CENTRE DE RECHERCHES ADIS

ANALYSE DES DYNAMIQUES

INDUSTRIELLES ET SOCIALES

Asset Seeking Foreign Direct Investment:

the Role of Lead Users
Thse pour obtenir le grade de

DOCTEUR EN SCIENCES CONOMIQUES

Prsente et soutenue publiquement par

Noha AHMED IBRAHIM EL-DEMERY

Le 16 mars 2011

Composition du jury de soutenance

M. Adel BEN YOUSSEF (Directeur de Thse)

Matre de Confrences HDR, Universit Nice Sophia-Antipolis.

M. Alain RALLET (Prsident)

Professeur, Universit Paris-Sud 11.

M. El Mouhoub MOUHOUD (Rapporteur)

Professeur, Universit Paris Dauphine.

M. Fabrice LE GUEL (Examinateur)

Matre de Confrences, Universit Paris-Sud 11.

M. Hatem MHENNI (Rapporteur)

Professeur, cole Suprieure de Commerce de Tunis, Universit de la Manouba.

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Luniversit nentend donner aucune approbation

ni improbation aux opinions mises dans les thses,

ces opinions doivent tre considres comme

propres leurs auteurs.

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REMERCIEMENTS

Je tiens en premier lieu exprimer ma reconnaissance M. Adel BEN YOUSSEF, qui

ma fait confiance en acceptant dtre mon directeur de thse. Tout au long de ces

annes dtude, jai trouv auprs de lui le savoir et lexprience qui mont guide dans

mes choix de recherche ainsi que la patience et lencouragement. Je lui tmoigne ma

gratitude pour mavoir pousse aller jusquau bout de mes ides et les valoriser.

Jai t trs sensible lhonneur que mont fait les membres de mon jury de soutenance,

M. Alain RALLET, M. El Mouhoub MOUHOUD, M. Fabrice LE GUEL et M. Hatem

MHENNI, davoir accept de soumettre leur regard critique et avis ce travail. Je

remercie profondment M. Hatem MHENNI pour son aide sincre et pour le temps

prcieux quil ma accorde.

Mon immense gratitude mes amis du laboratoire de recherche Analyses des

Dynamiques Industrielles et Sociales (ADIS) de la Facult Jean Monnet. Je remercie

ceux qui mont claire quand jen avais le plus besoin avec des commentaires prcieux

sur mon travail, ceux qui mont aide rsoudre des problmes logistiques et ceux qui

mont accorde leur soutien et leur amiti.

Mes remerciements vont aussi lUniversit Paris-Sud 11 et au gouvernement franais

qui ont financ une partie de ce travail.

Enfin, surtout, je remercie ma famille et je suis reconnaissante mes trs chers parents

pour leur confiance, leur coute et leur soutien pendant ces annes.

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 To all of us: the users

You see things that are, and ask why?

I dream of things that never were, and ask why not?

Bernard Shaw, (1856-1950)

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ABSTRACT

Literature on asset seeking foreign direct investment (FDI) ignores the role of the host

countrys lead users. The thesis through two game theoretic models shows the impact of

lead users on FDI decision versus exports. All other things equal, the 1st model proposes

that, FDI is more profitable in a technology push innovation, in order to learn about lead

users advanced needs, the higher the risk of product misspecification relative to local

needs. The probability of misspecification increases in the radicalness of the technology

and in the difference in the use environment between the two countries. The 2nd model

studies the impact of lead users innovation. All other things equal, lead users who

reveal their innovation attract FDI, the higher the tacit knowledge incorporated in their

innovation. To push the foreign investor to develop their innovation, lead users shall

maximize its generality and its tacit component. If the multinational has high firm-

specific assets, then an arrangement to privilege the foreign investor relative to his

potential competitors would arise. To have a Pareto optimum equilibrium, the foreign

investor shall maximize the improvements he brings to lead users innovation and shall

privilege lead users relative to other users. The thesis observes Egyptian information

and communication technology sector (ICT). There are obstacles interfering between

the adoption decision and actual adoption. Integrated subsidiaries within local

innovation networks can play a role in reducing the digital divide related to usage.

Interviews with electronic governments executives show that the government in order

to diffuse ICT may become an innovator lead user.

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Keywords: Asset seeking foreign direct investment, lead users, demand uncertainty, use

environment, new product development, innovation, information and communication

technologies.

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 LInvestissement Direct tranger (IDE) la Recherche
dActifs: le Rle des Utilisateurs lAvant-garde du March
RSUM

La littrature de lIDE la recherche dactifs ignore le rle des utilisateurs lavant-

garde du march (lead users). La thse, travers deux modles de thorie des jeux,

montre limpact des lead users sur larbitrage entre lIDE et lexportation. Toutes

choses gales par ailleurs, selon le 1er modle, lIDE est plus profitable dans une

innovation pousse par loffre, pour apprendre sur les besoins avancs des lead users,

mais plus lev est le risque de spcification errone du produit par rapport aux besoins

locaux. La probabilit de spcification errone augmente avec la radicalit de la

technologie et la diffrence entre lenvironnement dusage des deux pays. Selon le 2me

modle, le lead user rvlant son innovation attire lIDE en augmentant la

connaissance tacite incorpore dans linnovation. Pour pousser linvestisseur

dvelopper linnovation, le lead user maximise la gnralit de linnovation et sa

composante tacite. Si la multinationale a un niveau lev dactifs spcifiques, un

arrangement lavantagera par rapport ses concurrents potentiels. Pour un quilibre de

Pareto, linvestisseur maximise lamlioration quil apporte linnovation et privilgie

le lead user par rapport aux autres utilisateurs. En Egypte, des obstacles interviennent

entre la volont dadopter la technologie de linformation et de la communication (TIC)

et son adoption effective. Des filiales intgres dans les rseaux dinnovation locaux

contribuent la rduction de la fracture numrique lie lusage. Les entretiens avec les

responsables du gouvernement lectronique montrent que le gouvernement voulant

diffuser les TICs peut devenir un lead user innovateur.

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Mots cls: linvestissement direct tranger la recherche dactifs, les utilisateurs

lavant-garde du march, incertitude de la demande, environnement dusage,

dveloppement de nouveaux produits, innovation, technologies de linformation et de la

communication.

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RSUM EN FRANAIS

Linvestissement direct tranger (IDE) est une action stratgique qui implique une sortie

importante de ressources, alors que ses bnfices dans le long terme sont incertains.

Cest une dcision coteuse et difficilement rversible. Cependant, les flux dIDE

augmentent dune manire continue depuis les annes 80, except en temps de crise. La

motivation derrire cette stratgie et le choix de localisation constituent un sujet de

recherche renouvel avec lvolution du contexte de lconomie mondiale. La

motivation des investisseurs trangers avec la libralisation des marchs et les

dveloppements des nouvelles technologies de linformation et de la communication

(NTICs) nest plus la mme quautrefois. La firme multinationale ne cherche pas

seulement internaliser le march de ses actifs spcifiques afin de les protger dans un

contexte de contrats imparfaits (Caves, 1971; Rugman, 1986; Buckley, 1993). Elle

cherche aussi augmenter son avantage comptitif en ayant accs des actifs

complmentaires immobiles dans le pays hte (Wesson, 1999; Dunning, 1998). Les

rseaux de la firme contribuent renforcer ses capacits et impactent sa performance

(Hakansson et Snehota, 2006). Le premier chapitre de la thse prsente une revue de

littrature concernant lvolution de la pense sur la motivation des investisseurs

trangers, en mettant laccent sur la monte de limportance des IDEs la recherche

dactifs comptitifs dans le pays hte.

Lobjectif des IDEs la recherche dactifs est daccder aux actifs qui protgent ou font

avancer lavantage comptitif de la firme et/ou rduisent lavantage comptitif de ses

rivaux. Ces actifs, quand ils sont employs en combinaison avec les avantages

spcifiques de la firme, permettent de maintenir ou damliorer sa position comptitive

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au niveau global (Dunning et Lundan, 1998). Les IDEs la recherche dactifs peuvent

tre motivs par des facteurs lis aux conditions de loffre ou aux conditions de la

demande dans le pays hte. La thse clarifie le rle de la demande comme un facteur

dattraction de ce type dinvestissement. Le choix de cette dimension est d la raret

de la recherche sur celle-ci, ce qui laisse des aspects importants de cette dcision en

besoin dune analyse approfondie. Les conditions de demande favorables constituent un

des piliers de la dfinition de Porter (1990) des avantages comptitifs des nations. von

Hippel (2005) interprte les conditions de demande favorables de Porter (1990) en

termes d'utilisateurs lavant-garde du march (lead users ). Le deuxime chapitre

analyse les lead users comme un avantage comptitif du pays hte susceptible

dattirer les investisseurs trangers.

Les producteurs standardisent souvent leurs produits alors que les besoins des

utilisateurs sont htrognes. Par consquent, les utilisateurs innovent pour satisfaire

leurs besoins quand ils peroivent un bnfice en modifiant le produit ou le processus

en question. Les utilisateurs innovateurs, soient les individus ou les firmes sont des

contributeurs principaux lhistoire de linnovation (Urban et von Hippel, 1988). Avec

les dveloppements des NTICs, les utilisateurs ont eu accs des outils de conception

(design) avancs. Dsormais, des politiques publiques cherchent favoriser linnovation

des utilisateurs, comme aux Etats Unis et au Danemark (Innovate America, 2004; Nye

Mal Regerings Grundlag, 2005). Les innovations des utilisateurs sont concentres entre

les lead users (von Hippel, 2005).

Le concept de lead user a t dvelopp et test dans la littrature du management du

dveloppement des nouveaux produits. Les lead users ont deux caractristiques selon

von Hippel (1986). Premirement, ils sont lavant-garde dune tendance importante du
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march. Ils exprimentent donc des besoins en avance par rapport aux autres

utilisateurs. Cest pourquoi, leurs innovations bnficiant dune relle exprience

dutilisation, russissent souvent en cas de commercialisation. Deuximement, ils

anticipent un bnfice lev en trouvant une solution pour rpondre leurs besoins

avancs, cest pourquoi beaucoup dentre eux innovent. La thse dmontre quen

mobilisant le concept de lead user au sein de la littrature des IDEs, de nombreux

aspects de la dcision des IDEs la recherche dactifs comptitifs lis aux conditions de

la demande dans le pays hte seront clarifis. La littrature a laiss des questions

ouvertes sans rponse.

La littrature de lIDE la recherche dactifs comptitifs lis aux conditions de la

demande sintresse surtout lIDE cherchant sinstaller dans un march directeur

(lead market) (Wesson, 1999; Ernst, 2005) pour anticiper la demande dans le pays mre

ou dans un troisime pays. Linvestisseur anticipe que la conception prfre dans le

march directeur russira au niveau international (Beise et Cleff, 2004). Une question se

pose alors; quen est-il de la prdiction de la tendance de la demande dans le pays hte

mme comme motivation des IDEs ? Il est important de tenir compte de lincertitude

associe la demande et surtout lenvironnement dusage dans le pays hte. La

littrature montre que lhypothse des IDEs horizontaux qui cherchent servir le

march du pays hte explique mieux le comportement des IDEs que lhypothse des

IDEs verticaux qui cherchent bnficier de la diffrence de la disponibilit des

facteurs de production entre pays (Brainard, 1997; Carr et al., 2001; Chakrabarti, 2001;

Markusen et Maskus, 2002; Blonigen et al., 2003). Mais les investisseurs trangers sont

moins informs sur le pays hte par rapport leurs rivaux locaux (Hymer, 1976). Les

pays peuvent avoir des demandes de caractristiques diffrentes (Deaton et Muellbauer,

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1980). En effet, chaque pays a son environnement dusage particulier. De mme, au sein

dun mme pays, chaque ville a sa particularit, puis au niveau des utilisateurs des

particularits persistent. La diffrence dans lenvironnement dusage implique des

diffrences de prfrences. De plus, il y a une tendance de demande personnalise. De

nos jours, les consommateurs sont mieux informs et ont un choix plus largi en partie

grce au commerce lectronique.

Malgr ces lments, la littrature de lIDE dans un contexte dincertitude concernant la

demande (Das, 1983; Rob et Vettas, 2003; Aizenman et Marion, 2004; Moner-

Colonques et al., 2007) sintresse plutt lincertitude concernant la taille de la

demande et aux chocs de demande. Elle ntudie pas lincertitude de la demande

concernant la particularit de lenvironnement dusage dans le pays hte par rapport au

pays mre. Cette incertitude est davantage amplifie dans le contexte de dveloppement

de nouveaux produits. Contrairement Ethier et Markusen (1996), la thse ne considre

pas la russite de nouveaux produits comme garantie. Il y a un grand risque que

lintroduction dun nouveau produit dans un march choue (Poolton et Barclay, 1998).

Ce risque est surtout associ au manque de comprhension des besoins des utilisateurs

de la part des producteurs (Un et Price, 2007; Poolton et Barclay, 1998; von Hippel,

2005). Le producteur tranger a donc besoin dinformation pour surmonter cette

incertitude (Tushman et Nadler, 1978).

Avec la rduction de la dure de vie des produits notamment dans les secteurs de haute

technologie, laugmentation de la flexibilit des mthodes de production et

laugmentation de la comptition, le dveloppement de nouveaux produits est devenu

une stratgie plus frquemment employe et la diffrentiation au niveau du pays est

devenue moins coteuse. Dans ce contexte, sinformer sur lenvironnement dusage et

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les besoins qui distinguent le pays hte est crucial pour la russite de la multinationale.

Cest notamment le cas pour lintroduction dune nouvelle technologie radicale (Gales

et Mansour-Cole, 1991; Friar et Balachandra, 1999). La radicalit de la nouvelle

technologie augmente avec lapprentissage et le changement de comportement requis

pour que lutilisateur adopte la technologie (Friar et Balachandra, 1999).

Qui peut informer les investisseurs trangers sur les besoins futurs du pays hte? Et ds

lors quun agent peut prdire les besoins futurs, quel est limpact de lexistence de cet

agent sur la dcision dIDE ? Le troisime chapitre a pour objectif de rpondre ces

questions en se rfrant au concept de lead user.

Les lead users sont avantags par rapport aux producteurs et aux experts du march

(von Hippel, 2005; Ozer, 2009) puisquils bnficient dune information qui sappuie

sur une exprience relle de lenvironnement dusage. Cest pourquoi ils sont capables

de prdire de manire relativement plus prcise les besoins futurs. Les tudes

empiriques prouvent que les nouveaux produits dvelopps en collaboration avec les

lead users russissent sur le march (Urban et von Hippel, 1988; Morrison et al.,

2000; Olson et Bakke, 2001; Lilien et al., 2002; Frank et von Hippel, 2003; Franke et

Shah, 2003; Lthje, 2004; Morrison et al., 2004; Franke et al., 2006). Les lead users,

travers linformation quils gnrent, peuvent jouer un rle important dans la

rduction de lincertitude lie lenvironnement dusage pour les producteurs en

gnral, et pour les trangers en particulier.

La thorie des jeux est employe dans la littrature pour expliquer le comportement des

investisseurs trangers. Le troisime chapitre dveloppe un modle de thorie des jeux

o un producteur tranger faisant face une incertitude concernant lacceptation dun

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nouveau produit dans le pays hte doit choisir entre exporter ou investir dans le pays

hte. Cette incertitude est associe une asymtrie dinformation favorisant les

producteurs locaux qui peuvent accder les informations concernant les besoins avancs

des lead users. Ces besoins refltent les besoins futurs du march local. Le chapitre

montre que lIDE est un quilibre parfait de sous-jeux, toutes choses gales par ailleurs,

mais plus lev est le risque de spcification errone du produit par rapport aux besoins

locaux. La probabilit de spcification errone est une fonction croissante dans la

diffrence de lenvironnement dusage entre le pays mre et le pays hte et dans la

radicalit de la nouvelle technologie.

Ces rsultats sont cohrents avec ceux de Markusen (1995) et Moner-Colonques et al.

(2007) o les IDEs augmentent quand il y a une asymtrie dinformation en faveur des

producteurs locaux. Toutefois, le modle diffre des modles prcdents dans la mesure

o il explique lincertitude concernant la demande par la diffrence de lenvironnement

dusage entre le pays mre et le pays hte. Ceci implique une diffrence de besoins et

donc un risque de spcification errone. De plus, contrairement Ethier et Markusen

(1996), la russite de lintroduction du nouveau produit nest pas garantie surtout quand

il sagit dune technologie radicale. Le modle donne la demande mme un rle actif

pour rsoudre cette incertitude travers les lead users; il va donc au del de

lincertitude pour trouver lagent qui peut la rsoudre. Mme si Wesson (1999) donne

la demande un rle actif, son modle sintresse leffet de linvestissement dans un

march directeur sur la rduction de lincertitude concernant la demande dans le pays

mre sans sintresser lincertitude concernant la demande dans le pays hte.

Les rsultats du troisime chapitre impliquent que dans un contexte dinnovation

pousse par loffre, un producteur tranger qui est averse au risque peut investir dans le
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pays hte pour accder linformation que gnrent les lead users. Cest notamment

le cas lorsque la diffrence dans lenvironnement dusage entre le pays mre et le pays

hte est significative et que linnovation est radicale. Linteraction entre le producteur et

lutilisateur peut transformer une innovation pousse par loffre en une innovation

guide aussi par la demande, augmentant ainsi ses chances de russite sur le march.

Limplication des lead users dans le processus dinnovation napporte pas seulement

une information concernant leurs besoins avancs mais aussi des solutions ces

besoins. Avec linstabilit de la conception des produits, les firmes cherchent gnrer

des ides innovantes travers leurs rseaux (Garel et al., 2009). La littrature de lIDE

la recherche dactifs a accord une attention particulire au rle des capacits

dinnovation du pays hte dans lattraction des IDEs (Kogut et Chang, 1991; Cantwell

et Santangelo, 1999; Serapio et Dalton, 1999; Kuemmerle, 1999; Frost et Zhou, 2000;

Cantwell et al., 2004). Nanmoins, cette littrature ne distingue pas clairement le rle

des utilisateurs mme sil a t prouv quil est dune grande importance. Ivarsson et

Jonsson (2003) montrent que la technologie dveloppe dans le pays hte en

collaboration avec les utilisateurs amliore la comptitivit des filiales trangres et de

la multinationale. De plus, la commercialisation tait plus russie sur le march que

dans le cas o la technologie est dveloppe sans la participation des utilisateurs. Ceci

amne des questions; quest ce qui distingue les utilisateurs en tant quinnovateurs des

producteurs ? Quel est limpact des innovations des utilisateurs sur les dcisions des

producteurs trangers? Pour rpondre ces questions, le quatrime chapitre analyse le

rle des lead users en tant quinnovateurs. Les lead users innovent (Urban et von

Hippel, 1988; Olson et Bakke, 2001; Lilien et al., 2002; Lthje et Herstatt, 2004) et

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leurs caractristiques sont corrles avec une plus forte probabilit dinnovation

(Morrison et al., 2000; Franke et Shah, 2003; Lthje, 2004; Morrison et al., 2004).

Limpact des innovations des utilisateurs sur le producteur tranger est diffrent de celui

des innovations des concurrents locaux. Comme lexplique le quatrime chapitre, il y a

une possibilit que les utilisateurs rvlent gratuitement leurs innovations (Harhoff et

al., 2003). A linverse, il est probable que les producteurs locaux essaient de ne pas faire

profiter les producteurs trangers des effets spillovers de leurs innovations (Pugel et

al., 1996). Les connaissances que gnrent les lead users sont plus susceptibles dtre

absorbes que les connaissances gnres par les concurrents. Les producteurs ont un

savoir plus important par rapport aux utilisateurs dans le domaine concern. Toutefois,

il y a un risque que labsorption soit limite par lincapacit des lead users traduire

leurs prfrences et besoins dans un langage technique comprhensible par les

producteurs (Olson et Bakke, 2001). Pour bnficier des externalits des innovations

des lead users, la proximit gographique est ncessaire car il nya pas de proximit

organisationnelle entre les utilisateurs et les producteurs telle que dfinie par Rallet et

Torre (2005).

Le quatrime chapitre dveloppe un modle de thorie des jeux o un producteur

tranger choisit entre les IDEs et lexportation pour servir le pays hte. Le lead user

dans le pays hte innove et son tour choisit entre rvler ou cacher son innovation.

Lutilisateur innovateur rvlera son innovation, plus faibles seront les pertes en profit

dues la gnralit des besoins pour lesquels linnovation a t conue et la

concurrence entre utilisateurs par rapport aux gains de profits dus lintervention du

producteur pour amliorer linnovation. Le modle interprte la gnralit de

linnovation du lead user en fonction de la diffrence denvironnement dusage entre

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le pays mre et le pays hte. Plus cette diffrence est importante, plus linnovation de

lutilisateur rpondra des besoins spcifiques lenvironnement dusage du pays hte

et donc communs avec ses co-utilisateurs locaux. Le modle propose que toutes choses

gales par ailleurs, le lead user rvlant son innovation attire les IDEs en augmentant

la valeur de la connaissance tacite incorpore dans son innovation. Pour pouvoir exercer

une pression sur linvestisseur tranger pour dvelopper son innovation, le lead user

doit maximiser la gnralit de son innovation et la connaissance tacite quelle

incorpore. Si le niveau dactifs spcifiques de la multinationale est lev, constituant

ainsi une barrire lentre de ses rivaux, on sattend une sorte de contrat qui

avantage le producteur tranger par rapport ses concurrents potentiels. Pour avoir un

quilibre Pareto optimal, linvestisseur tranger doit son tour maximiser lamlioration

apporte linnovation du lead user et avantager celui-ci par rapport aux autres

utilisateurs.

Ces rsultats sont cohrents avec la littrature sur la diversification globale de

linnovation par la multinationale. La littrature affirme que la multinationale peut

gnrer linnovation au niveau global en adaptant ses produits aux besoins des

utilisateurs locaux; cette stratgie est dite local pour local (Bartlett et Ghoshal,

1990; Archibugi et Michie, 1995, 1997a). Si le pays hte est un march directeur, alors

le processus dinnovation sera local pour global .

Le dveloppement de nouveaux produits peut tre pouss par des dveloppements

technologiques ou guid par la demande. Dans les deux cas, les lead users peuvent

tre une source dinformation importante pour les investisseurs trangers attirant ainsi

les IDEs la recherche dactifs comptitifs.

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La contribution des lead users est surtout requise dans les secteurs o linnovation est

rapide et o le cycle de vie des produits est rduit. Dans ces secteurs, les firmes ont

besoin dtre mises jour concernant les besoins de leurs utilisateurs de manire

continue. Dans les technologies gnriques en particulier, les lead users peuvent

contribuer amliorer lefficacit du processus dinnovation. Dans ces technologies,

lenvironnement dusage joue un rle critique dans le dveloppement et lemploi de la

technologie.

Le cinquime chapitre analyse le secteur des technologies de linformation et de la

communication (TICs), un secteur de haute technologie gnrique caractris par une

trajectoire dinnovation rapide. La thse prend comme unit danalyse un pays en

dveloppement, lEgypte, afin de montrer limpact de la diffrence de lenvironnement

dusage entre le pays mre de la technologie et le pays rcipient. Le chapitre discute du

rle des utilisateurs dans la diffusion de la technologie de deux perspectives lies.

Premirement, les premiers adoptants de la technologie peuvent tre des directeurs

dopinion (opinion leaders) qui influencent la dcision des autres utilisateurs concernant

ladoption de la technologie (Rogers et Shoemaker, 1971). Mais il faut tenir compte de

lapproche de Midgley et Dowling (1978) dite innate innovativeness o linnovation

est une caractristique intrinsque et o des facteurs dits circonstanciels, comme le

revenu et lducation, peuvent intervenir entre la dcision dadoption et ladoption

effective. Deuximement, les lead users peuvent contribuer la diffusion de la

technologie en amliorant la connaissance des producteurs sur les besoins des

utilisateurs, en anticipant ces besoins et/ou en innovant des solutions adquates au

contexte local. Dans les deux perspectives, les utilisateurs peuvent jouer un rle dans la

rduction de la fracture numrique lie lusage (Ben Youssef, 2004).

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A travers lobservation du secteur des TICs gyptien et des entretiens avec des

responsables de lapplication du gouvernement lectronique, le chapitre montre

comment linteraction entre les diffrents acteurs peut jouer un rle dans la diffusion de

la technologie. Premirement, le gouvernement cherchant diffuser la technologie pour

atteindre les zones dfavorises peut devenir un lead user innovateur. Afin de

rpandre les applications du gouvernement lectronique, il faut des solutions innovantes

pour minimiser les cots et pour surmonter les barrires lies lenvironnement dusage

qui limitent la diffusion de la technologie. Deuximement, parfois lorsquil existe des

utilisateurs locaux innovants, il ny a pas des filiales trangres en recherche et

dveloppement (R&D) suffisamment indpendantes vis--vis la firme mre pour

cooprer avec linnovation locale. Ceci implique une perte de temps et de ressources

pour la multinationale et pour le march local. Troisimement, pour que les utilisateurs

jouent leur rle anticip, comme directeurs dopinion, anticipateurs de demande ou

innovateurs, il faut faire face aux obstacles intervenant entre la dcision dadoption et

ladoption effective de la technologie.

Le rle des lead users discut tout au long de la thse implique un changement dans

la faon dont les investisseurs, le gouvernement, et les utilisateurs eux mme raisonnent.

Concernant les managers des multinationales, lvaluation des capacits dinnovation

dun pays doit prendre en compte les activits de ses lead users. Les filiales peuvent

jouer un rle plus important dans le processus dinnovation de la multinationale. Pour

jouer ce rle, elles doivent sintgrer dans les dynamiques dinnovation du pays hte et

avoir plus dindpendance vis--vis la firme mre. Les filiales ont intrt tablir des

mcanismes dans le pays hte pour interagir les lead users, les recherchant

volontairement pour augmenter les bnfices mutuels et donc le bien tre social.

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La plupart des gouvernements cherchent attirer les IDEs travers des incitations

financires coteuses. Or, les IDEs la recherche dactifs, qui sont une source plus

probable de spillover pour le pays hte que les autres formes dIDEs, ont galement

dautres finalits (Dunning et Narula, 2000). Les investisseurs trangers cherchent

accder aux avantages comptitifs immobiles du pays hte parmi lesquels les lead

users. Conscients de la valeur des lead users, les gouvernements peuvent jouer un

rle en encourageant leurs innovations comme cest le cas aux Etats-Unis et au

Danemark. La majorit des innovations des utilisateurs ne figurent pas dans les

statistiques gouvernementales, alors quelles constituent une part importante de

linvestissement en innovation dans un pays (von Hippel, 2005). La contribution des

utilisateurs linnovation a besoin dtre value en vidence, par exemple en menant

une enqute au niveau du pays qui prend en considration linnovation des utilisateurs,

comme celle mene sur la population de la Grande Bretagne par Flowers et al. (2010).

Si les autres acteurs reconnaissent le rle des lead users, ceux-ci seront plus incits

participer aux processus dinnovation, innover et rvler leurs innovations puisquils

sattendront ce que les autres acteurs rcompensent ceux qui contribuent au

dveloppement des nouveaux produits.

Les lead users sont un avantage comptitif qui peut tre cr. Les producteurs

peuvent crer leurs utilisateurs innovateurs en permettant laccs aux outils de

conception (toolkits). Les dcideurs politiques peuvent les crer travers des incitations

linnovation comme celles octroyes aux producteurs. Ils peuvent tre crs en

encourageant les communauts des utilisateurs innovateurs augmentant ainsi les

ressources leur disposition. Ils peuvent tre crs travers les efforts des autres

acteurs pour surmonter les obstacles circonstanciels qui interviennent entre linnovation

20
comme une caractristique personnelle et sa ralisation. Ces facteurs peuvent priver un

innovateur potentiel de contribuer au dveloppement de la technologie. La

concentration des outils dinnovations nest pas efficace selon von Hippel (2005), car

les innovateurs importants ne sont connus quaprs avoir dvelopp une innovation

importante.

Wesson ( 1999) dfinit les conditions de demande favorables dans le pays hte qui

attirent les IDEs la recherche dactifs comme tant celles qui peuvent partiellement

prdire la demande dans le pays mre. Son modle interprte les conditions de demande

favorables de Porter en termes de marchs directeurs. La thse dfinit les IDEs la

recherche dactifs lis aux conditions de demande dans le pays hte autrement.

Premirement la multinationale peut chercher anticiper la demande dans le pays hte

lui-mme et pas uniquement dans son pays mre, afin damliorer sa comptitivit au

niveau international. Deuximement, la thse interprte les conditions de demande

favorables de Porter sous langle des lead users. Cest pourquoi la thse argumente

que les IDEs la recherche dactifs lis aux conditions de demande dans le pays hte

sont motivs par la volont de la multinationale dtre expose aux lead users dans le

pays hte car ceux-ci peuvent anticiper les besoins de leur march local et sont

susceptibles dinnover des solutions ces besoins. Dans le cas o le pays hte est un

march directeur, alors le bnfice pour la multinationale dtre expose aux conditions

de demande dans le pays hte aura un effet multiplicateur dans dautres pays qui suivent

une tendance proche du pays hte, quil sagisse du pays mre ou dautres pays o la

multinationale opre. La connaissance est suppose transfrable au sein de la

multinationale puisquil y a une proximit organisationnelle entre ses composantes.

21
La thse contribue la littrature de lIDE en clarifiant les aspects des IDEs la

recherche dactifs lis aux conditions de la demande en formalisant limpact des lead

users du pays hte. La thse contribue aussi la littrature des lead users; elle

formalise leur rle comme un avantage comptitif pour leurs nations, en tant

quanticipateurs des besoins, innovateurs et/ou source de pression sur loffre pour

rpondre aux besoins locaux.

Des tudes empiriques futures sont ncessaires pour tudier limpact des besoins

avancs et des innovations des lead user sur la dcision dIDE. Les recherches futures

sur les IDEs cherchant accder les capacits dinnovation du pays hte doivent

distinguer la contribution des utilisateurs innovateurs, ce qui rendra la valeur des lead

users reconnue. Les communauts dutilisateurs mritent une attention particulire.

Grce aux NTICs, les utilisateurs peuvent plus facilement se runir en communauts

virtuelles, ce qui leur permet dchanger leurs ides et rend leurs innovations plus

efficaces puisquelles bnficient des essais dinnovation des autres utilisateurs. Le

processus pour trouver les lead users devient alors plus facile et donc moins coteux.

De plus, tre membre dune communaut dutilisateurs augmentera la pression des

lead users sur les producteurs pour dvelopper leurs innovations. Les ides des lead

users seront testes dans leurs communauts et auront une plus grande probabilit de

reflter un besoin gnral. En effet, dans le monde virtuel, les producteurs

internationaux cherchent et crent des communauts internationales dutilisateurs pour

connatre leurs besoins et leurs innovations.

22
SUMMARY

GENERAL INTRODUCTION...24

CHAPTER I.33

ASSET SEEKING FDI: THE IMPLICIT ROLE OF LEAD USERS.33

CHAPTER II...67

LEAD USERS: A COMPETITIVE ADVANTAGE FOR NATIONS...67

CHAPTER III..96

FDI: THE IMPACT OF LEAD USERS ADVANCED NEEDS.......96

CHAPTER IV....134

FDI: THE INFLUENCE OF INNOVATOR LEAD USERS134

CHAPTER V.................................................................................................................177

EGYPTIAN ICT SECTOR: USERS INTERACTION WITH THE TECHNOLOGY

...................................................................................................................177

GENERAL CONCLUSION..............................................................................210

REFERENCES..216

LIST OF TABLES.239

LIST OF FIGURES...239

CONTENTS......240

23
GENERAL INTRODUCTION

Foreign Direct Investment (FDI), sometimes called Global Diversification

distinguishing it from Industrial Diversification, is undertaken by multinational

enterprises1 (MNEs). MNEs are firms that engage in direct foreign investment, defined

as investments in which the firm acquires a substantial controlling interest in a foreign

firm or sets up a subsidiary in a foreign country (Markusen, 1995). According to the

Organization for Economic Cooperation and Development (OECD) benchmark

definition of FDI, the distinguishing characteristic of FDI in comparison with foreign

portfolio investment is that it is undertaken with the intention of exercising control over

an enterprise. The benchmark is 10% or more of the ordinary shares or voting power of

an enterprise (unless the 10% dont allow the foreign investor an effective voice in the

management or that a lesser percentage allows it). Effective voice implies that the

foreign investor can influence the management of an enterprise, but doesnt imply full

control.

Since the 1980s, FDI flows are continuously increasing except in crisis periods, where

they might witness some decline. In 2007, FDI flows were $ 1.7 trillion. In 2009, the

level of inflows dropped to around $1.2 trillion due to the economic and financial crisis,

which started at the second half of 2007. However, overall policies have remained

favourable regarding FDI in the time of crisis. A full recovery is expected in 2011

(World Investment Report, 2009).

The motivation behind FDI and its location choice is a continuously renewed subject of

research with the evolution of the world economy context. The motivation behind FDI

1
The terms multinational enterprise and foreign direct investment will be used interchangeably.
24
under trade barriers is not the same as it is in an increasingly liberalized world economy.

What FDI is seeking and what it can access with the developments in information and

communication technologies (ICTs) is not the same as what it was before the new

economy sets its rules. The MNE is not only seeking to internalise the market of its

specific assets to secure its rents under imperfect contracts (Caves, 1971; Rugman,

1986; Buckley, 1993). The MNE seeks complementary immobile created assets in the

host country to augment its competitive advantage (Wesson, 1999; Dunning, 1998).

Nowadays, the network of the firm contributes to its capacity building and impacts its

performance (Hakansson and Snehota, 2006). Chapter one will go through the evolution

of thought about FDI motivation, emphasizing the rising importance of asset seeking

FDI.

The objective of strategic asset seeking FDI is to access assets which protect or advance

the firms competitive advantage and/or reduce the competitive advantage of its rivals.

Those assets, when deployed with the firms ownership advantage, help sustain or

improve its global competitive position (Dunning and Lundan, 1998). Asset seeking

FDI can be motivated by assets related to the supply or the demand factors in the host

country. The thesis objective is to highlight and further explain the role of demand in

attracting asset seeking FDI. This is because, previous research on this dimension is

scarce, so that there are notable aspects which need to be analysed in depth. In Porter

(1990)s definition of the competitive advantages of nations, favourable demand

conditions constitute one of the main pillars. von Hippel (2005) interprets Porters

favourable demand in terms of lead users. Chapter two will analyse lead users as a

potential created competitive advantage, attracting asset seeking FDI.

25
Innovator users, whether firms or individuals, are fundamental contributors to

innovation (Urban and von Hippel, 1988). Although users innovation is an old

phenomenon, with the developments in new information and communication

technologies (NICTs), users are having access to advanced design tools. Supporting

user innovation is now a priority for many policy makers, such as in the United States

and in Denmark (Innovate America, 2004; Nye Mal Regerings Grundlag, 2005). Users

invent when they perceive a benefit in modifying the product or the process. Their

innovations are concentrated among lead users whose innovations are often

commercialized (von Hippel, 2005).

Lead users are conceptualised and tested within the literature of the management of new

product development. Lead users have two characteristics according to von Hippel

(1986). First, they are at the leading edge of an important market trend(s).

Consequently, they experience needs in advance relative to the other users. Therefore,

their innovations, benefiting from a real life experiment, often success when they are

commercialized. Second, they expect high benefits from getting a solution to respond to

their advanced needs. Therefore, many of them innovate. The thesis claims that

developing lead user concept within FDI literature can clarify the aspects of asset

seeking FDI decision driven by demand conditions. This is because, literature leaves

unanswered questions.

Literature about asset seeking FDI driven by demand conditions focuses on FDI seeking

to invest in a lead market to predict demand back home or in another third country. This

is because, lead markets preferred design is expected to be internationally successful

(Beise and Cleff, 2004). Wesson (1999)s game theoretic model explains that foreign

investors are seeking to interact with demand in the host lead market to partially predict
26
demand back in the home market. Ernst (2005)s empirical findings show that foreign

investors, internationalizing their innovation process, are seeking to access supply

factors in the host but also to access sophisticated regional lead users.

A question follows; what about predicting demand trend in the host country itself as a

motivation for FDI? Uncertainty about demand in the host country and particularly the

one associated to the use environment is an important dimension in studying FDI.

Literature shows that horizontal FDI, which seeks to supply the host countrys market,

explains better FDI patterns than vertical FDI, which seeks to benefit from different

factor endowments across countries (Brainard, 1997; Carr et al., 2001; Chakrabarti,

2001; Markusen and Maskus, 2002; Blonigen et al., 2003). Foreign investors are less

informed about the host country compared with their local competitors (Hymer, 1976).

Countries may have different demand patterns (Deaton and Muellbauer, 1980). Each

country has its particular use environment, and even within the same country each city

has its particularity, arriving to the scale of each user, particularity persists. The

difference in the use environment implies difference in preferences. In addition, on the

demand side, we witness a trend of customized demand. Nowadays, customers are

better informed and have wider choice through electronic commerce (e-commerce).

However, literature about FDI under demand uncertainty (Das, 1983; Rob and Vettas,

2003; Aizenman and Marion, 2004; Moner-Colonques et al., 2007) is preoccupied by

the effect of demand chocks and uncertainty regarding demand size in the host. It

doesnt address demand uncertainty regarding the particularity of the use environment

in the host country relative to the home country.

27
This uncertainty is even amplified in the context of new product development. Unlike

Ethier and Markusen (1996), the thesis doesnt take new product success for granted.

There is a high risk that new product introduction into a market fails (Poolton and

Barclay, 1998). This risk is mostly associated with the shortage in producers

understanding of users needs (Un and Price, 2007; Poolton and Barclay, 1998; von

Hippel, 2005). The foreign producer then needs information processing to overcome

this uncertainty (Tushman and Nadler, 1978).

With the reduction of the product life cycle, especially in high technology sectors, with

the flexibility in the production methods and the increase in competition, new product

development has become a frequently employed strategy. Learning about the use

environment and the distinctive needs of the host country is a critical factor for

successful new product development for the MNE. This is especially the case, when the

technological development driving the new product is radical (Gales and Mansour-Cole,

1991; Friar and Balachandra, 1999), which means that the new technology adoption

requires high level of learning and of behavior change (Friar and Balachandra, 1999).

Although technological developments have permitted country level differentiation at

lower cost, who can inform producers about future needs in the host country? Besides,

if there is an agent who can predict future needs, what is the impact of the presence of

this agent on FDI decision? It is the aim of the third chapter to answer these questions

through referring to lead users concept.

Lead users are privileged in comparison with manufacturers and business experts (von

Hippel, 2005; Ozer, 2009), since they benefit from knowledge about the real use

environment. That is why; they are capable to relatively more correctly predict future

needs. Indeed, empirical findings prove that new products developed in collaboration
28
with lead users are commercially successful (Urban and von Hippel, 1988; Morrison et

al., 2000; Olson and Bakke, 2001; Lilien et al., 2002; Frank and von Hippel, 2003;

Franke and Shah, 2003; Lthje, 2004; Morrison et al., 2004; Franke et al., 2006).

Therefore, lead users through the information they generate can play an important role

in reducing use environment uncertainty for producers in general and for foreign ones in

particular. Besides, they can reduce uncertainty related to new product development.

Lead users input in the innovation process is not only advanced needs, they are also

themselves potential innovators. With the instability of products design, firms seek to

generate innovative ideas from their network (Garel et al., 2009). In a context of rapid

path of innovation, asset seeking FDI literature has given particular attention to the role

of the innovation capabilities of the host country in attracting FDI (Kogut and Chang,

1991; Cantwell and Santangelo, 1999; Serapio and Dalton, 1999; Kuemmerle, 1999;

Frost and Zhou, 2000; Cantwell et al., 2004). However, this literature doesnt clearly

distinguish the role of users, although there is evidence it is of big importance. Ivarsson

and Jonsson (2003) find that the technology developed in the host in collaboration with

business customers enhances the competitiveness of the foreign affiliates and of the

MNE. Besides, it was commercially more successful in comparison with the technology

developed without users involvement. Some questions follow; what distinguishes users

as innovators in comparison with manufacturers? What is the impact of users

innovations on foreign producers decisions? To answer these questions, chapter four

will demonstrate the particularities of lead users as innovators. Lead users do innovate

(Urban and von Hippel, 1988; Olson and Bakke, 2001; Lilien et al., 2002; Lthje and

Herstatt, 2004). In addition, their characteristics are correlated with innovation

29
likelihood (Morrison et al., 2000; Franke and Shah, 2003; Lthje, 2004; Morrison et al.,

2004).

The thesis mobilises lead users concept to understand the role of demand in attracting

asset seeking FDI. Game theory is usefully employed in literature to explain FDI. The

thesis develops two game theoretic models. Each model aims to formalize the effect of

one of the outputs of lead users in the host country on FDI entry decision. The first

model in chapter three is in the context of a technology push innovation. A foreign

producer willing to introduce a new product in the host market faces uncertainty

regarding the host countrys use environment. The model formalizes the effect of lead

users advanced needs in comparison with other users, on the foreign producers

decision to conduct FDI versus to export to serve the host country. The second model in

chapter four is in the context of a demand driven innovation. It studies the impact of

lead users decision to reveal versus not to reveal their innovations on two levels. First,

on foreign producers decision whether to conduct FDI or to export then on foreign

investors decision whether to develop lead users innovations or not.

The contribution of lead users is most of all needed in rapid innovation sectors, where

the product life cycle is shortened. In those sectors, firms continuously need to be

updated about their users needs. In General purpose technologies (GPTs) in particular,

lead users can contribute to the efficiency of the innovation process. In those

technologies, the use environment plays a critical role in the technology development

and employment.

The fifth chapter analyses ICT sector, a fast moving sector of GPT. The thesis takes

Egypt, a developing country, as a unit of analysis to show the impact of the difference

30
in the use environment between the home country of the technology and the recipient

country. The chapter discusses users role in diffusing the technology from two related

perspectives. Firstly, first adopters can be opinion leaders influencing their fellow users

decision to adopt the technology (Rogers and Shoemaker, 1971). However, taking into

consideration innate innovativeness approach (Midgley and Dowling, 1978), there are

situational factors that may interfere between the decision to adopt and actual adoption.

Secondly, lead users can contribute to the technology diffusion process by innovating

adequate solutions to local needs or by helping producers predict those needs. However,

lead users cant always find an independent foreign subsidiary to cooperate with, in

order to develop their innovations. The chapter aims to show how the interaction

between the different actors can play a role in diffusing the technology by better

adapting it to local context and by dipping the situational factors that may slow down

the diffusion process. This is through close observation of Egyptian ICT sector and

interviews with the executives of electronic government (e-government).

The thesis is structured as follow; the first chapter reviews selected hypotheses about

FDI motivation and location choice. This chapter will show that lead users concept

has remained an implicit actor in this literature and needs further attention. The second

chapter discusses the role of lead users as a competitive advantage for nations. Lead

users contribute to the success of new product development through the information

they process, whether about their advanced needs or about their innovated solutions.

The third chapter models the impact of lead users advanced needs on FDI decision,

under demand uncertainty related to new product development. The fourth chapter

models the impact of lead users innovations on foreign producers decisions. Finally,

31
the fifth chapter analyses Egyptian ICT sector to highlight the role of foreign investors

and of local users in developing the sector and in diffusing the technology.

32
 CHAPTER I

ASSET SEEKING FDI: THE IMPLICIT ROLE OF LEAD USERS

33
Introduction

FDI is a strategic action that stimulates an important outflow of resources, while its

benefits in the long term are uncertain. It is a hardly and costly reversible decision. Yet,

since the mid of 1980s, FDI is witnessing important growth, except some periods of

economic and financial crisis. A question follows; why would a MNE choose to

conduct FDI instead of exporting, licensing or other modes, in order to extend its

territorial horizon beyond its country of origin? Another question concerns the host

location choice; why would a MNE choose a particular location?

FDI is a complex decision; it is based on factors concerning the characteristics of the

firm, the industry, the home and the host country. Understanding the logic behind the

occurrence and the distribution of FDI flows requires going through various literatures;

mainly, the theory of the firm especially transactions cost theory, international

economics, international business and economic geography.

This chapter highlights selected hypotheses that explain FDI, while it identifies the gap

in literature which the thesis aims to fill. On one hand, foreign investors are seeking to

exploit their advantages in new markets through horizontal FDI. With the reduced life

cycle of products, they introduce new products to keep their competitive position. This

requires updated information about the host countrys needs. This information can be

acquired through lead users who experience advanced needs in comparison with their

market. However, literature about asset seeking FDI driven by demand conditions

doesnt consider the role of lead users as a factor attracting foreign investors. On the

other hand, nowadays, facing a highly competitive world business environment, foreign

investors aim not only to exploit their own advantages, but also to augment those

34
advantages through their operations abroad. Foreign investors undertake asset seeking

FDI to diversify their innovation experience. Lead users are among the stakeholders in

the innovation process in the host country. However, literature about asset seeking FDI

driven by the innovation capabilities of the host country ignores the role of lead users.

The chapter is structured as follows; the first section goes through the first explanations

of FDI decision in literature, it will give particular attention to the internalization

hypothesis and to Dunning OLI electric paradigm. The second section focuses on

horizontal and vertical FDI models and the recent hybrid models integrating both. The

third section is concerned with asset seeking FDI, it will present the role of clusters, of

institutions and of the innovation capabilities of the host country. Finally, the fourth

section reviews literature on asset seeking FDI driven by demand conditions.

1.1. Why would a MNE conduct FDI in first place?

The relation between FDI and exports, between FDI and the investing firms assets and

between FDI and the market structure were and still are a starting point in reviewing

FDI literature.

1.1.1. FDI versus exports

Theoretic models, as it will be shown through the thesis, usually model FDI versus

exports under various hypotheses.

Some research perceives FDI as a substitute for exports to a host country (Buckley and

Casson, 1981). Exports involve lower fixed costs relative to FDI, but higher variable

costs of transportation and trade barriers. This suggests a natural progression from

exports to FDI, once the foreign markets demand for the MNEs products reaches a

large enough scale. But, early papers by Lipsey and Weiss (1981, 1984) find positive

35
coefficient when regressing USA (United States of America) outbound FDI on exports

to the host country. These results are inconsistent with the idea that FDI replaces

exports. Grubert and Mutti (1991), using similar data to Lipsey and Weiss (1981),

estimate a negative coefficient statistically insignificant.

To solve this contradiction, Blonigen (2001) proves that new FDI in the USA by

Japanese firms increases Japanese exports of related intermediate inputs, whereas new

FDI decreases Japanese exports of the same finished products to USA. Head and Ries

(2001) and Swenson (2004) show similar results.

1.1.2. Firm-specific assets and market structure

Analyzing FDI motivation usually starts by a reminder of Hymers (1976) pioneering

work. Hymer considers that national firms have an advantage in comparison with

foreign ones. National firms are better informed concerning the country, the economy,

the language, the system rules, etc. The cost of acquiring such information for a foreign

investor is high. However, it is a fixed cost handled only once. Foreign investors may

face discrimination by government, consumers and suppliers in the host country.

Moreover, they risk expropriation. There might also be an advantage/disadvantage

associated to the home country and its rules (taxes, policy, etc.). Therefore, the foreign

firm on its turn must have an advantage relative to the host countrys local rivals.

Hymer explains that, the foreign investing firm has a specific or a monopolistic

advantage of which the host country is deprived or doesnt have the required tools in

term of finance or expertise to exploit it. This advantage can also be not monopolistic,

like the advantage of firms who operate in a country where there is a strong currency

36
(Casson, 1987). It is this firm-specific advantage in comparison with host countrys

firms that motivates the foreign investor to conduct FDI.

Another factor in explaining FDI decision in Hymer (1976) is concerned with market

structure. The MNE reduces competition by buying or replacing it. Frequently,

enterprises from different countries compete. If markets are imperfect, monopoly or

oligopoly, some forms of coalition will be profitable. One form of coalition is to have

diverse enterprises controlled by one firm. A necessary condition is the difficulty of

entering the market and the limited number of firms. Otherwise, any increase in profits

will be lost with the entry of new firms. In addition, cooperation is difficult between

multiple firms. Caves (1971) argues that FDI appears in industries most of all

characterized by oligopolistic market structure in the home and the host country and by

product differentiation.

The important capacity Hymer attributes to MNEs in limiting the market was criticized

(Dunning and Rugman, 1985). This is because; it led those who followed Hymer to

focus their research on the conflict between MNEs and governments. Similarly, Caves

(1971) was criticized, because the capacity of MNEs to close the market (by product

differentiation, scale economies, distribution chain, etc.) is limited by the dynamics of

international competition. Rugman (1986) explains that the oligopoly structure cant

perfectly justify FDI. Along the life cycle of the product, its differentiation will

decrease. In addition, barriers to entry in the industry may also be reduced with the

product maturity. In an industry with constant or decreasing scale and with fixed costs

that are not so high, this means that the market might become competitive.

37
However, the impact of FDI on market structure, which reflects the strategic role of

FDI, remains an important line of research. In Horstmann and Markusen (1992), a game

theoretic model, where market structure is determined endogenously as the outcome of

plant location decisions by firms. In a world of two identical countries, producing a

homogeneous good, firms in each country choose between, maintaining a plant in both

countries, i.e. becoming a MNE; serving both markets from a single home plant i.e.

exporting; or not entering the market at all. The first equilibrium arises when plant-

specific fixed costs (i.e. the cost of establishing an affiliate) are low relative to firm-

specific costs (i.e. the advantage the MNE has in comparison with local firms). The

second structure arises when plant-specific fixed costs are large relative to firm-specific

costs and tariff/transport costs.

In the context of differentiated goods, Motta (1994) establishes a game theoretic model

of two countries internationalization decision. The countries have different sizes. The

bigger market is assumed to produce better quality products. It is a model of vertical

differentiation. When trade opens, two-way trade occurs only if the countries are similar

enough (i.e. if the quality gap is not too large). When foreign investment occurs, the

survival of the small countrys firms is harder, the larger the quality gap. Therefore,

foreign investment sometimes deters local entry. This is because, when the foreign firm

was exporting, supporting the burden of export costs, the local entrant had a cost

advantage. However, if countries are similar enough, two-way foreign investments may

occur at equilibrium, if transportation costs are high relative to market size.

Head et al. (2002) interpret the relation between FDI and the industry structure

differently. The paper models Knickerbocker (1973) hypothesis, according to which

firms in oligopolistic industries would follow each others location decisions. It is an

38
oligopolistic reaction that Head et al. (2002) define as: The decision of one firm to

invest overseas raises competing firms incentives to invest in the same country. They

find that, under uncertainty, risk aversion firms would follow their rival, out of fear that

their competitor would have a cost advantage. The incentive to follow is reduced in the

case of uncertainty accompanied with risk neutrality and in the case of certainty.

1.1.3. Internalization hypothesis

Hymers thesis couldnt explain why in some industries, in a certain moment, there can

be MNE and in other industries and in other moments there will be other forms of

coalition like cartel, in order to increase the global profits in the industry. This is

because, Hymer doesnt distinguish between, on one hand, the transaction costs related

to proprietary rights definition, negotiation and the control and the reinforcement of

contracts. On the other hand, the transaction costs related to the structure of the market,

in terms of concentration of supply and purchasing power, and the associated

phenomenon of strategic interdependency between oligopolistic firms (Dunning and

Rugman, 1985; Casson, 1987). The question then, is why cross border transactions are

internalized within the MNEs borders and are not conducted through external markets.

According to the internalization hypothesis, in an environment of imperfect

competition, where contracts are incomplete and have negative externalities, the MNE

internalizes the market of its intangible specific asset. In this context, the MNE will

choose FDI to ensure its gains from its specific asset. This asset has the character of a

public good in the firm (Caves, 1971; Rugman, 1986); it can be employed

simultaneously in many plants without reducing its value. Casson (1987) groups the

knowledge that can procure the MNE with such advantage in three types; technical

39
knowledge, marketing knowledge and managerial knowledge. It is difficult to attribute a

price for knowledge in an imperfect market.

Licensing to a foreign producer risks dissipate the knowledge advantage. Only in the

case where the product which incorporates the knowledge becomes standardized, or

when the technology is not itself the source of advantage, the risk of dissipation then

becomes sufficiently weaker to make the license modality acceptable (Rugman, 1986).

Markusen (1995) explains that, if the intangible asset of the firm is the reputation of the

quality of the product, it is hard to control neither to observe before the contract the

maintenance of this quality by the licensed. Besides, if the foreign firm tries to extract

all the gains from the licensed, the licensed might in this case produce at low quality in

the first period to realize positive gains. Moreover, there is an asymmetry of

information. The licensed, informed about the level of demand in the market, may not

reveal the true information to the foreign firm, in order to discourage FDI.

However, there is a risk of knowledge dissipation associated with FDI. Ethier and

Markusen (1996) establish a game theoretic model, where home country firms compete

to introduce new products. A successful firm has a temporary ownership advantage in

its new product and chooses between costly exports, license and FDI to exploit this

advantage in the host country. Under inability to enforce contracts, if the home country

firm chooses to conduct FDI, it risks to dissipate its knowledge capital early. The paper

finds that similarities in relative factor endowments between the home and the host

country may encourage FDI.

There are empirical attempts to test the internalization hypothesis. Mostly, advertising

and research and development (R&D) intensity relative to competitors are used as

40
proxies for the intangible assets internalized. For example, Brainard (1997)s tests,

which are not constructed for this purpose in first place, give support for the

internalization hypothesis.

FDI is a complex decision. It is not only concerned with the internalization of the

market of the foreign firms specific advantage; it also includes deciding upon the

location choice of the host country.

1.1.4. OLI framework in the age of Alliance Capitalism

Trying to answer the why, where and how questions about MNEs activities, Dunning

(1973) proposes an integrated electrical model (OLI), emphasizing three conditions for

FDI. First, Ownership advantage (O) of the foreign investing firm. It reflects the

specific asset that might be a product or a process of production to which other firms

dont have access. Second, a Location advantage (L), specific to the host country, which

makes production in this country more profitable. Third, Internalization (I), it means

replacing imperfect (or inexistent) external markets by internal ones (Buckley, 1993).

Internalization leads to combining those O specific advantages with the foreign based

assets L through FDI.

Some researchers find Dunnings OLI framework no longer appropriate for explaining

the spatial behavior of MNEs (McCann and Mudambi, 2004). Dunning reappraised the

electric paradigm many times to account for the evolution in the world economy

context. Dunning (1995) explains that the composition and the significance of the OLI

variables will change according to first, the kind of MNE activity being considered

(market seeking FDI, resource seeking FDI, efficiency or strategic asset seeking FDI);

second, the portfolio of location assets of the home and the host country; third, the
41
technological and other attributes of the considered sector and fourth, the specific

characteristics of the firms undertaking the investment.

In the new age of alliance capitalism -non equity external alliances as an alternative to

react to market failure- is FDI still the most cost effective mode of earning rents on a

firms specific advantage? In Dunning (1995), a reconsideration of the coverage of

OLIs three dimensions in light of the new age of alliance capitalism and of innovation-

led growth economy. The reconsideration of OLI suggests that, the ownership

advantage of firms should accounts not only for the advantages generated within the

firm itself, but also the advantages resulting from inter-firm relationships and

transactions (both at home and abroad), especially through strategic alliances and

networks. Besides, the location advantage of host countries needs to consider the

conditions within a country that might or might not encourage inter-firm alliances.

According to Dunning (1995), there is a two side answer concerning how alliance

capitalism as an alternative organisational form affects FDI. On one hand, the

opportunities for networking in a specific country may increase FDI, especially when a

MNE acquires a firm that is already a member of a network. On the other hand, the

potential to network may also decrease FDI. This is because; it permits the foreign

investor to acquire the desired assets through alliance, without having to conduct FDI.

Which effect will dominate, this will depend on industry, firm and country-specific

factors.

Alliance capitalism allows firms more flexibility in their location strategies. However,

business alliances should not be viewed as substitutes for FDI. This is because, they

have very specific purposes. Although recognizing that alliances are used to access

42
foreign companies advantages and can be used as hedging against risk without losing

independency, Porter (1990) discourages alliances. This is because, alliances imply high

costs related to coordinating operations, reconciling objectives, creating a competitor

and giving up profits. These costs make alliances short term rather than long term

relationships. FDI is still the main mode through which MNEs can guarantee the rents

of their ownership-specific advantages (Dunning, 1995).

The relation between FDI and exports depends on the context. The relation between FDI

and market structure remains a subject of debate. Internalization hypothesis has proved

its accuracy in explaining MNEs behavior. After having discussed why would a MNE

undertake FDI in first place, the next section presents the main hypotheses concerning

the host countrys characteristics driving this decision.

1.2. Vertical versus horizontal FDI and further complicated models

International Economics literature distinguishes between two types of FDI; vertical

FDI and horizontal FDI. Besides, recent more complicated models have emerged.

1.2.1. Vertical FDI

The vertical MNE is one which geographically fragments production by stages on the

basis of factor intensities. Sometimes, it is called the factor proportions hypothesis, it

explains the MNEs activity in term of vertical integration of production across borders

to benefit from factor price differences.

Helpman (1984)s model, in the context of differentiated products, examines the effect

of differences in relative factor supplies on production-location decisions. When relative

factor endowments are sufficiently similar between countries, factor price will be

43
equalized through trade. In this case, there is no incentive for cross border investment

and there is two-way trade in differentiated products and one-way trade in homogeneous

products, reflecting factor proportions differences. If relative factor supply differs

sufficiently, so that factor price is not equalized through trade, there will be cross border

investment.

1.2.2. Horizontal FDI

Horizontal MNE (Markusen, 1984; Horstmann and Markusen, 1987, 1992) is one which

produces the same goods and services in multiple countries. In Horstmann and

Markusen (1987)s model of horizontal MNE, the technology of production is assumed

to involve certain firm-specific activities like, R&D, organizational activities and

marketing. These activities result into multi-plant scale economies, which give the MNE

a cost advantage over potential domestic producers. Plant production is then encouraged

by the existence of international transportation costs. On the opposite, plant scale

economies (i.e. savings on FDI costs) encourage centralized production i.e. serving

foreign markets through exports. The model predicts that at equilibrium, MNEs

production occurs if firm-specific and export costs are large relative to plant scale

economies.

The proximity-concentration hypothesis is in this same logic of thinking (Brainard,

1993 a). It claims that the multinationals location decisions reflect a trade off between

achieving proximity to customers and concentrating production to achieve scale

economies. Brainard (1997) conducts the first tests to measure the role of scale

economies. The paper finds that, multinationals foreign production increases relative to

exports, the higher are transport costs, trade barriers and corporate scale economies and

44
the lower are investment barriers and scale economies at the plant level relative to

corporate level.

Brainard (1997)s tests also show that, increase in per-worker income differentials

reduce affiliates sales both absolutely and relative to trade, while having either a

positive or negligible effect on trade. Though, according to factor proportions

hypothesis, within traditional trade theory (Helpman, 1984), firms integrate production

vertically across borders to take advantage of factor price differences. Brainard (1997)

explains that this result doesnt mean that the proximity-concentration and vertical

hypotheses are incompatible. When firms decide about their international activities, they

consider the relative importance of factor proportion differences and a proximity-

concentration trade off. When factor proportions differ sufficiently, vertical

multinationals emerge, especially but not exclusively, when concentration advantages

are more important relative to proximity advantages.

1.2.3. Export platform FDI

There are models that have elements of both horizontal and vertical FDI, for example,

export platform FDI. Export platform FDI refers to the situation where the majority of

the output of a foreign affiliate is sold in a third market, not in the host country, or is

exported back to home country. In Ekholm et al. (2003), a model of three regions,

where there are two big economies with high costs and one small low cost economy.

Export platform FDI takes place when one of the high cost economies wants to serve

the other identical economy through investing in the low cost one.

In export platform FDI, production most of the time aims to serve a large integrated

market like in horizontal FDI, but a particular location within the market is chosen on
45
the basis of cost advantage like in vertical FDI. Export platform FDI is promoted by low

host country trade barriers and discouraged by large host country markets (Hanson et

al., 2001).

There are other recent hybrid models, which enabled testing the horizontal versus the

vertical hypothesis.

1.2.4. The Knowledge Capital Model

A recent model, the Knowledge Capital Model (KKM) of the MNE (Markusen, 1997,

2002) explains the volume of foreign affiliates production by the characteristics of the

home and the host country. The model allows simultaneous horizontal and vertical FDI

motivation and shows certain interactions, for example between size and endowment

differences. On one hand, the vertical early models assume there are no trade costs,

accordingly, excluding the possibility of occurrence of horizontal FDI. On the other

hand, early horizontal models assume that different production stages use factors in the

same proportions or that there is only one factor of production, consequently, excluding

vertical motivation for FDI.

The KKM is based on the idea that MNEs are intensive in the use of knowledge-based

assets (for example R&D), which have three properties. The first is transportability or

fragmentation; they can be geographically separated from production and supplied to

production facilities at low cost. The second is factor intensity; they are skilled labor

intensive relative to production. Finally, the third property is jointness; they can be

supplied to additional production facilities, without reducing their value in existing

facilities. Knowledge is a joint input or a public good within the firm.

46
The first two assumptions can explain vertical FDI. The idea is to locate R&D activities

in the country where skilled labor are relatively abundant and cheap, while locating

production in the country where unskilled labor are relatively cheap. If there are plant

level scale economies, the market size will be an additional motivation for FDI. The

third assumption explains horizontal FDI motivated by firm level scale economies.

Jointness leads to firm level scale economies, which gives multi-plant firm a cost

advantage in comparison with single-plant firm. A question follows; can we link these

assumptions about FDI within international economics literature to the internalization

hypothesis and OLI paradigm within international business literature presented in the

first section.

The KKM doesnt seek a linkage with internalization hypothesis. However, Markusen

(2001) acknowledges that, the joint input property of knowledge, which makes it easily

transported to foreign plants, makes the knowledge easily dissipated. Relating the KKM

to Dunnings electric paradigm, the knowledge asset can be regarded as the ownership

advantage. As for the location advantage within the KKM, it depends on whether it is a

vertical or horizontal investment. In vertical FDI, different factor prices between

countries will be a location advantage. Yet, trade costs will be disadvantageous, since

they will increase the cost of exporting the final output back to the home country. In

horizontal FDI, transport costs are advantageous, since they favor FDI relative to

exports to the host. But, plant level fixed costs are disadvantageous. Consequently, there

is a pressure between those two factors; transportation costs and plant fixed costs. The

question now, which component of the KKM has better survived empirical research?

Several empirical investigations test the KKM. The first attempt of Carr et al. (2001)

was subject to criticism due to its incapacity to prove the vertical motivation. Markusen
47
and Maskus (2002) nest the three models; vertical, horizontal and KKM. Their tests

reject the vertical model and cant reject the horizontal one. They interpret their results

as strongly supporting the KKM, but not allowing distinguishing it in aggregate data

from the horizontal model. Blonigen et al. (2003) find no support for the KKM; instead

horizontal hypothesis is strongly supported. FDI between countries decreases when

absolute difference in skill labor abundance increases, like predict Markusen and

Venables (2000).

There are attempts to explain these doubted results. Blonigen and Wang (2004) pool

data of developed and less developed countries (LDCs), expecting that vertical

motivation will be more evident in FDI in LDCs. Although the LDCs results show

positive relation between skill difference and FDI, it is not statistically significant.

Braconier et al. (2005) claim that, the inconsistency between theory and tests is due to

the choice of data, a choice which doesnt fit with the predictions of the KKM. The

KKM predicts that FDI flows essentially from small skilled-labor abundant countries to

large unskilled-labor abundant ones. Braconier et al. (2005)s data better covers the

factor-endowment combinations, where vertical FDI should occur. Their results

strongly support the KKM. FDI increases if the home country is small and high-skilled

labor abundant, which proves the vertical FDI component of the KKM.

The theoretical models and the empirical findings presented above support the

horizontal motivation, while the vertical motivation remains a subject of disagreement.

That doesnt mean that there is no vertical FDI motivation in reality, but it means that it

doesnt explain the majority of FDI decisions. The vertical motivation cant explain the

overall pattern of FDI in the world which is consistent with Brainard (1993 a, 1997)s

results. This underlines the importance of the market size of the host country in
48
attracting FDI. Chakrabarti (2001), in a sensitivity analysis of cross country regressions,

proves that the market size of the host country significantly explains FDI. Head and

Mayer (2004) find that Japanese investments in the European Union are influenced by

the host markets size. Their results show that, a 10% increase in a market potential

implies an increase of 3% to 11% of the probability foreign investors choose it.

That is why; the literature studies the effect of demand uncertainty on FDI decision

(Das, 1983; Rob and Vettas, 2003; Aizenman and Marion, 2004; Moner-Colonques et

al., 2007) as it will be further discussed in chapter three. The thesis is locating the actor

who can solve uncertainty regarding the particularity of the use environment and needs

in the host country i.e. lead users.

Now lets move back to international business literature to see if the MNE is seeking

more than favourable factors costs and firm scale economies while internalizing its

ownership advantage. Globalization encourages another complementary motivation for

FDI, which is asset seeking FDI aiming to augment the MNEs competitive advantage.

1.3. Asset seeking FDI

The international business literature often refers to the classification of market seeking

FDI, resource seeking FDI, efficiency seeking and asset seeking FDI. Dunning and

Narula (2000) explain each category:

Market seeking FDI occurs when there are export barriers to the host country or when

the local or nearby markets offer opportunities to achieve economies of scale. But, if the

market cant absorb new potential entrants, it will lose its attractiveness overtime, since

it will no longer be able to offer economies of scale to its members.

49
Resource seeking FDI is associated generally with low value adding activities and low

capital expenditure on plant and equipment (extractive industries are the exception). It

occurs when a country or a region possesses absolute advantage in particular scarce

resources. When the cost of these resources increases, FDI is discouraged. For example,

if the resource in question is unskilled labor, if wages increase while productivity

doesnt, the location becomes less attractive for potential FDI. This is because,

productivity didnt compensate for the increase in cost.

Efficiency seeking and strategic asset seeking FDI, these two types of investment

normally require a certain level of created immobile assets in the host country, and both

tend to be encouraged by globalization. Efficiency seeking investment is when different

aspects of manufacturing activity are located in particular locations, in order to exploit

the economies of cross border specialization and the uneven distribution of immobile

created assets. Through a survey of 144 of the Fortune Global 500 industrial firms,

Dunning (1996) shows that, the host countries specific advantages contribute by 40%

to 50% in average to the location advantages contribution to MNEs competitiveness.

The importance of asset seeking FDI is rising. The term asset refers to any asset that

the foreign firm might perceive as valuable and which is available in better terms in the

host country relative to the home country. The foreign firm seeks to access those

valuable assets in the host country to create competitive advantage2. On the contrary,

the internalization hypothesis, sometimes called asset exploiting FDI (Wesson, 1999),

2
When a firm sustains profits that exceed the average for its industry, the firm is said to possess a
competitive advantage over its rivals. Porter (1985) identifies two main types of firm competitive
advantage: cost advantage (when the firm delivers the same benefits as its rivals, but at a lower cost) and
differentiation advantage (when the firm delivers benefits that exceed the benefits of its rivals products).

50
is the best way by which a firm can gain the rents of its own proprietary assets in the

host country under imperfect contracts. Wesson (1999) explains that, in asset seeking

FDI, similarly to asset exploiting FDI, the firm internalizes a cross border transaction,

for which efficient market does not exist. In order to undertake profitable asset seeking

FDI, the firm must find that FDI is the best modality to create advantage from these

assets and is the most efficient access mode in term of cost. Besides, these assets must

have the characteristic of having greater value when combined with the assets possessed

by the investing firm, than their value when used by the host countrys producers. If this

is not the case, the hosts producers would be exploiting these assets more efficiently

than foreign investors. Asset seeking FDI is complementary to asset exploiting FDI.

The foreign firm must possess an advantage over its local rivals in order to undertake

FDI. Therefore, pure asset seeking FDI cant take place, on the contrary there is pure

asset exploiting FDI. However, asset seeking FDI motivation clarifies some aspects of

FDI decision, for which internalization hypothesis cant give explanation on its own.

For example, FDI from LDCs to developed countries can be interpreted as strategic

investment, aiming to redress disadvantage imbalance in LDCs competitive or resource

position (Moon and Roehl, 2001).

Asset seeking FDI can be driven by supply or demand factors in the host country. It

may aim to access clustering benefits in the host country, the hosts institutional assets

or innovation/technological capabilities. There is scarce literature about asset seeking

FDI driven by demand conditions in the host country.

51
1.3.1. The role of Clusters

Clusters, geographic concentrations of interconnected companies and institutions in a

particular field, are source of immobile competitive advantage to the locations where

they exist (Porter, 1998 a).

1.3.1.1. Clusters potential benefits

In Marshalls (1920) tripartite explanation of the advantages of agglomeration, the firm

benefits from the externalities associated with local information spillovers, local skilled

labor pool and local non-traded inputs. New economic geography (Fujita et al., 1999)

demonstrates that, on one hand, there are forces which foster geographic concentration

of economic activity and on the other hand, forces which work in favor of dispersion.

Among the factors favoring concentration and which generate agglomeration effects;

first, big market size which allows scale economies; second, availability of inputs at low

cost; third, knowledge spillover.

Porter (1998 a) further explains clusters benefits for competition. First, several factors

work together to enhance the productivity of the companies in the cluster. Geographical

proximity of suppliers and end-users gives clusters members the advantage of quick

flow of information and communication. Besides, there is a better access to employees,

suppliers, institutions and public goods. Second, within a cluster, innovation is

accelerated. This is because; proximity to rivals creates pressure to innovate. In

addition, the cluster can serve as a test site for R&D work, and innovations are diffused

faster within a cluster. Third, the cluster encourages new businesses, which on their turn

strengthen the cluster. Having already a customer-base, cluster should lower risks for

new entrants. The gaps in products or services are easily identified within a cluster. New
52
entrants can benefit from established relations. In Porters opinion, barriers to entry in a

cluster are lower than elsewhere. But, is it always beneficial to locate within a cluster?

1.3.1.2. When it is beneficial to take part of a cluster?

It is not always beneficial to take part of a cluster. McCann and Mudambi (2004)

criticize that, Porter doesnt clarify when a MNE should and when it should not locate

in a particular industrial cluster. In other words, what is the balance between the costs of

locating in a cluster and the opportunity costs of not locating there? Especially that, in a

cluster, firms are concentrated and factors prices are high. The answer depends on the

clusters structure. This structure influences the inflow versus the outflow of

knowledge. This is because, while the MNE seeks to internalize informations

transactions costs within its borders, the rationale for industrial clustering is to

internalize informations transactions costs within the cluster. Industry structure may

impact perceptions of knowledge outflows, because unintentional knowledge outflows

have both positive and negative effects on the firm. On one hand, the outflow of the

firms valuable intellectual capital would always be viewed negatively. On the other

hand, the potential positive effect is the public good aspect of knowledge, which makes

the cluster more attractive for other firms, leading to larger knowledge inflows in the

future.

McCann and Mudambi (2004) give some examples. Competitive market structure is

characterized by a large number of firms, each with a relatively small market share and

profits. In a competitive market structure, firms will be gaining more than loosing from

knowledge flows. The public good aspect of knowledge may predominate and

knowledge outflows are viewed as overall positive. On the contrary, in an oligopolistic

53
industry structure, where there are few large firms, each with a large market share,

knowledge outflows to rivals can be extremely costly, leading to loss in competitive

advantage. The overall effect of the knowledge outflows is perceived to be negative. It

is worth noting that, usually MNEs emerge in sectors characterized by oligopolistic

structure (Caves, 1971). This brings us to the role of the institutional structure in the

host country.

1.3.2. The role of institutions

Asset seeking FDI may aim to access the host countrys institutions. This is mostly the

case when the business and social culture in the host country are perceived as more

competitiveness enhancing than the home countrys ones. The MNE will be motivated to

undertake FDI, the higher the quality and the transactions costs effectiveness of the host

countrys institutions, which affect the MNEs resources, capabilities and markets

(Dunning, 2006).

FDI literature of the 1970s and 1980s did study host governments policies effect on

FDI location choice (taxes, fiscal incentives, etc.), their effect is ambiguous. New

importance was attributed to the institutional structure of societies as a determinant of

economic success. North (1990) defines institutions as institutions include any form of

constraint that human beings devise to shape human interaction. Institutions structure

incentives in human interaction whether political, social or economic. The institutional

framework of a country consists of both formal and informal dimensions. Although

foreign investors can observe formal institutions and access their legal framework,

informal institutions will be source of uncertainty, since they are less transparent

(Meyer and Nguyen, 2005).

54
Several recent empirical studies prove institutions influence on the MNEs location

choice. Disdier and Mayer (2004) investigate the determinants of French multinationals

location choice in Eastern and Western Europe. Institutional quality, indeed, positively

and significantly influences location choice. Agglomeration effects are less important in

Central and Eastern Europe compared with Western Europe. Bnassy-Qur et al.

(2007), based on French institutional profile database, prove that institutions in the host

country significantly impact FDI decisions, especially bureaucracy, corruption,

information, the banking sector and legal institutions. They find that, FDI is discouraged

by weak capital concentration and employment protection. Besides, based on the USA

Fraser database, they show that the home countrys institutions have little impact on

outward FDI.

1.3.2.1. Harmonizing institutional structures

The MNE has to adapt its internal incentive structure, which makes part of its home

countrys institutional framework, to the host countrys particular requirements. The

liberalization of markets and the growing integration of many developing countries into

the global economy have resulted into an increased harmonization of intra-firm

incentive structures between countries.

However, if the costs of reconciling different incentive structures, associated to the

production of a particular product in a foreign country, exceed export costs, then exports

or partnership with a local producer will be more profitable than FDI (Dunning, 2006).

Indeed, Bnassy-Qur et al. (2007) find that institutional distance between the home

and the host country influences FDI more than the quality of institutions. Institutional

55
distance negatively impacts FDI, especially when it concerns credit market regulations,

legal constraints in recruiting and firing and decentralization of wage bargaining.

What about the role of the technological and innovation capabilities of the host country

in attracting asset seeking FDI in an innovation-led growth world economy?

1.3.3. The role of innovation capabilities

Nowadays, the MNE is not only perceived as an organization that might generate

spillovers to the host countrys firms (Veugelers and Cassiman, 2004; Baldwin et al.,

2005), but also as an organization playing an important role in international technology

creation and innovation (Cantwell, 2001). It is convenient to briefly define some

concepts; innovation, technology, R&D and the relation between them.

Innovation is defined as the introduction of new products or new processes. Technology

is the capability to efficiently sustain these processes that generate quality products.

Technology used to be defined as scientific and engineering knowledge and blueprints

across national boundaries. Nowadays, technology incorporates the corporate capability

to operationalize and effectively use this knowledge in production. Technology is not

reducible to the output of R&D facilities. The R&D function is one (particularly

important) contributor to the learning process that characterizes innovation and leads to

the creation of new technology in the sense of new production systems (Cantwell,

2001).

Linking FDI to technology is not new. The internalization hypothesis was mainly

concerned with the technical knowledge of the firm that the market fails to price;

therefore, the market was internalized through FDI. In asset seeking FDI, which is

56
complementary to the internalization hypothesis, the MNE is seeking exposure to the

technological capabilities of the host country, in order to remain competitive.

Earlier, Vernon (1966)s product-cycle model claimed that, having introduced in the

home market a new product or a new technology, the MNE in order to exploit its

advantage would then export or conduct FDI. The home market would generally be

characterized by outputs at earlier stages in the product cycle and the foreign markets

by products in the later stages. The product cycle model was proved to be inaccurate in

explaining FDI behavior. The MNE undertakes contemporaneous R&D activities in the

host countries.

Recently, developments in ICT have enabled managing dispersed R&D activities more

efficiently. Those developments have also allowed the integration of R&D fields which

used to be separated. Santangelo (1998) finds that, an increase of the firm specialization

in ICT is associated with an increase of R&D internationalization.

1.3.3.1. MNE: an organization globalizing innovation

In general, firms which diversify into international markets perform better than their

domestic competitors and they are more innovative (Hitt et al., 1998). Referring to

Italian manufacturing industry, Castellani and Zanfei (2007) give evidence on the

relationship between firms performance and internationalization modes. Without being

able to identify the direction of causality, their study shows that higher international

involvement is associated with a higher productivity for any given level of

innovativeness of firms. Moreover, multinationals with manufacturing activities

perform better than multinationals with non-manufacturing activities in term of

57
productivity and innovation. However, multinationals with non-manufacturing activities

outperform both; exporters and purely domestic firms.

The MNE is an organization globalizing innovation. On the theoretical side, Fosfuri and

Motta (1999) model a game, where foreign investors in a less technologically advanced

country conduct FDI in a more advanced one. This is to acquire knowledge to increase

their competitive advantage. The paper goes to the extent that, even if the subsidiary is

not profitable, FDI will occur motivated by knowledge acquisition purpose. As for the

more advanced countrys investors, they will prefer not to conduct FDI in the less

advanced one, in order not to dissipate their knowledge.

On the empirical side, literature proves that geographic dispersion of R&D is growing

and the number of patents registered by MNEs outside their home country is increasing.

Kogut and Chang (1991) find that Japanese FDI entry in the USA is attracted by R&D

expenditures in the home and the host country. Serapio and Dalton (1999) investigate

the motivation behind foreign R&D investment in USA. The paper finds that foreign

investors seek to access science and technology in the host country. Kuemmerle (1999)

finds that, on one hand, foreign investment aiming to exploit the MNEs specific assets

would be attracted by the host countrys market size. On the other hand, foreign

investment aiming to augment the MNEs assets would be attracted by the host

countrys knowledge base size and quality. Similarly, Frost and Zhou (2000) find that

the scale and the quality of technical local activity have a high significant effect on

R&D foreign investment decision in USA. Besides, the proximity to universities is an

important factor driving new green field investment, which underlines the importance of

agglomeration. Cantwell et al. (2004), through a survey of USA subsidiaries in the

United Kingdom (UK), show that USA subsidiaries are looking to tap into the
58
innovation capabilities of UK. Sometimes, even tacit knowledge, which is normally

highly localized, is internationalized. This can be due to the specialization of the host in

the concerned field, or to a firm strategy of learning technology through global

networks (Cantwell and Santangelo, 1999).

But, does the globalization of technological knowledge change the technological

specialization profile of nations? In Mouhoud (2004)s view, it doesnt. This is because,

first, innovation activities remain highly concentrated in developed countries to benefit

from agglomeration. Second, R&D FDI in developing countries aims mainly to adapt

products to local demand. Adapting products to local demand is more concerned with

development activities than with research ones. Finally, R&D FDI is most of all

between developed countries.

Mouhoud (2004) argues that, although the globalization of technological knowledge

doesnt weaken the national systems of innovation and the technological specialization

of the home country, it deepens the cognitive dimension of the international division of

work. Work specialization is not according to a task like the Taylor tradition suggests; it

is rather according to a domain of competence, in order to maximize the learning and

innovation capacity. Technology globalization is mainly realized through the mobility

of qualified workers and migration of south qualified workers towards the north, joining

innovation activities of big agglomerations. That is why, the globalization of innovation

doesnt seem to put in question the stable character of regional systems of innovation;

rather it makes it more open and more interdependent.

59
1.3.3.2. Spillover barriers

The expected gains from asset seeking FDI depend on the absorptive capacity of the

investing firm. Cantwell and Piscitello (2002) show that the location of technological

activities of MNEs in European regions is positively associated with the local market

size, the local scientific and educational infrastructure and the potential for intra- and

inter-industry spillovers. Makino et al. (2002) study the location choice of firms from

newly industrialized economies, using a sample of Taiwanese firms. They find that

firms invest more in developed countries than in LDCs, when firms have previous asset

seeking FDI experience and an advantage in technological capabilities relative to local

firms. Those findings confirm the importance of the absorptive capacity of the investing

firm to benefit from the host countrys targeted assets.

Spillovers occurrence depends also on the barriers to entry set by local rivals. Pugel et

al. (1996) extend Kogut and Chang (1991) analysis of Japanese FDI in USA. The paper

finds Japanese R&D and marketing assets positively significantly associated with FDI,

which proves the internalization hypothesis. The paper also finds that FDI is positively

insignificantly associated with USA R&D. However, FDI is negatively significantly

associated with USA marketing intensity. Japanese firms couldnt access marketing

assets through FDI. This shows that, on one hand, when the intangible asset of the host

country is the technological capability, a foreign entrant may overcome his disadvantage

by learning the technology over time. On the other hand, when the intangible asset is

related to marketing capabilities, it is harder to imitate with well established brand

names. Therefore, local competitors deter foreign entry by creating barriers related to

marketing. The total sign of the effect of the host countrys intangible assets depends on

the relative strength of two effects; the first effect is positive, when FDI permits the
60
foreign firm to access those assets. The second effect is negative, since local firms will

try to deter FDI to protect those assets. But, are all the holders of an intangible asset

willing to put barriers inhibiting its acquisition by others?

As it will be shown in more details in the coming chapters, innovator users on the

contrary might be willing to freely reveal their innovations (Harhoff et al., 2003).

Moreover, collaboration between foreign investors and users in the innovation process

has proved to be distinguishably successful (Ivarsson and Jonsson, 2003). This brings

into discussion the role of demand factors in attracting asset seeking FDI.

1.4. Asset seeking FDI driven by demand conditions

Few researches study the impact of the host countrys demand conditions on asset

seeking FDI. These researches highlight the concept of lead market. According to

Lallement et al. (2002), nowadays, subsidiarys R&D activities are less concerned with

an adaptation of already existing products and processes to the needs of relatively

secondary markets, but it is increasingly concerned with the logic of learning by

anticipating future needs in strategically important lead markets.

1.4.1. The role of lead markets

The concept of lead market in international management explains some of the aspects

of asset seeking FDI motivated by demand conditions in the host. Beise and Cleff

(2004) define lead markets as regional markets with specific attributes that increase the

probability a locally preferred innovation design becomes internationally successful as

well. The authors explain that, the factors which make a country a lead market are

market context factors and are not based on technological advancement. Lead markets

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are markets whose choice of technology is followed by other markets, which doesnt

require being the most innovative ones. This is because, the benefit of a technology is

not the same everywhere; it is environment-specific.

Beise and Cleff (2004) list five country-specific attributes, which support the

internationalization of a locally preferred innovation design. First, demand advantage, it

is similar to lead user advantage. The lead market faces needs earlier relative to other

markets, due to environmental conditions or technology. Second, price advantage, it

reflects relative price reduction of the design preferred by the lead market. Third,

transfer advantage, observing the success of the innovation adoption in the lead market

reduces uncertainty and risks for lagging markets. The lead markets design preference

can also be transferred abroad through for example business persons and tourists.

Fourth, export advantage, if the country is export oriented, then the product design will

incorporate features to approach preferences abroad. Consequently, the design will have

better chances to become the globally dominant one. Fifth, market structure advantage,

when local competition is high, the country has a bigger chance of developing a design

that will be preferred by local and foreign markets.

Indeed, Ernst (2005) explains why chip design is moving to Asia, based on interviews

with companies and research institutions doing leading-edge chip design in Asia. The

paper shows that MNEs are attracted by supply-oriented forces, especially the lower

cost of employing a chip design engineer in Asia. However, demand-oriented factors are

equally important. Global firms are seeking to relocate design close to the rapidly

growing and increasingly sophisticated Asian markets, to be able to interact with Asias

lead users of novel or enhanced products or services.

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In a close reasoning, Wesson (1999) establishes a model of asset seeking FDI driven by

favourable demand conditions in the host. Wesson (1999) refers to Porter (1990)s

definition of favourable demand conditions. Porter defines four attributes that constitute

a diamond of national advantage, like it will be explained in the next chapter; factors

conditions, demand conditions, related and supporting industries and firms strategy,

structure and rivalry. Concerning favourable demand conditions for investors in the

home market, Porter (1990) describes them as ones which predict or clarify demand

patterns in the world. The motivation behind FDI driven by demand conditions in

Wessons model is to access demand conditions in the host country that can help a

foreign investor to partially predict demand back in the home country.

The model applies for example, for a firm working in fashion industry that would

conduct FDI in Italy to predict demand back home, since Italy has accumulated

intangible assets in this sector. Another example is the information technology (IT)

industry, where demand is partially a function in new developments in technology,

which tend to occur mainly in a limited group of nations. In Wessons model, demand

in period t in the technologically leading nation would be a function in technological

developments in that nation in period t. However, these developments would not reach

other nations until period t+1. Therefore, demand in the technologically leading nation

in t will provide information concerning demand in the less technologically advanced

nation in period t+1. The technological developments that drive this model may be

made in a related industry not in the industry in which the FDI occurs itself.

Some questions follow; what about the particularity of the host countrys demand as a

motivation for FDI? What about the movement towards a more personalized demand,

which gives more importance to direct interaction with local users through FDI? If lead
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markets on the regional/international level influence FDI location choice, then at the

country level, what is the influence of lead users who can predict the needs of their local

market? Moreover, if a MNE seeking successful innovation shall locate in a lead

market, then shall a MNE seeking successful introduction of innovation in a host

country seek its lead users?

1.4.2. Subsidiaries independence

This section has showed the importance of asset seeking FDI as a strategic strategy to

augment MNEs competitiveness. This implies further integration of the affiliate in the

innovation process of both; the headquarter and the host country.

The role of subsidiaries is now perceived from a new scope. They are gaining more

autonomy and are becoming more embedded (Phelps, 1997) in local networks of

suppliers, customers and institutions in the host country (Andersson and Forsgren,

2000). However, this embeddedness may lead to a conflict between the local networks

objectives and the MNEs strategy. Therefore, there should be a coordination that

allows this embeddedness and in the same time preserves the interests of the MNE. In

Mccann and Mudambi (2004)s view, the firm may switch from a strictly optimizing

strategy to a conflict-resolution approach. Andersson et al. (2005), studying MNEs

subsidiaries in Finland and China, show that when headquarters set knowledge creation

rather than profit as a target for subsidiary, this encourages further local embeddedness.

Hitt et al. (1998) explain that, in this context, where there is a need for higher level of

cooperation between headquarters and subsidiaries, the traditional vertical structure of

organization is inefficient. Vertical structure makes decision making process and

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implementation longer. It makes innovation more rigid and slows responsiveness to

change in the environment and demand.

Conclusion

Internalization hypothesis continues to be the main explanation for FDI motivation.

Recently, asset seeking FDI was found to be a complementary one. Asset seeking FDI

can be driven by supply or demand factors. This chapter highlighted the gap in literature

in analyzing the role of demand. The importance of the market size in attracting FDI is

theoretically and empirically proved. The horizontal hypothesis survived empirical

investigations, while vertical hypothesis validity is still ambiguous. The literature

investigates the effect of uncertainty concerning the magnitude of demand on FDI

decision (Das, 1983; Rob and Vettas, 2003; Aizenman and Marion, 2004; Moner-

Colonques et al., 2007), like it will be shown in chapter three. However, the effect of

uncertainty regarding the qualitative characteristics of demand in the host country on

FDI decision is not yet clarified. Although lead market concept is preoccupied by this

aspect, it doesnt consider the particularity of each country. Uncertainty regarding the

particularity of the use environment in the host country is still unaddressed.

Moreover, the role of users as innovators and their specific characteristics are not

analyzed. Although Ivarsson and Jonsson (2003) and Ernst (2005) point to users role,

they dont go further in explaining it. Their empirical findings underline the need to

theoretically formalize the effect of innovator users, particularly lead users, on FDI

decision.

Linking the concept of innovator users/lead users with FDI can fill those two gaps,

clarifying then important aspects of FDI decision. Who are lead users? Why they can be
65
a source of competitive advantage for their nations? It is the objective of the next

chapter to present the role of users as a source of innovation and in particular the role of

lead users as potential needs predictors and likely innovating agents.

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 CHAPTER II

LEAD USERS: A COMPETITIVE ADVANTAGE FOR NATIONS

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Introduction

Innovator users are gaining increased attention. Nowadays, users are better empowered

thanks to technological developments, which have democratized innovation (von

Hippel, 2005). Some countries support user-centered innovation in order to improve

national competitive advantage. Indeed, the Danish government has set user driven

innovation as a national priority, developing a particular program for this purpose,

Danish companies build their ability to change on knowledge which comes from many

different sources and Danish companies may have specific capabilities when it comes to

creating successes based on an effective interplay between companies and users (Nye

Mal Regerings Grundlag, 2005). In the National Innovation Initiative Summit in 2004,

entitled Innovate America, the final report highlights the new shape of innovation of

user-producer based innovation. The report states that, this trend significantly mobilizes

the nations innovation capabilities, making out of it a nation of innovators.

However, innovator users impact on FDI decision is not yet highlighted. The thesis

mobilizes management and marketing literature about the role of lead users in new

product development to fill this gap. This will answer the questions raised in chapter

one. It will clarify first, the role of lead users under uncertainty regarding the host

countrys use environment and users needs and second, the impact and particularity of

users innovations.

This chapter shows through literature review and analysis that innovator users in

general and lead users in particular are a source of competitive advantage for nations;

they provide favourable demand conditions for foreign investors. This is because,

literature theoretically demonstrates and empirically proves that lead users experience

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advanced needs in comparison with their fellow users and they may perceive a benefit

in innovating a solution to these needs. The chapter is structured as follow; the first

section presents the concept of innovator users. The second section moves to the

concept of lead users. The third section discusses other related concepts; first adopters

and innate innovativeness. The fourth section is concerned with how to find and utilize

lead users in practice. Finally, the fifth section focuses on the role of lead users as a

source of competitive advantage for nations.

2.1. Users: an important source of innovation for nations

In the R&D literature, the term innovate means to develop a new product or process.

In technology diffusion/adoption literature, the term refers to the timing of the

adoption of a new product or process. Both definitions concern both individuals and

organizations (Morrison et al., 2004). The thesis is concerned mainly with user

innovation as defined by R&D literature.

The sources of innovation of nations are not limited to their resident firms innovation

capabilities; they are extended to encompass the innovation capabilities of users (von

Hippel, 1988). Concerning firms, a clarification is needed. If a firm benefits from using

a given product, process or service innovation, then it is a user. If it benefits from

manufacturing it, then it is a manufacturer. If it benefits from supplying the components

or materials necessary to build or use the innovation, then it is a supplier. There are also

innovation distributors and insurers (von Hippel, 1998). A question follows, are users

innovations valuable?

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2.1.1. Importance of users contribution to innovation

It is important to note first that minor innovations are source of advantage and of cost

reduction, their accumulation leads to technical progress as was shown in general

purpose digital computers (Knight, 1963). von Hippel (2005) summarizes studies about

user innovations and shows that, the frequency with which users develop or modify

products for their own use ranges from 10% to 40% in the studied fields. The author

reminds that these studies were conducted on particular fields and results don't reflect

the populations rate of innovation. Besides, questionnaires were used to assess

innovativeness, there might be response bias. People when asked whether they invented

something or not are more inclined to a yes answer.

Innovation history is a trusted witness; indeed it shows that users innovations are

significant. In industrial products, about all of the most important petroleum processing

innovations were developed by user-firms (Enos, 1962). The most widely licensed

chemical production process was developed by user-firms (Freeman, 1968). Users

developed 80% of the most important scientific instruments innovations. They also

developed the majority of the most important innovations in semiconductor processing

(von Hippel, 1988). A big percentage of British firms inventions were for in-house use

(Pavitt, 1984).

Recently, innovator users in consumer goods have been studied, especially in sport

equipment. Shah (2000) investigates innovation in sport equipment of snowboarding,

skateboarding and windsurfing; he finds that major innovations were developed by end

users rather than firms. Lthje (2004) surveys 153 users of outdoor-related consumer

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products in Germany. The results show high level of innovation by these consumers.

But, why would users invent and why their innovations are becoming more spotted?

2.1.2. New technologies empowered innovator users

Users have heterogeneous needs, but manufacturers often find it more profitable to

identify and serve few market segments. Therefore, users who perceive a benefit from

satisfying their needs might invest in innovating a solution to these needs, in case

manufacturers dont.

Developments in ICTs have provided users with design tools, which have increased

users capacity to innovate. Physical product prototyping has become easier with the

simultaneous increase in sophistication and decrease in price of computer driven 3D

parts printers. This trend democratized innovation, however, users still dont have the

privilege of accessing, at an affordable price, kits that offer basic electronic and

mechanical building blocks (von Hippel, 2005).

Therefore, users innovation although it is not a new phenomenon, it is gaining new

tools augmenting its magnitude, its value and its influence. But, is there a specific group

of users whose innovations are expected to be commercially more attractive relative to

other users innovations?

2.2. Lead users: the concept

During the 1950s, innovation was perceived as a technology push process, where new

products are the result of R&D. It was in the mid of the 1960s when market-led

innovation process was recognized.

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Successful innovation process requires both (Poolton and Barclay, 1998). Like there is a

need to understand technology, its capacity and potential, there is an equal need to

understand people (Un and Price, 2007). Yet, traditional market research is seeking to

collect information concerning market segments, competitors and brand preferences.

According to People research approach (Un and Price, 2007), it is peoples values and

needs, their lives -rather than technology- which are critical to understand. The outcome

of people research should be integrated in the development and design of innovative

solutions (Un and Price, 2007). A big percentage of industrial innovations commercially

fail (Poolton and Barclay, 1998). This is in first place due to innovator manufacturers

low level of understanding of users needs (von Hippel, 2005).

2.2.1. Lead users: theoretical foundation

Market research doesnt give enough information to ensure new product success within

very novel products or in product categories characterized by rapid change like high

technology products. That is why, von Hippel (1986) proposes to focus on lead users in

marketing research analysis, Lead users are users whose present strong needs will

become general in a marketplace months or years in the future. Since lead users are

familiar with conditions which lie in the future for most others, they can serve as a

need-forecasting laboratory for marketing research. Moreover, since lead users often

attempt to fill the need they experience, they can provide new product concept and

design data as well. Lead users have two characteristics (von Hippel, 2005):

- They are at the leading edge of an important market trend(s). Consequently, their

current needs would be the future needs of other users in the considered market. That is

why; their innovations are attractive and are often later commercialized.

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- They anticipate relatively high benefits from obtaining a solution to their needs.

Therefore, many of them innovate. They bear the cost of investing in innovation

because of the expected benefits.

Morrison et al. (2004) argue that the two components are reflective and interchangeable.

Franke et al. (2006) prove that the two components are independent, so neither can be

dropped without loss of information.

To understand the theoretical foundation that led to defining lead users in this way, an

overview of von Hippel (1986) is needed. von Hippel (1986) has founded lead users

theory on two literatures. First, research into problem solving shows that familiarity

with existing product attributes and uses inhibits the individuals ability to conceive

novel attributes and uses. There is a functional fixedness effect; entities are strongly

constrained by their real world experience (Duncker, 1945; Birch and Rabinowitz,

1951; Adamson, 1952). Consequently, typical users of existing products, who normally

represent the targeted population of market research, can hardly assess unfamiliar

products and process needs. In high technology industries, with high rate of innovation,

product life cycle is reduced and real-world experience of ordinary users becomes

obsolete by the time a product is developed or during the time of its projected

commercial lifetime. Therefore, lead users who have real-life experience with future

needs can provide market research with very important data. For example, firms who

today need and could obtain significant benefit from a type of office automation that the

general market will need tomorrow are lead users of office automation.

The second literature which explains lead user definition is diffusion literature. Lead

users with future needs do exist because in new product diffusion process, the diffusion

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is progressive (Rogers and Shoemaker, 1971; Rogers, 1995). The time of adoption

depends on the adopters perception of the benefit of the product in question, which

depends on its turn on the time of need occurrence and its importance. Schmookler

(1966) was the first to investigate the connection between innovation activity and

expectation of economic benefit. The higher the benefit a given user is expecting from a

needed novel product or process, the higher the effort and resources he will be

mobilizing to get a solution (von Hippel, 1986).

Those findings, concerning functional fixedness and gradual diffusion, have led to the

hypothesis that users at the leading edge would be the best positioned to understand

what will be needed later by other users. This is because; their present-day reality

represents aspects of the future for the other users.

Accordingly, the expected benefit component indicates innovation likelihood, because

it reflects the high personal need for innovation. The ahead on an important

marketplace trend component of the lead user definition was included because of its

expected impact on the commercial attractiveness of innovations developed by users

residing at that location in a marketplace (von Hippel, 1986). However, Franke et al.

(2006) find that the ahead on an important marketplace trend component informs not

only about innovation attractiveness, but also about the possibility that a user would

invent. Franke et al. (2006) explain their findings; being ahead of a market trend means

that the lead user experience needs that the other users would experience later. Since the

leading edge of the market is small and maybe uncertain, the supply side would not yet

be giving a solution to these needs. Therefore, the lead user will have to invent a

solution himself, if he doesnt want to waite. The further ahead of a trend a user is, the

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lower the possibility of an existing solution and, as a result, the higher the likelihood to

innovate due to this supply-side motivator.

2.2.2. Developments in lead users concept

The concept of lead users was subject to some developments. However, the two

characteristics presented above have remained the base of analysis.

Lead users are generally experts in the field or activity from which their needs arise

(von Hippel, 2005). They are expected to innovate repeatedly, since they are at the

leading edge and expect relatively high benefit from innovating. Therefore, they will

find it beneficial to acquire the needed technical knowledge (Morrison et al., 2000).

Lthje et al. (2005) find that use experience type and degree explains why some users

have had an idea for improvement of mountain biking equipment, while others didnt.

However, use experience was not able to explain why some users only developed idea

(concept), while others went beyond the idea and developed full prototype. This can be

explained by users technical skill related to biking equipment. Bikers who developed

prototypes had significantly higher general technical knowledge in biking equipment

than those who did not. Hence, there is an association between domain expertise and

being a lead user.

Bcheur and Gollety (2006) interview 10 lead users. The qualitative analysis of the

interviews points to some characteristics of lead users; they are precursors, creative,

general experts in the concerned domain and relatively not satisfied with the current

product. The relative no-satisfaction with the current product constitutes an internal

motivation to invent. Another internal motivation is the need to realise the invention and

that others appreciate it. Bcheur and Gollety (2006) undertake then a quantitative
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analysis on a sample of students using Internet. The results show that, indeed, there is a

relation between lead user, internal motivation and expertise. Internal motivation is

correlated with lead userness but insufficient to qualify lead user. The strongest relation

is between lead user and expertise. The paper suggests checking for self evaluation bias,

when searching for lead users, through checking whether the individual has high level

of expertise and of internal motivation.

Another extension of lead user theory is in Schreier and Prgl (2008). The paper

explores the antecedents and the consequences of consumers lead userness in three

sports, focusing on individual end users. Concerning antecedents, the paper finds that

field-related variables help explain an individuals lead userness; first, consumer

knowledge from various sources beyond product usage and second, use experience of

the product in question. Besides, field-independent personality variables also give

explanation for an individuals lead userness; first, locus of control (i.e. the degree to

which people believe that desired outcomes are controlled by their own actions) and

second, innate innovativeness (i.e. a persons predisposition toward new and uncertain

situations). As for consequences, the tests find that lead users adopt new commercial

products more heavily and faster (innovative behavior as defined in diffusion literature)

than other users. The relationship between lead users and the speed of adoption of new

products was mentioned repeatedly. That is why; it is convenient to shed some light on

innovator users concept in diffusion literature.

2.3. Related concepts: innovator users in technology diffusion literature

The term innovator user within lead user theory is concerned with the development of

new products, services or process. However, the lead user theory, as was mentioned

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above, finds partially its explanation in diffusion literature, where innovator user is

defined differently. That is why, it is important to go further in explaining the terms

definition in diffusion literature and its relationship with lead users.

2.3.1. Time of adoption approach

In diffusion literature, there are two main constructs to measure innovativeness. The

first is concerned with the time of adoption (TOA), it measures a behavior. Rogers and

Shoemaker (1971) define innovators as individuals or other unit of adoption possessing

a high level of innovativeness, where innovativeness is the degree to which an

individual or other unit of adoption is relatively earlier in adopting new ideas than other

members in the social system. By relatively earlier is meant earlier in term of actual

time of adoption, rather than whether the individual perceives he adopted the innovation

relatively earlier than others in his system (Morrison et al., 2004). Rogers and

Shoemaker (1971) classify individual adopters by using the standard deviation from the

average time of adoption. Rogers (1995) makes some propositions about innovators

behavior. For example, they are active information seekers more than later adopters,

more exposed to mass media and rely less on their social systems members subjective

evaluation of the expected results of technology adoption. Those early adopters are

change agents and opinion leaders and they facilitate further diffusion of the

technology.

2.3.2. Innate innovativeness approach

The TOA measurement was criticized. Flynn and Goldsmith (1993) explain that

personal innovativeness is a hypothetical construct. Defining and measuring this

construct as an observable phenomenon obscures the true abstract definition of the

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concept. Besides, this measurement doesn't allow making predictions, since

innovativeness is measured after the decision of adoption was already taken. Midgley

and Dowling (1978) propose instead innate innovativeness construct, which measures

an inherent characteristic or trait. They define innate innovativeness as an inherent

desire to experiment with the novel, rather than a situational response. It is the degree to

which an individual is receptive to new ideas and makes innovation decisions

independently of the communicated experience of others. Therefore, the adoption

decision of this individual will depend on individual situations, personal characteristics

and product interest.

It is more realistic to incorporate in technology diffusion analysis the process

intervening between trait and behavior. Midgley and Dowling (1978) explain that, in the

real world, there are situational factors that affect innovativeness. For example, income,

the latent need for the perceived benefit of the innovation, the situation in which the

user discusses the new product, users network of communication and his reception of

the communicated experience. Those situational factors might be different from one

product to another. In consequence, innovativeness concerning a product doesn't

necessarily mean innovativeness concerning another. The time of adoption has no direct

or simple relationship with an individual's personal characteristics, especially in the

context of a specific single innovation.

2.3.3. Measurement of user innovativeness in diffusion literature

In diffusion literature, various measurements of innovativeness are employed. For

example, a variant of the time of adoption method, where innovators are the units of

adoption who purchase in the first y weeks, months, etc. after launching the product, or

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who represent the first y percent of a given market to purchase. A second method,

ownership of new products consists of determining how many of a pre-specified list of

new products, a particular individual has purchased at the time of the survey (Midgley

and Dowling, 1978). Another method, cross sectional method measures

innovativeness across several products categories (Summers, 1971). This method is

more abstract, approaching innovativeness as a generalized personality trait (Midgley

and Dowling, 1978).

2.3.4. Linkage between innovator users in diffusion literature and lead users

After having presented the measurement of user innovativeness in diffusion literature,

the question is whether it is related to the measurement of lead users or not. Morrison et

al. (2004) introduce the concept of Leading Edge Status (LES), a continuous variable.

They define LES as the degree to which organizations use and apply technology

innovations in new and different ways to solve the problems faced by the organization

and the degree and earliness to which they perceive the benefits of new products relative

to other users. They define lead users to be those organizations exhibiting high levels of

LES. The paper compares between LES and the two constructs presented above; TOA

and the innate or dispositional innovativeness of adopters. The comparison yields that

LES is strongly related to the two constructs and that LES is more related to innate

innovativeness construct than to the TOA construct. In addition, Morrison et al. (2004)

find that the lead user measure complements the two constructs in some ways, as it

provides additional information.

The empirical findings of Urban and von Hippel (1988) and Schreier and Prgl (2008)

prove that lead users are early adopters of new products and services. These findings

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support the ahead of the field position of lead users. Urban and von Hippel (1988)

propose that lead users could be opinion leaders, helping then to diffuse innovations

related to their needs. Indeed, Bcheur and Gollety (2007) investigate the relation

between opinion leaders and lead users. Both actors are most needed in radical

innovations. Lead users participate in the development of the innovation, while opinion

leaders participate in the diffusion process of the innovation. Opinion leaders

communicate their ideas to their network and influence other users perceptions. The

paper studies a sample of Internet users in France and in USA. 5% and 18%

respectively, of the French and the American sample, show high intensity of lead users

characteristics. The authors explain the higher percentage in the American sample by

the higher familiarity with Internet usage in USA compared with France. The paper then

investigates the relationship between the two constructs; opinion leaders and lead users.

The authors find that lead users are frequently opinion leaders. Lead users have higher

scores of opinion leadership in comparison with no-lead users.

So far, the chapter has clarified the lead user concept, its relation with other concepts

and lead users role in successful new product development. A question follows; how to

find and utilize lead users in practice?

2.4. Lead users in practice

In empirical literature, lead users are usually localized through surveys. For example, in

Urban and von Hippel (1988), they investigate users innovativeness related to a type of

software used to design printed circuit boards. They collected a sample of user-firms

employees and asked questions concerning the position of each firm on the trend. Then,

to learn about expected benefits, they asked about how satisfied firms are with current

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capabilities. Finally, to learn about user-firms innovation activities, they asked about

whether firms had modified or built their own software.

This section aims to go through the procedures literature proposes to benefit from lead

users.

2.4.1. Lead user method

Utilizing lead users is not only important in the phase of new product development.

After product launch, lead users can play the role of opinion leaders or they can be

followed to learn about their modifications of the product in question (Urban and von

Hippel, 1988).

To further formalize the practice, von Hippel (1986) and Urban and von Hippel (1988)

demonstrate a four-step process to utilize lead users. The first step consists of

identifying an important market or technical trend. Identifying market trend is most of

all an art. Experts can help in the process. In the case of industrial products, the trend is

clear for industrys members and expertise. Besides, potential buyers evaluate proposed

new industrial products in economic terms. Net benefit (B) in economic term is the

benefit a user-firm expects to obtain from a solution to a given need: B=(V)(R)-C-D

where V is the dollar volume of product sales or processing activity, to which the user

plans to apply the solution; R is the increased rate of profit per dollar of this volume,

resulting from applying that solution; C is the user's anticipated costs of developing

and/or adopting the solution; and D is the net benefit which the user would have

obtained from old process, equipment, etc.

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In the case of consumer goods, trend identification is more difficult. This is because;

there is no unified starting point like economic value in the case of industrial products.

Surveys can help then assess consumers perceptions for trends and their relative

importance.

The second step is identifying lead users. After having identified market trend, the firm

shall identify lead users, who are (1) at the leading edge of each identified trend in terms

of related new product and process needs and (2) who expect to obtain a relatively high

net benefit from solutions to those needs. In case of industrial goods, experts usually

know user-firms position on trends. The target after is to identify, within those users at

the forefront of the trend in question, users who are expected to realise high net benefit

by adopting a solution to trend-related needs. Therefore, measures of potential benefit

should be defined. Urban and von Hippel (1988) suggest some proxies, for example,

user dissatisfaction with current products, services or processes. Another potential

proxy is the speed of adoption of innovations, since early adoption was found to be

correlated with the adopters perception of related benefit (Rogers and Shoemaker,

1971). Identifying lead users can also be done by searching for users who innovate to

solve problems at the leading edge of a trend. That is because, innovation is costly and

users who would be innovating are the ones who expect high benefit from finding a

solution.

In the case of consumer goods, lead users can be identified through surveys. There are

some difficulties in lead users segmentation. First complexity is when lead users are

customers of a competitor or are outside the industry which the firm is serving. In this

case, the firm must take into consideration the differences between the lead users it is

assessing and the users it is targeting. A second complexity is that lead users are not
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necessarily at the leading edge of all the attributes of the product in question. They may

be lead users of some of the attributes or maybe only one attribute that the firm wants to

investigate. The third complexity is that lead users sometimes develop solutions to their

needs. Therefore, searching for lead users who expect high benefit from a solution can

be misleading, since they may have already acquired the benefit through their innovated

solution. That is why; market research should capture both lead users groups; those

who had developed a solution and those who had not, in order to benefit from both

groups data.

The third step consists of analyzing lead user need data to generate new concept

(product). Sometimes, lead users invest in developing a solution for their needs. This

might be through using the existing products or components in a new way not predicted

by their manufacturers or by developing complete new products. Those innovated

solutions are based on lead users real life experiment. That is why; they are usually of

commercial interest.

Finally, the fourth step is to project lead user data onto the general market of interest.

Lead users needs are not precisely the same as the expected future market needs. In

diffusion literature the early adopters of a novel product differ in a significant way from

the follower users (Rogers and Shoemaker, 1971). Therefore, lead users data need to be

tested for the degree of its applicability on the targeted market. Concerning industrial

goods, since their users evaluation is based on an economic cost/benefit analysis, then

it is expected that all users will have the same economic analysis as lead users. As for

consumer goods, in case the economic analysis is not the benchmark for consumers

preferences, then applicability of lead users needs and concepts has to be checked more

rigorously. This can be done through prototyping the novel product and testing it on a
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sample of typical users. But, what if no-lead users find lead users methods generated

concepts not attractive?

In case no-lead users dont like products developed based on lead users needs, there are

two possibilities (Urban and von Hippel, 1988). First, that the concept is so novel for

no-lead users and in the future with the development of no-lead users needs, they will

adopt the concept. In this case, the product will eventually commercially success. The

second case is when only lead users like the product and even with the development of

no-lead users needs, they will not adopt it. Herein, there are indicators (Urban and von

Hippel, 1988), showing whether concepts developed based on lead users needs will

appeal to no-lead users or not. The concepts developed based on lead users needs are

expected to succeed, if lead and no-lead users have the same evaluative structures in

term of dimensions and utility weights. Besides, if no-lead users are classified into

classes of experts, experienced, knowledgeable and unaware users and one observes a

more positive response from customers with more expertise.

Millier (2005) explains that lead user is a starting point, but is not enough for project

success. This lead user has to be representing a group of users who share the same

values, the same technical problems, the same attitudes and the same motivations for

being interested in the innovation in question. This group of clients is the cluster in

which the innovation will diffuse; it is the segment of the market that the innovation

will serve.

2.4.2. How to find lead users

Although the lead user method explicitly identifies steps to utilize lead users, finding

lead users is not an easy task. The process of searching for lead users is a creative one
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that must be tailored specifically for each field (Lthje and Herstatt, 2004). It is very

costly to search for lead users among all users through a full screening methodology.

Networking, through interviewing a sample of users, asking them to nominate

innovators, can be more efficient. Innovators in a population are likely to have a

reputation and to be known by many others in that population. Morrison et al. (2000)

study users innovations in Australian libraries to computerized information search

systems called Online Public Access Computerized Systems (OPAC). The libraries

were asked to rank themselves on a number of characteristics. After that, self evaluation

bias was checked by asking respondents to name other libraries that they consider

having the characteristics of lead users. Self evaluation and evaluation by others didnt

differ significantly.

Networking can also be done from innovators to more advanced innovators

(pyramiding). People with a strong interest in a topic or a field will be searching for

people relatively more expert (von Hippel, 2005).

There are methods other than nomination. The antecedents of consumers lead userness

might help in identifying the most promising persons to start with in the search process

for lead users (Schreier and Prgl, 2008). Customer complaints and reports of sales

representatives can be used to efficiently identify lead users (Lthje and Herstatt, 2004).

A firm may search for its targeted lead users in specialized rendezvous, for example,

sport competitions for sport field (von Hippel, 2005). If no specialized rendezvous are

available, the firm will be benefiting from creating them. von Hippel (2005) gives the

example of StataCorp, a supplier of statistical software, who provides users with tools to

develop statistical tests. Users then, between them, share the tests they develop on other

websites. Stata personnel visit those websites and observe users evaluation for users
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developed tests. Stata personnel then choose successful ideas to develop proprietary

versions.

In consumers markets of millions of users, targeting some innovative users

communities may be an efficient method for identifying users commercially attractive

innovations (Franke and Shah, 2003).

Lead user idea generation methods (von Hippel, 1988) involve searching among users

innovations that already exist, in order to find attractive new solutions to a given

problem. Lthje et al. (2005) suggest a different approach; it consists of pre-identifying

users likely to develop a specific type of innovation. The paper studies innovator users

in mountain biking. For example, if the firm wants to develop safer mountain bikers, it

shall search for mountain bikers who need safety. Accordingly, firms can invest in likely

to innovate users, in exchange for access to their innovations on better terms in

comparison with competitor firms. Moreover, one can predict the nature of the

innovations users will develop. Users depend on local need information, since the

benefit they gain from innovating is related to their in-house use. They also rely on local

solution information due to the stickiness of information (as it will be further discussed

in chapter four). This is because, if the innovator users take into consideration the needs

of others, they shall learn about the others use context and shall learn new skills, which

will increase the cost of innovation.

Now that the methods of finding and utilizing lead users have been presented, the

question is about the continuity of lead user method application.

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2.4.3. Continuity of lead user method application

In practice, there are some difficulties in ensuring continuous integration of lead user

method in new product development process within a firm. Olson and Bakke (2001), in

a first longitudinal study, apply lead user method in Cinet Company (IT Company in

Norway). The method resulted into new successful products, both in software and

hardware. However, coming back about a year later to the company to investigate

whether lead user method has become an integrated stable part of product development

process, the authors find that the idea was abandoned. The company got back to a

technology push process for developing new products.

The company explains this by high turnover. The originally involved personnel in the

lead user process, most of them left and did not transfer their experience and enthusiasm

towards the method to their followers neither to other personnel. The method is time

and effort consuming; it is costly to identify lead users. The engineers use very technical

language, while users are sometimes ambiguous in the way they express their

preferences and needs. Sometimes, lead users cant translate their needs in technical

solutions, which may results into underestimating their added value. In product

development, engineers prefer collaborating with other engineers in more powerful

supply firms, rather than collaborating with users.

Therefore, Olson and Bakke (2001) point to the importance of training and experience

transfer from personnel involved in lead user method to other personnel. This is to

inform the other personnel about the methods advantages, in order they dont perceive

it as a burden. The paper proposes that the company establishes a board for new product

development approval, one which forces developers to integrate in their proposal

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customers evaluation of the idea. However, the authors acknowledge that this can turn

new product development process into a bureaucratic one. Therefore, they suggest

instead to isolate and to measure the effect of lead users ideas on products profits or

sales, in order to encourage lead user method application.

Lead users involvement in the new product development process, although it is hard

and costly, it is a source of risk reduction and of innovative ideas. That is why,

manufacturers would be benefiting from searching for lead users. The next section,

further clarifies the value of innovator users in general and of lead users in particular to

nations competitive advantage. This is because, MNEs seek complementary created

and immobile assets in the host country, like it was demonstrated in chapter one.

2.5. Lead users: favourable demand conditions

With faster transportation, communication and liberalization, did the location factor

loose its importance? Porter (1998 a) presents the paradox of location: Anything that

can be efficiently sourced from a distance through global markets and corporate

networks is available to any company and therefore is essentially nullified as a source of

competitive advantage. However, the paradox is that the endurable competitive

advantage in our global economy is becoming more dependent on local things, like

knowledge, relationships and motivation, which competitors in other locations cant

imitate.

2.5.1. The diamond of national advantage

In Porter (1990)s view, nation's competitiveness depends on the capacity of its industry

to innovate and upgrade. Porter (1990) defines the diamond of national advantage. The

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diamond incorporates four dimensions. These dimensions do not rely on the inherited

advantages of nations but on their created ones, which are scarcer and harder for foreign

competitors to imitate:

First, factor conditions, where it is the efficiency of creating, upgrading and using

factors that matters, rather than their availability. Moreover, a disadvantage in term of

availability might turn to be an advantage, if it pushes to innovate and if it is

accompanied by strengths in other dimensions of the diamond. In contrast, an advantage

might turn to be a disadvantage, if it leads to inefficiency.

Second, demand conditions, where the character of home demand is more important

than its size. Nations gain competitive advantage in industries where the home demand

predicts consumers needs, and where consumers are the worlds most sophisticated.

This environment would push firms to innovate faster and to gain more sophisticated

competitive advantage than their foreign rivals.

Third, related and supporting industries, where the presence in the nation of suppliers

industries and other related industries that are internationally competitive creates

advantage in downstream industries. This is because; they deliver the most cost

effective inputs.

Fourth, firm strategy, structure and rivalry, this dimension is concerned with the

institutional conditions of firms. It consists of the conditions of firms creation,

organization and management, and the nature of domestic rivalry. Local rivals push

each other to lower cost, improve quality and service, and to innovate.

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The diamond is essentially based on local domestic competitive advantages. In Porters

opinion, local innovation instead of outsourcing is the best way to overcome local

disadvantage. But, Dunning and Lundan (1998) explain that the integration of the world

economy, with the new developments in ICTs and liberalisation, has given a rising

importance to the potential competitive advantages that can be generated from foreign

sources. The MNE can have multiple home bases and can source competitive

advantages from its operations worldwide. Rugman and Verbeke (2001) suggest setting

a benchmark level of competencies concentration in home country below which, the

firm would be considered as having multiple home bases.

2.5.2. Lead users within the diamond

The thesis agrees with von Hippel (2005)s proposition that, when Porter defines

favourable demand conditions in his diamond, he is actually talking about the value of

nations domestic lead users to national competitive advantage. Although Porter is

assuming that it is manufacturers who innovate in response to users advanced needs,

von Hippel (2005) argues that lead users input is not only advanced needs but also

innovations. Users impact production location. Indeed, Simmie (1998) investigates the

reasons for innovation clustering in Hertfordshire in UK. The paper finds that demand

pull for innovation is one of the significant explanations. Besides, the interaction with

customers contributes to the set of the characteristics of innovations.

In addition, the thesis argues that lead users in the host country are a source of

competitive advantage attracting foreign investors. However, this is not only realized by

seeking the most sophisticated buyers as Porter suggests.

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Innovation consists of finding solutions for sophisticated and no-sophisticated buyers.

Innovation is not concerned about the degree of sophistication, but rather with the

novelty of the product or process and its value for users, since in essence producers

innovate to satisfy users needs. Besides, no-sophisticated buyers represent a wide

promising market, with specific demand patterns. According to Cantwell (1995), there

are now multiple locations for innovation, and even lower-order or less developed

centres can still be sources of innovation. Morrison et al. (2000) study OPAC, which

was initially developed by users in the USA and was then used by Australian libraries.

Australia is not a leading market in the field. However, the paper explains that,

innovation appears among lead users in local communities, when either or both of two

conditions hold. First, if the local community has unique needs. Second, if it is cheaper

to invent than to search for or acquire a needed innovation, which may exist elsewhere.

The thesis studies lead users in the host country, as a source of competitive advantage,

regardless their sophistication or international leadership.

2.5.3. Lead users: a created competitive advantage

There is a shift in thought concerning business organization. The focus is moving away

from the internal processes of organization to the organization-environment interface.

Hakansson and Snehota (2006) propose a network model of organization-environment

interface. According to the network model, business organizations behavior is

conditioned by their context, where the other entities are seeking their own objectives.

The relationships between the business organization and the different entities allow

exchanging resources between them and linking their activities. This requires adaptation

of both parties. The capabilities of the organization are built through those relationships.

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Therefore, the performance of the organization is conditioned by the network as a

context.

Through a historical tracking of innovation, Garel et al. (2009) show that innovation

started by independent entrepreneurs, than innovation moved to regulated conception in

the enterprise. Within regulated conception, the enterprises competed to innovate more

rapidly, less costly, and the dominant design was stable. The recent developments and

intensive innovation have changed the context of innovation. Intensive innovation is

putting continuously in question the identity of products and services. Nowadays, it is

hard to define the functions of a mobile phone. In this context of rapid innovation and of

unstable design, the firms innovation staff is not the only contributor to the innovation

process; there are potential contributors in the firms network.

Innovator users are an entity in the MNEs network, who can contribute to its

innovation process. Accordingly, they can play a role in building the MNEs

capabilities and in influencing its performance. For a sample of majority owned foreign

affiliates in Sweden, Ivarsson and Jonsson (2003) investigate the technology

development activities and their use purposes. Their investigation shows that, jointly

developed technology with business customers is exploited internationally by foreign

affiliates; it is not limited to local adaptation of technology. Technology developed in

collaboration with business customers enhances the technological capability of the

foreign affiliate and of the MNE. Besides, the affiliates who cooperate with business

customers have higher export intensity relative to affiliates who only collaborate with

suppliers, business service firms and R&D institutions. Ivarsson and Jonsson (2003)

conclude that, locations with demanding customers and advanced suppliers of materials

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and know how are interesting locations for MNEs who wish to establish technological

linkages to augment their competitive advantages.

The thesis focuses on lead users in particular among the population of innovator users,

because empirical findings have confirmed their theoretical foundation. Empirical

findings prove that lead users characteristics are correlated with innovation likelihood

(Morrison et al., 2000; Franke and Shah, 2003; Lthje, 2004; Morrison et al., 2004).

Tests results also prove lead users capacity to predict other users needs; products

developed based on lead users are commercially attractive (Urban and von Hippel,

1988; Morrison et al., 2000; Olson and Bakke, 2001; Lilien et al., 2002; Frank and von

Hippel, 2003; Franke and Shah, 2003; Lthje, 2004; Morrison et al., 2004; Franke et al.,

2006). Even if lead users proposed needs and solutions are not new to the firm, they

play the role of test laboratory for those uncertain emerging needs.

According to Lundvall (1992), National System of Innovation is The elements and

relationships which interact in the production, diffusion and use of new and

economically useful knowledge . . . and are either located within or rooted inside the

borders of a nation state. Indeed, lead users are rooted and located in their nations.

They can interact in the innovation process with producers to create new knowledge.

Their interaction may make the innovation process more efficient. This is because, lead

users, predicting local needs, reduce uncertainty associated to new product

development. Besides, they work on adapting better the technology to local use

environment. Moreover, lead users can play a role in diffusing new technologies, since

they are frequently opinion leaders. Lead users are an important actor in the National

System of Innovation and can be created.

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Lead users are a created asset. Manufacturers can encourage users innovation by

working on increasing users innovation related benefits. They can also place users in

conditions that they expect to predict future general market conditions, for example, by

allowing users to experience prototypes of proposed new products to test their reactions

(Urban and von Hippel, 1988). Like innovator manufacturers, innovator users need to

be encouraged through incentives, like R&D subsidies and tax credits. von Hippel

(2005) suggests, for social welfare purposes, that policy makers link those incentives to

free revealing of users innovations. Consequently, excluding duplication of efforts by

users interested in the same innovation. von Hippel (2005) notes that, on the contrary,

manufacturers efforts to restrict the use of their products and the possibility of their

modification reduce users innovations and increase their costs. This is because, users

often develop prototypes of new products based on the products they buy and modify.

Conclusion

This chapter has analysed the role of lead users as a competitive advantage for nations.

Like it was shown in chapter one, foreign investors are sometimes motivated by their

willingness to access the host countrys immobile assets, whether related to supply or

demand. It was also explained in chapter one that Wesson (1999)s model defines

favourable demand conditions in the host country, attracting asset seeking FDI, as ones

which can partially predict demand patterns back in the home country. Wessons model

interprets Porters favourable demand conditions in term of lead markets

characteristics.

The thesis defines asset seeking FDI driven by demand conditions differently. This is

because, first, the MNE may seek to anticipate demand in the foreign market itself not

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only in its homeland, in order to enhance its position in international competition.

Second, like it was explained in this chapter, the thesis interprets Porters favourable

demand conditions in the context of lead users.

Therefore, the thesis argues that asset seeking FDI driven by demand conditions is

motivated by the investing firm's willingness to expose itself to lead users in the host

country. Lead users may anticipate the trend of demand in their local market and may

innovate potential solutions. In the case where the host is a lead market, then, the

benefit of being exposed to the hosts demand patterns will have a multiplier beneficial

effect. This is because, knowledge is assumed to be transferable between the boundaries

of the MNE. The MNE as an organisation benefits from organized proximity, which

allows knowledge synergies (Rallet and Torre, 2005).

Lead users outputs are advanced needs and solutions. The next two chapters formalize

through game theoretic models the impact of lead users outputs in the host country on

foreign producers decisions. The third chapter studies the effect of lead users capacity

to predict the trend of demand. The fourth chapter studies the case when lead users

innovate a solution to respond to local predicted needs.

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 CHAPTER III

FDI: THE IMPACT OF LEAD USERS ADVANCED NEEDS

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Introduction

Literature review in chapter one shows that, horizontal FDI hypothesis, according to

which the MNE is seeking to serve the host countrys market, has proved its validity

theoretically and empirically (Markusen, 1984; Horstmann and Markusen, 1987, 1992;

Brainard, 1997; Carr et al., 2001; Markusen and Maskus, 2002; Blonigen et al., 2003).

That is why; uncertainty concerning demand in the host country is an influential factor

in the MNEs decision. Uncertainty regarding the magnitude of demand reflects also

uncertainty regarding users preferences and needs. Preferences and needs on their turn

reflect, among others, the particularity of the use environment. However, the impact of

the difference in the use environment between the home and the host country on FDI

decision is not yet formalized. Besides, how to solve this uncertainty remains an open

question, which the thesis tries to answer in this chapter by introducing lead users

advanced needs impact on FDI decision.

The higher uncertainty, the higher is the need for information (Tushman and Nadler,

1978). In todays economy, uncertainty has increased in general (Hitt et al., 1998), and

in particular for foreign investors who are less informed in comparison with local ones

(Hymer, 1976) and more particularly in the context of new product development. Like it

was explained in chapter two, a big percentage of new products introduction fails

(Poolton and Barclay, 1998), especially due to lack of understanding of users needs

(von Hippel, 2005). Therefore, lead users potential capacity to provide data, predicting

the hosts needs and reducing risk, can be an important source of information for

foreign investors.

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The objective of this chapter is twofold; first, to highlight the importance of learning

about lead users current needs, which can help predict other users future needs in their

country. This data is valuable for producers in general and for foreign investors in

particular, under demand uncertainty related to new product development. Second, the

chapter formalizes how, in the context of a technology push innovation, this data can

impact foreign producers decision whether to conduct FDI or to export in order to

serve the host country.

The chapter is structured as follows; the first section reviews literature about FDI under

demand uncertainty. The second section focuses on uncertainty regarding new product

development. The third section is concerned with the role of lead users in reducing

uncertainty. Finally, in the fourth section, a game theoretic model investigating the

effect of lead users advanced needs on FDI decision.

3.1. FDI under demand uncertainty in literature

Literature models the impact of demand uncertainty on FDI decision. This literature can

be divided into two main groups. The first group considers the impact of information

asymmetry, while the other doesnt.

The first group shows that, FDI may increase when information asymmetry favors local

producers with information about demand in the host country (Markusen, 1995; Moner-

Colonques et al., 2007; Wesson, 1999).

In Markusen (1995), demand uncertainty, associated with information asymmetry, can

be one of the factors why a foreign investor would prefer FDI over licensing to a local

agent. A local agent is better informed about the level of local demand in comparison

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with foreign investors. Consequently, he might find it profitable to make the foreign

investor mistakenly think demand is limited for the product in question. This is to

discourage direct investment and to procure part of the rents. The MNE can avoid

sharing rents through FDI.

Taking into account information asymmetry, Moner-Colonques et al. (2007) develop a

game theoretic model, where local firms and foreign firms, producing in a

homogeneous good industry, compete. It is an incomplete information game of two

stages. In the first stage, foreign firms decide whether to conduct FDI or to export. In

the second stage, firms compete on quantity. There is uncertainty concerning the

intercept of the inverse demand function in the host market. Only local firms and

foreign firms who invest in the first stage know this information, while exporters dont;

there is an asymmetry of information. The equilibrium number of foreign investors is

increasing in the informational parameters, in market size and in unit export cost. It is

decreasing in investment fixed cost.

According to Moner-Colonques et al. (2007), if the number of local firms increases, the

informational advantage is weakened, since it will be shared between many competitors.

Consequently, foreign firms will not be capable of compensating their fixed costs. Here

the authors are excluding the effect of the ownership advantage of the MNE, which

provides the MNE with an advantage in comparison with local firms. On the contrary,

the authors assume that, if the number of foreign firms increases, the strategic learning

effect of FDI persists in comparison with exports.

In Wesson (1999)s game theoretic model, discussed in chapter one, there are two

countries H and F, each has one firm in the industry in question, h and f respectively.

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Firm h has a disadvantage in the industry in comparison with firm f. Therefore, demand

in f in period t partially anticipates demand in h in period t+1. This information about

demand cant be acquired except through FDI in F in period t.

The model establishes conditions regarding C* (subsidiarys establishing and operating

cost level), under which h will be investing in F and f will be investing in H, or h will be

investing in F while f doesnt invest in H and vice versa or both firms stay in their

respective home market. The motivation for FDI under C* is that participating in one

market can provide advantage in the other.

The second group of research doesnt consider information asymmetry. Its results show

that demand uncertainty and demand shocks decrease operations in the host country

(Das, 1983; Rob and Vettas, 2003; Aizenman and Marion, 2004).

Das (1983) examines the effect of changes in profit tax and in tariff rates imposed by

the host country, under cost and demand uncertainty. The MNE produces and sells a

single product in the home and the host country. Demand uncertainty is represented by a

random term in the revenue function of the host country. The model concludes first, that

as a result of cost uncertainty in the host country, the MNE reduces investment and

production in the host country, while investment and production in the parent country

and the volume of trade rise. Second, demand uncertainty in the host country results

into a reduction of the MNEs investments in both countries and of the volume of intra-

firm trade.

Rob and Vettas (2003)s model refers to Vernon (1966)s product cycle model.

According to the product cycle model, a multinational starts new business in a foreign

market by exporting its product, then, depending on the results, it may conduct FDI.
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Rob and Vettas (2003) consider a foreign market, where demand is growing

stochastically over time. This market can be served through exports and/or through FDI.

If demand turns out to be large, it can cover then FDI entry cost. Otherwise, the

multinational is better off exporting the product. An interesting interior solution, where

the market is served through both exports and FDI, may arise under demand

uncertainty.

In order to explore the impact of uncertainty on vertical and horizontal FDI, Aizenman

and Marion (2004) develop a model where the MNE faces productivity and demand

shocks. Productivity shocks increase the expected profits of horizontal FDI. This is

because; the multinational will be relocating production and employment from less

productive plants to more productive ones. In contrast, productivity shocks reduce the

expected profits from vertical FDI. With limited substitutability, low realized

productivity in a plant in the vertical chain increases demand for labor in that plant, in

order to compensate for the productivity loss. Demand shocks discourage both vertical

and horizontal production modes. Aizenman and Marion (2004)s empirical tests then

prove their assumptions. The paper employs the volatility of output per worker as proxy

for supply shocks and inflation volatility as proxy for demand shocks.

To sum up, literature models the impact of uncertainty concerning the host demand on

FDI decision (Das, 1983; Markusen, 1995; Rob and Vettas, 2003; Aizenman and

Marion, 2004; Moner-Colonques et al., 2007). Like it was highlighted before, this

literature ignores the preferences underlying demand. More precisely, it ignores the

particularity of the use environment of the host country as a source of uncertainty for

the MNE.

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Although Wesson (1999) considers preferences, his model is concerned with the

capacity of the host countrys current preferences to partially predict future preferences

back in the home market. His model explains asset seeking FDI driven by demand

conditions related to a lead market. But, what about predicting future preferences in the

host country itself? It is the objective of this chapter to fill this gap in literature. This is

through highlighting and modeling lead users role in reducing MNEs risk of new

product misspecification relative to the host countrys particular use environment. The

next section discusses the uncertainty faced by the MNE, concerning demand

particularity in the host country, especially in the context of new product development.

3.2. Uncertainty associated with new product development

The MNE as an organization faces different levels of uncertainty3 related to work unit

uncertainty (i.e. innovation project) and/or to subunits interdependencies in their tasks

and/or to the environment. Environment uncertainty is due to the organizations

dependence on inputs from this environment, which is out of its control (Tushman and

Nadler, 1978). The foreign producer faces a higher level of uncertainty concerning the

host countrys environment relative to local firms, implying an additional cost. Like it

was explained in chapter one, due to this cost to acquire knowledge about the local

market, the MNE must possess an advantage in comparison with local firms (an

ownership advantage) (Hymer, 1976). Since contracts are imperfect, the foreign firm

internalises the market of its ownership advantage through FDI to fully benefit from its

rents (Caves, 1971; Rugman, 1986; Buckley, 1993). This environmental uncertainty is

3
Uncertainty is defined as the difference between information processes and information required to
complete a task (Downey and Slocum, 1975).

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not only concerning the business environment in the host, but also concerning the use

environment.

3.2.1. Rising demand for customized products

According to consumer behavior economic theory, different consumption patterns in

countries can result of different budget constraints, different prices of the goods in the

two countries and/or different preferences for the properties of goods because of

different environmental contexts or tastes (Deaton and Muellbauer, 1980). With the

recent trend towards customized demand, those differences are accentuated.

Globalization, driven by liberalization and the developments in ICTs, has changed the

world economic context. On one hand, with liberalization, locations compete to attract

FDI (Dunning and Narula, 2000). On the other hand, developments in ICTs have

provided the MNE with timely information about input and output markets. This has

permitted the MNE to respond relatively more quickly to changing demand and supply

conditions in the host countries (Hitt et al., 1998; Dunning and Narula, 2000).

On the demand side, there is a trend of demand for customized products. Customers

also have become better informed thanks to the new technologies. They are increasingly

up-to-date concerning new technologies and new trends. Besides, they are having a

wider choice that exceeds their national territory through e-commerce.

With these developments, in order to remain competitive, the MNE continues to profit

from exploiting economies of scale and scope, while at the same time incorporating

the possibility of significant country-specific differentiation to satisfy increasingly

informed users (Mccann and Mudambi, 2004). Especially that, the technological

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developments have helped reduce the cost of design and production, hence, the cost

for manufacturers to satisfy users heterogeneous needs.

Moreover, in high technology sectors, the product life cycle was reduced and

innovation is necessary for firms survival. Accordingly, new product development is

an important strategy, however, a risky one.

3.2.2. MNE and uncertainty regarding new product development

In Ethier and Markusen (1996)s game theoretic model, the home countrys firms

compete to introduce new products in the host country. There is a risk of knowledge

dissipation. Therefore, the model finds that, factors similarities between countries

increase FDI. Ethier and Markusen (1996) dont consider the risk of no-acceptance of

the new product. In their model, the appearance of a new good decreases the consumers

satisfaction of the old good relative to the new one.

Unlike Ethier and Markusen (1996)s model, in the model presented in this chapter, the

new product acceptance is not taken for granted. Like it was mentioned in chapter two,

commercial failure of new products is mainly due to low level of manufacturers

understanding of users needs (Un and Price, 2007; Poolton and Barclay, 1998). The

risk associated with new product development is even higher when the product aims to

serve a foreign market. This risk implies recurring to lead users who are the best placed

to help manufacturers better understand their customers needs.

The level of uncertainty associated with new product development may differ from one

innovation to another. Gales and Mansour-Cole (1991) clarify that, when the

technological development is predictable, simple, incremental and/or familiar, there is

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low level of uncertainty. When the technological development is unpredictable,

complex, radical and/or unfamiliar, there is high level of uncertainty. Gales and

Mansour-Cole (1991) study 44 toxic waste treatment projects, participating in United

States Environmental Protection Agency. They find that successful projects, whether

with high or low level of uncertainty, are associated with higher level of users

involvement in the innovation process relative to unsuccessful ones. However,

successful projects with high level of uncertainty witness higher level of users

involvement relative to the ones with low level of uncertainty. This is because; large

users involvement in low-uncertainty projects may be costly and time consuming.

Users interaction with technology developers increases with innovation uncertainty, in

order to keep performance at the commercialization stage.

Friar and Balachandra (1999) explain that, marketing strategy for new products differs

according to the radicalness of the technology of the new products. The radicalness

increases in the amount of learning and/or behavior change needed from the consumer,

in order to use the technology. The innovation might be an incremental innovation, i.e.

having the same scientific principle as the old one and having the same functions. In

this case, it replaces an existing product and attracts new customers by having better

performance or lower cost. If the technology is radical, customers might be reluctant

from using a new technology for the same applications. This is because, the old

technology was already tested, while the new one risks of not being as good as the old.

Besides, the new technology may require considerable learning from customers, which

might discourage the adoption of the new technology for its existing applications.

Therefore, an expansion strategy, according to which the new product and technology

provide potential successful new applications, will keep already existing customers and

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create new customer groups. If the technology is so radical, in a way that there are no

applications for established markets, then new markets (customers) have to be created.

The paper analyses the appropriate marketing strategy of three radical technologies;

supercomputers, computer aided software engineering and blood gas monitoring. Friar

and Balachandra (1999) find that, although 68% to 97% of total sales were mostly to

existing customers, they were for completely new applications. Those findings imply

that, in the technology substitution process (substituting an old technology by a new

one), companies should target existing customers of the earlier technology without

asking what needs to be improved, but rather, what new applications need to be

developed. Therefore, the higher is the radicalness of the innovation, the higher is

uncertainty and the higher the need for users involvement.

The thesis argues that lead users can be a factor of success for the MNEs new product

development strategy. Through the data they provide about their advanced needs, lead

users can increase the possibility of substituting the old concept by the new one and

even expanding the market further. This is because; lead users would be identifying the

new required applications for the host market.

In the context of fast moving sectors, like ICTs for example, the work unit uncertainty

related to innovation projects is augmented. This is because, in such sectors, the product

life cycle is shortened and producers need to continuously innovate to remain

competitive. In the context of GPTs, uncertainty concerning the use environment is of

bigger concern. This is because, GPTs can be adapted to a variety of usages and

successful product differentiation becomes a critical factor for technology diffusion.

The need to localize an agent for information processing, concerning local needs and

106
local use environment, is more vital in those technologies. In chapter five, the thesis

observes Egyptian ICT sector, a GPT sector, to analyze the role of users in technology

development and diffusion.

The MNE, facing work unit uncertainty concerning an innovation project and

environmental uncertainty concerning the use environment in the host country, must

develop information processing mechanisms. The more uncertainty increases the more

the need for information and accordingly the need for information processing capacity

(Tushman and Nadler, 1978). Lead users can play an important role in processing

information to foreign investors. The coming section reviews literatures findings about

lead users capacity to predict their markets future needs.

3.3. Lead users for successful new product development

What is the advantage users in general and lead users in particular have in comparison

with producers? The advantage that enables users to play a role in reducing producers

uncertainty in an innovation process.

3.3.1. The advantage of users relative to other actors

Users are the best placed to define their needs and to anticipate the needs of other users.

While manufacturer firms have specialized knowledge about the technology and the

process of development of products and services, users benefit from a real life

experiment of the product. Although firms experiment in their laboratories, real life

experience is the ultimate judge, since manufacturers innovate in order to meet users

needs. Each party needs the others experience (von Hippel, 2005).

107
Lead users can more effectively predict demand than product expertise. Ozer (2009), in

a case study concerning a camera phone, shows that lead users and product expertise

(industry experts, academicians and/or company executives), both can evaluate the

markets potential of new products. However, lead users predictions are more accurate.

This is because, lead users benefit from knowledge about users needs (demand side

knowledge) and about market trend (supply side knowledge). As for product experts,

their knowledge is limited to the product related information (supply side knowledge).

3.3.2. The commercial attraction of lead users based products

Like it was demonstrated in chapter two, von Hippel (1986) explains lead users

concept referring to; first, functional fixedness literature (Duncker, 1945; Birch and

Rabinowitz, 1951; Adamson, 1952), according to which users are limited by their real

world experience. Users who are habituated to use a product in a certain way find it

hard to imagine new functions or new ways of using it. Only users who experience

advanced needs relative to other users can give such innovative insights. The second

literature, explaining lead users concept, is diffusion literature (Rogers and

Shoemaker, 1971; Rogers, 1995). It explains why lead users with advanced future needs

exist. According to diffusion literature, new products diffuse gradually. This is because;

the decision to adopt a new product is function in the individuals perceived benefit of

the product in question. This benefit, on its turn, depends on the level of the individuals

need for this product. The time of need occurrence differs from one person to another.

Consequently, lead users, who experience advanced needs relative to other users and

who can conceive new applications that the market will need in the future, do exist.

Lead users have two characteristics. First, they are at the leading edge of an important

market trend(s). Second, they anticipate relatively high benefits from obtaining a
108
solution to their needs. Being ahead of the market trend implies that new products

developed based on lead users needs are expected to be more commercially attractive.

Indeed, empirical findings highlight the commercial attractiveness of the innovations

based on users and especially on lead users. Urban and von Hippel (1988) assume that

the ideas generated by the more experienced lead users would have an advantage. They

apply lead user method on computer-aided systems for the design of printed circuit

boards (PC-CAD). The new PC-CAD system concept, generated by lead user group,

was proposed to a sample of no-lead users among other concepts of which the most

advanced commercially available product. The concept generated by lead user group

was more preferred and users were willing to pay it a higher price. In Morrison et al.

(2000), OPACs manufacturers find many of their users innovations of commercial

interest. Olson and Bakke (2001) apply lead user method (defining lead user

stakeholders, stakeholders define a market trend, finding lead users on this market trend

and involving lead users in new product development) in Cinet company. Lead users

based ideas for product development were appealing to 13 out of 15 asked routine

customers; besides, customers were willing to pay it between 5% and 10% higher than

existing products. In Lilien et al. (2002), in a natural experiment at 3 M, their

comparison shows that, in the same division of a firm, products concepts generated by

seeking out and learning from lead users have significantly bigger market share and

higher potential to become a product line. Franke and Shah (2003), applying to four

sports communities; sailplaning community, canyoning community, boardercross

community and handicapped cycling community, find that users innovate in the

considered communities and that around one quarter of their innovations are or will be

commercialized.

109
Moreover, empirical findings prove the correlation between lead users characteristics

and commercial success. Franke and von Hippel (2003), in their study of innovator and

no-innovator users in Apache Web server software, show that the attractiveness of

users innovations increases with the characteristics of lead users. Franke et al. (2006)

study a sample of users and innovator users from kite surfing. The paper finds a

correlation between the commercial attractiveness of users innovations and the

intensity of lead users characteristics of innovator users.

Lead users can play a role in reducing foreign investors uncertainty, by helping foreign

firms predict their host markets needs. They are the best informed about the use

environment generating those needs. Consequently, the foreign investor, through the

information processed by lead users, can have more successful country-level product

differentiation. The aim of the next section is to mobilize a local agent in the host

country lead users, and to formalize the effect of the capacity of this agent to predict

demand trend, more accurately than market researchers and product expertise (Ozer,

2009), on FDI decision.

3.4. The impact of lead users advanced needs on FDI decision: game theoretic

model

This section develops a non cooperative game, a complete information one. It is a finite

game of two periods, and then the possibility of repetition for a third period is

considered. Figure (3.1) shows the extensive form of the game4, which makes explicit

4
A Special class of extensive games, it is a multistage game of observed actions. These games have k
stages such that (1) all players knew the actions chosen by all players including Nature at all previous
stages 0, 1, k-1 when choosing their actions at stage k and, (2) each player moves at most once within a
given stage, (3) players move simultaneously in each stage k. This doesnt exclude the games where
players move in alternation and the situation where some players choice set only includes to do
nothing. If in at least one stage both players move simultaneously, then it is an imperfect information
110
the order in which players move and what each player knows when making each of his

decisions.

All things being equal, an international economy, where there are two countries M and

H. M has one firm in the sector in question (m) and H has one potential entrant in the

same sector (h). It is a fast moving sector, with a high rate of innovation, because it is in

this kind of industries that lead users inputs are the most needed (Urban and von

Hippel, 1988). Besides, Dunning and Lundan (1998), in a survey of the worlds largest

500 industrial corporations, investigate to which extent corporations perceive that their

competitive advantage is generated form their operations abroad. The results show that

firms from high technology sectors are more dependent on the foreign sourcing of

competitive advantage.

game (Fudenberg and Tirole, 1991, p.70). Here, it is a game of imperfect information, since there is more
than one node at the same set of information.
111
Figure 3.1. Game structure

FDI Export

h h

Entry No Entry Entry No Entry

m m m m

0 0 0 0

. . .
h h h h

0 DN 0 DN

m m m m

1 1 1 2 1 2

.... ....... . ..
.
h h h h h h

1 DN 1 1 DN DN

DN: Do nothing

112
First period, first stage, m has to decide whether to export or to conduct FDI to access

Hs market. Simultaneously, h has to decide whether to enter or not the market. The

model doesnt consider the case where the host country H invests or exports back in the

home market M5. Besides, operations of m in H dont impact its operations in M.

Therefore, the model will only consider profits realised in H6.

In the second stage, whatever was ms decision in the first stage, it will produce 0 to

serve market H. If h has decided to enter the market, it will also supply 0 , if it has

chosen not to enter, then it will do nothing in the second stage.

In the second period, firm(s) competes to introduce a new product technology to market

H. There is a risk the new product fails. This is because, consumers might be reluctant

from learning a new technology, or because they are more confident in the product they

have already experienced. In order to reduce risk, the firm(s) shall add new

functionalities to the new product, relative to the old one, in order to encourage its

adoption (Friar and Balachandra, 1999). Suppose the firm(s) has to choose between two

new functionalities, the first yields product 1 and the second yields product 2 . Once a

producer has introduced a product to the market, he cant change it within the period7.

The question now is which functionality to choose? The model assumes the particularity

of the demand patterns of each nation (Deaton and Muellbauer, 1980). Herein, appears a

second source of uncertainty for m, other than the one associated to new product

development; it is uncertainty due to the foreign producers ignorance of the host

countrys use environment. If m/h has invested in H in the first period t0 , it will have

5
Following Smith (1987) model assumption.
6
Following Motta (1992) model assumption.
7
Following Wesson (1999) model assumption.
113
information derived from observing lead users needs8 about the new functionalities the

market will prefer in the next period t+1 and will produce 1 . Product 1 reflects a

solution to lead users needs. It is assumed that lead users advanced needs are within

the set of new applications pre-defined by the firm, within its usual product space. This

is because, sometimes manufacturers do know about the lead users advanced needs;

however, according to Morrison et al. (2000)s findings, they might not respond to those

needs immediately.

In the model presented here, it is assumed that lead users current needs do reflect

general market future trend and that the information about lead users needs cant be

accessed through license or exports. Accordingly, the firm which has invested in H in

t0 will produce 1 , based on both technology and demand factors.

If m has chosen to export to H in t0 , there is a probability ( 0 1 ) of

misspecification, leading to produce 2 . In case 1 is supplied simultaneously by a local

entrant, then 2 will be a commercial failure. This is because, 1 developed based on

lead users needs is more adequate with H market relative to 2 . In order to give a

meaning, f (d , r ) , where d ( 0 d 1 ) is the difference in the use environment

between the home and the host country, concerning the product in question. This is

because, the higher the difference in the use environment between the two countries, the

less the exporter capacity to anticipate the host countrys needs; therefore, the higher the

probability of misspecification . While r ( 0 r 1 ) is the degree of radicalness of the

concerned technology. The higher the radicalness of the new technology, the higher is

uncertainty concerning new product development commercialisation success, the higher

8
Lead users are whether individuals or organisations.
114
then the need for users involvement in the innovation process, i.e. for lead users

information (Gales and Mansour-Cole, 1991; Friar and Balachandra, 1999). is then

an increasing function in d and r, both are exogenously given in the model and common

knowledge for all players. Players are risk neutral (evaluating the risk equivalent exactly

to the probability times the outcome).

Hs market size is n, n>1. Since firms are not competing on price, price per unit for all

products is set to one, without loss of generality9. In case there are two producers

(foreigner and local), serving the market with the same product, sales are divided

between them.

Demand in the first period for 0 is D0 n 1 . At least the lead user himself is not

satisfied with the current product. In the second period, demand for 1 is D1 n .

Demand for 1 will substitute demand for 0 and will expand to cover the remaining

share of the market, which is set here at its minimum level, i.e. the lead user. The lead

user will only buy the new product 1 , which is developed based on lead users needs,

for the new functions it provides.

In the second period, an exporter m, in case of misspecification, producing 2 , while a

local entrant h is supplying 1 , will face a demand D21 0 . If h didnt enter the market

in t0 , m will have the advantage of being a sole vendor through exports. In this case, m

will keep 0 consumers; however, it will not expand its consumer base, D2 n 1 .

9
Following Wesson (1999) model assumption.
115
The costs of FDI and of exports will be incurred in every period. FDI costs are incurred

in every period, because of the costs of operating a foreign subsidiary and the difficulty

of reversing FDI decisions (Wesson, 1999).

In case m chooses to FDI, its costs will be constituted of first, a fixed cost (G). It is the

cost of establishing a foreign affiliate, which incorporates the cost of plant set up and of

applying lead user method. Second, there is a constant marginal and variable cost taken

as zero without loss of generality10.

If h enters the market, its costs will be the same as m under FDI scenario, except an

additional cost F. According to internalization hypothesis, it is assumed that m has

already accumulated at home country a specific asset, a public good acting as joint input

across the same firms plants (Markusen, 1984); multi-plant economies of scale arise

(Horstmann and Markusen, 1992). But, the potential entrant h has yet to incur this firm-

specific cost (Horstmann and Markusen, 1987), in order to efficiently benefit from the

information generated by the lead user as much as m. The firm-specific cost can be

thought of as the cost of R&D required to acquire the efficient technology (Smith,

1987).

In case m exports, it will face an export cost11 (T) and the risk of product

misspecification.

The firms seek to maximize their expected discounted profits. In finitely repeated

games, total payoffs are usually taken to be the time average of the per-period payoffs12.

For simplicity, it is assumed that there is no discounting of future cash flows13.

10
Following Motta (1992) model assumption.
11
Export costs are natural (transportation costs) and artificial (tariffs for example) (Motta, 1994).
116
To sum up before detailing, the tables below summarize results. The strategic form of

the game yields the following payoffs table, where m is the row player and h is the

column player:

Table 3.1. Payoffs

h Entry No entry
m

FDI 1 1 1 1 1
( n 2G , n 2G F ) ( 2n 2G 1 , 0)
2 2 2 2 2

Export 1 1 1
( n n 2T ,
2 2 2
1
1 n 1 ( 2n 2T 1 , 0)
n 2G F ) 2

2 2 2

12
Fudenberg and Tirole, 1991, p. 165.
13
Following Wesson (1999) model assumption.
117
The table below shows conditions under which payoffs are feasible, i.e. when profits are

bigger than zero:

Table 3.2. Conditions under which payoffs are feasible

h Entry No entry
m

FDI 1 1 1
( n 2G , n 2G F ) ( n G , 0)
2 2 2

Export 4T 1 2(2G F ) 1 ( 2n 2T 1 , 0)
( 2 , 2)
n n

The game is divided into two main subgames; one under FDI scenario and one under

export scenario.

Consider first the subgame under FDI scenario:

First case: the game results into (FDI, no entry)

M M : Firm ms profit when it is a monopolist in the host market, served via a subsidiary:
118
First period profit n 1 G

In the second period, m produces 1 , gaining n market share, substituting 0 and

expanding towards the remaining share of the market:

Second period profit n G

1
Both periods profit: M M2 2n 2G 1
2

Under condition:

1
2n 2G 1 0
M M2
2
1
nG
2

Second Case: (FDI, entry)

M MH : m profit when m conducts FDI and entry from h:

n 1
First period profit G
2

The second period, both firms will produce 1 and will be dividing the market:

n
Second period profit G
2

2 1 1
Both periods profit: M MH n 2G
2 2

Under the condition:

119
 1 1
2
M MH n 2G 0
2 2
1
n 2G
2

H HM : h profit when m conducts FDI and entry from h:

n 1
First period profit G F
2

n
Second period profit G
2

2 1 1
Both periods profit: H HM n 2G F
2 2

Under the condition:

1 1
2
H HM n 2G F 0
2 2
1
n 2G F
2

Lets look for subgame equilibrium in pure strategies. First, lets consider the

misspecification probability as given and take into account the variation of the market

size n.

1
When n 2G , the market is large enough for m to FDI whatever is the decision of
2

h. h aware of m dominant strategy, its best response is not to enter the market, until n

1
satisfies n 2G F , then the market will be large enough to cover F. Therefore, if
2

120
 1 1
G n 2G F , strict Nash14 equilibrium is a monopoly, where only m serves
2 2

1
H. If n 2G F , strict Nash equilibrium is a duopoly, where a foreign and a local
2

investor serve the market.

Consider the subgame under export scenario:

First case: (export, no entry)

Let M E : firm ms profit when it is the only firm selling in the host market, served via

exports:

First period profit n 1 T

In the second period, there is a probability that m produces 2 , having n 1 market

share and a probability (1 ) it produces 1 , gaining n market share:

Second period profit:

(n 1) (1 )(n) T
n T

1
Both periods profit: M E2 2n 2T 1
2

Under the condition:

14 * * * *
A Profile of strategy p ( p1 ,..., pn ) (where pi Pi , i 1,...n) is a Nash equilibrium such that no
*
player i would have an interest in deviating unilaterally from his strategy pi when the other players
* * * *
continue to play pi . Consequently, we will have ui ( pi , p i ) ui ( pi , pi ), pi Pi , i 1,...n.
pi* is a strict Nash equilibrium if ui ( pi* , p* i ) ui ( pi , p* i ), pi Pi , i 1,...n. (Yildizoglu, 2003,
p. 36).
121
 1
M E2 2n 2T 1 0
2
2n 2T 1

Second case: (export, entry)

M EH : m profit when m exports and entry from h:

In the first period m and h divide the market;

n 1
First period profit T
2

The second period, there is a probability that m produces 2 , having zero market

n
share and a probability (1 ) it produces 1 , gaining market share:
2

n
Second period profit (0) (1 )( ) T
2

n
(1 ) T
2

2 1 1 1
Both periods profit: M EH n n 2T
2 2 2

Under the condition:

1 1 1
2
M EH n n 2T 0
2 2 2
4T 1
2
n

H HE : h profit when m exports and entry from h:

122
 n 1
First period profit G F
2

The second period, there is a probability that m produces 2 , consequently h will

gain all the market n. There is a probability (1 ) m produces 1 , consequently h will

n
gain market share:
2

n
Second period profit (n) (1 )( ) G
2

n n
n G
2 2

2 1 n 1
Both periods profit: H HE n 2G F
2 2 2

Under the condition:

1 n 1
2
H HE n 2G F 0
2 2 2
2(2G F ) 1
2
n

Solving for subgame equilibrium, consider market size n as given and take into account

4T 1
various values of . If 2 , m will export whatever is h decision. Aware of
n

2(2G F ) 1
m dominant strategy, h will enter while m is exporting only if 2 . In
n

order the profile (export, entry) becomes equilibrium, the condition

123
2(2G F ) 1 4T 1
2 2 must be satisfied. Consider different values of
n n

2(2G F ) 1
2:
n

If

2(2G F ) 1 4T 1
2 2
n n
1
n G T (1 F )
2

In this case, the market size can cover the costs of the exporter and of the local entrant.

There will be then export and entry at equilibrium in the area

2(2G F ) 1 4T 1 2(2G F ) 1
2 2 , while only exports where 2 and
n n n

4T 1
only a local monopolist where 2 .
n

If

4T 1 2(2G F ) 1
2 2 2n 2T 1 , there will be only exports without entry in
n n

2(2G F ) 1
the area 2 , while there will only be a local monopolist in the area
n

2(2G F ) 1
2.
n

124
If

2(2G F ) 1
2 2n 2T 1 , there will be only exports without entry in the area
n

2n 2T 1 , while there will only be a local monopolist in the area

2(2G F ) 1
2.
n

The equilibrium in all cases, depending on variables value, would be a strict Nash

equilibrium, reflecting the best response of both players. In order to have more useful

insights, while keeping generality, suppose the game is repeated.

In case the game is repeated for a third period:

We are in a sector where in each period producer(s) introduces a new technology to the

market. Wesson (1999) explains that in an industry like personal computers for

example, technology is constantly changing in a way that, in each period consumers

might have to choose over a different set of products; since new products are introduced

using new technologies and old products are dropped from manufacturers product line.

This assumption is consistent with todays reduced life cycle of products in high

technology industries.

FDI and entry decisions induce high fixed costs; therefore, they are considered as

irreversible decisions (Smith, 1987). As for export and no entry they are possibly

reversible and revocable decisions in the third period.

If the profile strategy chosen at the first stage is (FDI, entry) no change is expected in

the next periods:

125
 n
m profit in the third period: G
2

3 1 3n 1
For the three periods: M MH 3G
3 2 2

Under the condition:

1 3n 1
3
M MH 3G 0
3 2 2
1
n 2G
3

n
h profit in the third period: G
2

1 3n 1
For the three periods: H 3HM 3G F
3 2 2

Under the condition:

1 3n 1
H 3HM 3G F 0
3 2 2
2 1
n 2G F
3 3

If the first stage result was (FDI, no entry), then the local potential rival may change

strategy15 in the third period and decides to enter:

n
In this case h profit in the third period would be: H (3H ) M G F
2

Under condition:

n
G F 0
H (3H ) M
2
n 2(G F )

15
To distinguish in notation the strategy that might be reversed, it will be put between brackets in profit
notation.
126
h will switch its strategy and enter, if the market size for the new technology promises

to cover entry costs.

n
In case h enters the market m profit in the third period: G
2

1 5
For the three periods: M M3 ( H ) n 3G 1
3 2

While if h stays out of the market m profit in the third period: n G

1
For the three periods: M M3 3n 3G 1
3

M M3 M 3M ( H ) ; therefore, the foreign investor would be benefiting from continuously

augmenting his firm-specific assets (F), in order to delay his local competitors entry.

If the first stage has resulted into (export, entry), then m may decide to switch its

strategy in the third period to FDI. This will yield a result of (FDI, entry). In this case:

n
h profit in the third period in case (export, entry) shift into (FDI, entry): G
2

1 3 n 1
For the three periods: H 3H ( M ) n 3G F
3 2 2 2

n
While m profit in the third period: G
2

1 3 1 1
For the three periods: M (3M ) H n n 2T G
3 2 2 2

n n
But, if m doesnt change its strategy, its third period profit T
2 2

3 1 3 1
Its profit for the three periods would be M EH n n 3T
3 2 2

127
Therefore, m would switch to (FDI, entry) profile if:

1 3 1 1 1 3 1
M (3M ) H n n 2T G M EH
3
n n 3T
3 2 2 2 3 2 2
2(G T )

n

m will switch to FDI, the higher the radicalness of the new technology and/or the higher

the difference in the use environment concerning the new technology between the home

and the host country. Besides, the lower are FDI costs relative to export costs and to

market size.

If the profile strategy chosen in the first stage was (export, no entry), then one of the

players or both may decide to switch strategy in the third period. There are four possible

profiles of strategies divided into two main subgames. The first subgame is under entry

scenario, where there are two possible profiles of strategies; (export, entry) or (FDI,

entry). The second subgame is under no entry scenario, where there are two possible

profiles of strategies; (export, no entry) or (FDI, no entry).

First subgame under entry scenario:

Case 1: (export, entry):

n n
h profit in the third period: H (3H ) E n G F
2 2

Under condition:

128
 n n
n G F 0
H (3H ) E
2 2
GF
1
0.5n

h will enter the higher the probability of misspecification for the exporter and the lower

is the cost of entry relative to market size.

n n
m profit for the third period T
2 2

1 5n n
For the three periods: M E3( H ) 3T 1
3 2 2

Case 2: (FDI, entry):

n
h profit: H (3HM ) G F
2

Under condition:

n
G F 0
H (3HM )
2
n 2(G F )

If the market size promises to cover entry costs, h will enter.

n
m profit in the third period: G
2

1 5n
For the three periods: M (3MH ) 2T G 1
3 2

129
In order FDI becomes a subgame equilibrium, there must be:

1 5n 1 5n n
M (3MH ) 2T G 1 M E3 ( H ) 3T 1
3 2 3 2 2
2
(G T )
n

The higher is the probability of misspecification and the lower are FDI costs relative to

export costs and to the market size.

Second subgame under no entry scenario:

Case 1: (export, no entry):

m profit in the third period: n T

1
For the three periods: M E3 3n 2 3T 1
3

Case 2: (FDI, no entry):

m profit in the third period: n G

1
For the three periods: M (3M ) 3n 2T G 1
3

Therefore, in order FDI becomes a subgame equilibrium there must be:

1 1
3n 2T G 1 M E3 3n 2 3T 1
M (3M )
3 3
G T

The higher is the probability of misspecification and the lower are FDI costs relative to

export costs.

130
To sum up, FDI would be a subgame perfect equilibrium16, the lower are FDI costs

relative to export costs and to the market size. Besides, the higher is the probability of

misspecification due to the radicalness of the technology and/or to the particularity of its

use environment in the host country relative to the home country.

FDI sets a barrier to local entry the higher are the MNEs specific assets. Those assets

allow scale economies for the foreign investor, while they increase the costs of entry for

competitors. This effect can be lessened by the increase in market size; this is because,

when market size increases, the local potential rival will be able to recoup his entry

costs.

In order to simplify the model, it was assumed that the lead users current needs

represent the future needs of the market in its totality. To attenuate the effect of this

assumption, the expected expansion in the market was limited to the lead user himself,

setting D0 n 1 . If market expansion was not set to 1, then results would have yield

that, FDI would increase the higher the risk of misspecification i.e. the higher the

market share gained through supplying 1 (set here to 1) and the higher the probability

of product misspecification . The degree of generality of lead users needs will be

introduced in the next chapters model.

Conclusion

The chapter has developed a model where a foreign producer, facing uncertainty

regarding new product acceptance in the host country, shall decide whether to export or

to conduct FDI. This uncertainty is associated with information asymmetry, favouring

16
A strategy profile is a subgame perfect equilibrium if it is a Nash equilibrium of every subgame of the
considered game (Fudenberg and Tirole, 1991).

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local producers who can learn about lead users advanced needs. In case lead users

needs are general, the model proposes then, that all other things equal, in a technology

push innovation, FDI increases the higher the probability of product misspecification

relative to the host countrys needs. The probability of misspecification increases in the

radicalness of the new technology and in the difference in the use environment between

the home and the host country concerning this technology.

Within literature on FDI under demand uncertainty, those findings are consistent with

Markusen (1995) and Moner-Colonques et al. (2007), where FDI increases when there

is an asymmetry of information regarding demand between a producer in the host

country and an exporter. The model presented here differs from previous literature. This

is because; it explains demand uncertainty by the difference in the use environment

between the home and the host country, inducing a difference in needs and a probability

of product misspecification. Besides, unlike Ethier and Markusen (1996), new product

introduction success is not guaranteed. This is especially, when the new product

incorporates a radical technology. In addition, the model gives the demand itself an

active role in reducing uncertainty through lead users. So it goes beyond uncertainty to

search for the agent who might resolve it. Wesson (1999) gives demand an active role;

however, his model studies the effect of FDI in a lead market on reducing uncertainty

regarding demand in the home country, without considering demand uncertainty

concerning the host market.

The model considers only one potential local and foreign producer. On one hand, if the

number of local firms increases, unlike in Moner-Colonques et al. (2007), it is not

expected that the information advantage dissipates. This is because; the model presented

here, following internalization hypothesis, assumes that the foreign investor benefits
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from a specific asset that advantage him relative to local rivals. On the other hand, like

Moner-Colonques et al. (2007), if the number of foreign investors increases, the

beneficial effect of the information generated by lead users persists in comparison with

exports.

The chapters findings imply that, in a technology push innovation, a risk aversion

foreign producer may undertake FDI to access the information generated by lead users.

This is especially when the difference in the use environment between the home and the

host country is significant and when the innovation is radical. The interaction between

producers and users can turn a technology push innovation into also a demand driven

one, increasing then its chances of success.

In this chapter, one potential output of lead users was modelled; it is their advanced

needs. Lead users needs were within the product space defined by the producer, and

lead users oriented the producer choice. What if lead users needs were outside the well

known solution space? The next chapter models the second potential output of lead

users; it is their innovation.

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 CHAPTER IV

FDI: THE INFLUENCE OF INNOVATOR LEAD USERS

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Introduction

Users innovate to satisfy their needs. This is because; manufacturers usually standardize

their production, while users needs are heterogeneous. Innovation history witnesses the

importance of users contribution to innovation (Enos, 1962; Freeman, 1968; Pavitt,

1984; von Hippel, 1988; von Hippel, 2005). Nowadays, thanks to the new technologies,

users are having access to design tools (von Hippel, 2005), which enable them to

concretize their innovations easier and cheaper. However, like it was highlighted in

chapter one, literature on asset seeking FDI, aiming to access the host countrys

innovation and technological capabilities (Kogut and Chang, 1991; Cantwell and

Santangelo, 1999; Kuemmerle, 1999; Serapio and Dalton, 1999; Frost and Zhou, 2000;

Cantwell et al., 2004), ignores the identification of the role of users, unless few

exceptions (Ivarsson and Jonsson, 2003; Ernst, 2005).

Innovation is not a characteristic of lead users, but an outcome. Lead users, who

anticipate a benefit from getting a solution to their needs, are expected to innovate. The

higher this anticipated benefit, the higher the resources lead users employ in their

innovation process (von Hippel, 1986). In addition, since lead users needs are situated

at the leading edge of the market place, which is an uncertain small area of the market,

then supply response to those needs is of low probability. That is why, at this forefront

leading edge, lead users innovation likelihood is high (Franke et al., 2006).

The first objective of this chapter is to show that lead users innovations impact

producers differently relative to competitors innovations; therefore, they require

distinct analysis. The previous chapter formalized the effect of lead users advanced

needs on FDI decision. The second objective of this chapter is to formalize the influence

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of the second output of lead users, which is their innovation. Besides, it formalizes

foreign investors response to a demand driven innovation whether to develop it or not.

The chapter is structured as follows; the first section presents lead users as a source of

innovation spillover. The second section clarifies the resources on which lead users rely

in their innovation process. The third section discusses the cost of accessing lead users

innovations. The fourth section explains the particularities of the impact of users

innovations on manufacturers in comparison with competitors innovations. Finally, the

fifth section is a game theoretic model, exploring the influence of lead users

innovations on foreign producers decisions.

4.1. Lead users: a potential source of innovation spillover

Innovation is crucial for firms survival. According to Hitt et al. (1998), the world

economy is experiencing a new competitive landscape, driven by technological

developments and globalization. This new competitive landscape is characterized by

hyper competition, emphasize on price, quality, satisfaction of customer needs and

increasing focus on innovation. The time framework of all strategic actions is being

reduced. Firms exist in highly turbulent and chaotic environments. Those elements have

led to reduced life cycle for products and patents have become less efficient in

protecting new technologies. In this context, continuous innovation is necessary in order

firms remain competitive.

4.1.1. The MNE exploits and generates innovation globally

The relation between the MNEs innovation capabilities and FDI is two sided. On one

hand, firms need to invest in R&D in order to remain competitive and to open new

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markets to recoup their fixed costs before their products become redundant (Dunning

and Narula, 2000). On the other hand, FDI allows the MNE exposure to diversified

distinctive technological experiences. Consequently, the MNE augments its competitive

advantage by making its own technological experience more complicated. This rich

exposure helps reduce uncertainty for the MNE while increasing it for competitors,

since it makes imitation more difficult for them (Hitt et al., 1998). Innovation is firm-

specific and location-specific; the scientific and technological history, the shared

experience between actors, the education system, the business practices, all those factors

make each location distinctive (Nelson, 1993). Moreover, adapting the MNEs

technology to the host countrys conditions creates new ideas. Those new ideas feed

back home, further developing the entire system and enhancing the MNEs innovation

capabilities (Cantwell, 1989).

According to Archibugi and Michie (1995, 1997a), there are three categories of

globalization of innovation. First, innovators try to exploit internationally the innovation

created in domestic markets. International markets create opportunities to expand

product life cycle and to earn greater returns on innovation. Second, global

technological collaborations, when two (or more) different firms decide to establish a

joint venture, in order to develop technical knowledge and/or products. Third, global

generation of innovation, this category is only realised by MNEs. Bartlett and Ghoshal

(1990) explain that, in this last category there are three main strategies for MNEs.

The first strategy is called center for global; the MNE concentrates technological

activities in headquarter and when some R&D is undertaken abroad, it is mainly to

adapt products to the needs of local users. The second is local for local; each

subsidiary develops technological know how to serve local needs. In this context,
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interaction between subsidiaries is weak, but they are integrated into the local industry.

The third one is local for global; R&D is distributed in various host locations. The

innovation process is distributed among the most convenient locations.

The MNE is an organisation generating innovation globally. Lead users make part of

the sources of innovation in the host market. They can play a role in enhancing the

MNEs competitiveness.

4.1.2. Lead users: successful innovators

In Forary (2004)s opinion, users are at the center of knowledge production. Therefore,

one of the main challenges for managers is to capture the knowledge being created by

users and to integrate it in the knowledge created in the laboratories. Manufacturers

have the advantage of established distribution channels, brands and established

producing facilities (Baldwin et al., 2006). They tend to know more about solution

possibilities and most effective production technology. As for users, they tend to know

more about their particular needs and their particular use environment (Franke and von

Hippel, 2003).

Users innovations are concentrated among lead users, whose innovations have proved

their novelty and commercial success. Urban and von Hippel (1988) apply lead user

method on PC-CAD. Among respondent user-firms, 23% have developed their own in-

house PC-CAD, employing substantial resources. A sample of the lead user group

joined a creative group to develop improved PC-CAD. Olson and Bakke (2001) apply

lead user method in Cinet company, two new products were developed, 78% and 73%

respectively of the software and hardware products developments where based on lead

users ideas. In Lilien et al. (2002), in a natural experiment at 3 M, their comparison

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shows that products concepts developed based on lead users ideas are significantly

more novel and are strategically more important. Lthje and Herstatt (2004) study

HILTI, the leading manufacturer of fastening systems for the construction industry,

which has begun applying lead user method since 1980s in the pipe hangers field

(water, air conditioning, sanitary) and air duct in buildings. They also apply lead user

method at Johnson and Johnson (J&J) in the division of surgical hygiene products. At

HILTI, an innovative concept for a fastening system was generated through the lead

user workshop and was patented shortly. The new developed products have become a

main production line in HILTI. The application of lead user method at J&J has helped

formulate four complete and detailed concepts. Some of the new products ideas were

totally new for J&J and for competitors.

Moreover, empirical findings prove the correlation between lead users characteristics

and innovation. Morrison et al. (2000) find that 26% of users do modify OPAC in order

to meet their needs, and some of users innovations were novel. The study shows that

innovator users are distinguished by their leading edge status and their high in-house

technical capability related to the field. Franke and Shah (2003), studying four sports

communities, find that innovator users have lead users characteristics which

differentiate them from no-innovator users. Lthje (2004) surveys a sample of users of

outdoor-related consumer products in Germany. The results show that innovator

consumers are distinguished by the benefit they expect from using their innovations and

by their level of expertise of product use. Morrison et al. (2004) prove high correlation

between the actual development of innovations and the two characteristics of lead users.

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The question now is what distinguishes users as innovators? The following sections will

be answering this question. The next section is concerned with the resources on which

users rely in their innovation process.

4.2. The resources on which users rely in their innovation process

The accessible resources for the user and for his community impact the probability that

the user will invent and the commercial usefulness of his innovation (Franke et al.,

2006; Morrison et al., 2000; Lthje et al., 2002; Franke and Shah, 2003). Lthje et al.

(2005) study innovations developed by mountain bikers and show that a significant

percentage of the questioned sample has developed new or improved equipment. The

majority of users who developed prototypes already had the technical knowledge

required for their innovation. Only 15.6% of innovator users acquired new knowledge

for the development of their solution. Innovator users are found to rely on their local

information in determining the needs and solutions, because it is less costly.

4.2.1 Information stickiness

The transfer of information from manufacturer to users and vice versa is costly due to

information stickiness. The stickiness of a unit of information is defined as the

incremental expenditure required to transfer that unit of information to a specified

location in a form usable by a specified information seeker (von Hippel, 1994). Polanyi

(1958) noted that many human skills are tacit -lack explicit encoding-, the skilled

person is usually unaware of the rules he is following and whoever wants to acquire the

skill must observe him. This makes the transfer of knowledge costly, because it cant be

prescribed and can only be acquired through apprenticeship, through giving the example

from the master to the apprentice (Hippel, 2005). Information stickiness depends as well
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on the absorptive capacity of the receiver, whether it is a firm or an individual. The

capacity to absorb new outside technical information depends to a large extent on the

previous knowledge the recipient has already accumulated related to this information

(Cohen and Levinthal, 1990). Total information stickiness, related to solving a specific

problem, is also determined by the amount of information needed by a problem solver.

As a result, each innovator would depend in his innovation process on the information

he already has, because this is the cheapest way. Users will rely on their knowledge

about their needs and use context, and manufacturers will rely on their knowledge about

the types of solutions in which they are specialized (Arora and Gambardella, 1994; von

Hippel, 1994). Among the resources available for the innovator user is his community

of users.

4.2.2 The role of users communities

Users communities can be a factor fostering users innovation. Users communities are

engaged in innovation when there are users who have incentives to innovate, who

perceive a benefit in revealing their innovations, and finally when user-led diffusion of

innovations can compete with commercial production (von Hippel, 2001). Users

communities can play a role in reducing the cost of revealing innovation. This is

because; they help exclude the cost of diffusion of the innovation, since it will be

diffused within the community itself and its network. Besides, participants benefit from

the externalities of each other, which help avoid error repetition in the innovation

process (von Hippel, 2001).

Franke et al. (2006), examining kite-surfing communities, find that, the available

resources for the user and for his community influence the probability he will invent
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and the attractiveness of his innovation. This is because; the innovator relies on the

communitys internal resources (technical capabilities, degree of support from top

management or from a community of peers, time constraint, funds for testing and

refining the innovation). Shah (2000) and Franke and Shah (2003), analyzing sport

communities, find that, innovators receive information and assistance from their user

community members, whether directly or through individuals they know outside the

community. Besides, innovations are shared freely within the community. Franke and

Shah (2003) show that assistance and free reveal decrease with increased competition in

the community. The motivation behind assistance is not monetary, rather it was found to

be having fun, and conforming to the social norm of the community. However, the

authors note that assistance is a necessary but not a sufficient condition for innovation

diffusion, since it cant turn an originally poor idea into a breakthrough innovation.

4.2.3. Unsticking the information

Although the cost of information transfer from manufacturers to users and vice versa is

high, it is argued here that producers shall search for direct interaction with lead users.

This is to help producers better address their users needs in order to remain

competitive. Market research is by definition seeking to define users needs not their

eventual solutions to satisfy those needs. Since users are the best placed to define what

they want, this shortage in market research entails a wasted chance for manufacturers to

better understand their customers and to develop or commercialize users innovated

solutions (von Hippel, 2005). Therefore, enlarging market researchers task to include

searching for users innovations can be advantageous for firms. It is also advantageous

to develop direct channels of communication between innovators in the laboratories and

innovators in the real environment and their communities.

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Firms may benefit from providing users with toolkits to innovate and to customize

products (Franke and von Hippel, 2003). Toolkits for user innovation are coordinated

sets of user-friendly design tools that enable users to develop new product innovations

for themselves via iterative trial and error users can create a preliminary design,

simulate or prototype it, evaluate its functioning in their own use environment, and then

iteratively improve it until satisfied (von Hippel and Katz, 2002). The higher the

heterogeneity of users needs faced by the manufacturer, the higher the incentive for

manufactures to unstick the information and to transfer it to users in the form of toolkits

(von Hippel and Katz, 2002). It is now becoming cheaper to design and produce to

satisfy users heterogeneous needs. However, Franke and von Hippel (2003) point that,

if market analysis proves that users needs are highly heterogeneous, a toolkit approach

can be more efficient than an approach aiming to satisfy the maximum of those needs.

Franke and von Hippel (2003) study Apache web server software, an open software

whose design allows free users modifications. The paper finds that many users were

not satisfied by the existing standard Apache software offerings. Users were willing to

pay a considerable amount to have their needs met. The users with high technical skills

were able to modify the product. The paper shows that low skilled users share to a

certain extent high skilled users needs. Consequently, in case high skilled users

innovations are freely revealed, low skilled users can benefit from them. Therefore, the

paper concludes that, even if the percentage of users who might use toolkits is small,

manufacturers might find it beneficial to implement toolkit approach.

However, users positive response to toolkit approach depends on users cost analysis,

which takes into consideration the ease of use of the toolkit and the cost of designing

and implementing modifications (Franke and von Hippel, 2003). Moreover, the issue of
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intellectual property rights needs to be addressed before users involvement in the

innovation process. On one hand, users will be investing in their innovation; therefore,

their cooperation with manufacturers will depend on their cost benefit analysis of their

participation. Users, especially manufacturer ones, might prefer to keep their innovation

a secret (Lthje and Herstatt, 2004). On the other hand, manufacturers might find it

profitable to put mechanisms to ensure their property rights. This is for example by

giving the original producer exclusive rights on the users modified version for a certain

period of time. The coming section clarifies the cost of accessing users innovations.

4.3. The cost of accessing users innovations

Innovators have a choice between keeping their innovation a secret, freely revealing it

or licensing it. On one hand, keeping an innovation a secret is not effective, this is

because, the innovation is based on an information that other innovators might have a

substitute for. Consequently, the innovator who finds revealing costless or a source of

gain will be revealing despite others willingness to keep the secret (Harhoff et al.,

2003). Mansfield (1985) shows that, on 100 studied American firms, information about

development decisions reaches rivals between 12-18 months, and the detailed

information concerning new products or process reaches them within a year. On the

other hand, literature shows that license and copyrights are not effective in protecting

innovations, unless some exceptions. Acquiring a patent is costly and copyrights protect

the innovator but dont protect the innovation itself. For example, a software can

acquire a copyright, but it can be imitated under another name with the same

functionalities (Harhoff et al., 2003).

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4.3.1. Users benefits from freely revealing their innovations

Hence, remains the option of free revealing. Harhoff et al. (2003) explain that when the

innovator freely reveal proprietary information, all intellectual property rights related

to this information are voluntarily given up by that innovator and all parties are given

equal access to it. The information becomes then a public good. For example, putting it

on a website or publishing it in a journal. However, this doesnt exclude the possibility

that the recipient of the information pays another cost. The recipient may pay to

subscribe in the journal, to travel to access the information (to establish a foreign

subsidiary, like will be the case in the model developed later) or to acquire additional

costly information to be able to exploit the targeted information. As long as the

innovator does not profit from any such expenditures, the information incorporated in

the innovation is itself freely revealed. Harhoff et al. (2003) acknowledge that this

definition is extreme, since revealing with small constraints would largely achieve the

same economic effect.

Free revealing can provide the innovator with many potential benefits. The innovator

can gain a reputation or a higher evaluation on the labor market. He can gain from

improvements and feedback from other users, increasing then his satisfaction from the

innovation in question. He can gain from a producers decision to manufacture the

innovation. Consequently, the innovator will procure his innovation in perhaps better

material and at lower cost. The innovator may be rewarded by the joy of creativity

and/or the honor of participating into an innovation project, and/or by obtaining the

developed product earlier than others (Lthje and Herstatt, 2004). When the benefits of

free revealing exceed the benefits of keeping an innovation a secret or licensing it, a

profit seeking firm or individual will choose to freely reveal (Harhoff et al., 2003).
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4.3.2. Users freely reveal their innovations: theoretical and empirical findings

Harhoff et al. (2003) develop a game theoretic model of two potential innovator user-

firms. The model assesses when voluntary free revealing to manufacturer firm would be

profitable and when it is more profitable for innovator users to hide information about

their proprietary innovations. The manufacturer firm shall then decide whether to

improve the innovation and to supply it to both user-firms or not. The model assumes

that free revealing the innovation to one manufacturer implies revealing it to the world,

there is no exclusivity. For simplicity, Harhoff et al. (2003) dont include some

variables when calculating users payoffs. For example, the benefits generated from the

community related to free revealing, the enhancement of the physical or reputational

assets of the user-firm due to the complementarities with the innovation, and the cost of

maintaining the innovation a secret or of diffusing it in case of revealing, are not

represented in the model.

The model incorporates four variables that influence the user-firm decision. The first

variable is the intensity of competition among user-firms (), where 0<<1. The

increase in the payoff of one user-firm entails loss for the other, the higher is

competition. The second is the degree to which the innovation has a bias favouring the

innovator user (), where 0<<1. When the technology is completely specific to the

innovator user =0. When the technology is completely general and benefiting all users

equally =1. The third is the degree of improvement or cost reduction due to

manufacturers involvement (). The innovator user value the innovation, after the

improvements made by manufacturer, higher by (1+) than the original innovation.

Finally, the fourth variable is the cost of adopting the improved commercial product (c)

(price or switching costs) for each user.

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On one hand, the undisclosed innovation yields an increment in present discounted

profits to the innovator user. On the other hand, revealing implies disadvantages; the

revealed information will be available to all. All other users will benefit equally from

the improved lower cost version supplied by the manufacturer. This is because; the

manufacturer will improve the innovation only if it can be sold to other users. The

innovator users profit from the improved version is then = (1+ ) with 0. When

the innovator users competitors adopt the innovation, the innovator payoff is - -c,

while the other users payoff is --c, where c is the respective users cost of

adoption. The innovator user will reveal when c/; the higher the value of the

improved version relative to the original one, and the lower the cost of adoption relative

to the original version value. While the other users will adopt when >c/. The model

assumes voluntary information spillover without monetary compensation, which

increases welfare.

Real cases show that users do freely reveal their innovations. In open source software,

users reveal the code of their software and allow other users to use it. The server

software Apache, its original code was posted on the web and received modifications

and developments from users, nowadays it competes with Microsoft and Netscape (von

Hippel, 2001). Morrison et al. (2000), in their study of OPAC, find that users share

information about their modifications. In De Jong and von Hippel (2009), a survey of

high technology Small and Medium Enterprises (SMEs) in the Netherlands shows that,

54% of these firms developed or modified new process equipment or software for their

in-house use, baring significant private expenses. Out of those users innovations, 25%

were transferred to producer firms to be commercialised of which 48% were transferred

for free, especially for the suppliers with whom innovators already had a relationship.

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If lead users might freely reveal their innovations, what is the effect users innovations

generate on the manufacturer in comparison with the effect of competitors innovations?

The following section will be devoted to this question.

4.4. The interactions between lead users innovations and manufacturers

Lead users innovations can enhance welfare (von Hippel, 2005). Social welfare here

concerns total income and not income distribution. This is because, having advanced

needs and benefiting from a real life experiment, lead users can play a role in better

adapting the supply for demand needs. Besides, they might freely reveal their

innovations (Harhoff et al., 2003) and they are not competing with manufacturers in the

short term (von Hippel, 2005). Moreover, the thesis claims that lead users can play a

role in attracting asset seeking FDI, which may generate spillover effects.

The interaction between innovator users and manufacturers has its particularities. What

kind of pressure users innovations exercise on manufacturers? How their innovations

become commercialized? What is the potential that producers benefit from users

innovations spillover? This section aims to answer those questions.

4.4.1. Lead users innovations magnify their markets future needs

The thesis highlights the pressure lead users may exercise on manufacturers to respond

to local needs. Lead users innovations concretize the future market emerging demand.

This might push supply to innovate, in order to respond to those needs, materializing

then lead users innovated idea or enhancing their innovated prototype. Morrison et al.

(2000), in their research on OPACs users innovations, find that producers incorporated

lead users ideas in their products. Interestingly, producers said that they already knew

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about lead users needs and only 10-22% of lead users innovations constituted new

information. This shows that, sometimes manufacturers do know lead users needs but

dont find it profitable to develop solutions for an emerging need until several years

later. Observing the degree of success of lead users innovations between other users

can give manufacturers information about the potential size of the market for this

innovation (von Hippel, 2005).

Users innovations in short term are not substitutes for manufacturers products, rather

complements (von Hippel, 2005). This is because; they are at the leading edge of the

market, where potential sales are small and uncertain, while manufacturers prefer to

serve large more certain markets. In the long term, the market catches up the needs that

motivated users innovations and manufacturers begin to find production of similar

products commercially attractive.

Consequently, the thesis argues that proximity to innovator users exercises a different

kind of pressure on manufacturers to innovate in comparison with proximity to

innovator competitors. Competitors exercise pressure by supplying potential

substituting products. Lead users can exercise pressure through freely revealing their

innovations, magnifying then the market future needs and opening a new segment, the

higher is the generality of their innovation and the knowledge it incorporates. This is the

hypothesis tested in the next section.

But, how valuable users innovations become commercial products and what is the role

of manufacturers in the process?

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4.4.2. How users innovations become commercial products

To understand how users innovations become commercial products, Baldwin et al.

(2006) apply to the case of Rodeo kayaking, which is both a sport and an industry. They

find that users innovations are transformed into commercial products as follow; first,

one or more users recognize a new set of design possibilities and begin to innovate.

Second, they join communities motivated by the increased efficiency of collective

innovation. Some users begin to manufacture using high-variable/low-capital cost

production methods. When innovator users make copies of their innovations and sell

them to other users, they become user manufacturers. User manufacturers have the

advantage of knowing users needs and might benefit from free assistance of their users

community. With time, the nature and the size of market demand becomes clearer. If the

market promises high potential, then manufacturers may enter using high-capital/low-

variable cost production methods and/or user-founded firms may increase in size and

capacity.

Users can develop and market their information products on the web without

manufacturers involvement (Kollock, 1999). As for physical products, while first units

can be developed and diffused without manufacturers support, mass production

involves activities of significant economies of scale that requires manufacturers

intervention.

von Hippel (2005) suggests three ways by which manufacturers can play a role in user-

centered innovation. First, manufacturers may produce users innovations for general

commercial sale and/or offer a custom manufacturing service to specific users. Second,

manufacturers may sell kits of product design tools and/or product platforms to make

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users innovation process easier. Third, manufacturers may sell products or services

which complement users developed innovations.

In some cases, manufacturers might not be interested in users innovations. However, it

is worth reminding that, with recent developments in the world economy context, driven

by technological progress which democratized innovation (von Hippel, 2005); users

innovations are getting increased attention. But, what is particular about spillover

effects of users innovations?

4.4.3. The particularity of the externalities generated by users innovations

Some research finds that spillover effects increase with proximity. Verspagen and

Schoenmakers (2000) investigate a sample of European MNEs patents geographical

distribution. They find that, between firms and within firms, citations occur between

units located relatively near each other. Geographical distance makes the transfer and

the absorption of tacit knowledge difficult (Jaffe, 1989; Feldman, 1994; Canils, 2000).

In Rallet and Torre (2005), the authors distinguish between geographical proximity and

organized proximity. Geographical proximity is concerned with the physical space

between actors, while organized proximity is concerned with the belonging to the same

organization, implying complicity between agents. The authors emphasize that,

geographical proximity on its own is not enough to generate synergies. In order actors

interact together, geographic proximity needs to be activated by organized proximity. In

some cases, through organized proximity and NICTs, the transfer of tacit knowledge

can be realized without face to face interaction.

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However, Rallet and Torre (2005) explain that face to face interaction, in order to share

tacit knowledge, remains essential in two situations. First, when actors having different

reasoning modes and different knowledge base start an innovative project; second to

manage conflicts between innovators and for negotiation purposes.

FDI, implying direct interaction, is necessary in order the foreign producer benefits

from users innovations spillover. This is because; lead users and producers have

different objectives with different reasoning, different background and knowledge.

Therefore, direct interaction is needed in order to access the information generated by

lead users.

Another particularity concerning users innovations in comparison with competitors

innovations is concerned with the probability of spillover occurrence. Fosfuri and Motta

(1999) develop a game theoretic model, where firms might conduct technology

acquisition FDI in a leading firms country. The efficient technology is represented by

a lower cost of production. Even when export costs are zero and when the technological

follower doesnt have an advantage in comparison with the leader, FDI may occur to

benefit from technology spillovers. However, in Fosfuri and Motta (1999) model,

technology spillovers are uncertain, and their occurrence is associated with a

probability. Like it was explained in chapter one, in order the MNE benefits from

spillover effects from the host country, there must be no barriers set by local

competitors (Pugel et al., 1996). Besides, the investing firm must possess the necessary

absorptive capacity (Makino et al., 2002).

It is argued here that, in case the foreign investor is seeking access to users innovations,

the probability of spillover might be higher. This is because of the expected free

152
revealing of users innovations, when free revealing benefits exceed its costs (Harhoff et

al., 2003) as it was explained in the previous section. Besides, usually users are not

competing with manufacturers. The question of barrier to entry set by the innovator user

becomes a concern in case the user becomes a manufacturer user. Moreover, the

knowledge generated by innovator users may be absorbed easier by the manufacturer

than the knowledge generated by competitors. This is because; the manufacturer firm

has the advantage of specialisation and of understanding of the technology underlying

the product better than users. But, like it was explained in chapter two, Olson and Bakke

(2001)s findings point to the difficulty users encounter in translating their ideas into a

language understandable by the technical staff of the firm. This difficulty may inhibit

the absorption process.

Lead users are self motivated innovators, who are best positioned to predict the needs of

other users and who might find it profitable to freely reveal their innovations. Investors

should be hunting them, especially foreign investors who face a higher level of

uncertainty in comparison with local ones. The next section models the impact of lead

users decision to reveal versus not reveal their innovation on the foreign producers

decision to conduct FDI versus to export and then, on the foreign investors decision

whether to develop or not lead users innovation.

4.5. The impact of lead users innovation on foreign producers decisions: game

theoretic model

This section presents a sequential move game of perfect and complete information. It is

a finite game of two periods and then, the possibility of repetition is considered. Figure

(4.1) shows the extensive form of the game:

153
Figure 4.1. Game structure

FDI Export

m m

0 0

L L

Innovate 1 Innovate 1

L L

Reveal No reveal Reveal No reveal

m m m m

1 0 0 0 0

All things being equal, an international economy where there are two countries M and

H. We are in a fast moving sector with a high rate of innovation. Like Harhoff et al.

(2003), the model fits with innovator users in the copper-interconnections, clinical

chemistry analyzers, and ICTs. In those fields, innovations were freely revealed by

users and then were adopted by manufacturers who commercialized them, making them

available for all users.

154
M has one firm in the industry in question (m) and H has n user-firms of the industry in

question, among which L an innovator lead user, n 1 . The model is concerned with

user-firms, although it can be applied to consumers with some modifications. The

possibility that a firm from H operates in M is excluded17. Besides, operations of m in H

dont impact its operations in M18. Consequently only profits realised in H will be

considered.

First period, first stage, L does nothing, while m has to decide whether to export or to

conduct FDI to access Hs market. For the time being, ms decision holds for all the

periods of the game. In the second stage, m produces 0 . The third stage, the lead user L

innovates 1 , a new concept based on 0 . Lead users innovation ranges from an idea to

a full prototype. The fourth stage, L shall decide whether to freely reveal or not its

innovation. Users sometimes find it profitable to reveal their innovations (Harhoff et al.,

2003; De Jong and von Hippel, 2009).

The previous model in chapter three supposed producers already knew lead users based

innovation; it was within the well known solution space. In this model, it is supposed

that the new applications innovated by the lead user are not within the set of product

characteristics defined by the firm.

Consider first, the case if in the first period m has undertaken FDI and L has revealed

1 . In this case, in the second period, m has two choices; whether to continue producing

0 or to develop 1 solution, which is an improved version of 1 . It is assumed that

17
Following Smith (1987) model assumption.
18
Following Motta (1992) model assumption.
155
once a producer has introduced a product to the market, he cant change it within the

period19.

If m decides to produce 1 , it will support an extra fixed cost c in its totality, to develop

a commercial product 1 based on 1 . However, the firm m will gain a more diversified

innovation experience, increasing its competitive advantage, leading to long term cost

reduction. This spillover effect is reflected in an expected discounted per period profit ,

where is the value of lead user innovation 1 . It is assumed that the manufacturer and

the user value 1 similarly, according to the tacit knowledge it incorporates.

If m decides to continue produce 0 , in this case, it will not bear c and will still have

access to . Once L reveals 1 , all local manufacturers can benefit from the tacit

knowledge it incorporates. However, since Ls revealed innovation opens a new

segment in the market, m will risk a new entrant.

To account for the credibility of the threat of entry by a local competitor, let the

1
probability of entry be , where F is ms accumulated firm-specific assets, which
F

increase the cost of entry for its rivals, F 1 . It is assumed that players are risk neutral.

If F is at its minimum level of 1, then the probability of entry will be at its maximum of

1. If F is at its maximum level of infinity, then the probability of entry will be at its

minimum of zero.

The threat of entry is considered as a move by Nature after m decides whether to

produce 1 or not. This makes the game an uncertain one. To transform uncertainty into

19
Following Wesson (1999) model assumption.
156
a game of certainty, without changing the equilibrium, following Rasmusen (1989),

Nature move will be eliminated and replaced by the payoffs, taking into consideration

1
the probability of entry set by Nature.
F

The information about lead users innovation cannot be licensed. This can be explained

by the difficulties of contracting under asymmetric and incomplete information,

especially when the knowledge in question is tacit in nature and difficult to codify

(Wesson, 1999). This knowledge also cant be acquired through exporting to H.

Although the exporter conducts market research in order to adapt the product to the

importing countrys demand patterns, market research doesnt give full information

about local needs or local propositions for ultimate solutions (von Hippel, 2005).

Besides, lead users and manufacturers have different knowledge base and logic of

thinking, there is no organised proximity between them as defined by Rallet and Torre

(2005). Therefore, geographic proximity is necessary to access the knowledge created

by L. Only a direct interaction with the characteristics of lead users innovation, through

manufacturing subsidiary, enables accessing this tacit knowledge, due to the stickiness

of this kind of information (von Hippel, 1994, 2005). Therefore, if m has chosen to

export to H in t0 , it will continue produce 0 in the second period.

To determine Ls payoffs, the model refers to some of the variables of Harhoff et al.

(2003) model. It is assumed that is the value of 1 in present discounted profits to the

innovator lead user (in the context of consumers, can be thought of as the utility of

1 ). is the intensity of competition between user-firms; when the payoff of one firm

increases, the others decreases, the higher is competition, 0 1 (in the context of

consumers, may represent the extent of the persons individualism). The degree of
157
generality of the need for which lead users solution was developed is , where

0 1 . When the technology is completely specific to the innovator user, 0 ,

while when the technology is completely general and benefiting all users, 1 . The

degree of improvement of 1 due to manufacturers involvement (whether m or a new

entrant), transforming it into 1 , will be represented by , where 0 . The value of 1

to the innovator lead user is bigger by (1+ ) than the value of 1 . It is assumed that the

users will not pay an extra cost for 1 .

In order to give a meaning within the model presented here, can be regarded as an

increasing function in d, where d is the difference in the use environment between M

and H. In the previous chapters model, it was claimed that, the higher the difference in

the use environment d between the home and the host country, the higher the

probability that users in H will have different needs relative to users in M, implying a

probability of product misspecification by the foreign producer. In this chapter, the

implications of this difference are pushed further. The higher is d, the more the user will

be incited to innovate to compensate for this misspecification. Users innovation then

would be incorporating a solution to a general local particular need lacking in 0 . If the

use environment of both countries is close, then users innovation is expected to

respond to specific needs of the innovator. d is exogenously given in the model and

common knowledge for all players, 0 d 1 .

m on its turn is seeking to maximize its profits. Export costs and FDI costs are incurred

in every period. In case m exports it will bear an export cost T.

158
In case m chooses to FDI and to produce 0 , it will bear a cost G; a fixed cost of

establishing a foreign affiliate which incorporates the cost of plant set up and the cost of

applying lead user method. Besides, a constant marginal and variable cost taken as zero

without loss of generality (Motta, 1992). In case m chooses to FDI and to produce 1 , it

will bear an extra cost c to develop the new product 1 .

Price per unit for all products is equal one, without loss of generality. When there are

two producers supplying the same product, sales are divided between them. In the first

period, demand for 0 is D0 n . In the second period, first, demand for 1 is D1 n .

Second, demand for 0 in case 1 is not supplied by a competitor is D0 n . If a

potential local entrant decides to enter the market and produces 1 , demand for 0 in

this case will be D01 n n n(1 ) . This is because, the more the need

concretised by lead users innovation is general within 0 users, the less the adopters of

0 in the second period.

Both players aim to maximise their expected discounted profits. It is assumed that there

is no discounting of future cash flows. Below are presented payoffs and conditions

under which payoffs are feasible. Concerning m, it is the case when profits are bigger

than zero. Concerning L, it will reveal its innovation in case profit under revealing

exceeds profit under no revealing.

Let;

M EN : m profit when m exports, produces 0 , under no reveal from L:

First period profit: n T

159
Second period profit: n T

Both periods:

2 1
M EN 2 n 2T
2
2
M EN n T

Under condition:

2
M EN n T 0
T

n

LNE : L payoff when m exports, produces 0 , under no reveal from L:

First period profit:

Second period profit:

Both periods:

1
L2NE 2
2
L2NE

Under condition:

1
2 2
2 F F


(2 F )

M ER : m profit when m exports, produces 0 , while L reveals:

First period profit: n T

160
Second period profit:

1 1
(1 F ) n ( F ) n(1 ) T

n(1 ) T
F

2 1
Both periods: M ER n(2 ) 2T
2 F

Under condition:

2 1
M ER n(2 ) 2T 0
2 F
T
2 F (1 )
n

LRE : L payoff when m exports, produces 0 , while L reveals:

First period profit:

Second period profit:

1 1
(1 F ) ( F ) (1 ) (1 )

(1 )
F F

1
Both periods: L2RE 2 2
2 F F

Under condition:

1
2 2
2 F F


(2 F )
161
M MN : m profit when m conducts FDI, produces 0 , under no reveal from L:

First period profit: n G

Second period profit: n G

Both periods:

2 1
M MN 2 n 2G
2
2
M MN n G

Under condition:

2
M MN n G 0
G

n

LNM : L payoff when m conducts FDI, produces 0 , under no reveal from L:

First period profit:

Second period profit:

Both periods:

1
L2NM 2
2
L2NM

Under condition:

162
 1
2 2
2 F F


(2 F )

M MR 0 : m profit when m conducts FDI, produces 0 , while L reveals:

First period profit: n G

Second period profit:

1 1
(1 F ) n ( F ) n(1 ) G

n(1 ) G
F

2 1
Both periods: M MR 0 n (2 ) 2 2G
2 F

Under condition:

2 1
M MR 0 n(2 ) 2 2G 0
2 F
( G )
2 F (1 )
n

LRM 0 : L payoff when m conducts FDI, produces 0 , while L reveals:

First period profit:

Second period profit:

163
 1 1
(1 F ) ( F ) (1 ) (1 )

(1 )
F F

1
Both periods: L2RM 0 2 2
2 F F

Under condition:

1
2 2
2 F F


(2 F )

M MR1 : m profit when m conducts FDI, produces 1 , while L reveals:

First period profit: n G

Second period profit:

1 1 n
(1 F ) n ( F ) 2 G c
n
n G c
2F

2 1 n
Both periods: M MR 1 nn 2 2G c
2 2F

Under condition:

2 1 n
M MR nn
1
2 2G c 0
2 2F
1 2 2(2 2G c)
2
F n

164
LRM 1 : L payoff when m conducts FDI, produces 1 , while L reveals:

First period profit:

Second period profit:

(1 ) (1 )

1
Both periods: L2RM 1 2 2
2

Under the condition:

1
2 2
2


(2 )

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The tables below summarize results. The strategic form of the game yields the

following payoffs table, where m is the row player and L is the column player:

Table 4.1. Payoffs

L Reveal No reveal
m

FDI/ 1 1 n Excluded
( n n 2 2G c ,
2 2F possibility
1
2 2 )
2

FDI/ 0 1 1 ( n G , )
( n(2 ) 2 2G , 2 2 )
2 F 2 F F

Export/ 0 1 1 ( n T , )
( n(2 ) 2T , 2 2 )
2 F 2 F F

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Table 4.2. Conditions under which payoffs are feasible

L Reveal No reveal
m

FDI/ 1 1 2 2(2 2G c) Excluded possibility

( 2 ,
F n

)
(2 )

FDI/ 0 ( G ) G
( 2 F (1 ), ) ( , )
n (2 F ) n (2 F )

Export/ 0 T T
( 2 F (1 ), ) ( , )
n (2 F ) n (2 F )

Solving for equilibrium by moving backward:

m is the last mover:

First, consider if G T ,

167
Whatever is L decision, FDI will strictly dominate export. Under reveal scenario,

FDI/ 1 will strictly dominate FDI/ 0 if M MR1 M MR 0 :

1 n 1
nn 2 2G c n(2 ) 2 2G
2 2F 2 F
1 n n c

F n(0.5 )

Therefore, if G T , FDI is strictly dominating, while under reveal scenario FDI/ 1 is a

1 n n c
strictly dominant strategy if .
F n(0.5 )

Second, if G T ,

There are two possibilities:

1- The first is that G T .

2- The second is G T .

1- If G T , Export/ 0 will strictly dominate FDI/ 0 .

In order FDI/ 1 strictly dominates Export/ 0 in case of reveal, there must be:

M MR1 M ER

1 n 1
nn 2 2G c n(2 ) 2T
2 2F 2 F
1 n n 2G c 2T 2

F n(0.5 )

1 n n 2G c 2T 2
Otherwise, (if ), Export/ 0 will strictly dominate.
F n(0.5 )

168
2- If G T

Under no reveal scenario, Export/ 0 will strictly dominate FDI/ 0 , while under reveal

scenario, FDI/ 0 will strictly dominate Export/ 0 . FDI/ 1 will strictly dominate FDI/ 0

1 n n c
in case of reveal if .
F n(0.5 )

The next mover backward is L, L is aware of ms payoffs:

Whatever is m decision, if , L will not reveal.
(2 )

If , then L will reveal whatever is m decision.
(2 F )

If , L will reveal only if m chooses to FDI/ 1 .
(2 F ) (2 )

At , the maximum level of at which L would reveal; where L is sure, in
(2 )

case it reveals, m will develop and supply 1 .

Searching for Nash equilibrium in pure strategies:

First, in the area where , L will reveal whatever is m decision. Aware of
(2 F )

L dominant strategy, ms best response at this level of , i.e. Nash equilibrium, will be

according to the relation between G, T and :

169
 If G T or if G T and G T , there will be (FDI/ 1 , reveal) at

1 n n c
equilibrium in the area , while there will be (FDI/ 0 , reveal) in
F n(0.5 )

1 n n c
the area .
F n(0.5 )

If G T and G T , there will be (FDI/ 1 , reveal) at equilibrium in the area

1 n n 2G c 2T 2
, while there will be (Export/ 0 , reveal) in the
F n(0.5 )

1 n n 2G c 2T 2
area .
F n(0.5 )

Second, in the area where , L will reveal only if m chooses to
(2 F ) (2 )

FDI/ 1 . It is the area where the highest level of at which L would reveal. Then, from

m solving, the following conditions must hold:

If G T or if G T and G T , there will be (FDI/ 1 , reveal) at

1 n n c
equilibrium if .
F n(0.5 )

If G T and G T , there will be (FDI/ 1 , reveal) at equilibrium if

1 n n 2G c 2T 2
.
F n(0.5 )

Third, if , whatever is m decision L will not reveal. Aware of L dominant
(2 )

strategy, ms best response concerning its mode of supplying 0 at this level of will

be according to FDI costs relative to export costs:

If G T , (FDI/ 0 , no reveal) will be a Nash equilibrium strategy.

170
 If G T , (Export/ 1 , no reveal) will be a Nash equilibrium.

There are several possible equilibriums, depending on variables values. To sum up,

under no reveal scenario, the foreign producer m will conduct FDI, if FDI costs (G) are

less than export costs (T). The lead user L will reveal the innovation, the lower is the

expected loss in profits ( ), due to the innovations generality and to competition

between users, relative to the expected increase in profits due to manufacturers

improvements ( ). L will be more inclined to reveal, when it expects that the foreign

investor will find it profitable to develop the innovation. Under reveal scenario, FDI

appears at equilibrium, the lower are FDI costs (G) relative to export costs (T) and to the

value of the tacit knowledge incorporated in lead user Ls innovation ( ). The foreign

investor will develop Ls innovation in order to be commercialised, the less the

1
probability of entry by a competitor ( ) and the higher the market share of Ls
F

innovation ( ) relative to the cost of developing it (c) and to the other products market

share ( ).

What if the game is repeated?

Suppose that, in the following periods, L will continue innovating new concepts.

Concerning L, the choice whether to reveal or not reveal remains open each period. As

for m, while it can switch from an export to a FDI strategy, it can not reverse its

decision to FDI. However, in case of FDI, if L reveals, m will have to decide whether to

develop Ls innovation or not.

171
Consider the third period for example, L will not reveal whatever is m decision, as long

2
as . If ms choice so far was to export, it will switch to FDI strategy in
(3 2 )

the third period, if export costs increase relative to FDI costs, such that G T .

2
If , L will reveal whatever is m decision. If m strategy so far in the
(3F 2 )

game was to export, m will switch to FDI strategy in the third period, if G T or if

G T and G T . Therefore, all other things equal, when the lead user L reveals its

innovation, it can attract FDI through increasing the tacit knowledge incorporated in the

innovation. What about m decision whether to develop Ls innovation or not?

If the profile of strategy of the second period was (FDI/ 1 , reveal), we can expect that L

observing that m did develop its innovation in the second period, will be more inclined

2
to reveal in the period after, as long as , which is the condition under
(3 2 )

which the scenario (FDI/ 1 , reveal) is profitable for L. However, L is aware that m will

continue developing its innovations only if it is responding to a general need, where

3G 2c n 3
, which is the condition under which m profit under (FDI/ 1 ,
1
n(2 )
F

reveal) scenario is positive. Therefore, L is expected to develop an innovation at the

maximum level of generality at which L would reveal and the minimum level of

generality at which m will produce.

However, if m defects in the coming periods and doesnt develop Ls innovation or if

the second period has resulted into (FDI/ 0 , reveal) profile, the lead user L may punish

172
the foreign producer m. In case the probability of a competitors entry is low i.e. F is

high, the punishment will be through not revealing in the next period. This threat is

credible, the higher is , inducing a loss for the investor in term of knowledge spillover

in case L doesnt reveal. Besides, lead user can act as an opinion leader, pushing other

users to punish m through boycotting its product. This can only be done, if the

innovation is useful for other users as well i.e. if it is responding to a general need in the

local market. Therefore, L is better off innovating at the maximum profitable level of ,

in order to encourage m to develop the innovation and to be capable of lobbying with

other users in case m deviates. It is not expected that L will continue punish m through

not revealing all along the game. This is because; L itself will incur a cost due to the

loss of its innovation potential improvement. As long as the actualisation parameter is

close to one (in this game it is set to one), there is no need to continue punishment to

ensure cooperation.20 Since F is high, a commitment may arise, according to which m

will develop Ls innovation and in counterpart m will have a proprietary advantage over

Ls innovation for a certain period of time.

In case the probability of entry is high; F is not important enough to deter competitors

entry, L will continue reveal its innovation. The punishment in this case will be through

opening a new segment for a rival. To ensure the credibility of Ls threat, L shall

maximise the tacit knowledge incorporated in its innovation and innovations

generality , in order to encourage a new entry. Therefore, at different levels of F, the

lead users threats would be credible the higher and .

20
Yildizoglu (2003), p. 93.

173
Improving may be costly and increasing will increase the number of adopters of

the new product among Ls competitors. Those measurements then, to ensure that Ls

threats would be credible, will increase the profits of Ls competitors, while they may

decrease Ls own profits; the higher is competition between users. Therefore, to reach a

Pareto optimum equilibrium, the foreign investor, willing to encourage the lead user L

to enhance those variables, shall on his turn enhance the improvement he brings to

Ls innovation. Besides, the foreign investor shall also privilege L relative to other

users. This can be done for example through giving the lead user a first access to the

product or through adding a specific required improvement benefiting the lead user.

For simplification, it was assumed that, at the departure, the foreign producer m was

monopolizing the market. If at the departure there was another producer, local or

foreign, this wouldnt have changed results. The other producer would have faced the

same choice as m. He would have had to decide whether to develop lead user based

innovation or not. This is because; lead users innovation is out of the well known

product solution space of the supply side. Then, both producers would have faced the

threat of entry by a third producer to serve the new segment lead users innovation has

opened. Consequently, having an oligopoly at the departure would yield the same result

as introducing the probability of entry as a move by nature, following the foreign

investors decision. Even with multiple competitors, the advantage of accessing lead

users innovation would have persisted. However, the market would have been divided

between many suppliers.

174
Conclusion

Through literature analysis, the chapter proposes that foreign investors can benefit from

lead users innovations spillovers. However, geographic proximity is necessary.

The chapter has developed a game theoretic model to detect the impact of the host

countrys innovator lead users decision to reveal versus not reveal their innovation on

foreign producers decisions. The model proposes that, all other things equal, lead users

can attract FDI when they reveal their innovation, the higher the tacit knowledge it

incorporates. The foreign investor will develop lead users innovation, the higher is lead

users innovation market share relative to the cost of its production and to the market

share of other products. Besides, the less credible is the threat of entry of his

competitors, i.e. the higher is the foreign investors specific assets. This result is

consistent with horizontal FDI models, according to which FDI increases, the higher are

the investing firms specific assets (Horstmann and Markusen, 1987, 1992).

The model interprets the generality of lead users innovation as a function in the

difference in the use environment between the home and the host country. The higher is

this difference, the more users will find a benefit in innovating to respond to their use

environment particular needs, consequently, the more their innovation would be

addressing a common need with other users.

In a repeated game, whether in a market with high entry cost or in a market

characterized by low entry barrier, when lead users reveal, they would be pushing the

foreign investor to develop their innovation through maximising the knowledge

incorporated into the innovation as well as its generality. However, under high cost of

175
entry for competitors, a commitment to secure the foreign investors privileges in

comparison with potential entrants may take place.

Lead users innovation will then be developed, incorporating the potential level of tacit

knowledge, generating the maximum spillover effects and benefiting the maximum

number of users.

In order to encourage lead users efforts to increase the tacit knowledge of the

innovation and its generality, players shall reach a Pareto optimum equilibrium.

Therefore, the foreign investor shall increase the improvements he brings to lead users

innovation and shall privilege lead users relative to other users.

Those findings are consistent with literature on global diversification of innovation by

the MNE, suggesting that, the MNE may globally generate innovation to adapt products

to the needs of local users, which is a local for local strategy (Bartlett and Ghoshal,

1990; Archibugi and Michie, 1995, 1997a). If the host country is a lead market then the

innovation process would be a local for global one.

So far, several concepts and the relation between them were discussed; lead market,

lead users, first adopters, and innate innovativeness. Now, there is a need to give a real

life example of how those concepts interact together within a high technology sector.

The next chapter observes the Egyptian ICT sectors users.

176
 CHAPTER V

EGYPTIAN ICT SECTOR: USERS INTERACTION WITH THE

TECHNOLOGY

177
Introduction

In the third and fourth chapters, it has been shown that, the higher the difference in the

use environment between the home and the host country, the higher the need for foreign

investors to locate in the host country to access the information generated by lead users

concerning their advanced needs and innovated solutions. In GPTs, the use environment

is a critical factor. This is because, GPTs have a potential to be adapted to their users

needs. That is why; this chapter focuses on the ICT sector, a fast moving sector, where

users input is of great value for technology diffusion and development.

The chapter refers to ICT usage in a developing country, Egypt. Emerging markets with

big populations like China, India, and Egypt are offering wide opportunities for ICT

sector expansion. The role of the user is crucial in this process. The technology is

usually originally developed in advanced countries and then adapted for developing

countries needs. However, the direct interaction with local use environment and

especially with lead users reveals more clearly what are the solutions needed to

efficiently diffuse and deploy the technology.

The objective of this chapter is to illustrate through a real case example, the concepts

discussed so far in the thesis; first adopters, opinion leaders, innate innovativeness, lead

market and lead users. Besides, it aims to show how users from all those concepts

perspectives can play a role in diffusing and developing the technology. The analysis

relies on close observation of the Egyptian ICT sector and interviews with e-

government officials.

In order to have lead users, there must be users first. The chapter discusses the factors

restricting individuals and the business sectors adoption of the technology. It then
178
highlights the role of foreign investors in developing the host countrys ICT sector. It

also shows how foreign investors collaboration with local users can materialize users

innovations and may open new markets for foreign investors in case the host is a

regional lead market.

The chapter is structured as follow; the first section presents ICTs as GPTs, where users

are strategic actors. The second section describes Egyptian ICT sector structure, ICT

diffusion indicators and obstacles, and some of the efforts being made to diffuse the

technology. The third section observes the role of foreign investors. In the fourth

section, an example of governments lead userness and its interaction with MNEs.

5.1. ICTs general purpose technologies: the role of users

ICTs are GPTs; they have a wide scope for improvement and elaboration, they can be

applied across a large variety of uses, and they have strong complementarities with

existing and potential new technologies (Bresnahan and Trajtenberg, 1995; Lipsey et

al., 1998). They are also characterized by innovational complementarities which

means that, innovation in GPTs triggers the productivity of R&D in downstream sectors

(Bresnahan and Trajtenberg, 1995). Those characteristics result into increasing return to

scale, rapid technical progress and economic growth.

5.1.1. ICTs impact growth through their usage

The term new economy was first adopted in the context of the USA. It was then

applied to the rest of the world, when growth was led by the adoption of NICTs, which

entails significant modifications in the organization of work relative to the old economy.

ICT can impact more the economy through its usage and application externalities, than

179
through its contribution to the gross domestic product (GDP) as a production sector. In a

study of USA economy, Stiroh (2002) shows that gains from ICT investment in various

sectors of the economy are positive and complementary to gains from the ICT

producing sector. Atkinson and McKay (2007) find that, although developing countries

sample is relatively specialized in IT, growth gains related to ICT are driven by ICT

producing sector. On the contrary, in developed countries, gains are mainly driven by

ICT use and application. Similarly, Bayoumi and Haacker (2002)s sample of

developing countries has smaller demand boost from IT spending in comparison with

developed countries.

Developing countries attracted investment in ICT sector and their share in world

production of ICT is increasing. However, demand for ICT is mainly from developed

countries. Few exceptions exist, for example, China. Therefore, further ICT usage

diffusion can trigger growth in developing countries.

5.1.2. The role of users in ICT diffusion and development

Being general purpose technologies, ICTs can be adapted to various use environments

needs. The sector production is shifting from technology oriented products, to

commercial, often user driven new applications of ICTs (Information Economy Report,

2008).

The chapter divides users role in the technology development process into two related

dimensions. The first dimension is viewed from the diffusion literature perspective; the

early adopters of the new technology are change agents and opinion leaders who

facilitate further diffusion of the technology (Rogers, 1995). Agarwal and Prasad (1998)

180
define domain-specific innovativeness in the field of IT as the willingness of an

individual to try out any new IT.

The second dimension is from the R&D literature perspective; the computer based

relatively easy design tools, available now for users at affordable prices, democratized

innovation (where innovation means new products or processes) (von Hippel, 2005).

The added value of innovator users to ICTs can be witnessed in many real cases, among

which Linux and Napster. ICTs innovator users are privileged, since they are the users

of the services and products of the sector that empowers other sectors users with

innovation tools.

Users from both perspectives can play a role in diffusing ICTs, reducing then the digital

divide related to ICT usage. In diffusion literature, innovator users contribute to

innovation diffusion by being opinion leaders who give positive signals to the market

about the product. Innovator users/lead users, as defined in R&D literature, also impact

the diffusion speed of innovation. This is because; their collaboration with producers

works on better adapting the technology to local context and needs.

It is worth reminding that the two dimensions are interrelated. Lead users find their

theoretical explanation partially in diffusion literature (von Hippel, 1986), like it was

demonstrated in chapter two. Besides, empirically, it was found that the concepts; lead

users, innate innovativeness, first adopters and opinion leaders are interrelated (Urban

and von Hippel, 1988; Morrison et al., 2004; Bcheur and Gollety, 2007; Schreier and

Prgl, 2008). The next sections will illuminate users role through observing Egyptian

ICT sector.

181
Egypt has adopted an information society initiative since 1998. Many developments

took place in terms of infrastructure and legislative and administrative environments.

The initiative has two strategic objectives; to spread ICT tools nationwide and to set the

foundation of an export oriented ICT industry. Many sub-initiatives have followed, they

consist of two main rounds; first, deregulation of the ICT sector and access for all

programs. Second, the establishment of R&D centers of excellence. ICT sectors

contribution to Egyptian real GDP is 3.8% in 2008-2009, while its contribution to real

GDP growth is 0.51%. Direct employment in ICT sector accounts for 181,734 in

200921.

5.2. Innate innovativeness versus actual adoption

In chapter two, the reminder of Morrison et al. (2000), Lthje et al. (2005) and Schreier

and Prgl (2008) findings pointed to the use experience as a factor explaining lead

userness and innovativeness. In order users play their role in diffusing and developing

the technology, they should first be able to access the technology in question.

In the technology diffusion literature, Midgley and Dowling (1978) criticized the time

of adoption approach of Rogers and Shoemaker (1971), where an individuals

innovativeness is justified by the earliness of his actual adoption of a new technology

relative to the other members of his society. Instead, Midgley and Dowling (1978)

introduce innate innovativeness approach, according to which in the real world there

are situational factors that affect the adoption decision. Those situational factors might

be income, education or the perceived benefit of the new technology, etc., like it was

explained in chapter two. So, what are those situational factors in Egypt that might

21
Egypt ICT Indicators Portal.
182
interfere between innate innovativeness as a personal characteristic and the actual

adoption of ICTs? There are positive and negative factors. Lets start by the process of

the sector deregulation.

5.2.1. ICT Sector deregulation process

In a research covering 200 countries between 1985 and 1990, Wallsten (2002) proves

that, in the telecommunication sector, the sequence of regulatory reforms and

privatization is important for technology diffusion. Establishing a regulatory authority

before privatizing the telecom firm is correlated with increased telephone penetration,

telecom investment, and mobile cellular subscriptions. Without having a regulatory

framework prior to privatization, investors will require a risk premium to compensate

them for future change in rules (Stiglitz, 1999).

In Egypt, the set up of a regulatory authority was prior to the deregulation process of

ICT sector. Until 1996, the Arabic Republic of Egypt National Telecommunications

Organization was the only provider of all public telecommunications services, and after

was renamed Telecom Egypt (TE). In 1998, TE became a joint stock company 100%

owned by the government. The National Telecommunications Regulatory Authority

(NTRA) was established to undertake the regulatory functions and TE became an

independent operator. The Ministry of Communication and Information Technology

(MCIT) offered 20% stake in TE on the Cairo and Alexandria Stock Exchange in

December 2005. The initial public offering (IPO) is the biggest flotation the Cairo and

Alexandria Exchange has witnessed until then and the biggest sale of state-owned

assets. Subscription for shares offered to private investors in the IPO was 70%

oversubscribed, witnessing a successful experience of ICT sector deregulation. Until

183
now, end 2010, TE continues to monopolize the fixed-line market. In 2008, an auction

for a second fixed-line telephony started, but it has been delayed several times. The

regulator explained postponement by the world economy crisis.

In Varoudakis and Rossotto (2004), they confirm that telecommunication liberalization

is conductive to a higher efficiency, contributing then to ICT growth. Bialiamoune-Lutz

(2003), using data from developing countries, find that liberalization indices may or

may not affect ICT diffusion. Today, ICT sector in Egypt is partially liberalized.

Concerning the mobile market, it is an oligopoly of three operators. In 1998, Mobinil

Company and Vodafone Egypt Company obtained two Global System for Mobile

Communications (GSM) operators licensing. In 2006, a third GSM license has been

granted to Etisalat Company, which started offering its services in the Egyptian market

in the first half of 2007. The arrival of a new operator in the mobile segment

considerably increased the number of subscribers. Annual growth of subscribers was

64.2% in 2007 compared with 29.6% in 2006.

As for the IT market, it is served by major international investors. There is also a

substantial number of local integrators with strong market presence, such as Raya

integration. The number of IT companies grew to reach 2322 in 2009, with an annual

growth of 17.5%. 22 The number of IT services companies was 460 in 2009, increasing

by 22% in comparison with 2008.

Although the sector is partially liberalized, the local and foreign investors play a crucial

role in diffusing ICT within Egypt as partners in various Public Private Partnerships

(PPP) programs. Recent research has indicated several weaknesses in ICT policymaking

22
Egypt ICT Indicators Portal.
184
in most developing countries, among which lack of engagement of the expertise of the

private sector and of the civil society (Maclean et al., 2002). The ICT sector deepened

PPP experience in Egypt. However, SMEs who represent about 92.7%23 of private-

sector business in Egypt face difficulties, which inhibit them from fully playing their

role in the sector development.

In a joint MCIT/ITIDA24 survey of 151 ICT companies in 2007, respondents pointed to

difficulties in attracting new customers and lack of access to financial markets as the

main obstacles to their business development. These factors were followed by high

costs of office rent and slow Internet connections. A large majority of the respondents

were domestically owned SMEs. In contrast, an A.T. Kearney25 study (2005), focusing

on service offshore business in Egypt, shows that from a financial perspective,

including office renting costs, Egypt is an attractive location for foreign companies.

When taking into account the spending on specialized personnel, infrastructure costs

and tax regulations, A.T. Kearney ranked Egypt among the top five most financially

attractive offshore locations.

After having presented the sector structure, before moving further, lets look at ICT

diffusion indicators.

5.2.2. ICT diffusion indicators

Egypts ICT diffusion indicators are below the Middle East and North Africa (MENA)

region average.

23
MCIT year book 2008.
24
The Information Technology Industry Development Agency (ITIDA) was established to support the
Egyptian ICT industry and exports.
25
United States management consultant firm A.T. Kearney.
185
Looking at the telephone segment, the telephone itself is a factor of ICT diffusion.

Chinn and Fairlie (2006) find that telephone density is associated with technology

penetration rates and has a statistically significant relationship with computer

penetration.

Telephone penetration rate in Egypt is constantly increasing, driven by the mobile

segment. Mobiles subscribers are increasing with high percentages, while fixed-lines

subscribers follow slow growth path. In the end of 2008, fixed and Mobile telephones

penetration rates represented respectively, 14.6% and 50.6%26, with an annual growth of

3.5% and 25.8%. The MENA region average for fixed and mobile penetration rates was

21.3% and 84.8% respectively in 200827.

The mobile operators have introduced various packages to attract low spending

customers to their network. The operators prepaid users number increases

continuously, and with the entrance of the third operator in the market in 2007,

competition has led to more attractive schemes for customers. Moreover, fixed-line

service is not equally spread over the Egyptian territory. In urban areas, fixed telephone

density was 23.7% in the end of April 201028, while in rural areas it was only 5.7%.

With the majority of the population living along the Nile River, the percentage of the

population covered by the mobile cellular telephone is 95% in March 201029.

As for computers, in July 2009, only 15.04% of Egyptian families own computers30.

Although cooperation with international technology providers has resulted in discounts

of up to 50% on hardware, the price of computers remains a constraint for low income
26
Egypt ICT Indicators Portal.
27
International Telecommunication Union.
28
MCIT website.
29
Egypt ICT Indicators Portal.
30
ibid.
186
customers. In 2002, the government joined forces with the private sector, and has begun

computer in every home initiative, with a payment plan in cooperation with TE. A

plan according to which, computers are paid for in monthly installments to be charged

on the telephone bill. The initiative was then restructured; being a TE customer is no

longer necessary and financing banks offer the required loans through facilitated retail

banking procedures. IT clubs are being established, they provide Internet access and

training for individuals, local organizations and SMEs. In December 2008, they

constitute 1776 clubs31 nationwide. There are also specific programs to diffuse

computers within several sectors of activity.

Concerning Internet, its capacity in Egypt has accelerated since its introduction to reach

almost 27.08 Gigabits per second (Gbps) in December 2008, compared with 14.87 Gbps

in December 2007. In rural areas, where infrastructure is less developed, Worldwide

Interoperability of Microwave Access (WIMAX), which provides broadband wireless

access, can help diffuse broadband services. There are ongoing trials of WIMAX. The

center for wireless studies, electronic and electrical communication department at Cairo

University applied for two patents concerning Mobile WIMAX. Another challenge is

the English content of the majority of the World Wide Web material and of the user

interface in operating systems. The Arabic content initiative established a community

development portal kenanaonline, which targets citizens in rural areas with around

50,000 pages32 online. The portals users were 22,000 per day in average in 2008 33
. It

covers topics including; how to start a small business, how to develop skills, a guide to

civil society, agricultural development issues and health issues.

31
MCIT year book 2008.
32
MCIT year book 2007.
33
MCIT year book 2008.
187
Between 1999 and end 2008, Internet tariffs were reduced by 90.9%.34 Since 2002,

access to the Internet has been available for the cost of local telephone call. Successive

reductions of the cost of broadband took place, it dropped by 30%35 in 2007 compared

with 2004. Those reductions aim to stop the line sharing practice, which seeks to split

the line cost between users. Even though, Internet service remains too expensive for

most Egyptians. In 2008, the percent of inhabitants using Internet was only 16.7%, with

an annual growth of 11.4%. The MENA region average percent of inhabitants using

Internet was 32.3% in 2008. The number of broadband subscribers percent of

inhabitants in Egypt was 0.94% in 2008, with an annual growth of 56.6%. The MENA

region average number of broadband subscribers percent of inhabitants was 7.3% in

200836. The limited percentage of households owning computers makes cybercafes the

main access points to Internet.

Despite these efforts to diffuse ICTs, people in the capital and big cities remain the

main beneficiaries. In 2005, a Universal Service Fund was established under the control

of NTRA to correct for market failures, which disadvantaged people living in rural areas

and poor communities. This is realized via incentives for PPP, to serve those segments

of the population. The task is not an easy one and results are sometimes below

expectations.

ICT diffusion rates in Egypt point to income, education and rural areas access as main

obstacles for the technology diffusion. like it was discussed in chapter two, Morrison et

al. (2004) demonstrate that the leading edge status, characterizing lead users, is more

related to innate innovativeness than it is to the time of adoption construct. Innate

34
Egypt ICT Indicators Portal.
35
MCIT year book 2007.
36
International Telecommunication Union.
188
innovativeness construct (Midgley and Dowling, 1978) takes into consideration the

obstacles that may obstruct the willingness to adopt a new technology. Le Guel (2004),

studying the measurement of the digital divide related to Internet, distinguishes two

situations. The first is when two individuals have different dates of adoption. In this

case, the digital divide is temporal and it is expected that both adopters will converge.

The second is when both adopters start adoption at the same time, but ones adoption is

slowed down (the less qualified individual) while the others is maintained with high

speed (better qualified individual). In this case, the digital divide is structural and is of

bigger concern. Lets look closer to the individual users adoption obstacles.

5.2.3. The individual users adoption constraints

Egypt benefits from a big market, with a population of 75.2 million in 200837, with a

diversity of needs and expectations. Getting back to the situational factors that might

influence the adoption decision of the new technologies, two factors are considered; per

capita income and education.

Egypt is a low-income country, with an annual GDP per capita at current prices of

almost US$ 2160 in 200838. In Chinn and Fairlie (2006), they find that income per

capita is associated with differences in Internet penetration between countries. Besides,

the tests reveal statistically significant relationship between income per capita and

computer penetration. Bialiamoune-Lutz (2003), using data from developing countries,

examines the links between ICT diffusion and per capita income. The results show that

income influences ICT diffusion and Internet hosts seem to be positively associated

with income.

37
International Monetary Fund Data & Statistics.
38
ibid.
189
High proportion of developing countries citizens has little experience even of

telephone. This might limit the end users role in terms of price and product definition

in developing countries, since the concerned technology is not common for him.

Adopting new ICTs is much faster and easier in societies in which citizens are used to

the older ICTs. Although data is unavailable about adopters behavior, observing the

mobile market can help make some deductions. In 2004, there were boycotts in the

mobile market from disappointed consumer rights groups, because of price hikes in

mobile's charges. There is a continuous revision of the terms of mobile use to offer a

variety of packages and to address low income customers. For example, there is a credit

transfer service from one customer to another, which can be useful within low income

families. Also, there are special tariffs for rural areas. Between 1999 and end 2008,

mobile tariffs were reduced by 91.8%.39 It can be said that the consumers are actively

responding to market conditions. When the market is proposing adequate packages to

local needs, the consumer can realize his willingness to adopt the technology,

overcoming the low income handicap. Indeed, in Egypt, the mobile segment is

witnessing the highest penetration rates compared with other ICTs.

Concerning education, Durate and Simoes (2004) study a sample of developing

Mediterranean countries, among which Egypt. The paper detects the role of human

capital as a facilitator of technological diffusion i.e. the transfer of technology from

developed countries to developing countries, since it determines the absorptive capacity

of the recipient. The results support higher education as a main determinant of ICT

diffusion, a result accordant with the idea that, the diffusion of ICT needs more than

basic literacy levels. Bialiamoune-Lutz (2003), using data from developing countries,

39
Egypt ICT Indicators Portal.
190
investigates the link between ICT diffusion and education. Unlike expectations, ICT

diffusion is not associated with education. This result can be explained by the difference

in the required skills to use different segments of ICTs. Computers usage may require

substantial levels of education, but telephone and Internet may not (Dasgupta et al.,

2001). Indeed, Chinn and Fairlie (2006) find evidence that years of schooling and

illiteracy have statistically significant relationship with computer penetration. The table

below, showing the repartition of Internet usage by education level, confirms that, even

with a primary or informal level of education, the user can access Internet.

Table 5.1. Proportion of individuals who used the Internet (from any location) in the last

12 months by education level and gender in July 2009

Female Male

Tertiary 39.71 60.29

Upper secondary or post 42.72 57.73

secondary

Lower secondary 39.18 60.82

No formal or primary 47.22 52.78

Source: Egypt ICT Indicators Portal.

Table (5.2) shows that, Internet usage is above all for education and learning activities,

followed by communicating, video games and download songs and software. E-

commerce is at the last position in usage repartition.

191
Table 5.2. Internet activities undertaken by individuals in the last 12 months in July

2009

Activity Percentage Activity Percentage

Education or learning 43.85 Information related to health 7.32

activities

Communicating 42.9 Getting information from 6.99

governmental organizations

Video games 32.39 Dealing with governmental 5.68

organizations

Download songs and 21.57 General web browsing 3.51

software

Information about 9.15 Purchasing goods or services 1.32

goods or services

Reading electronic 9.06

books

Source: Egypt ICT Indicators Portal.

In Egypt, families invest heavily in educating their children. At the school level, there

are initiatives to provide schools with ICT tools. The Egyptian education initiative

involves among others, MNEs like Microsoft, Intel, IBM, Oracle, Cisco, HP, and

192
Siemens. 40 However, the high percentages of illiteracy among the Egyptian population

and of English-language ignorance constitute major obstacles for ICT diffusion.

Conversely, the cost effectiveness of the new technologies can help overcome the

illiteracy problem, since the teaching of language and numeric literacy can be combined

with the basic steps of computer literacy. The illiteracy eradication initiative of the

government is producing CDs for elementary self learning of Arabic and mathematics.

The CDs decreased the learning time to 5 months compared with 10 months in

traditional methods. They are available for free, but the challenge is to reach the

targeted population. Only 5000 people benefited from the CDs until end 200841, while

illiteracy percentages, within adult and youth population, were respectively 33.6% and

15.1% in 2006.42

The business sector is also constrained by situational factors that slow down ICT

adoption.

5.2.4. The business sector: the gap between convictions and adoption

ICT investment costs are generally much higher in developing countries, where almost

all ICT equipments are imported. If we compare between developing countries and the

OECD countries, we find that investment finance is available for OECD firms, because

of investors confidence in their business expertise, the risk business environments, and

their big experience in managing change and in restructuring business operations to take

advantage of new technological and management techniques. Companies in developing

40
MCIT yearbook 2008.
41
ibid.
42
UNESCO Statistics.
193
countries have much less experience of restructuring and much less access to high

quality business advice and venture capital.43

An investigation covering 105 Egyptian private firms in the manufacturing sector, with

20-500 employees, was part of Bellon et al. (2004). The majority of questioned

managers believes that ICTs play an important role in growth and development; they

reduce production and communication costs, enhance products' quality, facilitate

accounting and personnel management, increase sales and enable better decision

making by allowing access to more information.

However, these convictions are not necessarily translated into a high investment in these

technologies. ICT spending is considered in many cases as expenditure and not as an

investment. Most firms are buying new material to respond to a current need and a

current competition and not according to a real strategy. In some cases, the entrepreneur

mistakenly considers that his firm has achieved the required level of ICT investment

and that further investment would induce constant return to scale. Besides, the higher

the average age of employees, the more ICT investment is discouraged. This is because,

ICT training becomes costly and organizational change is avoided, since employees fear

to be replaced by younger ones who are more familiar with the new technologies. Costs

of equipments, of amortization, of training and low level of education and of English-

language knowledge within the personnel represent major obstacles for ICT investment

in the business sector.

Accessing ICTs equipments is not enough to benefit from ICTs usage; beyond usage,

there is the question of intensity of usage. Astebro (2004) finds that, focusing on the

43
ICTs and Economic Growth in Developing Countries. OECD, Development Assistance Committee
Network on Poverty Reduction, 10 December 2004.
194
depth of adoption is more important when considering firms decision to adopt a new

technology. This is because; the depth of usage reflects people engagement. Adopting

the new technology involves three decisions; first, whether to adopt or not; second, the

replacement speed of the old technology by the new one; third, the depth of adoption

i.e. the extent to which the new technology will be exploited by the firm.

Although developing countries bridge the gap in term of equipment, this doesnt

necessarily reflect an intensity of usage. Ben Youssef et al. (2009) explore the dynamics

of ICTs usage and intensity of usage (intra-firm diffusion) in Tunisian SMEs. Their

results show that, firms adoption and intensity of usage are positively correlated to

firms size and age. The speed of adoption (the inverse of the time taken by each firm to

adopt a new technology), having a website, the absorptive capacity (qualification of

employees) are significant variables, explaining the adoption and the depth of adoption

of ICTs. Those findings suggest that, in a developing country, ICT intensity of use

doesnt only depend on a cost/benefit analysis as claimed by the equilibrium theory

(Battisti and Stoneman, 2005); it depends on time. The use of technology increases over

time, since the risk associated with new technology adoption decreases through

learning. This is the approach of the so-called disequilibrium theory (Mansfield, 1963;

Antonelli, 1985).

The tables below give a picture of ICT usage in Egyptian business sector:

195
Table 5.3. Proportion of different uses of ICTs by the business sector in July 2008

Proportion of Size

Business
Enterprise Medium Small

Using Computers 96.8 79.8 40.2

Using Internet 82.6 52.7 20.3

Accessing Internet 79 87 88

through ADSL44

Having a Website 65.2 33.1 10

or Web Presence

Receiving Orders 17.8 24.6 16.6

over the Internet

Placing Orders over 18.8 22.7 16.6

the Internet

With a Local Area 69.7 45.2 15.4

Network (LAN)

With an Extranet 4.5 3.6 1.2

With an Intranet 65.8 36.1 11.1

Source: Egypt ICT Indicators Portal.

44
Asymmetric Digital Subscriber Line (ADSL).
196
The table shows that computers are largely diffused. Internet usage is less diffused and

is mainly through ADSL. Networking within the same enterprise is far ahead from

networking with other entities. E-commerce is not developed for the three categories of

enterprises; receiving and placing orders on the Internet represent mediocre

percentages of usage. The table below details Internet usage activities:

197
Table 5.4. Proportion of business using Internet by type of activity in July 2008

Activity Size

Enterprise Medium Small

Customer Service 39.8 40.6 32

Dealing with 21.1 13.7 9.5

Government

Developing 30.5 30.3 22.2

Products Online

Information 77.3 68.6 60.1

about Goods or

Services

Information from 57 42.9 31.7

Government

Internet Banking 37.5 29.1 18.6

R&D 47.7 32 21.6

Sending or 86 79.4 77.5

Receiving emails

Source: Egypt ICT Indicators Portal.

Table (5.4) illustrates that sending and receiving emails, information about goods or

services, Information from government are ranked among the first uses for the three
198
categories of firms, while Internet banking and Dealing with the government are

among the last ones. This shows that communication and information seeking are the

main usage purposes of Internet.

R&D activities are ranked ahead the bigger is the size of enterprises; it is at the fourth

position for big enterprises, at the fifth for medium ones and at the sixth for small ones.

SMEs in developing countries, among which Egypt, face difficulties in benefiting from

ICT led innovation. R&D requires high fixed costs; it is difficult for SMEs to access

human capital and financial resources. Besides, SMEs are more vulnerable to the risk of

market negative response to innovation. Those factors put SMEs in a disadvantaged

position, which inhibits their engagement into innovative activities. The development of

specific Internet usages can help overcome those difficulties. E-commerce can help

SMEs in developing countries marketing their products and services less costly and on a

wider scale. Participating in open source innovations can play a role in deepening local

innovation experience. Indeed, in the table above, Customer service and developing

products online are ranked ahead the smaller is the size of enterprises.

SMEs need to be strategically targeted in Egypt. Oracle Company is forecasting that

SMEs would emerge as the main drivers of Egyptian applications spending. The

company strategy is to promote a tailored approach for SMEs. A PPP project to

empower SMEs with ICT brings together international investors in the country, like

Microsoft and Cisco.45 Several times so far, the chapter has referred to foreign

investors role in developing the sector; the next section looks closer at this role.

45
MCIT yearbook 2008.
199
5.3. Foreign investors in Egyptian ICT sector

FDI towards and from developing countries has remarkably increased in recent years.

The last economic crisis led to increasing inflows to developing and transition

economies and decreasing ones to developed economies. In 2008, despite the crisis, the

global share of flows to developing and transition economies reached 43% (World

Investment Report, 2009).

FDI in the ICT sector is following the same path. In this sector also, developing

countries have become an attractive destination. Besides, South-south investments in

the telecommunication sector are increasing. MNEs have contributed to the

development of telecommunication infrastructure in developing countries. In addition,

they have played a role in diffusing the technology, especially through investing in the

mobile segment (World Investment Report, 2008).

5.3.1. Egypt: a lead market

Egypt is considered as a lead market within its region. In 2008, its FDI net inflows were

almost 9.5 billion in current $US46. It hosts the International Telecommunications

Union office in the Arabic region. International investors presence is significant, for

example, HP, IBM, Wipro, Saytam, Intel, Microsoft, Cisco, Oracle, Orange, Alcatel,

Teleperformance, SQS, Valeo and Vodafone. There is also an outflow of FDI from

locally developed ICT companies. For example, Orascom Telecom, following the trend

of south-south investment, is operating in Irak, Pakistan, Algeria, Tunisia, Bangladesh

and Zimbabwe and it has also expanded to Italy.

46
World Bank Data & Research.
200
In Export oriented IT enabled services industry, the country has a remarkable position.

In 2008, Egypts exports of ICT based services were up to $750 million. The country is

ranked as a location for offshoring and outsourcing services by several international

institutions. For example, in 2008, Egypt was the outsourcing destination of the year

according to the British National Outsourcing Association and it was ranked at the fifth

world position by McKenize.

Egypt reaches the Arabic large population and has an advantageous geographic position

in proximity to Europe, Africa, the Middle East and Asia. It benefits from multilingual

and cost effective human capital, with a neutral dialect compared with other countries.

The Kearney47 Outsourcing Index ranks the high end of Egypt's IT professionals among

the best in the world. According to Kearney report, due to long-established international

education institutions in Egypt and to the tourism industry, Egypt has unique

multilingual capabilities and it may be said that the entry offers a better mix of

capabilities than any other single location.

Human capital is a main determinant of innovation not of imitation (Benhabib and

Spiegel, 2002; Durate and Simoes, 2004), especially acquired through high education

(Durate and Simoes, 2004). It facilitates domestic technological innovation and

technological catch-up. In Egypt, based on PPP, numerous training programs exist; the

Basic Skills Development Training Program, the Professional Training Program etc.

Besides, the Information Technology Institute and Nile University were established to

target the highest-ranking graduates.

47
Egypt information Technology Report Q1, March 2006.
201
Despite its policy objective to have an export-oriented industry and its ICT skilled

professionals, Egypt remains an importer of ICT. There are efforts to boost local

creativity. There is an initiative to create centers of excellence, according to which each

center is created in the form of a consortium, consisting of leading industrial

organizations, Egyptian expatriates, both public and private sector entities and in

collaboration with Egyptian universities and research institutions. Three centers are

being established. The first center is concerned with data mining and computer

modeling; it will develop tools to locate information within electronically created

Arabic and English documents. The second is on wireless technologies; while the third

is on mobile, electronic service and electronic design. There are also programs to

develop tools to detect some diseases and to design and develop drugs. In 2001, the

Software Engineering Competence Center, which is the first center of its kind in the

Middle East and Africa, was established to promote and support the development of the

local software industry. In 2003, the Smart Village Pyramids was founded. It is a high-

tech business park that has attracted big local and international companies. A new park

is being established. In 2006, Nile University was inaugurated, dedicated to excellence

in technology and related fields. In June 2010, the MCIT signed an agreement with the

USA Ministry of Foreign Affairs to implement a program to support creativity,

modernization and business leadership. Egypt will be the first country to implement

such program. A joint electronic gate will be launched and American universities will

cooperate with Nile University to achieve programs objectives.

To encourage innovative business ideas, the annual ICT business plan competition

rewards innovation. The winners, beside the financial prize, are allocated equipped

space for 18 months in the Smart Village and they have access to advice on business

202
process. An example of a SME which won the business plan competition prize is Salis.

Salis develops software for the food and agricultural industry. Its first successful

product was for export control; it enables to track all the characteristics of the product

from farm to importer. This is a local innovation, addressing local needs; therefore,

further diffusing ICTs. Now all Egypt's big exporters have installed the Salis. This

example shows that when incentives are there, national SMEs innovations manifest

themselves. What about foreign investors efforts to respond to local needs?

5.3.2. Foreign investors and locally adapted content

Innovation to address local needs is necessary to bridge the digital divide related to ICT

usage. Ben Youssef (2004) explains that, the cognitive capacities of agents and the lack

of local content for some social groups or territories, strongly limit their usage of the

new technologies. Ben Youssef (2004) argues that the divide related to usage put the

divide related to equipments in question. This is because; the real value generated from

these technologies is derived from their usage and not from equipments. Besides, the

value of a network of users is not derived from their number but from their added value.

That is why, local content innovation is important.

Being a lead market in the region, international investors establish R&D and technical

support centers in Egypt to serve the MENA region and to develop locally adapted

content. The Indian IT company Satyam has established its first global solutions center

in the MENA in Cairos Smart Village. The center will serve as a major technological

development and software support center for the companys customers in the region and

Europe. The first nanotechnology center in North Africa will be established in

collaboration with IBM. IBM will also engage to develop a services science university

203
curriculum and a global service delivery center based in the country. France Telecom

inaugurated in 2008 its 18th technology innovation center around the world. The center

aims to deliver innovative services to its customers, especially in MENA region. Best

Service, which is a Raya holding company, inaugurated recently a Nokia regional

support and training center, offering technical support and training for MENA countries.

These tasks used to be assumed by Nokias support center in Germany. Intel will

establish a center to study the needs of customers of the Middle East and Africa,

defining and developing platforms designed specifically for the users of the region.

This section highlighted local capabilities and discussed foreign investors role, lets

turn back to users, more precisely to the concept at the heart of the thesis i.e. lead

users. The next section observes the outcome of the interaction between a lead user in a

lead market and foreign investors.

5.4. ICT sector: the government a potential lead user

Some forms of innovation that take place in developing countries enterprises are

difficult to capture by patent statistics. This is the case in creative imitation, when a

new innovation is being introduced to a developing country, and is being adapted to

local needs and context. This section focuses on the government as a lead user. It aims

to highlight the new role ICTs incite governments to play as users, in order to diffuse

the technology. The section aims also to show how the collaboration between the host

countrys lead user and the foreign investor can be beneficial for both parties, especially

when the host country is a lead market.

The government is one of the users of the technology, whose usage leads to further

usage for the other actors, since ICTs applications become their interface with the
204
administration. Ben Youssef (2004) argues that the government can initiate a dynamic

of usage by giving the example.

E-government means the strategic, coordinated use of ICT in public administration and

in political decision-making. It is expected to lead to greater efficiency of the

institutions concerned, improvements in public services and political participation and

transparency (von Haldenwang, 2004). However, there is the risk of the digital divide

between those who have and those who have not, which might increase the already

existing disparities in ICT diffusion within the population. According to Basu (2004), it

would be possible to achieve in a developing country the same level of efficiency and

flexibility achieved in developed countries' e-government applications, if governments

are willing to decentralize responsibilities and processes, and if they start to use

electronic tools. Many projects are in place to implement e-government initiative in

Egypt. Interviews with the executives of e-government pointed to e-government

applications main obstacles; the highly centralized administration and responsibilities

in Egypt, the difficulty in reaching rural areas citizens, the cost of applications, and

peoples acceptance of the new system.

The government is an innovator user who introduced new usages in the market. There

are projects to digitally document Egypts heritage. For example, the Center for

Documentation for Culture and Natural Heritage developed Eternal Egypt website in

cooperation with IBM to create an interactive multimedia experience of Egyptian

cultural artifacts, places and history. Eternal Egypt received the World Summit Award

205
November 200548. There are also projects to digitize the Egyptian Philatelic Museum

and to produce watermarked high-resolution digitized images for the National Library

and Archive. Another initiative in place, which would help keep the Egyptian dialect

diffused within the Arabic world as it was before the era of digital competition, is to

create a database for theatrical work, to establish a digital library for Egyptian radio and

television production and to scan Egyptian books. Those initiatives, not only help Egypt

keep its historical position in some domains, but they also create new jobs and introduce

to the Egyptian market new notions of specialization like electronic documentation.

Literature points to the lack of integration of ICT policymaking within other areas of the

government, in particular the Ministry of Finance and the ministries responsible for

development, as a major weakness in ICT policymaking in developing countries

(Maclean et al., 2002). That is why, the Ministry of Finance was chosen as an example

for e-government application in Egypt. Interviews with the executives of e-government

in the Ministry of Finance have revealed that the government is an innovator user who

perceived new modified products.

The Ministry has undertaken a plan to automate financial units nationwide, and to

connect major financial units to their affiliates. This project, which has started in 2005

and shall end in 2010, would increase efficiency by providing advanced technical tools

for calculating the cash flows and the financial position of the government. However,

the use environment in Egypt has its particularity. As it was highlighted in the previous

sections, accessing rural areas is a major obstacle for technology diffusion. If those

areas are targeted, project implementation would be excessively expensive. Therefore,

48
It is a global competition, for selecting and promoting the worlds best electronic content and
applications, held in the framework of and in cooperation with the World Summit on the Information
Society.
206
the available solutions for automation were not satisfactory. Without innovated

solutions, adapted to local use environment, the plan implementation would be

restricted to some major cities in Egypt. There was a perceived benefit in innovating a

solution, in order to implement the project at the widest possible scale. Indeed, this plan

has resulted into designing an innovative simplified computer to be used for

transactions' settlement. Herein appears the characteristic of a lead user as defined by

von Hippel (1986).

The government as an innovator user, like theory predicts, has perceived a benefit in

innovating in term of cost and efficiency. The new design has no storage capacity; it

only has a compact flash and an operating system. Consequently, it heavily reduces the

cost of acquiring computers for financial units. It takes the form of a laptop in the

areas where electricity is not stable and the form of a desktop elsewhere, to avoid

electricity shortage in some areas in Egypt. Besides, it is easier to use and training for

employees would be faster. Hence, it will help to spread the e-government applications

in more financial units than it would have been the case with a standard computer.

The local national designer didn't find decisive R&D foreign subsidiary in Egypt to

cooperate with, in order to develop a prototype. Finally, the prototypes were produced

abroad at headquarter, inducing a waste of time and resources. The machine was then

developed in collaboration with local national companies. Consequently, the users -the

governments- innovation has resulted into synergies between the local business sector

and the foreign investor.

This case reminds the question discussed in chapter one about the accurate degree of

subsidiaries independence towards headquarter and of embeddedness in the host

207
countrys networks (Phelps, 1997; Andersson and Forsgren, 2000). The MNE needs to

align two objectives (Mccann and Mudambi, 2004). The first is the integration of

subsidiaries within host economies networks and innovation process, the second is the

endurance of the MNEs overall strategy. Andersson et al. (2005) find that subsidiaries

engagement in local innovation depends on the order of the objectives set by

headquarter, whether profits realization comes first or knowledge creation.

Foreign investors seek to access lead markets (Wesson, 1999; Ernst, 2005). Like it was

explained in chapter one, a lead market as defined by Beise and Cleff (2004) is a

regional market with specific attributes that increase the probability a locally preferred

innovation design becomes internationally successful as well. In the case presented

above, the foreign investor who produced the prototypes was willing to commercialize

the locally innovated design in other countries, expecting successful commercialization.

Indeed, when the host country is a lead market, the development of the lead users

innovation has a multiplier beneficial effect for the MNE, like it was claimed in

chapters two definition of asset seeking FDI driven by demand conditions.

Conclusion

In GPTs and particularly in ICT sector, users can play a significant role in technology

diffusion. Opinion leaders can encourage the followers to adopt and innovator lead

users can play a role in better adapting the technology to local use environment.

However, to enable those active users play their role; the obstacles intervening between

the willingness to adopt and the implementation of the adoption decision have to be

addressed, like income and education, especially in developing countries.

208
Foreign investors can play a role through PPP in working against those obstacles, and

further diffusing the technology. This can be through working on solving the digital

divide related to infrastructure and equipment but also related to usage.

Solving the digital divide related to usage requires local solutions adapted to local use

environment. This necessitates independent R&D subsidiaries, integrated in local

networks. If the host country is a lead market, the foreign investors benefits from

developing local adapted solutions will not be limited to the host country.

The government can play a role in working against the obstacles inhibiting technology

diffusion, not only as a policy maker favouring ICT diffusion, but also as a user. It can

be an opinion leader, since its own adoption changes the citizens interface with the

administration and pushes him to adopt the technology. It can also be a lead user,

innovating cost effective adequate solutions to diffuse e-government applications in

disadvantaged areas. Besides, e-government application can introduce new ICTs

specialties in the market.

209
GENERAL CONCLUSION

Lead users are a competitive advantage for nations. They can be a factor of attraction

for asset seeking FDI through the information they process. This is because; being

ahead of the market trend gives lead users the capacity to predict the needs of their

fellow users. Besides, when lead users perceive a benefit from getting a solution to their

advanced needs, they innovate. Benefiting from a real use environment experience of

the product in question, the lead users based innovations are often successfully

commercialized.

The thesis proposes then, a new definition for asset seeking FDI driven by demand

conditions relative to Wesson (1999) definition, like it was demonstrated in chapter two.

Asset seeking FDI driven by demand conditions is motivated by the investing firm's

willingness to expose itself to the information processed through lead users in the host

country. Lead users may anticipate the trend of demand in their local market and may

innovate potential solutions. If the host country is a lead market, then the MNE will

benefit from lead users data in its operations in other markets. In this case, lead users

data would have a multiplier beneficial effect.

Todays economy is characterised by high uncertainty. The product life cycle has been

reduced in high technology sectors. Innovation is vital for firm survival. Therefore, new

product development is an important strategy in order firms keep their markets, expand

it or create new ones. When the new product aims to serve a foreign market, uncertainty

is more irritating. This is because; each country has its particularity. That is why; the

use environment of products and services differs from one country to another. New

210
product development can be technology push or demand driven; in both cases lead users

can be a source of useful data for the foreign investor, attracting then asset seeking FDI.

Through game theoretic modeling, chapter three examines the role of lead users in a

technology push new product development process, while chapter four examines the

role of lead users in a demand driven one. In both models, the thesis proposes that the

higher the difference in the use environment between the home and the host country, the

higher the value of lead users data. This is because, on one hand, in a technology push

innovation, the probability of product misspecification relative to the host countrys

needs is an increasing function in the difference in the use environment between the two

countries. On the other hand, the probability that users solutions will be responding to a

general need in the local market is also an increasing function in the difference in the

use environment between the home and the host country.

Chapter three proposes that, all other things being equal, a producer willing to introduce

a new product to a foreign market shall choose FDI instead of exports in order to learn

about lead users advanced needs, the higher the risk of product misspecification. This

means the higher the generality of lead users needs and the higher the probability of

product misspecification relative to local needs. The probability of misspecification is

an increasing function in first, the radicalness of the innovation, which reflects work

unit uncertainty in a MNE, and second, in the difference in the use environment

between the home and the host country, which reflects environment uncertainty faced

by the MNE. A risk aversion investor would benefit then from involving lead users in

the new product development process, making out of it not only a technology push

process but also a demand driven one.

211
The impact of users innovations on foreign investors is different from the impact of

local producers innovations. Like it was explained in chapter four, users may freely

reveal their innovations (Harhoff et al., 2003). On the opposite, local innovator

manufacturers may put barriers to ensure that foreign investors wont benefit from

spillover effects (Pugel et al., 1996). The knowledge generated by users may be

absorbed more easily, since manufacturers are better specialized in the concerned field

compared with users. However, users have to translate their preferences and needs in a

language understandable by manufacturers technical staff (Olson and Bakke, 2001).

Otherwise, there may be a difficulty in the absorption process. To benefit from lead

users externalities, geographic proximity is necessary due to the lack of organized

proximity between users and producers as defined by Rallet and Torre (2005).

Chapter four makes some propositions about the impact of lead users innovation on

foreign producers decisions. All other things being equal, lead users can attract FDI

when they reveal their innovation. This is through increasing the tacit knowledge

incorporated in the innovation. To push the foreign investor to develop lead users

innovation, lead users shall maximize the generality of their innovation and its tacit

component. If the foreign investor benefits from high firm-specific assets, constituting a

barrier to entry for his competitors, then an arrangement according to which the foreign

investor acquires an advantaged position relative to his potential competitors would

arise. In order to have a Pareto optimum equilibrium, the foreign investor on his turn

shall maximize the improvements he brings to the innovation and shall advantage lead

users compared to other users.

Being a fast moving sector of GPT, ICT sector is an ideal example to illustrate the

contribution of users. From the developing countries perspective, open user-centred

212
innovation approaches and low skill innovations, which enhance the life of low income

population, would reduce the digital divide (Information Economy Report, 2008).

Chapter five, analyzing the Egyptian ICT sector, shows that, first, the government

aiming to diffuse the technology to reach disadvantaged areas may become an innovator

lead user. E-government implementation nationwide necessitates innovative solutions to

minimize costs and to overcome the use environments barriers which inhibit

technology diffusion. Second, sometimes, while there is local user innovativeness, there

is no sufficiently independent -towards headquarter- foreign R&D subsidiary to

cooperate with local innovators. This entails a waste of resources for both the MNE and

the local market. Third, in order users play their anticipated role in the innovation

process, whether as opinion leaders, demand predictors or innovators; the obstacles

intervening between the users decision to adopt the technology and actual adoption

should be pulled down.

This discussed role of lead users implies different reasoning for investors, governments

and users themselves. Concerning MNEs managers, the evaluation of a countrys

innovation capabilities should consider lead users activities. This also implies more

important role for subsidiaries in the MNEs innovation process. Conversely, it implies

more independence towards headquarter, while more integration in the host countrys

innovation dynamics. Subsidiaries need to establish mechanisms in the host country to

interact with lead users and their innovations, searching for them deliberately to

increase mutual benefits and hence social welfare.

Most governments now aim to attract FDI through costly financial incentives. Asset

seeking FDI, which is a more probable source of spillover for the host country

compared with other types of FDI, is looking for more than financial incentives
213
(Dunning and Narula, 2000). Asset seeking FDI is looking to tap into the nations

competitive advantages. Among those immobile advantages are the countrys lead

users. Taking into consideration the value of lead users, governments can play a role in

encouraging their innovations. Indeed, the American national innovation initiative

highlights the role of users as partners in innovation and the Danish government is

focusing on user driven innovations.

Although users innovations constitute a big percentage of total investment in

innovation in a country, the majority of users innovations are not recorded into

governments statistics (von Hippel, 2005). The contribution of users to innovation

should be accounted more rigorously to highlight their role to managers and to policy

makers. For example through country level survey, which includes users innovations,

like the one conducted on UK population in Flowers et al. (2010). If the other actors

become aware of the role lead users can play, lead users will increasingly find it

beneficial to participate in the innovation process, to innovate and to reveal their

innovations. This is because; lead users will expect that the other actors will be

rewarding their contributions.

Lead users are an immobile created asset. Producers can create their innovator users by

allowing access to toolkits. Policy makers can create them through incentives. They can

be created through encouraging innovator users communities, consequently, increasing

the resources available in users innovation process and the efficiency of the process.

They can be created through other actors efforts to work against the situational factors

that may interfere between innovativeness as an innate characteristic and its realisation.

Those situational factors, like low income for example, may deprive a potential

innovator from contributing to the development of the technology. According to von

214
Hippel (2005), the concentration of innovation-support resources among few people is

inefficient. This is because, the important innovators are not known until they develop

an important innovation.

The thesis contributes to FDI literature by clarifying the aspects of asset seeking FDI

driven by demand conditions. This is through formalizing the impact of the host

countrys lead users. The thesis contributes also to lead users literature. This is

because, it formalizes lead users role as a competitive advantage for their nations, as

need predictors, innovators or a source of pressure on the supply side to respond to local

needs.

Further empirical research is needed to investigate the effect of lead users advanced

needs and solutions on FDI decision. In addition, there is a need to distinguish in future

research on asset seeking FDI driven by the innovation capabilities of the host, the

contribution of innovator users. This would make lead users value better recognized.

Moreover, research is needed on user communities. Thanks to NICTs, users can more

easily gather into virtual communities. Users can benefit then, from the trial and error

experience of their co-community members and from brainstorming their ideas, making

their innovation process more efficient. Besides, when there are well known user

communities, the process of finding lead users becomes easier and less costly.

Furthermore, it is expected that being a member of a community of users would make

the pressure lead users exercise on producers to respond to local needs more intense.

This is because; users ideas will be tested within the community and will have bigger

probability of reflecting a general need. Indeed, in the virtual world, we are witnessing

international producers who seek and create international communities of users to learn

about their needs and solutions.

215
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LIST OF TABLES

Table 3.1. Payoffs..117

Table 3.2. Conditions under which payoffs are feasible...........................................118

Table 4.1. Payoffs. 166

Table 4.2. Conditions under which payoffs are feasible...167

Table 5.1. Proportion of individuals who used the Internet (from any location) in the last

12 months by education level and gender in July 2009.191

Table 5.2. Internet activities undertaken by individuals in the last 12 months in July

2009...192

Table 5.3. Proportion of different uses of ICTs by the business sector in July 2008... 196

Table 5.4. Proportion of business using Internet by type of activity in July 2008198

LIST OF FIGURES

Figure 3.1. Game structure....112

Figure 4.1. Game structure... 154

239
CONTENTS

SUMMARY............................................................................................................... 23

GENERAL INTRODUCTION................................................................................. 24

CHAPTER I .............................................................................................................. 33

ASSET SEEKING FDI: THE IMPLICIT ROLE OF LEAD USERS .................... 33

Introduction........................................................................................................... 34

1.1. Why would a MNE conduct FDI in first place? ............................................ 35

1.1.1. FDI versus exports.................................................................................................35

1.1.2. Firm-specific assets and market structure ..............................................................36

1.1.3. Internalization hypothesis ......................................................................................39

1.1.4. OLI framework in the age of Alliance Capitalism...................................................41

1.2. Vertical versus horizontal FDI and further complicated models.................. 43

1.2.1. Vertical FDI ..........................................................................................................43

1.2.2. Horizontal FDI ......................................................................................................44

1.2.3. Export platform FDI ..............................................................................................45

1.2.4. The Knowledge Capital Model...............................................................................46

1.3. Asset seeking FDI............................................................................................ 49

1.3.1. The role of Clusters ...............................................................................................52

1.3.1.1. Clusters potential benefits ..............................................................................52

1.3.1.2. When it is beneficial to take part of a cluster?..................................................53

1.3.2. The role of institutions ...........................................................................................54

1.3.2.1. Harmonizing institutional structures ................................................................55

1.3.3. The role of innovation capabilities .........................................................................56

1.3.3.1. MNE: an organization globalizing innovation.................................................57

1.3.3.2. Spillover barriers.............................................................................................60

240
 1.4. Asset seeking FDI driven by demand conditions........................................... 61

1.4.1. The role of lead markets ........................................................................................61

1.4.2. Subsidiaries independence....................................................................................64

Conclusion ............................................................................................................. 65

CHAPTER II............................................................................................................. 67

LEAD USERS: A COMPETITIVE ADVANTAGE FOR NATIONS .................... 67

Introduction........................................................................................................... 68

2.1. Users: an important source of innovation for nations................................... 69

2.1.1. Importance of users contribution to innovation.....................................................70

2.1.2. New technologies empowered innovator users .......................................................71

2.2. Lead users: the concept .................................................................................. 71

2.2.1. Lead users: theoretical foundation.........................................................................72

2.2.2. Developments in lead users concept......................................................................75

2.3. Related concepts: innovator users in technology diffusion literature........... 76

2.3.1. Time of adoption approach ....................................................................................77

2.3.2. Innate innovativeness approach .............................................................................77

2.3.3. Measurement of user innovativeness in diffusion literature.....................................78

2.3.4. Linkage between innovator users in diffusion literature and lead users ..................79

2.4. Lead users in practice..................................................................................... 80

2.4.1. Lead user method ..................................................................................................81

2.4.2. How to find lead users ...........................................................................................84

2.4.3. Continuity of lead user method application ............................................................87

2.5. Lead users: favourable demand conditions ................................................... 88

2.5.1. The diamond of national advantage .......................................................................88

2.5.2. Lead users within the diamond...............................................................................90

2.5.3. Lead users: a created competitive advantage .........................................................91

241
 Conclusion ............................................................................................................. 94

CHAPTER III ........................................................................................................... 96

FDI: THE IMPACT OF LEAD USERS ADVANCED NEEDS ............................ 96

Introduction........................................................................................................... 97

3.1. FDI under demand uncertainty in literature................................................. 98

3.2. Uncertainty associated with new product development .............................. 102

3.2.1. Rising demand for customized products ............................................................... 103

3.2.2. MNE and uncertainty regarding new product development ..................................104

3.3. Lead users for successful new product development................................... 107

3.3.1. The advantage of users relative to other actors ....................................................107

3.3.2. The commercial attraction of lead users based products .....................................108

3.4. The impact of lead users advanced needs on FDI decision: game theoretic
model.................................................................................................................... 110

Conclusion ........................................................................................................... 131

CHAPTER IV ......................................................................................................... 134

FDI: THE INFLUENCE OF INNOVATOR LEAD USERS................................. 134

Introduction......................................................................................................... 135

4.1. Lead users: a potential source of innovation spillover ................................ 136

4.1.1. The MNE exploits and generates innovation globally ...........................................136

4.1.2. Lead users: successful innovators ........................................................................138

4.2. The resources on which users rely in their innovation process................... 140

4.2.1 Information stickiness...........................................................................................140

4.2.2 The role of users communities .............................................................................141

4.2.3. Unsticking the information...................................................................................142

4.3. The cost of accessing users innovations ...................................................... 144

4.3.1. Users benefits from freely revealing their innovations.........................................145

242
 4.3.2. Users freely reveal their innovations: theoretical and empirical findings..............146

4.4. The interactions between lead users innovations and manufacturers....... 148

4.4.1. Lead users innovations magnify their markets future needs................................ 148

4.4.2. How users innovations become commercial products..........................................150

4.4.3. The particularity of the externalities generated by users innovations...................151

4.5. The impact of lead users innovation on foreign producers decisions: game
theoretic model .................................................................................................... 153

Conclusion ........................................................................................................... 175

CHAPTER V........................................................................................................... 177

EGYPTIAN ICT SECTOR: USERS INTERACTION WITH THE

TECHNOLOGY ..................................................................................................... 177

Introduction......................................................................................................... 178

5.1. ICTs general purpose technologies: the role of users .................................. 179

5.1.1. ICTs impact growth through their usage .............................................................. 179

5.1.2. The role of users in ICT diffusion and development ..............................................180

5.2. Innate innovativeness versus actual adoption.............................................. 182

5.2.1. ICT Sector deregulation process ..........................................................................183

5.2.2. ICT diffusion indicators .......................................................................................185

5.2.3. The individual users adoption constraints...........................................................189

5.2.4. The business sector: the gap between convictions and adoption ...........................193

5.3. Foreign investors in Egyptian ICT sector.................................................... 200

5.3.1. Egypt: a lead market............................................................................................200

5.3.2. Foreign investors and locally adapted content .....................................................203

5.4. ICT sector: the government a potential lead user ....................................... 204

Conclusion ........................................................................................................... 208

GENERAL CONCLUSION ................................................................................... 210

REFERENCES ....................................................................................................... 216

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LIST OF TABLES .................................................................................................. 239

LIST OF FIGURES ................................................................................................ 239

CONTENTS ............................................................................................................ 240

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