FIRST-MOVER (DIS) ADVANTAGE AND REAL OPTIONS

Journal of Applied Corporate Finance S U M M E R 2 0 0 1 V O L U M E 1 4 . 2

First-Mover (Dis)advantage and Real Options by Tom Cottrell and Gordon Sick, University of Calgary

41BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

FIRST-MOVER(DIS)ADVANTAGE ANDREAL OPTIONS

by Tom Cottrell andGordon Sick,University of Calgary

he benefits accruing to a firm that is firstinto a market are often referred to as first-mover advantages. Chief among suchbenefits in the corporate strategy litera-

niques when there is uncertainty about the upsidepotential or downside risk of an investment. In thiscase, the challenge for the investment decision-maker is to determine exactly when (that is, underwhat conditions) the firm should commit to theinvestment. But in order to have the ability to choosethe optimal timing of exercise, the firm must be ableto delay the investment decision. If a competitorthreatens to enter the market ahead of the firm, thevalue of the real option can be significantly reduced,or even eliminated.

In many cases, however, the competitive threatof a potential entrant pushes the first mover to enterthe market more quickly than the value-maximizingstrategy would dictate.1 And in this article, weconsider the trade-off between real options and first-mover advantages. We start by reviewing two well-known cases of successful second movers: the battlebetween Betamax and VHS in VCRs and Microsoft’sremarkable late entries. Then we go on to presentmore broadly based historical evidence for our viewthat first-mover advantages often fail to confer lastingvalue. We close with an assessment of first-moveradvantages in the new economy, including a brieflook at recent developments in the Internet andtelecom sectors.

ture are those stemming from a strong image andreputation, brand loyalty, technology leadership,and the possibility of moving down the “learningcurve.” However, one of the key strategic insights ofthe real options approach is that the right to defer thestart of a project until conditions become morefavorable, or to minimize the firm’s investment untilmore is learned about the project’s real potential, canhave considerable value. Corporate strategists oftendismiss the real options valuation approach becauseof their tendency to emphasize first-mover advan-tages. Rather than adopting the real options frame-work, they argue that if entry is delayed, one of thefirm’s competitors will reap the rewards of movingfirst. But there can also be significant advantages todelaying entry. For example, there are often advan-tages to observing how the market responds to a newproduct before putting one’s name brand and qualityreputation on the line.

As discussed in several other papers in thisissue, the real options approach has significantadvantages over traditional capital budgeting tech-

T

1. Recent academic work on this concept is found in two articles by StevenGrenadier, “The Strategic Exercise of Options: Development Cascades andOverbuilding in Real Estate Markets,” Journal of Finance, 51, (1996); and “OptionExercise Games: The Intersection of Real Options and Game Theory,” Journal ofApplied Corporate Finance, 13(2) 2000. See also James Brickley, Clifford Smith, andJerold Zimmerman, “An Introduction to Game Theory and Business Strategy,”Journal of Applied Corporate Finance, 13(2), 2000, pages 84-98; Bart Lambrechtand William Perraudin, “Real Options and Preemptions,” JIMS Working Papers(1997); and Bart Lambrecht and William Perraudin, “Strategic Sequential Invest-ments and Sleeping Patents,” Oxford University Press. Chap. 15, pages 297-323,2000. Many first-mover advantages are based on network effects, and these arediscussed in Helen Weeds and Robin Mason, “Networks, Options and Preemption,”Real Options Conference, Cambridge, UK (2000).

Real options analysis of the capital project adoption decision involves atradeoff between uncertainty and convenience value. With more uncertainty, it isoften better to delay adoption. Convenience value is the value forgone by nothaving the project in operation. If there is more convenience value, it is generallybetter to adopt the project earlier. Convenience value can take the form of, forexample, forgone rental of undeveloped real estate. In other settings, it can bemeasured by a cost-of-carry analysis in a commodity futures market (see, forexample, Gordon Sick “Real Options,” Chapter 21 of Finance, Volume 9 inHandbooks in Operations Research and Management Science, Elsevier North-Holland, 1995). The first-mover advantage works like a convenience valuewhereby delaying a project increases the risk that the firm will be the second toenter the market.

42JOURNAL OF APPLIED CORPORATE FINANCE

TWO SUCCESSFUL LATE MOVERS

VHS versus Betamax2

Commercial video tape recorders (VTRs) weredeveloped in 1956 by the Ampex Corporation inRedwood, California. In 1961, Ampex invented theinnovative helical scanning technology that alloweda high-frequency television signal to be stored on arelatively slow-moving magnetic tape. AlthoughAmpex products were the standard equipment intelevision studios, the product was difficult to threadand the company could not market its product tohomes, schools, or even industrial users because ofthe complexity and cost. Moreover, because Ampexdidn’t have experience with transistorized circuits, itnegotiated a deal with Sony in 1960 whereby Sonywould supply transistorized circuits for Ampex’sVTR products and would have the right to makeVTRs with the helical scanning technology for non-broadcast users. This sharing arrangement led todisputes, which were settled out of court in 1968.Sony then proceeded to develop products for thehome and commercial markets.

In 1970 Sony showed its new U-matic helicalscan cassette tape system to Matsushita and itsaffiliate JVC. The cassette simplified loading and wasmore compact than the reel-to-reel system. The threecompanies agreed to share this common standard,subject to incorporating some JVC technology forcolor. Although they were equal partners, Sonymade the most revenue and profit from the partner-ship. The product never found a significant marketfor home use, but it became popular in professionalsettings and with TV networks. It used a ¾-inch tapeand was limited to one hour of recording time.

The Japanese companies experimented withvarious VCR products for the home consumer, butnone caught on. In December of 1974, Sony demon-strated its new Betamax (then with a one-hourrecording time) to JVC and invited the company toshare in the use of a standard along the lines of thestandard of the U-matic cassette system. But JVC,convinced that a two-hour recording time was morevaluable to consumers and concerned that Sony had

benefited disproportionately from the U-matic stan-dard, developed the Video Home System (VHS) tocompete with Sony’s Betamax.

Sony entered the market in 1975 and ralliedZenith, Emerson, Sanyo, and Toshiba around itsBetamax standard. JVC started selling its VHS systemin 1977, and enlisted the other major consumerelectronics manufacturers—including Matsushita(with its Panasonic brand), Hitachi, Sharp and RCA—under the VHS standard. Sony shipped 30,000Betamax units to dealers in 1976, and 140,000 in1977—the same year in which total VHS salescommenced with 80,000 units.3 In each subsequentyear, VHS outsold Betamax, with Betamax peakingat 1,538,400 units in 1985 and VHS reaching a highof 11,582,000 units in 1987.4

VHS won the battle on two fronts, and it won thebattle quickly.

1. It had two-hour capability when Betamax hadone-hour. Then it developed four-hour capabilitywhen Betamax had two-hour capability. Sony even-tually caught up with the recording length, but bythen it was too late.

2. VHS established liaisons with the nascent videorental industry, which created a network effect inwhich consumers with VCRs that were compatiblewith most other VCRs had a wider selection of videotitles at rental shops. Meanwhile, the rental shopsknew that more consumers had VHS-compatiblemachines and stocked more videos for that format.

This example serves to highlight the importanceof marketing and network externalities, and therelative unimportance of being first to market. Betamaxwas first to market and had a reputation of higherquality. The user interface was also better; forexample, it was easier to set up the timer forrecording on a Sony VCR. And a variation of theBetamax system, called Betacam, became the stan-dard professional recording system for TV newscast-ers. Despite these advantages, Sony failed to recog-nize the importance of the length of recording timesfor consumers and came up against a group ofcompetitors that were upset that they hadn’t beentreated fairly in the earlier partnership. In the end, itlost out on the positive feedback of the network

2. This account of the video cassette recorder (VCR) adoption and standardswar draws on James Lardner, Fast Forward: Hollywood, the Japanese, and theOnslaught of the VCR (WW Norton, New York. 1987) and Stan J. Liebowitz andStephen E. Margolis, Winners, Losers Microsoft: Competition and Antitrust in HighTechnology (The Independent Institute, Oakland, 1999).

3. Fortune, July 16, 1979, pp. 110-116.

4. EIA Consumer Electronics U.S. Sales, 1985-1992, as cited in Sangin Park,“Competition and Organization in Technology-intensive Industries,” from NBERUniversities Research Conference, 1997 and Sangin Park, “Quantitative Analysis ofNetwork Externalities in Competing Technologies,” working paper, Departmentof Economics, SUNY Stony Brook, 2001

43VOLUME 14 NUMBER 2 SUMMER 2001

effect. Sony quickly lost its first-mover advantageand ended up selling VHS VCRs to its customers.

Microsoft: A Frequent Follower that Wins

Many industry observers note that Microsofthas rarely been an innovator in the software mar-ket. Instead, the company has learned from watch-ing consumers and other developers to determinewhich features are valued. Then it moved to eitheracquire a firm with appropriate technology or de-velop its own.

The software business has two sources ofsignificant economies of scale,5 which in turn createthe potential for a monopoly in the market. For asoftware developer, the programming cost is basi-cally a fixed cost that is largely independent of thenumber of users. Software distribution and customersupport are variable costs. Thus, a company withdeep pockets can gain entry to an existing market byabsorbing the fixed costs and pricing the product justabove variable cost on the assumption that it can gainmarket share and move to a more profitable pricepoint. In this fashion, a second mover can end updominating a market, particularly if it can reducedevelopment costs by observing the successes andfailures of the first entrant.

The history of the software business also illus-trates the concept of serial monopoly,6 which ischaracterized by a series of different monopolistsover time in a particular product space. For example,WordStar had a dominant market share in the word-processing market, and was followed by WordPerfect,which was finally displaced by Microsoft Word. DanBricklin and Bob Frankston invented the spread-sheet in 1979 and called their product VisiCalc. Itdominated the market for several years; but, with theintroduction of the IBM PC, it was superseded by thecompeting product Lotus 1-2-3. With the introduc-tion of Microsoft Windows, Lotus 1-2-3 was in turndisplaced by Microsoft Excel. The operating systemmarket for microcomputers was originally domi-nated by CPM, then by Apple II, Microsoft DOS, and

Microsoft Windows. All but the last of these transi-tions were accompanied by a change in the hard-ware standard.

In the case of a serial monopoly, the initialmonopolist is displaced by a well-funded competitor(like Microsoft) that is able to cover the fixed costsof development on the assumption of gaining domi-nant market share. The story of how market share isgained varies from product to product—and alsoaccording to who is telling the story. Some argue thatMicrosoft is just a better software developer,7 othersthat the company has achieved a monopoly positionby tying end-user software to the operating systemmarket that it dominates.8 For our purposes, theimportant observation is that Microsoft has been avery successful second mover. It demonstrates that,even in a market with a dominant player, it is possibleto enter as a second mover and end up with a veryhigh market share and return on investment.

The other source of economies of scale in thesoftware market is the network effect that we saw atwork in the VHS versus Betamax case. Users sharefiles and thus would like their co-workers to havecompatible software. If your co-workers select thesame software as you, that raises the value of yourown software choice to you as well as to them. Andwhen your co-workers adopt your software stan-dard, they also generate the same network effectwith other users.

It is interesting to see how quickly an incumbentcan be overtaken, especially when it relies on pastsuccess rather than carefully monitoring the compe-tition. In a 1987 interview, Microsoft’s Jeff Raikes wasasked about the future of Excel, which had beensuccessful on the Macintosh, but had not yet enteredthe PC market. Raikes predicted, “We’re going to bethe dominant spreadsheet.” Although this predictionproved to be accurate, it seemed unlikely at the time,given that the incumbent software, Lotus 1-2-3, heldthe lion’s share of the PC market. When asked aboutthe prediction, Jim Manzi, chairman of Lotus, replied,“If there’s a Rock of Gibraltar in this marketplace, it’s1-2-3.” Initially Manzi seemed to be right, for in 1988

5. When there are economies of scale, the average cost of producing a unitdecreases with increases in output: large fixed costs and network effects. If thereare large fixed costs of production and small variable costs, there are oftenimportant strategic effects of scale economies.

6. See, for example, Liebowitz and Margolis, cited earlier.7. This is the position often cited in Liebowitz and Margolis cited earlier. For

example, their chapters 8 and 9 point out how the successful software developertypically had high reviews from computer magazines prior to winning marketshare.

8. This is the position advanced by the Department of Justice in the recentMicrosoft anti-trust case. Still others, such as Liebowitz and Margolis, are quick topoint out that Microsoft dominated the spreadsheet and word processor categoriesof the Macintosh market without having control of the operating system. Somewithin the Macintosh community point out that Apple has had to develop itsoperating system under the constraint that it wouldn’t “break’’ the dominantMicrosoft software. The reasoning is that users would drift away from the Macintoshif they couldn’t share word processing and spreadsheet files with users of Microsoftproducts.

Corporate strategists often dismiss the real options valuation approach because oftheir tendency to emphasize first-mover advantages.


Lotus had captured an almost 70% unit share of thespreadsheet market while Excel had only 10%. Butby 1992, Lotus’s share had dipped to less than 50%while Excel’s grew to 30%. By 1997, the reversal wascomplete, with Excel holding approximately 70%,and Lotus under 30%, of the spreadsheet market.9

Part of the reason for the switch from Lotus 1-2-3 to Excel was the superior quality of Excel. Theother reason was that the switching costs werereduced as consumers made the transition from DOSto Windows. Lotus chose to protect its legacy DOSuser interface, while Microsoft was free to developa graphical user interface consistent with Windows.Since users were migrating to Windows, the switchin spreadsheets didn’t cost them as much in personaltraining as if they had already been in Windows withLotus 1-2-3 or had stayed in DOS.

A similar transition occurred with word process-ing. In 1986, there were over eight word processorson the PC platform. The largest revenue market sharewas WordPerfect with almost 20%, followed byAshton-Tate’s Multimate at about 15% and MicrosoftWord (Windows and DOS) at less than 10%.10 By1990, consolidation had begun, with WordPerfectpeaking at about a 45% revenue share, and Word forDOS and Windows at approximately 30%. By 1997,the Windows version of Word had risen to over 90%,while the competitors shared the remainder. As withLotus 1-2-3, the dominant DOS product was dis-placed by the improved graphical user interfaceprovided under Windows. The switching costs asso-ciated with moving to a new word processor werereduced as users moved to a Windows operatingenvironment. It is also important to remember thatthe overall microcomputer market was growingstrongly in this period and new consumers hadincurred few legacy costs from switching.

A similar story occurred in the operating sys-tems environment. Although Xerox pioneered thegraphical user interface with the Alto computer, Applemade it well-known to the public in 1984, with itsMacintosh computer. Microsoft followed with Win-dows and now dominates the market for operatingsystems that have a graphical user interface. Microsoftdid enjoy a dominant position with the DOS operating

system, and gradually migrated users to Windows,while maintaining compatibility with their legacyDOS software and files.

Of course, second movers don’t always win. Inthe Macintosh market, the first major spreadsheetwas Microsoft Excel, and the first major wordprocessor was Microsoft Word. The mid-1980s ver-sions of these products became prototypes for theWindows versions. In 1988, Microsoft Excel hadover 60% of the Macintosh spreadsheet market.Lotus had entered the Macintosh market in 1985with an integrated software product called Jazz thatincluded a spreadsheet and a word processor.However, it was announced prematurely and verylate in coming. It also needed more memory thanwas readily available in early Macintosh comput-ers—and eventually it failed. Informix (a large Unixsoftware vendor) entered the market with Wingz in1989 and captured almost a 20% market share. Butthat share later declined, even when the productwas taken over by Apple’s own software company,Claris, and renamed Resolve.11

In the Macintosh word processor market, Applebundled MacWrite in 1984 and Microsoft introducedWord in 1985. When competitors from WordPerfectand an independent company WriteNow entered in1988, all started with market shares of 20% to 30%.By 1991, Microsoft held over 60%, and the otherswere under 20%.12

A BRIEF LOOK AT FIRST-MOVERADVANTAGES

In a 1994 book entitled Managing ImitationStrategies: How Later Entrants Seize Markets fromPioneers, Steven Schnaars provided a list of oftencited first-mover advantages. That list included thefollowing: image and reputation, brand loyalty andswitching costs, market positioning, technologicalleadership, setting of product standards, access todistribution, experience effects, and patents. 13 In hisbook, Schnaars also identifies many consumer prod-uct markets in which imitation strategies succeededagainst first movers. (Table 1 provides a list of suchmarkets.) To help understand why followers often

9. These figures are from Liebowitz and Margolis, cited earlier, Figure 8.6, page175. In Figure 8.7, they show that Microsoft was able to increase its price whileLotus had to decrease its price by 1997, since the disparity in revenue was evengreater than that in unit share.

10. See Figure 8.8 of Liebowitz and Margolis.11. See Figure 8.16, Liebowitz and Margolis.

12. The data for 1988 and subsequently are from Figure 8.17, Liebowitz andMargolis, while the discussion of the earlier market is from one of the author’spersonal experience.

13. Steven P. Schnaars. Managing Imitation Strategies: How Later EntrantsSeize Markets from Pioneers. The Free Press. New York., 1994.


prevail over first movers, we now take a closer andcritical look at a number of these alleged advantages.

Image and Reputation. One important motivefor innovation is that consumers will associate thefirm with creativity. While it is hard to argue with thebenefits of a strong reputation, we question thedurability of this reputation effect in a wide varietyof markets. Consider the first commercial jet aircraft,the Comet. With the introduction of the first jet,consumers attributed technological and innovativeleadership to the company. Later, however, theworld discovered that the airframe was unsafe. Steelused in the pressurized cabin became brittle overtime and several planes exploded at high altitudes.Comet eventually went bankrupt, despite its innova-tive design and early market share.

The possibility of associating one’s name withsuch a colossal failure is, of course, a huge risk, andsecond movers have fared well in part by avoidingsuch risks. While less dramatic, the failure of theIridium satellite network faced similar criticism. Earlyentry surely afforded important advantages, but thedownside risk of bankruptcy might have beenreduced with a more cautious roll-out.

Brand Loyalty and Switching Costs. Early en-trants may gain advantages in the form of loyalcustomers who are unlikely to try competing fol-lower products. To the extent there are costs in-volved in switching to a new technology, the firstentrant into a market benefits because consumerswho adopt the product would have to incur suchcosts to use a competing product. This means thatlater entrants must offer a discount to the first mover’s

installed base or else expect customers’ switch totheir products to be a gradual, and therefore lessprofitable, one.

Yet we find several examples where switchingcosts are not important. We have seen that althoughApple was quick to adopt and promulgate a graphi-cal user interface, Microsoft Windows, the laterentrant, now has a dominant position. While theloyalty of Apple users is legendary, the growth in themarket meant that brand loyalty was less importantthan market position. This suggests that other as-pects of brand management can be more importantin retaining customer loyalty than being first tomarket with the product.

Experience Effects. Learning curves play a rolein competition in many industries, and the ability toenter early and move quickly down the cost curve isoften considered important in corporate strategy.Yet it is sometimes difficult to convert the benefits oflower costs into higher profits. The semiconductorindustry is famous for the benefits of learning curves,and Texas Instruments once dominated the industry.The cost curve was important at TI, where unit costsfor semiconductors were found to decline by 27%with each doubling of production. Throughout the1960s and ’70s, TI aggressively pursued growth andoutput in order to gain a low-cost producer position.

By 1982, however, TI’s market position hadbegun to erode. The company’s single-minded fo-cus on pushing down the experience curve ledeventually to standardized commodity products,and the return on investment declined. In addition,the kind of semiconductor manufacturing that TI

TABLE 1PRODUCT MARKETSWHERE IMITATORSSUCCEEDED PIONEERS

35mm cameras Money-market mutual fundsAutomated Teller Machines Magnetic Resonance ImagingBallpoint pens Nonalcoholic beerCaffeine-free soft drinks Personal computer operating systemsCAT Scanners Paperback booksCommercial jet aircraft Personal computersComputerized ticketing services Pocket calculatorsCredit/Charge cards Projection TVDiet soft drinks SpreadsheetsDry beer Telephone answering machinesFood processors Video Cassette RecordersLight beer VideogamesMainframe computers Warehouse clubsMicrowave ovens Word-processing software

Source: Steven Schnaars

In a widely-cited 1987 study of corporate innovation by four Yale researchers,patents were found to be one of the weakest methods for capturing the returns

from innovation.


specialized in became obsolete with the advent ofnewer metal-oxide technologies. As a result, com-petitors Intel and Motorola, which had been work-ing on the new semiconductors, found themselvesin a stronger position. In sum, TI’s focus on earlyentry and rapid market expansion, and its effort torealize experience curve benefits, turned out to bea myopic corporate strategy.

Patents. Biotech industry giant Genentech iswidely known as an innovative and aggressivecompetitor. As an early entrant, Genentech wasquick to build a strong patent base and to developa thicket of patents around not only molecules butalso the processes by which useful products weremanufactured. Founded by noted scientist HerbertBoyer with Robert Swanson in 1976, Genentechpioneered and patented innovative biotech prod-ucts and processes. However, defense of thosepatents came at a price. Intellectual property lawfor the technology required legal precedent forlitigation. While the patent provides prima facieprotection for the product, it is left for litigation andcourt challenges to determine the true strength ofthe protection.

Throughout its history, Genentech has investedin litigating alleged patent infringements. At thesame time, industry followers have been able to playa far less risky wait-and-see game to find out how thecourts would interpret intellectual property protec-tion in the industry. Some have argued that theexpense and uncertainty associated with the litiga-tion process resulted in a cash-starved Genentechthat was an easy target for the $2.1 billion mergerwith Roche Holdings in 1990.

In a widely cited 1987 study of corporateinnovation by four Yale researchers,14 patents werefound to be one of the weakest methods for captur-ing the returns from innovation. The effectiveness of

patents in securing a competitive advantage wasrated by 650 respondents on a Likert scale from 1-7(with 7 being the most effective). The responsesrelated to innovation in both new products and themanufacturing processes itself. The results, as sum-marized in Table 2, show that being first to invent andgaining a patent are generally overrated. Sales andservice tended to be equally important if not morecritical to success than the other techniques—patents,lead time, and learning curve strategies—that typicallyinvolve an accelerated development schedule.

The success of the open-source software move-ment, as promoted and used by organizations likethe GNU Public License and Linux, demonstratesthat product learning may be more important thanintellectual property protection. Software develop-ers are willing to put software into an open-sourcelicense because they believe it will help their productto become more standardized and hence moreresistant to competitive threat. Without patent pro-tection, the developer may lose first-mover advan-tage, but it will also likely benefit from greaterproduct knowledge. In the open source softwarecommunity, the advantage to moving first may be theopportunity to influence the standards upon whichlater versions of the software are based.

IMITATOR ADVANTAGES

Besides expressing skepticism about first-moveradvantages, Schnaars’ book lists several advantagesto being a follower:

avoiding products that have no potential (asdemonstrated by the failed first mover);

lower R&D expenditures;lower costs for imitating than innovating;ability to catch innovator with heavy marketing

expenditures;

TABLE 2EFFECTIVENESS OFVARIOUS METHODS OFAPPROPRIATING THEVALUE OF INNOVATION

Method of appropriation Processes Products

Patents to prevent duplication 3.52 4.33Patents to secure royalty income 3.31 3.31Secrecy 4.31 3.57Lead time 5.11 5.41Learning Curve 5.02 5.09Sales or Service 4.55 5.59

14. Richard C. Levin, and Alvin K. Klevorick, and Richard Nelson, and SydneyG. Winter, 1987. “Appropriating the Returns from Industrial Research andDevelopment,” Brookings Papers on Economic Activity, 3, pages 783-820.


lower costs of educating customers about innova-tive product ideas;

the possibility of stranding the innovator with anobsolete product standard; and

ability to benefit from or avoid the pioneer’smistakes.

Of these potential advantages, perhaps the mostwidely accepted is the fact that it is cheaper to copyan innovation than to create it in the first place. A1981 study of 48 innovations in chemicals, drugs,electronics, and electrical machinery reported thatimitators’ costs averaged 65% of innovators’ costs, inpart because of imitators’ reduced product develop-ment time.15 The Yale study cited above provided amuch more comprehensive and extensive survey ofimitation costs and product development time. Aspart of the study, survey respondents were asked toestimate the costs of duplicating an innovation as a

percentage of the innovator’s R&D cost. Whilepatents had the effect of increasing both the time andthe cost of duplication, most innovations in thesurvey could be duplicated at considerable costsavings to the imitator (see the Panel A of Figure 1).Respondents to the survey also indicated that inno-vations can usually be duplicated within one to threeyears. To be sure, these estimates vary by line ofbusiness and the follower firm’s capabilities. Buteven so, they serve as an important benchmark inconsidering the real impact of imitation strategies.

MORE CASES OF SUCCESSFUL FOLLOWERS

Providing further support for Schnaar’s argu-ments, we provide our own list of successful followersin Table 3 (some of which appeared in Schnaar’s list)and discuss a number of them in more detail below:

FIGURE 1ESTIMATED COST TODUPLICATE PRODUCTS, ASA PROPORTION OF COSTREQUIRED BY INNOVATOR

PANEL A: NEW PRODUCT COSTS FOR A TYPICAL INNOVATION

PANEL B: NEW PRODUCT COSTS FOR A MAJOR INNOVATION

15. Edwin Mansfield, Mark Schwartz, and Samuel Wagner “Imitation Costs andPatents: An Empirical Study,” The Economic Journal, 91, 1981, pp 907-918.

% o

f R

esp

on

ses

Costs as % of Innovation

30

60

50

40

20

10

0<25% 26-50% 51-75% 76-100% >100% Cannot

Patented

Unpatented

% o

f R

esp

on

ses

Costs as % of Innovation

30

60

50

40

20

10

0<25% 26-50% 51-75% 76-100% >100% Cannot

Patented

Unpatented

While patents had the effect of increasing both the time and the cost of duplication,most innovations could be duplicated at considerable cost savings to the imitator.


Motorcycles. The Europeans and Americansdeveloped the motorcycle market in the 20th cen-tury. The Japanese entered in the 1960s with theHonda 50, and came to dominate the market, exceptfor a few niche brands like the German BMW andAmerican brands that (like Harley Davidson) soldlifestyle more than technology. While the Europeanshad a strong first-mover advantage and a technologyadvantage over the Americans, they failed to listento their consumers (and to their magazine reviews).European designs took years to improve. If a motor-cycle magazine reviewed a Japanese motorcycle inthe 1960s and found fault with part of the design, thefault would be fixed within months. If they foundsimilar fault with a British motorcycle, it could takedecades for the fault to be fixed, if it ever was.Moreover, while the British would keep a basicengine design for years, the Japanese would delivermultiple engine designs. For example, Honda hasbeen very successful with four-cylinder motorcycleengines in all the basic configurations: inline 4, flat4 and V-4. There has only been one successfulEnglish four-cylinder motorcyle—the Ariel SquareFour of the 1930s. The Japanese achieve their variedproduct designs with flexible assembly lines—an-other idea from real options.

Real-time information. Julius Reuter created asystem to augment the telegraph system and transmitstock news and price information to brokers in 1851.His company, Reuters, developed the ticker tapesystem in 1928. It introduced the Videoscan system

for news text display in 1968. Foreign exchangedealers could trade over Reuters video terminals in1981, and the company expanded to news picturesand TV news in 1985.

Telerate, which started as Dow Jones Markets,pioneered electronic delivery of information aboutfixed-income markets in 1975. In 1998, Telerate wasacquired by Bridge, a company that began to deliveronline data and analytics to the market in 1974 . By2001, the company served 90,000 terminals. Bycomparison, Michael Bloomberg’s information ser-vice, which was started in 1981, was serving 150,000terminals by 2000. Today Reuters, Bridge/Telerate,and Bloomberg are the major online (real time)information providers to the financial industry. Al-though each has its own niche, Bloomberg enteredlast and has, by many measures, the leading marketshare. Bloomberg succeeded in part by being re-sponsive to consumer needs for analytics. In addi-tion to supplying raw data, it offered customers theability to compare data series and apply valuationformulas, such as option pricing models, to the data.

LEO satellite communications. The low-earthorbit (LEO) satellite communications business is stillin turmoil, so it is not clear that any of the players willever be profitable. What is clear is that the earlymovers lost a great deal of money. This market canbe thought of as lying between cellular communica-tions, which only work in urban regions with earth-based transmission towers, and the high orbit geo-stationary communications satellites that carry TV

TABLE 3 PRODUCT MARKETS AND SUCCESSFUL FOLLOWERS

Product First Mover Second Mover Followers Outcome

Personal Computer Apple IBM PC Compaq, Dell Followers dominated the marketGraphical User Xerox Alto and Apple Macintosh Microsoft Followers dominated the marketInterface (GUI) Xerox Star WindowsSpreadsheet VisiCalc Lotus 1-2-3, Excel Follower dominated the market

Quattro ProWord Processor WordStar WordPerfect Microsoft Word Follower dominated the marketMotorcycle European: Ariel, Honda Yamaha, Suzuki, Second mover and followers dominated

BSA, BMW, Kawasaki the marketEnsign, Norton,TriumphAmerican: HarleyDavidson andIndian

Real-time Financial Reuters Dow Jones Bloomberg Follower dominates, but first moversNews Retrieval Telerate have significant positionLow Earth Orbit (LEO) Iridium Globalstar Teledesic, ICO Nobody has a profitable position yetSatellite Communication Global

Communications


signals. The geostationary satellites are so high thatthere is an unacceptable delay in receiving the signalto use them for telephone conversations. The low-earth orbit satellites do not have this delay. But partlyoffsetting this advantage is their need for a largeconstellation of satellites to cover the whole earth,which required a massive capital investment. Iridiumwas first to market in 1998, with a $5 billioninvestment, but it filed for bankruptcy in 1999.Shortly afterward, ICO Global Communicationsfiled for bankruptcy (but at least it hadn’t incurredthe cost of sending up satellites). Globalstarentered the market in 2000, and lost $3.8 billionthat year.

The basic problem was this: the phone costsassociated with this technology are so high they canbe afforded only by business users—but the phonesdon’t work inside office buildings, only in direct lineof sight to the satellites. To address this problem,another system has been proposed by Teledesic andCraig McCaw, the cellular phone pioneer who hasalso acquired the assets of ICO. McCaw’s plan is tobuild on the earlier failures, allowing the phones towork inside office buildings. One major challenge tothis project is the need to secure rights to thebroadcast spectrum now used by land-based cellularsystems, rights that the cellular companies now claimto own. McCaw also plans to deliver wireless datawith the system (an “Internet in the sky”). It is notclear that there will be a successful player in the LEOsatellite communications business, but the earlymovers certainly paid a heavy price and left the latemovers with lots of opportunity to learn from theirmistakes.16 ICO launched the first of its 12-satelliteconstellation in June 2001 to allow for testing beforebuilding out a full system.

MOVING AT e-SPEED

The recent rise and fall of e-Commerce stocksprovides a cautionary note to companies that placea high value on moving first. Competing in “Internettime,” many first movers in the Internet businessfailed to discover a lasting competitive advantage. Bymoving at “e-Speed,” competitors promised to quicklyout-distance “brick-and-mortar” rivals. However,many of the firms aggressively investing in electroniccommerce misunderstood the source of competitive

advantage, and moving at such high speed hasturned out to be quite costly in comparison to thelong-term benefits.

So, although the Internet initially reduced bar-riers to entry, a period of consolidation and retrench-ment has followed. The democratizing effects of theInternet have allowed craftsmen in small towns tomarket their products all around the world, therebyincreasing consumer product choice. But this isprecisely the opposite of what is needed to createbarriers to entry for second movers. In sum, recentcompetition on the Internet has provided a numberof warnings for would-be first movers.

Lycos was the first online search engine, whichbecame popular just as Netscape was launching itsInternet browser. But Lycos’ first-to-market techno-logical leap was rapidly imitated. Yahoo! followedaggressively, providing a structured index into re-sources on the Web. Both firms expanded theirproduct offerings by expanding the available Webreal estate, providing e-mail and website hosting,country localization, and news links. Based on anadvertising model, both Lycos and Yahoo! generaterevenue from advertisers rather than users. As longas users are more inclined to search for informationfrom Yahoo! first, or set their browser home pageto Yahoo!, then Yahoo! can earn its advertisingrevenue. But the barriers to entry in the searchengine/portal industry are not high. Companieslike Google have offered speedy searches withother services, such as the ability to combine mul-tiple search engines.

And because there are few barriers to entry forcompetitors of Lycos, Yahoo! and Google, the first-mover advantage is likely to prove transient. Lycos’failed attempt to merge with Home Shopping Net-work further illustrates the need to develop aworking business model. Internet business modelshave always been in flux, and the proposed Lycosacquisition of HSN’s product portfolio was intendedas a way to combine advertising reach with onlineproduct sales. Although the effort failed, subsequentacquisition activity, such as the AOL/Time Warnerdeal, demonstrates the importance of a more devel-oped business model.

America Online (AOL) was able to establish adominant position in the Internet by being a secondmover. CompuServe introduced electronic mail ser-

16. For a recent discussion of the issues, see Peter Elstrom, “Craig McCaw’sSpace Shot,” BusinessWeek, July 30, 2001

A recent study of 80 Internet companies found that only 10% of them achieved asustainable market advantage by moving quickly. Such findings reinforce the

importance of creating entry barriers in order to preserve the first-mover advantage.


vices as early as 1979, a full six years before AOLentered the market. Initially a dominant networkservice provider, CompuServe was eventually ac-quired by the newer, more flexible AOL in 1998. AndCompuServe was not alone: many early entrants,including well-funded Prodigy, struggled to gainearly advantage. Prodigy’s credits include: first tooffer full service across the United States by 1990, thefirst online network to link to the Internet (e-mail in1993), and the first such provider of access to theWorld Wide Web by 1995, at which time it was theworld’s largest provider of dial-up access to theInternet. Nevertheless, by 2001, AOL had clearlyoutstripped Prodigy, reporting 21 million membersto Prodigy’s three million.

As early entrants in the years well before thepopularity of the Internet, AOL and Prodigy coulduse the size of their internal network as a competitivetool, since subscribers preferred a larger network to

a smaller one. But once they provided subscriberswith Internet access, the nature of competitionchanged. This early network benefit evaporated asthe companies were faced with the prospect ofcompeting as dial-up Internet Service Providers(ISPs), which is a far more competitive market.

AOL’s later entry has been accompanied byeffective strategic maneuvering and timing. To thesurprise of many observers, AOL’s installed baseand proprietary products have made it the domi-nant partner in its merger with Time Warner. Atleast on paper, AOL’s properties pale in compari-son with Time-Warner’s Time magazine and SportsIllustrated, as well as its copyrighted music andmovie products. In fact, some argue that Time-Warner broadband cable modems even offeredconsumers better Internet access than AOL. Thus,AOL’s shareholders may have simply been luckythat its management chose to merge with Time

Measuring the First-Mover Advantage

With significant advantages to imitation,corporate strategists should be wary of toooptimistic assessments of first-mover advan-tages, particularly when the option value ofwaiting is potentially large. Reluctance to delaybecause of concern over the loss of first-moveradvantages can be evaluated directly againstthe estimated value of the option. While formalmodels of strategic interaction can be quitecomplex, and require careful applications ofgame theoretic reasoning, we advocate startingwith a simpler approach.

First, estimate the value of the option to delay(ignoring for the moment the threat of entry). Thisdepends on the currently expected value of theproject and its current costs, the volatility of theunderlying business opportunity, and the ex-pected time over which this option retains itsvalue. There is an extensive literature on thepracticalities of real option valuation in which themethods assume a monopoly opportunity.

Next, evaluate the likely impact of anotherentrant on the stand-alone value of the project. Insome cases, this can be done with considerableprecision. For example, in the oil industry, the costof delay when a competitor begins to drain an oilfield in which both parties have developmentrights can be estimated based on the price of oiland the rate at which the reservoir is drained. In

durable goods markets, it is the same principle,but one should substitute the market share of thecompetitor for the rate at which the reservoir isdrained. Based on our reasoning above, estimatesof reduced follower costs should also be addedinto the cost function in determining the righthurdle price for development. If costs are fallingover time because of the benefits of movingsecond, the optimal adoption hurdle price as afollower may be quite different from the hurdleprice as a first mover. These can easily beadapted to the real option valuation models inthe literature.

It is also possible to introduce the threat of anew entrant into a real options valuation model.Based on the rationale provided above, it seemsclear that if the cost savings to being a follower aresignificant, it will also be important to model thebenefit to delay that derives from implementingan imitation strategy. In cases where imitationstrategies are a significant benefit, then second-mover advantages will lead to even greater delay.

Finally, compare an estimate of the value offirst-mover advantages to the loss in the value ofthe option to delay. If first-mover advantagesdetermine that entry must occur, then aggres-sively pursue the market. However, weigh thiscarefully against the more conservative strategythat delays the risky investment.


Warner near the peak of the dot-com mania thatcarried its share price to such an extraordinarylevel. But whatever the role of luck and timing inits achieving its current position, AOL has suc-ceeded as a second mover by developing its ownnetwork effects and branded products.

As if to confirm the wisdom of AOL’s strategy,a recent study17 of 80 Internet companies found thatonly 10% of them achieved a sustainable marketadvantage by moving quickly. As the authors of thestudy noted, such findings reinforce the importanceof creating entry barriers in order to preserve the first-mover advantage. An example of combining first-mover with entry barriers is Qwest Communication’sexclusive right to lay fiber optic cable along railroadlines. By moving first with exclusionary rights, thecompany’s position in fiber optic became a barrierto entry for other telecom providers. The authors alsonote that wireless communications companies canform barriers by buying broadcast spectrum, thuspreempting others from using the same spectrum.However, it is not clear that this strategy of buyingspectrum has worked, since many observers feel thatthese companies overpaid in their purchases ofspectrum licenses. Partly as a consequence of suchoverpayments, there have been huge losses and adrastic retrenchment not only by the telecom com-panies, but also by hardware providers like Lucent,Nortel and JDS Uniphase.18

The study concluded with the suggestion that afirst-mover advantage could accrue to a companythat moves quickly to initiate a very large market. Butit offered one important proviso: such a strategy mustbe buttressed with some entry or mobility barriersuch as product branding, network effects, or con-sumer switching costs.

SUMMARY AND CONCLUSIONS

The purpose of this paper has been to considerthe expected value of first-mover advantages andtheir effect on managers’ decisions to exercise realoptions early. In those cases where first-moveradvantages are clearly very great, managers shouldadopt any positive-NPV project that they find inorder to preempt the competition and achieve thefirst-mover advantage. But strategists need to becareful when making assumptions about the valueand importance of first-mover advantage. As oursurvey of recent research and experience suggests,it is very common to find followers taking over themarket after learning from the actions of the firstmover. In fact, it is very difficult to find exampleswhere the first mover in a new market was actuallyable to sustain a long-term competitive advantagethat created shareholder value. (General Electricseems to be one of those exceptions that prove therule.) At the same time, there are abundant examplesof innovators that developed strong markets butspent so much time protecting the original marketthat they missed the evolution to a competingmarket. Xerox and Polaroid readily come to mind.Both companies are currently in a distressed condi-tion despite creating their respective markets andthen dominating for decades.

We do not mean to imply that first-moveradvantages do not exist or are never important forstrategy. Our aim is rather to show that there arelimits to the value of first-mover advantages, and thatsuch limits should be carefully weighed againstsuccessful imitator strategies that provide a valuableoption to delay. First-mover advantages may not bethat important after all.

17. Marty Bates, Syed Rizvi, Prashant Tewari and Dev Vardhan, “How Fast isToo Fast?,” The McKinsey Quarterly 2001(3)., pages 52-61.

18. See, for example, Almar Latour, “Europe’s Telecom Firms Paid Billions For‘3G’ Licenses, Costs Still Loom,” The Wall Street Journal, June 5, 2001, which reportsthat wireless companies bid a total of $100 billion for spectrum licences and haveyet to spend the extra $100 billion in unproven hardware to develop their services.

TOM COTTRELL

is Associate Professor of Finance in the Faculty of Managementat the University of Calgary. Much of his research is in the areaof strategy and in the innovation process in the softwareindustry.

GORDON SICK

is Professor of Finance in the Faculty of Management at theUniversity of Calgary. His 1989 Monograph, Capital Budgetingwith Real Options (in the Series in Finance and Economics,Salomon Brothers Center for the Study of Financial Institutions,Leonard N. Stern School of Business, New York University), wasone of the first comprehensive treatments of real options. Hedoes most of his real options consulting under subcontract toStern Stewart & Company.

It is very difficult to find examples where the first mover in a new market wasactually able to sustain a long-term competitive advantage that created

shareholder value.

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FIRST-MOVER (DIS) ADVANTAGE AND REAL OPTIONS