Knowledge Inheritance and Vertical Integration
KNOWLEDGE INHERITANCE, VERTICAL INTEGRATION,
AND ENTRANT SURVIVAL IN THE
EARLY U.S. AUTO INDUSTRY
Nicholas Argyres
Olin Business School, Campus Box 1133
Washington University in St. Louis
One Brookings Drive
St. Louis, MO 63130
Phone: 314-935-6391
and
Romel Mostafa
Ivey Business School
Western University
1255 Western Road
London, ON N6G 0N1, Canada
Phone: (519) 661-4206
January 2015
Running Head: Knowledge Inheritance and Vertical Integration
Acknowledgment: We are grateful to Lyda Bigelow and Steven Klepper for sharing data, and Dan Dunn and Leslie Kendall for sharing their expertise on the early U.S. auto industry. Feedback from AMJ associate editor, Kyle Mayer, and three anonymous referees improved the paper significantly. Rajshree Agarwal, Brian Anderson, Pratima Bansal, Stefano Brusoni, Xavier Castaneda, Ronnie Chatterji, Adam Fremeth, Tony Frost, Brent Goldfarb, Barton Hamilton, Guy Holburn, Tammy Madsen, Joanne Oxley, Claus Rerup, Brian Richter, Oliver Williamson, and Chris Zott also offered helpful comments. Finally, Katherine Dobscha, Jared Siegel, and James Wright provided outstanding research assistantship.
KNOWLEDGE INHERITANCE, VERTICAL INTEGRATION,
AND ENTRANT SURVIVAL IN THE
EARLY U.S. AUTO INDUSTRY
Abstract
A key finding in the literature on industry evolution and strategy is that knowledge “inherited” from the founder’s previous employer can be an important source of a new firm’s capabilities. We analyze the conditions under which knowledge that is useful for carrying out a key value chain activity is inherited, and explore the mechanism through which such an inheritance shapes an entrant’s strategies and, in the process, influences its performance. Evidence from the early U.S. auto industry indicates that employee spinoffs generated from incumbents that had integrated a key value chain activity were also more likely to integrate that activity than other entrants, which, we suggest, reflects the application of knowledge inheritance relative to that activity. Moreover, we find that the integration of this key activity, stimulated by knowledge inheritance, contributed to the establishment of defensible strategic positioning, thereby enhancing the survival duration of inheriting spinoffs. We thus link together the phenomena of knowledge inheritance, vertical integration, and strategic positioning to explain entrant performance. These three phenomena tend to be treated disparately in the literature, rather than in combination.
179 words
Key words: knowledge inheritance, vertical integration, and strategic positioning
INTRODUCTION
One of the most robust findings in the literature on industry evolution and strategy is that a firm’s pre-entry experience has a persistent effect on its post-entry performance, suggesting that a firm’s capability development processes are influenced by its heritage (e.g., Carroll, Bigelow, Seidel, & Tsai, 1996; Dunne, Roberts, & Samuelson, 1988; Klepper & Simons, 1997). Recently, scholars have explored this effect of pre-entry experience by studying new firms established by former employees of industry incumbents—so-called “employee spinoffs.”[1] Several studies have demonstrated that spinoffs constitute a substantial source of entrants into a variety of industries and tend to outperform other new entrants (for a review, see Klepper 2009).
The superior performance of spinoffs has been attributed to their founders’ industry-specific, pre-entry experience, which is lacking in non-spinoff entrants. Some studies suggest that spinoffs build on the same knowledge that was initially exploited by their founders’ former employers (i.e., the parent firms) (Agarwal, Echambadi, Franco, & Sarkar, 2004; Chatterji, 2009; Klepper & Sleeper, 2005). Such involuntary transfer of knowledge from parent firms to their spinoffs, commonly referred to as “knowledge inheritance,” is thought to be an important source of spinoffs’ capabilities. However, the ways in which parental capabilities shape a spinoff’s knowledge inheritance by influencing its strategic choices, thereby contributing to a spinoff’s superior performance, remain poorly understood.
This paper aims to shed light on the mechanism through which knowledge inheritance operates. We first examine the role of knowledge inheritance as a determinant of an entrant’s decision to integrate value chain activities. Our analysis focuses on the integration decisions of “key” value chain activities that can enable the firm to create and capture substantial value (Brandenburger & Stuart,1996). We study the determinants of early integration choices at the level of individual key activities because such strategic choices can reflect the application of a firm’s initial capabilities (Argyres & Zenger, 2012) and can, therefore, expose the underlying mechanism through which knowledge inheritance operates. We examine whether, beyond immediate transaction cost considerations (Williamson, 1985), the decision to integrate a key value chain activity is influenced by knowledge inheritance that is traceable to the parent firms’ own integration decision of that key activity. We then analyze whether and how the integration of a key value chain activity that is shaped by knowledge inheritance can, in turn, contribute to the establishment of a strategic market position of either cost leadership or differentiation (Porter, 1980, 1985), thereby influencing a firm’s survival chances. In so doing, we extend prior work that posits that decisions regarding vertical integration and positioning are made jointly (Ghosh & John, 1999; Nickerson, Hamilton, & Wada, 2001) by incorporating the possibility that such decisions are influenced by knowledge inheritance.
Our study focuses on the U.S. automobile manufacturing industry during 1917-1931, a period in which the industry was characterized by rapid technological change and intense competitive pressures (Carroll et al., 1996; Klepper 2004; Suarez & Utterback, 1995). We focus on engine manufacturing as the key value chain activity in our context, although our notion of a key value chain activity is quite general, and in other contexts could even encompass a capability to design contracts with suppliers and distributors, perform logistics activities, or otherwise manage outsourcing (e.g., Argyres & Mayer, 2007; Mayer & Salomon, 2006).
Our study provides several related insights. First, it sheds light on factors that give rise to firms’ initial capabilities, and thereby, to some of a firm’s ultimate sources of competitive advantage. In addition, because our analysis is at the level of individual value chain activities, it provides insight into the kinds of knowledge that are transmitted through the spinoff process, and that are especially valuable to firms in technologically progressive industries (Elfenbein, Hamilton & Zenger 2010). Moreover, whereas transaction cost economics ascribes no special status to early versus later vertical integration decisions, our analysis points to the especially long-run performance consequences of such early decisions (cf. Mayer, Somaya & Williamson 2012). Finally, whereas prior research attributes spinoffs’ superior performance simply to their lineage, we provide a more nuanced explanation of the knowledge inheritance mechanism. Our findings suggest that by influencing strategic choices concerning vertical integration and positioning, knowledge inheritance contributes to superior performance. We thus link together knowledge inheritance, vertical integration, and strategic positioning. These three phenomena tend to be treated disparately in the literature, rather than in combination.
LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT
Strategy scholars have argued that firms achieve a competitive advantage by carving out unique, defensible strategic positions in the market (e.g., Porter, 1980; 1985). Such advantages are thought to be sustainable if they are supported by a difficult-to-imitate configuration of activities, capabilities, or resources (e.g., Barney, 1991; Dierickx & Cool, 1989; Lippman & Rumelt, 2003; Porter, 1996; Rumelt, 1984). A firm is expected to integrate a value chain activity that require capabilities and resources uniquely complementary to its existing capability-resource profile (Argyres & Zenger, 2012), in order to avoid the transaction costs associated with accessing them through contracts (Klein, Crawford, & Alchian, 1978; Williamson, 1985). Therefore, a firm’s strategic decisions regarding its positioning and vertical integration are made jointly—in a way that is anticipated to provide it with a competitive advantage (e.g., Demsetz, 1988; Kogut & Zander, 1992; Argyres 1996; Ghosh & John, 1999; Nickerson et al. 2001; Argyres & Bigelow, 2010). Although the literatures on firm boundaries and strategic positioning are thus becoming reconciled, this effort has been silent in terms of the sources of capabilities that may differ between rivals, which may contribute to variations in integration choices and strategic positioning, and, therefore, to variations in firm performance.
Researchers have long emphasized, however, that inter-firm personnel migrations can lead to transfers of valuable knowledge and resources between organizations (e.g., Aldrich & Pfeffer, 1976; Almeida & Kogut, 1999). Such transfers are particularly important when the firm is founded (Stinchcombe, 1965). For example, founding conditions can have an enduring impact on the firm’s organizational structures and inter-organizational networks (Baron, Hannan, & Burton, 1999; Marquis, 2003). Moreover, research suggests that the firm’s pre-entry experiences, which are expected to influence its founding conditions, have a persistent effect on its post-entry performance (e.g., Carroll et al., 1996; Dunne et al., 1988; Klepper & Simons, 1997), as well as on its decisions regarding the integration of links in its value chain (Qian, Agarwal, & Hoetker, 2012).
Recently, attention has shifted to employee spinoffs, which are thought to draw on valuable knowledge from their parent firms (Agarwal et al., 2004; Chatterji, 2009; Klepper & Sleeper, 2005). Because of capabilities’ path-dependent development, the initial capabilities that a spinoff derives from its knowledge inheritance can significantly influence the shaping of its future capabilities (Helfat & Lieberman, 2002; Lieberman & Montgomery, 1988). Numerous studies have demonstrated that spinoffs outperform other new entrants, and that those spinoffs spawned from more capable parent firms typically achieve superior performance (for a review, see Klepper, 2009). Moreover, in some industries, the departure of employees to establish spinoffs has been shown to negatively influence parental performance, suggesting that value creation by spinoffs can be associated with value destruction in parent firms (e.g., Wezel, Catani, & Pennings, 2006; McKendrick, Wade & Jaffee, 2009; Campbell, Ganco, Franco & Agarwal 2012). These studies suggest that knowledge inheritance not only can represent a differential source of capabilities between spinoffs and other new entrants but can also be linked to the capabilities of spinoffs’ parent firms. Far less understood, however, is exactly how the parental firm’s capabilities influence a spinoff’s knowledge inheritance, and how such an inheritance, in turn, spurs the spinoff’s strategic choices—specifically, its vertical-integration profile and strategic positioning—that ultimately contribute to the spinoff’s superior performance.
Vertical Integration
When making strategic decisions, firms face the daunting task of anticipating their future competitive environment, including possible shocks to demand, regulations or technology (e.g., Suarez & Utterback 1995; Tegarden, Echols & Hatfield 1999; Nickerson & Silverman 2003; Bayus Agarwal, 2007; Argyres, Bigelow & Nickerson, 2013). Such shocks can intensify competitive pressures by creating opportunities for new entrants, leading incumbents to become more aggressive in defending their own strategic positions, and in attacking others’ (Schumpeter, 1934).[2] Therefore, firms at their very formation have to make conjectures under uncertainty about which positioning and integration choices would provide them with a competitive advantage. Based on their conjectures, firms assemble the bundle of capabilities and resources that is needed to carry out those activities (Rumelt 1984; Lippman & Rumelt 2003), taking into account any unique complementarities between such activities (Argyres & Zenger, 2012). Over time, as uncertainty becomes resolved, a firm that has integrated a value chain activity that turns out to be “key” –i.e. the activity potentially enables the firm to create and capture substantial value—can enjoy a sustained competitive advantage. Our analysis, therefore, focuses on the decision to integrate a value chain activity that turns out to be key; in the following subsection, we examine how this integration decision through the firm’s choice of positioning influence its performance.
As noted earlier, an important source of a firm’s initial capabilities is knowledge inheritance that it may possess as a spinoff. The literature on firm boundaries has argued, and shown, that such boundaries are determined both by a firm’s capabilities for carrying out the activity in question, relative to potential suppliers’, as well as the transaction costs associated with that particular activity or transaction (e.g., Argyres, 1996; Leiblein & Miller, 2003; Argyres & Zenger, 2012). The literature on knowledge inheritance would suggest, in turn, that a spinoff’s initial capabilities (relative to its suppliers) are influenced by any knowledge that may have been inherited from a parent firm. Because of this inheritance, and because the parent firm’s vertical integration of an activity that turns out to be key reflects the latter’s own knowledge relative to that activity, the underlying knowledge relevant to carrying out that activity in-house is more likely to be transmitted through the spinoff process when the parent firm also performs that activity internally. Incorporating the key arguments from the literature on firm boundaries would suggest that capabilities derived from such knowledge will influence the spinoff’s vertical-integration decision to pursue the focal activity, after accounting for any asset specificity associated with that activity. Therefore, controlling for the level of transaction costs associated with a key activity, a spinoff spawned from a parent firm that vertically integrated a key activity is more likely to also integrate that activity than entrants that lack the same specific knowledge inheritance.[3]
Note that there are two types of entrants that lack knowledge inheritance of this kind: (1) spinoffs generated from parent firms that do not integrate the key activity, and (2) non-spinoffs that by definition have no parent from which to draw knowledge. These two types may differ in that while both lack a knowledge inheritance regarding the key activity, the first type (but not the second) may benefit from knowledge inheritance regarding other activities that are, to some degree, related to the key activities that its parent performed inhouse (e.g., Qian et al. 2012). Because the effects for each type may differ, we separately compare each of the two types to spinoffs that do inherit knowledge of the key activity. Our arguments, therefore, suggest that
Hypothesis 1(a): A spinoff spawned from a parent firm that integrates a key activity is more likely to integrate that activity than a non-spinoff firm.
Hypothesis 1(b): A spinoff spawned from a parent firm that integrates a key activity is more likely to integrate that activity than a spinoff whose parent firm did not integrate that activity.
Positioning and Survival
Prior research suggests that spinoffs build on the knowledge they inherit from their parent firms and, on average, outperform other new entrants. But how exactly does an initial capability that is gained through knowledge inheritance improve a spinoff’s chances of survival? As noted earlier, entrants are expected to make joint decisions regarding their vertical integration profile and strategic positioning. Here we argue that knowledge inheritance stimulates both such decisions in a way that their combined influence contributes to superior performance. Because the strategic positioning choice must be supported by the vertical integration choice (Ghosh & John, 1999; Nickerson et al. 2001), we suggest that the underlying capabilities that are reflected in the vertical integration of an activity that turns out to be key will improve an entrant’s performance to the extent that they enable the entrant to establish a defensible strategic position in the industry (Porter, 1980, 1985). In other words, an entrant benefits from such capabilities if those capabilities are important in creating and capturing value through a greater willingness-to-pay (and price), lower costs, or some combination of the two (e.g., Brandenburger & Stuart, 1996).