Networks and market creation

381

Networks and market creation * Morris Teubal Economics

Tamar

Department,

The Hebrew

University, Mount Scopus, Jerusalem,

Israel

Yinnon of Theoretical Chemistry, The Hebrew University, Givat Ram, Jerusalem,

F. Haber Institute

Israel

Ehud Zuscovitch Department

of Economics,

Ben Gurion University,

1. Networks and evolutionary 1.1. Network

organization

Beersheva,

Israel

differentiation

and market

creation

It is widely accepted that a network organization linking firms or economic agents represents an intermediate “system of governance” that lies between hierarchic organization (“ the firm”) on the one hand, and “classical” or spot transactions (“the market”), on the other. 1 Not all intermediate arrangements could be called networks: an isolated bilateral agreement involving “neoclassical” rather than “classical” contracting [40] is not an indication of a network relationship. Neither should some forms of cooperative partnerships be termed network relationships. Two essential elements actually delimitate the area of interfirm relationships called networking: first, recurring transactions and interactions and, second, a long-run stable relationship. Both imply the presence (through evolution) of mechanisms of * Thanks

to R. Nelson for preliminary discussions on the issues raised in this paper; to C. DeBresson for detailed and useful comments; and to L. Westphal, R. Walker and the referees for helpful suggestions. The authors are members of the Industrial Development Policy Group (IDPG), The Jerusalem Institute for Israel Studies, Jerusalem, Israel. The extreme cases have been extensively discussed by Williamson [40] and Teece [32]. According to Imai, the networks phenomena is an example of “interpenetration of market and organization, i.e., a loosely coupled relationship having a core with both weak and strong ties.. a mechanism by which connection of people are formed in such a way that spontaneity is not lost.. and a certain organizational effort can be designed.. .” [16].

Research Policy 20 (1991) 381-392 North-Holland

0048-7333/91/$03.50

0 1991 - Elsevier Science Publishers

mutual firm adaptation to the unfolding of uncertainty, i.e., to the distribution of unexpected gains or to additional effort required on the part of the firms. They also imply the existence of rules or norms concerning the use of information provided by one firm in its interactions or transactions with other firms. The network phenomenon has gained importance due to the current technological revolution. ’ There are many types of networks, but for our purposes it may be useful to consider two main types: the component supplier-assembler network which characterizes, for example, the automobile industry (network type Nl); and the user-producer networks characterizing, for example, many emerging capital-goods markets (network type N2). All networks involve flows of information among the various nodes (for instance, component specifications or the adaptation of a particular capital good to the needs of users), although in both types, this flow “supports” the flow of commodities (transactions). Within networks a critical distinction exists between simple networks nodes and the central network agency. The network language is less useful if, in relation to N2, user 1 - a simple network node - communicates directly with user 2 of the capital good - another such node. * The increasing

importance of networks has been attributed to increasing information and variety in a broad sense [41]. Moreover, the corresponding upsurge of uncertainty in the economic environment has made “simple ex ante planning and control obsolete” (a disadvantage of a hierarchical context) [16]. Information technology enhances the needs of inter-firm coordination among technical specializations, which, when coupled with the needs for rapid adaptation to the economic environment, leads to flexible although cohesive patterns of relationships among firms.

B.V. All rights reserved

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When direct communication does not exist or is inefficient, it is important to consider an agency which we term “the central (network) agency” which mediates among the various users. Thus, the existence of a distinct central agency - which we will term the “network PBX” (drawing upon a similarity with the standard telephone network) is a third critical characteristic of networks. The fundamental task of the network PBX is to facilitate interaction and information flow. This may provide private and social functions beyond those involving information. For example, when the PBX of N2 is also the supplier of a novel capital good, its activity will create a social pool of knowledge concerning the capital good in question, i.e., a pool accessible to every user linked to the network. This task involves exploiting economies of scale in the generation, diffusion and use of user-related information and experience, a critical function in the process of creating a market for a novel capital good. In Nl the fundamental task of the PBX (which is also the system integrator or assembler) is to coordinate the production process among a set of independent suppliers. This will sudcessfully enable the incorporation of new technology into existing products. Note that in both cases the tr~saction-relevant i~ormation activities may involve much more than simple facilitation of information flow. The nature of the information itself may also under go significant changes. The central theme of this paper is the relationship between networks and market creation, especially the emergence of N2 networks as a mean of generating a market for a novel capital good with a high (potential) social profitability. The thesis propounded, and elaborated upon in the second section, is that the emergence of such a form of organization may be a critical mediating factor linking a radical capital-good invention to its subsequent contribution to the national economy. Under certain circumstances, the process of “collective learning” requires “network creation”. There may be market failure, however: a low level equilibrium trap which only rare entrepreneurship and/or government policy may overcome. Our focus differs from recent work on network externalities in economic theory 3 and also from 3 See [9,19]_ For a good summary 404-4093.

see J. Tiroie (1989) [37, pp.

and market creation

Lundvall’s work on user-producer relationships. Economic theory dealing with the economics of networks such as telephones and computers focuses on issues such as compatibility and standards. These are important for physical communication or transportation networks more than for networks of firms. 4 One of the main issues considered is whether the benefits from standardization may trap an industry into an obsolete or inferior standard when there is a better alternative available (“excess inertia” or the “lock-in” phenomena). In contrast, we focus, first, on networks of firms rather than physical networks and, second, on network creation rather than competition among alternative products, technologies or physical networks. ’ The main reason why networks are critical for market creation is their contribution to learning, specifically to the generation of a broad social pool of knowledge related to the capital good in question. Users learn through time how to discriminate among various types of the novel product class. They also learn from others, whereas the network PBX-capital good supplier develops an increasing ability to couple product types to new users (based on information obtained from existing users). In the next section we attempt to introduce a discriminating capability variable (the Z-variable) which is the result of learning, as well as being instrumental in generating the new information which sustains network evolution. We believe that by introducing this variable we are setting the basis for a more systematic and rigorous analysis of learning, network evolution and market creation. 6

4 Similar issues arise from competition between technologies under conditions of “‘increasing returns to adoption” [l]. 5 Lundvall’s discussion of user-producer relationships [20,21] emphasizes somewhat different phenomena. He assumes that the *‘organized market” (a network) will arise naturally once participants real&e the importance of credibility and Iongterm relationships. This is not necessarily so, since there may be real failures in network creation, especially surrounding a novel capital good. Moreover, his policy conclusions relate to incomplete or sticky networks rather than to market/network creation. 6 Needless to say, while the usefulness of this discriminating capability variable will be demonstrated, its systematic exploitation must be left to future work.

M. Teubal et al. / Networks and marker creation

1.2. User discriminating evolution

capability

and

network

1.2.1. The concept Network development may be viewed as an evolutionary process triggered by innovation, that is, by the increasingly successful coupling of technology (or technological knowledge) and user needs. ’ This coupling is ignored in economic theory. since it is usually assumed that products and technology already exist, so that the only problem is to determine equilibrium prices and quantities. The qualitative coupling phenomenon is implicit in the analysis; its lack would mean that no market exists. Given a set of alternative product options available, success in coupling or matching technology with user needs depends on the discriminating capability of users (or more generally of those involved in the actual choice), by which we mean their ability to search for and to home in on a product option providing a satisfactory level of (net) functional utility. 8 This is critical when uncertainty is great both as to the functional utility of the various options and to the consequences of inappropriate choices. Its importance is also enhanced in an environment where variety has increased, as in the opportunities made available by information technology. We present a framework for relating discriminating capability to the evolution of networks. Specifically, we introduce a variable which purports to represent discriminating capability across a hierarchy of increasingly specific product types. For clarification, consider a product class, “cars”, belonging to the broad category “means of transportation”. Associated with this product class we may introduce a set of nested subsets of product options (product types) which conform to a hierarchy e.g. zll - small cars and z12 - large cars; Z 111 small cars with automatic gear change, z~,~

For the use of term “coupling between technology and needs”, see Myers and Marquis [24] and Teubal et al. [36]. Alternatively, of choosing a product option which is adapted to their needs.

383

_ small cars with manual gear change _. . etc.. 9 The hierarchy is composed of levels of increasing product type specificity, at the i level, the ij level, and so on. Going down the hierarchy would mean going from a more general to a more specific product type. We will say that this involves an increase in 2. ‘O The next elements in our framework relate to users. We assume that: (i) each user, at each moment of time, has a preferred product type; (ii) the degree of specificity of this product type (or, alternatively, the hierarchy level to which it belongs) depends on its discriminating capabilities (Z); (iii) that success in coupling needs to the product class (or alternatively, “goodness of fit”) depends on the specificity of the preferred product type. Once a product type, say zllz above, is preferred by a user, its search of product options is focused within this type; so is the actual option chosen. Whether the preferred type belongs to level ij (“small cars”) or to level ijk (“small cars with manual gear changes”) depends on a firm’s discriminating capabilities. An increase in this capability will enable the user to home into a more specific preferred product type and ” thereby focus its search more than before. We also assume that this will lead to a better choice, i.e., a needsproduct class coupling with greater functional utility (net of cost). I2 Maximum discriminating capa-

A hierarchy of increasingly specific product types has been proposed by Teubal et al. [36] and by Teubal [33] in relation to user preferences. Clark [3] has convincingly suggested that a design hierarchy for complex products exists as well. Neither has yet considered the connections between both kinds of hierarchies. Clark [4] relates changes in R&D strategy and organization of firms to shifting up or down along the design hierarchy. In Teubal [33] the term “market or need determinateness” is used to describe an increasingly specific preferred product type. We reason as follows: If the ex ante specificity of the coupling exists at the product class level only, then the probability of good ex post fit or coupling at the specific feature level is low, since there will be a significant element of randomness in actual choice. This probability is higher when a well-based “preferrence” arises for a more specific product type involving also clear preference for specific product features. Need Determinateness would be the user capabilities counterpart of a firm’s R&D capabilities in the sense proposed by Nelson: “From this vantage point R&D capabilities can be recognized as connected with knowledge of how to search efficiently” [25, p. 4541.

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M. Teubal et al. / Networks and market creation

bility (Z) leads to a preferred product type which lies at the bottom of the hierarchy.

The above framework allows us to link increased sales of the new capital good (market creation) with network evolution which is defined as an increasingly widespread and fruitful exchange of information and experience among a growing number of users. Thus an increase in user discriminating capabilities - an increase in Z will increase sales since the expected net functional utility of the products purchased increases. Increased sales in turn widens the experience base for collective learning about the coupling of the new technology base or product class to needs; and if this can effectively be harnessed by the PBX through network evolution then the result will be even greater discriminating capabilities and so on. In the next section we discuss the conditions for collective learning while focusing on the activities and characteristics of the PBX. Up to now the analysis has assumed a single user type so the effect would be increased product standardization, the central result of “classical” innovation cycle analysis f39]. Network evolution in this context could involve increased information exchange concerning the technology/needs coupling of an unchanging set of homogeneous users. The impact of information technology, however, is both increased product variety and increased user differentiation. Users, as before, increasingly learn from experience how to discriminate among finer product characteristics and product types, e.g., first among blue and red and then among various hues of red. But the increased variety opens up opportunities for users (all of whom having chosen red when the available product types at the relevant - say ij - level of the hierarchy are red and blue) a distinction might be made between those preferring dark red and those preferring light red (product types at the ijk level of Z): User differentiation also expresses itself by the incorporation of new user types, which become differentiated from those potential users who have not yet adopted the new product class. The outcome of the above is that the technology knowledge base or new product class gets increasingly well adapted or coupled to the changing needs of users, both old and new. Network evolution is correspondingly richer and more

varied and so are the possibilities for collective learning. When considering the effects on discriminating capabilities it is important to note: (i) that these relate not only to users (and certainly not only to a single user type) but also to firms; (ii) that the inputs involve not only user experience but also producer-initiated availability of new product features, Moreover, the effect is increased sales through the creation of submarkets or market niches - rather than through mass-market creation - and wide diffusion of the new product class 1331.I3

2, Network creation: Learning, en~eprene~hip and the effects of info~ation technology

A central force in the creation and evolution of a network is learning. We will attempt to describe some aspects of this process. ~roughout the discussion we will be assuming the introduction of a novel capital good, i.e., a “breakthrough” innovation creating a completely new product class. The focus is on possible forms of organization between the innovation-cuPn-capital-goods supplier and its users. l4 One possibility is to link the various economic agents into a network. This has advantages over atom&tic economic agents since a network will stimulate “learning through others”, the incorporation of individual learning earning by using”) into a social pool of knowl*3 The above perspective is not inconsistent with a modified _ version of the innovation cycle, especially one based on the generalization proposed by Clark [4]. Clark’s “design’ and “customer concepts” hierarchies are consistent with our “product-type” hierarchy and his “shifting down through the hierarchy” is also stimulated by enhanced discriminating capability by both users and producers. Moreover, his framework may incorporate increased variety. Our frame work, however, is less consistent with that underlying most diffusion models since these assume a standard commodity and a given potential demand for the innovation [5,22]. Others such as Metcalfe [23] or Stoneman and Ireland [30], stress supply side interactions, but again withii an essentially static framework. Our framework suggests that innovation diffusion analysis under the impact of information technology should not ignore product variety and user differentiation. The successful diffusion of a novel capital good may only be potentialized through these processes. And these, in turn, may necessitate network creation and evolution. 14 Throughout the discussion we will ignore additional suppliers of the capital good.

M. Teubal et al. / Networks

edge available, in principle, to everyone. In the absence of a network, there may be constraints on the flow of information between users, either because of lack of initiative or because of positive disincentives, as when users are competitors. Thus, the issue of network creation and evolution is critical in relation to market creation vis-a-vis a novel capital good. 15,16 2.1. Learning Learning provides a rationale for emergence of a PBX linking the various users within a network. The process of learning described in the previous section (user need-determination) is applicable to a user of the novel capital good. When considering other users, two main issues arise: first, what is the direct and potential usefulness of this knowledge to other users (the “externalities” issue); and, second. what incentives or disincentives exist to transmit the information (the “incentives” issue). When users are identical vis-a-vis the innovation (and are non-competing), the information and discriminating capabilities attained by the first user are directly applicable to other users; therefore both potential and actual externalities are great. When information and capabilities are not directly applicable due to user heterogeneity, the capital goods producer may have to make an explicit effort to adapt it to other users. For example, the original user, due to enhanced discriminating capability, has identified product type “compact cars with automatic gear change” as the most relevant type. This information may be indirectly useful to another user whose most relevant product type is “compact cars with manual gear change” only if considerable effort has been made to interpret the implications of the first user’s choice in the light I5 Schumpeter

emphasized the importance of dynamic competition and the individual entrepreneur in materializing the potential contribution of an innovation to economic growth. By contrast, we emphasize the importance of network creation and its role in promoting “learning by others”. We will see that this assigns a very important role to the entrepreneur (the “PBX” of the network). For the relative disadvantages of a vertical integration set-up in user-producer relationships, see Lundvall [20]. For example, users who compete with the integrated user may avoid interacting with the producer. This will affect both the long run competitiveness of the user/producer and “learning by others”. I6 Whether or not it will expedite the transformation of the new area or market into a ‘neoclassical” market is another issue which we will not deal with in this paper.

and market creation

385

of what is known of the second user’s characteristics. ” Knowledge of the characteristics and general needs of other users (actual or potential) and the importance of technology in evaluating the desirability of various product types suggests: (i) that it may be difficult for the information/capability to flow from the original to subsequent users; (ii) that the capital-goods supplier/innovator may be strategically situated in order to perform this role and thereby, via increased sales of capital goods, to materialize the potential externalities generated by the original user. Otherwise, actual externalities may be low even though potential externalities are high. A central issue, then, is the conditions under which the innovator/capital-goods supplier will in fact perform this role. The incentives problem depends on whether or not users are competitors and, if so, whether or not the capital good in question is a critical aspect of competition. If subsequent users are not competitors of the original user, they will have no incentive to withhold information. However, since the original user will not actively promote diffusion of his experience (and since sophisticated adaption may be required) the need for a “mediator” may still arise. Note that non-competing users who also learn through others exist in large numbers in relation to many novel capital goods (e.g., hospitals in relation to novel operating equipmentor households and firms in relation to personal situations involving computers. is However, (knowledge) complementarity and product (weak or strong) competition should also be considered, despite the possible existence of disincentives to information transfer. i9 The emergence of a PBX

Thus the contribution of the first user’s information and experience to the second one is indirect. It operates by enhancing the ability of the PBX to Link product types to user types. We term this “enhanced coupling capabilities”. Major innovations will always involve significant user-segments which do not compete in the markets for final outputs. This is true for machine tools [27]. Semi-conductors and computers. Lundvall’s [20] does not consider this possibility since it is more adapted to improvements of existing goods rather than major or radical innovations. From the innovation-diffusion literature we know that even under strong competition information about the performance of the new capital good is transmitted either directly by the supplier or indirectly through the influence of adoption on competitors’ performance as observed in the market place [26].

M. Teubal et al. / Networks and market creation

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linking these users within a network may, however, reduce disincentives considerably. 2o Thus, this organizational set-up may promote dynamic efficiency and growth due to: (i) economies of scale in information gathering, processing and diffusion; (ii) better sharing of information and experience among users while maintaining a competitive framework.

2.2. Entrepreneurship and the emergence of a PBX The central issue is the conditions under which the supplier of a novel capital good will become a PBX of an emerging network linking the various users. The transition is not trivial since it may involve a completely different objective or strategy than those existing originally. Moreover, even if such a transition occurs, there is no assurance that the PBX will succeed in creating a full-wedged network. Despite the potential business opportunities involved in facilitating the transfer of learning and capability among the various users, it should be noted that the environment is one of fundamental uncertainty in the sense of not knowing either the full set of possible states of nature nor the critical parameters which will assure success. Following Imai’s [15] definition of the entrepreneur we could say that a necessary condition is his ability to create a new context, in this case a market-generating network linking users to the innovator. Thus, in the case of an independent technical innovator a serious change in perspective must take place, one involving a direct coupling with the needs of an expanding set of users over and beyond the initial application. The difficulty of this transition has been amply demonstrated in the histories of new high-tech start-ups. There are at least two different aspects of such expansion: (i) effectively integrating production and marketing activities to existing R&D and (ii) widening the scope of R&D, particularly the development and engineering component, to encompass an increasing set of applications. This may imply a relative shift of emphasis away from original tech-

a0 See Hakanson

(121, Lundvall

1201 and Gelvan

[ll].

nical effort. 2’ In Teece’s (1987) language, transformation of the inventor into a full-fledged PBX may be hindered by the need to acquire sufficient complementary assets to support the development and diffusion of the innovation [23a]. Thus, in certain areas such as instrumentation and electronics, the market creation task could be performed by imitators than by the independent inventor-innovator. ” When the technical breakthrou~ comes from an innovative user, an effective transfer of technology and innovation to an outside supplier of capital goods should take place [13,14]. Only then may further development and diffusion of the

In this connection we should distinguish innovation capabilities from invention (or original innovation) (see Teubal[34] in relation to the early development of Israel’s high-tech sector). Examples of innovative firms that have managed to make this transition are SCITEX (the originator and leader of CAD systems for the printing industry); OPTROTEK (originator and one of the leaders in computer-based inspection and quality control systems for the printed board indust~); and FANUC (a leader in robotics). Drawing from Imai and Baba [16], the transition of this last firm to PBX status in robots involved raising the ratio of software resources from 40 percent (1982) to 60 percent (1985) and entering into a joint venture with GM. “Without having the software capability and consulting capability, robot manufacturers can degenerate to the status of mere equipment providers” 1161. For example, GE in relation to Computerized Axial Tomography (CAT) rather than EMI [31] Teece analyzes the distribution of profits among the original inventor (or innovator) and both imitators and owners of complementary assets, under varying circumstances such as the appropriation regime. etc. He concludes that imitators have frequently appropriated a significant share of the profits of innovation. Our emphasis here is on market creation (and social profitability) via success in creating a network of users, rather than on “commercial success”. Successful imitation might have been the only way a new market could have arisen. Moreover, absence of successful imitation might have been the reason why numerous breakthrough inventions with high potential social profitability have never led to new markets. In some cases an appropriate PBX may involve a partnership between the independent inventor and the imitator-owner of complementary assets. Thus, the approach taken here when considering a successful imitator who significantiy contributed to the creation of a new market could emphasize the enhancement of overall social profita~Iity rather than the reduction of private profitability.

M. Teubal et al. / Networks and market creation

innovation be assured. 23 Finally, especially in a newly industrialized country, the original importer of a novel capital good may have to add substantial engineering and even R&D capabilities to the new technologies over and beyond existing marketing capabilities in order to be able to perform the PBX function at all. 24 These examples suggest that the emergence of an entrepreneur is not a trivial matter. A critical problem facing an entrepreneur on the way to being a successful PBX is, to put it simplistically, the development of a “critical mass”. The opportunity for expanding sales of the novel capital good through network creation and exploitation of economics in information gathering and diffusion (e.g., concerning discriminating capabilities 2 and specific options chosen) depends on success in linking up a large number of new users. This process, however, may be extremely difficult during the formative stages of the new market. On the one hand, the capabilities and information that the entrepreneur can initially offer are low since little collective learning by using has taken place. Therefore, the incentives to link up may be low. On the other hand, with few, if any, new users linking up, the possibilities of developing new capabilities may be limited. Therefore, the emerging market may be caught in a “low-level equilibrium trap”, i.e., the entrepreneur will not be able to evolve into a network-generating PBX. Critical ex ante coordination problems may have to be solved before the

23 In numerous cases, a spin-off from the innovator-first user is the source of the PBX, e.g., a spin-off from General Dynamics which created “Computer Vision”, a leading CAD firm. See also Rosenberg’s [27] example of gun-making. In other cases the innovator-firm/user may become the PBX. 24 This may be particularly so if a standardized set of equipment undergoes a variety-enhancing or a system-enhancing transformation, e.g., as a result of information ‘technology (see previous example of FANUC) or when a monolithic technology evolves into a lego-type technology. In this case, effective market creation may require the importer to become an “assembler” of components and/or systems in order to achieve a better coupling with the needs of local users. This example also pertains to transformation (via a network) of a mass market into a set of submarkets or market segments. This paper does not deal with the specific managerial and organizational aspects of the transformation.

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network begins to evolve naturally and continuously. 25 In economists’ terminology, the profitability to a marginal user of initial link-up may be negative, while that of a block of new users may be positive 26. Thus, a major function of the entrepreneur is to deal with discontinuous change in an environment of fundamental uncertainty. *’ If he does not deal with this issue, the market for the new capital good may never materialize. Alternatively, assemblying a critical core of innovative users may be a necessary condition for self-sustained network evolution and market creation. The Scanning Tunnelling Microscope (SMT), for example, is currently being experimented with by all major Japanese chip makers even though it has not yet been effectively incorporated as a central quality-control device of the production process [6]. Thus, although the new market has not yet developed, a core of innovative users already exists. According to our view, the stage is set for market creation, provided the supplier of the “Nanoscope” (Digital Instruments of California) is acting as a PBX, and provided that we are, in fact, witnessing a radical innovation. In terms of innovation diffusion we suggest here that the teething problems faced by the innovation users can be more easily supported if information is exchanged. This suits the view that R&D partnership is particularly effective during the pre-competitive stage before the market is stabilized [18].

25 One may infer from lmai [15] that entrepreneurial ex ante coordination may involve commitments from a number of sophisticated users to use and test the novel capital good prior to ascertaining how many users are linked and how much they will learn from each other. 26 This may be especially so when the capital good and market structure are such that first movers will suffer a disadvantage relative to later movers, since the latter can wait until1 the bugs have been eliminated from the system. On the other hand, this disadvantage will be reduced when the initial user is a repetitive purchaser rather than a one-time purchaser. We owe this comment to L. Westphal. *’ This function of the entrepreneur cannot be termed profit maximizing (at least in one sense) since prevailing fundamental uncertainty precludes and possibility of computing benefits and costs. This will change at a later stage, once the marginal profitability of hooking-up becomes positive. As we know from Schumpeter [29] the entrepreneur bets on another system of relative prices than the one that prevails. To be more precise his profits come from an arbitrage between the prevailing and the future price vectors [42].

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2.3. Overcoming

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the critical mass problem

and market creation

2.4. Observations on transaction of information technology

costs and the effect

A number of factors may diminish the seriousness of the critical mass problem in network formation. The first are the reputation, complementary assets and capabilities of the entrepreneur of potential PBX. The greater they are the lower the critical mass and/or the easier will be overcoming it. An example is how IBM created the PC market by generating a network of PC users, in a way that was not possible for MITS, the original inventor. These factors make it easier to convince the initial core of innovative users to form a network, despite the uncertainty; it also enables better and cheaper interaction to take place. *s Second, a tradition of past cooperation among the parties concerned, such as the vertical and horizontal links among the firms of a Keiretsu in Japan, can pave the way to joining into the user network for a new capital good. 29 Finally, the effects of information technology involve a chain of new opportunities and networks (called the fusion and fission of new technologies by Imai and Baba) such that success at one stage reduces the critical mass required for another. For example, the Japanese firm Nintendo, having succeeded in creating the Family Computer market in Japan 3o is on the brink of entering the sophisticated (home-delivered) on-line services market, starting with home stock-trading services and continuing onto home banking and flight booking services [16]. The opportunity is due, in part, to Nintendo’s previous relationships with the final users, although close ties with brokerages, banks and airlines are also required. Thus, one effect of information technology is to reduce the critical level of effort required to create the network for materializing new market opportunities. 31

A critical issue in the success of network creation is the disposition of and incentives for prospective users to link up, especially in the very early stages. These depend also on transactions costs, in particular how a network may reduce these costs through time, but also on how distrust between the PBX and prospective users may block user incorporation during the critical formative stage 32. Transaction costs will cease to be a serious obstacle to the incorporation of a prospective user once it becomes clear that the PBX can extract dynamic, market-creating profits from maximum transmission of available information and capabilities. These profits can be derived directly through additional sales of capital goods to the user in question, or from the indirect contribution derived from the user’s contribution to the stock of knowledge (e.g., through the stimulation of additional sales to other users, actual or potential). More generally, transaction costs will not be a relevant factor in linking up once it is clear that the PBX is directly concerned with every user’s survival and prosperity and that critical information and capabilities generated by one user will not reach prospective competitors. 33 Success in creating a new market will benefit all parties concerned and establish the conditions for a reduction in transactions costs. 34 The problem is, once again, the transition to a self-sustaining evolution of the network. The “low-level equilibrium trap”, mentioned above, will be reinforced by the lack of sufficient initial trust and insufficient experience with which to build it. The characteristics of the entrepreneur firm may be critical,

‘* Abundant complementary marketing search, for example, contribute not only to more efficient distribution but also to more effective interaction. 29 Imai and Baba [16] mention, in relation to Japan, how trust, mutual dependence and the habit of using interactive innovation as a competitive tool facilitates both personnel exchange and exchanges of technological knowledge. 3o See Economist [7]. 31 Thus some kinds of network creation may become less discontinuous than what they would otherwise be.

32 This last point has not been sufficiently emphasized in the literature. A long-term non-opportunistic perspective may not be enough to solve the initial chicken and egg problem of trust and interaction. It can help, however [2]. 33 By recognizing the likelihood that the mutual advantages derived from joint development of the new market overshadow the risks derived from cooperating. 34 We are excluding here the case of strong competition between users and potential new markets which have failed to materialize.

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including investment in building up the capabilities of early prospective users. 3s It is widely recognized that information technology has a strong impact in the productive system as a whole [41]. It is a generic technology which is bound to propel1 the economy into a self-sustained process of continuing innovation and differentation. Imai and Baba [16] mention the fusion and the fission of technologies and refer to accompanying network organization implications. We will attempt to recast some of the process that they have analyzed in terms of the concepts and categories presented here. Over and beyond the immense set of new market opportunities created by technological fusion and fission, we will deal with two implications of information technology: (i) lower cost of interaction and (ii) enhanced opportunities of coupling technology to needs wirhin a product class or systems. Concerning the cost of interaction, the effect goes beyond cost savings of existing types of interaction. It also enables firms to enter into new types of interaction which were previously unfeasible and/or uneconomical. Probably the main new thrust is interaction in R&D, even among engineers who are geographically distant from each other. This has implications first and foremost in component suppliers-assemblers type networks (Nl networks) where the emerging pattern of cooperation involves both production and R&D. 36 It also may have far-reaching implications for supplier-user networks (N2 networks) considered in this paper, since it can facilitate interaction between the entrepreneur-PBX and a core of innovative users. Thus, the latter should be viewed as participating together with the PBX in the innovation process as a whole, including learningby-using, joint problem-solving and R&D. The possibility of collectively overcoming the low-level equilibrium trap seems, therefore, to be elucidated earlier in the game. Since the chances of succeed-

” Savenian [28] emphasizes the importance of social climate and common educational background in generating trust among Silicon Valley entrepreneurs. 36 See the Economisr [6,7] for developments in the automobile industry and in Boeing. Saxenian [28] describes such network in relation to computerized work stations in Silicon Valley.

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ing increase, the entrepreneurial task of assembling the initial core of users would presumably be simplified. Network creation will thus be facilitated. New opportunities for coupling technology to needs derive from the enhanced variety and systems aspect of the capital good class being considered. In terms of the Z variable, it will be possible to proceed along finer sequence of product types and associated discriminating capabilities, so each user - once network evolution reaches a plateau will have arrived at a higher level of 2. Moreover, the effect will also be increased user differentiation and a wider scope of network evolution. The upshot is increased potential for positive sum situations resulting from cooperation between the parties of the network, both in network creation and in network evolution. This will help firms to overcome the hurdles posed by the incentive problem.

3. Summary and policy implications The emergence of a market for a radical capital good invention with high potential social profitability may critically depend on the creation of a network involving users of the product. A network, in contrast to atomistic economic agents setting and vertical integration, is a dynamically efficient organizational set-up for creating a social pool of information and knowledge concerning an invention and its uses. Absence of such a process of collective learning may block market creation. Thus, networks become a critical dynamic link between an innovation (and an innovative firm), on the one hand, and the market, rather than a static “intermediate” system of governance opposed, in some sense, to the market. This paper presents a framework of analysis rather than a formal model. Network evolution is viewed as related to an increasingly better coupling between technology and needs, process occurring accross a hierarchy of product types and fueled by enhanced user and producer discriminating capabilities. Discriminating capabilities develop in response to user experience and in response to the activity of the central network agency or PBX. Going down the hierarchy involves increased product variety and user differentiation

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rather than increased standardization as described by classical innovation cycle theory. They enable wide diffusion of the new product class. Network creation, on the other hand, is not automatically assured since there may be a problem involved in assembling a core of innovative users (the lower level equilib~um trap problem). Without these, the minimum trust and capabilities enabling incremental network evolution may fail to materialize. This points to the critical role of entrepreneurship and to possible market failures in market creation. A successful entrepreneur should, in our context, achieve what may be termed “user coordination for collective learning”. The major policy question arising from our analysis is: to what extent does the market spontaneously supply all the factors required for market creation? If the answer is negative, then what help does the network perspective of market creation give us in identifying adequate policies? Before proceeding it is important to recall that the existence of indivisibilities and critical mass problems in network creation and of externalities in network evolution are not by themselves sufficient for justifying government intervention. Market forces by themselves (our unaided entrepreneur/ PBX) may succeed in linking the critical core of users required for sustained network evolution and market creation. A good example is the emergence and growth of a separately identifiable machine-tool sector in the US during the nineteenth century: a cluster of significant innovations of potentially wide application throught the metalworking and machinery branches of industry was launched, improved upon, adapted and diffused through the actions of entrepreneurs some of them ex-users of equipment [27]. There undoubtedly are numerous examples of spontaneous market creation surrounding novel capital goods. They represent the actions of successful key firms. However, the quality and strategic outlook of entrepreneur/PBXs and the complementary assets they can assemble may block network formation in other, socially profitable, cases. However, it is too early to postulate clear criteria for identifying most, excepting the most glaring cases of potential failure in market creation. These include cases of transfer of technology and diffusion of technology where, unlike the breakthrough capital good innovation case, the social profitability of some technologies (such as

and market creation

introducing information technology into production systems) is pretty clear due the experience accumulated abroad or in other regions. Both technology transfer and diffusion policies have an explicit market-creation component that could be addressed within our framework. The experience of Italy, Germany and Switzerland ]S] points to be the importance of infrastructure-oriented diffusion policies which involve first the generation of technological capabilities to adapt and diffuse technology which has been developed abroad and second the market creation of either for technological services (e.g., analytical services, quality control services, or design services for small and medium-sized enterprises) or for the imported technology itself (e.g., new CAD equipment for plastic firms, introduction of application specific integrated circuits into the products and processes of the Swiss watch industry and German metalworking firms, or CNC and FM equipment to Italian firms). Our N2 innovator would here be represented by, e.g., the group of firms, local government or industry association that promotes the creation of a regional center for housing and developing these capabilities. The PBX would be the technology center itself which after assuring itself of the required critical mass of capabilities, actively pursues the business of creating the market for the services directly provided by the capability or for the novel equipment imported to the area. The capabilities provide a link between a nonarticulated local need and external sources of supply. For example, even if small metalworking firms need chips, they cannot define their needs in technological terms (low “need determinateness”) and therefore have difficulty in accessing foreign suppliers. The center also generates demand - via promoting awareness of need and promoting need-technology coupling capability. PBX also promotes the supply side of the market - principally the capacity of mediating between demand and supply - through explicit training of a pool of skilled personnel who eventually will spin off to the private sector. The effective generation of a local market for services or for novel equipment depends on the technology center’s success in generating a network of users and in transforming individual experience with the foreign/novel technology via collective learning into a body of knowledge about the coupling of technology to needs. In this process networks externalities are

M. Teubal et al. / Networks

the critical market failure which have to be dealt with. Our framework is also useful in identifying possible market failures in the cooperative development of new generic technological capabilities, e.g., those associated with the production and design of a new class of semiconductor devices 37, when this requires active user participation. The well-known market failure here is indivisibilities. However, a closer look at the potential requirements for intimate core-user cooperation suggests a number of additional network-related potential market failures Japan’s VLSI project is a good example where such cooperation was a condition for successful capability development. In this program, relations among participating users - the large Japanese electrical firms of the second half of the 1970s - were characterized by: (i) setting a commonly agreed research agenda; (ii) pooling resources including free inter-firm flows of information; and (iii) simultaneous consideration of their needs through the capabilities development process. These are aspects of user network creation which are critical for overcoming the indivisibilities of technological capability creation. They suggest a shift in the possible roles of government, especially when cooperation is difficult due to the fact that users are also competitors, and in the absence of an established tradition in this respect. Thus government’s role may in some cases be that of our N2 entrepreneur/PBX, orchestrating and even initiating and partially financing such attempts. 38 These are the counterparts of the coordinating functions required by our entrepreneur in order to

37 The classic example is the development in Japan of such capabilities for 1 Megabit Drams during the late seventies. Details of the Government Program supporting this development (the VLSI program initiated and orchestrated by MITI) are described in [29a]. ‘s Such a role was played by MIT1 in Japan’s VLSI project. It is worthwhile noting, however, that through the 1980s large Japanese electrical companies have increasingly taken over these functions so that the role of MIT1 both as as an initiator and entrepreneur and as a source of finance has declined. Imai [15] has suggested that the more radical types of entrepreneurship in high-tech areas may originate in the public sector or at universities.

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overcome the low level work creation. 39

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The network perspective on technological capability creation adds additional insight into the uncertainty factor potentially justifying government intervention. Over and beyond the uncertainties associated with novel technologies, we should add those associated with cooperation and networking. Can competitors cooperate? If so, what are the appropriate contexts and organizational forms for cooperative technological development? We propose that these uncertainties may be predominant factors blocking the development of socially desirable technological capabilities, especially in the crucial transition phase from individualistic to cooperative patterns of cooperation in technological development. This adds another dimension to government intervention - the catalytic effect of supporting the first attempts of a country at undertaking cooperative, pre-competitive R&D. Since significant reductions in uncertainty may be expected in the future - especially when the first projects are successful - the role of government in overcoming even significant indivisibilities should inevitably decline.

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