Industry growth through spinoffs and start-ups

The length of time industries prosper varies significantly. This column examines why some industries grow and prosper for a long period of time through the lens of submarket creation and destruction. Using data from the Japanese Census of Manufacture, it shows that the creation and the destruction of products allow an industry to continue attracting new entrants, that start-up and spinoff firms are more likely to enter a newly created submarket than incumbent firms, and that new entry is encouraged when unrealised business opportunities are reallocated smoothly.

The industry lifecycle literature has documented a stylised fact that an industry starts off with a very few number of firms, but the number of active firms rapidly increases through new entry until a ‘shakeout’ takes place, and, post-shakeout, the industry typically becomes dominated by a few firms (Gort and Klepper 1982, Klepper and Graddy 1990, Filson, 2001). The continued entry of firms is a driving force for sustaining industry growth, and therefore determines the length of industry prosperity. As we observe that some industries continue to grow while others stop in a very short of period of time, the length between the industry take-off and shakeout varies significantly from industry to industry. Klepper (2016), for example, documents that it took 15 years or more for the number of firms to reach their peaks in the US tire and automobile industries, whereas the number of firms in the penicillin and television receiver industries reached their peaks very quickly in less than 10 years. This finding indicates that sustaining industry growth is not an automatic process once the industry takes off. Therefore, understanding the mechanism through which an industry grows steadily for a long period of time is of primary importance for academic researchers in various fields of social science, as well as for policymakers.

What causes such differences across industries? To answer this question empirically, in a recent paper I focused on the relationship between new entry and the evolution of submarkets (i.e., the product innovation process) in a given industry, as well as the roles of firm heterogeneity played out in product innovation and industry growth (Ohyama 2017). More specifically, I asked three questions to investigate a mechanism that encourages or discourages new entry in a given industry.

• The first question is whether creation and destruction of submarkets in an industry affect the length of positive net entry periods and subsequent entry rates in that industry.
• The second question is what types of firms—start-up firms, spinoff firms, or incumbent firms—are more likely to be actively engaged in a newly created or destructed submarket.
• With the third question, I asked how frictions to the pursuit of business opportunities by incumbent firms and to the reallocation of unrealised opportunities from incumbent firms to spinoff firms affect the entry process at the industry level.

The unique approach of this research is to examine industry growth through the lens of submarket creation and destruction. There is anecdotal evidence that spinoff firms tend to pursue business opportunities that their parent firms gave up pursuing, and then they create a submarket and compete with their parent firms by providing a new product in the industry where their parent firms currently operate. A good example of this anecdotal evidence is the ‘Fairchildren’ phenomenon of the semiconductor industry in Silicon Valley. Like a parent-child relationship, many firms in the semiconductor industry, such as the Intel Corporation and AMD, were spawned from Fairchild Semiconductor and have their roots in the company. In fact, the lion's share of firms in the semiconductor industry are spinoff/spinout firms established by former employees of Fairchild Semiconductor and its related entrepreneurs. The prosperity of the semiconductor industry in Silicon Valley appears to suggest an important role played by spinoff firms and submarkets in industry growth. In the meantime, we have witnessed the difficulty of achieving the policy goal of making a second Silicon Valley, although many policymakers dream of it. What are the fundamental roles of spinoff firms and submarkets in continued industry growth? Is the ‘Fairchildren’ phenomenon an exception? In this research, I try to obtain some inferences about these questions by examining the Japanese Census of Manufacture, which contains a large number of establishment-level observations across several industries.

To answer the questions mentioned above, I mainly used the data from the Census of Manufacture between 1980 and 2013, supplemented with 2012 Economic Census for Business Activity. For this study, product information is the most important piece of information from the Census of Manufacture. An industry or a market is empirically defined at the four-digit level, and a submarket is empirically defined at the six-digit level. By using these definitions, I identified the creation and destruction of a submarket in an industry and investigated their effects on industry growth. To identify when and how firms were established, the data from the Basic Survey of Japanese Business Structure and Activities are utilised and merged with the Census of Manufacture.

My main finding regarding the first question is that the creation and destruction of a submarket allow an industry to continue attracting new entrants, so that the timing of a shakeout is delayed. More specifically, the baseline estimation result shows that the length of positive net entry becomes longer, relative to the base category (i.e. no creation and no destruction), by about two years when an industry both creates and destroys a submarket. This result is partially consistent with Klepper's (2016) conjecture that an industry continues to attract new entrants when a submarket is created within that industry. In addition to this, the results reveal the importance of submarket destruction for industry dynamics as well. The resource reallocation literature has documented that a significant portion of outputs and inputs is reallocated across establishments or firms through entry and exit (Foster et al. 2001). The submarket creation and destruction can be thought of as playing a similar role to the one played by entry and exit, and resources may need to be relocated from a destroyed submarket to a newly created submarket for industry growth.

I also find that start-up firms or spinoff firms are more likely to enter a newly created market than incumbent firms. This indicates that start-up and spinoff firms are the main players in a new submarket.

Regarding the third question, I show that new entry is encouraged when unrealised business opportunities are reallocated smoothly to spinoff firms from incumbent firms. This finding can be interpreted as indicating that the reallocation of unrealised opportunities from incumbent firms to spinoff firms sparks subsequent entries. The cumulative nature of business and innovation opportunities generates a self-enhancing process through which the realisation of one such opportunity becomes a basis for the realisation of a next opportunity.

The empirical analyses of my study show that the creation and destruction of products have a positive impact on the length of entry periods and entry rates, that start-up firms and spinoff firms are more likely than incumbent firms to be involved in a newly created submarket, and that an industry continues to attract new entrants when reallocation of unrealised opportunities among different firm types functions well, without serious frictions.

Editors' note: The main research on which this column is based first appeared as a Discussion Paper of the Research Institute of Economy, Trade and Industry (RIETI) of Japan.

This article first appeared on www.VoxEU.org on December 14, 2017. Reproduced with permission.