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KNOWLEDGE INHERITANCE, VERTICAL INTEGRATION,

AND ENTRANT SURVIVAL IN THE

EARLY U.S. AUTO INDUSTRY

Nicholas ArgyresOlin Business School, Campus Box 1133

Washington University in St. LouisOne Brookings DriveSt. Louis, MO 63130Phone: [email protected]

and

Romel MostafaIvey Business SchoolWestern University1255 Western Road

London, ON N6G 0N1, CanadaPhone: (519) [email protected]

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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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’ industry-

specific, 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

1 “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.”

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(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

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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;

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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

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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

account any unique complementarities between such activities (Argyres & Zenger, 2012). Over

2 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).

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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 vertical-

integration 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

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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

decisions in a way that their combined influence contributes to superior performance. Because 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.

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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-to-

pay (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

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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

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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 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

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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

high degree of vertical integration of component fabrication, which Henry Ford believed was

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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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

specificity calls for vertical integration due to the potential for opportunistic hold-up

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(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,

compared with the industry’s earlier period (Argyres & Bigelow, 2007). An important driver of

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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

different (often larger) engines from which to develop a new car models. These examples can be

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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

whose sales were disappointing and whose ownership had been re-organized several times. The

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


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 pre-

entry experiences and their effects on vertical-integration choices at entry.

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 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


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

addition, because transactional hazards are expected to diminish with greater availability of

idiosyncratic suppliers (Williamson, 1975), we include the variable # of Large Engine Suppliers,

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 “non-spinoff” category. Including a separate de alio category does not change the results of any of our estimations.

19


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

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

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 size does not significantly alter our results. Because we are missing size information for some firms, we excluded it from the reported results.

20


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

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

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


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.

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

22


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

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

23


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-

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

24


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

component were not more likely to produce that component in-house. Hence, we find no

evidence of knowledge inheritance relative to these activities.

25


----------------------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

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

26


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

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

27


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 high-

performance 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-

Royce. Established in 1920, Kenworthy survived only two years in the cut-throat competitive

environment.

28


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

context only allows a test of whether such integration enables defensible differentiation

29


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.

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

30


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

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.

31


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


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TABLE 1

In-house Production of Key Components for Auto Models (1917–1931)

Year # of Models% of Models with In-house Production:

Engine Transmission Clutch Steering Frame1917 182 47.46% NA NA NA NA1918 173 50.58% NA 40.99% NA NA1919 122 53.72% 47.90% 42.86% NA NA1920 122 52.88% 40.57% 35.58% 25.24% 20.83%1921 158 50.96% 35.51% 27.86% 23.31% 13.49%1922 172 56.36% 39.39% 31.21% 20.75% 17.95%1923 142 60.00% 40.77% 33.08% 25.58% 16.80%1924 97 64.58% 46.81% 41.05% 39.77% 19.00%1925 92 66.67% 48.57% 50.00% 23.44% 17.46%1926 85 69.41% 53.85% 48.10% 30.38% 20.75%1927 94 70.97% 55.06% 32.22% 21.74% 17.39%1928 92 70.93% 55.13% 21.79% 20.99% 16.13%1929 95 78.82% 55.00% 18.29% 12.99% 26.15%1930 102 82.98% 47.19% 15.91% 13.75% 18.75%1931 89 80.68% 53.49% 22.09% 9.46% 25.71%

NA = not applicable

Source: Compiled from Lester-Steele (1960).

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TABLE 2

Qualitative Information on Auto Industry Entrants

Firm Background Firm Names Notes on FoundingIntegrated spinoff with an integrated parent

Dusenberg, Falcon, Gray, Holmes, La Fayette, Lincoln, Porter, Revere, Rickenbacker, Parenti, Wills

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, Driggs-Seabury, 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., Driggs-Seabury, Fox, Rubay, Stephens

Some firms manufactured “assembled cars”: Bowman, Rotary, Templar

Some firms suffered from high executive turnover: e.g., Earl, Northway, Pan

De-integrated non-spinoff

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

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

De-integrated spinoff with de-integrated parent

ACE, H.C.S., Kenworthy, Kurtz, Meteor

Founders’ experiences tended to be in sales, marketing, or finance.

Note: Firms making “assembled cars” fabricated very few car components.

41

TABLE 3

Descriptive Statistics for Auto Entrants (1917–1931) and Variable Intercorrelations

Var

iabl

e

Mea

n

Std.

D

ev

Min

Max 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 –2.04 3.05 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 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


Table 3, Continued

Var

iabl

e

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:Model 1Vertical

Integration(Probit)

Model 2Market

Segment(IV OLS)

Model 3Survival

Years(IV Tobit)

Model 4Top 25%Surviving Entrants

(IV Probit)

Model 5Survival

Years(IV Tobit)

Parent’s Key Activity and Transaction Costs VariablesParent Engine In-house 1.69*

(0.69)Parent Engine Outsourced –0.14

(0.68)Relative HP 0.31+

(0.17)# of Large Engine Suppliers 0.20

(0.29)

Predicted ValuesPredicted Vertical Integration

1.26**(0.45)

Predicted Log Price 0.56+

(0.32)1.01*

(0.48) 0.93*

(0.41)ControlsParent Market Share (log) –0.06 0.01 0.26+ 0.66 0.29+

(0.50) (0.17) (0.15) (0.63) (0.16)# of Models –0.44 0.65* –0.46+ –0.81 –0.69*

(0.51) (0.26) (0.27) (0.60) (0.31)Early Entrant –1.82* 0.30 0.87** 1.03+ 0.76*

(0.90) (0.33) (0.28) (0.61) (0.30)Michigan 0.46 –0.84* 0.53 1.36 0.60

(0.86) (0.41) (0.41) (0.95) (0.43)Industry Production –0.71

(0.83)–0.31(0.26)

–0.11(0.23)

–0.97+

(0.50)–0.15(0.25)

GNP 0.05 –0.02 0.01 0.04+ –0.01(0.03) (0.01) (0.01) (0.03) (0.01)

Other inhouse- components (clutch, transmission, steering, frame)

Included

Constant –5.62+ 7.91** –4.26 –12.14** –6.38+

(3.36) (1.51) (2.80) (4.17) (3.30)N 60 60 60 60 56

Note: Standard errors in parentheses. + p < 0.10, * p < 0.05, ** p < 0.01

44

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