Endogenous Transformation in the
Automobile Industry
Manuel Bouza, Silvia Ulli-Beer, Philipp Dietrich, Alexander Wokaun
Paul Scherrer Institut
Dynamics of Innovative Systems
OVGA 115
5232 Villigen PSI
Switzerland
+41 56 310 2441
manuel. bouza@psi.ch
Abstract Established industries develop and mature along continuous trajecto-
ties defined by the underlying technological paradigm relevant to serve the value
network of the industry. Technological discontinuities and/or preference shifts at
the higher levels of the value network may trigger a technological transformation in
the industry. Depending on different circumstances, the technological transforma-
tion process may have significant impact on the industry, reverting the continuous
maturation process, creating new structures and changing the way business is done
in the future. Here we describe the transformation process that is evident in to-
day’s automobile industry, which we call Endogenous Transformation, and compare
it two transformation processes previously described in the literature (Disruptive
and Radical Transformation). In an Endogenous Transformation process, a new
technology is developed in a joint effort by most organizations in the industry to
substitute the old technology, with which their value network cannot be served any
longer in the future. An important condition for an Endogenous Transformation.
process is that new knowledge can effectively be protected from being freely copied
by the competition and that new knowledge is traded between organizations, pre-
venting significant knowledge asymmetries in the industry.
Key Words: Innovation, Endogenous Transformation, Automobile Industry, Knowl-
edge Diffusion, Spillover, R@D Strategy
Endogenous Transformation in the Automobile Industry Manuel Bouza et al.
1 Introduction
Climate change regulations and high oil prices are pressurizing today’s socio-technical
regime in the automobile industry, based on the internal combustion engine (ICE) tech-
nology and liquid fossil fuels. This pressures are expected to increase in the future,
anticipating important changes of the underlying technological paradigms in the indus-
try. In our group, we intend to model the automobile industry on a micro-level, to
better understand the factors influencing a possible technological change, the possible
development paths that such a change can take and the final industry structure it may
lead to. We think that this will be of great help for developing efficient policies that
facilitate a transition towards a more sustainable propulsion technology with minimal
social and economic sacrifices during the transition period. In the following sections,
the concepts and dynamical hypothesis that have been developed for system dynamics
modeling are described. This work continues the work of Mathias Bosshardt [4, 3] in our
group and complements the fleet dynamics with innovation and competition dynamics
in the automobile industry.
2 Theoretical Background
An industry is formed by companies organized in a value network producing and com-
mercializing goods or services with the quality preferences demanded by their customers.
A value network is defined as a “nested commercial system” composed of supplying, man-
ufacturing and commercializing companies, the scope and boundaries of which “is defined
by the dominant technological paradigm and the corresponding technological trajectory
employed at the higher levels of the network” [6], ie. proximal to the final system-of-use.
In analogy to the Khunian definition of “scientific paradigm”, a technological paradigm
is defined as “a model and a pattern of solution of selected technological problems, based
on selected principles derived from natural sciences and on selected material technolo-
gies” [8]. Technological paradigms always imply a technological trajectory, which is “the
direction of advance within a technological paradigm” |8] and along which technological
progress can be measured as the improvement of the relevant problem solving variables
defined by the underlying paradigm.
Under normal operation and because of competitive pressure, companies in an industry
with a stable paradigm will focus on the continuous improvement of their products along
the trajectory defined by the underlying technological paradigm of the value network
they are serving. In order to increase efficiency and competitiveness, successful routines
providing a competitive advantage will be selected and stabilized by organizations [11].
This leads to a maturing process in the industry, where the initial explicitly available
knowledge of organizations is continuously embedded into routines and communication
channels, so becoming ever more tacit and consequently harder to change [10], and
increasing organizational inertia [12]. This is a reason why the further technological
Endogenous Transformation in the Automobile Industry Manuel Bouza et. al.
development in maturing industries is path dependent and follows the technological
trajectory relevant in the industries’ value network.
Technological discontinuities in an industry may cause the displacement of the exist-
ing technological paradigm by a new paradigm. With the new paradigm, new knowledge
and competences become relevant for obtaining a distinctive competitive advantage in
the industry, causing environmental turbulence [14] and the reversion of the continu-
ous maturity process [1]. This does not happen in the form of a punctuated change
but is often a complex transformation process in which the structure of the industry
(number of firms, firm sizes and leading companies), as well as the business models may
undergo significant change. During the transformation process, organizations need to
make the tacit knowledge embedded into routines and communication channels explicit,
before it can be updated and new, more appropriate routines and communication chan-
nels established. This organizational transformation is specially challenging and costly
for established organizations, often having important competitive implications with the
consequence, that they may succumb to new market entrants [10]. Usually, at the be-
ginning new technologies are inferior to the prevalent technologies in existing industries,
but often have or promise to have important advantageous characteristics which are
demanded in market niches for specialized value networks. Therefore, new technologies
tend to be developed by new companies in protected market niches without competing
with the established technology and where the users are willing to pay a higher price
for the exceptional features the new technology offers [9]. As the new technology ma-
tures, it may improve along the variables which are relevant in the value network of the
established industry as well, and when costs are reduced, it starts competing with the
established technology. This development is further enhanced through the fast techno-
logical development of the established technology considerably beyond what the value
network actually requires and what customers can exploit and are willing to pay for [6].
Although the new technology may still underperform the established technology, it still
complies with the actual needs of the value network but at lower (unit [2|) costs. This
results in a rapid switch ! of the customers in the established value network to the new
technology, causing a disruption in the industry where incumbent organizations, which
did not foresee the technological potential of the new technology and therefore contin-
ued to focus on the further improvement of the established technology (often also as a
strategic response to the threat of the new technology ), are displaced by the newcomers,
which were formerly confined to the specialized market niche |6]. It is apparent that
such a disruption leads to a important transformation of the industry structure and a
switch of the valid technological paradigm to the new one. But, as the new paradigm
is able to comply with the relevant values demanded in the established industry (other-
wise disruption would not have occurred), it does not necessarily change or redefine the
technological trajectory of the industry in the following maturation process. We call the
industry transformation process described above Disruptive Transformation, following
1 Assuming low switching costs.
Endogenous Transformation in the Automobile Industry Manuel Bouza et. al.
the notation established by Clayton M. Christensen |6].
Radical technological discontinuities and new paradigms may be either introduced by
new market entrants or incumbent organizations in a mature industry, as did newcomers
with electronic calculators in the calculators industry or incumbents like Hudson and
IBM with the closed steel body in the automobile industry [1] and with the Winchester
design in the hard disk industry |6], respectively. While the initial intention for the
development and marketing of a radical technology by the innovating organization usu-
ally is to better serve the existing value network in a new and innovative way, a radical
technology tends to establish a new paradigm in the value network, defining a new tech-
nological trajectory with new relevant variables for the future development. Therefore,
radical and architectural innovations change the way business is done and “influence the
established systems of production and marketing” [1], requiring organizations to reorient,
reversing the process of industry maturity and causing industry transformation, similar
to the disruptive innovations described above. A good example of this is the closed steel
body in the automobile industry, which created completely new relevant values like pas-
senger comfort, room heating and ventilation, which until then were irrelevant because
of the open wooden bodies then on the market [1]. Because the radical innovation fulfills
the requirements of the value network and is broadly adopted, incumbent organizations
in the industry quickly perceive the threat and react to it by reorganizing and build-
ing up the required knowledge and competences to absorb and further develop the new
technology in order to improve their competitiveness, as did Chevrolet and GM with the
closed steel body [1]. Also, new organizations may enter the industry following a techno-
logical discontinuity because of lower market barriers [8], posing a significant threat to
incumbent organizations that need to reorganize. We call the industry transformation
process described above, which is initiated by a radical innovation launched either by an
incumbent firm or a newcomer, destined to better serve an existing value network but
which will change its valid paradigm and its future technological trajectory, as Radical
Transformation. What makes it different from the Disruptive Transformation is the fact
that the relevant improvement variables and the technological trajectory are maintained
in the Disruptive Transformation *, while it is changed in the Radical Transformation
process. What is common to both is that the transformation process is triggered by a
technological discontinuity which is available and marketable from the beginning (Figure
lj}e
Besides the two industry transformation processes described from the literature above,
we postulate a third transformation process, which we call Endogenous Transformation
(Figurel) and which is evident in today’s automobile industry. New climate change
regulations and fluctuating fossil fuel prices are pressurizing the socio-technical regime
of the automobile industry based on the internal combustion engine (ICE) and liquid
fossil fuels (gasoline and diesel). These pressures are calling for new drive train tech-
2 Actually, the new technology is adopted by the value network because it complies with its’ require-
ments but at lower costs compared to the current technology
Endogenous Transformation in the Automobile Industry Manuel Bouza et. al.
nologies based on alternative fuels to primarily reduce CO, emissions, but also decrease
the dependence on oil, causing changes in the relevant variables of the value network
and forcing the industry to look for new solutions based on alternative paradigms, as
the current paradigm reaches its technological limits (e.g. thermodynamic efficiency).
What differentiates the Endogenous Transformation process from the former two trans-
formation processes is that an alternative technology to solve the pressure and problems
of the current regime is not available, but needs to be developed first.
=o :
cs Endogenous Radical
SE Changed & Transformation Transformation
oe making old
BS technology Exploration phase Pioneers triggering
& 8 = obsolete mutually lead by transformation and
Eee established companies playing a dominant role
EgS
ene
ee)
Ess Incremental
362 Maturation
©. Maintained
Dog Industry structures are
soe stabilized & market
os structures reinforced
Not available/ Available &
immature marketable
Availability or marketability of new technologies to
fulfill the requirements of the value network
Figure 1: Transformation processes in industries
3 Methods
In order to identify important feedback loops for technological change we developed a
first dynamical hypothesis [13] (working paper[5| available on request). Our dynamical
hypothesis builds mainly on concepts from the research literature cited in the introduc-
tion |8, 1, 14, 10, 6, 9] and can be summarized as follows:
(i) During normal phases of the industry maturation process, organizations focus
on continuous innovations and on improving the current technology following the
technological trajectory given by the relevant paradigm in the value network
(ii) New technological discontinuities which could better serve the value network or
pressures on the current socio-technical regime of the value network may cause
organizations to change the focus from continuous innovations to develop radical
innovations
Endogenous Transformation in the Automobile Industry Manuel Bouza et. al.
(iii) A focus shift from continuous to radical innovations requires incumbent organiza-
tions to reorient, which is a difficult and costly organizational process
(iv) The industry enters a ferment exploration phase characterized by technological and
market uncertainty and in which different designs are developed and marketed by
different organizations; usually, this is accompanied by newcomers entering the
market due to lowered market. barriers
(v) When a new dominant design emerges, i.e. is successfully selected by and penc-
trates the market, the ferment exploration phase comes to an end
(vi) The whole industry focuses again on the continuous improvement of the domi-
nant design following the trajectory defined by the underlying new technological
paradigm
(vii) Pioneering companies successfully developing and marketing the dominant design
become the new leaders in the new industry era
(viii) The industry follows either a Radical or Disruptive Transformation process, de-
pending whether incumbent organizations recognize the potential of the new tech-
nology to serve their value network or not, respectively
In order to verify the dynamical hypothesis, we have conducted several interviews with
automobile industry members (N=3) and experts (N=2). In the following we describe
the results and conclusions obtained from the interviews and the underlying systemic
mechanisms that drive the whole industry to develop a solution in a common effort
from within, leading to the postulated Endogenous Transformation process, as can be
evidenced today.
4 Interview Results
The automobile’s industry regime based on the ICE technology and liquid fossil fuels
is under pressure. Mainly regulatory requirements for the reduction of green house
gas emissions, which are expected to tighten in the near future, and possible fuel price
fluctuations, exert the pressure on the current ICE regime. This pressure is causing
a focus change from improving the ICE technology alone to also develop alternative
drive train technologies for their future commercialization. It is estimated that the ICE
technology will not be able to fulfill future market requirements after the next 10 to 25
years and that an automobile manufacturer focusing on the improvement of the ICE
technology alone will not be able to sustain a competitive advantage after the same
period.
Organizational change costs (e.g. build up of new competencies in R&D and market-
ing teams, write-off of obsolete infrastructure and investments into new infrastructure)
are not regarded as an impediment for the development of alternative drive train tech-
nologies.
Investments into the development of alternative drive train technologies have mostly
Endogenous Transformation in the Automobile Industry Manuel Bouza et. al.
started around the year 2005 and are expected to increase. Between 2012 and 2020 the
share of R&D expenses for alternative drive train technologies will have reached 50%
of total R&D expenses, as estimated by automobile industry members. Automobile
industry experts estimate this to happen only between 2030 and 2040. In general, it
can be expected that R&D expensed for alternative drive train technologies will increase
to a significant share in the next years to come. By 2050, little if not nothing will be
expended for the further development of the ICE technology.
Patents are effective means to protect new technological developments from the com-
petition. It is very usual between automobile manufactures to trade patent licenses, as is
the case with Toyota’s hybrid technology and Ford’s Diesel technology. Knowledge diffu-
sion is high in the automobile industry, meaning that new technological developments are
quickly absorbed and applied by the competition as well, but it is bidirectional, meaning
that an automobile manufacturer can only benefit from this knowledge diffusion if it has
something to offer on its own. Other means of protecting new developments are secrecy,
i.e. keeping the knowledge in-house without patenting it and making it public. Speed to
market and the image of technological leadership are key factors to obtain a competitive
advantage in the highly competitive automobile industry.
The following alternative drive train technologies are regarded as having the greatest
potential to have a market share of over 20% by the year 2050 (ranked by highest
potential):
(i) hydrogen fuel cell
) battery electric
(iii) electric-gasoline hybrid
) electric-natural gas hybrid
) alternative liquid fuels (e.g. bio-ethanol, bio-diesel) with ICE.
(vi) natural gas ICE.
Here it must be noted that the technologies have been rated quite differently (high
standard deviations), this being symptomatic for the uncertainty prevalent during the
exploration phase and it is yet unknown what technology will be best suited for fu-
ture marketability, ie. fulfilling individual mobility requirements at affordable costs
compared to today.
5 Conclusions
Both tightening green house gas regulations and changing customer needs * are pressur-
izing the current socio-technical regime of the automobile industry and transforming it’s
value network. Automobile manufacturers have become aware of these changes and they
regard alternative drive train technologies as a solution to solve the current pressures
*Increasing preferences for small and energy efficient cars can be observed
Endogenous Transformation in the Automobile Industry Manuel Bouza et. al.
and meet future market requirements, despite the challenging and costly reorganizations
that they imply. This awareness and change of strategic orientation creates sufficient
drive to overcome organizational inertia[12] reducing the inner-organizational resistance
to and costs of change. From this it can be concluded that a Disruptive Transformation
process is unlikely to happen in the automobile industry and consequently, that new
automobile manufacturers offering vehicles based on alternative drive train technologies
will have a difficult stand to compete against incumbent manufacturers.
Because of the significant knowledge trading between organizations in the automobile
industry, the need to undertake own R&D efforts is specially high for companies. If a
company does not research and develop new technical knowledge, it is excluded from
the knowledge trading process, increasing it’s technical gap significantly with time. This
may also explain why most leading automobile manufactures are investing significantly
in the R&D of alternative drive train technologies. An additional motivation for these
investments may be the build up of absorptive capacity [7] and the resulting capabili-
ties to perceive and quickly react to technological developments and breakthroughs of
competitors in alternative drive train technologies. The high risk of a car manufacturer
to solely pursue the development of an alternative drive train technology, as well as the
consequences of not partaking in the development of alternative drive train technolo-
gies other car manufacturers are pursuing (both excluding the car manufacturer from
the knowledge trading process and increasing the technological gap) may lead to the
creation of a common focal point in the industry, where the development of a selected
alternative drive train technology is emphasized by all manufacturers at the same time.
This may explain the congruent efforts undertaken by the leading car manufacturers
to develop and commercialize battery electric cars today. Depending on how successful
this commercialization will be, these efforts are either continued and intensified or aban-
doned. In the latter case, this would probably lead to the formation of a new focal point,
putting emphasis on another alternative drive train technology in the future, starting
the whole process again and prolonging the Endogenous Transformation process.
Bringing all these different aspects of technological transformation in today’s auto-
mobile industry together, it can be concluded that the following is necessary for an
Endogenous Transformation process to develop:
(i) A mature, knowledge intensive and highly competitive industry with a stable socio-
technical regime exists
(ii) Overlying economic, sociological and /or ecological systems put pressure on the cur-
rent industry’s socio-technical regime, causing a shift in the values of the industry’s
value network
(iii) Further improvements of the current technology is not a solution to solve the
pressure, either because it is the cause of the problem itself (e.g. dependence on
oil) or because it is reaching it’s technological limits and further improvements are
prohibitively expensive (e.g. thermodynamic efficiency)
(iv) Incumbent companies in the industry realize that, in order to solve the pressure
Endogenous Transformation in the Automobile Industry Manuel Bouza et. al.
and to fulfill future market requirements, a paradigm change is necessary (making
a Disruptive Transformation process very unlikely)
(v) No alternative technology is available to substitute the old technology and solve
the pressure; possible alternative technologies exist, but are yet immature to be
commercialized and need to be developed first
(vi) No sudden, unexpected and radical technological breakthrough occurs, i.e. alter-
native technologies evolve gradually and without creating significant knowledge
asymmetries between companies in the industry (otherwise the transformation
process would become a Radical Transformation
(vii) New knowledge can be effectively protected from being freely copied by the com-
petition and is traded in the industry; this prevents significant knowledge asym-
metries in the industry
In Figure 2 the factors and dynamic structure leading to an Endogenous Transforma-
tion process are shown in a casual loop diagram [13]. The interview results allowed us
to refine the most important loops (six reinforcing and three balancing loops), which are
listed and described in Table 1.
Parceived need
Different & company Racicainess of new ganization
dependent technological “\ se is
developments of new for change
ae i
Technical iis of :
emer
a4 Organlzational
~ absorptive capacity ot | change costs, os
new ant
* improvement of current \ Perceived disturbance &
Konto Vang technology pressure on curent |
between competitors / regime |
3 tndustry V a . \ *
| investments into new
technology Focus \ ‘a Actual & expected future
market success and revenues
y wy 7 &) wi Rescay mrwulroe
: ‘technology can better serve
the value network
New technological Maturity of new me 7 Domiance of current,
developments (e.g. rom _ technology ( ak } technology in the
taco) ee | ine
7 Dominance of new ‘ mi
technology inthe Delaying development = ("ag
+ “industry, of new technology %
Actual & expected future
‘market success and revenues
{rom new technology
4+ Risk & thread that competitors
‘or new entrants develop &
‘market new technology
Figure 2: Casual loop diagram of Endogenous Transformation process
Endogenous Transformation in the Automobile Industry
Manuel Bouza et. al.
Table 1: Feedback loops of casual loop diagram
Nz.
Loop Name
Polarity
Description
Technological Trajectory
Technological Limits
Competitive R&D
Technological Maturity
Absorptive Capacity
Focus on continuous innovations im-
proves current technology and in-
creases current and expected future
market success, as well as current
technology dominance
Reaching the limit of the current
technology reduces marginal im-
provements and makes continuous
innovation unprofitable
Danger or the perceived risk that
competitors or new entrants develop
the new technology decreases the ex-
pected future profits from the cur-
rent technology and so favors a fo-
cus shift towards the development of
new technologies
Initial R&D investments leads to
increased technological maturity,
which increases actual and expected
future market success and revenues
from the new technology, given that
it fulfills the requirements of the
value network
Technological uncertainty motivates
companies to invest into different
technologies to develop absorptive
capacity and to be able to per-
ceive and react to new technologi-
cal developments of competitors; ab-
sorptive capacity facilitates absorb-
ing new knowledge and favors knowl-
edge trading
10
Continued on next page
Endogenous Transformation in the Automobile Industry Manuel Bouza et. al.
Table 1 — continued from previous page
Nr. Loop Name Polarity Description
6 Knowledge Balancing t New technological developments are
traded between competitors result-
ing in bidirectional knowledge diffu-
sion, avoiding significant knowledge
asymmetries in the long run and in-
creasing the maturity of the new
technology
7 Technological Dominance Technological maturity of the new
technology increases it’s technolog-
ical dominance, increasing a focus
shift towards the development of
new technologies and so motivating
even higher R&D investments for
the new technology
8 Organizational Effectiveness Focus on continuous innovations in-
creases efficiency and consequently
current and expected future market
success
9 Organizational Inertia - Focus on continuous innovations in-
creases organizational inertia[12], re-
sistance to change and organiza-
tional change costs
6 Outlook
Our dynamic hypothesis will be further refined with ongoing interviews of automobile
industry members and experts. The following steps will be the development of a system
dynamics model with game theoretic concepts to simulate the competitive dynamics
under an Endogenous Transformation process in the industry on a micro or firm level.
The purpose is to develop effective policies which support a smooth transition towards
sustainable alternative propulsion systems with low green house gas emission under
minimal social and economic transition costs.
11
Endogenous Transformation in the Automobile Industry Manuel Bouza et. al.
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