Governance inseparability and the evolution of US biotechnology industry

Journal of Economic Behavior & Organization Vol. 47 (2002) 197–219

Governance inseparability and the evolution of US biotechnology industry Nicholas S. Argyres a,∗ , Julia Porter Liebeskind b,1 a b

School of Management, Boston University, 595 Commonwealth Avenue, Boston, MA 02215, USA Marshall School of Business, University of Southern California, Los Angeles, CA 90089-0808, USA Received 30 March 1999; received in revised form 26 March 2001; accepted 4 June 2001

Abstract This paper explores mechanisms through which a party’s choice of governance mode for a focal transaction is constrained by the governance choices it made for other, prior transactions. We argue that this condition of “governance inseparability” plays an important role in determining the differential organizational costs incurred by various firms when undertaking the same new activity, and is therefore important for theories aimed at predicting what kinds of firms will undertake such an activity. We develop these arguments by showing how governance inseparability conditions help explain the persistent fragmentation of the US biotechnology industry. © 2002 Elsevier Science B.V. All rights reserved. JEL classification: L1; L2; O3 Keywords: Governance; Transaction costs; Industry evolution

1. Introduction Ronald Coase’s (1937) article on “The Nature of the Firm” posed the twin questions that have become central to transaction cost economics (TCE). First, Coase asked why some transactions are conducted inside firms rather than through markets. Second, supposing that firms retain a transaction cost advantage over markets, why is all production is not carried out in “one big firm”? More recently, Coase (1988) observed that while progress has been made in answering the first question, the second question is less well understood. He argued that answering ∗ Corresponding author. Tel.: +1-617-353-4152. E-mail addresses: [email protected] (N.S. Argyres), [email protected] (J.P. Liebeskind). 1 Tel.: +1-213-740-0749.

0167-2681/02/$ – see front matter © 2002 Elsevier Science B.V. All rights reserved. PII: S 0 1 6 7 - 2 6 8 1 ( 0 1 ) 0 0 2 0 2 - 5

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this second question requires understanding “the effect of the activities in which a firm is already engaged on its costs of undertaking additional activities” (Coase, 1988; p. 40). Since the set of activities that a firm carries out at any point in time typically differs from the set carried out by any other firm, Coase’s statement implies that firms will differ in the “organization costs” they incur if they undertake a given new activity. Currently, TCE is capable of, and has been quite successful at, predicting how a particular transaction will be governed: either within a hierarchy, through a market, or through a “hybrid” organization of some kind (Williamson, 1985; Klein and Shelanski, 1995). Developing Coase’s insight about organization costs, however, is important for developing the theory’s ability to predict what kind of firm, or even which particular firm, will undertake a given type of activity. 2 This paper aims to provide some grounding for the development of TCE in this direction. It does so by exploring the organization of economic activity in the US biotechnology industry. The biotechnology industry is particularly interesting because it has been characterized by extreme and persistent fragmentation since its inception in the mid-1970s. Our inquiry here is focused on two questions. First, we explore the question of why early entry into the biotechnology industry was dominated by new firms, rather than by incumbent firms that owned complementary resources and capabilities. Second, we explore the question of why, over time, consolidation of firms within the industry has not taken place. We interpret these phenomena as emerging from constraints on vertical integration and horizontal expansion that operate (in different ways) in both large and small firms involved with biotechnology. These constraints, we argue, impose comparatively high organization costs on existing firms, making it more likely, ceteris paribus, that new activities in biotechnology will be carried out by new firms. These constraints obtain when a firm’s prior governance choices reduce the range of its governance choices for subsequent and different types of transactions. Thus, a firm may face a constraint on differentiating governance arrangements across transactions. Alternatively, a firm with a history of governing a given transaction in a certain way may find it difficult to change its governance arrangements if the underlying conditions of the transaction change. That is, a firm’s prior governance choices may constrain it from switching governance modes. When constraints on a firm’s choice of governance mode for new activities arise because of its governance choices in previous periods, we say that the firm is subject to a condition of governance inseparability (Argyres and Liebeskind, 1999). We argue that governance inseparability is important in explaining why the preponderance of entry into the biotechnology industry has been in the form of new firms; why the largest firms in the biotechnology industry have not integrated backward through acquisition to any significant degree; and why the successful entrants into the industry have not grown to large scale and scope. Another approach that has been used to explain the differential organizational costs associated with undertaking new activities is based on the idea that organizations are heterogeneous in their capabilities, including their capabilities for conducting research 2 While the sources of organizational costs have yet to be fully understood, the costs themselves have been measured precisely; in particular by Masten et al. (1991).

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(e.g. Arrow, 1974; Nelson and Winter, 1982; Henderson, 1993; Kogut and Zander, 1996). According to this view, the fragmentation of the biotechnology industry may be explained by the fact that large incumbent pharmaceutical firms may possess organizational routines and communication channels that are ill suited to the requirements of biotechnology research (e.g. Gambardella, 1995). Such theories would arguably require significant elaboration, however, in order to explain (for instance) why large pharmaceutical firms did not form separate “new venture divisions” to organize biotechnology research activities at the inception of the biotechnology revolution, or why they have not subsequently integrated backwards by acquiring new biotechnology firms (NBFs). Nor can these theories explain why biotechnology research and commercialization is carried out by a large population of small firms, rather than by a new generation of larger biotechnologyspecialized entities. Governance inseparability arguments can help to explain such phenomena, and therefore can be seen as complementary to capabilities-based theories of the firm, explaining the mechanisms whereby such differentiation in capabilities is brought about. Following our analysis of the structure of the biotechnology industry we suggest some implications of the governance inseparability phenomenon for TCE. Governance inseparability implies that the organizational cost associated with a particular transaction can be affected, inter alia, by governance choices made by transactors for other transactions that they entered into at an earlier point in time. To the degree that these prior governance choices vary among different transactors, we would expect to observe differences in organizational costs among different transactors for similar types of transactions. This implies that exclusive use of a focal “transaction” as the unit of analysis can inhibit understanding of the sources of variance in organization costs. Considering the bundles of transactions in which particular transactors are involved may allow more accurate prediction of which transactions will be internalized in which types of firms, or even, which particular firms. The paper proceeds as follows. Section 2 describes the market structure of biotechnology and its evolution. Sections 3 and 4 present our explanations of these in terms of constraints on governance differentiation and governance switching. Section 5 begins to conceptualize the sources of governance inseparability, in an effort to identify conditions under which it does or does not arise, and suggests implications for TCE. Section 6 concludes and suggests avenues for future research.

2. The structure of the biotechnology industry Biotechnology is a group of technologies based on molecular biology that enable scientists to genetically manipulate and replicate living cells. Biotechnology has a host of applications in areas such as medicine, agriculture, food processing, and energy. The birth of biotechnology is usually traced to two seminal scientific discoveries. The first was a technique for recombining DNA developed by Stanley Cohen at Stanford University and Herbert Boyer at the University of California, San Francisco in 1973. The other basic technology was discovered by Cesar Milstein and Georges Kohler at the University of Cambridge in 1975, and involved a technique for producing monoclonal antibodies known as “hybridoma” technology. The commercial potential of these technologies was recognized fairly quickly,

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and by 1976, Genentech, known as the first NBF, was founded to commercialize products of genetic engineering. Other NBFs entered quickly thereafter. According to Shan (1987) and Orsenigo (1989), the rate of NBF founding in US increased every year through 1981; by 1982 over 200 NBFs were active. The population continued to grow rapidly during the 1980s and 1990s so that by 2000, the total number of US and large foreign firms in the US biotechnology industry was 949, according to Bioscan, the most comprehensive source of data on biotechnology companies. 3 Thus, an entirely new population of firms has emerged and persisted. However, NBFs have remained small in size. Fig. 1 presents data on the size distribution of NBFs in terms of number of employees for the year 2000, drawn from Bioscan. The figure shows that 87% of NBFs had less than 300 employees. 4 Large pharmaceutical and chemical firms became interested in biotechnology very early on. Ely Lilly began collaborating with Genentech to clone human insulin in 1978, the same year in which Hoffman-LaRoche (“Roche”) began its collaborative research with Genentech on interferon. Large chemical firms such as DuPont and Monsanto built laboratories for biotechnology research in the 1980s. The Office of Technology Assessment (1984) estimated that Monsanto, Eli Lilly, Schering Plough and Hoffman-LaRoche spent roughly US$ 60 million on biotechnology R&D in 1982, while DuPont spent approximately US$120 million. Ciba-Geigy, Merck and Hoechst had also established in-house biotechnology R&D programs by 1978. But despite this early and sustained interest in biotechnology by these and other large pharmaceutical and chemical firms, the biotechnology industry has remained highly fragmented, and NBFs have continued to proliferate. This persistent fragmentation after more than 20 years of industry history is arguably surprising, in view of evolutionary trends in other industries. For example, Chandler (1990) showed that increasing consolidation has characterized many industries worldwide since the Second Industrial Revolution, as larger firms made investments in large-scale production, marketing and distribution networks and integrated managerial hierarchies to coordinate and control the functional activities. The industrial organization literature has identified “shakeouts,” in which many small firms exit, as a common and important phenomenon in industry evolution (e.g. Klepper and Graddy, 1990). The economic historian Rosenberg (1990) predicted such a shakeout in the biotechnology industry, arguing that because the vast majority of NBFs lack the market power and the downstream assets necessary to appropriate returns from the basic research they undertake, they will eventually be forced to exit or sell out to larger firms. Despite such predictions, however, the US biotechnology industry continues to be populated by many hundreds of small NBFs, alongside a few giant pharmaceutical, chemical, and agricultural firms.

3 This count excludes small foreign firms, since their parentage is sometimes difficult to trace in Bioscan. It appears to be more common, however, for large foreign firms to establish small R&D subsidiaries in US. This implies that backward integration may be more common among foreign firms, although not with regard to acquisitions of small US firms. Our arguments explaining the paucity of backward integration involving US firms as acquirer or target are in any case US-specific, since they are predicated on certain institutional features of US product and capital markets. 4 This fraction is probably an underestimate, since the 38 firms for which no size data was reported are likely to be small.

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Table 1 Acquisitions of NBFs in US by large pharmaceutical/chemical firms, 1979–1999a Acquirer

Target

Year

Bristol-Meyers Eli Lilly Chugai Pharmaceutical Abbot Laboratories Sandoz Perkin Elmer Monsanto Baxter International Dow Chemical Monsanto Pharmacia & Upjohn Schering AG Pudue Pharma Johnson & Johnson Medimmune Millenium Pharmaceuticals

Genetic Systems Hybritech Gen-Probe Damon Biotech Gene Therapy Inc. GenScope Calgene Somatogen Mycogen DEKALB Genetics SUGEN Diatide CoCensys Centocor US Bioscience Leukosite

1986 1986 1989 1989 1995 1997 1997 1998 1998 1998 1999 1999 1999 1999 1999 1999

a

Sources: Wall Street Journal Index, LEXUS/NEXUS, ABI/INFORM.

Any adequate explanation for this persistent fragmentation in the biotechnology industry must account for at least two noteworthy phenomena. First, it must explain the pattern of entry in this industry: why were so many of the potential R&D projects in biotechnology undertaken by small, new entrants, rather than by large firms with established and related R&D programs in pharmaceuticals, chemicals, and agribusiness, and with extensive complementary resources and capabilities (Teece, 1986)? Second, it must explain why this early fragmented industry structure has persisted and even become more marked over time. One part of this latter explanation must address the question of why the large pharmaceutical, chemical and agribusiness firms that are now involved in biotechnology research and commercialization have not backward integrated more extensively by acquiring NBFs, nor forced most of these NBFs to exit the industry by outperforming them in R&D. Table 1 shows all the acquisitions of NBFs made by large established firms that were reported in three major media sources from 1979 to 1999. The table shows that only 16 NBFs were acquired by large established firms between 1986 and 2000. Another part of the explanation for the persistence of fragmentation in the biotechnology industry must address the issue of why NBFs, especially the most successful ones, have not grown larger, either through internal growth, forward integration, or merger with other NBFs. Table 2 shows all mergers between NBFs reported in the same three major media sources. Only a very small fraction of all NBFs have been involved in such mergers. In addition, only nine NBFs had grown to over 1000 employees by 2000. 5

5 The nine are: Chiron (6400 employees) Amgen (5500), Genentech (3800), Genzyme (3500), DEKALB (2037; acquired by Monsanto), Genetics Institute (1200), Biogen (100), Genencor (1100) and Mycogen (1000).

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Table 2 Mergers/acquisitions between NBFs in US, 1979–1999a Firm 1

Firm 2

Year

Calgene Genzyme Cambridge Bioscience Genex Chiron Amgen Chiron Cell Genesys Genzyme

Plant Genetics Integrated Genetics Biotech Research Labs Enzon Cetus Synergen Viagene Somatix Therapy Pharmagenics

1989 1989 1990 1991 1991 1994 1995 1997 1997

a

Sources: Wall Street Journal Index, LEXUS/NEXUS, ABI/INFORM.

Our explanations for these phenomena focus on the condition of governance inseparability. We argue that both early direct entry by the large firms, and their later entry though backward integration, have been constrained by the difficulties associated with differentiating their internal governance arrangements. These constraints stem from prior commitments to managers of existing internal divisions of the firms. We argue that the vertical and horizontal growth of NBFs, on the other hand, has been constrained by prior constitutional contractual commitments to its early employee-owners, and by contractual agreements with large firms.

3. Explaining the pattern of entry into the biotechnology industry The first phenomenon we seek to explain is why entry into the biotechnology industry has been dominated by NBFs rather than by established firms in industries that produced products similar to those produced by biotechnology. A number of studies provide empirical evidence that the proportion of diversified incumbents or diversified entrants varies across industries (e.g. Hatfield et al., 1996). The common explanations for this phenomenon are first, that certain industries offer economies of scope that are sufficiently high to drive out specialized firms and second, that diversified firms can overcome entry barriers that exclude new, small firms. In the case of biotechnology, a number of factors would have suggested, at first blush, that this new activity would be undertaken by existing firms that were operating in related areas. Biotechnology is applicable to the “upstream” activities of R&D and manufacturing. The downstream activities needed to market and distribute biotechnology products are essentially identical to those required for established pharmaceutical, chemical, and agribusiness products. Given the existence of these downstream assets, the fact that R&D activities are typically vertically integrated with downstream activities (because of asset specificity and the possibility of leakage of valuable information between non-integrated firms), and the fact that these downstream activities are characterized by economies of scale, the expectation would be that incumbent firms would eventually integrate backwards into

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biotechnology. 6 Moreover, many biotechnology products are complementary to, rather than competitive with, the existing products of chemical and pharmaceutical firms, so concerns about product cannibalization would be minimal. 7 However, while there have been some cases of acquisitions of NBFs by large firms, these instances are remarkably infrequent, as shown in Table 1. Indeed, rather than becoming an internalized R&D and production technology in a series of established industries, commercial biotechnology research has to a significant degree been carried out by entirely new, small firms (NBFs), creating a new industry along the way. Our argument for the surprising infrequency of backward integration through internal development (or through acquisition of NBFs) rests on what we term governance differentiation constraints. Specifically, we argue that at the inception of this new technology, large incumbent firms were unable to offer the kinds of organizational arrangements that small firms could offer to attract, retain, and motivate biotechnology researchers. This was due to the incumbents’ contractual commitments to managers and workers in their established divisions. At the inception of the biotechnology industry, biotechnology research was being conducted in universities (Kenney, 1986); all the skilled researchers were faculty, students, or professional laboratory staff. As the commercial promise of biotechnology began to be recognized, the question arose as to where commercialization would take place. Certainly, the organization of the university posed its own constraints on commercialization (Argyres and Liebeskind, 1998). For one, many commercially important biotechnology discoveries in universities predated the Bayh–Dole Act of 1980, which allowed universities to claim ownership of patentable discoveries stemming from federally-funded research. Ownership of discoveries before this date was questionable, and often required a lengthy and cumbersome application process to the federal government. In addition, university research funding and professional advancement is directed towards discovery and not commercialization activities. University-based research is also subject to the norms of “open science”, making it difficult for maintaining the level of confidentiality required for commercial research. 6 Note that in the case of NBFs, Stigler’s (1951) arguments about backward integration and the industry life cycle are not directly applicable. Stigler applied his theory to industries that, when they are born, demand inputs that are producible by profit-seeking firms, but are currently unavailable on the market. Stigler’s theory assumes that key inputs required by young firms are industry-specific, since it assumes that firms that supply goods to other industries do not already produce these inputs. Since NBFs act as suppliers to the pharmaceutical and agricultural industries, this was not a case of a new industry arising that demanded new inputs, but a case of a new base of suppliers arising to serve existing industries and/or markets. Moreover, biotechnology firms often produce nothing but ideas, so their activities occur quite early (i.e. upstream) in the value-added chain of production (e.g. for pharmaceuticals or agricultural products such as foodstuffs, seeds or crop treatments). The key input required by NBFs is intellectual capital, which inheres in people as they acquire an advanced education within universities. Since neither people nor universities can be “vertically integrated” as such, backward integration and disintegration are not the key phenomena to be explained in biotechnology. Moreover, since the other inputs to NBFs are usually not industry-specific (computers, office buildings, lab equipment, etc.), independent suppliers that capture economies of scale are available to young firms from the start. Backward integration by NBFs into these other inputs is therefore unnecessary. 7 For this reason, theories of investment behavior that only assume competition between old and new technologies in explaining technology adoption by incumbents and entrants, such as Arrow (1962), Gilbert and Newbery (1982) and Reinganum (1983), are less useful for explaining the level of investment in biotechnology by large pharmaceutical firms.

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These differentiation constraints within universities impelled the activity of commercializing biotechnology research towards firms. Historically, the most talented scientific researchers have sought academic careers; careers in industry have been considered inferior alternatives. Universities offer scientists recognition for their contributions and discoveries, in the form of promotions, status, research funding, and honorific awards. In commercial firms, scientists’ discoveries are owned by the firm, and recognition is often obscured or denied by firms’ need for secrecy. University-based research careers offer researchers far more freedom of inquiry that commercial firms, where research is directed towards certain commercially oriented research programs. University scientists are also able to collaborate freely on research projects; firms often forbid or at least limit and control such collaborations to protect current or future intellectual property interests. Because of university scientists’ preferences and prejudices, any firm seeking to attract and retain highly talented university researchers would need to offer “university-like” organizational arrangements, as opposed to replicating the organizational arrangements commonly found in the R&D departments of existing pharmaceutical and chemical firms. Evidence indicates that NBFs are organized in ways that replicate university-like conditions in many different ways. For example, scientists in NBFs collaborate extensively with other scientists (Powell et al., 1996; Liebeskind et al., 1996). Scientists in NBFs also typically have significant ownership stakes and board representation (Liebeskind, 1999). Their ownership stakes accord NBF scientists substantial monetary rewards in recognition of their efforts, and also allow them some considerable degree of control over the firm’s research agenda through their board representation. Apparently, it has been relatively difficult for existing pharmaceutical and chemical firms to replicate these organizational arrangements. After a quarter of a century, NBFs continue to be founded, and the vast majority of patents and new drugs in biotechnology to date have been issued to, and developed by, these firms. We attribute this difficulty in existing firms to the fact that their ability to differentiate their organizational arrangements to accommodate biotechnology research was, and remains, constrained. Studies of internal business venturing reveal that established firms frequently fail in their efforts to establish new ventures (Hlavacek, 1974; Fast, 1978; Burgelman and Sayles, 1986). One argument for these frequent failures is that firms experience difficulty in achieving effective organizational differentiation. For new ventures to succeed, a new set of organizational arrangements will typically be desirable, because the arrangements in place of an established firm are ordinarily not well suited to innovative activity. For instance, a new venture may need to reward its employees differently because the firm’s existing arrangements would be inefficient—from an incentive point of view—for the new venture’s progress. For example, the new venture may require stock options for top managers or scientists (an arrangement pervasive among NBFs). It also may require different accounting and capital allocation rules. Why do organizations face difficulties in differentiating their internal arrangements? The explanation offered by Williamson (1985) is that corporate management cannot credibly sustain differentiated arrangements because it has the authority to change the internal organization of the firm at will. Elaborating on Williamson’s argument, Milgrom and Roberts (1988, 1990) argue that differentiation efforts fail because some internal parties in a firm will persistently seek to influence top management to favor their own interests, at the expense

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of other internal parties whose interests differ from their own. In this argument, managers and workers are understood to be “opportunistic with guile” (Williamson, 1985). Influence activity is motivated by this strong-form opportunism, and increases as the interests of the different parties diverge. Social comparison theory has similar implications: envy and self-concern will engender internal influence activity, in this case promoting the generation of standardized arrangements of performance assessment and rewards (Frank, 1985; Milgrom and Roberts, 1992; Mui, 1995). In all these arguments, corporate management is swayed by parochial interests within a firm. Our argument offers a supplementary or even alternative explanation of the failure to differentiate. We predict that influence activity will be observed predominantly when a new activity threatens a firm’s outstanding contractual commitments. To the degree that a new business venture’s governance arrangements will dilute or abrogate a firm’s commitments to its managers and/or workers, the latter will act to protect their interests by either stifling the new venture altogether, or by forcing it to conform its governance arrangements to those that govern the other activities of the firm. Corporate management will than take these potential costs into account in its internalization decision. One source of these costs lies in the commonly observed “multidivisional” form of internal organization. In these organizations, managers of different divisions are paid according to the profits generated, or value added, by that division, as well as by the global profits of the diversified firm (Williamson, 1985). Consider the local profit-sharing element of this incentive system when a new venture division conducts internal transactions of goods or services with other divisions. In this case, the measured profit or value added of each division, and therefore the rewards will depend, inter alia, on the firm’s transfer pricing policies for inputs and outputs of that division (Williamson, 1975). Hence, any change in this policy will constitute a change in the reward contract of division managers, and will be opposed by existing division managers. Thus, a new division must be able to conform efficiently to existing transfer pricing policies, if it is not to bear excess transaction costs, because the firm cannot differentiate its transfer pricing arrangements at low cost. 8 Now consider the global profit-sharing element of business managers’ rewards. Again, the implication is that a new division will be opposed, if it threatens to undermine existing reward schemes. For instance, the new division may increase the bankruptcy risk of the firm because it has higher cash flow variance than existing businesses, or it may be associated with tort liabilities that decrease the value of managers’ outstanding claims on the firm’s cash flows (Bethel and Liebeskind, 1998). In these instances, governance inseparability arises because outstanding contractual commitments are secured on a specific set of transactions, so that changes in the character of these transactions will change the value of the contract to certain parties. As a result of these considerations, contractual commitments can be understood to operate as one form of entry barrier for specific types of entrants. Note that our explanation here emphasizes the multilateral aspect of the transactions between top management, venture management, management of established divisions, and 8 Empirical evidence indicates that most multidivisional firms have standardized transfer pricing policies (Eccles, 1985; Poppo, 1995), even though standardization, in theory, would impose excess transaction costs.

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investors. 9 By contrast, Williamson’s (1985) argument focuses on the bilateral transaction between top management and venture management. Moreover, in our explanation, internal parties are self-interested only to the degree that they are not prepared to relinquish the terms and conditions of agreements made in prior periods. Concomitantly, if their interests are not so threatened, we would predict that organizational differentiation will not be opposed. Thus, our arguments contemplate a somewhat weaker form of opportunism than Milgrom and Roberts (1988, 1990) and do not involve pure envy as per Mui (1995). 10 There are some ways in which corporate management can moderate the negative influence of a new business on its outstanding contractual commitments. For instance, in the example given above, top management can change the basis on which profit is calculated for the purpose of performance assessment in the existing business. However, this adjustment may dilute the incentives of line managers and workers, so that additional organization costs will be incurred either way. Corporate management can also create a new legal entity for conducting the new business, so that the profit streams of the existing and new businesses are separated rather than pooled. However, there are instances in which separation is not economically feasible, either because new ventures are intended to exploit economies of scope, and/or it is not incentive-compatible for top management who ultimately determine the firm’s organizational form (Bethel and Liebeskind, 1998). In cases such as these, where organizational differentiation is costly, internal venturing activity may be choked off. In other instances, the new business may be internalized, but it will bear excess transaction costs, relative to being organized in a firm where locally first-best organizational arrangements could be put in place. The difficulties existing firms face in differentiating their governance arrangements— which results in constraints on adding new types of activity—can have far-reaching effects on competition and on industry evolution. In particular, when new business opportunities arise and incumbent firms cannot efficiently accommodate these new opportunities within their organizations, a new population of firms will emerge. We would argue that the evolution of the biotechnology industry itself is an example of this phenomenon.

4. Explaining the persistence of fragmentation in the biotechnology industry A second phenomenon that must be explained is the persistent fragmentation of the biotechnology industry. On the one hand, there have been very few takeovers of NBFs by established firms, as shown in Table 1. On the other hand, few NBFs have expanded 9 This explanation is thus close to Dixit’s (1996) treatment of the “common agency” problem. He models bureaucracy as an agent serving multiple principals whose interests conflict. He shows that when the principals each design high-powered incentive schemes for the agent, but in an uncoordinated way, the agent ends up facing low-powered incentives overall. This is effectively the condition of undifferentiated governance to which we refer. 10 This weaker form of opportunism may have been at work in the recent merger between Daimler Benz and Chrysler Corp. It was reported that top management at each firm initially committed to merge the engineering groups of the firms on an equal basis. When Daimler engineers were given more authority, Chrysler engineers objected strongly. Daimler–Chrysler responded by reverting to separate organization of the two groups (Meredith, 1999). This may be an instance where enforcement of prior commitments by internal parties constrained the choice of internal governance arrangements.

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significantly as shown in Fig. 1. Again, we explain these phenomena in terms of governance inseparability considerations. 4.1. Constraints on established firms’ acquisition of NBFs Even though established firms in the pharmaceutical, chemical and agribusiness industries may not have been able to differentiate their organizational arrangements sufficiently to enter biotechnology at the early stages of the industry, one might have expected these constraints to become relaxed over time. For example, the supply of capable scientists has increased, and the stigma of commercial research may have declined as both major scientific discoveries and personal fortunes have been made by scientists working in the industry (Rabinow, 1996). Nonetheless, new entry by newly-founded NBFs continues, and very few acquisitions have taken place, indicating that incumbent firms face persistent constraints on their ability to differentiate their organizational arrangements. The case of Genentech’s acquisition by Roche provides some detailed insights into the kinds of constraints operating on an established firm seeking to acquire an NBF. Genentech was the first biotechnology firm to successfully develop and commercialize a biotechnology drug. The firm grew rapidly during the 1980s. In 1990, Roche acquired a 60% equity stake in Genentech for US$ 2.1 billion. However, by taking only two seats on Genentech’s 13-member Board of Directors, Roche prevented itself from exercising a controlling interest. This arrangement preserved the ability of Genentech’s scientists to retain control of the firm’s research agenda and its internal organizational arrangements, and protected them against strategic interference by Roche (Hellmann, 1998). Despite these provisions to preserve scientific and managerial autonomy, the entire protein chemistry group left Genentech to form a new firm after the stock purchase was announced. One reason for their departure may have been that the deal between Roche and Genetech effectively capped the price of Genentech’s stock: it allowed Roche to increase its holdings in Genentech up to 100% within 5 years. Although the share price in this agreement was increasing steeply, it was nonetheless estimated to be significantly below the price the shares would have commanded, had the Roche agreement not been in place. Thus, the Roche agreement reduced the value of any stock options held by Genentech scientists at the time the partial takeover was announced. Other important scientists also left the firm during this period. Partly in response to this problem of retaining key personnel, Roche decided not to exercise its right to acquire the remaining stock in 1995, but instead agreed to a 4-year extension of its option. In reporting the reasons for the delay, the Wall Street Journal (1995; p. B2) reported the following: “Yesterday, both Roche and Genentech asserted that Roche had determined it didn’t want to exercise the option because of concerns about what impact a complete takeover would have on Genentech’s free-wheeling, independent culture, and on its ability to retain top scientists with stock options. Roche isn’t known for being as generous with stock options and incentives as Genentech, where many young scientists have become millionaires as a result of such programs.” [Emphasis added.] Roche finally decided to exercise its option to acquire the remainder of Genetech’s shares just before it was set to expire in 1999. However, this purchase was accompanied by what the

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Wall Street Journal described as an “unusual” arrangement, under which Roche proposed to immediately re-issue between 10 and 19% of Genentech stock in a public offering. This arrangement would allow Genentech to “offer meaningful financial incentives to employees with its performance reflected in a publicly traded stock” (Wall Street Journal, 1999; p. A3). Roche also announced that Genentech’s management would continue to have operational autonomy. Roche clearly trod very carefully with regard to controlling Genentech, seeking to avoid the loss of both managerial autonomy and financial rewards that might have accompanied a complete takeover. To this day, Genentech is only partially owned by Roche. Nonetheless, there has been a significant loss of scientific personnel from the firm in the past decade. Similar concerns were reported to have been operating in a deal in 1994, in which Ciba-Geigy, a large drug company, stopped short of taking control of Chiron, a successful NBF, by limiting its equity purchase to a 49.9% stake. Ciba-Giegy’s CEO at the time, Heini Lippuner, was quoted as saying that “taking control from the beginning and directing operations would have defeated the purpose. We want Chiron to continue to be independent and creative” (Wall Street Journal, 1994; p. B5). 4.2. Constraints on the growth of NBFs A second factor that explains the persistent fragmented structure of the biotechnology industry is lack of growth among NBFs (see Table 2). These firms could expand by inward investment in new R&D projects (horizontal expansion), by horizontal merger with other NBFs, or by forward integration through internal investment in downstream product development, marketing, distribution, etc. We offer two explanations for this limited expansion in terms of governance inseparability. First, we argue that NBFs are constrained by prior commitments to scientists who joined the firm at its inception: what can be termed “constitutional commitments”. Second, we argue that early commitments to large firms in the form of strategic alliances have served as constraints on later expansion. 4.2.1. Constitutional commitments as constraints on growth An NBF is typically founded by a group of scientists, sometimes together with a manager and/or venture capitalist. The purpose of these new firms is to pursue a commercially motivated research agenda. The founding scientists typically own a substantial portion of the firm’s equity in the form of direct share ownership and share options (Liebeskind, 1999). These ownership stakes provide high-powered incentives for scientists to vest their human capital in the firm, and option structures with long vesting horizons and non-transferability provisions serve as “golden handcuffs” that can help tie scientists to a specific firm for a period of time sufficient to allow their basic research ideas to be transformed into intellectual property in the form of patents. Founding scientists are also typically members of the board of directors. This combination of share ownership and representation can be considered to be a “constitutional” commitment—affecting in the most basic way how an NBF is organized and controlled. If an NBF expands its equity base in order to raise new capital, these constitutional commitments may be abrogated and their incentive effects thereby attenuated. First, the incentive effects of share ownership of residual claims will be diluted by free rider effects (Grossman and Hart, 1986; Zenger, 1994). Second, expansion of the

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equity base may result in new outside blockholders such as venture capitalists or corporations whose voting power may be used to oppose scientists’ long-run economic interests through, for example, strategic interference (Hellmann, 1998). This will not always be the case: certain levels of new equity will be incentive-compatible, if they provide for wealth gains to scientists that are sufficient to offset the wealth effects of dilution of control. Nonetheless, as an NBF expands, individual scientists’ incentives may be weakened. Given that valuable knowledge in biotechnology resides in the heads of only a handful of individuals, this may have a significant impact on an NBFs competitive capability. By remaining small in size, an NBF may be better able to sustain an incentive structure that secures the interests of its critical employees. 4.2.2. Long term contracts as constraints on growth Because NBFs are not forward integrated at their inception, and because they are typically capital-constrained, young NBFs frequently enter into long-term contracts (or “strategic alliances”) with large established firms. In such alliances, an NBF typically receives research funding for developing a specific product in exchange for supplying knowhow in the form of patents or product licenses to the incumbent firm, which undertakes to develop, test, market and distribute the product. For our argument, we are particularly interested in the contractual terms that specify the breadth and strength of the ownership rights to intellectual property that are allocated to the large firm in these alliances. For instance, some contracts call for the NBF to carry out research to discover a new drug useful to combating a particular disease. This research may yield a number of valuable ideas, some of which may turn out to have applications to other disease classes. Unanticipated discoveries are of course very common in basic research. It is therefore impossible to write a “complete contract” that clearly specifies the allocation of ownership rights ex ante (Grossman and Hart, 1986). Hence, firms must rely on incomplete contracts that specify quite general “rights of control” to the intellectual property produced by the NBF. The question is, to how many of the discoveries does the large firm have ownership (or control) rights in an R&D contract, and how strongly protected are these rights? Two factors may increase the bargaining power of the large firm in these situations. First, the NBF may be quite desperate for capital to fund its research, especially in view of the high degree of uncertainty surrounding the future value of its research projects. Second, the large firm may have much deeper pockets than the small firm to finance litigation to assert its ownership over intellectual property rights (Lanjouw and Lerner, 1996). For both these reasons, an NBF may relinquish more intellectual property to a large alliance partner early in its history than would a firm that is less capital-constrained. This conjecture is supported by Lerner and Merges (1998), who find that capital-constrained small firms cede more control rights in contracts with large firms than small firms that are more financially secure. Again, such contractual provisions may constrain the direction and rate of firm growth. For instance, a capital-constrained NBF will face reduced incentives to invest in new R&D projects that are closely related to its outstanding contract research, since the results of these projects are more likely to be claimed by the large firm as its property. And even if the large firm promises not to make such claims, in order to see further research carried out, it cannot credibly commit not to enforce its contracted rights. Hence, an NBF that

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formed a strategic alliance when it was capital-constrained can be expected to develop a less diversified portfolio of R&D programs than a firm that was either not capital-constrained, or one that has no outstanding contracts allocating intellectual capital to other parties. This of course puts the firm that was capital-constrained at its inception at a competitive disadvantage for some time, relative to rivals that can exploit economies of scope in R&D in an unencumbered fashion. Furthermore, if the NBF was highly capital-constrained, or has a non-extensible knowledge base, its growth may be stalled altogether, because it cannot fund or find any promising new avenues of research that would not be subject to an ownership claim by an alliance partner. Indeed, industry observers have noted that the fact that NBFs often give up rights to sell products they develop has served to discourage investors other than alliance partners, which tightens NBFs’ capital constraints even further (Pollack, 1998). These kinds of constraints on growth will also tend to limit the vertical scope of NBFs. Without new R&D projects, the small firm cannot develop enough output volume to cover the high fixed costs of downstream activities. This in turn removes the incentive for these firms to pursue forward integration. Thus, we can conjecture that NBFs founded when capital markets were relatively illiquid are less likely to expand their product lines and forward integrate in later periods than firms that were originally founded under more favorable capital market conditions.

5. Implications for transaction cost economics Using the evolution of the biotechnology industry as an exemplar, we have argued that explaining which type of organization, or which particular organization, will undertake a given transaction often requires understanding the set of prior and contemporaneous commitments various candidate organizations have made. This is because firms with different constellations of commitments face different governance choice constraints when organizing new activities at the margin. These differences in governance choice constraints will then result in greater or lesser organizational costs for a new transaction, depending on the degree to which the constraints are binding on the comparatively efficient organization for this new transaction. If the constraints are not binding, then the new transaction can be internalized within an existing firm without incurring excess organizational cost. If the constraints are binding, however, then ceteris paribus the cost of organizing the new transaction will be lower in a new firm, which can be designed around its specific governance requirements, than in an existing firm, where such differentiation may not be achieved, or can be achieved only at the relatively high cost of abrogating prior commitments. We understand the development of NBFs in this latter context. As an organizational form, the NBF was able to provide comparatively efficient organizational arrangements for conducting commercial R&D using scientists who had previously worked for universities, and whose organizational requirements could not be accommodated by existing firms. As a population of firms, NBFs themselves have proliferated because the growth of individual NBFs is limited over time by ownership and governance commitments made early in their development to founding scientists whose expertise continues to be critical to the firm over time. Incorporating considerations of governance inseparability into TCE may allow more precise predictions to be made regarding governance choice. For instance, a number of pre-

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vious transaction cost analyses of the biotechnology industry have focused on explaining the structure of alliance contracts between NBFs and large firms. As an example, Pisano (1989) found that alliances that involve equity investments by an established firm in an NBF are more likely to be used when the good being transacted is R&D output. He argued that returns from R&D investments in biotechnology are difficult to appropriate due to weak property rights protections offered by the legal system, and that these transactions therefore required safeguards to protect against opportunistic appropriations of R&D returns. Equity investments by the large firm, he further argues, serve as bonds against such opportunistic appropriation. 11 Pisano (1989) found empirical support for this argument in data on biotechnology alliances. Gulati (1995) and Oxley (1997) also found empirical support for it in cross-sectional studies of alliances. Recognizing the role of governance inseparability can improve the predictive power and range of this kind of approach for studying the structure of alliance contracts. For example, some NBFs may be more highly constrained than others in the terms they can offer a new partner. NBFs which, for example, ceded very broad property rights over their R&D outputs to a large firm early in their histories, when their bargaining power was low, may be able to offer fewer and narrower rights over new R&D output than NBFs that were able to retain more rights for themselves in their early R&D alliances. Thus, taking prior commitments into account can help predict the allocation of rights in alliance contracts of this kind, and can thereby add to understanding of the entire alliance contract structure. And of course, governance inseparability considerations can also help explain why the problem of safeguarding R&D investments in biotechnology has only rarely been solved by backward integration, rather than alliance contract, as the case of Roche’s acquisition of Genentech so amply illustrates. Taking prior commitments into account in a transaction cost analysis of this kind is not possible if the unit of analysis is defined ex ante to be the transaction that is governed by the alliance contract. To test whether governance inseparability constraints are operating, an entire stream of transactions must be analyzed. Williamson (1985; p. 393) recognized that these interactions can be important when he noted that TCE “. . . normally examines each trading nexus separately. Albeit useful for displaying core features of each contract, interdependencies among a series of contracts may be missed or undervalued as a consequence. Greater attention to the multilateral ramifications of contract is sometimes needed”. The concept of governance inseparability we have presented in this paper derives centrally from firms’ contractual commitments made in earlier periods. Without such commitments, 11 There are several reasons to doubt the explanation in Pisano (1989) on its own merits, at least as applied to biotechnology alliances. First, equity investments are not neutral: they increase the likelihood that that investing firm will strategically interfere in the affairs of the biotechnology firm (Hellmann, 1998). Hence, such investments may exacerbate rather than moderate the relative bargaining power of the large firm. Second, these equity investments tend to be small in size, because NBFs firms have relatively small market capitalizations. Thus, the market value of Merck, a major pharmaceutical firm, in 1997 exceeded the total market value of the entire population of US NBFs (Fortune, 1997). It would therefore be difficult for a large pharmaceutical firm to post a credible bond in an NBF. Finally, a recent, more comprehensive analysis of biotechnology alliances by Han (2001) finds very few examples of the use of equity in those involving R&D.

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there would be no constraints on their governance choice in subsequent periods. We have argued that in the biotechnology industry, both the entry of large incumbent firms, and the growth of early-founded NBFs, has been constrained by prior commitments. One question that can be raised in regard to our analysis is this: why would firms not simply avoid commitments that might constrain them in the future? One answer to this question is that firms may not be able to foresee all the possible future events that could cause current commitments to impose costs on them in future periods. In particular, firms may be faced with deep uncertainty, or what Savage (1954) calls “second order uncertainty”, 12 at the time that they make their early governance choices. 13 It is of course recognized within TCE that foresight may be limited: the assumption of bounded rationality implies that not all future contingencies affecting a contractual relationship can be foreseen (Williamson, 1985). But while TCE assumes that actors are unable to foresee all contingencies from the point of view of drawing up complete contracts, the theory also assumes that actors are able to foresee threats to their specific investments and hence, make optimal governance choices. As Williamson (1996; p. 9) notes, TCE “. . . concedes that comprehensive contracting is not a feasible option (by reason of bounded rationality), yet it maintains that many economic agents have the capacities both to learn and to look ahead, perceive hazards, and factor these back into the contractual relation, thereafter to devise responsive institutions. . . ” We would argue that, under conditions of second order uncertainty, it may be difficult for actors to “look ahead. . . and devise responsive institutions”, especially in terms of avoiding commitments that subsequently expose transactors to constraints on governance choice. 14 Regardless of the level of uncertainty, some early commitments that later engender governance inseparability may be unavoidable because of the bargaining power of other parties. For example, a firm may rely on exceptionally talented individuals to conduct its business. If these individuals are in short supply, they will use their bargaining power to obtain the best terms and conditions of employment at the time. Thus, a high-scoring baseball player, a talented musician, or a highly trained biotechnology scientist may demand a long-term contract for his or her services. Firms in these businesses must meet these demands, or exit. Moreover if, as part of the initial contractual arrangement, talented individuals or other contractual partners are also awarded rights to affect key decisions of the firm, they may use these rights to block changes in governance or changes in the firm’s strategies that might harm their interests. In this way, long-term commitments caused by bargaining power advantages at time t1 may be carried over to time t2 , even if market conditions have changed to the detriment of the formerly powerful party. 12 Second order uncertainty is similar to Knight’s (1921) treatment of uncertainty, as distinct from risk: “. . . in [risk] the distribution of the outcome in a group of instances is known (either through calculation a priori or from statistics of past experience), while in the case of uncertainty this is not true, the reason being that it is impossible to form a group of past instances, because the situation dealt with is in a high degree unique” (p. 233). 13 This emphasis on uncertainty implies that, while prior commitments generate path dependency, the inefficiencies that arise are irremediable (Williamson, 1996). 14 Note that the adaptive features of firms (Williamson, 1979) apply only when uncertainty calls for adjustment of transactions and conditions of trade, as opposed to switching or differentiation of governance modes themselves.

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Ex ante bargaining power is not a feature of the established TCE argument. Typically, it is assumed that factor and product markets are contestable ex ante, so that firms are under competitive pressure to economize on their transaction costs. Moreover, firms are generally assumed to be free to choose those governance arrangements that they believe will minimize their transaction costs. Bargaining power threaten to emerge only ex post, when commitments to specific assets have been made, and it is the potential for this ex post bargaining power that determines efficient governance arrangements in the presence of incomplete contracts (Klein et al., 1978; Williamson, 1979; Grossman and Hart, 1986; Hart and Moore, 1990). However, there are arguably many instances where parties to transactions have ex ante bargaining power, and that bargaining power can be an important force in engendering commitments that in turn engenders governance inseparability. This appears to have been the case with respect to NBFs’ lack of bargaining power in negotiating R&D agreements early in their histories, as indicated by Lerner and Merges’ (1998) analysis, discussed above. Bargaining power may also arise ex post, but in an unanticipated fashion that would also obligate a firm to enter into otherwise unwanted contractual commitments. For instance, a firm may hire a group of workers who later organize themselves into a union and obtain long-term employment contracts. Or, a firm may grant a series of franchises to independent franchisees who later organize themselves into a franchisee bargaining organization that is powerful enough to foreclose any possibility of the franchisor adjusting franchise contracts as circumstances change. Even absent bargaining power, early commitments may be unavoidable. For example, Sutton (1991) considers situations where firms make early sunk-cost investments in R&D, advertising or manufacturing capacity, thereby raising entry barriers into an industry, and generating above-normal profits. In some cases, these sunk-cost investments will involve contractual commitments. For instance, a pharmaceutical firm that seeks to preempt rivals by investing heavily in R&D may need to make long-term contracts with scientists. Similarly, large-scale sunk-cost investment in specialized manufacturing capacity may not be efficient unless a firm also makes long-term contractual commitments to employees that motivate them to invest in firm-specific skills (Williamson, 1991). In sum, entering into unavoidable commitments early in the life of a firm due to lack of foresight, or because commitments are unavoidable, may result in a situation where that firm is constrained in its governance choices for subsequent transactions. These constraints may preclude the firm from becoming a party to some transactions that it would otherwise be interested in entering into. Hence, consideration of governance inseparability augments the governance calculus from the basic market-hybrid-hierarchy choice set of established TCE theory to a one that can also account for differences among hierarchies (and, by implication, among hybrids and markets as well). From the point of view of industry structure, the phenomenon of governance inseparability can affect both the character of entrants, and the growth, scale, and scope of incumbent firms. In the biotechnology industry, we have argued that governance inseparability has led to an industry structure that comprises a large population of NBFs that entered the industry early, and continue to enter, and a few large later-entering established firms. Transactions between these hierarchies are then governed by hybrid arrangements such as long-term contracts, joint ventures, and licensing. Were established firms not subject to governance

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inseparability constraints, we might have observed an entirely different “industry” emerging, one in which biotechnology was absorbed into the R&D activities of existing pharmaceutical, chemical and agribusiness firms, and few new firms were established. Which one of these two alternative structures eventually arose depended, we would argue, on their relative costs of organization. On the one hand, the current industry structure bears the costs of fragmentation, particularly in terms of governing transactions of knowledge through hybrid arrangements, which may be costly, relative to governing those transactions through a hierarchy (Teece, 1986). On the other hand, the current structure avoids the excess costs of organization within existing hierarchies that are subject to constraints on differentiation. In the case of the biotechnology industry, NBFs have evolved, we argue, to bypass the governance constraints in existing firms. In other industries, however, the evolution of new firms may be prevented by the existence of non-governance-related entry barriers such as learning curve effects (Spence, 1981; Lieberman, 1984), scale effects (Ghemawat, 1987), or to uncontestable market positions deriving from sunk-cost investments in plant, advertising, or R&D (Dixit, 1980; Schmalensee, 1983; Sutton, 1991), customer switching costs, or network externalities. In instances such as these, governance inseparability might well result in the adoption and perpetuation of second-best governance arrangements. Hence, the relationship between governance inseparability and industry structure is recursive: not only may governance inseparability influence the organization of economic activity in an industry, but the microeconomic structure of activity in an industry may also affect the degree to which governance inseparability constraints are binding on firms. In a perfectly competitive world, firms that can enter into certain transactions only by governing them with second-best governance arrangements (due to governance inseparability) would be displaced by other firms which, lacking historical constraints, would be able to put first-best arrangements in place and reduce their costs. If competition is attenuated, however, this displacement may not take place. Still, it is perfectly consistent with our arguments to take the view that any inefficiency in governance under circumstances such as these is unavoidable and irremediable. The organization of economic activity would then be considered inefficient in a limited sense only (Leibowitz and Margolis, 1995; Williamson, 1996).

6. Conclusion This paper has sought to explain the extreme and persistent fragmentation of the organization of economic activity in the biotechnology industry by analyzing the historical constraints on governance choices faced by both potential entrants and by incumbent firms. Thus, our analysis has sought to answer in some part Coase’s (1937) question of why all production is not carried out by “one big firm”. Specifically, we have argued that economic activity in the biotechnology industry—and by implication, in the economy at large—is spread among numerous firms because, as new economic activities emerge, and as the conditions governing transactions change, existing firms are unable to govern transactions as efficiently as new firms. This is because existing firms face constraints in differentiating their governance arrangements to suit the requirements of transactions with different

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characteristics, and in switching governance modes for the same kind of transaction as its underlying characteristics change. Future research should continue to develop the conceptualization of governance inseparability and its underlying sources, and the conditions under which it has more or less important effects on industry evolution. One difficulty with the concept of governance inseparability, however, is that its effects, and the precise routes through which these effects are transmitted, are likely to be specific to particular industries, firms and/or historical periods. This makes it difficult to develop highly generalized hypotheses that could be tested on a cross-section of industries (nevertheless, see Argyres and Liebeskind (1999) for examples). Game-theoretic models in industrial organization, it has been argued, suffer a similar disability (see, e.g. Shapiro, 1989; Sutton, 1991). In view of this, historical or other kinds of longitudinal industry and company studies would seem to be a particularly appropriate empirical approach for studying governance inseparability. In addition, it would be useful to extend analysis of the effects of governance inseparability to markets and hybrid arrangements. For example, the governance terms that are part of a firm’s long-term contract with one buyer may constrain the choice of governance terms for the firm’s long-term contracts with other buyers. Much of the game-theoretic literature in industrial organization treats contractual commitments as mechanisms through which firms can earn rents by pre-empting competitors, controlling entry, signaling quality, etc. In this paper, by contrast, we have emphasized the constraints imposed by governance inseparability purely as costs to a firm, costs that may or may not be offset by compensating rents. Future research should also investigate how these costs interact with the strategic benefits of contractual arrangements over time in the presence of governance inseparability. For example, to the extent that governance inseparability serves to perpetuate contractual arrangements that deter entry, or that exclude rivals from access to specialized inputs or production processes, the condition may result in a net strategic benefit to a first mover. This net benefit may eventually disappear, however, with difficult-to-anticipate changes in the economic environment. The way in which industry dynamics are affected by contractual commitments is a question ripe for future research.

Acknowledgements We thank Oliver Williamson for comments on an earlier paper that discussed some of the ideas in the current paper. We also thank Joanne Oxley, and seminar audiences at the Anderson School at UCLA, The Wharton School at the University of Pennsylvania, Harvard Business School and the Western Economic Association for helpful comments on earlier versions.

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