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Growing importance of marketing strategies for the software industry
Growing Importance of Marketing Strategies for the Software Industry P. M. Rao Joseph A. Klein The paper examines the appropriability problem (i.e., the inability of$rms to pro$tfillyfiom their innovations) with respect to investments in intellectual property development in general and software in particular; evaluates marketing, legal, and technological dimensions of the appropriability issue in the global so&are industry; and concludes that increasinglyjrms will supplement legal mechanisms with investments in complementary marketing assets and development of marketing strategies aimed at strategic alliances and divers&ation into related services in order to enhance the appropriability of thefiits of their investments in sofrware development.
INTRODUCTION With the rapid growth of knowledge-based industries, the management of intellectual property, of which software is a part, is becoming an important activity for many firms and central for the software firms. Software is emerging
Address correspondence to Long Island University, C.W. The views expressed in this necessarily reflect the opinions
P.M. Rao, College of Management, Both Hall, Pbst Campus, Brookville, New York 11548. paper are solely those of the authors and do not or policies of Bell Communication Research, Inc.
Industrial Marketing Management 23, 29-37 (1994) Q Elsevier Science Inc., 1994 655 Avenue of the Americas, New York, NY 10010
as a significant global industry in recent years. According to one estimate, the worldwide market for software and related services was about $110 billion at the end of 198Os, with a commanding 57 % held by U.S. companies [l] . More important, software has become the driving force behind productivity gains in numerous manufacturing as well as service industries. It is also the source of many marketing innovations in such diverse industries as telecommunications, banking, and airlines. The purpose of this paper is to discuss the growing need for marketing strategies in the emerging global software industry. Specifically, the paper examines the legal, technological, and marketing dimensions of intellectual property and their implications for the importance of marketing strategies in the software industry. Although the term intellectual property can be defined to include a wide range of intangible “assets” described in such terms as knowledge base and know-how, our definition is grounded in investments in technology and property rights. Thus, for purposes of this paper, the term intellectual property refers to all technology-based intangible assets of a firm-an idea or a design for a new product or a process, a computer software package, and the like29 0019-8501/94/$7.00
Computer software, as intellectual property, must be protected within the current legal framework. that may be protected as a property right under the legal framework that includes patents, copyrights, or trade secrets. The term software refers both to the instructions that direct the operation of computer equipment and information content and to data that computers manipulate. There are two general types of software: applications software, whose purpose is to solve computer users’ own problems (e.g., word processing and spreadsheet programs), and systems sojlwure, which is used to manage the components of a computer system (e.g., operating systems, which control the hardware and compilers, and interpreters, which translate programs into a form that can be executed by a computer). Systems integration, which is sometimes referred to as integrated software systems, combines standard hardware with custom software or modified standard software packages in a unique configuration tailor-made to end users’ requirements [2-41.
APPROPRIABILITY
PROBLEM
It has long been established in the economic and business literature that the “market” for intellectual property suffers from certain unique problems that are not present in markets for other goods and services [5-81. These problems are often referred to as problems of market failure. That is, competitive markets underinvest in the production of intellectual property, which is essential to the international competitiveness of a nation and its economic well
I? M. RAO is Associate Professor of Marketing at the College of Management, Long Island University/C. W. Post Campus, Brookville, New York. JOSEPH A. KLEIN is Assistant Vice President and General Attorney at Bell Communications Research, Inc., Livingston, New Jersey.
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being. Chief among the sources of market failure is the problem of appropriability, the conceptual issue around which implications for marketing strategies are discussed in this paper. The problem of appropriability arises because firms operating in a competitive market structure are unable to internalize or appropriate the full economic benefits of their investment in the development of intellectual property. This is because intellectual property, which is often expensive to produce, can be copied by competitors and end users alike often at little or no cost to them. KEY DIMENSIONS
OF APPROPRIABILITY
Profit maximizing firms rely on a variety of protective instruments to enhance appropriability of their intellectual property development. Broadly speaking, these protective instruments fall into three major categories or dimensions: legal, technological, and marketing. Of these three, technological and marketing dimensions affect appropriability as well as being affected by it. Each of these dimensions, which are very broadly and roughly organized around the conceptual framework developed by Teece and Winter [9, lo], are discussed below: Legal Dimension In the United States the legal framework for protecting intellectual property consists of five regimes: patents, copyrights, semiconductor protection, trademarks, trade secrets, and misappropriation. Although the Semiconductor Chip Act of 1984 is sometimes referred to as a separate legal regime, it is closer to the copyright regime designed to reflect the particular needs of the semiconductor industry [l, 111. PATENTSANDCOPYRIGHTS. Both have a foundation in the U.S. Constitution (Article 1, Section 8 of the U.S. Constitution) and in various federal statutes (including Patent Act and Copyright Act) and therefore constitute the highest form of protection, at least from a legal standpoint.
SECRETS. Unlike patents and copyrights, there are no federally created rights in trademarks. However, the federal framework (Lanham Act) does provide a system of registration and enforcement. Regardless of the degree of legal protection accorded to trademark, its significance to the appropriability issue is in its use as a major marketing tool. The same point applies to a trade secret although to a far lesser extent, and it represents an entirely different kind of marketing tool from trademark. Protection of trade secrets is grounded entirely in state law and the scope of protection varies among states. TRADEMARKS
AND
TRADE
MISAPPROPRIATION.This regime refers to a legal doctrine adopted by courts, under a general rule of unfair competition, to protect against taking of information of commercial value, but outside the reach of laws governing intellectual property. While a full evaluation of the degree of protection offered by each regime is beyond the scope of this paper, as our discussion of the software industry shows, even the most uniform and perhaps the strongest of legal regimes-patents and copyrights-is inadequate in overcoming the appropriability problem. There is substantial evidence that suggests that “inventing around” patents is common [lo, 121. Legal Protection
of Software
Computer software, including computer program design, code, and documentation to achieve specified functions implementable by computer hardware, constitutes a form of intellectual property that has been protected to a degree by one or more legal mechanisms embodied in patent, copyright, and trade secret law. Each form of protection has advantages and disadvantages. Patents, when applicable, provide the most comprehensive protection against appropriation by others. They protect against infringement of nonobvious ideas reduced to practice, not just a particular expression of that idea, and independent creation is not a defense to an infringement suit as it would be for copyrights or trade secrets. However, a software algorithm in and of itself is not patentable; the software must fall under the statutory subject matter applicable to method and apparatus or process. The patent application procedures are also very time consuming and expensive and require substantial disclosure that could undermine trade secret protection. Computer programs may also not be patentable in other countries and therefore not protected under their patent laws. For these reasons, although an increasing number of software patents have been issued by the U.S. Patent Office in the last de-
cade, reliance on copyright protection for software programs is more prevalent. Copyright protection is often used for software (by analogy to protection of literary works), but it only applies to particular expression- not the underlying idea-and cannot be used to bar an independently developed system performing the same functions. The law is also permitting some degree of copying, as discussed below, which may dilute the scope and practical value of copyright protection. Trade secret law can protect information that has an economic value conferring competitive advantage and is not generally known and treated by its owner as a secret. It is less useful for widely distributed systems and difficult in any case to police. Impact of Changing Technology and Customer Demands The effectiveness of intellectual property protection for software is also being impacted by converging developments in software technology and customer demands. Our discussion focuses on four key developments: 1. DEVELOPMENTOF INDUSTRYSTANDARDS-BASED OPEN OPERATINGSYSTEMS. Technology enables-and sophisticated customers increasingly expect- the development of more open operating systems that permit portability of specific customer applications from one computing environment to another. Customers want the flexibility to “mix and match” hardware and software from different vendors to build systems from components that they choose based on desired cost and features. As networking among distributed personal computers, desk top work stations and even nomadic hand-held units replace stand-alone mainframe computers, market pressure is toward more open system-to-system and user interfaces. This is seen in the increasing popularity of the relatively open UNIX operating system and in such industry consortiums as the Open Software Foundation that strive to develop “vendor-neutral” standards to enable software and hardware from different sources to talk to each other [l]. This trend is at odds with the incentives of large mainframe computer companies, albeit in a passing era, to keep customers bound to a single proprietary system of vendor-specific hardware and compatible software. 2. CUSKJMERDEMANDFOR GREATERCONTROL OF SOFTWARE. Customers want-and are increasingly obtaining more control over how they can use the software they are acquiring. Technology and customer demand are converging toward products that enable customers to easily create, 31
Legal forms of intellectual property protection have reduced usefulness. manipulate, customers can then use freely for their own financial benefit. For example, heavy users of multiple commuservices today are faced with many Local Area Network (LAN), Systems Network Architecture electronic mail, and videoconferencing networks. disparate networks will not only provide a virtual meeting space with all the computer support but also give the user greater control over the use of network resources, EMERGENCE OF“FACTORY” APPROACH TOSOETWARE DE-
VELOPMENT. The software development process itself is undergoing massive change. Historically, software has literally been developed one line of code at a time- a slow, laborious process. Customizable systems will increasingly be composed from common reusable segments of code that perform some overall function, made possible by such technologies as object-oriented programming and inexpensive computer hardware. This modularization or the “factory” approach reduces the labor intensity of software development by eliminating unnecessary redundancy in writing the same code that can be used again and again as a common portion of diverse application systems [13]. It also supports the development, discussed above, of common interfaces among systems from multiple vendors and the system easeof-use that supports customer control of applications. 4. SHORTENINGOF PRODUCTLIFE CYCLE FORSOFTWARE. With rapid technical change and a competitive market, the product life cycle for software has been shortening. Reducing the time to market a product and increasing comparative customer value are becoming crucial to achieving a competitive edge before a product’s features become obsolete. The transactional costs and delays associated with obtaining some forms of intellectual property protection (e.g., the patent application process or protracted software license negotiations over confidentiality provisions) before a product is marketed may result in losing the market to another product. Indeed, the burdensome nature of intellectual prop-
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erty restrictions imposed by one vendor on customer use of its product may be a factor leading customers to choose a less encumbered product from a flexible vendor. In light of the above trends, legal forms of intellectual property protection may not be as relevant or useful in the future in fully protecting the value of a software developer’s investment. Changing
Scope of Copyright
Protection
REVERSEENGINEERING. Copyright protection, although clearly precluding the copying of the literal expression of software code, does not necessarily preclude one from reverse engineering another’s object code (i.e., converting such computer machine-readable code into human-readable language) to figure out how the underlying software functions were designed and put together-a job that will presumably be made technically easier by the modularization of software development discussed above. Under the European Community Software Copyright Directive to which the copyright laws of the member states must be harmonized, a person is explicitly free to reproduce or translate the form of another’s program code for the specific purpose of facilitating interoperability with an independently developed system [14]. In the United States, there is no explicit exemption from copyright protection for reverse engineering but case law appears to be moving closer to the European Community position. For example, in Sega Enterprises, Ltd. v. Accolade Inc. , the court allowed as fair use the reverse engineering of a computer video product to permit development of an interoperable product [15]. The parties are free in the United States to agree to a contractual restriction on reverse engineering and often do as a standard part of a license. But aside from enforceability problems, such restriction could presumably be ignored by licensees using and marketing the system in the European market where such contractual restrictions are precluded if they interfere with interoperability. USER AND SYSTEMINTERFACES. On a broader plane, the degree of copyright protection for user and system inter-
faces and for program structure is far from clear. The unsettled nature of the law in the U.S. is illustrated by the differences in result between such cases as Computer Associates International, Inc. v. Altai, Inc. in which the court took a restrictive view of the scope of copyright protection and Atari Games Corp. v. Nintendo of America, Inc., in which a somewhat broader view of the scope of copyright protection was taken [16, 171. It has also been more difficult to protect interface information from disclosure to others in Europe than in the United States-indeed, in some circumstances, disclosure of interface information can be required under application of European Community Competition law where such would not necessarily be required in the United States. The trend discussed above toward more open interfaces and control by customers of how they will use someone else’s software product are placing greater focus on the fuzzy distinction that has always been drawn in copyright law between a non-protectable idea and protectable expression. For example, to what degree can the “look and feel” of the user interface or screen display be protected from unauthorized use or reproduction by another (e.g., the location and functions of icons in a computer graphic screen display)?
by The Computer Software and Services Industry Association, one of every two copies of personal computer software used by corporations in the United States is illegal [l]. Worldwide, the cost of piracy to software producers is estimated to be between $10 and $20 billion in lost revenues [18]. The globalization of the software market and the easier reproducibility of software code will probably tend to worsen this trend. The result of all this is that the legal forms of intellectual property protection for software cannot be relied upon by software developers as effective means to fully appropriate the benefits of their innovations.
TECHNOLOGICAL
DIMENSION
The relationship between technology and appropriability is complex and has several dimensions. Winter [lo], for example, examines the relationship in terms of technology being: Tacit vs. articulable Nonobservable in use vs. observable in use Complex vs. simple An element of a system vs. independent
Software piracy costs between $10 billion and $20 billion. As the domain of nonprotectable ideas is expanded by courts in case by case adjudications, a software vendor can no longer assume exclusive proprietary status to adhere to its entire product. Software
Piracy and Misuse
While legal forms of intellectual property protection for software, particularly copyrights, appear to be less than airtight in the United States and Europe, outright software piracy by firms that copy software for resale is also an increasing problem-particularly in parts of the Far East and Latin America where recognition of intellectual property rights is paid only lip service. In addition, end users around the world, including the United States, illegally copy software for internal use beyond the scope permitted in their licenses with software vendors. According to an estimate
Note that the right side of each of the above dimensions in indicative of ease of technology transfer and hence low appropriability. Our ability to place technology along such dimensions is extremely important to our understanding of strategic marketing issues concerning intellectual property. For example, by the dimension of tacit versus articulable, much of software is codified and therefore highly articulable (i.e., easily communicated from the possessor to another person) and therefore has low appropriability. Similarly, as discussed earlier, increasing customer demands for greater control over software means that “observability in use” (i.e., the extent of disclosure of underlying codes necessary for its use) -no matter how complex the program - must be high, thus compounding the appropriability problem. The relationship between technology and appropriabil-
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ity has also to do with the extent to which the development of intellectual property is endogenous. Thus, one would expect innovator firms that look upon the intellectual property development as an endogenous or an internally controlled process to design technologies with an eye toward achieving a high degree of appropriability. This could take the form of specialized software tailored to a new line of mainframe computers. Or it could take the form of de facto software standards associated with dominant suppliers in hardware markets (e.g., IBM in data processing and DEC in minicomputers). In short, an innovator firm could try to enhance appropriability through technological barriers. However, such barriers, as shown in the past by the experience of dominant firms in the computer and communications industries, are unsustainable when they are in serious conflict with the user requirements and hence result in reducing rather than enhancing appropriability over the life of the product [19].
MARKETING
DIMENSION
The preceding discussion suggests that legal instruments and technology-related solutions are inadequate to overcome the appropriability problem faced by software innovators. However, beyond the legal and technological dimensions, there are a number of key industry characteristics that affect marketing strategies - some compounding the appropriability problem, others that are either symptoms or mitigators of the problem, and still others that present both risks and opportunities. These industry characteristics are noted below. Industry
ter, this means the industry is characterized by a good deal of technological uncertainty (i.e., no one knows what technology will ultimately prevail), strategic uncertainty (i.e., no “right” strategy has been formulated yet), a large fraction of first-time buyers and newly formed firms, and the presence of a large number of relatively small firms made possible by easy entry and diverse market needs [20]. END USER COMPETITIONAND IMITATION. Often software
suppliers have to not only compete with the end users’ inhouse development but also cope with their ability and incentive to imitate what is supplied to them. HIGH LEVEL OF R&D INTENSITY. According to Business
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HIGH DEGREE OF INTEGRATIONWITH HARDWARE. According to available estimates, hardware manufacturer share of merchant software market in 1985 represented about 40 %
of the worldwide
revenues in the United States [4].
HIGH DEGREEOF SPECIALIZATION. For example, all but 3 of the top 25 independent software suppliers in the United States in 1984 had derived 90-100% of their revenues from software [3]. COMPLEMENTARITY W~THHARDWAREANDCOMPUTER
SERVICES. Complementarity arises because software is jointly used with hardware and a whole range of services that include customization, consultancy, training, and data processing [4]. HIGH LEVEL OF MAINTENANCEAND MARKETINGCOSTS. Some 50-70 % of software costs are estimated to be maintenance costs that consist mostly of enhancements and alterations. Typically, maintenance costs over the life cycle can exceed development costs by a margin of two to one. Moreover, because of greater level of customer support given to software, marketing costs are significantly greater for software compared with hardware [22]. Overall, the characteristics of an emerging industry, particularly specialization, combined with end user competition and imitation compound the appropriability problem for innovator firms.
Characteristics
AN EMERGINGFRAGMENTEDINDUSTRY. Following Por-
We&
ranked highest in terms of F&D intensity or the ratio of R&D to sales with 14 % versus 12% for computer communications, and 10% for semiconductors and 9% for computers. Individual firms such as Software Publishing have been reported to spend as high as 40% of their sales on F&D [21].
1991 R&D Scoreboard,
software firms as a group
Marketing
Assets and Strategies
If industry characteristics do not favor a strong appropriability regime, legal protection of software is weak, and technological barriers are counterproductive, what other means are available to firms to profit fully from their innovations? Increasingly, the evidence appears to be pointing toward investing in complementary marketing assets and developing marketing strategies by the innovator firms as a means of overcoming the appropriability problem. The results of a Yale University survey of research and development executives produced the strongest support yet for this view [lo, 121. For example, in fully 9 out of 18 or 50% of the industry groups surveyed the respondents ranked “superior sales or service efforts” highest among the five methods of protecting gains from product innovations (the other four
methods were: “patents,” “secrecy,” “lead time,” and “moving quickly down the learning curve”). Lead time was rated highest in 7 (or 39%) of the industries and patents in only 2 (or 11%) of the industries, and both were chemicals where appropriability is weak because chemical formulas are easy prey for imitation. It is important to note that lead time, the second highest ranked method, is not unrelated to superior sales or service efforts, the highest ranked method. Often, lead time gained from innovations is necessary not only to maintain technological leadership but also to build a whole range of complementary “marketing assets” (among them superior sales and service efforts) and develop marketing strategies that are critical to enhancing appropriability. While marketing strategies cover a wide range of areas that include strategies for differentiation, product positioning, and distribution, the discussion below emphasizes strategic alliances and diversification into related services. INVESTMENT IN COMPLEMENTARYMARKETING ASSETS. The essential point about complementary marketing assets is they are complementary to innovation and they enhance appropriability. This suggests that the lower the protection from the standpoint of legal and technology dimensions discussed earlier (and hence low appropriability), the greater the need for reliance on complementary marketing assets. A whole range of items comprise such assets and they include not only sales and service efforts but also trademarks that take on the function of product identification and whose value is enhanced not so much by legal protection but by the superiority of the product and customer awareness of it built by promotion; investment in channel development; superior information systems concerning markets, customers, competitors, and more. In short, they include all marketing activities that make up what Porter calls reputation of the first-mover, which depends not only on the superiority of a firm’s innovation but also on its capacity to invest in marketing assets [23]. As applied to the marketing of software, a firm may build the infrastructure needed to emphasize customer post-sale support services in the areas of installation, training, maintenance, and enhancements and alterations to ensure workability, integration, and upgrading of the firm’s software product in the customer’s entire environment. The relatively high cost of software maintenance referred to earlier can be viewed as an index of high degree of customer interaction and the importance of post-sale customer support services. For example, in a 1991 survey of information systems managers undertaken by Input, it was deter-
mined that vendor reputation for support, ease of use of the system, and whether the vendor is regarded as a specialist in the product area were the most important vendor selection criteria-even more important than relative price 1241. STRATEGICALLIANCES. Sometimes referred to as collaborative ventures, quasi-integration, and “teaming,” strategic alliances -both domestic and international -are being increasingly utilized as a marketing strategy designed to overcome the problem of appropriability. They take various forms including marketing and distribution agreements, technology licensing, joint product development, and research partnerships. The results of a study by Pisano, Shan, and Teece, which examined collaborative arrangements in the context of weak appropriability innovations in the biotechnology industry, are relevant for the software industry [25]. Two conclusions of the study are especially significant for the software industry. First, collaborative arrangements were predominantly (62 % of a random sample of 200 relationships examined) between new and established firms because new firms lacked the complementary marketing assets. Therefore, in virtually all arrangements between the new and established firms new (and probably smaller) firms supplied the technology and established firms commercialized it. Second, because of the appropriability problems, the nature of arrangements between new and established firms is collaborative (i.e., quasi-integration) not arms-length. We view such alliances as even more important for software firms in light of strong complementarity and technological interconnectedness between hardware and software. Often large hardware firms even when integrated into software do not have the benefit of specialized R&D performed by the independent software firms. Similarly, many independent software firms lack the ability to make large investments in marketing assets. As a result, strategic alliances are becoming common in software and electronics industries. Among the key findings of a recent survey of 455 electronic executives conducted by Electronic Business [26] were: Software companies relied on alliances the most with nearly 80% ranking the importance of alliances as extremely high or high in their strategic plan. The need to access new markets and to enhance marketing, distribution and sales operations was the main force (80 % of the respondents) behind alliances, and they are expected to increase over the next 5 years. Companies that spend heavily on R&D are more likely
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l
to form marketing, development, and technology licensing alliances because R&D commitments leave fewer resources for other activities. Smaller companies are more likely to consider alliances critical to their success.
There is also evidence of an increasing number of alliances between large integrated mainframe firms and independent software vendors. IBM’s cooperative software program and marketing assistance program is one such example
r11. DIVERSIFICATION. As noted earlier, a high degree of specialization combined with the high level of F&D intensity produces significant technological as well as commercial risks for independent software firms. The risks associated with specialization are especially significant because specialization does not lead to lower unit costs (i.e., economies of scale) in this industry. This is because software design, while increasing in efficiency, as indicated earlier, is still largely a craft that uses little automation [3]. Diversification into related professional service areas, such as custom software development, information systems consulting, user education, and training, could enhance appropriability by enlarging the software customer base while at the same time reducing the risks of specialization. Inp&S findings on the U.S. professional service market in 1991 suggest that some software firms, including American Software, System Software Associates, Computer Associates, and Oracle, are beginning to go in that direction. Consulting related to the information system needs of the customer is a fast-growing part of the service area [27].
CONCLUSIONS An examination of the appropriability problem with respect to investments in intellectual property development in general and software in particular indicates that innovator firms have great difficulty protecting themselves against imitation. An evaluation of legal protection of software particularly copyright- in light of changing technology and customer demands suggests that it is likely to be less effective in the future. From the standpoint of the technology dimension, the nature of software technology- highly codified and articulable - does not seem to produce a high degree of appropriability. Moreover, past experience in communications and computer industries suggests that technological barriers as a means of enhancing appropriability (e.g., vendor-specific standards) are counterproductive. Increasingly, firms in the global software industry are plac-
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ing greater reliance on investments in complementary marketing assets (e.g., a superior sales and service infrastructure), development of effective marketing strategies, which include domestic and international strategic alliances in the form of R&D contracts, licensing, and marketing agreements, and diversification into related services.
REFERENCES 1. U.S. Congress, Finding a Balance: Computer Sofiware, Intellectual Property and the Challenge of Technological Change, Office of Technology Assessment, Washington, D.C., 96-103, 1992.
2. Schware, Robert, The World So&ware Industry and Software Engineering, The World Bank, Washington,
D.C.,
l-25,
40-66,
1989.
3. OECD, Sofhyare: An Emerging Industry, Paris, 1985. 4. OECD, Internationalizadon of So&are and Computer Services, Paris, 1989. 5. Arrow, Kenneth J., Economic Welfare and Allocation of Resources for Invention, in Tne Rate and Direction oflnventive Activity, R. Nelson, ed., Princeton University Press, Princeton, 609-624, 1962.
6. Bator, Francis N., Anatomy of Market Failure, Quarterly Journal of Economics, 72, 351-379
(1958).
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8. Nordhaus, Williams D., Invention, Growth and Welfare, MIT Press, Cambridge,
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9. Teece, David J., Profiting from Technological
Innovation: Implications for Integration, Collaboration, Licensing, and Public Policy, in The Competitive Challenge, David J. Teece, ed., Harper & Row, New York, 185-219, 1987.
10. Winter, Sidney G., Knowledge The Competitive York, 159-184.
Challenge,
and Competence as Strategic Assets, in David J. Teece, ed., Harper & Row, New
11. Bensen, Stanley M., and Raskind, Leo J., An Introduction to Law and Economics of Intellectual Property, Journal ofEconomic Perspectives 5,3-27 (1991). 12. Levin, R., Klevorick, A. K., Nelson, R. R., and Winter, S. G., Survey Research on R&D Appropriability and Technological Opportunity, Working Paper, Yale University, New Haven, 1984. 13. Cusumano, Michael A., Japan’s Sofrware Factories: A Challenge to U.S. Management, Oxford University Press, Oxford, 1991. 14. European Community 14, 1991.
Software Copyright Directive, No. 91/250iEC,
May
15. Sega Enterprises Ltd. v. Accolade, Inc., 977 F.2d 1510 (9th Cir. 1992). 16. Computer Associates international, Cir. 1992).
Inc. v. Altai, Inc., 982 F.2d 693 (2d
17. Atari Games Corp. v. Nintendo ofAmerica 1992).
Inc., 915 F.2d 832 (Fed. Cir.
18. Cain, Alan, Software Group Steps Up Action Against Theft, Financial Times, Dec. 10.7 (1992). 19. Scherer, F. M., and Ross, David, Industrial Market Structure and Economic Performance, Houghton Mifflin, Boston, 459-464, 1990. 20. Porter, Michael E., Competitive 191-236, 1980. 21. R&D Scoreboard,
Business
Strategy,
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The Full Press, New York, (June 29, 1992).
22. Frank, Werner L., Critical Issues in Sofhyare, John Wiley & Sons, New York, 7-8, 22, 1983. 23. Porter, Michael E., Competitive Advanrage, The Free Press, New York, 186-187, 1985.
Collaboration in the Biotechnology Industry, in Inrernational Collaborarive Ventures in U.S. Manufacmring, David C. Mowery, ed., Ballinger Publishing Company, Cambridge, 183-222, 1988.
24. Input, U.S. Systems So&are Products, 1991-1996, IV-14, Exhibit IV-1 1 (1991).
26. Almassy, Stephen E., and Baa& E. B., 455 Electronic Executives Say Rugged Individualism is Fading, Electronic Business 38-40, (March 30, 1992).
25. Pisano, Gary P., Weijian Shan, and Teece, David J., Joint Ventures and
27. Input, U.S. Professional Services Market, 1992-1997, VII-3, lo,15 (1992).
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INTRODUCTION With the rapid growth of knowledge-based industries, the management of intellectual property, of which software is a part, is becoming an important activity for many firms and central for the software firms. Software is emerging
Address correspondence to Long Island University, C.W. The views expressed in this necessarily reflect the opinions
P.M. Rao, College of Management, Both Hall, Pbst Campus, Brookville, New York 11548. paper are solely those of the authors and do not or policies of Bell Communication Research, Inc.
Industrial Marketing Management 23, 29-37 (1994) Q Elsevier Science Inc., 1994 655 Avenue of the Americas, New York, NY 10010
as a significant global industry in recent years. According to one estimate, the worldwide market for software and related services was about $110 billion at the end of 198Os, with a commanding 57 % held by U.S. companies [l] . More important, software has become the driving force behind productivity gains in numerous manufacturing as well as service industries. It is also the source of many marketing innovations in such diverse industries as telecommunications, banking, and airlines. The purpose of this paper is to discuss the growing need for marketing strategies in the emerging global software industry. Specifically, the paper examines the legal, technological, and marketing dimensions of intellectual property and their implications for the importance of marketing strategies in the software industry. Although the term intellectual property can be defined to include a wide range of intangible “assets” described in such terms as knowledge base and know-how, our definition is grounded in investments in technology and property rights. Thus, for purposes of this paper, the term intellectual property refers to all technology-based intangible assets of a firm-an idea or a design for a new product or a process, a computer software package, and the like29 0019-8501/94/$7.00
Computer software, as intellectual property, must be protected within the current legal framework. that may be protected as a property right under the legal framework that includes patents, copyrights, or trade secrets. The term software refers both to the instructions that direct the operation of computer equipment and information content and to data that computers manipulate. There are two general types of software: applications software, whose purpose is to solve computer users’ own problems (e.g., word processing and spreadsheet programs), and systems sojlwure, which is used to manage the components of a computer system (e.g., operating systems, which control the hardware and compilers, and interpreters, which translate programs into a form that can be executed by a computer). Systems integration, which is sometimes referred to as integrated software systems, combines standard hardware with custom software or modified standard software packages in a unique configuration tailor-made to end users’ requirements [2-41.
APPROPRIABILITY
PROBLEM
It has long been established in the economic and business literature that the “market” for intellectual property suffers from certain unique problems that are not present in markets for other goods and services [5-81. These problems are often referred to as problems of market failure. That is, competitive markets underinvest in the production of intellectual property, which is essential to the international competitiveness of a nation and its economic well
I? M. RAO is Associate Professor of Marketing at the College of Management, Long Island University/C. W. Post Campus, Brookville, New York. JOSEPH A. KLEIN is Assistant Vice President and General Attorney at Bell Communications Research, Inc., Livingston, New Jersey.
30
being. Chief among the sources of market failure is the problem of appropriability, the conceptual issue around which implications for marketing strategies are discussed in this paper. The problem of appropriability arises because firms operating in a competitive market structure are unable to internalize or appropriate the full economic benefits of their investment in the development of intellectual property. This is because intellectual property, which is often expensive to produce, can be copied by competitors and end users alike often at little or no cost to them. KEY DIMENSIONS
OF APPROPRIABILITY
Profit maximizing firms rely on a variety of protective instruments to enhance appropriability of their intellectual property development. Broadly speaking, these protective instruments fall into three major categories or dimensions: legal, technological, and marketing. Of these three, technological and marketing dimensions affect appropriability as well as being affected by it. Each of these dimensions, which are very broadly and roughly organized around the conceptual framework developed by Teece and Winter [9, lo], are discussed below: Legal Dimension In the United States the legal framework for protecting intellectual property consists of five regimes: patents, copyrights, semiconductor protection, trademarks, trade secrets, and misappropriation. Although the Semiconductor Chip Act of 1984 is sometimes referred to as a separate legal regime, it is closer to the copyright regime designed to reflect the particular needs of the semiconductor industry [l, 111. PATENTSANDCOPYRIGHTS. Both have a foundation in the U.S. Constitution (Article 1, Section 8 of the U.S. Constitution) and in various federal statutes (including Patent Act and Copyright Act) and therefore constitute the highest form of protection, at least from a legal standpoint.
SECRETS. Unlike patents and copyrights, there are no federally created rights in trademarks. However, the federal framework (Lanham Act) does provide a system of registration and enforcement. Regardless of the degree of legal protection accorded to trademark, its significance to the appropriability issue is in its use as a major marketing tool. The same point applies to a trade secret although to a far lesser extent, and it represents an entirely different kind of marketing tool from trademark. Protection of trade secrets is grounded entirely in state law and the scope of protection varies among states. TRADEMARKS
AND
TRADE
MISAPPROPRIATION.This regime refers to a legal doctrine adopted by courts, under a general rule of unfair competition, to protect against taking of information of commercial value, but outside the reach of laws governing intellectual property. While a full evaluation of the degree of protection offered by each regime is beyond the scope of this paper, as our discussion of the software industry shows, even the most uniform and perhaps the strongest of legal regimes-patents and copyrights-is inadequate in overcoming the appropriability problem. There is substantial evidence that suggests that “inventing around” patents is common [lo, 121. Legal Protection
of Software
Computer software, including computer program design, code, and documentation to achieve specified functions implementable by computer hardware, constitutes a form of intellectual property that has been protected to a degree by one or more legal mechanisms embodied in patent, copyright, and trade secret law. Each form of protection has advantages and disadvantages. Patents, when applicable, provide the most comprehensive protection against appropriation by others. They protect against infringement of nonobvious ideas reduced to practice, not just a particular expression of that idea, and independent creation is not a defense to an infringement suit as it would be for copyrights or trade secrets. However, a software algorithm in and of itself is not patentable; the software must fall under the statutory subject matter applicable to method and apparatus or process. The patent application procedures are also very time consuming and expensive and require substantial disclosure that could undermine trade secret protection. Computer programs may also not be patentable in other countries and therefore not protected under their patent laws. For these reasons, although an increasing number of software patents have been issued by the U.S. Patent Office in the last de-
cade, reliance on copyright protection for software programs is more prevalent. Copyright protection is often used for software (by analogy to protection of literary works), but it only applies to particular expression- not the underlying idea-and cannot be used to bar an independently developed system performing the same functions. The law is also permitting some degree of copying, as discussed below, which may dilute the scope and practical value of copyright protection. Trade secret law can protect information that has an economic value conferring competitive advantage and is not generally known and treated by its owner as a secret. It is less useful for widely distributed systems and difficult in any case to police. Impact of Changing Technology and Customer Demands The effectiveness of intellectual property protection for software is also being impacted by converging developments in software technology and customer demands. Our discussion focuses on four key developments: 1. DEVELOPMENTOF INDUSTRYSTANDARDS-BASED OPEN OPERATINGSYSTEMS. Technology enables-and sophisticated customers increasingly expect- the development of more open operating systems that permit portability of specific customer applications from one computing environment to another. Customers want the flexibility to “mix and match” hardware and software from different vendors to build systems from components that they choose based on desired cost and features. As networking among distributed personal computers, desk top work stations and even nomadic hand-held units replace stand-alone mainframe computers, market pressure is toward more open system-to-system and user interfaces. This is seen in the increasing popularity of the relatively open UNIX operating system and in such industry consortiums as the Open Software Foundation that strive to develop “vendor-neutral” standards to enable software and hardware from different sources to talk to each other [l]. This trend is at odds with the incentives of large mainframe computer companies, albeit in a passing era, to keep customers bound to a single proprietary system of vendor-specific hardware and compatible software. 2. CUSKJMERDEMANDFOR GREATERCONTROL OF SOFTWARE. Customers want-and are increasingly obtaining more control over how they can use the software they are acquiring. Technology and customer demand are converging toward products that enable customers to easily create, 31
Legal forms of intellectual property protection have reduced usefulness. manipulate, customers can then use freely for their own financial benefit. For example, heavy users of multiple commuservices today are faced with many Local Area Network (LAN), Systems Network Architecture electronic mail, and videoconferencing networks. disparate networks will not only provide a virtual meeting space with all the computer support but also give the user greater control over the use of network resources, EMERGENCE OF“FACTORY” APPROACH TOSOETWARE DE-
VELOPMENT. The software development process itself is undergoing massive change. Historically, software has literally been developed one line of code at a time- a slow, laborious process. Customizable systems will increasingly be composed from common reusable segments of code that perform some overall function, made possible by such technologies as object-oriented programming and inexpensive computer hardware. This modularization or the “factory” approach reduces the labor intensity of software development by eliminating unnecessary redundancy in writing the same code that can be used again and again as a common portion of diverse application systems [13]. It also supports the development, discussed above, of common interfaces among systems from multiple vendors and the system easeof-use that supports customer control of applications. 4. SHORTENINGOF PRODUCTLIFE CYCLE FORSOFTWARE. With rapid technical change and a competitive market, the product life cycle for software has been shortening. Reducing the time to market a product and increasing comparative customer value are becoming crucial to achieving a competitive edge before a product’s features become obsolete. The transactional costs and delays associated with obtaining some forms of intellectual property protection (e.g., the patent application process or protracted software license negotiations over confidentiality provisions) before a product is marketed may result in losing the market to another product. Indeed, the burdensome nature of intellectual prop-
32
erty restrictions imposed by one vendor on customer use of its product may be a factor leading customers to choose a less encumbered product from a flexible vendor. In light of the above trends, legal forms of intellectual property protection may not be as relevant or useful in the future in fully protecting the value of a software developer’s investment. Changing
Scope of Copyright
Protection
REVERSEENGINEERING. Copyright protection, although clearly precluding the copying of the literal expression of software code, does not necessarily preclude one from reverse engineering another’s object code (i.e., converting such computer machine-readable code into human-readable language) to figure out how the underlying software functions were designed and put together-a job that will presumably be made technically easier by the modularization of software development discussed above. Under the European Community Software Copyright Directive to which the copyright laws of the member states must be harmonized, a person is explicitly free to reproduce or translate the form of another’s program code for the specific purpose of facilitating interoperability with an independently developed system [14]. In the United States, there is no explicit exemption from copyright protection for reverse engineering but case law appears to be moving closer to the European Community position. For example, in Sega Enterprises, Ltd. v. Accolade Inc. , the court allowed as fair use the reverse engineering of a computer video product to permit development of an interoperable product [15]. The parties are free in the United States to agree to a contractual restriction on reverse engineering and often do as a standard part of a license. But aside from enforceability problems, such restriction could presumably be ignored by licensees using and marketing the system in the European market where such contractual restrictions are precluded if they interfere with interoperability. USER AND SYSTEMINTERFACES. On a broader plane, the degree of copyright protection for user and system inter-
faces and for program structure is far from clear. The unsettled nature of the law in the U.S. is illustrated by the differences in result between such cases as Computer Associates International, Inc. v. Altai, Inc. in which the court took a restrictive view of the scope of copyright protection and Atari Games Corp. v. Nintendo of America, Inc., in which a somewhat broader view of the scope of copyright protection was taken [16, 171. It has also been more difficult to protect interface information from disclosure to others in Europe than in the United States-indeed, in some circumstances, disclosure of interface information can be required under application of European Community Competition law where such would not necessarily be required in the United States. The trend discussed above toward more open interfaces and control by customers of how they will use someone else’s software product are placing greater focus on the fuzzy distinction that has always been drawn in copyright law between a non-protectable idea and protectable expression. For example, to what degree can the “look and feel” of the user interface or screen display be protected from unauthorized use or reproduction by another (e.g., the location and functions of icons in a computer graphic screen display)?
by The Computer Software and Services Industry Association, one of every two copies of personal computer software used by corporations in the United States is illegal [l]. Worldwide, the cost of piracy to software producers is estimated to be between $10 and $20 billion in lost revenues [18]. The globalization of the software market and the easier reproducibility of software code will probably tend to worsen this trend. The result of all this is that the legal forms of intellectual property protection for software cannot be relied upon by software developers as effective means to fully appropriate the benefits of their innovations.
TECHNOLOGICAL
DIMENSION
The relationship between technology and appropriability is complex and has several dimensions. Winter [lo], for example, examines the relationship in terms of technology being: Tacit vs. articulable Nonobservable in use vs. observable in use Complex vs. simple An element of a system vs. independent
Software piracy costs between $10 billion and $20 billion. As the domain of nonprotectable ideas is expanded by courts in case by case adjudications, a software vendor can no longer assume exclusive proprietary status to adhere to its entire product. Software
Piracy and Misuse
While legal forms of intellectual property protection for software, particularly copyrights, appear to be less than airtight in the United States and Europe, outright software piracy by firms that copy software for resale is also an increasing problem-particularly in parts of the Far East and Latin America where recognition of intellectual property rights is paid only lip service. In addition, end users around the world, including the United States, illegally copy software for internal use beyond the scope permitted in their licenses with software vendors. According to an estimate
Note that the right side of each of the above dimensions in indicative of ease of technology transfer and hence low appropriability. Our ability to place technology along such dimensions is extremely important to our understanding of strategic marketing issues concerning intellectual property. For example, by the dimension of tacit versus articulable, much of software is codified and therefore highly articulable (i.e., easily communicated from the possessor to another person) and therefore has low appropriability. Similarly, as discussed earlier, increasing customer demands for greater control over software means that “observability in use” (i.e., the extent of disclosure of underlying codes necessary for its use) -no matter how complex the program - must be high, thus compounding the appropriability problem. The relationship between technology and appropriabil-
33
ity has also to do with the extent to which the development of intellectual property is endogenous. Thus, one would expect innovator firms that look upon the intellectual property development as an endogenous or an internally controlled process to design technologies with an eye toward achieving a high degree of appropriability. This could take the form of specialized software tailored to a new line of mainframe computers. Or it could take the form of de facto software standards associated with dominant suppliers in hardware markets (e.g., IBM in data processing and DEC in minicomputers). In short, an innovator firm could try to enhance appropriability through technological barriers. However, such barriers, as shown in the past by the experience of dominant firms in the computer and communications industries, are unsustainable when they are in serious conflict with the user requirements and hence result in reducing rather than enhancing appropriability over the life of the product [19].
MARKETING
DIMENSION
The preceding discussion suggests that legal instruments and technology-related solutions are inadequate to overcome the appropriability problem faced by software innovators. However, beyond the legal and technological dimensions, there are a number of key industry characteristics that affect marketing strategies - some compounding the appropriability problem, others that are either symptoms or mitigators of the problem, and still others that present both risks and opportunities. These industry characteristics are noted below. Industry
ter, this means the industry is characterized by a good deal of technological uncertainty (i.e., no one knows what technology will ultimately prevail), strategic uncertainty (i.e., no “right” strategy has been formulated yet), a large fraction of first-time buyers and newly formed firms, and the presence of a large number of relatively small firms made possible by easy entry and diverse market needs [20]. END USER COMPETITIONAND IMITATION. Often software
suppliers have to not only compete with the end users’ inhouse development but also cope with their ability and incentive to imitate what is supplied to them. HIGH LEVEL OF R&D INTENSITY. According to Business
34
HIGH DEGREE OF INTEGRATIONWITH HARDWARE. According to available estimates, hardware manufacturer share of merchant software market in 1985 represented about 40 %
of the worldwide
revenues in the United States [4].
HIGH DEGREEOF SPECIALIZATION. For example, all but 3 of the top 25 independent software suppliers in the United States in 1984 had derived 90-100% of their revenues from software [3]. COMPLEMENTARITY W~THHARDWAREANDCOMPUTER
SERVICES. Complementarity arises because software is jointly used with hardware and a whole range of services that include customization, consultancy, training, and data processing [4]. HIGH LEVEL OF MAINTENANCEAND MARKETINGCOSTS. Some 50-70 % of software costs are estimated to be maintenance costs that consist mostly of enhancements and alterations. Typically, maintenance costs over the life cycle can exceed development costs by a margin of two to one. Moreover, because of greater level of customer support given to software, marketing costs are significantly greater for software compared with hardware [22]. Overall, the characteristics of an emerging industry, particularly specialization, combined with end user competition and imitation compound the appropriability problem for innovator firms.
Characteristics
AN EMERGINGFRAGMENTEDINDUSTRY. Following Por-
We&
ranked highest in terms of F&D intensity or the ratio of R&D to sales with 14 % versus 12% for computer communications, and 10% for semiconductors and 9% for computers. Individual firms such as Software Publishing have been reported to spend as high as 40% of their sales on F&D [21].
1991 R&D Scoreboard,
software firms as a group
Marketing
Assets and Strategies
If industry characteristics do not favor a strong appropriability regime, legal protection of software is weak, and technological barriers are counterproductive, what other means are available to firms to profit fully from their innovations? Increasingly, the evidence appears to be pointing toward investing in complementary marketing assets and developing marketing strategies by the innovator firms as a means of overcoming the appropriability problem. The results of a Yale University survey of research and development executives produced the strongest support yet for this view [lo, 121. For example, in fully 9 out of 18 or 50% of the industry groups surveyed the respondents ranked “superior sales or service efforts” highest among the five methods of protecting gains from product innovations (the other four
methods were: “patents,” “secrecy,” “lead time,” and “moving quickly down the learning curve”). Lead time was rated highest in 7 (or 39%) of the industries and patents in only 2 (or 11%) of the industries, and both were chemicals where appropriability is weak because chemical formulas are easy prey for imitation. It is important to note that lead time, the second highest ranked method, is not unrelated to superior sales or service efforts, the highest ranked method. Often, lead time gained from innovations is necessary not only to maintain technological leadership but also to build a whole range of complementary “marketing assets” (among them superior sales and service efforts) and develop marketing strategies that are critical to enhancing appropriability. While marketing strategies cover a wide range of areas that include strategies for differentiation, product positioning, and distribution, the discussion below emphasizes strategic alliances and diversification into related services. INVESTMENT IN COMPLEMENTARYMARKETING ASSETS. The essential point about complementary marketing assets is they are complementary to innovation and they enhance appropriability. This suggests that the lower the protection from the standpoint of legal and technology dimensions discussed earlier (and hence low appropriability), the greater the need for reliance on complementary marketing assets. A whole range of items comprise such assets and they include not only sales and service efforts but also trademarks that take on the function of product identification and whose value is enhanced not so much by legal protection but by the superiority of the product and customer awareness of it built by promotion; investment in channel development; superior information systems concerning markets, customers, competitors, and more. In short, they include all marketing activities that make up what Porter calls reputation of the first-mover, which depends not only on the superiority of a firm’s innovation but also on its capacity to invest in marketing assets [23]. As applied to the marketing of software, a firm may build the infrastructure needed to emphasize customer post-sale support services in the areas of installation, training, maintenance, and enhancements and alterations to ensure workability, integration, and upgrading of the firm’s software product in the customer’s entire environment. The relatively high cost of software maintenance referred to earlier can be viewed as an index of high degree of customer interaction and the importance of post-sale customer support services. For example, in a 1991 survey of information systems managers undertaken by Input, it was deter-
mined that vendor reputation for support, ease of use of the system, and whether the vendor is regarded as a specialist in the product area were the most important vendor selection criteria-even more important than relative price 1241. STRATEGICALLIANCES. Sometimes referred to as collaborative ventures, quasi-integration, and “teaming,” strategic alliances -both domestic and international -are being increasingly utilized as a marketing strategy designed to overcome the problem of appropriability. They take various forms including marketing and distribution agreements, technology licensing, joint product development, and research partnerships. The results of a study by Pisano, Shan, and Teece, which examined collaborative arrangements in the context of weak appropriability innovations in the biotechnology industry, are relevant for the software industry [25]. Two conclusions of the study are especially significant for the software industry. First, collaborative arrangements were predominantly (62 % of a random sample of 200 relationships examined) between new and established firms because new firms lacked the complementary marketing assets. Therefore, in virtually all arrangements between the new and established firms new (and probably smaller) firms supplied the technology and established firms commercialized it. Second, because of the appropriability problems, the nature of arrangements between new and established firms is collaborative (i.e., quasi-integration) not arms-length. We view such alliances as even more important for software firms in light of strong complementarity and technological interconnectedness between hardware and software. Often large hardware firms even when integrated into software do not have the benefit of specialized R&D performed by the independent software firms. Similarly, many independent software firms lack the ability to make large investments in marketing assets. As a result, strategic alliances are becoming common in software and electronics industries. Among the key findings of a recent survey of 455 electronic executives conducted by Electronic Business [26] were: Software companies relied on alliances the most with nearly 80% ranking the importance of alliances as extremely high or high in their strategic plan. The need to access new markets and to enhance marketing, distribution and sales operations was the main force (80 % of the respondents) behind alliances, and they are expected to increase over the next 5 years. Companies that spend heavily on R&D are more likely
35
l
to form marketing, development, and technology licensing alliances because R&D commitments leave fewer resources for other activities. Smaller companies are more likely to consider alliances critical to their success.
There is also evidence of an increasing number of alliances between large integrated mainframe firms and independent software vendors. IBM’s cooperative software program and marketing assistance program is one such example
r11. DIVERSIFICATION. As noted earlier, a high degree of specialization combined with the high level of F&D intensity produces significant technological as well as commercial risks for independent software firms. The risks associated with specialization are especially significant because specialization does not lead to lower unit costs (i.e., economies of scale) in this industry. This is because software design, while increasing in efficiency, as indicated earlier, is still largely a craft that uses little automation [3]. Diversification into related professional service areas, such as custom software development, information systems consulting, user education, and training, could enhance appropriability by enlarging the software customer base while at the same time reducing the risks of specialization. Inp&S findings on the U.S. professional service market in 1991 suggest that some software firms, including American Software, System Software Associates, Computer Associates, and Oracle, are beginning to go in that direction. Consulting related to the information system needs of the customer is a fast-growing part of the service area [27].
CONCLUSIONS An examination of the appropriability problem with respect to investments in intellectual property development in general and software in particular indicates that innovator firms have great difficulty protecting themselves against imitation. An evaluation of legal protection of software particularly copyright- in light of changing technology and customer demands suggests that it is likely to be less effective in the future. From the standpoint of the technology dimension, the nature of software technology- highly codified and articulable - does not seem to produce a high degree of appropriability. Moreover, past experience in communications and computer industries suggests that technological barriers as a means of enhancing appropriability (e.g., vendor-specific standards) are counterproductive. Increasingly, firms in the global software industry are plac-
36
ing greater reliance on investments in complementary marketing assets (e.g., a superior sales and service infrastructure), development of effective marketing strategies, which include domestic and international strategic alliances in the form of R&D contracts, licensing, and marketing agreements, and diversification into related services.
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