Integration and innovation of the firm

The ideas of Goldberg and others on the role of long-term commitments in coping with specific capital investments in the context of technical change lead naturally to an appraisal of the firm as a device for initiating change. In subsection 4, our attention was focused on flexibility and adapt­ability in the face of an exogenously changing environment. Here we see the firm not as a passive response to the environment but as an active determi­nant of the technical conditions prevailing.

Invention, the perception of new technological possibilities, is inevitably the product of personal insight and personal circumstances. Although it is possible to argue that invention may be stimulated by bringing together within the firm groups of ingenious people, all with the characteristics of curiosity and technical knowledge, many of the inventive insights appear still to originate from people outside (Jewkes et al., 1969). However, to go from a new concept and perhaps a working model to the launching of a commercially viable product or process, usually requires the close cooper­ation of many people over long periods and involves the exercise of entre­preneurship of the Schumpeterian variety. Innovation and the firm are therefore intimately associated. Perhaps the most famous historical example concerns the association between James Watt, who appears to have had a working model of his steam engine operating as early as 1765, and Matthew Boulton, whose entrepreneurial flair and financial assistance were required before the first commercial engine was installed in 1776. Development expenditures amounted to at least sixty man-years of skilled labour (Scherer, 1980, p.412).

1. Research and Development

1.1. Innovation and scale

Enormous institutional changes have occurred since those early years of the industrial revolution, and, in the modern world, research and develop­ment expenditure amounting to many billions of dollars is undertaken every year.23 In fields such as chemicals, drugs, electronics, communica­tions, instrumentation, aircraft, and electrical and mechanical engineering, investment in research and development commonly exceeds three per cent of sales revenue. Other industrial groups, such as food, textiles or paper, undertake much less research and development as a percentage of sales revenue, but individual firms assigned to these industries may vary consid­erably in research effort.

The effects of continuing innovation within the firm on its size and struc­ture have been debated fiercely for many years and a full review cannot be attempted here.24 It has been argued that large firms are required for suc­cessful innovation, reasons given being: (i) innovation is now beyond the resources of smaller enterprises; (ii) there are ‘economies of scale’ associ­ated with research and development (sophisticated scientific equipment is ‘indivisible’ as is the knowledge to which its use may give rise); (iii) large size permits the pooling of risks over many projects, and (iv) market power is required to produce an environment sufficiently stable to provide the long­term confidence necessary for the innovator.25 Others have pointed out that a flow of small to medium-scale innovations well within the capacity of firms of moderate size to undertake continues from year to year, and that only in the ‘spectacular’ fields of nuclear power, weapons and space research (mostly government funded) is very large size a prerequisite. Smaller firms may be more flexible and less prone to bureaucratic inertia, while the risks associated with innovation will vary widely and may, on many occasions, be perceived as not all that great. Most businessmen and women will try to ensure that the majority of significant technical problems have been satisfactorily resolved by relatively inexpensive research before the start of full-scale development.26 Several smaller competing firms may provide an environment more stimulating to the pace of innovation than a single large firm by increasing the incremental reward attached to a more rapid completion of a project, but, as already noted in subsection 5, too many potential imitators or improvers may have an adverse effect and reduce the scope for profitable innovation.27

1.2. Innovation and the multinational

From the point of view of the transactions cost approach to the firm, the implications for firm structure of research and development expenditure depend upon the ability to trade in the information to which the research gives rise. Where the information is difficult to communicate simply, or where licensing the use of the information exposes the firm to opportunism, we would expect the firm to achieve its return by expanding internally. It is this reasoning which forms the basis of the theory of multinational enter­prise associated with Dunning (1981), Buckley and Casson (1976), Hymer (1976) and Rugman (1980). Information, to quote Rugman, ‘is the oil that lubricates the engine of the multinational enterprise’ (p.368). Firm-specific information which cannot be traded and which cannot be used to increase direct exports (perhaps because of tariffs, quotas, transport costs or other barriers to trade) will lead to geographical expansion.

At first sight, the above paragraph might appear simply to reiterate the ‘internalisation’ rationale for the multinational. Because markets in infor­mation are exposed to hazards, information is exploited within the firm. ‘Internalisation’ on its own explains why, given some informational advan­tage, a firm may become a multinational. In this somewhat static context, the relevant ‘advantage’, coming as it were from ‘nowhere’, is easily per­ceived as ‘monopolistic’ in nature. This is precisely how Hymer interpreted the situation, as mentioned earlier in section 5.3.2. However, the emphasis in this section is on the generation of new information. The ability to dis­cover new information within the firm is itself a type of ‘advantage’; an advantage which may require a firm to adopt a multinational strategy if it is to be fully exploited. The dynamic nature of this ‘advantage’ means that it can fit into an analytical framework of Schumpeterian competition rather than static monopoly.

This view of multinational production has been termed the ‘eclectic approach’ because it combines the ‘internalisation’ theory with that of the generation of ‘competitive’ or ‘ownership advantages’. Dunning (1991) is particularly associated with the development of the eclectic paradigm. Cantwell (1991, p. 32) sums up the eclectic view by arguing that ‘innovation and the growth of international production are seen as mutually support­ive’. Indeed the ability to transfer knowledge within the firm may be seen not only as a means of making the most of existing information but also as an important prerequisite for producing yet more innovations. The gener­ation and use of new information is at the heart of what Chandler (1990) calls ‘organisational capabilities’.

Some link is therefore expected to exist between research and develop­ment expenditures and international and conglomerate expansion. Wolf (1977), for example, finds a statistically significant relationship between the extent of multinational operations and technical capability defined as the percentage of scientists and engineers in total employment. Vaupel (1971) found for a sample of 491 US companies, divided into national, transna­tional (operating in under six foreign countries) and multinational classes, that research and development expenditure as a proportion of sales was 2.4 per cent for multinationals, 1.6 per cent for transnationals and 0.6 per cent for national enterprises. Similarly, Dunning (1973) reports the results of his own study of US affiliates in the UK: US affiliates tend to be more con­centrated in faster-growing and export-oriented industries. They are also attracted to the technologically advanced industries and to those where both capital and advertising expenditure are slightly above average (p. 322). Pavitt (1987) similarly argues that the accumulation of technological knowledge within the firm is closely linked with the process of multina­tional expansion.

Markusen (1995, 1997) uses these results in his incorporation of the multinational firm into the theory of international trade. Multinational firms are characterised by a relatively high ratio of R&D expenditure to value of sales; a large proportion of professional and technical staff; significantly high levels of advertising and product differentiation; frequent introduction of new and complex products; and a high value of intangible assets to total market value. All these features can be seen as indicating significant ‘ownership advantages’ and thus as supporting a theory of the scope of the firm based upon the exploitation of firm-specific resources.28

1.3. Innovation and the conglomerate enterprise

Evidence is less clear in the case of conglomerate diversification. Wolf (1977) again finds evidence that domestic diversification is related to tech­nical capability as defined above, but, as Scherer (1980) points out (p. 422), studies of very broad diversification (across two-digit industry groups) do not reveal a close positive relationship with research and development expenditure. This may indicate that most research and development is product- or process-specific and does not typically confer benefits on activ­ities in many different product markets.29 If this is so, conglomerate diversification cannot generally be explained in terms of economies in the use of research and development resources, and might be better viewed, as in section 4, as a defensive response to the possibility of technological ‘mugging’.

Innovation is not only about R&D however, and companies with inter­nal ‘resources’ such as management skills, marketing expertise, valuable brand name recognition and so forth could use these resources by moving into differing markets – just as the Virgin brand has supported operations as different as cola, music stores, a radio station, an airline and rail trans­port. In other words, the arguments used to explain multinational expan­sion could be deployed also in the context of diversification into different markets. Thus, the use of firm-specific and non-tradable resources might still be an element in an explanation of conglomerate diversification.30

1.4. Vertical integration and innovation

Another attempt to study the association between integration (this time, vertical integration) and research, is that of Armour and Teece (1980). They hypothesise that vertical integration will increase the productivity of resources devoted to research, essentially because of improved flows of information between stages of production. In a sample of petroleum firms for the period 1954-75, vertical integration was measured by the number of primary production process stages undertaken (for example, crude pro­duction, refining, transport and marketing). Other ‘exogenous’ variables included size, cash flow and diversity (the number of activities in which the firm was engaged; for example, coal, uranium exploration/milling/mining, shale reserves, and so on). Their results indicated that ‘vertical integration significantly influences … basic and applied research expenditures’ (p. 473). Thus the direction of ‘causation’ is seen by Armour and Teece as flowing from ‘strategy’ to research expenditure rather than from research expendi­tures to ‘strategy’. In principle, of course, both factors will react on one another and it may be misleading to consider that one ‘causes’ the other.

2. Schumpeter’s Entrepreneur

As was seen in Chapter 3, Schumpeter argued that large corporations ‘ousted’ the entrepreneur and technical progress developed a momentum of its own. Thus, the influence of research and development on firm structure and strategy can be seen as part of a theory of the development of these mature corporations which have managed to ‘institutionalise’ technical change. In this subsection, however, we return to the original Schumpeterian vision of the innovating entrepreneur forcing through tech­nical developments. Some theorists, and especially Silver (1984), have used this view of the entrepreneurial process to explain vertical integration.

Firms integrate forwards or backwards not merely to protect the infor­mation at their disposal from alert opportunists (as under subsection 6.1) but to force through changes which others are insufficiently alert to appre­ciate or who steadfastly refuse to be convinced of the need for them. The difficulties faced by an entrepreneur in convincing a financier of his or her ability and judgement were mentioned in Chapter 3, and the advantages of the entrepreneur having access to private resources were recognised, but this problem does not stop at the stage of finance. An innovating entrepre­neur will have to persuade all the people playing a part in his or her plans that s/he has the skill and expertise to carry them through, and that s/he can fulfil his/her promises to suppliers and potential customers alike. Many of these may be suspicious of new ideas and doubtful about the possibilities of success. A supplier may be particularly reluctant to cooperate if heavy transaction-specific investment is involved. This is not simply because of the recontracting problem discussed earlier or the fear of further technical change. Even abstracting from these problems, the supplier would need to be reassured that the innovating entrepreneur had plans which were com­mercially viable.

Silver (1984) argues that much historical experience of integration is con­sistent with this view of the entrepreneurial process. New ideas are imple­mented by aggressive forward or backward integration and, after they have become accepted and information about the new ways of doing things has become more widely available, disintegration may occur and the ‘invisible hand’ may begin to reassert itself. Note that vertical integration, far from being to restrict access to information, is, in this view, a device to dissemi­nate information which would otherwise simply not get across.

When the meat packers of Chicago wished to transport meat to the eastern cities of the USA they integrated forwards into retailing and whole­saling. Local wholesalers were initially unwilling to risk the introduction of refrigerated warehouses for handling large transhipments of meat, as they had no experience of what quality could be expected or of consumers’ reac­tions. Once markets had been tested and established, independent whole­salers were willing to enter the trade and the meat packers withdrew entirely from retailing. A similar story can be told concerning the forward integra­tion of oil refiners into the retailing of gasoline in the USA. We are so famil­iar with the service station, designed specifically for the motorist, that it is easy to forget how novel the idea must have seemed eighty years ago when gasoline would have been purchased from a general-purpose store. Once the construction of a network of outlets was complete, a move towards dis­integration could occur, mainly through franchise arrangements.

A notable example from British economic history of the resistance to new ideas, which Schumpeter’s entrepreneur overcomes, is provided by the introduction of Henry Bessemer’s process for making steel. When first announced, unexpected difficulties were encountered because Bessemer had unwittingly used low-phosphorus iron in his experiments and the process turned out to be unsuitable for the high-phosphorus pig-iron used by most manufacturers. Bessemer discovered the source of the problem and by using non-phosphoric pig-iron imported from Sweden was able to reduce the cost of steel from £50 to £7 a ton. In spite of these technical developments: ‘I was paralysed for the moment in the face of the stolid incredulity of all practical iron and steel manufacturers . . . None of the large steel manufacturers of Sheffield would adopt my process, even under the very favourable conditions which I offered as regards licences, viz. £2 per ton.’ Bessemer responded ‘by adopting the only means open to me – namely, the establishment of a steel works of my own in the midst of the great steel industry of Sheffield’.31

Each of the examples cited thus far has concerned developments of some historic importance. The argument is applicable in many other areas, however. When efforts were made to redevelop a British watch industry in the decade after 1945 (apparently as part of the defence programme), man­ufacturers were forced to undertake the production of components and tools. As a result, the structure of the industry was quite different from that found in Switzerland at the time, where many firms were highly specialised (see again note 13). A process of very gradual historical evolution may produce a complex pattern of market cooperation between independent firms. Rapid development is rarely compatible with such a structure, and integration is required to marshal the available technical knowledge and disseminate it. To quote Edwards and Townsend once more, ‘an industry cannot be started by the integration of a large number of small firms across the market if few people have the necessary technical knowledge, organis­ing knowledge and enterprise’ (p. 242). In another case study, the managing director of Aero Research Ltd, a company mainly concerned with devel­oping glue (and acquired in the 1950s by Ciba Ltd), emphasised the impor­tance of ‘customer education’. Although full forward integration to overcome this problem did not take place, measures were required such as the installation at cost price of tanks and apparatus at customers’ works to permit bulk delivery of the new materials, the production of a monthly technical bulletin, and the running of summer schools.32

A final example concerns the case of Alcoa, already discussed in section 5. There it was seen that Perry (1980) explains Alcoa’s strategy of forward integration as a means of instituting a regime of price discrimination. Silver (1984) argues, however, that the evidence can be interpreted in a different light. Alcoa integrated forwards into those areas where they could assist in establishing new uses for aluminium. Perry dismissed this kind of explana­tion as ‘naive’ but, as Silver points out, Perry’s evidence is not sufficient entirely to discredit it.

Source: Ricketts Martin (2002), The Economics of Business Enterprise: An Introduction to Economic Organisation and the Theory of the Firm, Edward Elgar Pub; 3rd edition.

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