Firms and the Creation of New Markets - A New Institutional Economics Perspective

It’s an unfortunate truth that while profitable firms innovate, not all innovative firms are profitable. Often, one firm will innovate but another will reap the benefits by marketing the product either quicker or more effectively. Whether a firm engages in internal new product development or collaborates with third parties, creating new markets is difficult. In this new Working Paper, Professors Erin Anderson and Hubert Gatignon argue that the comparative perspective articulated by New Institutional Economics provides the best framework for understanding this problem.

by Erin Anderson,Hubert Gatignon
Last Updated: 23 Jul 2013

In recent years, it has become increasingly apparent that some of the key teachings of classic economic theory do not fit today’s business environment. Though firms try to follow economic logic, the nature of innovation strains their capacity to do so. From the inadequacy of classic economic theory to explain the constraints acting on firms, New Institutional Economics (NIE) was born. Combining several approaches, including property rights, transaction cost economics (TCE), evolutionary reasoning, the contractual nature of the firm, and allocation of common resource pools, NIE offers a new approach for understanding firm behaviour.

Taking NIE by the handle, Erin Anderson and Hubert Gatignon, both chaired professors of Marketing at INSEAD, set out to shed some light on the question of how firms create new markets. Prepared for publication in <i>The Handbook of New InstitutionalEconomics,</i> this paper focuses on transaction cost economics and evolutionary reasoning.

Firms can create new markets in one of two ways: either they find a new market for an exisiting product, or they create a new product that addresses a market need. Much of the paper focuses on the latter question and on the trials of new product development. A firm can develop new products in three ways: internally, via market contracts and third parties, or by acquiring or appropriating products developed elsewhere. As new product development is inherently uncertain and entails a great deal of risk, a number of constraints operate upon firms attempting to innovate. These are best understood under the umbrella of the TCE mechanisms of asset specificity, environmental uncertainty, and internal uncertainty (difficulty of assessing performance using output measures). In addition, evolutionary economics and path dependence can determine how successful a firm will be in collaborating with others. Each approach brings its own governance issues.

When engaging in internal development, firms are challenged to overcome barriers to communication, tacit knowledge, unwillingness of individuals to cooperate, and what is known as ‘the economics of atmosphere’. Through this, how an organization structures its internal processes, i.e. whether they engage in sequential or concurrent development, is important. Though a firm may have superior project development, the benefits this proposes can be offset by inferior commercialization.

An entirely separate set of problems accompanies outsourcing product development. Here, the situation is ripe for opportunism. Though this can be overcome by creating mutual vulnerability by tying product success together (taking hostages), institutional environment and past history of the relationship can play determining roles.

In product development by acquisition or appropriation, some of the same problems apply. As complex contingent claims contracting requires a high level of rationality and information, it is generally not a practical way of safeguarding against opportunism. Also, though licensing innovation is a possibility, it is extremely difficult for firms to assess innovations developed elsewhere, or even to uproot and use the innovation themselves. Vertical integration is a way of counteracting these transaction costs, but it is expensive and time consuming.

Even if a firm succeeds in developing a new product, it faces a number of challenges in successfully bringing it to market. Consumers are not perfectly informed about how well an innovation meets their needs. They might not even sense these needs at all. In order to overcome consumer reticence, firms must find, target and convince lead prospects in a country. This requires an intense marketing effort and raises the possibility that an excellent innovation might not create a market, simply because its introduction was mishandled. In sum, how a firm takes an innovation to market can determine whether a market comes into existence at all.


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