Dan Sullivan – Pure Genius

Essays on product development and market structure

Essays on product development and market structure

This thesis consists of three essays that study the relationships between product development processes and market structure. It applies extreme value models of product development to study the links between innovative activity, the cost of R&D and industry structure. Extreme value theory differentiates probability distributions by their tail shapes as short-tailed, exponential-tailed or heavy-tailed. The first essay studies the relationship between innovation and vertical industrial structure, using a vertical differentiation model of R&D. It compares industries where R&D and production are vertically integrated to “sliced” industries, where upstream firms engage in R&D competition and downstream firms compete in the product market. It finds that the properties of the market equilibrium are substantially affected by the tail shape of the distribution of project outcomes. In the second essay, a quality-adjusted demand model of product development and quantity competition is advanced and the relationship between the distribution of project outcomes, technology costs and entry into a market is analyzed. It finds that heavy-tailed industries have fewer firms that conduct more experiments, resulting in higher-quality products and greater R&D spending. As technology costs decline, heavy-tailed industries go through market consolidation, whereas industries with exponential or short tails become more fragmented. In the third essay, the model of the second essay is modified to include firms facing differing technology costs and project outcome distributions and the effect of dueling technological competencies on the market outcome is studied. For firms with differing advantages in the cost and upside potential of their innovative processes, an advantage in the cost dimension determines the market leader to a large extent in the case of firms with limited innovative potential, whereas, an advantage in the innovative potential dimension overrides any realistic level of superiority in the cost dimension for firms in heavy-tailed industries. For firms with different sources of advantage in their cost structure, we find that even a slight advantage in the cost of experimentation results in market leadership for the firm with that advantage in industries with heavy-tailed distributions.
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