Toward a Theory of the Evolution of Business Ecosystems:

Inter-Organizational Architectures, Competitive Dynamics, Firm Performance and Industrial Co-Evolution

Dr. Theodore F. Piepenbrock MIT Sloan School of Management tfp@mit.edu

July 2010

Copyright 2010 by Theodore F. Piepenbrock

Working papers are distributed in draft form for purposes of comment and discussion only. They may not be reproduced without permission of the copyright holder.

TOWARD A THEORY OF THE EVOLUTION OF BUSINESS ECOSYSTEMS: Inter-Organizational Architectures, Competitive Dynamics, Firm Performance & Industrial Co-Evolution INTRODUCTION Dominant Designs, Disruptive Innovations and Dynamic Capabilities Significant research exists in the field of technology and innovation management, which has generated theory about the causes and consequences of technological innovation on the lifecycles and evolution of firms and industries. While this research agenda has generated powerful concepts like dominant designs (Abernathy & Utterback, 1978) and disruptive technological innovations (Christensen & Bower, 1996; Adner 2002), a gap exists in understanding the organizational mechanisms which both enable and constrain the evolution of technology and innovation trajectories. My research therefore attempts to bring adjacent discourse to bear on this topic, namely strategic managements dynamic capabilities (Eisenhardt & Martin, 2000; Teece et al., 1997) in order to build a theory of the evolution of innovation ecosystems. Ecosystem Evolution and Inter-Species Competition The question of how dynamic capabilities, which underpin the emergence of dominant designs and disruptive technological innovations, are created and sustained over time motivates a larger, more general question posed by evolutionary theorists in economics (Nelson & Winter, 1982; Nelson, 1991) and sociology (Hannan & Freeman, 1977; Carroll, 1993): Why do firms in the same industry vary systematically in performance over time? My research, therefore seeks a systematic explanation of a longitudinal phenomenon, which inevitably requires characterizing the evolution of inter-species competition within the ecosystem as both the organizations (firms) and their environments (markets and technologies) are co-evolving.1

Such an explanation must embrace questions about entry order of incumbents and newcomers (e.g. Mitchell, 1989), and will inevitably shed light on the industry structure vs. capabilities debate (Henderson & Mitchell, 1997).

RESEARCH METHODOLOGY A Three-Stage Mixed-Methods Study As building and testing grounded theory (Glaser & Strauss, 1967) of ecosystem evolution implies the study of a longitudinal phenomenon, I employed a three-stage mixed-methods research logic in which I collected and analyzed data and tested hypotheses from three temporal regimes: past, present and future, using the following methods: historical comparative analysis, field-based case studies and dynamic simulation modeling. Each is described below. In-depth Field-based Case Study. I build grounded theory (Eisenhardt, 1989; Yin, 2003) from an in-depth, field-based case study, in which coding of observational, interview and archival data, generated robust sets of constructs and propositions. The field-based data were largely taken from over 3,500 hours of clinical methods participant observation (Schein, 1987) and ethnography (Van Maanen, 1988) with over 200 managers and executives in the extended enterprises of a competitive duopoly, spread over seven years from 2002 to 2009. Historical Comparative Analysis. I extend the analysis back in time following methods of business history (Chandler, 1962, Christensen, 1993; Penrose, 1960) using secondary data sources in the theoretical sample. Historical data sources included public documents and official records (e.g. annual company reports and SEC filings), private documents (e.g. internal company memos) and mass media (e.g. interviews of leaders in the business press and trade journals). Dynamic Simulation Models. In order to formalize and test the emerging theoretical framework, dynamic simulation models were created to integrate the explicit causal structures and to explore the dynamic behavior (Davis, Eisenhardt, and Bingham, 2007). The models utilized a system of simultaneous differential equations (Forrester, 1961; Sterman, 2000), which captured the interacting state variables of industry and firm growth.

Research Setting & Empirical Sample A theoretical sample (Eisenhardt, 1989; Yin, 2003) was chosen to expose and explain variance in both the dependent variable (firm performance) and independent variable (interorganizational architecture), while balancing the needs for generalizability and parsimony in this exploratory stage of grounded theory building. As a result, pairs of dominant firms (incumbent and late entrant) were chosen from three industries ranging from manufacturing to services, and in socio-economic environments including the US, Europe and Japan: Boeing and Airbus in the global commercial airplanes industry, General Motors and Toyota Motors in the global automotive industry, and United Airlines and Southwest Airlines in the US airline industry. SUMMARY OF MAJOR FINDINGS Technological and Market Environments. A review of longitudinal industry-level data of the theoretical sample reveals the changing rates of market growth and technological innovation over the life cycle of an industry as illustrated in the large commercial airplane industry in Figure 1. As the rates of technological innovation change from increasing to

decreasing, product innovation gives way to process innovation (Abernathy & Utterback, 1978) and late entrants attack incumbents in underserved markets (Christensen & Bower, 1995). Inter-Organizational Architectures. Additionally, the architectures of the inter-

organizational strategic networks (Gulati, 1998) similarly appear to evolve from highly integral forms (which facilitate radical, discontinuous innovation) to highly modular forms (which facilitate incremental, continuous innovations), before a new class of late entrant disruptive innovator begins again with integral organizational architectures (Afuah, 2001; Baldwin & Clark, 2000). A representation of the evolution of the inter-organizational architectures of Boeing and Airbus in the large commercial airplane industry can be seen in Figure 2.

Technology and Market Strategies. Longitudinal firm-level data of the theoretical sample reveals the evolution of strategies of the dominant firms in both technology quality (i.e. what types of innovation differentiation or cost leadership) and market quantity (i.e. how fast to supply the market). Incumbents (General Motors, United Airlines and Boeing) begin as discontinuous or disruptive innovators (Christensen & Bower, 1996) offering products/services to under-served mass markets at increasing rates of both technological performance (Abernathy & Utterback, 1978) and market quantities. Eventually, they over-serve the markets, maintaining a trajectory of continuous or sustaining innovations at decreasing rates of both technological performance and market quantities. Late entrants (Toyota Motors, Southwest Airlines and Airbus) also begin as disruptive innovators offering products/services to over-served markets at increasing rates of both cost/quality performance and market quantities. Eventually, they over-serve the markets,

maintaining a trajectory of continuous or sustaining innovations at decreasing rates of both cost/quality performance and market quantities. Table 1 illustrates qualitative examples of

senior leaders discourse regarding their strategies for technology quality while Figures 3-5 illustrate quantitative examples of strategies for market quantity. Firm Performance. A review of the longitudinal financial data of both top-line revenues and bottom-line profits of the theoretical sample reveals that late entrant disruptive innovators having integral inter-organizational architectures (Toyota, Southwest and Airbus) outperform incumbent sustaining innovators having modular enterprise architectures (General Motors, United and Boeing) over the long term. Interestingly, these late entrants, which are not focused solely on maximization of shareholder value, deliver significantly more shareholder value than their incumbent competitors, who are focused on shareholder value maximization.

SUMMARY OF THEORETICAL FRAMEWORK Inter-Organizational Architectures. From these empirical findings, I propose a

typology of inter-organizational architectures (Gulati, 1998) based on constituent architectural components: objective functions, enterprise boundaries and stakeholder interfaces, see Figure 6. A continuum of inter-organizational architectures, possessing different dynamic capabilities, spans between the polar types of modular and integral (Sanchez & Mahoney, 1996; Schilling, 2000). This primary construct underpins the definition of an organizational species, and lays the foundation for a theory of inter-species competition (Brittain & Freeman, 1980). Fit-Form-Function-Performance Framework. The theoretical framework is

comprised of four constitutive construct sets representing the highest-level system properties of environmental fitness (Burns & Stalker, 1961; Lawrence & Lorsch, 1967), inter-organization architectural form (Sanchez & Mahoney, 1996; Schilling, 2000), firm function (Porter, 1980) and performance. These constructs are linked by four pairs of propositions representing

technological innovation and market maturity variables as shown in Figure 7. The theoretical framework also captures the evolutionary processes of variation, selection and retention, as expressed in evolutionary sociology (Aldrich, 1979) and evolutionary economics (Nelson & Winter, 1982). The framework captures the path-dependent evolution of heterogeneous populations of inter-organizational architectures engaged in symbiotic inter-species competition and posits the evolution of dominant designs in inter-organizational architectures that oscillate between modular and integral states throughout an industrys life-cycle. Architectural

innovation at the extended enterprise level is demonstrated to contribute to the failure of established firms (Henderson & Clark, 1990; Tushman & Anderson 1986), with causal mechanisms developed to explain tipping points as described in Figure 8.

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TABLES & FIGURES Table 1: Sample Qualitative Data on Firm Strategies for Technology Quality
Industry Large Commercial Airplanes Focal Firm (Architecture) Boeing (Modular) Quotation (Source) In 1966 The Boeing Company will observe its fiftieth anniversary. It is difficult to conceive any other half-century in mans history more stimulating, challenging and more rewarding. In those fifty years mans scientific and technological progress has surpassed the total of such advancement in all previous history, and Boeing is proud to have played a leading role in that fantastic acceleration. There is a moment now for a rededication to the next fifty years, and the next, and the next... (Source: The Boeing Company, Annual Report, 1965). Our products bring better value to our customers, and our pricing reflects that value. We also have a responsibility to our shareholders, and that means pricing that allows us to make our financial goals. Do I think that we will ever be the lower-price option? No. Do I think that should keep us from gaining more than 50 percent market share? I answer "no" to that as well. (Source: Scott Carson, Vice President of Sales, Boeing Commercial Airplanes, Boeing Frontiers, April 2005). Fundamental, game-changing innovation like that were pursuing on the 787 usually has a bleeding-edge quality to it meaning it goes beyond leading edge into a realm where both the risks and the potential returns are high. Were on the bleeding edge of taking a big, big step that was just a quarter step too far. (Sources: Jim McNerney, Chairman & CEO, The Boeing Company; BusinessWeek, 23 April 2008; The Chicago Tribune, 22 May 2008). When we set up 30 years ago, Airbus goal was to pool European capabilities and technological resources to build an aircraft that would reliably and costeffectively carry passengers in true wide-body comfort. The name Airbus is synonymous with lower operating costs for airlines. Airbus has continually increased its market share. Why? Operational efficiency is the first and last word in analyzing Airbuss unique market success. (Source: EADS Annual Report 2000). Heres whats new about GMs strategy this year: Nothing. GM brought brand differentiation to the world in the 1920s. As the decades passed, and our product portfolio expanded, we slowly drifted away from that simple but effective strategy. Today the GM product revolution again is strengthening our brands. (Source: General Motors Annual Report, 2003, pp. 3 and 8). Cost Reduction is the Goal: At Toyota, as in all manufacturing industries, profit can be obtained only by reducing costs. Cost reduction must be the goal of consumer products manufacturers trying to survive in todays marketplace. (Source: Taiichi Ohno 1978). We have chosen to close our discount subsidiary, Ted in order to focus on our strengths in serving our premium customers the historic source of our competitive advantage. Southwests business model, like that of Toyota, is to provide a low-cost product by utilizing its resources efficiently, while providing record levels of reliable service. (Source: Jody Hoffer Gittell, 2003 pp. 3-4.)

Airbus (Integral)

Automobiles

General Motors (Modular)

Toyota Motors (Integral)

U.S. Airlines

United Airlines (Modular) Southwest Airlines (Integral)

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Figure 1: Technological Trajectory of the Commercial Airplane Industry

Figure 2: Evolution of Dominant Designs in Inter-Organizational Architectures: Commercial Airplane Industry

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Figure 3: Quantity Growth of Competing Inter-Organizational Architectures in the Commercial Airplane Industry

Figure 4: Quantity Growth of Competing Inter-Organizational Architectures in the Automotive Industry

Figure 5: Quantity Growth of Competing Inter-Organizational Architectures in the US Airline Industry

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Figure 6: Typology of Inter-Organizational Architectures

Figure 7: Overview of Theoretical Framework

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Inter-species Competition in a Diffusing, Commoditizing Market. The framework defines the state of evolutionary maturity of the environment in two dimensions: quantity and quality that is, how much product/service is produced/consumed, and what type of product/service is produced/consumed. This section combines these two characterizations of the market environment into one model, where two different species of firms (characterized by the architectures of their respective inter-organizational networks) compete. The extent of competitive intensity is defined by the ability of each firm to overcome architectural inertia and transition from niche D to niche C as the market evolves. A summary of the coupled system of differential equations is shown below.
rX>rY when (X+Y)<K/2 rX<rY when (X+Y)>K/2 dX/dt = rXX rXX2/D rXXYXY/K rXXYXY/(D+C) dY/dt = rYY rYY2/C rYXYYX/K rYXYYX/(D+C) dK/dt = rdK (1 K/CC) dD/dt = -rcD (1 D/K) dC/dt = rcC (1 C/K) (1) (2) (3) (4) (5)

Figure 8 below summarizes the causal structure and resulting behavior of this nonlinear fourthorder formulation which results in S-shaped growth of the general market K, and the niche, C. Due to architectural inertia, each species is constrained to its own niche resulting in early exit, late entry and dominance-switching throughout the life-cycle of the industry. Figure 8: Structure/Behavior of Inter-species Competition in a Diffusing, Commoditizing Market

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