Shedding New Light on Industry Shakeouts
Technology uncertainty, sunk costs, and industry shakeout
Shakeouts are a common feature of nascent industries. IESE Prof. Luís Cabral proposes a novel explanation for shakeouts based on sunk costs and technological uncertainty. Fearing they will back the wrong horse, firms initially invest conservatively, only expanding to their optimal capacity once the winning technology emerges, thereby triggering a shakeout.
In 1908, 206 firms were active in the U.S. auto industry. By 1920, this number had dropped to 126, and to 24 a decade later. By 1942, there were just eight active firms in the industry.
Such "shakeouts" – that is, dramatic drop-offs in the number of active market participants, which often occur during phases of rapid market expansion – are a common feature in the early development of nascent industries, from automobiles and video players, to computers and mobile phones.
Theoretical explanations for shakeouts have varied, but one common thread they share is that, at some point, the winning technology's marginal cost decreases, paving the way for larger firm sizes. If the increase in firm size is greater than the rate of market expansion, a shakeout takes place.
So far, so logical. But in the paper "Technology Uncertainty, Sunk Costs and Industry Shakeout," published in Industrial and Corporate Change, IESE Prof. Luís Cabral proposes a complementary explanation for shakeouts based primarily on sunk costs.