Returns to Specialization, Transaction Costs and the Dynamics of Industry Evolution

Abstract

When more than one component or activity is needed to produce the final product, a firm may use proprietary standards or adopt a common standard to integrate these components. We call these closed and open firms respectively, and develop a model of industry evolution to study the process by which type of firm comes to dominate the industry. Our simulations show that an industry may diverge from its long run equilibrium configuration for sustained periods of time. Typically, the industry is dominated by closed firms in the early history and by open firms later on. Entry and exit dynamics create transient biases in favor of open firms. First, a closed entrant can capture multiple profits whereas an open entrant faces a lower entry barrier. However, while the odds of closed entry (relative to open entry) are initially greater than one, they decrease with price and eventually open entry becomes more likely than closed entry. Second, though initially closed firms can offset losses in one component with profits from another and thereby have better survival as compared to open firms, when prices fall below a threshold level, a closed firm is more likely to exit than a comparable pair of open firms. Finally, entry by an open firm improves the relative odds of entry by a complementary open firm, especially when the two complementary sectors differ in size or efficiency.

Note: The final version of the paper has been published under the title "Open Versus Closed Firms and the Dynamics of Industry Evolution'' in Journal of Industrial Economics, 2007, vol. 55, issue 3, pages 499-527.

Keywords: Vertical Integration, Externalities, Positive Feedback, Industry Evolution, Transaction Costs, Simulation Models

JEL Classification: L14, L22, L23