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

Listed author(s):
  • Ashish Arora

    (Carnegie Mellon University)

  • Farasat Bokhari

    (Florida State University)

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.

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Paper provided by EconWPA in its series Industrial Organization with number 9606002.

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Length: 22 pages
Date of creation: 29 Jun 1996
Date of revision: 01 Jul 1996
Handle: RePEc:wpa:wuwpio:9606002
Note: Type of Document - PDF; pages:22 ; figures: included. Document submitted in pdf. Prepared on EXP V5, LaTex Type set.
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  1. David, Paul A, 1985. "Clio and the Economics of QWERTY," American Economic Review, American Economic Association, vol. 75(2), pages 332-337, May.
  2. Langlois, Richard N., 1992. "External Economies and Economic Progress: The Case of the Microcomputer Industry," Business History Review, Cambridge University Press, vol. 66(01), pages 1-50, March.
  3. Michael L. Katz & Carl Shapiro, 1994. "Systems Competition and Network Effects," Journal of Economic Perspectives, American Economic Association, vol. 8(2), pages 93-115, Spring.
  4. Klepper, Steven, 1996. "Entry, Exit, Growth, and Innovation over the Product Life Cycle," American Economic Review, American Economic Association, vol. 86(3), pages 562-583, June.
  5. Timothy F. Bresnahan & Franco Malerba, 1997. "Industrial Dynamics and the Evolution of Firms' and Nations' Competitive Capabilities in the World Computer Industry," Working Papers 97030, Stanford University, Department of Economics.
  6. Young, Allyn A., 1928. "Increasing Returns and Economic Progress," History of Economic Thought Articles, McMaster University Archive for the History of Economic Thought, vol. 38, pages 527-542.
  7. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
  8. Joseph Farrell & Hunter K. Monroe & Garth Saloner, 1998. "The Vertical Organization of Industry: Systems Competition versus Component Competition," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 7(2), pages 143-182, 06.
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