Innovation and competition in complex environments.

SUMMARY

The paper aims to shed light on the relation between technological research, competition and market dynamics, focussing on the role of product modularity. This relation is analysed via qualitative simulation modelling using a simple agent-based model. We define an economic system in which firms compete on the quality characteristics of a certain complex good, in a market where consumers have shown preferences for them. Firms are conceived as bounded rational agents that explore complex product technologies in order to improve their fitness in relation to the selection environment (i.e. the consumers' evaluation of the characteristics of the final good). The architecture of the good produced in the system is characterised by different degrees of modularity (i.e. the lower the correlations between the contributions of the different product components to the final product fitness, the simpler the good's technology and the higher the degree of modularity). On the other hand, the impact of product modularity on industrial dynamics is analysed using a set of quite homogeneous firms.

First, the model yields highly differentiated dynamics for firms that start from similar initial conditions, pointing to the importance of their research strategies. Second, the dynamic patterns obtained show that firms may easily end up in technological lock-in in spite of initial good performance, suggesting that path-dependence could be broken. Third, modularity impinges directly upon market results: a decrease in modularity, by increasing the difficulty in searching the complex technology, selects a limited number of firms, thus determining concentration in market shares. Finally, the industrial dynamics are influenced by the evolution of the quality of the final good.

KEYWORDS

product innovation; product modularity; market dynamics; technological search strategy; agent-based simulations

1. INTRODUCTION

Innovation is largely recognised as a key determinant of industry dynamics in terms of both their composition and organisation (Malerba 2005). Indeed, technological competition among firms develops through patterns of differentiated dynamics related to the capacity of firms to cope with 'complex' technological problems and hence to obtain quite different performances in the market.

Within this perspective, in this paper we focus on the relationships between the dynamics of an industry, in terms, for instance, of firms' market shares and product quality, and the nature of firms' technological competition. More precisely, we concentrate on the role of product modularity in determining the effects of firms' technological research and, hence their competitiveness in production. In the innovation literature (e.g. Langlois 2002), product modularity is interpreted as the way in which changes in one component (or module) of a good affect the other components (or modules) used to produce the final good. Indeed, it is now widely accepted in the literature that product modularity affects the way in which firms 'de-compose' both their production and search activities. Problem decomposition is the way in which firms may simplify a complex problem (such as technological research) by solving each sub-problem separately (e.g. Simon 1969). Therefore, the level of product modularity determines the decomposability of production and technological complexity faced by firms that attempt to increase their relative share of the market.

To this and related literatures on industrial organisation, we make two contributions. We provide a preliminary explanation of the transformation of an industry as an outcome of the relation between technological complexity, product modularity and technological research. We employ qualitative simulation modelling, suggesting a theoretical framework and methodology that disentangles explanations of emerging complex behaviours and can be easily expanded. (1) That is, we describe firm behaviour by means of an agent-based model, and analyse the results firm search at industry level. The computational model allows us to provide an interpretation of the complex dynamics that result from combining product characteristics and firm strategies.

We model an economic system that represents one industry in which a set of firms produces a heterogeneous good. The good is characterised by a complex architecture, and is produced by assembling a set of intermediate components (modules). Before it is sold, the good is evaluated and selected by consumers on the basis of its characteristics (user services). The quality of the good produced, the market concentration, and the firms' fitness are emergent properties of the firms' search process in complex technological 'landscapes' for innovations in product modules (components). It is our contention that the degree of modularity of the production process is a crucial variable in yielding different outcomes in terms of market competition.

The paper is organised as follows. In Section 2, we sketch the theoretical background to the paper. Section 3 provides an abstract interpretation of the issues by describing the model in qualitative form. The simulation results are presented in Section 4 and Section 5 concludes.

2. THEORETICAL BACKGROUND

Market competition through technological change is at the core of neo-Schumpeterian and evolutionary economics analysis (Nelson and Winter 1982). Indeed, it is now common knowledge that firms in innovative sectors compete with rivals by searching for goods and processes of higher quality in an attempt to gain temporary monopolistic profits, rather than displacing competition based on cheaper output or production factors. The relation between technological change at firm level--with all its specificities in terms of radicalness, path dependency, lock-in, and the like, market structure, and some measure of global fitness, has permeated several research strands, with different degrees of closeness to Schumpeter's original work (Fagerberg 2003) and with different focal questions. Some of the research results have become well-established theoretical explanations and empirical evidence from firms in the analysis of industrial competition has had implications for market structure and market dynamics. We focus on those issues that the literature usually explains in terms of non-linearities and positive feed-backs in the competitive process, such as: 'first-mover advantages' (Lieberman and Montgomery 1988), 'persistent behaviour', 'path-dependence' and 'technological lock-in' (David 1985; Cowan 1990; Liebowitz and Margolis 1995).

We show that, given some myopia in firm behaviour combined with different degrees of product modularity, lock-in to inferior technologies (quality of product characteristics in our framework) may occur as the outcome of an over-evaluation of short-term fitness and imperfect understanding of the product architecture. With some interesting departures, we replicate some stylised facts of industrial competition that emerge when the 'complex' nature of technological competition is given a central role. Competing through product innovation is an inherently complex process, which does not allow a firm to hold all the information necessary to find the 'optimal' path. Bounded rational firms tackle this complexity by decomposing the problem (product innovation) into a set of 'independently-solvable' sub-problems. This is typical of the Simonian perspective (Simon 1969), which has implications in terms of industrial competition and dynamics that are at the core of a strand of recent research in evolutionary economics that focuses on the organisation of problem solving activities (Marengo et al. 2000), a strand on which we draw in this paper.

In the case of modular production this means that firms attempt to innovate in individual components of a complex good. This means that (depending on their starting conditions) firms often behave differently from one another and achieve a different fit with respect to market evaluation. The interaction between innovative, bounded rational firms with the complex market environment in which they operate, yields several interesting insights into the processes of industrial organization (Marengo and Dosi 2005).

The second strand of literature on which we draw deals with the degree of 'de-composability' of an innovated product, that is, the modularity of its technology (Langlois 2002) or as Ulrich (1995), Baldwin and Clark (2000), and Schilling (2000) put it, its product architecture. Indeed, innovation is more complex when the contributions of the individual components (e.g. intermediate commodities) to a product's integral fitness are highly correlated; in other words, when the architecture is more integral. This has been extensively argued, but mainly from industry level perspectives: the first one is based on the effects that architectural vs. modular innovations have on the competition between incumbents and new entrants (Anderson and Tushman 1990; Henderson and Clark 1990); the second focuses on the evolution of the market structure and the product architecture itself (Abernathy and Utterback 1978; Utterback 1994). Although we draw on this literature, we maintain a consistent microperspective, which is in line with the Simonian view of problem decomposition, and more aligned with a recent literature that analyses the limits and opportunities of technological modularity (Ernst 2005) in close relation to the organisational structure of firms (e.g. Brusoni and Prencipe 2001). In other words, the way in which firms tend to align the structure of innovation and product architecture.