Innovation and the Firm: A New Synthesis.

• Author: Lee, Peter

Abstract. Recent scholarship highlights the prevalence in high-technology industries of vertical disintegration, in which separate entities along a value chain transfer knowledge-intensive assets between them. Patents play a critical role in this process by lowering the cost of transactions between "upstream" technology generators and "downstream" parties that further develop technologies, thus promoting vertical disintegration.

This Article challenges that prevailing narrative by arguing that vertical integration pervades patent-intensive fields. In biopharmaceuticals, agricultural biotechnology, information technology, and even university-industry technology transfer, firms are increasingly integrating under a common organizational framework rather than remaining separate and licensing patents between distinct entities.

This Article explains the surprising persistence of vertical integration by retheorizing the relationship between innovation and the firm. It therefore sheds new light on a longstanding debate over whether innovation should be organized within a hierarchical organization--the firm--or coordinated through market exchanges among separate entities. Synthesizing previously disconnected lines of theory, this Article first argues that the challenge of aggregating tacit technical knowledge--which patents do not disclose--leads high-tech companies to vertically integrate rather than simply rely on licenses to transfer technology. Relatedly, the desire to obtain not just discrete technological assets but also innovative capacity, in the form of talented engineers and scientists, motivates vertical integration. Finally, strategic imperatives to achieve rapid scale and scope also lead firms to integrate with other entities rather than simply license their patents. Tacit knowledge, innovative capacity, and strategic considerations explain not only why firms vertically integrate but also why they do so by acquiring preexisting organizations and granting them significant autonomy, an underappreciated phenomenon this Article describes as "semi-integration." The result, contrary to theory, is a resurgence of vertical integration in patent-intensive fields. This Article concludes by evaluating the costs and benefits of vertically integrated innovative industries, suggesting private and public mechanisms for improving integration and tempering its excesses.

Introduction I. Prevailing Accounts of Transaction Costs, Patents, and Vertical Disintegration A. The Theory of the Firm B. Patents as Mechanisms to Promote Transactions and Vertical Disintegration C. Scholarly Emphasis on Various Forms of Vertical Disintegration II. Tacit Knowledge, Innovative Human Capital, and Strategic Considerations Driving Vertical Integration A. Tacit Knowledge Transfer B. Innovative Human Capital C. Strategic Factors 1. Competitive considerations 2. Noncompetitive considerations D. Organizational Structures of Innovation and Semi-integration III. Vertical Integration in Patent-Intensive Industries A. Biotechnology and Pharmaceuticals B. Agricultural Biotechnology, Seeds, and Chemicals C. Information Technology and Startups D. University-Industry Technology Transfer IV. Analysis and Normative Assessment A. Industrial Dynamics, the Theory of the Firm, and Semi-integration B. Normative Assessment V. Prescriptions A. Private Ordering: Improving Vertical Integration B. Public Ordering: Balancing Efficiency and Innovation Gains Against Competitive Harms Conclusion Introduction

"Companies are buying innovation."

--Peter Levine (1)

Merck had a problem, and Afferent Pharmaceuticals offered a solution. Recent and upcoming patent expirations on key drugs like Remicade and Nasonex were severely threatening Merck's revenues. (2) Seeking promising drugs to fill its pipeline, in 2016 Merck looked to Afferent, a small biotechnology firm that develops drugs to treat various neurogenic conditions including chronic cough. (3) Afferent had two promising compounds undergoing clinical trials, both of which were subject to patents or patent applications. (4) Merck's interest in developing these compounds into marketable drugs was not surprising, and a well-established law and economics literature suggests that Merck should have simply licensed Afferent's intellectual property. (5) After all, patents represent a relatively low-cost means of transferring technology. (6)

But Merck did not just license Afferent's patents; it purchased the entire company in a deal worth up to SI.25 billion, (7) which is presumably much more than the value of the patents alone. Merck's acquisition of Afferent illustrates a significant trend, as major pharmaceutical firms have been vertically integrating by acquiring small biotech firms instead of simply licensing their patents. It also raises broader questions about the role of patents and technical knowledge in driving vertical integration and the impact of such industrial organization on innovation.

A striking pattern has emerged in patent-intensive industries: vertical integration. In a vertically integrated value chain, a single company combines two or more stages of production, such as basic research and further development of some technology, ordinarily performed by separate companies. In several fields, "upstream" technology suppliers (those that generate a foundational technology) like Afferent and "downstream" technology users (those that develop and add value to existing technologies) like Merck are integrating under common ownership rather than simply licensing patents between them.

This pattern is especially notable given substantial academic commentary emphasizing the decline of vertical integration in patent-intensive industries. (8) According to these accounts, patents facilitate market-based technology transactions between separate upstream and downstream entities. These accounts emphasize that such separation promotes efficiency by enabling specialization along vertically disintegrated value chains. To illustrate this trend, scholars have explored a proliferation of vertically disintegrated organizational forms, such as contracts for innovation, networks, and the commons. According to one commentator, "The day of the vertically integrated company has come to a close...." (9)

This Article challenges that conventional wisdom by subjecting the theory of the firm to the realities of modern industrial organization. Drawing on empirical accounts, this Article argues that in several key patent-intensive fields, firms are increasingly resorting to vertical integration rather than market exchanges (or other nonhierarchical mechanisms) to transfer and develop patented technologies. While industrial landscapes are, of course, complex and multifaceted, this development is evident in a spate of vertical acquisitions in the biopharmaceutical, agricultural biotechnology, and information technology industries. It is even evident to a lesser extent in a high degree of institutional meshing between universities and companies licensing academic patents.

The striking resurgence of vertical integration sheds new light on the relationship between innovation and the firm. It therefore intersects with a longstanding academic debate over whether productive activity--such as innovation--should be organized within a hierarchical organization--the firm--or coordinated through market exchanges among separate entities. This Article does not disclaim that patents lower transaction costs, thus promoting market exchanges and vertical disintegration, as the academic literature has demonstrated. Rather, this Article contends that countervailing forces pushing toward vertical integration often overwhelm the disintegrating force of patents.

Synthesizing and extending previously disconnected theories, this Article presents a novel framework for understanding such integration. First, it argues that the challenges of aggregating technical knowledge--particularly tacit knowledge not disclosed in patents--play a significant role in driving firms to acquire companies rather than simply license their intellectual property. Even when patents and licenses are available to transfer a technology, interaction with the original inventive entity is often necessary to unlock the full potential of that technology and commercialize it. Second and relatedly, it argues that the desire to obtain not just discrete technological assets but also innovative capacity, in the form of talented engineers and scientists, motivates vertical integration. Third, it argues that strategic imperatives to achieve rapid scale and scope, exclude competitors, and appease investors also lead firms to vertically integrate rather than contract with independent parties. Patents may promote vertical disintegration, but knowledge, human capital, and strategic demands often push harder in the opposite direction--toward vertical integration.

To elucidate this phenomenon, this Article draws on the sociology of knowledge to introduce the novel concept of "semi-integration." While vertical integration offers several benefits, it is not immediately clear why technology firms are absorbing preexisting companies and institutions rather than vertically integrating by simply hiring individual scientists and engineers in the labor market. This Article argues, however, that tacit knowledge and innovative capacity are socially embedded properties that inhere not only in individuals but also in organizations. The particular culture, processes, and modes of operation of a startup or university laboratory are critical to cultivating tacit knowledge and producing innovations; to gain the full benefit of such knowledge, a company must integrate with that entire organization rather than just cherry-pick individuals. The socially embedded nature of tacit knowledge and innovative capacity, however, poses a challenge for acquisitions. While a startup is valuable for its distinctive culture...