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Incumbents' Innovation Strategy Choice Under Market Uncertainty

Final Report Summary - INNOV-MARKET (Incumbents' Innovation Strategy Choice Under Market Uncertainty)

The desire to grow top-line revenues and maintain industry dominance drives incumbent firms to undertake innovation efforts. Though incumbents recognize the "innovation imperative", they often face tough choices about which innovations to invest in. Specifically, when a radical innovation opportunity arises in a given industry the incumbent must weigh the potential benefits of pursuing it against its costs and risks: radical innovations hold the promise of superior rewards, but ex-ante are highly uncertain. Beyond development risks (such as whether the firm's R&D effort will materialize in a working product), market acceptance of radical innovations, and hence their commercial returns, can be difficult to predict. Such market uncertainty arises because radical innovations often target projected consumer needs whose market adoption is difficult to anticipate prior to launch. An alternative innovation strategy for the incumbent is to pursue incremental improvements. Incremental innovations sustain the technological trajectory and perceived benefits of existing products, and hence involve less development and less market uncertainty. Furthermore, given their success with the existing technology, incumbents typically enjoy advantages over rival entrants in the development and marketing of incremental innovations.
For incumbents, the possibility of rival entry complicates the choice of an innovation path. Because radical innovations embody novel technologies and hold the promise of vastly superior customer benefits, they have the potential to supplant existing products and incremental improvements to them. This potential makes radical innovations especially appealing to entrants, who are apt to be disadvantaged in the existing technology and to require a drastic change to dislodge the incumbent from its dominant industry position. How does this threat of entry affect the incumbent's decision to pursue radical or incremental innovation?
To address this question, we must examine the implications of the market uncertainty that firms face when determining whether and how aggressively to pursue radical innovation. To generate profitability forecasts, each firm must assess the market potential for the radical innovation; as the preceding examples demonstrate, such assessments can differ across firms. Thus, the incumbent's pursuit of a particular innovation path may reveal its private assessment to competitors. Specifically, if the incumbent pursues the radical innovation opportunity, rivals that learn of this decision may infer that the incumbent thinks highly of the market potential and revise their own beliefs upward. By "validating" the market in this way, the incumbent encourages entrants to invest in the radical innovation. To the incumbent, this outcome is, of course, undesirable; it would rather keep the market to itself and not have to compete in a duopoly.
If, on the other hand, the incumbent forgoes (or postpones its plans to pursue) the radical opportunity and instead develops an incremental innovation, a rival entrant may infer that the incumbent considers the radical innovation's market potential to be low. In this case, the rival entrant may revise its own market-potential assessment downward, thereby reducing its incentives to invest. By selecting an incremental rather than a radical innovation path, therefore, the incumbent may "disvalidate" the market potential for radical innovation and discourage entry. This path can be beneficial for the incumbent if sustaining its dominant industry position via incremental improvements yields greater expected profits than the prospect of sharing the radical market with a new entrant or, worse, being dislodged if it fails to develop the radical innovation.
In this paper, we analyze which innovation strategy an incumbent firm will pursue when it takes into account how its decision may affect an entrant's beliefs about the market potential of a radical innovation. We develop a model in which the entrant and the incumbent each receives a private signal about the commercial potential of a radical innovation; these signals generate their initial market assessments. The reliability (or quality) of these signals can differ across firms, depending on their market-forecasting capabilities. For example, the quality of the signal can reflect how a firm gathers information on market demand for new products, how it disseminates such information within the organization and how its management uses the information to make strategic decisions.
We first analyze the case in which the incumbent's decision to pursue radical or incremental innovation is observable. We find that when its own signal is unreliable, the entrant tends to rely on the incumbent's actions to form beliefs about market potential. Foreseeing this outcome, the incumbent may seek to mask the signal it received from the strategic entrant. Specifically, the incumbent may opt for incremental innovation and delay plans to develop the radical innovation even when its signal is highly favorable in order to avoid validating the market and thus encouraging the entrant to pursue radical innovation aggressively. It bears emphasizing that if there were no threat of entry, the incumbent would pursue incremental innovation only if its signal was low. The competitive implications of its actions can thus cause the incumbent to act counter to its signal and to modify its innovation behavior.
Because firms' new product decisions are not readily apparent in some markets, we also examine which innovation path the incumbent pursues when its decision is not observable. In this case the incumbent must not only choose its innovation strategy, but also decide whether to make its decision known externally (such as via a preannouncement). We find that the incumbent may opt to pursue incremental innovation, and to communicate this decision, despite receiving a signal of high market potential for radical innovation. This outcome is surprising: the incumbent could have pursued radical innovation and concealed its plans so as not to validate the market potential to the entrant. But such behavior may not be sustainable in equilibrium because, if instead of remaining silent, the incumbent deviates to develop an incremental innovation and reveals that decision, the entrant infers that the incumbent's signal is low. This strategy can lead the entrant to downgrade its assessment of the market potential for radical innovation. In other words, the incumbent has an incentive to proactively disvalidate the market potential for radical innovation by pursuing a `soft' incremental path in order to reduce entry. Once again, the more unreliable the entrant's signal, the more drastically it will downgrade its beliefs about the market potential for radical innovation in light of the incumbent's actions. Hence the incumbent will engage in this behavior when the entrant's signal is sufficiently unreliable. By contrast, when the entrant's signal is relatively reliable an incumbent that deems the radical market potential to be high will attempt to develop the radical innovation and will communicate its plans to do so. In this case, the incumbent is less preoccupied with validating the market potential for the entrant (which tends to rely on its own accurate signal anyway) than with acting preemptively by appearing `tough' with respect to pursuit of the radical innovation in case the entrant has also received a high signal. The only way the incumbent can do so is by making its innovation decision perfectly informative and known in equilibrium: communicate it will pursue radical innovation when its signal is high and incremental innovation when its signal is low. Later, we extend the model to investigate the entrant's decision to communicate its innovation intentions (i.e. whether it plans to aggressively pursue the radical innovation). We find that the entrant will communicate that it plans to aggressively pursue the radical innovation only if the incumbent's signal is reliable enough. This is because an entrant that receives a high signal and thus plans to pursue the radical innovation aggressively wants to reveal these plans for preemptive reasons (i.e. signal to an incumbent that received a high signal that it will be a fierce competitor in the radical market). However, the entrant runs the risk that by communicating these plans it will encourage an incumbent that received a low signal to shift to pursuing the radical (rather than incremental) innovation path. But if the incumbent's signal is very reliable, this latter concern is mitigated as the incumbent tends to rely on its own signal.
Our contribution is fourfold. First, the extant literature ignores the possibility that different market-potential assessments regarding the economic returns to radical innovation across firms have strategic implications. We formally analyze how incentives to invest in radical innovation are affected by firms taking cues from rivals' actions. Second, we provide a single framework that can accommodate incumbents' contradictory desires to pursue radical innovation and to abstain from such an innovation course. Third, we offer an explanation for why incumbents might rationally and knowingly forgo radical innovation, at least for a while, that does not resort to arguments of incompetence or biased judgment. Finally, we explore the entrant's decision on whether to reveal its private assessment about the market potential for radical innovation. Although a number of scholars have indicated that firms monitor competitors' actions in circumstances of uncertain market potential for innovations, no analytic research has examined these issues and provided normative guidelines; our work fills this gap.