GOOD FENCES MAKE GOOD NEIGHBORS
Property Rights, Appropriability, and Open Firm Borders in Japan
W. Mark Fruin
College of Business Administration
San Jose State University
One Washington Square, San Jose, Ca. 95192
Abstract: Japan’s industrial firms are famous for robust operational efficiencies and organizational capabilities, witness the worldwide success of Toyota Motor’s lean production system. In lean production, final assemblers and leading parts and component suppliers freely exchange information with respect to motor vehicle design and development, essentially behaving as partners. Firm borders are open; ideas, know-how and knowledge move easily between firms. However, the resulting co-specialized knowledge is not well protected legally. This essay explores Toyota’s lean production model of open firm borders and low property rights protection, and considers whether or not it can become a worldwide model of best practice.
Submitted for publication consideration to California Management Review
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GOOD FENCES MAKE GOOD NEIGHBORS
Property Rights, Appropriability, and Open Firm Borders in Japan
In Robert Frost's turn-of-the-century day, Yankee ingenuity held that borders, boundaries, and fences were essential for managing human activity and private property. In Mending Wall, Frost asserts a primacy of property rights in relations characterized by specialized assets, writing:
And on a day we meet to walk the line
And set the wall between us once again,
We keep the wall between us as we go. (1)
Today, Frost's commonsense runs counter to a groundswell of popular writing that trumpets an eminent arrival of borderless national economies and seemingly effortless coordination across firm and national boundaries. Property rights are rarely mentioned in this global call-to-arms although they are considered a sine qua non of economic development (North, 1990).
Property rights are the normal expectations and legal guarantees that encourage investment, without which economies will not grow, enterprises will not profit, and entrepreneurs will not take risks. The expectations and guarantees that underpin property rights—termed "good fences" in this essay—mandate that sources of good ideas are identified and profits are returned in proportion to the value of contributions. But, as this essay shows, identifying where good ideas come from and actually profiting from them are not one and the same thing.
Appropriation or taking possession of property comes before profit-making and rent-seeking. Appropriation represents a crucial step in-between generating good ideas and profiting from them. Appropriability regimes differ by nation, and not too surprisingly, they are intimately related to how good ideas brought on by innovation and asset specialization make money. Teece characterizes appropriation regimes as loose or tight (Teece, 1986, 1998). In some places, generally less well developed places, the ability of individuals, including organizations legally recognized as individuals, to prosecute legal claims to property rights and the rents that flow from them are weakly supported. Low levels of legal protection are associated with high levels of appropriation. Japan, an advanced industrial economy, is surprisingly such a place.
This paper argues that intellectual property is not well protected and thus highly appropriable in Japan. Because of this, at least in part, firms cluster together to protect intellectual property. Within business clusters, variously known as kigyo shudan, keiretsu, and bizunesu gurupu, property rights are often shared, although access to clusters and, thereby, to intellectual property is tightly controlled. This characterization well describes Japan’s technology-based clusters, like Toyota Motor’s group of companies. Several examples of property rights protection and appropriation associated with this group of companies and the Toyota Production System (TPS) are analyzed in this paper. Also, using research on the Toshiba Corporation, additional examples are drawn from the electronics industry. But first, in order to highlight distinctive features of Japan’s model of property rights protection and appropriation, comparisons with Silicon Valley are assayed.
Toyota vs. Silicon Valley: Models of Openness
Japan’s firms are praised for their learning orientation, based on open borders with stakeholders, such as suppliers, labor unions, group (keiretsu) affiliates, and banks, but they are hardly ever touted for property rights protection or, for that matter, spillover effects (Cole, 1989; Porter, 1990; Fruin and Nishiguchi, 1993; Liker et al., 1999). Two explanations in this regard have been offered.
The first, more or less a cultural explanation, relies on trading experience, based on proximity and transactional frequency, to build up "trust" between parties. A business ethic infused with "goodwill" rather than "opportunism" is the result (Dore, 1983; Williamson, 1985). The second comes from classical game theory, especially non-cooperative Nash equilibrium games where neither player is motivated to change, nor agrees not to change (Morrow, 1994). Such games mitigate uncertainty while allowing for information exchange and emergent norms of fair governance; they are thought similar to the non-contractual, co-specialization activities of Toyota assemblers and suppliers (Womack et al, 1990; Clark and Fujimoto, 1991; Fruin, 1998a).
The Silicon Valley story seems to be that openness of firms, network organization, and asset co-specialization result in firm profits and regional prosperity with spillover effects yet, at the same time, property rights are protected and secure (Piore and Sabel, 1984; Helpman and Krugman, 1985; Porter, 1990; Saxenian, 1994). Silicon Valley’s open borders with inviolable property rights comes from blanketing employees and firms in legal contracts to protect proprietary knowledge and know-how. Low appropriation is combined with open borders and legal protection. While legal costs are high, the benefits of open borders with property rights protection go far in explaining Silicon Valley’s wealth-generating cornucopia. But it should be recognized that Silicon Valley’s combination of open borders and secure property rights may be more exceptional than normative, even in the United States (Saxenian, 1994; Bratton, 1989).
Differences abound between Toyota and Silicon Valley’s models of network organization: Toyota’s lean production model requires co-evolutionary experience as a prerequisite for exchanging specialized and proprietary information; Silicon Valley networks are less particularistic with low entry costs to transactional networks but with substantial legal and opportunity costs (associated with living and working in the San Francisco Bay Region). The effects of the lean production model, especially with regard to property rights appropriation, may limit its utility as a model of international best practice, although contrary views are sometimes heard (Womack et al., 1990; Nishiguchi, 1994).
The Problem of Firm Boundaries Restated
Different theories of the firm offer parallel but distinct ways of understanding economic exchange across and within organizational boundaries. There are three well-known theories that help us examine the question of property right protection and appropriation. First, there is an argument beginning with Ronald Coase that transacting is costly and that firms exist in large measure to save on transaction costs. In this view, firms manage their borders to minimize transaction costs and protect property rights.
In support of this, Monteverde and Teece found that when auto component suppliers in North America engaged in asset
co-specialization with final assemblers, assemblers internalized or integrated-in component manufacture and/or manufacturers more frequently (Monteverde and Teece, 1982). This presumably saved on transaction costs by reducing risk associated with price fluctuations and investment holdup. However, the growing popularity of lean production methods among North American assemblers and suppliers may contradict the currency of Monteverde and Teece's findings (Womack et al, 1991; Kenney and Florida, 1992; Helper and Sako, 1995; Liker et al., 1999).
A "nexus of contracts" or agency perspective finds it difficult to say what is "inside" and "outside" firms. Company purchasing officers and outside suppliers behave as if each and every instance of contracting is independent of all others. Boundaries are not so important in spot-like contracting because contracts are assumed to reflect full operational costs and firm asset value. These assumptions may not be realistic, however, due to agency and control problems arising from contractor opportunism (Jensen and Meckling, 1976; Leblebici and Fiegenbaum, 1986).
Finally, an organizational learning perspective argues in favor of unbridled knowledge-creation regardless of borders (Von Hippel, 1988; Clark and Fujimoto, 1991; Nonaka, 1995; Fruin, 1997; Spender and Grant, 1997). Potentially useful knowledge is held by many persons, inside and outside firms, and so open firm borders encourage a free-flow of information and know-how. However, assigning credit and ensuring property rights are among this position's difficulties (David, 1975; Nelson and Winters, 1982; Mowery, 1984).
Traditional theories of the firm do little to alleviate worries of contractor opportunism, assigning credit, and ensuring property rights, especially in environments that are moderately to significantly turbulent and where openness and cross-border learning are important. In response, several alternatives have been advanced as more advantageous to cross-border economic exchange. One is the Silicon Valley model and another is Toyota’s lean production model. But the attractiveness of each is tied to the nature of property rights protection and appropriation.
Firm Boundaries and Property Rights in Japan
Transaction-cost and nexus-of-contract theories of the firm are deficient for understanding cross-border exchange and property rights protection in Japan where late industrial development resulted in a combination of permeable organizational boundaries, a positive specialization of interorganizational assets, and an environment where property rights protection is notably deficient (Aoki, 1988; Fruin, 1992; Gerlach, 1992). Late-industrialization forced firms to specialize by function and product, pushing them into coalitions with other firms to secure needed resources outside their areas of specialization. Instead of internalizing resources and capabilities in ever-larger, Western-style, M-Form firms (Chandler, 1962; 1990; Fruin, 1995), inter-firm co-specialization of assets resulted in an institutional environment and property rights regime remarkably different from those of the West.
An undeveloped market for corporate control not only prevents individuals from cashing in on their good ideas but also limits mergers and acquisitions (M&A) (Kester, 1991; Gerlach, 1992; Porter, 1987). Although businesses are often spun-off from core firms within business groups, broad diversification by single firms is discouraged by the interlocking nature of groups (Fruin, 1992). Since 75 percent of industrial R & D funding is generated by private firms and they perform 80 percent of it, government’s direct involvement in generating and protecting intellectual property is limited (Branscomb and Kodama, 1993; Fransman, 1990, 1996; Odagiri and Goto, 1996). Valuable ideas are mostly generated and paid for privately, either by single firms or by clustered firms in alliances and coalitions. In the latter case, firms collaborate freely and often without concern for property rights. Toyota’s world-class high quality, low cost, lean production system relies on a combination of open borders, interfirm co-specialization of assets, and low levels of property rights protection, as depicted in Figure 1.
Figure 1 about here 1
Because the likelihood of repeated transactions is high in a country so geographically limited and demographically dense as Japan, long-term or relational contracting is prized. Relational contracting assumes a degree of long-term, co-specialization on the part of transacting parties. Additionally, the institutionalized personnel practices of large firms, such as lifetime employment and seniority-weighted reward, encourage low levels of occupational mobility and turnover (Abegglen, 1958). Given this and the lack of an open market for corporate control, inter-firm co-generation of intellectual property proceeds on three assumptions: first, inter-firm relations are characterized by long-term reciprocity; second, job-hopping between firms is constrained; third, unfriendly efforts to integrate-in proprietary resources are eschewed.
An absence of opportunism in the short-term and a preference for relational contracting in the long-term allow for the emergence of transaction-specific as opposed to residual property rights. Transaction-specific property rights (TSPR) are a means of recognizing the value of intellectual property in transfer prices. Residual property rights are de-emphasized because the legal system is not geared to a resolution of property rights disputes. Without means to benefit one-sidedly from the appropriation of intellectual property, firms seek to maximize the value of co-specialized intellectual property. In most cases, this is a straight, fixed cost calculation: x-number of people times y-number of hours.
However, another part of the reward is directly tied to suppliers’ firm-specific, self-developed technologies. Fair valuation of this variable cost is a function of assembler-supplier experience, interfirm governance arrangements, and (Fruin and Nishiguchi, 1994; Fruin, 1998a). TSPR will allow for an allocation of rewards and benefits on a transaction-by-transaction basis. Fair valuation is a function of good fences, in effect. The following examples portray the model.
The Auto Industry, Product Development, and Appropriability in Japan
The excellent work of Kim Clark and Takahiro Fujimoto on product development performance in Japan’s motor vehicle industry finds that effective product development hinges in large measure on what they call "heavyweight product managers" and "heavyweight product development organizations" (Clark and Fujimoto, 1991). These organizations are well led and provisioned projects that sit amidst divisionalized, often matricized, firms where what is fenced-in is more important than what is not because speed, quality, and efficiency are interdependent qualities of effective product development organizations.
Fencing-in projects with sufficient authority, autonomy, and team-specific assets is critical because if these are borrowed extensively from "under the table" or "over the wall", speed, quality, and efficiency suffer. Fencing-in avoids resource "hold-up" and allows for integrated problem solving, multifunctional coordination, and intensive product/process communications.
Fencing-in avoids problems of appropriation by coupling everything and everyone to heavyweight product managers and organizations.
Not fencing-in key resources blurs functional, technical and organizational requisites of effective product development. In addition, overlapping functions is more easily achieved within product development organizations because intramural coordination is different in any number of ways from interdepartmental coordination. The former economizes on time and resources by creating project teams that are typically small, polyvalent, and experienced while the latter tend to aggregate functional specialists without emphasizing team members' previous experience and time-to-market performance. (2) Coordinating within or between projects suggests different strategies: one of self-contained tasks in the former and good lateral relations in the latter (Galbraith, 1974).
Project Team Size
Clark and Fujimoto find that the larger the team, beyond a certain critical mass, the lower product development performance.
Size seems related to bureaucratization (DiMaggio and Powell, 1983) and appropriability because the larger the team, the more value created by the team has to be shared. How large is too large, therefore, is closely related to issues of openness.
In Japan, high value-added contributions by sub-assembly and sub-system suppliers are common, indeed the rule. In Toyota's case, auto components, sub-assemblies and sub-systems are about 70 percent "black box" parts, where suppliers provide parts and components of their own proprietary design to meet assemblers' functional requirements. Thus, the function, performance, and integrity of Toyota’s lean production system depend heavily on supplier "black box" parts, components, assemblies, and sub-systems. This dependence puts product development projects at risk relative to suppliers' capabilities, reflecting both the high systems engineering capabilities of suppliers and the quality of inter-firm relations (Clark and Fujimoto, 1991). Asanuma calls these embedded features, "relation-specific" skills(Asanuma, 1989).
Such capabilities and relations are embedded in an experience of frequent communications and information exchange across firm borders. These depend on good fences (expectations and rewards) because a Denso employee (Denso is Toyota and Japan’s largest supplier of automotive electrical/electonic parts), no matter how much time and effort s/he expends on behalf of Toyota, is a Denso employee. Long-term or "lifetime" employment is the norm and compensation is heavily weighed in favor of individual contributions to firm welfare plus experience. Internal labor markets and lifetime employment allow borders to be open and intellectual property co-developed. Property rights appropriation is not problematic.
The difficulties of valuing the contributions of persons inside and outside product development organizations are circumvented by recognizing that project members benefit more from continuing their current employment than they do by seeking greener pastures. Property rights are more organizational than individual. This explains the high ratio of newly designed parts to low ratio of in-house engineering (or the frequency of black-box parts) and Aoki's characterization of the centrality of purchasing managers’ roles in assembly firms (Aoki, 1986). Rents and opportunities for rent seeking are tied to organizational membership. Striking out on one’s own, even with good ideas, is not likely to bring big rewards.
The Electronics Industry, Product Development, and Appropriability in Japan
Product development organizations in the Japanese motor vehicle industry are relatively long-lived, some forty odd months or so. In the electronics industry, however, forty-month long development cycles are almost unheard of, except in the heavy and large power generation and transmission equipment segments of the industry. Do lean production models and heavyweight product organizations apply in the electrical equipment and electronics industry? In particular, does they apply in the micro-electronics end of the business, where product life cycles are shorter, technological discontinuities greater, and product scope wider?
Autos and electronics are quite different industries. Research suggest that two variables and not one are important in assessing the nature of property rights protection and appropriation in electronics (Fruin, 1998b). First, as in autos, product development and product life cycles have to be appraised. (These are positively correlated in Clark and Fujimoto's study, meaning the shorter the life cycle, the shorter the product development cycle.) Second, the degree of intergenerational differences in products must be assayed. That is, time-to-market (product development cycles) and degrees-of-difference in product generations (product markets) have to be concurrently considered. Putting these together suggests that heavyweight product development managers and organizations are needed when either product development cycles are short or intergenerational product differences are great.
At Toshiba’s main photocopier (PPC) factory in Japan, PPC development activities amount to little more than a kind of set-aside from normal production activities. However, in the case of laser printers (LP), technical discontinuity between generations is sufficiently great that engineers re-consider the entire design and production systems and sub-systems in terms of functions, features, performance, manufacturability, manufacturing and operating costs (Fruin, 1997). They also review hardware and software specifications in light of the latest microchip and semiconductor devices. For LP, like heavyweight development projects in the auto industry, teams are well fenced-in with their own resources, raison d'etre, and rhythms.
Low- or high-fences, however, hinge on two additional variables: organizational slack and the breadth and depth of team members' skills. When resources are not fully committed, permeable fences between development projects and the rest of the firm allow for an easy pass through of resources. An engineer here or there placed on loan for as much as a month or two may not present any particular staffing difficulties. When assets are loanable in this way, problems with appropriation are unlikely to arise and project manager authority is not diminished by borrowing outside resources.
It is easiest to imagine a loan of resources under three conditions: first, when skills are highly specialized, they cannot be easily substituted for; second, when development cycles are short, loaning resources is not so problematic; third, when property rights disputes are eschewed, borrowing resources will not result in residual claims. Clark and Fujimoto report two findings in these areas: product development team members in North America and Western Europe are typically more specialized in design and engineering skills, and product development cycles are longer (Clark and Fujimoto, 1991). To have sufficient breadth in product development skills when team members are highly specialized, larger-sized product development teams and greater reliance on organizational slack are the rule. More specialized and weighty contributions to product development projects may also be useful in supporting residual property rights claims.
But in Japan team polyvalence, kaizen, and limited organizational slack keep a lid on team size. Teams make up in breadth what they lack in depth. Imai et al. observe that in most cases development teams are not large, several dozens at best, although in later writings, Nonaka and Takeuchi emphasize the role of redundancy or slack in product development activities (Imai, Nonaka, and Takeuchi, 1985; Nonaka and Takeuchi, 1995). (3) Yet, if open borders are alternatives to organizational size and slack, breadth can be finessed by permeability. But the effectiveness of this solution, given its availability, depends on the quality of inter-organizational relations embodied in technology transfer and asset co-specialization processes. This explains why Japanese assemblers often rank the quality of supplier relations as highly as the quality of supplied parts and components (Asanuma, 1989; Fruin, 1998a).
Finally, if breadth and depth are substitutes in product development activities, smaller numbers of more widely skilled members are preferable. When lifetime employment norms are coupled with transaction-specific property rights, participation in development projects is one of the most important ways that employees, especially those with good ideas, benefit in flexible wage environments (Hashimoto, 1979; Fruin, 1997).
Property Rights, Appropriability, and Open Firm Borders
The necessity of inter-organizational coordination is acute today. The world is a global marketplace, and single firms find it increasingly difficult to manage design, development, production, and distribution of complex products around the world. Also, product line numbers and varieties are burgeoning and product life cycles are shortening. In direct proportion to these trends, inter-organizational arrangements are becoming more and more important.
Toyota Motor’s lean production system and Silicon Valley’s regional-relational system are two new models that are designed in part to respond to the need for inter-organizational cooperation. Toyota’s lean production model of cooperation with key suppliers and affiliates hinges on three critical elements:
1. flexible and equitable transfer prices between assemblers and suppliers based on transaction-specific as opposed
to residual property rights;
2. multilateral exchange of information and know-how based on strategies of co-specialization mediated, when
necessary, by supplier governance;
3. pay for performance in rewarding inter-organizational co-specialization.
In short, good fences make good neighbors (in Japan and elsewhere). In Toyota’s case, the intellectual property contributions of suppliers and Toyota engineers occur without incurring unreasonable monitoring costs or exceptional degrees of opportunism. Transaction costs are "low" in spite of high levels of inter-organizational resource dependency (Dyer, 1998). Expectations of reward based on work contributions and product/process innovations are built-into human resource strategies of Japanese firms, and research suggests that such strategies powerfully affect productivity and innovation (DeAlessi, 1983; Rosenberg and Frischtak, 1983). Property rights are recognized and intellectual property contributions are rewarded but in singularly Japanese ways.
Game theory gives us one way to think about this: in Nash equilibrium games, when players exchange information before and during games, neither player has incentives to change strategy unilaterally. Given the high levels of information exchange characterizing assembler-supplier relations and inter-organizational product development activities in Japan, opportunities to change strategy without incurring notable risks are few and far between. More importantly, the incentives for doing so are not great. Individuals and firms defect when the payoffs for doing so are greater than the benefits of staying put. Given low property rights enforcement in Japan, the incentives for defecting from co-specialized arrangements are not great.
Black-box suppliers are especially unlikely to defect. They enjoy a privileged position as "systems suppliers," providing entire, integrated solutions for customers. They control the flows of proprietary technology and are in a strong position to be well compensated in the form of transfer price-based, transaction-specific property rights. Employees involved in co-specialization activities benefit from flexible wage payments. Transaction costs appear low, based on transactional frequency and multilateral bargaining arrangements in supplier associations (Dyer, 1988; Fruin, 1998a).
Institutional and cultural models offer another interpretation of Japan’s good fences. Toyota’s lean production model arose in a particular institutional setting where know-how and knowledge were generated in firm clusters distinguished by low labor mobility, inter-firm governance structures, and asset co-specialization. These institutional features and others seem to be part and parcel of Japan’s late industrialization catch-up with the West. Given an absence of a market for corporate control and low levels of property rights protection, good ideas arising in business clusters are appropriable by cooperating parties but no others.
Silicon Valley rather than lean production appears to "have legs" or greater currency as a model of property rights protection in today’s world. The Silicon Valley model is grounded in the rule of law, and hence, property rights protection and appropriation are not so dependent on particularized institutional or organizations settings, as in Japan’s clustered model. Given the rule of law, switching, monitoring, and enforcement costs associated with Silicon Valley networks are lower than would otherwise be the case (Bratton, 1989). Today, property rights protection is a widely recognized condition, if not precondition, of international technology transfer and economic development. The rule of law, national as well as international, facilitates common standards and elicits cooperation. Japan’s national strategy of late industrialization and low property rights protection is unlikely to be repeated in quite the same way today as it unfolded in the past.
Robert Frost was actually ambivalent about fences, walls, and boundaries. He celebrated them as indispensable for good relations but he decried them as contrary to the human spirit. "Something there is that doesn't love a wall," he lamented, even while tumbled stones, fallen fruit, and organizational effectiveness apparently make good boundaries a neighborly necessity. Without fences, what's mine and yours are unclear, and ambiguity in property rights as in most everything else makes for poor performance.
*An early of this paper benefited from the helpful comments of members of PRISM (Pacific Roundtable on Industry, Society, and Management).
1. I am obviously using the metaphor of fences for borders, and I freely admit to borrowing Robert Frost's mastery of the image. See the original poem, "Mending Wall", Robert Frost, North of Boston, Henry Holt and Co., copyright, 1914.
2. My emphasis on product and production specialization as opposed to functional specialization differs other accounts. See Adler below as well as Takeshi Itoh, "Coordination and Specialization in Product Development Organization," paper, Japan in a Global Economy - A European Perspective, 5-6 September 1991, Stockholm School of Economics.
3. Although Japan’s firms are reputedly better at interorganizational coordination, a top American executive of a diversified electronics/electrical equipment firm told me, "no matter how I spoke to my Japanese counterparts about 'synchronous engineering,’ they could not understand my point. Either they were feigning ignorance or the problem was not framed sensibly to them. Conversation with J. B. at Fontainebleau, France on May 25, 1991.
But practices like synchronous engineering are not exclusively Japanese. As Mr. William Reed, President of Semiconductor Equipment and Materials International wrote to Senator Lloyd Bensen: "I find it plausible that in some cases suppliers will work more closely with their local customers in the development stages of their equipment. This practice is understandable, given proximity, cultural similarities and traditional customer/vendor relationships. An increasing number of US equipment suppliers are working closely with their American customers in an effort to design user-friendly equipment." Financial Times, Friday, 17 May 1991: 18.
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