Schumpeterian Competition and Diseconomies of Scope: Illustrations from the Histories of Microsoft and IBM

We address a longstanding question about the causes of creative destruction. Dominant incumbent firms, long successful in an existing technology, are often much less successful in new technological eras. This is puzzling, since a cursory analysis would suggest that incumbent firms have the potential to take advantage of economies of scope across new and old lines of business and, if economies of scope are unavailable, to simply reproduce entrant behavior by creating a "firm within a firm." There are two broad streams of explanation for incumbent failure in these circumstances. One posits that incumbents fear cannibalization in the marketplace and so under-invest in the new technology. The second suggests that incumbent firms develop organizational capabilities and cognitive frames that make them slow to "see" new opportunities and that make it difficult to respond effectively once the new opportunity is identified. In this paper we draw on two of the most important historical episodes in the history of the computing industry, the introduction of the PC and of the browser, to develop a third hypothesis. Both IBM and Microsoft, having been extremely successful in an old technology, came to have grave difficulties competing in the new, despite some dramatic early success. We suggest that these difficulties do not arise from cannibalization concerns or from inherited cognitive frames. Instead they reflect diseconomies of scope rooted in assets that are necessarily shared across both businesses. We show that both Microsoft and IBM were initially very successful in creating freestanding business units that could compete with entrants on their own terms, but that as the new businesses grew, the need to share key firm-level assets imposed significant costs on both businesses and created severe organizational conflict. In IBM and Microsoft's case this conflict eventually led to control over the new business being given to the old and that in both cases effectively crippled the new business.