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INNOVATION, EVOLUTION OF INDUSTRY
AND ECONOMIC GROWTH

David B. Audretsch and Steven Klepper, (eds.)


ISSN 00-3







David B. Audretsch
Ameritech Chair of Economic Development
Director, Institute for Development Strategies
School of Public and Environmental Affairs
Indiana University
1315 East Tenth Street
Bloomington, Indiana 47405-1701

Steven I. Klepper
Professor, Department of Social and Decision Sciences
Carnegie-Mellon University
500 Forbes Avenue, Porter Hall 219F
Pittsburgh, Pennsylvania 15213-3890



April 2000




INNOVATION, EVOLUTION OF INDUSTRY AND ECONOMIC GROWTH



by David B. Audretsch and Steven Klepper, (eds.)
































This research was undertaken by the Institute for Development Strategies. The
statements, findings, conclusions, and recommendations are those of the authors and do
not necessarily reflect the views of the Institute for Development Strategies, or the
Ameritech Foundation.





THE INSTITUTE FOR DEVELOPMENT STRATEGIES
INDIANA UNIVERSITY


The Institute for Development Strategies (IDS) was initially established by the Indiana
University Trustees in 1984 as the Regional Economic Development Institute. The
Institute was created to further research, graduate-level education, and scholarly exchange
in the area of economic development and development policy. The Institute reports to
both the University's Research and Graduate Development Office, and to the School of
Public and Environmental Affairs.

IDS serves as a focal point for Indiana University's intellectual contributions to the
economic development field through its coordination of faculty research, presentation of
seminars, course offerings, workshops, and conferences. Programs involve University
faculty and students from a variety of disciplines, including Business, Education,
Economics, Geography, Law, Political Science, Public and Environmental Affairs,
Sociology, and Telecommunications.

The Institute maintains a publications series based on the research it sponsors. A
publication list can be obtained from the Institute offices.

One of the major programs of the Institute between 1987 and 1992 was the Ameritech
Fellowship Program, financed by the Ameritech Foundation. The faculty research
projects supported by this Program targeted major issues related to the new and emerging
economies of mature economic regions, with particular emphasis placed on the American
Midwest. In 1992 the Foundation awarded the University an endowed chair to continue
this effort.





David B. Audretsch
Ameritech Chair of Economic Development
Director, Institute for Development Strategies
Innovation, Evolution of Industry and Economic Growth

Introduction

David B. Audretsch and Steven Klepper, eds.

Prepared for the Edward Elgar International Library of Critical Writings in Economics

Some of the most compelling developments in the economic landscape of the past
quarter century have greatly challenged traditional economic thinking. How do
traditional models, for example, measure up to explaining phenomena such as the
economic miracles that enabled Japan and Germany to rise out of the ashes of World War
II, only to be besieged by recent slumps in the last decade of this century? How do
traditional models explain the sustained growth and employment creation in the U.S. in
recent years while Europe and Asia stagnated, which only a decade earlier would have
been dismissed as a quixotic dream? How can traditional models account for IBM, the
giant which dominated the computer industry for a quarter of a century, suddenly
stumbling and giving way to two upstarts, Microsoft and Intel, that now rank among the
most profitable companies in the world? More fundamentally, how can traditional
models account for the precipitous decline of the leading U.S. automobile, steel, and
consumer electronics firms that not long ago dominated their world markets, and for the
equally impressive rise of U.S. software and biotechnology companies?
Traditional economics has been remarkably silent on pressing questions such as
these. The most obvious explanation for this reticence is the inherently static nature of the
discipline. The intellectual heritage of economics is rooted in equilibrium thinking, yet
the common denominator among the questions posed above is change. Traditional static
analyses have proven to be more of a burden than an instrument of enlightenment in
1making sense of many of these important issues. The growing gap between the methods
of the economics discipline and their ability to explain, understand, and predict the most
compelling economic events of our time is alarming. The validity of the discipline lies in
its ability to make sense of real world phenomena.
Perhaps in response to this gap, scholars in the past quarter century have begun
developing alternative frameworks and methodologies for analyzing economic
phenomena involving change. They seek to explain how and why firms are diverse and
how firms, industries, and regions change over time. They build on a rich intellectual
heritage dating back to an earlier tradition represented by scholars such as Josef
Schumpeter and Frank Knight.
The purpose of these volumes is to bring together the seminal contributions of this
emerging new literature. At first glance, these new approaches may seem disparate in that
they cover different subjects using different approaches and methodologies. However,
what links this new generation of scholarship is the focus on change as a central
phenomenon. Innovative activity, one of the central manifestations of change, is at the
heart of much of this work. Entry, growth, survival, and the way firms and entire
industries change over time are linked to innovation. The dynamic performance of
regions and even entire economies is linked to how well the potential from innovation is
tapped.
The contributions included in this volume can be grouped based on a number of
perspectives and lines of research. These perspectives span the firm, the industry, the
region, and the country, as well as the interactions among all of these. Our starting point
2is with a core theory that has been applied to each of these units of observation -- the
model of the life cycle.
The Product Life Cycle and Industry Evolution
One of the earliest acknowledgments that firms and entire industries may not be
well described by equilibrium models comes from investigations of how new product
industries evolve. Such industries commonly experience high initial rates of entry and
innovation, with the number of producers rising over time. In many instances, though,
entry eventually dries up and a shakeout occurs in which the number of producers
declines sharply for a prolonged period despite continued growth in the industry’s output.
Innovation also tends to become more incremental and oriented toward improving the
production process over time. Various models have been proposed to explain these
patterns, which collectively have come to be known as the “product life cycle.” We
begin this volume with various selections from the literature on the product life cycle.
This provides a broad overview of the forces governing industries as they evolve from
birth through maturity.
In “Research and Development Costs as a Barrier to Entry,” Dennis Mueller and
John Tilton use case study evidence to reflect on the forces contributing to the product
life cycle. They argue that when new products are introduced, customer wants are not
well known and the returns to R&D are uncertain. These circumstances favor small firms
and many new firms enter. Over time, uncertainty abates and R&D becomes more
ordered and structured, giving rise to scale economies in R&D, which favors larger firms.
Incumbents also acquire tacit knowledge and competition compresses price-cost margins.
This discourages entry and forces less able firms from the market, causing the number of
3firms to decline. Price competition also becomes more intense, and firms increasingly
devote their innovative efforts to lowering the cost of production.
In the second paper of this section, “The Life Cycle of a Competitive Industry” by
Boyan Jovanovic and G.W. MacDonald, a shakeout in the number of firms is brought
about by a major innovation which increases the minimum efficient scale of production.
Experienced firms are more able to develop the new innovation, and firms that fail to
develop it sufficiently quickly are forced out of the industry as expansion by successful
innovators forces down the industry’s price. The model is shown to account for the sharp
shakeout that occurred in the U.S. tire industry and also the time paths in tire prices,
output, and stock market valuations of publicly traded producers.
In “Entry, Exit, Growth, and Innovation over the Product Life Cycle,” Steven
Klepper develops a model in which firm size conditions the returns to innovation to
explain a number of regularities in the way new product industries evolve. Firms incur
costs of growth which limit their size, but over time successful firms expand. This causes
price to decline, which eventually renders entry unprofitable, and the number of firms
declines as the earliest entrants with the greatest capabilities take over an increasing share
of the industry’s output. Firm size conditions the returns to process more than product
innovation, and thus as the industry evolves firms devote an increasing share of their
innovative activity to improving the production process. The decline in the number of
producers also compromises industry diversity, which in turn retards the rate at which the
product is improved over time. The theory also explains various cross sectional
regularities involving firm size and R&D and average cost.
4In the final selection in this section, Steven Klepper and Kenneth Simons examine
the ability of alternative models of industry shakeouts, including the Jovanovic-
MacDonald and Klepper models and a third based on the concept of a “dominant design,”
to explain the technological and market evolution of four major new products that
experienced sharp shakeouts: automobiles, tires, televisions, and penicillin. Their
findings suggest that shakeouts are not triggered by particular technological
developments but by an evolutionary process in which technological innovation
contributes to a mounting dominance by early entrants in the industry.
The Startup of New Firms
Why are new firms started? The traditional, equilibrium-based view is that new
firms to an industry, whether they be startups or firms diversifying from other industries,
enter when incumbent firms in the industry earn supranormal profits. By expanding
industry supply, entry depresses price and restores profits to their long-run equilibrium
level. Thus, in equilibrium-based theories entry serves as a mechanism to discipline
incumbent firms. The papers in this section probe empirically this characterization of
entry. They also develop and evaluate alternative characterizations of entry based on
innovation and costs of firm growth.
In “What do We Know About Entry?,” Paul Geroski distills a series of “stylized
facts and results” from the empirical literature on entry. Four-digit SIC industries
regularly experience substantial entry by small startup firms. These firms have high
failure rates, and survivors often take more than a decade to reach the size of incumbents.
Entry within industries tends to occur in bursts that are related to innovation but are not
closely tied to the profitability of incumbents, and entry has limited effects on industry
5price-cost margins and incumbent behavior. Geroski concludes that entry is less a
mechanism for keeping prices down and more a mechanism for bringing about change
associated with innovation.
The other three papers in this section analyze the factors that stimulate entry. In
“Spin-Offs and the New Firm Formation Process,” David Gavin analyzes the
circumstances that lead employees of incumbent firms to start their own firms in an
industry. In reviewing evidence from a large number of industries, he finds such
“spinoffs” are more likely in younger industries whose technology is more embodied in
human rather than physical capital and which are composed of more specialized market
niches.
In a chapter from his book, Innovation and Industry Evolution, David Audretsch
analyzes the factors that influence the rate of new firm startups. He finds that such
startups are more likely in industries in which small firms account for a greater
percentage of the industry’s innovations. This suggests that firms are started to capitalize
on distinctive knowledge about innovation that originates from sources outside of an
industry’s leaders.
In “Entry, Industry Growth and the Micro-Dynamics of Industry Supply,” J.
Hause and G. Du Reitz develop a theory of entry based on firm costs of adjustment to
growth. Consistent with their model, they find that entry is greater in industries subject to
greater growth in employment.

6Sources and Implications of Diversity
Market competition is generally thought to pressure less efficient firms either to
copy their more successful rivals or to exit. Thus, strong selection forces exist to reduce
diversity among firms in the same industry. Nevertheless, considerable diversity exists
within industries. The papers in this section explore the nature, sources, and implications
of this diversity.
In “Heterogeneous Firms and the Organization of Production,” Walter Oi asks
why firms vary in size within industries and why larger firms are more capital intensive,
have higher capital utilization rates, invest more in new equipment, and employ more
educated, salaried, and full-time workers who receive more training and greater wages
and fringe benefits. Size differences are related to the types of needs firms service.
Differences in internal structure are related to differential abilities of entrepreneurs and
the need for entrepreneurs to monitor workers. More able entrepreneurs head larger firms
and have a higher opportunity cost to monitor workers and thus engage in various
practices to economize on monitoring costs, which includes using more capital intensive
methods of production and employing better quality and thus more highly compensated
workers.
Another source of industry diversity arises from differential firm experiences in
related industries. In “The Fates of De Ovo and De Alio Producers in the American
Automobile Industry, 1885-1981, “ Glenn Carroll, Lyda Bigelow, Marc-David Seidel,
and Lucia Tsai examine the relationship between the pre-entry background of entrants to
the automobile industry and the length of their survival. They show that among all firms
7

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