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1 Ths artcle was downloaded by:[jurdsche Bblotheek] [Jurdsche Bblotheek] On: 24 May 2007 Access Detals: [subscrpton number ] Publsher: Routledge Informa Ltd Regstered n England and Wales Regstered Number: Regstered offce: Mortmer House, Mortmer Street, London W1T 3JH, UK Internatonal Journal of the Economcs of Busness Publcaton detals, ncludng nstructons for authors and subscrpton nformaton: Strategc Postonng of Allances To cte ths Artcle: Rosenkranz, Stephane and Wetzel, Utz, 'Strategc Postonng of Allances', Internatonal Journal of the Economcs of Busness, 14:1, To lnk to ths artcle: DOI: / URL: PLEASE SCROLL DOWN FOR ARTICLE Full terms and condtons of use: Ths artcle maybe used for research, teachng and prvate study purposes. Any substantal or systematc reproducton, re-dstrbuton, re-sellng, loan or sub-lcensng, systematc supply or dstrbuton n any form to anyone s expressly forbdden. The publsher does not gve any warranty express or mpled or make any representaton that the contents wll be complete or accurate or up to date. The accuracy of any nstructons, formulae and drug doses should be ndependently verfed wth prmary sources. The publsher shall not be lable for any loss, actons, clams, proceedngs, demand or costs or damages whatsoever or howsoever caused arsng drectly or ndrectly n connecton wth or arsng out of the use of ths materal. Taylor and Francs 2007

2 Int. J. of the Economcs of Busness, Vol. 14, No. 1, February 2007, pp Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 Strategc Postonng of Allances STEPHANIE ROSENKRANZ and UTZ WEITZEL CIJB_A_ sgm / Internatonal Orgnal Taylor StephaneRosenkranz and & Artcle Francs (prnt)/ Journal Ltd Ltd of the Economcs (onlne) of Busness ABSTRACT In ths paper we use a smple lnear demand structure to analyze frms and allances strategc postonng wth regard to cost reducton and product dfferentaton. In partcular, we compare nvestment decsons under competton and n allances and analyze comparatve statc propertes concernng changes n market sze. In contrast to Porter (1980), ths model explctly allows frms to allocate ther budget between the two strateges. The analyss reveals that the optmal allocaton of resources for strategc postonng changes markedly when a frm enters an allance: the general nvestment level decreases wth a shft towards more cost reducton and less product dfferentaton. Another fndng s that allances (as well as ndependent frms) n larger markets nvest more n both strateges and nvestment s drven towards product dfferentaton. These results are n lne wth Klepper s (1996) fndngs as they show that the attractveness of followng cost leadershp or dfferentaton strateges changes through ndustry evoluton. Key Words: Allance; Strategc Postonng; Compettve Strategy; Cost Reducton; Product Dfferentaton; Innovaton; Game Theory. JEL Classfcatons: C72, L1, L13, O Introducton When managers dscuss the strategc postonng of ther products or companes they often argue along the lnes of two prmary strateges: cost leadershp and product dfferentaton. Compettve strategy s strongly nfluenced by these generc strateges defned over twenty years ago by Mchael Porter (1980), who argued that a frm s strategc poston wthn an ndustry s determned by ts compettve advantage, acheved by one of the two fundamental optons: offer the We are grateful to two anonymous referees and the edtor Eleanor Morgan, as well as Dorothea Herrener and Patrck Schmtz for helpful comments and suggestons. The paper also benefted from semnar partcpants at the Unverstes of Bonn, Berlu, Munch, and Kellogg Graduate School of Management. We gratefully acknowledge fnancal support of the German Marshall Fund and of the DFG through SFB 303. Of course, the usual dsclamer apples. Stephane Rosenkranz, Correspondng author, Utrecht Unversty, Utrecht School of Economcs, Vredenburg 138, 3511 BG Utrecht, The Netherlands, s.rosenkranz@econ.uu.nl, and CEPR. Utz Wetzel, Utrecht Unversty, Utrecht School of Economcs, Vredenburg 138, 3511 BG Utrecht, The Netherlands, u.wetzel@econ.uu.nl Prnt/ Onlne/07/ Internatonal Journal of the Economcs of Busness DOI: /

3 136 S. Rosenkranz and U. Wetzel Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 lowest prce or get closer to customer needs and dfferentate your offer. Frms that attempt to pursue both strateges smultaneously, he argues, often become stuck n the mddle between demand and cost parameters. 1 Even though Porter (1980) consdered the two strateges of cost reducton and dfferentaton to be bascally ncompatble, several emprcal and analytcal studes ndcate that the presumed trade-off may not be as strong as suggested and that a frm s advantage s rarely based entrely on cost or dfferentaton. 2 The followng analyss ntegrates these studes n such a way that frms do not necessarly have to choose between two mutually exclusve strateges, but rather allocate ther budget optmally among both alternatves. In such a less polarzed world, the optmal level of nvestment n cost reducton and n product dfferentaton, both determnng a frm s strategc poston, may alter sgnfcantly when externaltes of the frm s actvty on other frms profts are changed. Ths s especally the case when allances are formed. Porter s (1980) orgnal concept s prmarly focused on the dentfcaton and realzaton of compettve advantages n a market of ndvdual frms. As more and more frms are enterng cooperatve arrangements wth compettors or otherwse related frms, the followng analyss extends ths queston about the compettve strategy to allances. The ncreasng number of allances s related to the change n polcy orentaton n the US and Europe. Startng n the early 1990s, the per se rules of antcompettve effects of cooperatve agreements were replaced by a rule-of reason standard n the US and by block exempton regulatons under Artcle 81(3) n the EU. 3 Wth regard to strategc postonng, the agreement between PSA Peugeot/ Ctroën and Fat/Lanca may serve as a promnent example of a ont venture targetng both process and product nnovaton. Ths allance produces a mult purpose vehcle (MPV) dubbed Eurovan. Each of the companes nvolved produces a techncally dentcal van wth a slghtly dfferentated body and sells t under the brand names Peugeot 806, Ctroën Evason, Fat Ulysse, and Lanca Zeta. 4 By analysng ther R&D nvestment decsons, we see that allances show strkng dfferences to the strategc postonng of ndvdual frms and that they may n fact have welfare reducng consequences, even when the ont venture partners reman compettors on the product market. Another extenson, whch Porter s (1980) concept does not explctly cover, s the stage of ndustry evoluton at whch an allance s entered. Klepper (1996) analyses ndustry evoluton n a formal model and dentfes the role of frms nnovatve capabltes and sze n condtonng R&D spendng. Yn and Zuscovtch (1998) extend Klepper s analyss by consderng strategc effects. They fnd that the composton of frm s R&D portfolos ( ) depends on the frm s ntal market share and on the subsequent effects of R&D on the post-nnovaton market structure and that large frms nvest less n product and more n process nnovaton than small frms. Whle they consder an ex ante asymmetrc settng n whch the dfferent ncentves to ntroduce a drastc product nnovaton are analyzed, our analyss starts from a symmetrc stuaton. To ncorporate factors of ndustry evoluton, we consder the nfluence of market sze on an ndvdual frm s and an allance s strategc postonng and the comparatve statc propertes of ther R&D portfolos. Although Porter (1980) sparked off a stream of lterature n management, formal approaches n economcs only recently consdered the possblty that frms nvest n cost reducton as well as product dfferentaton. Most earler

4 Strategc Postonng of Allances 137 Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 models on nnovaton suggest that frms nvest ether n one or the other knd of nnovaton and determne optmal nnovaton strateges under ths assumpton. See, for example, Renganum (1989) and De Bondt (1997) for comprehensve surveys of nnovaton models. 5 Bonnano and Haworth (1998) consder a vertcally dfferentated ndustry wth unt demand and compare the choce of a frm between ether cost reducton or product dfferentaton dependng on the degree of competton (Cournot and Bertrand). Ther paper confnes the analyss to the decson of a sngle frm. In a settng of horzontal product dfferentaton and monopolstc competton Rosenkranz (2003) consders the smultaneous choce of cost and dfferentaton parameters and fnds condtons under whch frms nvest n both knds of actvtes. In contrast to that model, the followng analyss s extended to nclude vertcal product dfferentaton. Ths allows us to capture the noton of Porter s dfferentaton advantage n a broader sense, ncludng especally R&D as well as marketng actvtes, as hs argument s explctly concerned wth hgher qualty or better performng products and the fact that hgher advertsng and promoton expendtures are needed. In summary, the followng questons are gong to be addressed n the analyss: how does an allance s strategc postonng dffer from the postonng of two competng frms? Should an allance generally nvest more or less than two competng frms? Should an allance nvest more n cost reducton or more n product dfferentaton than two competng frms? What nfluence does potental market sze have on a frm s and on an allance s strategc postonng? Should frms or allances generally nvest more when the potental market sze ncreases? Should they nvest more n cost reducton or more n product dfferentaton? The paper s organzed as follows: secton 2 presents our model wth ts basc assumptons. In secton 3 we derve the optmal quantty choce for the product market. Moreover we characterze the mpact of cost reducton as well as product dfferentaton on quanttes. Secton 4 analyzes the strategc postonng of competng frms whle secton 5 consders the optmal postonng of allances. Secton 6 then focuses on how the technologcal lfe-cycle affects the optmal mx between cost reducton and product dfferentaton. In secton 7 we conclude ths paper wth a bref dscusson of the manageral mplcatons of our results. 2. The Model On the demand sde we assume that consumers buy all products but consder them to be at least partally substtutable to each other. Furthermore, we assume that a product s perceved substtutablty affects consumers choce n a non-ratonal manner, as t s a consequence of the product s mage due to persuasve and emotonal advertsng, a certan fashon or fashonable desgn. Due to the lack of a general comprehensve psychologcal theory of choce behavor n the context of non-nformatve advertsng, we sdestep the problem of modellng consumers choce by assumng for smplcty that frms, face lnear nverse demand functons of the followng form: P ( q, q, s ) = a ( q + s q ), and P ( q, q, s ) = a ( q + s q ).

5 138 S. Rosenkranz and U. Wetzel Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 where a > max{c, c } wth c, c representng frms margnal producton costs and s [0, 1] measures the degree of product substtutablty. The hgher s s, the hgher the degree of substtutablty s. When s tends to zero, frm effectvely becomes a monopolst, whle for s = 1 the good of frm s a perfect substtute to the good of frm. It s mportant that wth ths demand system, we assume that product substtutablty need not be symmetrc: a customer may vew the product of frm to be perfectly substtutable by the product of frm but not vce versa. Ths assumpton brngs together the deas of monopolstc competton models (see Dxt and Stgltz, 1977; Spence, 1976) and of models of vertcal product dfferentaton (see Gabszewcz and Thsse, 1979, 1980; Shaked and Sutton, 1982, 1983). In contrast to the latter models, there exsts a representatve consumer n ths model who consumes a bt of every avalable good. In contrast to the former models he may consume the products n dfferent quanttes. It s ths assumpton that allows us to ntroduce a feature of vertcal dfferentaton nto a model of monopolstc competton. 6 On the supply sde we consder an duopolstc ndustry, consstng of two frms, that produce quanttes q and q. The two frms operate under constant returns to scale. The frms unt costs of producton are gven by c and c wth c, c [0, a], whch can be chosen through the level of nvestment n cost reducton before the market opens. The product characterstcs whch determne the degree of product substtutablty gven by s and s can also be nfluenced by the frms, through nvestment n s, and s respectvely, wth s, s [0, 1]. These characterstcs, whch effectvely dfferentate the products, can be emotonal as well as physcal attrbutes whch the frm can nfluence by marketng or product development. The cost functons for nvestment n cost reducton (e.g. through process mprovements) and for nvestment n product dfferentaton (e.g. through marketng or product development) are the same for both frms and are descrbed by R(c ) and M(s ) respectvely, wth R < 0, M < 0 and R > 0, M > 0. 7 The hgher the margnal costs or the hgher the degree of substtutablty a frm chooses, the lower s the needed nvestment. Further, (to guarantee nteror solutons) we mpose that lm c 0 R(c ) = as well as lm s 0 M (s ) =. Frms play a non-cooperatve two-stage game under complete nformaton. In the frst stage, they decde on ther margnal costs by nvestng n cost reducton. Smultaneously, they decde on the optmal degree of product substtutablty by nvestng n product dfferentaton. In the second stage, frms choose the quanttes of the products they want to offer on the market. Snce these two-stage games are solved by backward nducton, we frst analyze frms quantty decsons n the second stage. 3. Decsons on Optmal Product Quantty The quantty game s a partal equlbrum model wth heterogeneous products and Cournot competton. Snce we are consderng a market n whch there are two frms offerng quanttes q and q, frm s proft functon s gven by: π ( q, q ) = q P ( q, q, s ) c q Each frm maxmzes ts proft gven the quantty chosen by the other frm. The frst-order condton of proft maxmzaton for frm s: 8

6 Strategc Postonng of Allances 139 π q = P ( q, q, s ) c q = 0. Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 Dervng the frst-order condton for frm, solvng for q, substtutng n the frstorder condton for frm and solvng for q gves the equlbrum soluton of the Cournot subgame: 9 q * s ( a c ) 2( a c ) ( c, c, s, s ) =. ( 1 ) ss 4 The game has obvously has a unque equlbrum n pure strateges n whch the frms choose q * ( c, c, s, s ) and q * ( c, c, s, s ). 10 For further analyss t s useful to analyze comparatve statc propertes of the optmal quanttes wth respect to changes n margnal costs and n the degree of product substtutablty. Dfferentaton of (1) wth respect to c and c yelds: q 2 s = q c ss < 0 and 4 = 4 ss * * c > 0. ( 2) Dfferentatng (1) wth respect to the levels of substtutablty s and s yelds: q * s * * 2q * sq = q s. ( ) ss < 0 and = 4 ss 4 > 0 3 As expected n a Cournot settng, each frm s optmal quantty decreases wth an ncrease of ts own margnal costs and ncreases wth the margnal costs of ts rval. Analogously, each frm s optmal quantty decreases wth an ncrease n the substtutablty of ts own product, whle t ncreases the hgher s the (ceters parbus) substtutablty of the rval s product. Hence, nvestments of both knds represent negatve externaltes, as the reduced form proft functon of frm s gven by: π * * 2 s a c 2 a c ( c, c, s, s ) = q ( c, c, s, s ) = 2 ( ( ) ( )) ( ss 4). ( 4) In the next secton the frst stage of the game s analyzed, n whch frms choose ther strategc postonng,.e. ther optmal level of margnal costs and product substtutablty Strategc Postonng of Indvdual Frms Antcpatng the outcome of the stage-two game, frms choose optmal nvestment levels. Wth a certan nvestment n cost reducton they choose margnal costs of producton and wth a separate nvestment n product dfferentaton they choose a degree of product substtutablty. Frms strateges are ( cν, sν) R 2, wth c v [0, a] and s v [0, 1] wth v =, and a beng consumers prohbtve prce (or wllngness to pay). The Nash-equlbrum strateges of both frms (c, s ) and (c, s ) are defned by the mutual best-response property. That s for frm : 11

7 140 S. Rosenkranz and U. Wetzel ( c, s ) argmax{ = π ( c, c, s, s ) R( c ) M( s )}, ( 5) c, s * Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 and frm s maxmzaton problem s defned analogously. Solvng (5) wth respect to c, substtutng (2) and rearrangng leads to the followng frst-order condton: q * 4 ( c, c, s, s )( ) = R ( c ) ( 6) ss 4 The optmal level of margnal costs s gven by the equalty of margnal revenues of cost reducton and margnal costs of cost-reducng actvtes. If such process mprovement actvtes are not too costly (6) should lead to a soluton n [0, a]. Due to the assumpton concernng the cost functon of process mprovements, the only corner soluton whch can arse s c * = a meanng that the frm does not nvest n cost reducton. Maxmzng the frm s proft wth respect to s, we restrct our attenton to symmetrc equlbra. Solvng (5), then substtutng (3), usng q * = q * and rearrangng yelds: q * ( c, c, s, s )( ) = M ( s ). ( 7) ss Snce the frms are dentcal at the outset, we fnd analogous condtons for frm. We assume that smultaneous solutons to (6), (7) and the analogous condtons for frm exst. Let those solutons be defned by c*, s * and c *, s *. If we assume that for (5) the followng second-order condton holds 2 * * cs cc ss ( π ) ( π R )( π M ) c = c, s = s ( 8) then the model satsfes all condtons for the exstence of a unque symmetrc equlbrum n pure strateges Strategc Postonng of Allances Now suppose that frms coordnate ther cost reducton and product dfferentaton actvtes wthn an allance whle they reman compettors on the product market (n the second stage of the game). 13 If frms coordnate ther actvtes n the frst stage, they choose nvestment levels so as to maxmze ther ont proft, π + π. Snce the second stage s unaffected, only optmal quanttes are presented here. We assume that n an allance frms are commtted to choose a common level of margnal costs c AL and of product substtuton s AL. 14 Ths mples that the frms wll offer symmetrc quanttes q AL under ths regme. Optmal quanttes can therefore be derved from equaton 1 by subttutng c AL for c and c, and substtutng s and s by s AL : AL AL AL AL a c q ( c, s ) = AL. s + 2 Dfferentaton wth respect to margnal costs yelds:

8 Strategc Postonng of Allances 141 Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 AL 1 q AL * = c AL, ( 9) s + 2 whch of course s dfferent to the compettve case, snce frms gnore strategc effects. Turnng to the frst stage, now assume that the frms coordnate ther strateges so as to maxmze ont proft but do not acheve effcency gans because they reman two ndependent enttes. The frms ont proft s AL AL AL AL AL AL = 2π * ( c, s ) 2R( c ) 2M( s ). Maxmzng ont proft wth respect to margnal producton costs, usng (9) and rearrangng leads to the followng mplct functon, whch characterzes optmal nvestment n process nnovaton c AL *: 4 AL q * AL AL AL c s = R AL (, ) ( c ). ( 10) s + 2 Maxmzng ont proft wth respect to the level of product substtutablty yelds the mplct functon for s AL *: 4 AL* 2 AL AL* AL q c s = M AL (, ) ( s ). ( 11) s + 2 Obvously also the allance fnds t optmal to nvest n both actvtes, leadng to a postve nvestment n cost reducton and product dfferentaton. Let us now examne the relatonshp between the frst-order necessary condtons f frms choose ther strateges so as to maxmze only ther ndvdual profts, expressons (6) and (7), and compare these to the condtons when they maxmze combned profts n an allance, expressons (10) and (11). Note that the two problems are comparable n the sense that e.g. n case of cost reducton AL = + AL, c c c and Π s the (negatve) externalty conferred by frm s cost reducton to the proft of ts rval. Analogously, also the (negatve) externalty nduced through product dfferentaton actvtes by frm on the proft of frm s added to the compettve advantage externalty whch the frm s dfferentaton nvestment has on ts own proft through decreasng the amount of substtutablty to ts compettor s product. Those externaltes are gnored when each frm chooses ts costreducng expendture so as to maxmze ts own proft. They are nternalzed when the frms coordnate ther strateges n an allance. Each frm s nternalzaton of these externaltes s what causes the ndvdual maxmzaton problems to be equvalent to the ont maxmzaton problem that would be solved by a sngle drector of the allance. 15 To determne the effect of those strategc terms, the frst-order condtons (10) and (11) can be rewrtten as

9 142 S. Rosenkranz and U. Wetzel π c R + βπ = 0, and ( 12) c Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 π s s M + βπ = 0, ( 13) respectvely, wth β = 1. By applyng comparatve statcs wth respect to β the effects of addng these strategc terms to the frms frst-order condtons of proft maxmzaton can be analyzed. 16 Ths allows us to determne the effect of an ncrease n β on the frms strateges whch s summarzed n the followng proposton: Proposton 1: A coordnaton of strateges nduces frms not only to decrease ther nvestment but also to shft ther nvestment towards cost reducton. Proof: See the Appendx. As expected, f frms coordnate ther strateges wthn allances, the nternalzaton of negatve externaltes nduces them to reduce both knds of nvestments. Snce the allance nvests less nto both knds of nnovaton t must be that, * AL* due to (2) and (3), for equlbrum quanttes the followng holds: q > q. Thus, we can also conclude that consumers wll not beneft from the allance. But snce producers profts ncrease, the net effect wll be unclear and wll depend on the specfcaton of R&D costs. More surprsng s the fndng that cooperatvely orented frms shft ther actvtes towards cost reducton, suggestng that the externaltes of ths knd of nvestment are less strong than those nduced by product dfferentaton. The reasonng behnd these results wll be presented n secton 7. The slope of the R&D cost functon wll also determne the welfare consequences n the case that the allance s able to addtonally reduce competton n the marketng stage. Moreover, the effect of ncreased market power n both stages on the strategc postonng of the allance wll also strongly depend on the shape of the R&D cost functons. But, ndependent of the R&D cost functons, t can be shown that an allance wth ncreased market power would reduce producton costs more and dfferentate products less compared wth the prevous scenaro of separate marketng. Although allances that nclude ont marketng are treated more and more favourably under current competton regulaton, we focus on allances that compete n the product market n order to lmt our assumptons on R&D cost functons. 6. Changes n Market Sze The analyss of the optmal strategc postonng for allances has revealed that frms nvestment decsons are nfluenced by strategc externaltes. How does ths optmal nvestment decson change wth the market sze? Comparatve statcs concernng consumers prohbtve prce helps to answer ths queston f the prohbtve prce s nterpreted as the market potental. Up to now, a was consdered to be a constant. If ths assumpton s relaxed, the symmetrc equlbrum quantty n the case of competton n the frst stage s gven by q * = q a c a c a s a s * (, ( ), ( ), (), ()) a. Hence, t s straghtforward to analyze comparatve statc propertes. Ths allows us to determne the effect of an ncrease n a on

10 Strategc Postonng of Allances 143 a frm s cost reducton and product dfferentaton strateges whch s summarzed n the followng proposton: Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 Proposton 2: When the market sze ncreases nvestment n both knds of actvtes s ncreased and frms nvest proportonately more n product dfferentaton than n cost reducton. Proof: See the Appendx. We observe that n a small market frms nvest less n both knds of actvtes than n a large market, whch s n lne wth ntuton snce absolute returns on nvestment ncrease wth market sze. More strkng s the fact that gven some ntal dstrbuton of nvestment, frms wll shft ther nvestment from cost reducton to product dfferentaton f they are confronted wth a larger market. As explaned n the followng secton, the margnal return to nvestments n dfferentatng products ncreases more than that of nvestments n cost reducton. It s easy to check that these results also apply to allances. 7. Implcatons and Concluson In ths paper we have used a smple lnear demand structure whch enables us to analyze frms and allances strategc postonng decsons n a vertcally dfferentated ndustry. In partcular, we compare nvestment decsons n cost reducton and product dfferentaton under competton and n allances and conduct some comparatve statcs concernng the market sze. The frst and rather general contrbuton of the paper s that t explctly allows frms to allocate ther budget optmally among the two strategc optons of cost reducton and product dfferentaton, nstead of forcng them nto a polarzed strategc poston. Only f the costs assocated wth ether process mprovement or marketng and product development make nvestments neffcent, does the the model support the extreme cases of complete specalzaton on ether cost leadershp or product dfferentaton, whch are most often dscussed n the lterature. In contrast to Porter s (1980) orgnal concept, ths mplcaton supports the results of Gupta and Loulou (1998) as well as Rosenkranz (2003) and hghlghts the mportance of studyng cost and demand parameters ontly. In the strategc postonng of ther companes, managers should be aware that a polarzed noton of cost leadershp and product dfferentaton as two mutually exclusve optons may lead to suboptmal results. A second contrbuton of the paper s the fndng that the optmal allocaton of resources between cost reducton and product dfferentaton changes when a frm enters an allance. In the case of coordnated strategc postonng, the frms n the allance should be able to cut ther combned budgets for both cost reducton and product dfferentaton, snce they may be able to spare each other the possbly negatve externaltes of competng aganst each other. Ths so-called busness stealng effect nduces non-cooperatng frms to ncrease ther nvestment n compettve advantages compared to non-strategc nvestment decsons n allances. Snce the coordnaton of strateges n allances nternalzes the busness stealng effect, t allows for a reducton n total nvestment. In such a case, managers should shft ther (combned) nvestment more towards cost reducton and away from product dfferentaton because, n a world of strategc nteracton, changes n product dfferentaton may have a drect effect on

11 144 S. Rosenkranz and U. Wetzel Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 demand, whle cost-reducng nvestments effect demand only ndrectly through possble (but nether necessary nor equvalent) changes n consumer prces. Due to ths asymmetry, product dfferentaton results n stronger negatve externaltes. Accordngly, allances are able to cut product dfferentaton budgets more than those for cost reducton actvtes and thus shft the strategc focus towards process mprovements. Ths fndng depends on the sgns of the externaltes and thus on the features of the demand functon. It s n contrast to Rosenkranz (2003) where, n a settng of horzontal product dfferentaton, any marketng or product development actvty mposes a postve externalty on a frm s compettor. It s mportant to note that, of course, the presented results depend on the assumptons that are (mplctly or explctly) mposed. Surely, removng symmetry, changng the process of nnovaton or the number of frms n and outsde of the allance wll affect our results n ways that may be worth-whle to analyse n future studes. Also the structure of, and the governng arrangements n, the allance, or the feasblty of ont proft maxmzaton are nterestng ssues that would extend the scope of our analyss. Yet, assumptons regardng the sequence of decsons do not seem to alter our fndngs drastcally. Consder the followng two modellng alternatves: a) Frms frst nvest (smultaneously) n R&D and then decde whether to cooperate. There wll be two Nash equlbra n ths scenaro. If frms had nvested frst accordng to the ndependent optmum, there would no longer be an ncentve to form an allance as they overnvested already. (The stuaton would be dfferent f ndependent decsons lead to undernvestment.) If both frms had nvested on the c AL and s AL level, they would fnd t optmal to cooperate. A pror, frms would be facng a coordnaton problem that would be dffcult to solve wthout further assumptons. Furthermore, nvestment could have a commtment effect f decsons were not smultaneous. b) If we alternatvely ntroduced a frst stage n whch frms decded on whether to cooperate or not, they would always choose to cooperate not because ths leads to hgher profts snce under ont decson makng frms could always mmc the ndependent stuaton f that would be proftable. As a thrd contrbuton, ths paper supports Klepper s (1996) formalzaton of the technologcal lfe-cycle n a non-strategc settng and shows t s not ust an artfact of the underlyng lnear demand structure. Gven our assumptons, the results show that the larger the market potental, the more allances ncrease ther optmal total nvestment. Ths also holds for frms under competton rrespectve of the busness stealng effect. However, f managers are faced wth a large market potental, as s usually the case n the early phases of the technologcal lfecycle, our model suggests that they should optmally nvest more n product dfferentaton than n cost reducton measures. Here, agan, the stronger externaltes of product dfferentaton shft the optmal strategc postonng of allances (and frms) towards a relatvely hgher budget for marketng and product development actvtes. Conversely, f market potental stagnates or decreases n later stages of the technologcal lfe-cycle, the model shows that nvestment n process mprovement and cost reducton should be the most mportant strategy for allances and competng frms alke. In summary, our game theoretc analyss n ths paper shows that the attractveness of followng cost leadershp or dfferentaton strateges may be dfferent dependng on both allance buldng and the phase of the technologcal lfe-cycle. It s our hope that ths model contrbutes to a more thorough understandng of

12 Strategc Postonng of Allances 145 allance buldng and the strategc postonng of allances n relaton to nteractons between demand as well as cost parameters. Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 Notes 1. See Porter (1980), chapter 2. Hs argument s based on the smple economc trade-off that hgher qualty or better performng products often cost more to produce. They may, for nstance, need more expensve components or hgher up-front nvestment n desgn work. Also, hgher advertsng and promoton expendtures may be needed to communcate to consumers that the dfferentated product meets ther needs n a better way. 2. In consumer durables ndustres, for example, Mller and Fresen (1986a, 1986b) found that frms wth dfferentaton advantages also tend to have costs per unt that were sgnfcantly lower than the ndustry average. See also Phlps et al. (1983), Wrght (1987) or Mller and Dess (1983). Gupta and Loulon (1998) present a four-stage game, whch analyzes cost leadershp and dfferentaton strateges under dfferent dstrbuton channel structures. 3. The Natonal Cooperatve Research Act (NCRA) n the US, frst lmted to pre-compettve research, was subsequently challenged to nclude downstream actvtes such as product development, prototypng and producton. Amendments to the NCRA were turned nto publc law known as the Natonal Cooperatve Research and Producton Act (NCRPA) n The prerequstes for collaboraton n producton were determned to be that, frst, the ont venture partcpants had also cooperated earler n R&D and that, second, they would not ex-clude ndependent actvtes n the same feld. See Vonortas (2000) or Scott (2006) for detaled descrbtons of the US polcy towards cooperatve esearch. The European Unon has always had a more postve atttude toward R&D cooperaton and n 2000 the European Commsson fnally stated that the development of new or mproved products and processes and measures openng up new markets, leadng to sales expanson nto new terrtores or to the enlargement of a supply of new products, wll generally be assessed favorably. See Notce Concernng Assessment of Cooperatve Jont Ventures Pursuant to Artcle 85, 1993, Offcal Journal (C43) 2, These are the brand names used for the frst generaton of Eurovans produced snce See also Jolly (1997) on ths case. 5. See e.g. Dasgupta and Stgltz (1980), Glbert and Newberry (1982), Renganum (1983) for the tradtonal lterature on cost reducton through process nnovaton. And see Motta (1992) and Rosenkranz (1995) as examples of the lterature on dfferentaton through product nnovaton. 6. Ths s n lne wth the approach of Symeonds (2003), but allows a less complex setup for our analyss. 7. In secton 4 t s shown that the slope of both cost functons has to be suffcently hgh to guarantee the exstence of a unque symmetrc pure strategy equlbrum. 8. In the followng we use subscrpts to denote partal dervatves. 9. The Cournot quantty s postve for any frst-stage nvestment decsons whch satsfy 2( a c s a c ) ( + ) s and c a a c 2 and s, c 0. In the symmetrc case, to whch we wll lmt our attenton n what follows, these condtons are reduced to c, c a, and s, s 2 and are thus always satsfed. 10. Second-order condtons are satsfed. 11. Frms second-stage profts net of cost-reducng nvestments are represented by π whle gross profts are denoted as Π. 12. Checkng all relevant dervatves reveals that frms ndvdual profts are not supermodular n the two nvestments. Therefore, also asymmetrc equlbra mght exst whch can presumably be characterzed by one frm nvestng more whle the other s less actve wth respect to both, cost reducton and product dfferentaton. 13. Ths s a common assumpton n analytcal studes on allances and ont ventures, based on the fact that n most countres ont ventures have to be regstered and then are montored by the anttrust authortes. As the Eurovan example (mentoned n the ntroducton) shows, ths assumpton s also plausble. Despte ont development and producton of the Eurovan, the allance partners reman compettors on the product market. 14. In general, when ths equal treatment constrant s not mposed, dependng on the R&D cost functon frms may have an ncentve to reduce costs n one frm so that suppled quantty rses to the

13 146 S. Rosenkranz and U. Wetzel Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 monopoly level and compensate the other frm va sde payments for not producng (see Salant and Shaffer, 1998; Amr et al., 2003). However, as emphaszed n the lterature, such solutons are hard to realze n practce, as they are generally prohbted, e.g. n Europe under Artcle 81(1) of the EC Treaty. A common level of product dfferentaton and margnal costs can also be observed n realty, as the Eurovan allance produces ontly, and markets separately wth dfferent brands and slght modfcatons, but very smlar prces. 15. See Kamen et al. (1992) for a smlar argument n the comparson of R&D-cartels to compettve R&D. They apply the same formal approach but n ther model frms choose only one strategc varable. 16. If β = 0 we are n the compettve case. 17. Although cost functons for cost reducton and for product dfferentaton are assumed to be the same under the two regmes, here we label them wth subscrpts and AL n order to be able to dstngush the compettve and the cooperatve case. References Bonnano, G. and Haworth B. (1998) Intensty of competton and the choce between product and process nnovaton, Internatonal Journal of Industral Organzaton, 16(4), pp Dasgupta, P. and Stgltz J. (1980) Uncertanty, ndustral structure, and the speed of R&D, Bell Journal of Economcs, 11(1), pp De Bondt, R. (1997) Spllovers and nnovatve actvtes, Internatonal Journal of Industral Organzaton, 15(1), pp Dxt, A. and Stgltz J. (1977) Monopolstc competton and optmum product dversty, Amercan Economc Revew, 67(3), pp Gabszewcz, J. and Thsse J.-F. (1979) Prce competton, qualty and ncome dspartes, Journal of Economc Theory, 20(3), pp Gabszewcz, J. and Thsse J.-F. (1980) Entry (and ext) n a dfferentated ndustry, Journal of Economc Theory, 22(2), pp Glbert, R.J. and Newberry D.M. (1982) Pre-emptve patentng and the persstence of monopoly, Amercan Economc Revew, 72(3), pp Gupta, S. and Loulou R. (1998) Process nnovaton, product dfferentaton, and channel structure: strategc ncentves n a duopoly, Marketng Scence, 17(4), pp Jolly, D. (1997) Cooperaton n a nche market: the case of Fat and PSA n mult purpose vehcles, European Management Journal, 15(1), pp Kamen, M.I., Muller E. and Zang I. (1992) Research ont ventures and R&D cartels, Amercan Economc Revew, 82(5), pp Klepper, S. (1996) Entry, ext, and nnovaton over the product lfe cycle, Amercan Economc Revew, 86(3), pp Mller, A. and Dess G.G. (1993) Assessng Porter s (1980) model n terms of ts generalzablty, accuracy and smplcty, Journal of Management Studes, 30(5), pp Mller, D. and Fresen P. (1986a), Porter s (1980) Generc strateges and performance: an emprcal examnaton wth amercan data. Part I: Testng porter, Organzaton Studes, 7, pp Mller, D. and Fresen P. (1986b) Porter s (1980) Generc strateges and performance. Part II: Performance mplcatons, Organzaton Studes, 7, pp Motta, M. (1992) Cooperatve R&D and vertcal product dfferentaton, Internatonal Journal of Industral Organzaton, 10(4), pp Offcal Journal (C43) 2, 17 Concernng assessment of cooperatve ont ventures pursuant to Artcle 85 (1993). Phlps, L., Chang D. and Buzzell R. (1983) Product qualty, cost poston and busness performance, Journal of Marketng, 46(1), pp Porter, M.E. (1980) Compettve Strategy (New York: The Free Press) Rosenkranz, S. (1995) Innovaton and cooperaton under vertcal product dfferentaton, Internatonal Journal of Industral Organzaton, 13(1), pp Rosenkranz, S. (2003) Smultaneous choce of process and product nnovaton when consumers have a preference for product varety, Journal of Economc Behavor & Organzaton 50(2), pp Renganum, J. (1983) Uncertan nnovaton a the persstence of monopoly, Amercan Economc Revew, 73(4), pp Renganum, R. (1989) The tmng of nnovaton, n: R. Schmalensee and R.D. Wllg (Eds) Handbook of Industral Organzaton, Vol. 1, pp (Amsterdam: North Holland).

14 Strategc Postonng of Allances 147 Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 Salant, S.W. and Shaffer, G. (1998) Optmal asymmetrc strateges n research ont ventures, Internatonal Journal of Industral Organzaton, 16, pp Scott, J.T. (2006) The natonal cooperatve research and producton act, n: Wayne Dale Collns (Ed), Issues n Competton Law and Polcy, (Amercan Bar Assocaton, Anttrust Secton, forthcomng). Shaked, A. and Sutton J. (1982) Relaxng prce competton through product dfferentaton, The Revew of Economc Studes 49(1), pp Shaked, A. and Sutton J. (1983) Natural olgopoles, Econometrca 51(5), pp Spence, M. (1976) Product selecton, fxed costs and monopolstc competton, Revew of Economc Studes, 43(2), pp Symeonds, G. (2003) Qualty heterogenety and welfare, Economcs Letters 78(1), pp Wrght, P. (1987) A refnement of Porter s strateges, Strategc Management Journal, 8(1), pp Vonortas, N.S. (2000) Technology polcy n the Unted States and the European Unon: shftng orentaton towards technology users, Scence and Publc Polcy 27(2), pp Yn, X. and Zuscovtch E. (1998) Is frm sze conducve to R&D choce? A strategc analyss of product and process nnovatons, Journal of Economc Behavor and Organzaton, 35(2), pp

15 148 S. Rosenkranz and U. Wetzel Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 Appendx Proof of Proposton 1 Takng all varables as functons of β, total dfferentaton of (12) and (13) wth respect to β yelds: cc cc cs cs c sc sc ss ss s ( π R + βπ ) d c + ( π + βπ ) d s + π dβ = 0, ( π + βπ ) dc + ( π M + βπ ) ds + π dβ = 0. Applyng Cramer s rule leads to: dc sgn ( ) = sgn( ( π M + βπ ) π + π ( π + βπ )), d β ss ss c s cs cs ds sgn ( ) = sgn( ( π R + βπ ) π + π ( π + βπ )). d β cc cc s c sc sc To ensure that there exsts an equlbrum for all values of β, the second-order condton, gven by (8), has to be transformed to: + ( π βπ ) cs cs M π + βπ ss ss. π + βπ R cc cc 2 By dfferentaton of (4) t s easy to check that as well as π > 0 and π. To ensure that there exsts an equlbrum for all values of > 0 c s c s β, second-order condtons must contnue to hold. It turns out that dc ds > 0 and > 0. d β d β A coordnaton of strateges leads to lower nvestments. Next consder the rato of (7) and (6) n the compettve case: 17 π c > 0 and π > 0 s M = q *, R and of (11) and (10) under cooperaton: M R AL AL AL = q *. AL AL Usng (2) and (3), we know that due to the fact that c < c and s < s for equlbrum quanttes the followng holds: AL * AL *. Hence, M M q > q meanng > AL, R R that, compared to the compettve case, frms under cooperaton proportonally nvest more n cost reducton than n product dfferentaton.

16 Strategc Postonng of Allances 149 Downloaded By: [Jurdsche Bblotheek] At: 13:44 24 May 2007 Proof of Proposton 2 Consderng equlbrum strateges only, we want the frst-order condtons (7) and (6) to hold, f a changes: c ( π R ) + s π + π = 0, a cc a cs ca ss a cs sa s ( π M ) + c π + π = 0. a Applyng Cramer s rule, the followng relatons hold: dc sgn ( ) = sgn ( ( π M ) π + π π ) da ss ca cs sa ds sgn ( ) = sgn ( ( π R ) π + π π ). da cc sa ca sc By dfferentaton of (4), t s agan easly checked that as well as π c < 0. To a π s < 0. To ensure that there exsts an equlbrum for all values of a, secondorder condtons must contnue to hold. We therefore a fnd dc da ds < 0 and < 0. da Dfferentatng the rato of (7) and (6) wth respect to a yelds: ' M = qa * + q c + q s + q c + q s > R c a s a c a s a 0. a Frst note that q * a > 0. Usng (2) as well as (3) t s easly checked that the rght hand sde s postve.