“Variation in Interfirm Governance Structures: Incremental Improvement Versus Radical Discovery”

Department : Law & Tax

Speaker : By Professor Juliet KOSTRITSKY from Case Western Reserve University

Room : S 119

Abstract

Vertically integrated production models once dominated as a way to leverage economies of scale while minimizing transaction costs and risks like supplier hold-up. However, the 20th and 21st centuries have seen a shift towards de-verticalization, with firms increasingly turning to external contractual partnerships in response to competitive pressure and the need for knowledge that firms cannot easily generate internally. Recent scholarship has identified the manufacturing and biopharmaceutical sectors as both featuring these “contracts for innovation”. In this context, contracts remain central, but less as vehicles for legal enforcement and more in the role of providing governance structure. Understanding industrial organization and the role of contract as governance requires distinguishing between the incremental innovation seen in the manufacturing sector and radical discovery characteristic of the biopharmaceutical sector.

Drawing on analysis of long-term manufacturing contracts, biopharma strategic alliance agreements, and anonymous interviews with biopharma decision-makers, this article shows how, despite both utilizing contracts for innovation, parties employ different governance structures and enforcement strategies depending on whether they are involved in incremental innovation (manufacturing) or radical discovery (biopharma). Manufacturing relies on hierarchical standard form contracts, quality control monitoring, and informal enforcement through reputational sanctions within supplier networks. In the biopharmaceutical sector, parties must contend with a higher degree of interdependence and increased likelihood of termination due to scientific failures rather than one-sided performance failures. In contrast to manufacturing, biopharma instead relies on consent-based committee governance, detailed intellectual property delineation, lock-in provisions, step-in rights, and complex milestone-driven financial structures. Informal sanctioning is largely unavailable in biopharma, as it would cast doubt on the project, harm the firm's standing with future innovators, and risk leaking proprietary information.

These differences are explained through the concept of discriminating alignment: parties structure their governance to match the specific demands and hazards of their collaborative context. Contract in biopharma functions primarily as a planning instrument rather than an enforcement tool, with property provisions governing at termination and other critical junctures. Understanding whether an alliance will succeed therefore requires looking well beyond contract provisions alone, to the full range of private strategies, institutional arrangements, and stage-specific governance mechanisms that parties deploy throughout the life of the relationship.

              As an industry, biopharma features high complexity, interdependence, innovation clockspeed, and investment intensity.  These characteristics shape the governance structures and strategies biopharma uses to solve problems like hold-up while minimizing transaction costs, such as joint committees and rising incentives for milestone progression.  Using this framework, scholars can determine if similar structures may be beneficial in manufacturing to solve problems such as “hedging,” where suppliers hold back information, or to prevent instances like the Boeing case where the parties failed to plan for greater communication to avert delays and failures.

This research ties the governance structures and strategies in biopharma, such as joint committees and rising incentives for milestone progression, to the industry’s contextual features of high complexity, interdependence, innovation clockspeed, and investment intensity. By understanding this framework, scholars can determine whether similar structures may be useful in manufacturing. These structures may have broader applicability in other sectors that share similar industrial features.