Microeconomic Theory of Spinoff Decisions

Introduction

Employees of a firm, especially from its R&D unit, develop new product ideas. Firms tend to protect these ideas through patents and non-compete covenants. Hence, the firm will have the first claim to integrate such products in its portfolio. However, they will take this decision only if the firm has the organizational capacity to integrate the new product and considers its implications for the revenue generation favorably. The parent firm rejects the idea otherwise. The employee may leave the firm to start a spinoff. Under certain conditions the firm may try to integrate the new product idea though not at an efficient level. For example, they may find that the existing product divisions gain by such integration due to consumer preferences in markets. However, the individual, who generated the new idea, may disagree with managerial choices (e.g., the scale of operation, organizational and coordination details, and/or compensation schemes) to implement it. The individual, who developed the new idea, then leaves the firm and creates a spinoff.

Spinoff firms have been a phenomenal success in many industries. As a result they attracted the attention of research workers in many areas. Empirical work and case studies documented a variety of stylized facts. Particular attention has been accorded to the reasons for the emergence of spinoffs and the performance of both the spinoffs and the parent firm. Many of them have been summarized in Klepper (2009).

The spectrum of reasons for spinoffs can be classified into the following main categories, viz., the technology and production organization, the information (primarily about markets) available to the managers with respect to new products, the availability of organizational capabilities, the priorities that management accords to different product divisions in the allocation of resources, and the mechanisms of sharing potential synergies¹. Each of these facets may give rise to disagreements, in the sense of Klepper (2007), between the top level management and the management of the new product division.

Observe that any one of these features may have a bearing on the spinoff decision of an entrepreneur via its effect on the revenue which the firm expects from integration. The piecemeal approaches adopted in the existing studies tend to produce contradictory evidences. For example, Klepper and Sleeper (2005) noted that “spinoffs pursue ideas involving new niche markets or technologies their parents are unwilling or slow to pursue. Industry conditions favorable to the new niche markets are thus conducive to spinoffs.” (p.1293). In contrast to this Cabral and Wang, (2008) suggested that employees will prefer a spinoff if the parent firm experiences cannibalization for its existing products when the new products have a high elasticity of substitution with existing products. In the analysis of this study the argument is that the elasticity of substitution and elasticity of demand together account for such cannibalization effects.

A CES function specification provides the best analytical framework to appreciate the role of each of these features on the decision to spinoff and resolve some of these contradictory evidences. In particular, it provides the best chance of isolating the role of the interaction of each of these features with the elasticity of substitution among products.

Conventional microeconomic theory, with its emphasis on efficiency, assumes that all agents maximize profit for the firm. To the extent that a spinoff is not purely due to profit considerations it is necessary to invoke behavioral economics to explain the observed patterns. In particular, such an approach (a) deals with the perception and behavior of economic agents in decision making and (b) incorporates bounded rationality and self interest seeking behavior of individuals in decision making. Such an approach also enables us to (a) examine the differences between market behavior and individual behavior and its implications for business and (b) identify its impact on decision making in business and organizations.