KNOWLEDGE INHERITANCE, VERTICAL INTEGRATION,
AND ENTRANT SURVIVAL IN THE
EARLY U.S. AUTO INDUSTRY
Nicholas Argyres
Olin Business School, Campus Box 1133
Washington University in St. Louis
One Brookings Drive
St. Louis, MO 63130
Phone: 314-935-6391
argyres@wustl.edu
and
Romel Mostafa
Ivey Business School
Western University
1255 Western Road
London, ON N6G 0N1, Canada
Phone: (519) 661-4206
rmostafa@ivey.uwo.ca
January 2015
Running Head: Knowledge Inheritance and Vertical Integration
Acknowledgment: We are grateful to Lyda Bigelow and Steven Klepper for sharing data, and Dan Dunn
and Leslie Kendall for sharing their expertise on the early U.S. auto industry. Feedback from AMJ
associate editor, Kyle Mayer, and three anonymous referees improved the paper significantly. Rajshree
Agarwal, Brian Anderson, Pratima Bansal, Stefano Brusoni, Xavier Castaneda, Ronnie Chatterji, Adam
Fremeth, Tony Frost, Brent Goldfarb, Barton Hamilton, Guy Holburn, Tammy Madsen, Joanne Oxley,
Claus Rerup, Brian Richter, Oliver Williamson, and Chris Zott also offered helpful comments. Finally,
Katherine Dobscha, Jared Siegel, and James Wright provided outstanding research assistantship.
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Knowledge Inheritance and Vertical Integration
KNOWLEDGE INHERITANCE, VERTICAL INTEGRATION,
AND ENTRANT SURVIVAL IN THE
EARLY U.S. AUTO INDUSTRY
Abstract
A key finding in the literature on industry evolution and strategy is that knowledge
“inherited” from the founder’s previous employer can be an important source of a new firm’s
capabilities. We analyze the conditions under which knowledge that is useful for carrying out a
key value chain activity is inherited, and explore the mechanism through which such an
inheritance shapes an entrant’s strategies and, in the process, influences its performance.
Evidence from the early U.S. auto industry indicates that employee spinoffs generated from
incumbents that had integrated a key value chain activity were also more likely to integrate that
activity than other entrants, which, we suggest, reflects the application of knowledge inheritance
relative to that activity. Moreover, we find that the integration of this key activity, stimulated by
knowledge inheritance, contributed to the establishment of defensible strategic positioning,
thereby enhancing the survival duration of inheriting spinoffs. We thus link together the
phenomena of knowledge inheritance, vertical integration, and strategic positioning to explain
entrant performance. These three phenomena tend to be treated disparately in the literature,
rather than in combination.
179 words
Key words: knowledge inheritance, vertical integration, and strategic positioning
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Knowledge Inheritance and Vertical Integration
INTRODUCTION
One of the most robust findings in the literature on industry evolution and strategy is that
a firm’s pre-entry experience has a persistent effect on its post-entry performance, suggesting
that a firm’s capability development processes are influenced by its heritage (e.g., Carroll,
Bigelow, Seidel, & Tsai, 1996; Dunne, Roberts, & Samuelson, 1988; Klepper & Simons, 1997).
Recently, scholars have explored this effect of pre-entry experience by studying new firms
established by former employees of industry incumbents—so-called “employee spinoffs.”1
Several studies have demonstrated that spinoffs constitute a substantial source of entrants into a
variety of industries and tend to outperform other new entrants (for a review, see Klepper 2009).
The superior performance of spinoffs has been attributed to their founders’ industryspecific, pre-entry experience, which is lacking in non-spinoff entrants. Some studies suggest
that spinoffs build on the same knowledge that was initially exploited by their founders’ former
employers (i.e., the parent firms) (Agarwal, Echambadi, Franco, & Sarkar, 2004; Chatterji, 2009;
Klepper & Sleeper, 2005). Such involuntary transfer of knowledge from parent firms to their
spinoffs, commonly referred to as “knowledge inheritance,” is thought to be an important source
of spinoffs’ capabilities. However, the ways in which parental capabilities shape a spinoff’s
knowledge inheritance by influencing its strategic choices, thereby contributing to a spinoff’s
superior performance, remain poorly understood.
This paper aims to shed light on the mechanism through which knowledge inheritance
operates. We first examine the role of knowledge inheritance as a determinant of an entrant’s
decision to integrate value chain activities. Our analysis focuses on the integration decisions of
“key” value chain activities that can enable the firm to create and capture substantial value
“Employee spinoffs” or “spin-outs” are intended to be distinguished from “corporate spinoffs,” which are formed
through divestitures made by industry incumbents. Hereafter, we refer to employee spinoffs as simply “spinoffs.”
1
3
Knowledge Inheritance and Vertical Integration
(Brandenburger & Stuart,1996). We study the determinants of early integration choices at the
level of individual key activities because such strategic choices can reflect the application of a
firm’s initial capabilities (Argyres & Zenger, 2012) and can, therefore, expose the underlying
mechanism through which knowledge inheritance operates. We examine whether, beyond
immediate transaction cost considerations (Williamson, 1985), the decision to integrate a key
value chain activity is influenced by knowledge inheritance that is traceable to the parent firms’
own integration decision of that key activity. We then analyze whether and how the integration
of a key value chain activity that is shaped by knowledge inheritance can, in turn, contribute to
the establishment of a strategic market position of either cost leadership or differentiation
(Porter, 1980, 1985), thereby influencing a firm’s survival chances. In so doing, we extend prior
work that posits that decisions regarding vertical integration and positioning are made jointly
(Ghosh & John, 1999; Nickerson, Hamilton, & Wada, 2001) by incorporating the possibility that
such decisions are influenced by knowledge inheritance.
Our study focuses on the U.S. automobile manufacturing industry during 1917-1931, a
period in which the industry was characterized by rapid technological change and intense
competitive pressures (Carroll et al., 1996; Klepper 2004; Suarez & Utterback, 1995). We focus
on engine manufacturing as the key value chain activity in our context, although our notion of a
key value chain activity is quite general, and in other contexts could even encompass a capability
to design contracts with suppliers and distributors, perform logistics activities, or otherwise
manage outsourcing (e.g., Argyres & Mayer, 2007; Mayer & Salomon, 2006).
Our study provides several related insights. First, it sheds light on factors that give rise to
firms’ initial capabilities, and thereby, to some of a firm’s ultimate sources of competitive
advantage. In addition, because our analysis is at the level of individual value chain activities, it
4
Knowledge Inheritance and Vertical Integration
provides insight into the kinds of knowledge that are transmitted through the spinoff process, and
that are especially valuable to firms in technologically progressive industries (Elfenbein,
Hamilton & Zenger 2010). Moreover, whereas transaction cost economics ascribes no special
status to early versus later vertical integration decisions, our analysis points to the especially
long-run performance consequences of such early decisions (cf. Mayer, Somaya & Williamson
2012). Finally, whereas prior research attributes spinoffs’ superior performance simply to their
lineage, we provide a more nuanced explanation of the knowledge inheritance mechanism. Our
findings suggest that by influencing strategic choices concerning vertical integration and
positioning, knowledge inheritance contributes to superior performance. We thus link together
knowledge inheritance, vertical integration, and strategic positioning. These three phenomena
tend to be treated disparately in the literature, rather than in combination.
LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT
Strategy scholars have argued that firms achieve a competitive advantage by carving out
unique, defensible strategic positions in the market (e.g., Porter, 1980; 1985). Such advantages
are thought to be sustainable if they are supported by a difficult-to-imitate configuration of
activities, capabilities, or resources (e.g., Barney, 1991; Dierickx & Cool, 1989; Lippman &
Rumelt, 2003; Porter, 1996; Rumelt, 1984). A firm is expected to integrate a value chain activity
that require capabilities and resources uniquely complementary to its existing capability-resource
profile (Argyres & Zenger, 2012), in order to avoid the transaction costs associated with
accessing them through contracts (Klein, Crawford, & Alchian, 1978; Williamson, 1985).
Therefore, a firm’s strategic decisions regarding its positioning and vertical integration are made
jointly—in a way that is anticipated to provide it with a competitive advantage (e.g., Demsetz,
1988; Kogut & Zander, 1992; Argyres 1996; Ghosh & John, 1999; Nickerson et al. 2001;
5
Knowledge Inheritance and Vertical Integration
Argyres & Bigelow, 2010). Although the literatures on firm boundaries and strategic positioning
are thus becoming reconciled, this effort has been silent in terms of the sources of capabilities
that may differ between rivals, which may contribute to variations in integration choices and
strategic positioning, and, therefore, to variations in firm performance.
Researchers have long emphasized, however, that inter-firm personnel migrations can
lead to transfers of valuable knowledge and resources between organizations (e.g., Aldrich &
Pfeffer, 1976; Almeida & Kogut, 1999). Such transfers are particularly important when the firm
is founded (Stinchcombe, 1965). For example, founding conditions can have an enduring impact
on the firm’s organizational structures and inter-organizational networks (Baron, Hannan, &
Burton, 1999; Marquis, 2003). Moreover, research suggests that the firm’s pre-entry experiences,
which are expected to influence its founding conditions, have a persistent effect on its post-entry
performance (e.g., Carroll et al., 1996; Dunne et al., 1988; Klepper & Simons, 1997), as well as
on its decisions regarding the integration of links in its value chain (Qian, Agarwal, & Hoetker,
2012).
Recently, attention has shifted to employee spinoffs, which are thought to draw on
valuable knowledge from their parent firms (Agarwal et al., 2004; Chatterji, 2009; Klepper &
Sleeper, 2005). Because of capabilities’ path-dependent development, the initial capabilities that
a spinoff derives from its knowledge inheritance can significantly influence the shaping of its
future capabilities (Helfat & Lieberman, 2002; Lieberman & Montgomery, 1988). Numerous
studies have demonstrated that spinoffs outperform other new entrants, and that those spinoffs
spawned from more capable parent firms typically achieve superior performance (for a review,
see Klepper, 2009). Moreover, in some industries, the departure of employees to establish
spinoffs has been shown to negatively influence parental performance, suggesting that value
6
Knowledge Inheritance and Vertical Integration
creation by spinoffs can be associated with value destruction in parent firms (e.g., Wezel,
Catani, & Pennings, 2006; McKendrick, Wade & Jaffee, 2009; Campbell, Ganco, Franco &
Agarwal 2012). These studies suggest that knowledge inheritance not only can represent a
differential source of capabilities between spinoffs and other new entrants but can also be linked
to the capabilities of spinoffs’ parent firms. Far less understood, however, is exactly how the
parental firm’s capabilities influence a spinoff’s knowledge inheritance, and how such an
inheritance, in turn, spurs the spinoff’s strategic choices—specifically, its vertical-integration
profile and strategic positioning—that ultimately contribute to the spinoff’s superior
performance.
Vertical Integration
When making strategic decisions, firms face the daunting task of anticipating their future
competitive environment, including possible shocks to demand, regulations or technology (e.g.,
Suarez & Utterback 1995; Tegarden, Echols & Hatfield 1999; Nickerson & Silverman 2003;
Bayus & Agarwal, 2007; Argyres, Bigelow & Nickerson, 2013). Such shocks can intensify
competitive pressures by creating opportunities for new entrants, leading incumbents to become
more aggressive in defending their own strategic positions, and in attacking others’ (Schumpeter,
1934).2 Therefore, firms at their very formation have to make conjectures under uncertainty
about which positioning and integration choices would provide them with a competitive
advantage. Based on their conjectures, firms assemble the bundle of capabilities and resources
that is needed to carry out those activities (Rumelt 1984; Lippman & Rumelt 2003), taking into
When the industry’s competitive environment is sufficiently forgiving, firms whose conjectures turn out to be
unprofitable may have sufficient time to re-assemble their capability bundles by hiring or firing personnel, acquiring
firms, etc. On the other hand, when competitive pressures are particularly intense, such firms may lack the time to
make the appropriate adjustments and may be forced to exit. Such competitive pressures and fundamental
uncertainty about strategic decision-making are especially prevalent in relatively new industries (Klepper, 1996;
Knight, 1921).
2
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Knowledge Inheritance and Vertical Integration
account any unique complementarities between such activities (Argyres & Zenger, 2012). Over
time, as uncertainty becomes resolved, a firm that has integrated a value chain activity that turns
out to be “key” –i.e. the activity potentially enables the firm to create and capture substantial
value—can enjoy a sustained competitive advantage. Our analysis, therefore, focuses on the
decision to integrate a value chain activity that turns out to be key; in the following subsection,
we examine how this integration decision through the firm’s choice of positioning influence its
performance.
As noted earlier, an important source of a firm’s initial capabilities is knowledge
inheritance that it may possess as a spinoff. The literature on firm boundaries has argued, and
shown, that such boundaries are determined both by a firm’s capabilities for carrying out the
activity in question, relative to potential suppliers’, as well as the transaction costs associated
with that particular activity or transaction (e.g., Argyres, 1996; Leiblein & Miller, 2003; Argyres
& Zenger, 2012). The literature on knowledge inheritance would suggest, in turn, that a spinoff’s
initial capabilities (relative to its suppliers) are influenced by any knowledge that may have been
inherited from a parent firm. Because of this inheritance, and because the parent firm’s vertical
integration of an activity that turns out to be key reflects the latter’s own knowledge relative to
that activity, the underlying knowledge relevant to carrying out that activity in-house is more
likely to be transmitted through the spinoff process when the parent firm also performs that
activity internally. Incorporating the key arguments from the literature on firm boundaries would
suggest that capabilities derived from such knowledge will influence the spinoff’s verticalintegration decision to pursue the focal activity, after accounting for any asset specificity
associated with that activity. Therefore, controlling for the level of transaction costs associated
with a key activity, a spinoff spawned from a parent firm that vertically integrated a key activity
8
Knowledge Inheritance and Vertical Integration
is more likely to also integrate that activity than entrants that lack the same specific knowledge
inheritance.3
Note that there are two types of entrants that lack knowledge inheritance of this kind: (1)
spinoffs generated from parent firms that do not integrate the key activity, and (2) non-spinoffs
that by definition have no parent from which to draw knowledge. These two types may differ in
that while both lack a knowledge inheritance regarding the key activity, the first type (but not the
second) may benefit from knowledge inheritance regarding other activities that are, to some
degree, related to the key activities that its parent performed inhouse (e.g., Qian et al. 2012).
Because the effects for each type may differ, we separately compare each of the two types to
spinoffs that do inherit knowledge of the key activity. Our arguments, therefore, suggest that
Hypothesis 1(a): A spinoff spawned from a parent firm that integrates a key activity is
more likely to integrate that activity than a non-spinoff firm.
Hypothesis 1(b): A spinoff spawned from a parent firm that integrates a key activity is
more likely to integrate that activity than a spinoff whose parent firm did not integrate
that activity.
Positioning and Survival
Prior research suggests that spinoffs build on the knowledge they inherit from their parent
firms and, on average, outperform other new entrants. But how exactly does an initial capability
that is gained through knowledge inheritance improve a spinoff’s chances of survival? As noted
earlier, entrants are expected to make joint decisions regarding their vertical integration profile
and strategic positioning. Here we argue that knowledge inheritance stimulates both such
3
Our arguments are based on value chain activities that turn out to be key in the future. A related question concerns
the impact of knowledge inheritance on a spinoff’s vertical integration decision when the activity in question does
not turn out to be key. Because such decisions tend to be context-specific (e.g., they depend on the level of
uncertainty inherent in a given context) we explore them empirically.
9
Knowledge Inheritance and Vertical Integration
decisions in a way that their combined influence contributes to superior performance. Because
the strategic positioning choice must be supported by the vertical integration choice (Ghosh &
John, 1999; Nickerson et al. 2001), we suggest that the underlying capabilities that are reflected
in the vertical integration of an activity that turns out to be key will improve an entrant’s
performance to the extent that they enable the entrant to establish a defensible strategic position
in the industry (Porter, 1980, 1985). In other words, an entrant benefits from such capabilities if
those capabilities are important in creating and capturing value through a greater willingness-topay (and price), lower costs, or some combination of the two (e.g., Brandenburger & Stuart,
1996).
Successful strategic positioning implies that a firm’s product or service is unique in some
way, whether in its features, cost of production, or some combination of features and costs. Thus,
successful positioning requires that firms develop and continue to develop their products’ or
services’ features and/or cost structures to an extent that few or no rivals can match. For most
firms, achieving and upgrading these unique features or cost structures over time requires unique
capabilities. For example, firms that successfully compete on differentiation may develop
capabilities in product design or brand development that are unique to their industries, whereas
firms competing on cost leadership may combine various assets and processes in a unique way to
achieve a sustained low-cost position (Porter, 1996).
Developing and sustaining a unique feature or cost structure requires investment to create
a distinctive combination of complementary human and/or physical assets, R&D projects, brand
development capabilities, and the like (e.g., Lippman & Rumelt, 2003). To develop such a
unique combination of assets, firms’ investments must be at least partly idiosyncratic (Argyres &
Zenger, 2012); highly idiosyncratic investments usually must be made internally because relying
10
Knowledge Inheritance and Vertical Integration
an outside supplier risks the possibility of hold up, quality-shading or appropriation of
intellectual property by an opportunistic such supplier (Williamson, 1975, 1985, 1991).
We further suggest that inherited knowledge relevant to a key activity contributes to
developing unique capabilities because it represents the accumulation of long production
experience, including innovation in carrying out the focal activity (e.g., Klepper, 1996; Nelson,
1991). That is, a long history of production and innovation is likely to encompass unique and
valuable experiences, a view consistent with theories that explain why spinoffs occur in the first
place (e.g., Anton & Yao, 1995; Bhide, 2000; Cassiman & Ueda, 2006; Klepper & Sleeper,
2005; Klepper & Thompson, 2009). According to these theories, employees encounter new ideas
in their workplaces, but because of their employers’ limited capacity to pursue new innovations,
some employees leave to form spinoffs that aim to commercialize these ideas. Empirical studies
also find that spinoffs build on their parent firms’ knowledge base to successfully enter into
industry segments different from those in which the parent firm competes, suggesting that
knowledge inherited through the spinoff process can be extended across industry segments
(Agarwal et al., 2004; Chatterji, 2009; Klepper & Sleeper, 2005).
Having a unique combination of complementary capabilities, perhaps bolstered by a
knowledge inheritance, may, however, be insufficient for achieving a sustained competitive
advantage, as firm performance is also affected by the strength of competition in the strategic
position the firm chooses to enter (e.g., Priem & Butler, 2001). For example, a firm with unique
resources or capabilities that targets customers already well-served by competitors may face
more difficulty in sustaining a competitive advantage than a firm that uses its unique capabilities
to target customers less well served by rivals. However, when unique capabilities are leveraged
to enter strategic positions that the firm can effectively defend, such unique capabilities will
11
Knowledge Inheritance and Vertical Integration
positively influence firm performance. This effect is enhanced when rival firms that initially
outsourced what turns out to be a key activity find it difficult to later pull the transaction inhouse,
thereby becoming weaker competitors (e.g., Mayer, Somaya & Williamson 2012). Importantly,
our argument that successful positioning rests on unique capabilities suggests a link between an
entrant’s choice regarding strategic positioning, and its choice regarding vertical integration of a
key activity.
Our theoretical framework departs in important ways from the few studies that have
studied the link between strategic positioning and vertical integration (Ghosh & John, 1999;
Nickerson et al., 2001). In Nickerson et al. (2001), for example, a firm’s strategic positioning
choice affects its choice of idiosyncratic resource profile, which, in turn, influences its vertical
integration decisions. Our framework accommodates knowledge inheritance that is passed on at
the time of the spinoff’s entry. Specifically, we argue that: (1) a spinoff’s knowledge inheritance
regarding a key activity stimulates its decision to vertically integrate that activity; (2) to be
defensible, a strategic position must be supported by unique capabilities, (3) knowledge
inheritance relevant to that key activity can contribute to spinoffs’ unique capabilities; and
therefore (4) a spinoff’s knowledge inheritance influences its choice of strategic positioning.
Moreover, our framework also emphasizes that early vertical integration decisions are made
under uncertainty about which activities will turn out to be key, and as this uncertainty becomes
resolved, spinoffs that inherit knowledge relevant to what turns out to be a key activity will have
an advantage because they can exploit their inheritance to integrate the activity and support their
positioning. Such an inheriting spinoff will enjoy superior performance, including longer
survival time than other entrants.4 Accordingly, we hypothesize that:
4
Note that our arguments can be extended by relaxing the assumption that knowledge inheritance involves new
ideas for a key activity. The integration of a key activity by a parent firm suggests that the parent firm’s underlying
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Knowledge Inheritance and Vertical Integration
Hypothesis 2(a). The integration of a key activity that is stimulated by the spinoff’s
knowledge inheritance contributes to the establishment of a defensible strategic position.
Hypothesis 2(b). Strategic positioning that is made defensible by the integration of a key
activity, which in turn is stimulated by the spinoff’s knowledge inheritance, increases its
survival time.
EARLY U.S. AUTO INDUSTRY CONTEXT
The early U.S. auto industry provides the testbed for our hypotheses. Because of much
interest by auto enthusiasts, unusually rich historical materials on U.S. auto manufacturers are
available, including information about their backgrounds, the main features of their cars, and the
key components they used. Klepper (2007) documents various types of entrants into the industry
during its formative years and demonstrates that spinoffs played a vital role in its early
development. Former employees of auto manufacturers founded some of the most innovative and
financially successful firms in the industry, including Ford, Chevrolet, Lincoln, Dodge,
Duesenberg, and Hudson. Many of these “first-generation” spinoffs led to a second generation of
spinoffs, further stimulating industry development. The frequency and importance of spinoffs are
thought to be an important reason for the agglomeration of the U.S. auto industry around Detroit
(Klepper, 2007).
Vertical-integration decisions loomed large in the early auto industry, as they continue to
do today. Many early auto firms initially lacked high levels of integration, operating as pure
assemblers only (Langlois & Robertson, 1989). Ford, on the other hand, became famous for its
capability is unique. If a spinoff of that parent firm exactly replicates the parent firm’s underlying capabilities
reflected in a key activity, the spinoff will also need to vertically integrate that key activity, as those capabilities are
unique in the market. For such a purely imitating spinoff, a knowledge inheritance can enable it to compete more
fiercely with the parent firm than other entrants that lack the relevant knowledge inheritance and yet vertically
integrate to participate in the focal market segment.
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Knowledge Inheritance and Vertical Integration
high degree of vertical integration of component fabrication, which Henry Ford believed was
necessary to implement his innovative assembly lines and system of interchangeable parts. Other
firms relied more heavily on component suppliers. Thus, consistent with the theoretical
discussion above, firms made varying conjectures regarding the kinds of capabilities to
develop—and, therefore, the value chain activities to integrate—to best enable them to create
and capture value.
Scholars have attributed Ford’s significant cost advantage in the 1910s and 1920s in part
to its high degree of vertical integration (Hounshell, 1984; Langlois & Robertson, 1989; Nevins
with Hill, 1954, 1957). As design and engineering standards were promulgated throughout the
industry in the early 1920s, however, firms that had integrated found they were increasingly able
to cut costs by vertically de-integrating the production of many components (Argyres &
Bigelow, 2010; Katz, 1977). On the other hand, during this period, firms were increasingly
internalizing the production of one component—the engine (see Table 1).
---------------------Table 1 about here
---------------------Three related reasons explain why companies increasingly integrated engine production
as the industry developed during the 1920s. First, engines, especially larger engines, featured
multiple subtle and complex engineering interfaces among multiple components, including,
among others, the transmission, ignition, and steering system. Coordinating component designs
across these interfaces required significant technical communication and therefore involved high
human asset specificity (e.g., Masten, Meehan, & Snyder, 1989; Monteverde, 1995). In contrast,
other components, such as the rear axle or frame, maintained simpler interfaces with other
components (Bigelow & Argyres, 2008). Following transaction cost theory, high human asset
14
Knowledge Inheritance and Vertical Integration
specificity calls for vertical integration due to the potential for opportunistic hold-up
(Williamson, 1985). Therefore, during this period as the average size of engines was increasing,
and so was their complexity, vertical integration of engine production became more common.
A second reason why firms increasingly sought to integrate engine production was that,
more than other components, engines were becoming a key differentiating factor for many cars.
For example, companies commonly advertised vehicles based on the quality and performance of
their engines (Argyres & Bigelow, 2010; Flammang & Kowalke, 1989). Driving conditions were
sometimes problematic in the 1920s, and many engines were underpowered or unreliable,
leading to driving difficulties. Therefore, customers paid significant attention to advertisements
extolling the mountains that cars were able to climb and the distances they were able to travel,
similar to today’s advertisements for pickup trucks and sport-utility vehicles (Interview, Dan
Dunn, Blackhawk Museum, Danville, CA; Interview, Leslie Kendall, Petersen Automotive
Museum, Los Angeles, CA). With the value of a company’s brand name resting heavily on the
performance of its engines, many companies—especially those in middle and higher tiers of the
market—were reluctant to outsource their engine production due to the potential consequences of
quality-shading, or otherwise underperformance, on the part of an independent supplier. For
larger engines, therefore, integration of the engine transaction was more efficient due to the
superior quality monitoring associated with internal organization (Barzel, 1982; Williamson,
1985).
Finally, the period of the 1910s and 1920s was one of fierce competition and involved a
severe industry shakeout (Carroll et al., 1996; Klepper 2004; Suarez & Utterback, 1995). In this
unforgiving competitive environment, firms in all segments that failed to efficiently organize
their transactions—especially their engine transactions— faced reduced chances for survival,
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Knowledge Inheritance and Vertical Integration
compared with the industry’s earlier period (Argyres & Bigelow, 2007). An important driver of
this increased competition was Ford’s 1908 introduction of the revolutionary and low-priced
Model T, which, by 1919, accounted for 50 percent of the U.S. market. Ford was able to take this
leadership position, in part because its overriding success had led to the exit of most firms
attempting to compete in the lowest-price industry segment (Argyres, Bigelow, & Nickerson,
2013; Smith, 1968). Survival chances were much higher for those firms that managed to avoid
direct competition with Ford by carving out their niches in higher-price segments, which called
for larger, more specialized engines.
Given the overriding relative importance of engines to automobile cost and performance
during the early years of the industry, engine production is the “key activity” to which we refer
in the hypotheses above. In these early years, technological innovation represented a major
success factor; only later did distribution through dealerships and other factors become important
(Smith, 1968). Our notion of “establishing a defensible strategic position” is defined in terms of
whether a given entrant was able to avoid competing in the lowest-price segment of the market
following the introduction of the Model T. Our theory thus suggests that in the early U.S. auto
industry, the higher was the price segment that an entrant could participate in by producing
specialized engines in-house the more defensible was its strategic positioning. Although price
was not the only form of segmentation in the auto industry at the time, its importance is
undeniable (Smith, 1968). Moreover, spinoffs that inherited knowledge about engine production
were advantaged because such knowledge contributed to building larger specialized engines,
thereby enabling inheriting spinoffs to better defend their positions in higher-price segments.
The early auto industry provides numerous examples of spinoffs whose founders and/or
early employees were formerly engine designers at a parent firm, many of whom left to build
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Knowledge Inheritance and Vertical Integration
different (often larger) engines from which to develop a new car models. These examples can be
found in the Standard Catalogue of American Cars, 1805–1942 (Kimes & Clark, 1989), which
includes entries on every known U.S. auto manufacturer during the period of our study. The
catalog represents the culmination of many years of research by historians, journalists, collectors,
and others. Using this catalog and other sources,5 we found historical evidence for transfer of
engine knowledge from incumbents to their spinoffs: Cleveland, Duesenberg, Falcon, Gray,
Harroun, Holmes, La Fayette, Lincoln, Parenti, and Sterling-Knight. Table 2 characterizes the
various types of entrants during the period of our study.
---------------------Table 2 about here
---------------------Henry Martyn Leland is an example of a firm founder who transferred key engine
knowledge from a former employer to his own start-up. Leland had designed the single-cylinder
engine that powered the first Cadillac and later oversaw the development of Cadillac’s
breakthrough V-8 engine. In 1917, however, Leland left Cadillac with his son Wilfred, who was
also instrumental in the development of the V-8 engine, after a dispute with General Motors’
head William Durant. Leland wanted Cadillac to convert to production of aviation engines for
the WWI war effort, but Durant refused. Leland founded the Lincoln Motor Company, produced
aviation engines for the war effort, and, after the war, began producing luxury cars with newly
designed V-8 engines. Lincoln’s first car, the Model L, was praised for its precision engineering
(Kimes & Clark, 1989: 866).
Other successful firm founders hailed from less successful parent firms. For example,
Fred and Augie Duesenberg had designed engines for Mason of Des Moines, Iowa, a company
5
In addition to Kimes and Clark (1989), the following examples draw from Yates (1994), Hyde (2005, 2009),
Stoddard (2011), and the websites of various university libraries and auto enthusiasts.
17
Knowledge Inheritance and Vertical Integration
whose sales were disappointing and whose ownership had been re-organized several times. The
company’s problems were not attributed to the Duesenberg-designed engines, but to
mismanagement of parts procurement (Kimes & Clark, 1989: 935). Eventually, the Duesenbergs
formed their own company, building high-performance cars using a horizontal-valve rocker-arm
engine technology similar to a system they had designed for Mason. Early Duesenberg models
were extremely successful on the racing circuit, and the company went on to become an icon of
the U.S. auto industry.
DATA AND ESTIMATIONS
The quantitative data for our analysis were drawn from a larger database that includes a
range of information on auto companies for virtually every firm in the U.S. auto industry during
the period 1895 to 1981. This larger database was constructed from a variety of historical
sources, including Baldwin et al. (1987), Flammang and Kowalke (1989), Georgano (1982),
Gunnell (1987), and Kimes and Clark (1989). For the current study, we combined these data both
with information gathered by Steven Klepper on every spinoff known to have occurred in the
early auto industry (Klepper, 2007) and with data from Lester-Steele (1960) on automobile
components and other characteristics.6
We focused on the early period, 1917–1931, for which we have information on engine
integration. The database identified 71 entrants in the early U.S. auto industry during this period.
Of these, we had sufficient data on 63 entrants. Despite this relatively small number of firms,
they closely resemble the population of entrants of interest for our study, given our focus on preentry experiences and their effects on vertical-integration choices at entry.
6
Various versions of the dataset have been studied by Argyres and Bigelow (2007, 2010), Bigelow and Argyres
(2008), Carroll et al. (1996), Dobrev (2007), Dobrev and Carroll (2003), Dobrev and Kim (2006), and Dobrev, Kim,
and Carroll (2002, 2003). None of these studies addressed the relationship between knowledge inheritance and
strategic choices.
18
Knowledge Inheritance and Vertical Integration
To test Hypotheses 1(a) and 1(b), we conducted probit estimations in which the
dependent variable, Engine In-house, takes the value of 1 if the firm in question vertically
integrated the production of the engine at the time of entry, and zero otherwise (see Table 3).7
The explanatory variable of primary interest in this estimation is Parent Engine In-house, which
takes the value of 1 if the firm was a spinoff and its parent produced at least one type of engine
in-house at the time of, or prior to, the spinoff’s entry, and zero otherwise. We also entered
Parent Engine Outsourced, which takes the value of 1 if the parent firm outsourced engine
production, and zero otherwise. The omitted category consists of non-spinoff firms.8 Hypothesis
1 predicts a positive and significant coefficient estimate for the Parent Engine In-house variable,
and this coefficient estimate will be significantly larger in magnitude than that for Parent Engine
Outsourced.
As noted in our theoretical framework, transaction cost economics predicts that the
higher the asset specificity associated with an activity, the greater the likelihood of integration of
that activity. We use two proxies for transaction costs associated with sourcing engines. We
include Relative HP (horsepower), calculated as a standardized score of the engine’s horsepower
using the mean and standard deviations of HP of car models in the industry at the time of a
firm’s entry. Interviews with experts at the Blackhawk and Petersen auto museums, and at the
National Automotive Historical Collection in Detroit, indicated that, during this period, the
larger engines tended to require more idiosyncratic, or at least more complex, investment
(Bigelow & Argyres, 2008), and therefore are more susceptible to transactional hazards. In
7
Very few entrants produced multiple models at their time of entry, and very few changed their engine integration
choice over the studied period.
8
Prior research has found that entrants from a related industry (de alio entrants) had greater survival chances for,
both in this and other industries (e.g., Argyres & Bigelow, 2007; Carroll et al., 1996; Klepper, 2002). Unfortunately,
our data did not allow us to conclusively distinguish those de alio entrants that were engine producers from those
that were not, prior to entering into the automobile industry. For this study, we included de alio entrants in the “nonspinoff” category. Including a separate de alio category does not change the results of any of our estimations.
19
Knowledge Inheritance and Vertical Integration
addition, because transactional hazards are expected to diminish with greater availability of
idiosyncratic suppliers (Williamson, 1975), we include the variable # of Large Engine Suppliers,
which represents the total number of suppliers in each year that were selling engines larger than
1 standard deviation above the mean level of horsepower in the sample.9
Firms may choose to vertically integrate the production of a component when they expect
to achieve economies of scope across multiple products that use the component. As Riordan and
Williamson (1985) show, such economies may exert an independent effect on vertical
integration, even when most of the overall effect is likely to be result from proxies for
transaction costs. We therefore included a measure of the number of car models produced by the
firm in the given year, # of Models. We also included a control to act as a proxy for the
transportation costs that might be involved with outsourcing engine production to a supplier. The
variable Michigan takes on the value of 1 if the firm in question was located in the state of
Michigan (relatively close to the engine supplier base), and zero otherwise. In this period, the
industry was heavily concentrated around Detroit, Michigan, and in the bordering states of Ohio
and Indiana. We included measures of Industry Production and GNP to act as proxies for
financial or other resource constraints that might have prevented firms from vertically integrating
during a given year, or from outsourcing due to supplier weakness.
We additionally controlled for the overall production capabilities of the firm by including
a variable, Early Entrant, that takes the value of one if the firm entered during 1919 or earlier,
and zero otherwise.10 Klepper (1996, 2002) emphasizes the importance of early entry for the
9
Our results do not change when we use the mean, or 2 standard deviations above it, as alternative cut-offs. Note
also that following the empirical literature in transaction cost economics it is assumed that asset specificity (engine
horsepower) is exogenous, although this is a limitation of such studies.
10
Firm size might be expected to affect vertical integration if larger firms face fewer capital constraints in pursuing
such integration. However, Bigelow and Argyres (2008) found no such effect in a larger sample from the same
dataset as reported on in this paper. Including the number of cars produced at the time of entry as a measure of firm
20
Knowledge Inheritance and Vertical Integration
development of superior production capabilities in general, including in the auto industry
(Klepper, 2004). We also included alternate measures of the quality of a parent firm’s overall
production capability as a control variable. Our first such measure is Parent Market Share
(measured in the year that the spinoff was established). In unreported regressions, we substituted
Parent Survival (the number of years that the parent firm survived) for Parent Market Share and
obtained similar results (the two variables are highly correlated, so we entered them separately).
Some studies have found that better-performing parent firms yield better-performing spinoffs (cf.
Klepper & Sleeper, 2005; Franco & Filson, 2006). If parent firms’ overall production capability
is associated with engine integration by spinoffs, then spinoffs from better-performing parent
firms would be more likely to integrate engine production.
To test Hypothesis 2, we created a proxy for strategic positioning, Log Price, which is the
log of the price of the automobile in question.11 Recall that higher-priced cars were relatively
insulated from direct competition with Ford’s Model T, the dominant product at the time. Thus,
in our setting, higher price segments will be reflected as more defensible strategic positioning. In
addition, we created two alternative measures of firm survival (for robustness). The first, Log
Survival Years, is the log of the number of years the firm survived. The second (Long Survivor)
is a dummy variable that takes the value of 1 if the firm survived five years or longer (top 25
percent of the sample), and zero otherwise.12 Prior studies examining firm performance in the
early U.S. auto industry used the hazard rate of exit. We instead adopted a continuous and
dichotomous measure to accommodate our use of a multi-stage estimation method that accounts
size does not significantly alter our results. Because we are missing size information for some firms, we excluded it
from the reported results.
11
The mean and standard deviation of car prices in the industry were similar across years during the period of our
study. The distribution of car prices in the sample is skewed to the right, and hence car prices were logged.
12
Our results do not change when we use the median number of survival years (3), or the alternative cutoffs of 4, 5,
6, or 7 years.
21
Knowledge Inheritance and Vertical Integration
for potential simultaneity in strategic decisions (see below). Hazard rate models have the
advantage of controlling right-censoring. Only three observations were right-censored (due to
acquisitions) and were dropped to accommodate our alternative survival measures, reducing the
sample to 60 entrants.
According to our theoretical framework, knowledge inheritance and transaction cost
considerations influence an entrant’s decision to vertically integrate a key activity. Vertical
integration of this key activity, stimulated by knowledge inheritance, influences a firm’s strategic
positioning, which in turn contributes to firm performance (because firms that are able to enter
more defensible positions will achieve superior performance). Thus, our theoretical framework
requires estimating three equations that explain: (1) vertical integration (Engine In-house), (2)
market positioning (Log Price), and (3) survival (Survival Years and Top 25% Surviving).
However, unobservable factors that influence the choice of vertical integration could be
correlated with unobservable factors that impact strategic positioning and survival. For example,
unobserved entrepreneurial ability could be correlated with vertical integration, market segment
choices and firm performance. Therefore, independently estimating the equations determining
vertical integration, positioning and survival would be problematic, because the error terms in
these equations could be correlated. To account for such potential simultaneity concern, we
estimated our three equations using a multistage estimation method, following Nickerson et al.
(2001) and outlined in Wooldridge (2002). The first stage involves estimating a probit model for
vertical integration choice, as described above, while the second and the third stages involve
estimating the effect of vertical integration on strategic positioning (Log Price), and the effect of
strategic positioning on survival (Survival Years and Top 25% Surviving), respectively, as
described below.
22
Knowledge Inheritance and Vertical Integration
A key assumption in our econometric approach is that parental capabilities associated
with the key activity, and transaction costs associated with that activity, do not have a direct
effect on strategic positioning or firm performance, but instead exert their influence through
vertical integration choice. Recall that whereas the literature on positioning ignores transaction
costs (Porter, 1980; 1985; 1996) and the literature on transaction costs emphasizes economizing
over positioning (Williamson, 1993), our own synthesis of them yields an important implication:
a firm’s strategic positioning and performance are linked to its capabilities as reflected in its
choice regarding whether to integrate the key activity in question or not. This implies that
whereas both parental capabilities and transaction costs will influence its decision to integrate the
key activity, these factors will influence positioning or firm performance insofar as they
contribute to capabilities reflected in vertical integration of the key activity. Accordingly, in our
second and third stage estimations, we excluded the variables Parent Engine In-house, Parent
Engine Outsourced, Relative HP and # of Large Engine Suppliers.
Because Engine In-house is a dichotomous endogeneous variable, we followed an
empirical technique outlined in Wooldridge (2002) to obtain consistent estimates and correct
standard errors. The predicted values from the probit estimation of the first stage were used in
lieu of actual values of Engine In-house in a linear probability model with vertical integration
choice as the dependent variable. We then included the predicted values of vertical integration
choice from the linear probability model in the Ordinary Least Squares (OLS) model with Log
Price as the dependent variable. All control variables from the first stage (probit model) were
included in the subsequent stages.
Finally, we estimated equations predicting firm survival according to our two alternative
measures, Firm Survival Years and Long Survivor. In these equations, we entered the predicted
23
Knowledge Inheritance and Vertical Integration
values of Log Price from the strategic positioning regression in lieu of actual values of Log
Price. We used tobit estimation to analyze Firm Survival Years, as this variable is bounded
below at zero and a probit estimation to analyze Long Survivor as this variable is dichotomous.
Again, in these estimations, we included all control variables that were used in the first stage.
Because predicted values of endogenous variables are constructed so as to be correlated with the
explanatory variables of interest, but not with the error terms, their use alleviates the problem of
correlated error terms across equations (Maddala, 1983).
RESULTS
Table 3 provides descriptive statistics and inter-correlations for variables in our
regressions. The high negative correlation between Industry Production and # of Large Engine
Suppliers (and between GNP and # of Engine Suppliers) likely reflects the trend toward vertical
integration of engines as industry production and gross national product (GNP) grew during the
period.
---------------------Table 3 about here
---------------------Table 4 provides the coefficient estimates for the equations in our models. Model 1
shows the probit estimations of engine vertical integration. Consistent with transaction cost
economics, our proxy for asset specificity is positive and significant in all four models. In
addition, the positive and significant coefficient estimates on Parent Engine In-house support for
Hypothesis 1(a) because they imply that spinoffs whose parent firms integrated the key activity
were significantly more likely to also integrate the key activity (engine production) than were
non-spinoff firms (the omitted category). The marginal effect based on our model implies that a
spinoff whose parent firm integrated engine production was 59 percent more likely than a non-
24
Knowledge Inheritance and Vertical Integration
spinoff firm to also integrate engine production. Moreover, consistent with Hypothesis 1(b), the
absolute value of the difference between the coefficient of Parent Engine In-house and that of
Parent Engine Outsourced is significantly different from zero (e.g., ᵪ2 = 3.48; prob. > ᵪ2 = 0.06).
Note also, as predicted by our theoretical framework, the coefficient estimate for Parent Engine
Outsourced is not significant, suggesting that spinoffs with parent firms that did not vertically
integrate were no more likely to vertically integrate than non-spinoffs (the omitted category)
because they both lacked knowledge inheritance specific to engines. Stated equivalently, spinoffs
with parent firms that contracted for engines were no more likely to contract for engines than
non-spinoffs.
The coefficient estimate on Early Entrant is negative and statistically significant. Later
entrants may have been more likely to vertically integrate because after Ford’s strong entry into
the low-price segment, differentiation, which required engine integration, became a more
attractive entry strategy. The coefficients on Industry Production, # of Large Engine Suppliers,
and GNP are not significant. Multi-collinearity is not the cause of this, however, because
dropping all but one of these variables from the models does not make the remaining variable
statistically significant.
We also carried out probit regressions similar to Model 1 for the vertical integration of
several components other than engines. The non-engine components for which we have
sufficient data are the transmission, steering, clutch, and frame. We wanted to explore whether
knowledge inheritance related to these other value chain activities was important. For example,
perhaps knowledge inherited regarding production of these other components can substitute for
engine production knowledge in enabling the spinoff to establish a defensible position. The
results, not reported here, suggest that spinoffs with parent firms that integrated a non-engine
25
Knowledge Inheritance and Vertical Integration
component were not more likely to produce that component in-house. Hence, we find no
evidence of knowledge inheritance relative to these activities.
---------------------Table 4 about here
---------------------Model 2 shows the coefficient estimates for the models of strategic positioning, while
Models 3 and 4 present the coefficient estimates for the survival equation. Model 5 includes
dummy variables for whether the production of the non-engine components was integrated,
which controls for potential interdependencies across components in vertical-integration
decisions (e.g., Bigelow & Argyres, 2008; Novak & Stern, 2009). Because data on these
components were missing for 4 entrants, the sample size dropped to 56 in model 5.
The coefficient estimate on the predicted value of vertical integration in Model 3,
Predicted Vertical Integration, is positive and statistically significant, indicating that firms
choosing to integrate engine production were more likely to position themselves in higher price
segments, away from Ford. This finding along with our results from Model 1, provide support
for Hypothesis 2(a). A spinoff’s knowledge inheritance relevant to production of engines
influenced its own decision to vertically integrate this activity, which contributed to the
establishment of a defensible position (in this case a differentiated position).
Models 3, 4 and 5 present our estimates for entrants’ survival duration. The coefficient on
Predicted Log Price in Models 3, 4, and 5 is positive and statistically significant, indicating that
firms choosing higher price segments survived longer on average. These two results, together
with the key results from Models 1 and 2 provide support for Hypothesis 2(b): the combination
of vertical integration of engines—the key activity in question—and differentiated positioning,
increased survival time; and, because spinoffs with a knowledge inheritance relevant to engine
26
Knowledge Inheritance and Vertical Integration
production were more likely to integrate and achieve such positioning, they out-survived other
entrants. The coefficient on # of Models is positive and significant in Model 2, likely because of
greater opportunities to differentiate across multiple car models in higher segments of the
market, due to the greater number of differentiable features of cars in those segments.
Our estimation method to account for endogeneity does not allow us to statistically
compare the survival durations of different types of entrants and their integration and positioning
choices. However, we estimated hazard rate models of firm survival and found that the positive
effect of a firm’s integration of engine production on firm survival was moderated by its
positioning, and this effect was larger for spinoffs whose parents integrated engines than for
integrated non-spinoffs. Although this estimation allows us to compare marginal effects by
entrant types, we do not report its results because it cannot account for simultaneity between the
choices of vertical integration and strategic positioning.
Alternative Explanations
One might expect that better-quality parent firms are more likely to integrate engine
production and secure defensible positioning, and for that reason we included alternate controls
for parent quality in our regressions. Our proxy for parent firm quality, however, may be noisy.
If so, a potential concern is that what is important to the spinoff’s vertical integration decision for
the key activity is not knowledge inheritance relevant to engine production per se, but rather
inheritance of overall knowledge of automobile production. As noted above, we take steps
empirically to account for the effects of unobserved heterogeneity in entrepreneurial ability on
both vertical integration and positioning. In addition, we noted above that we found no evidence
of application of knowledge inheritance relative to non-engine components, suggesting that
knowledge specific to engine production were exploited and not the overall production
27
Knowledge Inheritance and Vertical Integration
knowledge potentially “inherited” from their parent firms. Finally, our historical materials also
suggest that production of and innovation in engines required skills and knowledge that were
very specific and differed from other firm activities. In fact, all integrated spinoffs with
integrated parents reported in Table 2 were founded by engine engineers, whereas several of the
other types of entrants were founded by non-engineers. The Duesenberg case noted earlier
suggests that even when a parent firm failed, its spinoffs could vertically integrate engines and
compete successfully, provided the spinoff founders had the relevant production experience.
Another potential concern is that although our findings on the impact of the combination
of vertical integration and high-price segment positioning in the performance estimations are
consistent with our Hypotheses 2(a) and 2 (b), they may not be able to completely validate the
mechanism we propose was at work. Instead of enabling entrants to establish more defensible
strategic positions, the vertical integration of engines may have required participation in the
high-price segments that happened to be less prone to competitive threats. Note, however, that
our data do allow us to associate the firm’s early decision to vertically integrate engines with its
subsequent establishment of a strategic position and to associate these two choices with firm
survival. Quantitatively, we find these associations to be significant. Moreover, our historical
materials suggest that firms that vertically integrated engine production to produce highperformance cars trumpeted their engines in their advertisements, commanded high prices, and
often succeeded. On the other hand, firms that produced luxury or sports cars but did not
vertically integrate their engine production and, therefore, their advertisements did not
emphasize engine performance, often failed. For example, Kenworthy, a spinoff that purchased
its engines from Continental (an independent engine supplier), was one of the most expensive
cars of the time and was widely known as an automobile that resembled the English Rolls-
28
Knowledge Inheritance and Vertical Integration
Royce. Established in 1920, Kenworthy survived only two years in the cut-throat competitive
environment.
DISCUSSION AND CONCLUSION
Our results can be seen as contributing both to the literature on the determinants of firm
boundaries and to the literature on firm capabilities. With regard to vertical integration, scholars
have long argued that path-dependent learning processes lead to firms developing capabilities
that other firms lack, and that this specialization determines firm boundaries (e.g., Demsetz,
1988; Jacobides & Winter, 2005; Kogut & Zander, 1992). However, this literature generally does
not address the origin of those learning processes—that is, the factors that determine the
directions such learning takes (e.g., Jacobides & Winter, 2012). On the other hand, studies that
focus on founding conditions have not addressed the role of early boundary decisions (cf.
Klepper, 2009).
In this paper, we provide evidence to suggest that knowledge inheritance is an important
source of capabilities that help determine early boundary choices. In that sense, our results point
to an organizational mechanism—an organizational choice that spinoffs make to enable them to
take full advantage of their knowledge inheritance. Whereas the link between boundary choices
and strategic positioning has been drawn in the literature (Argyres & Bigelow, 2010; Ghosh &
John, 1999; Nickerson et al., 2001), our paper highlights the link between these two choices and
knowledge inheritance by entrants. More specifically, our results suggest that knowledge
inheritance and the integration choices it stimulates are valuable in terms of their contributions to
firm survival by enabling spinoffs to establish defensible strategic positions. A limitation of this
finding, however, is that whereas our theoretical framework suggests that integration of a key
value chain activity is necessary to establish defensible competitive advantage, our empirical
29
Knowledge Inheritance and Vertical Integration
context only allows a test of whether such integration enables defensible differentiation
strategies. Future research should examine whether cost leadership strategies similarly require
integration of a key value chain activity.
The integration of a key activity involves a significant resource commitment that is not
easily reversible and implies that some directions of spinoff development will be foreclosed.
Note, however, that the costliness of reversing early vertical-integration decisions also implies
that, in industries that experience dramatic technological changes—changes that destroy the
value created by firms’ key internalized activities—early vertical integration may later become a
competitive disadvantage (e.g., Afuah, 2001; Anderson & Tushman, 1990).
Our study also shows the intertwining of transaction costs and firm capabilities, both over
time and across parent firms and spinoffs. Recently, some have argued that firms can develop
capabilities for governing activities that then reduce the transaction costs associated with
carrying out those activities (e.g., Argyres & Mayer, 2007; Mayer & Argyres, 2004; Mayer &
Salomon, 2006;). On the other hand, Argyres and Zenger (2012) argue that some unique firm
capabilities originate from past internalized investments that were highly specific to the firm and,
therefore, have their roots in transaction cost-driven decisions. The current study points out that,
in many circumstances, the key specific investments that generate a firm capability were in part
made by a parent firm, and that some of the value from these investments may be appropriated
by a spinoff firm as it creates its own firm-specific capabilities. Spinoffs may build on their
knowledge inheritance with additional firm-specific investments, but the evolutionary process by
which capabilities are developed is not necessarily contained within a single firm, as the
underlying knowledge may spill over from parent firm to spinoff firm.
30
Knowledge Inheritance and Vertical Integration
The extant literature takes the view that knowledge inheritance is conditioned by the
performance of parent firms (cf. Franco & Filson, 2006; Klepper & Sleeper, 2005), which could
imply that the better performing the parent firm, the greater the extent of the spillover from
parent firm to spinoff firm. However, our findings suggest that even when a parent firm performs
poorly, knowledge inheritance can be valuable, provided it is relevant to a key value chain
activity. Moreover, our qualitative analysis suggests that whereas some founders gained
substantial experience in engine production by working in parent firms, others were already
highly knowledgeable in this activity prior to their hiring by their parent firms. Thus, the extent
of the spillover is likely to vary, based not only on the opportunities available to learn at parent
firms but also on the founder’s own education and work experiences prior to working for the
parent firm. Further research is needed to isolate such effects and provide more insights into the
extent of spillovers that occur through knowledge inheritance.
Future research should also continue to investigate the role of early firm boundary
choices in the exploitation of knowledge inheritance by spinoffs. For example, a question that
remains unaddressed concerns when firms can exploit their informal relationships with
employees of their former firms, or alliances with third parties, to take advantage of their
knowledge inheritance, and when vertical integration is necessary. The literature on the
“knowledge boundaries” of firms, as distinct from the “organizational boundaries” of firms, is
relevant here (e.g., Brusoni, Prencipe & Pavitt, 2001; Kapoor & Adner, 2012).
Another important open issue in the pre-entry experience literature concerns whether
spinoffs tend to imitate their parent firms, or instead position themselves away from them (e.g.,
Klepper, 2009). The qualitative information we have on engine integration in the early auto
industry suggests that spinoffs spawned by parent firms that featured integrated engine
31
Knowledge Inheritance and Vertical Integration
production tended to develop engines with some attributes that differed relative to their
parents’engines, suggesting that spinoffs tended to differentiate from their parent firms.
However, more systematic data are needed to bear on this question, with the aim both of
identifying the conditions under which spinoffs adopt differentiation or imitative strategies and
of understanding the implications for both spinoff and parental performance (e.g., Ioannou, 2013;
McKendrick et al., 2009; Wezel, et al., 2006).
Yet another question for future research concerns the type of pre-entry experience that
may best enhance firm performance by enabling superior positioning. In this paper, we have
focused on production capabilities for a key component of a complex product. In other
industries, however, different capabilities –such as contract design capabilities or supplier
management capabilities—may substitute for full integration of production (e.g., Argyres &
Mayer, 2007; Mayer & Salomon, 2006). In industries such as those involving computers,
software, or aerospace, do spinoffs inherit from their parent firms knowledge relevant to contract
design or supplier relationships? This approach is but one of many directions to pursue in the
important study of pre-entry experience, early integration decisions, and strategic positioning.
32
Knowledge Inheritance and Vertical Integration
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39
TABLE 1
In-house Production of Key Components for Auto Models (1917–1931)
% of Models with In-house Production:
Year
1917
1918
1919
1920
1921
1922
1923
1924
1925
1926
1927
1928
1929
1930
1931
NA = not applicable
# of Models
182
173
122
122
158
172
142
97
92
85
94
92
95
102
89
Engine
Transmission
Clutch
47.46%
50.58%
53.72%
52.88%
50.96%
56.36%
60.00%
64.58%
66.67%
69.41%
70.97%
70.93%
78.82%
82.98%
80.68%
NA
NA
47.90%
40.57%
35.51%
39.39%
40.77%
46.81%
48.57%
53.85%
55.06%
55.13%
55.00%
47.19%
53.49%
NA
40.99%
42.86%
35.58%
27.86%
31.21%
33.08%
41.05%
50.00%
48.10%
32.22%
21.79%
18.29%
15.91%
22.09%
Steering
NA
NA
NA
25.24%
23.31%
20.75%
25.58%
39.77%
23.44%
30.38%
21.74%
20.99%
12.99%
13.75%
9.46%
Frame
NA
NA
NA
20.83%
13.49%
17.95%
16.80%
19.00%
17.46%
20.75%
17.39%
16.13%
26.15%
18.75%
25.71%
Source: Compiled from Lester-Steele (1960).
40
TABLE 2
Qualitative Information on Auto Industry Entrants
Firm Background
Integrated spinoff with
an integrated parent
Firm Names
Dusenberg, Falcon,
Gray, Holmes, La
Fayette, Lincoln,
Porter, Revere,
Rickenbacker, Parenti,
Wills
Notes on Founding
In almost all cases, the firm was
founded by engineer(s) with engine
knowledge from employment at parent
firm. However, some important
features of engines developed by
spinoffs and parents differed.
De-Integrated spinoff
with an integrated
parent
Durant (D), Richelieu
(R), Hanson (H)
D: produced multiple models at the
time of entry, which made engine
integration difficult.
H: Founded by a former Franklin
salesman.
R: Founded by former Duesenberg
engineer and used Duesenberg
engines.
Integrated non-spinoff
Bowman, DriggsSeabury, Fox, Leach,
Metropolitan,
Northway, Pan,
Ranger, Rolls Royce of
America, Rotary,
Rubay, Spencer,
Stephens, Sun, Templar
Some firms entered from other sectors,
such as armaments, buggy or
coachwork industries: e.g., DriggsSeabury, Fox, Rubay, Stephens
De-integrated nonspinoff
De-integrated spinoff
with de-integrated
parent
Adria, Bay State,
Colonial, Comet,
Corinthian, Courier,
Douglas, Ferris,
Gardner, Hartman,
Huffman, Kelsey, Lone
Star, Lorraine, Merit,
Noma, Piedmont,
Romer, Ruxton,
Sayers, Seneca,
Skelton, Stanwood,
Washington, Winther
ACE, H.C.S.,
Kenworthy, Kurtz,
Meteor
Some firms manufactured “assembled
cars”: Bowman, Rotary, Templar
Some firms suffered from high
executive turnover: e.g., Earl,
Northway, Pan
Some founders came from buggy, toy,
shoe, or other industries: Bay State,
Comet, Gardner, Sayers, Skelton
Many firms manufactured “assembled
cars”: e.g., Adria, Comet, Corinthian,
Ferris, Gardner, Lone Star, Piedmont,
Noma, Sayers, Seneca, Skelton,
Stanwood, Washington
Founders’ experiences tended to be in
sales, marketing, or finance.
Note: Firms making “assembled cars” fabricated very few car components.
41
TABLE 3
Max
Min
Std. Dev
Mean
Variable
Descriptive Statistics for Auto Entrants (1917–1931) and Variable Intercorrelations
1
2
3
4
5
6
7
8
Independent and Control Variables
1
Parent Engine In-house
0.23
0.43
0
1
1.00
2
Parent Engine Outsourced
0.10
0.30
0
1
–0.05
1.00
3
Relative HP
–0.17
1.20
0.12
0.04
1.00
4
# of Large Engine Suppliers
3.97
1.33
0
6
-0.17
-0.12
0.18
1.00
5
Parent Market Share (log)
0.24
0.75
0
4.40
0.58
-0.10
0.08
0.07
1.00
6
# of Models
1.18
0.43
1
3
–0.14
0.25
0.12
0.13
-0.03
1.00
7
Early Entrant
0.32
0.47
0
1
0.13
–0.11
0.19
0.48
0.02
-0.04
1.00
8
Michigan
0.12
0.32
0
1
0.41
0.05
-0.08
–0.19
0.56
0.21
-0.14
1.00
9
Industry Production (1 Million)
1.84
0.69
0.94
3.82
0.13
0.09
-0.14
–0.80
0.04
-0.18
-0.49
0.18
10
GNP ($1 Billion)
143.5
–2.04
3.05
12.56
127.8
190.90
0.05
–0.05
–0.06
–0.26
–0.01
-0.22
-0.18
0.10
Dependent Variables
11
Engine in-House
0.43
0.50
0
1
0.39
–0.07
0.21
-0.03
0.24
-0.14
-0.9
0.21
12
Market Segment (log Price)
7.63
0.65
6.25
9.30
0.17
0.11
0.45
-0.14
-0.002
0.21
-0.05
-0.13
13
Survival Years (log)
1.12
0.74
0
2.78
0.40
–0.22
0.14
0.31
0.39
-0.14
0.55
0.16
14
Top 25% Surviving Entrants
3.33
0.48
0
1
0.36
–0.24
0.15
0.37
0.37
-0.06
0.58
0.18
42
Knowledge Inheritance and Vertical Integration
Variable
Table 3, Continued
9
10
11
12
13
14
Independent Variables
9
Industry Production (1 Million)
1.00
10
GNP ($1 Billion)
0.56
1.00
Dependent Variables
11
Engine in-House
0.10
0.11
1.00
12
Market Segment (log price)
0.01
–0.10
0.10
1.00
13
Survival Years (log)
-0.19
0.20
0.09
0.02
1.00
14
Top 25% Surviving Entrants
-0.31
0.20
0.17
–0.01
0.80
1.00
43
TABLE 4
Multi-stage Estimations for Vertical Integration, Strategic Positioning and Performance
DV:
Parent’s Key Activity and
Transaction Costs Variables
Parent Engine In-house
Parent Engine Outsourced
Relative HP
# of Large Engine Suppliers
Model 1
Vertical
Integration
(Probit)
# of Models
Early Entrant
Michigan
Industry Production
GNP
Model 3
Survival
Years
(IV Tobit)
Model 4
Top 25%
Surviving
Entrants
(IV Probit)
1.26**
(0.45)
–0.06
(0.50)
–0.44
(0.51)
–1.82*
(0.90)
0.46
(0.86)
–0.71
(0.83)
0.05
(0.03)
0.01
(0.17)
0.65*
(0.26)
0.30
(0.33)
–0.84*
(0.41)
–0.31
(0.26)
–0.02
(0.01)
0.56+
(0.32)
1.01*
(0.48)
0.93*
(0.41)
0.26+
(0.15)
–0.46+
(0.27)
0.87**
(0.28)
0.53
(0.41)
–0.11
(0.23)
0.01
(0.01)
0.66
(0.63)
–0.81
(0.60)
1.03+
(0.61)
1.36
(0.95)
–0.97+
(0.50)
0.04+
(0.03)
0.29+
(0.16)
–0.69*
(0.31)
0.76*
(0.30)
0.60
(0.43)
–0.15
(0.25)
–0.01
(0.01)
Other inhouse- components
(clutch, transmission,
steering, frame)
–5.62+
(3.36)
N
60
Note: Standard errors in parentheses.
+
p < 0.10, * p < 0.05, ** p < 0.01
Constant
Model 5
Survival
Years
(IV Tobit)
1.69*
(0.69)
–0.14
(0.68)
0.31+
(0.17)
0.20
(0.29)
Predicted Values
Predicted Vertical
Integration
Predicted Log Price
Controls
Parent Market Share (log)
Model 2
Market
Segment
(IV OLS)
Included
7.91**
(1.51)
60
–4.26
(2.80)
60
–12.14**
(4.17)
60
–6.38+
(3.30)
56
44