The role of standard setting organizations in deciding product quality and process innovation

Motivation

Standard-setting organizations (SSO) are bodies that set common standards for products. This standardization aids in enhancing interoperability, safety and quality, lowering the innovation costs, alleviating uncertainty, among other things. Such standardization procedures can be attributed right from the Industrial Revolution period and eventually paved the way for what came to be called the British Standard Whitworth (adopted by different countries) and ultimately the formation of modern-day SSOs. These bodies can be at the national level (e.g., the American National Standards Institute, the French Commission Permanente de Standardisation), the regional level (CEN, ETSI — at the EU level), or at the international level (International Telecommunication Union, ISO 9000).

In addition to the aforementioned roles of an SSO, the economics literature has conjectured another important link between firms investment in process innovation (R&D) and quality choice and their participation in SSOs where it has been suggested that SSOs act as crucial decision-makers in firms’ pathway to technological innovation. We question this very point and formalize our research question—what is the impact of SSOs on firms’ incentives to innovate? In other words, we analyse whether the presence of an SSO is relevant for product-quality standardization and can it influence firms’ choice of product quality and R&D.

Methodology

We construct a simple game theoretic model where we consider a duopoly market where firms choose their product quality, investment in process innovation, and prices. We assume firms to be identical but not coordinated in their R&D activities and further abstract away from the possibility of imitation or spill-over effects; we also assume the process innovation to be costly and consumers to be uncertain about the product quality. We then analyze firms’ strategies (prices, quality and R&D investment) in two cases: (i) without the presence of an SSO and (ii) with the presence of an SSO. These two cases would help in distilling the very role the SSO might play in determining the firms’ behaviour.

Key results and recommendations

When there is an exogenous absence of an SSO we find that an individual firm that chooses a higher product quality, undertakes less investment in process innovation at equilibrium and vice versa: this confirms the existence of substitutability between the choice of product quality and the investment in process innovation for an individual firm.

We then introduce an SSO to this environment and find that if the difference in the expected product quality increases, the firms find the presence of an SSO profitable. The intuition is that SSOs removes product standardization uncertainty, internalizes competition and thus enhances firms’ profits. The next result identifies that SSOs increase the technological gap between the firms. This result builds on two findings — the first that identifies an inverse relationship between product quality and the R&D investment and the second that the SSO could lead to improvement in firms’ profits improve. Finally, we also find that SSOs unambiguously improve buyer surplus and potentially even firm surplus thereby making the market more efficient.

Policy implications and conclusion

Several of our findings are in line with the literature. Our benchmark result of a negative relationship between choosing product quality and R&D investment is reflected in the theoretical findings of the literature. In addition, the literature also finds that the creation of the ISO 9000 quality standard has led the growth of the number of member firms at an increasing rate. This translates to the fact that developing countries like China has more incentive to look forward to the ISO certification to gain access to more and better-functioning markets. Our paper also lends evidence to the notion of coexistence of standardization and innovation and highlights the importance of having institutions like SSOs to establish quality standardization in industries—facts that are also put forward by other associated academic and professional viewpoints. As a final note, our paper also spells caution in suggesting that possible incentives to enhance process innovations, including R&D tax incentives and direct government support of business R&D, and so forth may not necessarily lead to an efficient outcome.