ \ ~of - - -pre-parodigmatic design - ~paradigmatic design phase - phase FIGURE 2 Innovation over the product/industry life cycle. dominant design emerges, the innovator might well end up in a disad- vantageous position relative to a follower. Hence, when imitation is cou- pled with design modification before the emergence of a dominant design, followers have a good chance that their modified product will be annointed as the industry stan~d, often to He great disadvantage of the innovator. Complementary Assets Let the unit of analysis be an innovation. An innovation consists of technical knowledge about how to do something better than He existing state of He art. Assume that the know-how In question is partly codified and partly tacit. For such know-how to generate profits, it must be sold or used in tile market. In almost all cases, the successful commercialization of an innovation requires that the know-how in question be used in conjunction with other capabilities or assets. Services such as marketing, competitive manufac- wing, and after-sales support are almost always needed. These services are often obtained from complementary assets Hat are specialized. For example, the commercialization of a new drug is likely to require He dissemination of information over a specialized information channel. In some cases, as when the innovation is systemic, He complementary assets may be other parts of a system. For instance, computer hardware typically

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CAPTURING VALUE FROM TECHNOLOCIC~ INNOVATION 71 requires specialized software, both for the operating system and for ap- plications. Even when an innovation is autonomous, as with plug-com- patible components, certain complementary capabilities or assets will be needed for successful commercialization. Figure 3 summarizes this rela- tionship schematically. An important distinction is whether He assets required for least-cost production and distribution are specialized to the innovation. Figure 4 illustrates differences between complementary assets that are genenc, spe- cialized, and cospecialized. Generic assets are general-pu~pose assets that need not be tailored to the innovation in question. Specialized assets are those where there Is unilateral dependence between the innovation and the complementary as- set. Cospecialized assets are those for which Here is a bilateral dependence. For instance, specialized repair facilities were needed to support the in- troduction of the rotary engine by Mazda. These assets are cospecialized because of He mutual dependence of the innovation on the repair facility. Conta~nenzation similarly required the deployment of some cospec~alized assets in ocean shipping and terminals. However, the dependence of truck Competitrve <~Manufactunng I\ / \ Other - Dist~butio~ / Other /> l I ~ Technological Know-How \ \//\ / Core ~ \ \ . _ . \ \ In Innovation / / I / /Complementc~ry \ \ / ~ Technologies Other - - /\\ Other - ~\/ FIGURE 3 Complementary assets needed to commercialize an innovation.

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72 DAVID]. TEECE o - c - c o - - o C c Q C) ~ [ it/ ~ /~0 ~ / genenc ~ AGE / .~ He'd ~\\~&eta~ he \/ \\~ed at sect I ' Dependence of Innovation on Complementary Assets FIGURE 4 Complementary assets: genenc, specialized, and cospecialized. -^ce ing on containerized shipping, was less than that of containerized shipping on trucking, as trucks can convert from containers to flatbeds at low cost. An example of a generic asset is the manufacturing facilities needed to make running shoes. Generalized equipment can be employed in the main, exceptions being the molds for the soles. IMPLICATIONS FOR PROFITABILITY These three concepts can now be related in a way that sheds light on the imitation process and the distribution of profits between innovator and follower. We begin by examining tight appropnability regimes. Tight Appropriabil~ty Regimes In those few instances when the innovator has an ironclad patent or copyright protection, or when the nature of the product is such that trade

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CAPTURING VALUE FROM TECHNOLOGIC~ INNOVATION 73 secrets effectively deny imitators access to the relevant knowledge, He innovator is almost assured Mat the Innovation can be translated into market value for some period of time. Even if the innovator does not possess He desirable endowment of complementary costs, ironclad protection of in- tellectual property gives the innovator He time to acquire these assets. If these assets are generic, a contractual relationship may well suffice, and He innovator may simply license He technology. Specialized R&D firms are viable in such an environment. Universal Oil Products, an R&D firm Hat developed refining processes for the petroleum industry, Is a case in point. If, however, the complementary assets are specialized or cospe- cialized, contractual relationships are exposed to hazards, because one or both parties Will have to commit capital to certain irreversible investments, which will be valueless if He relationship between innovator and licensee breaks down. Accordingly, the innovator may find it prudent to expand by acquiring or developing specialized and cospecialized assets. Fortu- nately, the factors that render imitation difficult will enable the innovator to build or acquire those complementary assets without competing with i~rutators for their control. Competition from Stators is muted in this type of regime, which sometimes characterizes the petrochemical industry. In this industry, the protection offered by patents is fairly easily enforced. One factor assisting the licensee in this regard is that most petrochemical processes are designed around a variety of catalysts that can be kept proprietary. An agreement not to analyze the catalyst can be extracted from licensees, affording extra protection. However, even if such requirements are violated by licensees, He innovator is still well positioned, as the most important properties of a catalyst are related to its physical structure, and the process for generating this structure cannot be deduced from structural analysis alone. Every chemical-reaction technology a company acquires is thus accompanied by an ongoing dependence on the innovating company for the catalyst am propriate to the plant design. Failure to comply with the licensing contract can thus result in a cutoff in the supply of the catalyst and possibly closure of the facility. Similarly, if He innovator comes to market in the pre-paradigmatic phase with a sound product concept but the wrong design, a tight apprm Inability regime will afford He innovator the time needed to perfonn the teals needed to get the design right. As discussed earlier, the best initial design concepts often mm out to be hopelessly wrong, but if the innovator is protected by an impenetrable thicket of patents, or has technology that is difficult to copy, then the market may well afford He innovator the necessary time to develop the right design before being eclipsed by imi- tators.

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74 DAVID]. TEECE Loose Appropriability Tight appropriability is the exception rather Can He rule. Therefore, innovators must turn to business strategy if they are to keep imitators at bay. The nature of the competitive process will depend on whether Be industry is in He paradigmatic or pre-paradigmaiic phase. Pre-para~igmanc Phase In the pre-para~igrnanc phase, the innovator must be careful to let He basic design "float" until there is sufficient evidence Hat the design is likely to become the industry standard. In some industries there may be little opportunity for product modification. In microelectronics, for ex- ample, designs become locked in when He circuitry is chosen. Product modification is limited to debugging and modifying software. An innovator must begin He design process anew if He product does not fit the market well. In some respects, however, He selection of designs is dictated by the need to meet compatibility standards so Hat new hardware can be used win existing applications software. In one sense, therefore, the design issue for the microprocessor industry today is relatively straightforward: deliver greater power and speed while meeting the computer industry stardoms of He existing software base. However, from time to time windows of opportunity emerge for the introduction of entirely new fam- ilies of microprocessors that will define a new industry and software standard. In these instances, basic design parameters are less well defined and can be permitted to '`float" until market acceptance is apparent. The early history of He automobile industry exemplifies the importance of selecting He right design in the pre-paradigmatic stages. None of He early producers of steam-powered cars survived the early shakeout when the internal combustion engine in a closed-body automobile emerged as the dominant design. The steamer, nevertheless, had numerous early vir- tues, such as reliability, which the cars with internal combustion engines could not deliver. The British fiasco with He Comet ~ is also instructive. DeHavilland had picked an early design that had both technical and commercial flaws. By moving into production, significant ~reversibilides and loss of reputation hobbled de Havilland to such a degree Hat it was unable to convert to Be Boeing design Hat subsequently emerged as dominant. It was not even able to occupy second place, which went instead to Douglas. As a general principle, it appears that innovators in loose appropriability regimes need to be intimately coupled to the market so that user needs can affect designs. When multiple parallel and sequential protot~rping is

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CAPTURING VALUE FROM TECHNOLOGICAL INNOVATION 75 feasible, it has clear advantages. Generally such Al approach is prohibi- dvely costly. When development costs for a large commercial aircraft exceed a billion dollars, var~abons on a theme are all that is possible. Hence, assessing the probability that an innovator will enter the para- digmatic phase possessing Be dominant design is problematic. The prob- abilities increase, the lower the relative cost of prototype and the more tightly coupled He finn is to the market. The latter is a function of organizational design and can be influenced by managenal choices. Me foreigner is embedded in He technology and cannot be influenced, except in minor ways, by managerial decisions. Consequently, in industries with large costs for development and prototyping hence significant irrever- sibilities and where ~nnovanon of He product concept is easy, the prob- ability Hat the innovator win emerge as a winner at the end of the pre- paradigma~ac stage is low. Paradigmatic Stage In Be pre-paradigrnatic phase, complementary assets do not loom large. Rivalry focuses on dying to identify the design that will be dominant. Production volumes are low, and there is little to be gained in deploying specialized assets, as scale economies are unavailable and price is not a principal competitive factor. As the leading design or designs begin to be revealed by the market, however, volumes increase and opportunities for economies of scale induce firms to begin gearing up for mass production by acquiring specialized tooling and equipment and possibly specialized distribution as wed. Since these investments impose significant i~Tever- sibilities, producers are likely to proceed win caution. Islands of spe- cialized capital will begin to appear in an industry Hat otherwise features a sea of general-pu~pose manufacturing equipment. But as the terms of competition begin to change, and prices become increasingly important, access to complementary assets becomes critical. Since He core technology is easy to State, by assumption, commercial success swings upon He terms and conditions affecting access to the required complementary assets. It is at this point Hat specialized and cospecialized assets become crit- ically important. Generalized equipment and skills, almost by definition, are always available in an industry, and even if Hey are unavailable, Hey do not entail significant i~reversibilities. Accordingly, firms have easy access to this Me of capital, and, even if the relevant assets are not available in sufficient quantity, they can easily be put in place as this involves few risks. Specialized assets, on the other hand, imply significant irreversibilities and cannot be easily acquired by contract, as Be risks are

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CAPTURING VALUE FROM TECHNOLOGIC~ INNOVATION ~5 a heavy commitment of resources will be incurred for little if any strategic benefit, Hereby exposing the innovator to even greater losses than would otherwise be Be case. On the other hand, if an innovator tries to contract for Me supply of a critical capability when it should build the capability itself, it may well find it has nurtured an imitator better able to serve the market. Mixed Modes The real world rarely provides extreme or pure cases. Decisions to integrate or license involve trade-offs, compromises, and mixed ap- proaches. It is not surprising, therefore, that the real world is characterized by mixed modes of organization, involving judicious blends of integration and con~achng. Sometimes mixed modes represent transitional phases. For instance, because of He convergence of computer and telecommuni- cahon technology, firms in each industry are discovering that they often lack the technical capabilities needed in the other. Since the technological interdependence of He two requires collaboration among Hose who design different parts of He system, intense cross-boundaty coordination and information flows are needed. For separate enterpnses, agreement must be reached on complex protocol issues among parties who see their interests differently. Contractual difficulties can be anticipated, as the selection of common technical protocols among the parties will often be followed by ~ansaction-specific investments in hardware and software. There is little doubt that this was the motivation behind IBM's 1983 purchase of 15 percent of the Rolm Corporation, manufacturer of business communica- tions systems. This position was expanded to 100 percent in 1984. IBM's stake in Intel Corporation, which began with a 12 percent purchase in 1982, is most probably not a transitional phase leading to 100 percent purchase, because both companies realized that the two corporate cultures are not compatible, and IBM may not be as impressed with Intel's tech- nology as it once was. The CAT Scanner and the IBM PC: insights from the Framework EMI's failure to reap significant returns from the CAT scanner can be explained in large measure by reference to the concepts developed above. The scanner that EMI developed was of a technical sophistication much higher Han would normally be found in a hospital, requiring a high level of training support and servicing. EMI did not possess these capabilities, could not easily contract for them, and was slow to realize their importance.

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86 DAVID J. NIECE It most probably could have formed a partnership win a company like Siemens to gain access to We requisite capabilities. Its failure to do so was a strategic error compounded by Me limited protection afforded by Me law for the intellectual property embodied in the scanner. Although subsequent Court decisions have upheld some of EMI's patent claims, once Me product was in Me market it could be reverse engineered and its essential features copied. Two competitors, General Electric and Technicare, already possessed tile complementary capabilities Mat the scanner required, and they were also technologically capable. hn addition, both were experienced mar- keters of medical equipment and had reputations for quality, reliability, and service. GE and Technicare were thus able to commit their R&D resources to developing a competitive scanner and improving on Me EMI scanner where they could while they rushed to market. GE began taking orders In 1976 and soon after made inroads on EMI's lead. In 1977 con- cem for rising heath care costs caused the Carter administration to iz}- traduce "certificate of need" regulation, which required approval by He Department of Heals, Education, and Welfare for expenditures on big ticket items like CAT scanners. This severely cut He size of the avail- able market. By 1978 EM] had lost the leadership in market share to Technicare, who was in turn quickly overtaken by GE. In October 1979 Geoffrey Hounsfield of EMI sham He Nobel Prize for invention of He CAT scanner. Despite this honor, and He public recognition of EMI's role in bonging this medical breakthrough to the world, He collapse of its scan- ner business forced EM] in the same year into He anns of a rescuer, Thorn Electrical Industries, Ltd. GE subsequently acquired what was EMI's scanner business ham Thom.6 Though royalties continued to flow to EMI, He company had failed to capture the largest part of He profits generated by the innovation it had pioneered and successfully commer- cialized. If EM! illustrates how a company win outstanding technology and an excellent product can fad] to profit from innovation while He imitators succeed, He story of the IBM PC indicates how a new product repre- senting only a modest technological advance can yield remarkable re- tu~ns to He developer. The IBM PC, introduced in 1981, succeeded despite the fact Hate its architecture was ordinary and its components standard. Philip Estridge's design team in Boca Raton, Florida, decided to use existing technology radler clan the state of He art to produce a solid, reliable microcom- puter. With a 1-year mandate to develop a PC, Esuidge's team could do little else.

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CAPTURING VALUE FROM T~CHNOLOGIC~ INNOVATION 87 However, the IBM PC did use what at Be time was a new tidbit m~- croprocessor (~e Intel 8088) and a new disk operating system (DOS) adapted for IBM by Microsoft. Other than the microprocessor and Be operating system, the IBM PC incorporated existing microcomputer '6standards" and used off-the-shelf parts from outside vendors. IBM did write its own basic input/ou~ut system (BlOS), which is embedded in a read-only memory chip, but this was a relatively straightforward pro . gramaung exercise. The key to He PC's success was not the technology. It was the set of complementary assets that B3M either had or quickly assembled around the PC. To expand the market for PCs, there was a clear need for an expandable, flexible microcomputer system wig extensive applications of software. IBM could have based its PC system on its own patented hardware and copyrighted software. Such an approach would cause complementary products to be cospecialized, forcing D3M to develop peripherals and a comprehensive library of software in a short time. In- stead, IBM adopted what might be called an induced contractual ap- proach. By adopting an open system architecture, as Apple had done, and by making technical information about die operating system publicly available, IBM induced a spectacular output of software by third-party suppliers. IBM estimated Hat by m~d-1983, at least 3,000 hardware and software products were available for He PC.' Put differendy, IBM pulled together the complementary assets, particularly software, required for success and did not even use contacts, let alone integration. This was despite He fact that the software developers were creating assets Hat were In part cospecialized to He IBM PC, at least in He first in stance. Several special considerations made this approach a reasonable risk for He software Enters. A critical element was IBM's name and com- mitment to the project. The reputation behind the letters l, B. M is per- haps He greatest cospecialized asset the company possesses. The name implied Hat the product would be marketed and serviced in the IBM tradition. It guaranteed that PC-DOS would become an industry stan- dard, so that the software business would not be solely dependent on B3M, because emulators were sure to enter. It guaranteed access to retail distribution outlets on competitive terms. The consequence was that IBM was able to take a product that was at best a modest technological ac- complishment and turn it into a fabulous commercial success. The case demonstrates the role of complementary assets in determining out- comes. Though He success of the IBM PC is ongoing, the appearance of ma- chines compatible wig the IBM PC (IBM compatibles and "clones") has

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88 DAVID J. TEECE somewhat attenuated PC market growth for IBM. The emergence and rapid acceptance of the IBM PC established a market-based software standard. Given IBM's reputation and the quality of He product, the emergence of a market standard was predictable, as was increased price compehiioI1 as compensators focused on cost reduction and performance enhancement. The fact that IBM is no longer Be overwhelmingly dom- inant PC manufacturer possibly because of its price umbrella and mod- est rate of performance improvement~oes not Finnish Me lesson of die IBM PC program wid1 regard to capturing returns from innovation. Despite competition from compatibles and clones, IBM's return on in- vesunent must surely have been attractive. IMPLICATIONS FOR R&D STRATEGY. INDUSTRY STRUCTURE, AND TRADE POLICY Allocating R&D Resources The analysis so far assumes Mat the firm has developed an innovation for which a market exists. It indicates the strategies that the firm must follow to maximize its share of industry profits relative to imitators and other competitors. There is no guarantee of success even if optimal strat- egies are followed. The innovating firm can improve its total return to R&D, however, by adjusting its R&D investment portfolio to maximize Be probability Mat the technological discoveries Mat emerge will be easy to protect win existing property law or will require for commercialization cospecialized assets already within the firm's repertoire of capabilities. Put differently, if an innovating fine does not target its R&D resources toward new products and processes that it can conunercialize advantageously relative to potential imitators or followers, then it is unlikely to profit from its investment in R&D. ~ this sense, a firm's history and the assets it already has in place ought to condition its R&D investment decisions. Clearly, an innovating fimn with considerable assets already in place is free to strike out in new directions, so long as it is aware of the kinds of capabilities required to commercialize the innovation. It is therefore clear Mat the R&D investment decision cannot be divorced from the strategic analysis of markets and industries, and Be fien's position in them. Small Firm Versus Large Firm Comparisons Business commentators frequently remark that many small entrepre- neunal firms that generate new, commercially valuable technology fail at

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CAPTURING VALUE FROM TECHNOLOGICAL INNOVATION' 89 the same time that a large multinational finn, even with a less meritorious record in innovation, will survive and prosper. One explanation of this phenomenon is now clear. Large grins are more likely to possess Me relevant specialized and cospecialized assets at the time a new product is introduced. They can therefore do a better job of using their technology, however meager, to maximum advantage. Small domestic firms are less likely to have the relevant specialized and cospecialized assets within their boundaries. They must therefore incur the expense of Dying, either to build the necessary assets or to develop coalitions with competitors or with owners of the assets. Regimes of Appropriability and Industry Structure In industries where legal methods of protection are effective, or where new products are just hard to copy, the strategic necessity for innovating firms to obtain cospecialized assets would appear to be less compelling than in industries where legal protection is weak. In cases where legal protection is weak or nonexistent, the control of cospecialized assets will be needed for long-run survival. In this regard, it is instructive to examine the U.S. drug industry (Temin, 19791. In the 1940s, the U.S. Patent Office began to grant patents on certain natural substances that involved difficult extraction procedures. Thus, in 1948 Merck received a patent on streptomycin, which is a natural substance. However, it was not the extraction process but the drug itself Hat received He patent. Hence, patents were important to the drug industry, but they did not prevent imitation as, in some cases, just changing one molecule would enable a company to come up win a similar substance not violating the patent (Tenon, 1979, p. 4361. Had patents been more inclusive-and this is not to suggest Hat they should be-licensing would have been an effective mechanism for Merck to profit from its innovation. The emergence of close substitutes for patented drugs, coupled with FDA regulation that had the effect of reducing the elasticity of demand for drugs, placed high rewards on a strategy of product differentiation. This strategy required extensive marketing, including a sales force that could directly contact doctors, who were He purchasers of drugs through their ability to create prescriptions.8 The result was exclusive production (that is, the earlier industry practice of licensing was dropped) and forward integration into marketing (the relevant cospec~alized asset). Generally, if legal protection of the innovators' profits is secure, in- novating fibs can select their boundaries according to their ability to identify user needs and respond to those needs through research and de- velopment. The weaker the legal methods of protection, the greater the

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9o DAVIDJ. TEECE incentive to obtain the relevant cospecialized assets. Hence, as industries in which legal protection is weak begin to mature, integration into innovation-spec~fic cospecialized assets will occur. Often this will take the forth of backward, forward, and lateral integration. (Conglomerate integration is not part of this phenomenon.) For example, IBM's purchase of Rolm can be seen as a response to the impact of technological change on the identity of the cospecialized assets relevant to IBM's future growth. Industry Maturity, New Entry, and History As technologically progressive industries mature, and a greater propor- tion of the relevant cospecialized assets are brought under the corporate umbrellas of incumbents, new entry becomes more difficult. Moreover, when it does occur it is more likely to include the early fo~mai~on of coalitions. Incumbents will own the cospecial~zed assets, and new entrants will find it necessary to forge links with them. Here lies the explanation for He sudden surge in strategic partnering now occumng internationally, and particularly in the computer and telecommunications industry. Note Hat this change should not be interpreted in anticompetitive terms. Given exist- ing industry structure, coalitions ought to be seen not as attempts to stifle competition, but as mechanisms for lowering entry requirements for inno- vators. In industries in which a technological change has occulted and required deployment of specialized or cospecialized assets, a configuration of firm boundaries that no longer have compelling efficiencies may well have an- sen. Considerations that once dictated inte~,rat~on may no longer hold, yet there may not be strong forces leading to divestiture. Hence existing firm boundaries in some industnes- especially those where the technological trajectory and attendant specialized asses requirements have changed may be fragile. In short, history is important in understanding the structure of the modern business enterprise. Existing fimn boundaries cannot always be assumed to have an obvious rationale in relation to today's requirements. The Importance of Manufacturing to International Competitiveness Practically all forms of technological know-how must be embedded in goods and services to yield value to He consumer. An important policy issue for the innovating nation is whether the identity of the fimns and nations performing this function is important. In a world of tight appropriability and zero transactions cost the world of neoclassical theory it is a matter of indifference whether an innovating firm has an in-house manufacturing capability, domestic or foreign. The

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CAPTURING VAl UE FRO.U TECH.VOLOCICAL I.~NOIATIO4Nt 91 firm can engage in arms-len~,th contracting (patent licensing, know-how licensing, coproduction, and so on) for the sale of the output of the activity in which it has a comparative advantage (in this case R&D) and will maximize returns by specializing in what it does best. However, in a regime of loose appropnability, and especially where the requisite manufacturin, assets are specialized to the innovation. which is often the case, participation in manufacturing may be necessary if an innovator is to appropriate the rents from its innovation. Hence, if an innovator's manufacturing costs are higher than those of an imitator, the innovator may well be put in the position of ceding the largest share of profits to the imitator. In a loose appropriability regime, low-cost im~tator-manufacturers could capture all of the profits from innovation. In a loose appropriability regime where specialized manufacturing capabilities are necessary to produce new products, an innovator with a manufacturing disadvantage may find that an early advantage at the research and development stage has no com- mercial value. This is a potentially crippling situation unless the innovator is assisted by governmental processes. For example, one reason why U.S. manufacturers did not capture the greatest part of the profits from the development of color TV, for which RCA was primarily responsible, is that RCA and its U.S. licensees were not competitive at manufacturing. In this context, concern that the decline of manufacturing threatens the entire economy appears to be well founded. A related implication is that as the technology gap closes, the basis of competition in an industry will shift to the cospecialized assets. This appears to be what is happening in microprocessors. Intel is no longer out ahead technologically. As Gordon Moore, CEO of Intel points out, "Take the top 10 [semiconductor] companies in the world . . . and it is hard to tell at any time who is ahead of whom.... It is clear that we have to be pretty damn close to the Japanese from a manufacturing standpoint to compete.',9 It is not just that strength in one area is necessary to compensate for weakness in another. As technology becomes more public and less proprietary Trough easier imitation, strength in manufacturing and other areas is necessary to benefit from whatever technological advantages an innovator may possess. Put differently, the notion that the United States can adopt a 'designer role" in international commerce while letting independent firms in countries such as Japan, Korea, Taiwan, or Mexico do the manufacturing is unlikely to be a successful strategy for the long run. This is because profits will accrue primarily to the low-cost manufacturers (by providing a larger sales base over which they can exploit their special skills!. Where imitation is easy, and even where it is not, it is difficult to do business in the market

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92 DAVIDJ. TEEM for know-how (Teece, 1981~. In particular, there are difficulties in pricing an intangible asset whose true performance features are difficult to predict. The trend in international business toward what Miles and Snow (1986) call dynamic networks- charactenzed by vertical disintegration and con- tracting therefore ought to be viewed with concern. Dynamic networks, or hollow corporations, may reflect innovative organizational fortes not so much as the disassembly of the modern corporation because of dete- rioration in manufacturing and over activities that complement techno- logical innovation. Dynamic networks may therefore signal not so much the rejuvenation of American enterprise as its piecemeal demise. How Trade and Investment Barriers Affect Innovators' Profits In regimes of loose appropr~ability, governments can move to shift the distribution of the gains from innovation away from foreign innovators and toward domestic finns by denying innovators ownership of specialized assets. The foreign firm, by assumption an innovator, will be left with the option of selling its intangible assets on the market for know-how if both trade and investment are foreclosed by government policy. This option may appear better than the alternative (no remuneration at all from the market in question). Licensing may Den appe~profitable, but only because access to He complementary assets is blocked by government. ~ s, when an innovating firm generating profits needs access to com- plementary assets abroad, host governments, by limiting access, can some- times milk the innovators for a share of the profits, particularly Hat portion that originates from sales in the host country. However, the ability of host governments to do so depends on the importance of the host country's assets to He innovator. If the cost and infrastructure characteristics of the host country are such that it is the world's lowest cost manufacturing site, and if domestic industry is competitive, then by acting as a monopsonist the government of the host country ought to be able to adjust the terms of access to the complementary assets to appropriate a greater share of the profits generated by the innovation.'0 If, on the other hand, the host country offers no unique complementary assets except access to its own market, restrictive practices by the government will only redistribute profits with respect to domestic rawer than worldwide sales. Implications for the International Distribution of the Benefits from Innovation Thus, it is clear that Hi, 7 _ nnovators who do not have access to the relevant specialized and cospecialized assets may end up ceding profits to imitators

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CAPTURING VALUE FROM TECHNOLOGlC~ lNNOVAT10N 93 and other competitors, or to Me owners of the specialized or cospecialized assets. Even when the innovator possesses the specialized assets, Hey may be located abroad. Foreign factors of production are thus likely to benefit from research and development occurring across borders. There is little doubt, for instance, that the inability of many U.S. multinationals to sustain competitive manufacturing in the United States results In de- clining returns to U.S. labor. Stockholders and top management probably do as weD if not better when a multinational gains access to cospecial~zed assets in He fi:m's foreign subsidianes. However, if there is unemployment in the factors of production supporting these assets, then the foreign factors Of production win benefit from innovation originating beyond national borders. This shows how Important it is Hat innovating nations maintain competence and competitiveness in the assets especially manufactur- ing that complement technological innovation. It also shows how im- portant it is that innovating nations enhance the protection afforded worldwide to ~nteDectual property. It must be recognized, however, Cat there are inherent limits to He legal protection of intellectual propel and Hat business and national strategies are therefore likely to be critical in determining how the gains from innovation are shared worldwide. By making He correct strategic decision, innovating firms can move to protect the interests of stockholders. But to ensure Hat domestic rather Han foreign cospecialized assets capture He largest share of the externalities spilling over to complementary assets, He supporting infrastructure for those complementary assets must not be aBowed to decay. In short, if a nation has prowess at innovation, then in He absence of ironclad protection for intellectual property, it must maintain weD-developed complementary assets if it is to capture He spillover ben- efits Tom innovation. CONCLUSION This chapter has attempted to synthesize from recent research In in- dustrial organ~zanon and strategic management a framework within which to analyze He distribution of the profits from innovation. The framework indicates that He boundaries of the firm are an important strategic variable for innovating firms. The ownership of complementary assets, particularly when they are specialized or cospecial~zed, helps establish who wins and who loses from innovation. Imitators can often outperform innovators if Hey are better positioned win respect to critical complementary assets. Hence, public policy aimed at promoting innovation must focus not only on R&D but also on complementary assets as well as He underlying infrastructure. If government decides to stimulate innovation, it is im

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94 DAVID J. TERCE portent to eliminate baITiers to die development of complementary assets Mat are specialized or cospecialized to ~nnovabon. To fad] to do so win cause a large portion of We profits from innovation to flow to imitators and over competitors. If these Inns lie beyond one's national borders, there are obvious implications for We international distribution of Income. When applied to world markets, results similar to Pose obtained from die "new trade theory" are suggested by Be framework. In particular, tariffs and over resmctions on made can In some cases injure Ovate firms while simultaneously benefiting protected firms when they are imitators. However, the propositions suggested by the framework vary according to appropnabili~r regimes, suggesting Cat economywide conclusions will be elusive. The policy conclusions for commodity petrochemicals, for in- s~nce, are likely to differ from those for semiconductors. The approach also suggests Rat the product life cycle model of inter- national trade will play itself out differently in different industries and markets, in part according to appropnabili~ regimes and the nature of He assets needed to convert a technological success into a commercial one. Whatever its limitations, the approach establishes that it is not so much He structure of markets as He saucers of firms, particularly He scope of Heir boundaries, coupled with national policies on He development of complementary assets, Hat detentes the distnbudon of the profits among innovators and ~m~tator-followers. ACKNOWLEDGMENTS I wish to Hank Raphael Amit, Harvey Brooks, Chris Chaplin, Therese Flaherty, Richard Gilbert, Bruce Guile, Heather Haveman, Mel Horwitch, David Hulbert, Carl Jacobson, Michael Porter, Gary Pisano, Richard Rumelt, Richard Nelson, Raymond Vemon, and Sidney Winter for helpful discussions relaurlg to the subject matter of this paper. ~ gratefully ac- knowledge the financial support of the National Science Foundation under grant no. SRS-8410556 to the Center for Research in Management, Uni- versity of Califomia, Berkeley. Versions of this paper were presented at a National Academy of Engineenng symposium bided "World Technol- ogies and National Sovereignty," February 1986; at a conference on in- novation at the University of Venice, March 1986; and at seminars at the Massachusetts Institute of Technology and Harvard, Yale, and Stanford universities. Helpful comments received at these conferences and seminars are gratefully aclalowledged. NOTES 1. Ice EMI story is summarized in Michael Martin, Managing Technological Innovation and Entrepreneurship (Reston, Va.: Reston Publishing Company, 1984).

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CAPTURING VALUE FROM TECHNOLOGICAL INNOVATION 95 2. Executive Vice President, Union Carbide, Robert D. Kennedy, quoted in Chemical Week. 3. Comment attributed to Peter Olson m, IBM,s director of business development, as reported in '~e Strategy Behind IBM's Strategic Alliances," Electronic Business, October 1, 1985, p. 126. 4. Comment attributed to Norman Farquhar, Cipher's vice president for strategic devel- opment, as reported in Electronic Business, October 1, 1985, p. 128. 5. See Business Week, March 3, 1986, pp. 57-59. Business Week uses Be tend "hollow co~poradon" to describe a find Mat lacks in-house manufacturing capability. 6. See "GE Gobbles a Rival in CT Scanners," Business Week, May 19, 1980. 7. F. Gens and C. Chrishansen, "Could 1,000,000 IBM PC Users Be Wrong," Byte, November 1983, p. 88. 8. In Be period before FDA regulation, all drugs other than narcotics were available without prescriptions. Since the user could purchase drugs directly, sales were price sensitive. Once prescriptions were required, this price sensitivity collapsed; doctors not only do not have to pay for the drugs, but in most cases they are unaware of the prices of the drugs they are prescribing. 9. "Institutionalizing the Revolution," Forbes, June 16, 1986, p. 35. 10. If the host country market structure is monopolistic, private actors might be able to achieve Be same benefit. Government can force collusion of domestic enterprises to Weir mutual benefit. REFERENCES Abernathy, W. J., and J. M. Utte~ack. 1978. Patterns of industrial innovation. Technology Review 80:7(June/luly):4047. Clarke, K. B. 1985. The interaction of design hierarchies and market concepts in tech- nological evolution. Research Policy 14:235-251. Dosi, G. 1982. Technological paradigms and technological trajectones. Research Policy 1 1(3):147-162. Kuhn, T. 1970. The Structure of Scientific Revolutions, 2nd ed. Chicago: University of Chicago Press. Levitt, R., A. Klevonclc, N. Nelson, and S. Winter. 1984. Survey research on R&D appropnability and technological opportunity. Yale University. Unpublished manuscript. McKenna, R. 1985. Market positioning in high technology. California Management Review XXVII:3(Spnng):82- 1 08 Miles, R. E., and C. C. Snow. 1986. Network organizations: New concepts for new forms. California Management Review XXVm:3(Spring):62-73. Norman, D. A. 1986. Impact of entrepreneurship and innovations on the distribution of personal computers. Pp.437439 in R. Landau and N. Rosenberg, eds., The Positive Sum Strategy. Washington, D.C.: National Academy Press. Teece, D. J. 1981. The market for know how and Be efficient international transfer of technology. Annals of the American Academy of Political and Social Science 458(November):81-96 Temin, P. 1979. Technology, regulation, and market structure in the modern pharmaceutical industry. The Bell Journal of Economics 10(2):429~146. Williamson, O. E. 1985. Economic Institutions of Capitalism. New York: The Free Press.