Paper to be presented at the DRUID Summer Conference 2003 on CREATING, SHARING AND TRANSFERRING KNOWLEDGE.

The role of Geography, Institutions and Organizations.

Copenhagen June 12-14, 2003

Theme A Technical Change, Corporate Dynamics and Innovation

Analysis of the coevolution of suppliers and users through an evolutionary modelling - The case of environmental innovations.

Maïder SAINT JEAN

IFREDE – E3i University Montesquieu Bordeaux IV

Avenue Leon Duguit 33608 PESSAC - France

phone: 33 (0)556848640 - fax: 33 (0)556848647 e-mail: saintjea@montesquieu.u-bordeaux.fr

May 12th 2003

Abstract The paper aims at exploring the co-evolutionary dynamics of two populations of firms interacting through vertical relationships using an original simulation model. Suppliers-users interactions govern the R&D decisions of firms offering the product for sale, but also the requirement levels to which the industrial clients can pretend. This explicit modelling of the suppliers-users interactions comes to an endogenous determination of the attributes of the product. The objective is to examine the promoting or inhibiting effect of particular demand configuration on the patterns of innovation performed by firms in the industry. A significant application of this modelling in the question of environmental protection enables us to analyse the adaptation of the supply by firms facing a demand of environmental quality (regulation of polluting emissions, green pressure groups…). We are able to show different scenarios of market structures that emerge in the long run with different implications in terms of environmental performances.

Keywords: Supplier-user interactions - evolutionary modelling - environmental innovations - industrial dynamics

JEL: : D83, L1, Q21

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Introduction Interactivity lies at the heart of innovative processes. In particular, innovation involves complex and sustained interactions between users and producers of technology as it is the case within vertical inter-firm relationships. Inter-firm linkages are far more than arms-length market relationships. Rather, they often involve sustained quasi-cooperative relationships which shape learning and technology creation. This paper aims at examining the promoting or inhibiting effect of particular demand configurations on the patterns of innovation performed by suppliers enclosed in vertical relationships. While the focus is put on the interactions between supply and demand, we illustrate our arguments with empirical evidence grounded on observations of environmental innovation. In order to analyse the coevolutionary dynamics of two populations of firms -respectively suppliers and industrial clients- interacting through vertical relationships, we propose to use an original simulation model. Suppliers-users interactions govern the R&D decisions of firms offering the product for sale, but also the requirement levels to which the industrial clients can pretend. This explicit modelling of the suppliers-users interactions comes to an endogenous determination of the attributes of the product. This work may be seen as part of the larger paradigm of evolutionary self-organisation (Lesourne, 1993). In particular, by emphasising the fact that an economic system can, by starting from the same initial situation, knows different evolutions depending on the uncertainties of its history, the framework proposes a coherent vision of the future, undetermined but engendered by a mixture of necessity, chance and will power : the necessity of heavy trends that can be modified only slowly, the random nature of scientific discovery, the appearance of exceptional figures or the conjunction of situations, and the desire of individuals or social groups to incorporate incompatible projects into reality. The qualitative coordination of suppliers and clients is illustrated in the case of demand of environmental quality. By considering that inter-firm relationships have to cope with demand of environmental quality, new insight is given to the interdependence between technological research and perceived needs of demand. A significant constraint is the regulatory context so that, if firms are to innovate, then they must do so with respect to certain performance parameters (Kemp et al, 2000). In innovation impact studies of environmental regulation the focus is on the regulated sector. Such studies analyse how this sector has responded technologically to regulatory demand for reduced emissions from manufacturing processes and for environment-friendlier products. Little attention has been paid to interdependent development of competence between suppliers and users that is required to achieve environmental improvements. Integral process change and product design are of prime importance to the economic competitiveness of the firm. The window of opportunity for making integral process change is limited. Moreover, environmentally improved products must meet important user requirements. This shows the importance of interfirm relationships for innovation. Environmental innovation requires changes across the production chain. Such changes are difficult to manage. They require adaptation at different levels. The question is then what are the impacts of such adaptations upon the outputs of innovation. The model we propose intends to tackle this question. The economic mechanisms integrated in the model are described in section 1. Section 2 gives a presentation of the main results.

1. The Model In the model, supply by firms evolves so as to adapt to demand pressures and requirements of clients evolve so as to adapt to technological changes and modifications of industrial structures. This produces an analysis of market interactions that takes into account the process

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of coevolution of supply and demand. Our purpose is to adopt a modelling of demand which enables us to integrate the interactions between suppliers and users of multi-characteristics products so as to develop an analysis of the coevolution of environmental innovations and demand of products with environmental performance characteristics.

1.1 The main building blocks The representation of demand is first presented. Since we assume vertically related firms, we then need to specify the modes of interactions between suppliers and clients we have assumed. At last, we explicit the modelling of technological change.

1.1.1 The representation of demand • The definition of goods in terms of characteristics According to Lancaster (1966, 1971), a good contains a bundle of performance characteristics or attributes. Firms fit into competition by offering the combination of characteristics that they think they are more attractive to consumers than those offered by their rivals. In this way each firm effectively offers consumers a distinct point within a multidimensional character space. Product innovation is the means by which firms search this character space. In our analysis, we consider that the product at stake in the transactions between vertically related firms is defined as regard to four "objective" characteristics : - the productive efficiency (noted Ap), i.e. the gains in productivity resulting from

innovations at the production process level; - the product performance (its economic efficiency, noted Am); - the environmental quality of the production process (noted Ip); - the environmental quality of the product (noted Im). Each characteristic is associated with a level of performance that is achieved by the supplier thanks to its innovative activities. Price are dependent upon the gains in productivity achieved thanks to process innovations. We consider that firms determine the price of their product founding on production costs with a mark-up rate and we have an inverse relation between the price of the product and the gains in productivity (Ap). The considered industry is thus characterised by a good differentiated by its economic and environmental performances and its price. • The representation of the preferences The four characteristics previously defined are the subject of the interests of the product users. We assume that the clients allocate a weight to each characteristic. The higher the weight of the characteristic, the more important this characteristic is for the client and inversely. The set of weights stands for the preferences of the client1. Heterogeneity of buyers can be grasped. Cowan et al (1997) have stressed that heterogeneity of consumers has a major influence on the dynamics of demand. According to Metcalfe (2001), these variations are constrained, guided by broader social and political forces, sometimes embodied in law (prohibitions on alcohol or tobacco), and often embodied in social constraints about what constitutes acceptable consumption. In our model, heterogeneity of buyers is reflected in the differentiated weight various groups of clients attribute to the product characteristics and also in the budget constraints. Environmental regulation plays clearly a major role in the nature of preferences and requirements related to demand of environmental quality.

1 This terminology may not be very adequate since we tackle the question of interfirm relationships and so the profitability considerations of the clients. However, for simplification, we still use this term of preference.

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• Price and out price constraints In order to take into account budgetary limits and requirements of minimal quality that clients want their suppliers to comply with, we introduce price and out-price constraints besides the subjective preferences. These constraints differ from one client to another. So we assume that each client is endowed with a reservation price. The economic interpretation is that intermediary clients have to cope with costs constraints concerning manufacturing of final product that they transmit to their suppliers at the time of commitment in contractual relations. So clients are characterised by a maximum level of price not to exceed given their cost constraints. Moreover, clients have claims in terms of minimum quality either for product performance (efficiency) or environmental quality. Concerning requirements of minimum product performance, it seems reasonable to consider that clients submit quality clauses to their suppliers (quality standards such as ISO9000 for example) in order to reach a certain level of product performance and efficiency. As to demand of minimum environmental quality, they are directly linked to environmental regulation. Emissions standards at the product level may exist so that producers of final good have to comply with it and may specify not to use some polluting and prohibited substances to their suppliers. As well final producers that anticipate a strengthening of regulation and wish to avoid the questioning of their product legitimacy may enforce their suppliers to comply themselves with regulation and may impose requirements relative to the production process. So the model takes into account such thresholds of minimum environmental quality that are enforced by regulation and that industrial clients put on their suppliers.

1.1.2 The modes of interactions • Modality of information gathering and transfer The model consists in a population of firms supplying an equipment (or intermediary) good, that faces a population of heterogeneous groups of users. This good is defined in terms of product characteristics in the Lancasterian sense. These characteristics need to be coordinated qualitatively by suppliers and users. This involves a transfer of information between both populations that we explicitly take into account. We assume that each firm knows the priority motivations of its clients and when it does not meet the minimum requirements. Clients motivations are given by the weight they destine for each characteristic. The higher the weight, the more important the characteristic is for the client and the higher the pressure it exerts to get a product with the corresponding profile. Moreover, we consider that the clients are likely to require from their suppliers that they reach at least an objective of minimum quality and that they do not exceed an upper price limit. If a supplier, chosen according its global performance, does not meet one of these requirements, we assume that the client voices the case where the performance levels of the supplier are not sufficient regarding its claim. The inquiry into the needs of the demand that goes to the suppliers is justified because the client knows better the supplier than in the case of a classical relationship buyer/seller, in particular because of a limited number of suppliers and clients facing together. Interdependent links that characterise interfirm relationships contribute to a better knowledge of firms between them and favour the specification of the significant performance characteristics as well as the voice. This share of information is essential in the perspective of a collaboration in product innovations. • The R&D investment decision rule of firms Such data are used to determine the firms strategies for orienting their R&D activities. So in our model, the R&D investment rule of firms evolves through time. We assume that firms

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decide to concentrate their R&D efforts on the base of the twofold information each of them is gathering from its clients and of the ability to propose an offer differentiated from the rivals one. So two types of data are used to guide firms choices : - the product characteristics that are considered as priority by the current clients, as regard

to the maximal weights they attribute to these characteristics, and that represent a source of technological lead for the supplier;

- the product characteristics for which the supplier holds performances inferior to those required at minima by the clients and that are likely to cause defections at the end of the product use period. Hence the supplier gathers data about these characteristics and takes it into account in its reallocation of the R&D budget across the various characteristics.

Such an assumption about the evolution of the R&D investment rule of firms seems particularly relevant as far as the firms carry out innovative steps to meet client needs and to pursue a product differentiation. This rule implies that the firms make evolve the share of their R&D investment across the various characteristics in an adaptive way in accordance with the demand needs and with the technological lead performed compared to the rivals. • The buying/defection rule of clients In the model, each client buys one single product and the replacement of product -which corresponds to an intermediary good or an equipment good by hypothesis- occurs after a certain period of use. When they choose a product, buyers examine the whole products currently available on the market and in some extent they are able to evaluate them. Restrictions are related to limitations in the cognitive capacities of the agents. We assume that the price and the product performance are two objective characteristics easily observable by the clients. This leads to consider that the clients are endowed with an adequate technical expertise that give them the possibility to check the product performance such as proposed by the suppliers. However, we assume that environmental characteristics are more difficult to verify by a buyer. The environmental quality perceived by a buyer will be drawn from a normal probability law. The purchase decision is made on the base of the global performance of suppliers which is accessible through the level of price, the product performance and the perceived environmental quality at the process and product levels. A form of inertia is introduced in the behaviour of buyers by accounting the market shares of firms in the buying decision of clients. Market shares are used as an indicator of the suppliers' reputation. Hence, one part of the information that guide the product choice is passed on through the past choices of the product users. The distribution of firms market shares accounts for the reputation a firm holds with its clients. In a context of uncertainty, an agent who wishes to buy a new product will tend to refer to the choice made by the other users in the past (Cowan et al., 1997, Valente, 1999; Malerba et al., 1999). This assumption introduces a form of mimetism in the behaviour of the product users. Another form of inertia is introduced in the behaviour of clients when they replace the product by a new one. We have firstly assumed that, when a client selects one supplier, it delivers information related to the characteristics that have insufficient levels of performance compared to the minimum performance requirements of the client. We consider that these information serve as criteria for the client to decide whether or not it leaves the current supplier. The comparison of the current performances of the supplier with the requirement threshold of the client enables it to determine whether or not it keeps this supplier. When the supplier reaches the minimum performance requirements of a client, the latter is satisfied, which introduces a form of stability in the suppliers-clients relationships. In general, the commitment underlying contractual relations between principals and subcontractors is conditioned by a price and a product quality agreement. There still exits an

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uncertainty about the ability of the supplier to offer, at the end of the commitment period, a product that comply with the criteria set by the client since suitable competences do not necessarily exist at the beginning of the contract and are still to be built. But nothing guarantees that the supplier will be able to develop the competences necessary to carry out its commitment and that it will succeed in meeting the client requirements in fine. That's why, in our model, we assume that, at the time of purchase, the client voices not only the most important characteristics for him but also the characteristics that do not reach the critical threshold even if it chooses the supplier on the base of its global performance. However, if at the end of the product using period the current supplier does not succeed yet in meeting the client's requirements, the latter will decide then to leave and will select among the other existing suppliers in the same way as before, that is on the base of their global performance. On the contrary, the satisfaction of the client leads to the voice and justifies the durability of the relationship. This illustrates an effect of development of customer loyalty that likely occurs within vertical interfirm relationships. • The evolution of minimal requirements of clients While the evolution of the product characteristics depends on the firms R&D investment, technological progress performed by firms is likely to change the requirements of clients. As technological progress proceeds -itself dependent on demand structure-, the uses of product may change and induce the clients to update their minimum requirements of product performance. This aspect grasps consumer learning and the fact that consumer experience shape the mode of product consumption and use. Past consumer experience and social interactions (learning by observing the experience of others) intervene as complement to the own direct experience of an individual consumer (Witt, 2001; Windrum and Birchenhall, 1998). We thus consider that the minimum requirements of clients are subject to adaptations through time depending upon the average performances of the industry. At each period, clients make a comparison between the level of minimum performance they attribute to one characteristic and the corresponding average performance of the industry weighted by the market shares. When the level of minimum performance a client attributes to a characteristic is below to the average performance weighted by the market shares, the client will revise increasingly the minimum requirement to which it can pretend given the average outcomes of the industry. This hypothesis illustrates the diffusion of information relative to the advances performed in the industry to the whole clients. The clients acquire indirectly the knowledge about the progress made on the product on the base of the average performances in the industry. In some extent, buyers are informed about these performances thanks to communication and advertising campaigns for example, which enable them to adjust their own requirements of minimum performance that they transmit to their suppliers at the time of purchase. The requirements thresholds of buyers evolve in an adaptive way in accordance with the average performance of the industry weighted by the market shares. So, the evolution of clients requirements depends not only upon the evolution of the product performances regarding the past requirements of clients, but also upon the innovative strategies of firms.

1.1.3 The stylised coevolution of supply and demand The model enables to apprehend the dynamics of coevolution of both populations of firms and buyers on the base of their interactions. Such interactions rely on three mechanisms : • Each purchase gives information to the selected supplier about the characteristics that the

client considers as most important. So the supplier takes the measure of the demand pressure that it faces in the period. It links this information with another one in order to

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limit the possible search directions. Hence, concerned about differentiating from rivals and seeking for dominant position, the supplier also takes into account the technological lead it holds regarding some characteristics. All in all, the supplier will take into consideration (by giving a positive score) the characteristics that are not only an opportunity to obtain and reinforce its technological lead but also that are priority for the clients. This type of information is used in the adaptation of R&D indexes that allow to allocate the R&D investment to the characteristics. By this way, demand influences supply through the consideration of the characteristics believed as priority by the clients while competition between suppliers shapes also production patterns.

• The purchase of a client gives another type of information to the selected supplier concerning its capacity to meet or not the minimum performances required by the client. In this respect, the supplier records which characteristic has an insufficient performance compared to the minimum requirements claimed by the client that chooses it (a negative score is attributed to the characteristics in question). This information is taken into account in the updating of R&D indexes that are used to orient R&D investment across characteristics. Again, through this mechanism, demand affects supply through the performance requirements to which clients can pretend a minima. This information is then used by the client to assess the current supplier after the period of product use. From this moment, the prevailing decision rule of the client uses the maximum price and the requirements of minimum performance for product efficiency and environmental quality, so that the client leaves the current supplier if one at least of those criteria is not reached.

• From one period to another, a client adjusts the threshold levels that it uses at the time of product replacement in order to decide whether it leaves or not its current supplier. Such adaptation depends upon the average performance of the industry on each characteristic. More specifically, for each characteristic, a client determines its threshold level by comparing the level of minimum requirement it actually claims for one characteristic and the average performance of the industry weighted by the market shares. Concerning the characteristics of quality (Am, Ip and Im), when the average performance weighted by the market shares comes over the level of minimum requirement of the client, the latter increases its threshold index in proportion with the lag on the average weighted by the subjective preference the client allows to the characteristic. As to the maximum price, it will come to decrease when the average price in the industry comes below the maximum price of the client while accounting for the gap with respect to the average weighted by the subjective preference for the price. Through this mechanism, supply by the industry shapes demand through average performance of the industry on each characteristic that guide the levels of claim in terms of minimal performance clients can require from their suppliers.

Scheme 1 summarises the mechanisms of interaction between suppliers and clients considered in the model. Firms know the profile of the current buyers (arrow 1) while purchase decisions of buyers are motivated by the global performance of a supplier (arrow 2) and also by their subjective preferences that are represented by the weights attributed to each characteristic (arrow 2'). Innovative activities carried out by firms lead to improve average performances of industry, which tend to pull maximum price down and to level up requirements of minimum performance of clients (arrow 3), all the more strongly that they assign a great priority to the considered characteristics (arrow 3'). Such requirements of minimum performance intervene in the decision to leave a supplier at the time of product replacement (arrow 4). In case of defection, the client will address to the other suppliers still active in the market and will make its purchase by comparing the various global performances weighted by its subjective

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preferences. In case of satisfaction, the client will renew the purchase among the same supplier.

Scheme 1 : Supply-Demand Interactions

1.2 The modelling of technological change • The main properties of technological change Literature in economics of innovation (Nelson and Winter, 1982; Dosi et al., 1988) stresses that the innovation process is interactive, cumulative, uncertain and firm specific. Innovative activities occur in technological paradigms (Dosi, 1988). The followed paths constitute the technological trajectories of firms. Such trajectories are guided by radical and incremental innovations. These features are translated into an appropriate formal writing. Our model belongs to the tradition of models that explore the disembodied features of technological innovations which can reside in (tacit) human skills, organisational competence or societal capabilities (Windrum, 1999). Moreover, innovation is treated as a stochastic process. As Silverberg and Verspagen (1995) note, this reflects a general consensus that stochasticity captures the uncertainty of the link that exists between innovative effects and final outcomes. Only new paradigms that modify the way firms conceive their modes of production are able to offer a framework that fully integrates the environmental constraint and where innovative activities of firms can deploy. The advent of new "green paradigms" in industrial sectors is a condition for trajectories of clean technologies to renew and to avoid the saturation of technological opportunities of initial paradigms. The advent of a new paradigm founds a new competitive space that calls for new technical competence and in terms of approach of environmental issues. This new space of opportunities induces a new variation in trajectories. However, the change of paradigm is generally associated to a creative destruction process, putting into question not only the knowledge base underlying the initial paradigm, but also past competencies. In the literature on technological change, such an effect is called competence destroying process (Tushman and Anderson, 1986; Henderson and Clark, 1990; Anderson and Tushman, 1990). • Illustration with environmental issues

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In our model, two environmental aspects are considered : the polluting impact of the production process and the polluting impact of the product from which it is manufactured. Clients have requirements on these two aspects. They are themselves subject to environmental regulation that they put on their suppliers. They are also sensitive to environmental demands emanating from customers as far as this pressure can constitute a threat for their activity in case of doubt about environmental quality of the product. In our model, two types of technological change are considered : an incremental change and a radical change. The incremental change arises within a given technological potential whereas the radical change corresponds to the change of potential. A potential represents opportunities and constraints that are offered by a generic knowledge base, that is a technological paradigm. Concerning the opportunities offered by the environmental dimension, we propose to distinct two paradigms (cf. figure 1) : the paradigm 1 with low environmental potential and the paradigm 2 with high environmental potential.

Figure 1 : the space of technological and environmental opportunities in the model

We assume that the switch carried out by a firm in the paradigm with high environmental potential leads to the following effects : - a shift in the frontier achievable on the dimension "environmental quality of

process" (Ip), the frontier on the dimension "productive efficiency" being unchanged. This effect means that the change of "green" paradigm leads the firm to reach higher values of environmental quality of process and to reach at best the upper value of productive efficiency set in the initial paradigm. Such a configuration lies on the hypothesis of a positive relation between eco-design and advanced technologies (Florida, 1996);

- A drop in the product performance (Am). This effect considers that the change of green paradigm, which corresponds to new manufacturing manners, is associated with an alteration of product performances. Under this restrictive hypothesis, we take into account the fact that the stage that follows the change of paradigm corresponds to a stage during which the new product is less efficient than the one it replaces (Belis et al., 2001);

- A decrease in the cumulated experience (E). The third effect reflects a "competence destroying effect" of technological change, generally associated to a change of paradigm. Entry in the new paradigm requires to begin a new learning phase in order to cumulate knowledge and competence adapted to the new productive practices. That's why we assume a decrease in experience when a firm enters the new green paradigm.

Apmax2 Apmax1

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Moreover we assume that a threshold exists in terms of productive efficiency (Apmax1 in figure 1) gained by firms that evolve in the first paradigm. According to this hypothesis, we take into account the fact that firms aiming at competitive advantages have to cross a first stage before being able to reach higher levels of productive efficiency. The crossing of this stage requires to develop new competence. Beyond this stage, a complete modification of the process is at stake and may lead to important gains in productivity linked for example to the improvement of trade image. However this can not involve a change of green paradigm as far as the type of product and its performances are not radically modified and there is no complete removal of the polluting substance subject to regulation.

2. The main results Before presenting the simulations results, we first need to explicit through the protocol of simulation the main initial conditions and the procedures of results analysis we have considered.

2.1 The protocol of simulation (experimental set-up) • Initial conditions We consider a population of 12 firms interacting with a population of 200 buyers. Each buyer makes a purchase at the first period and then renews randomly the purchase of the product in an interval comprising one to ten periods. Each simulation run comprises 500 iterations. Firms are initially identical so as the differences likely to emerge over the dynamics of the system result from their specific interactions with the set of buyers. Whatever the characteristics, initial technological level of each firm is set to 1. The evolution of product characteristics arises in a frame delimited by a potential of development. Each characteristic is endowed with a superior limit that represents technological constraints. We assume the coexistence of two paradigms differentiated in terms of potential for improving environmental quality of the process (cf. figure 1 infra). The model incorporates three stochastic processes that guide the evolution of variables. First, the selection of a supplier by a buyer brings in purchase probabilities that depend on the global performance of suppliers and on their market share but also on the subjective preferences. Second, the perception of the characteristics of environmental quality by buyers result from the drawing in a normal law with average, the level achieved by the supplier for the considered characteristic, and with standard deviation, a parameter calibrating the degree of error of evaluation of environmental quality. Third, the innovation process follows a two step procedure that enable to determine the access or not to the innovation and then the outcome of innovation in case of success. Only the first step is subject to a random drawing thanks to innovation probabilities for each product characteristic. Given these random processes, a high number of simulation runs needs to be carried out in order to stress the regularities of the industrial dynamics. We outline the emergent properties of the dynamics through batteries of simulations. To implement the model, we use the programming system LSD (Laboratory Simulation Development) developed by M. Valente at the IIASA. A complete report of the model, including equations and computer programming of the model, can be provided on request. Concerning the demand structure, two distinct groups of clients are considered. Differences across both groups lie on the subjective preferences, that is on the weight attributed to each characteristic for the evaluation of the suppliers performance, and also on the reservation price. The first group of clients (G1) strongly weights environmental characteristics whereas

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price and product performance are weakly weighted. This group represents 20% of demand. The inverse is assumed for the second group of clients (G2) which represents 80% of demand. Group 1 is supposed to have a reservation price relatively high in conformity with the assumption according which this type of clients is willing to pay higher price for products meeting environmental criteria. Group 2 which pays great attention to price and product performance is supposed to have a reservation price relatively low. The point is that a client that wants to adopt an environmental positioning on the final good market will consequently make stronger demands on environmental characteristics than on price to its suppliers since it wills to grant a more important budget to buy such a product. That's why weightings and reservation price are set in consistency with the orientation showed by the type of clients. The requirements in terms of minimum performance of product are supposed identical for both groups of clients. The requirements in terms of minimum environmental performance are the same for both groups since they are enforced by regulatory authority and apply homogeneously in the industry. However the various thresholds indexes evolve differently across groups of clients in accordance with their subjective preferences and the average performances of industry. The results presented below use the following parameterisation : maximum price for G1=4; maximum price for G2=1; minimum product performance=2 for both groups; minimum environmental standard for process=1.5 for both groups; minimum environmental standard for product=2 for both groups. • Analysis of results In order to exhibit the aggregated regularities of industrial dynamics, we present the aggregated results achieved with a battery of 50 simulations runs. The aim is to put the emphasis on the favourable conditions to the emergence of radically new clean technologies that enable to leave the paradigm with low environmental potential (§2.2). The detailed analysis of the coevolutionary dynamics of firms strategies and buyers requirements will lead to stress the main factors that contribute to the emergence of green market niches. Such analysis will be carried out thanks to specific individual simulation runs (§.2.3). The evolution of firms market shares and the trajectories of clean technologies grasped through the evolution of the four product characteristics will be depicted, as well as the evolution of firms performances in the space (Ap, Ip) where paradigms are defined, the evolution of product performance (Am) and the evolution of environmental quality of product (Im).

2.2 The main regularities of the industrial dynamics : the emergence of two alternative scenarios

2.2.1 The emergence of two alternative scenarios The aggregated results stress two alternative types of industrial structure emerging in the long run : - A concentrated structure constituted by firms with a specialisation on price and

product performance. The firms that survive after 500 periods are characterised by a high R&D investment in the economic performances of process (Ap) and product (Am) while complying with environmental regulation. However these firms do not change paradigm. This scenario emphasises the emergence of a monopolistic or oligopolistic structure with firms oriented toward the improvement of price competitiveness and product performance and that are evolving within the paradigm with low environmental potential. Over a battery of 50 simulation runs, 26 series correspond to this scenario. We call it "scenario HO" for homogeneous oligopoly;

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- A concentrated structure where coexist a "green" market niche and a low number of

dominating firms characterised by a technological lead on price and product performance. The "green" market niche results from the survival of a firm characterised by a high environmental R&D investment that enables it to change paradigm, but also by a high price and a low product performance. This scenario emphasises a market segmentation with the emergence of a green market niche dominated by a firm that mainly orients its R&D activities toward the improvement of environmental quality and that evolve in the paradigm with high environmental potential. This niche coexists with (at least) one firm specialised in price and product performance which dominates the market. Over a battery of 50 simulation runs, 20 series corresponding to this case have been observed2. We call it "scenario MS" for market segmentation.

Figure 2 represents the average of inverse Herfindhal index over the 50 simulation runs at different periods. This illustrates a progressive increase in the market concentration due to the survival of a limited number of firms specialised in a low number of product characteristics.

Figure 2 : Evolution of market concentration in the reference configuration

In both cases HO and MS, the most efficient firms in terms of productive efficiency and product performance are dominating the market and they benefit from a higher turnover thanks to numerous clients that voice strong pressures on price and product efficiency. This leads firms to concentrate their efforts on productive R&D3 and so to acquire market shares. Scenario HO represents the domination of a low number of firms all specialised in price and product performance. These firms favour investments in productive R&D so that alternative products existing in the market exhibit quite the same characteristics. This homogenisation corresponds to the emergence of a dominant design in the industry (Abernathy, Utterback, 1975). In the scenario MS, the industrial structure is characterised by the survival in the long run of an innovative firm which is the only one to offer a product meeting environmental criteria that some clients wish to value and will to pay a relatively high price. The capture of such a green group makes possible the constitution of a green market niche that coexists with a leading

2 Over a battery of 50 simulation runs, we have observed four specific cases which were characterised in the long run by a domination of firms specialised in economic performances and that had changed paradigm. The low frequency of apparition of this type of situation led us to focus on the analysis of the two other more frequent cases. 3 Productive R&D corresponds to R&D investment dedicated to the improvement of economic characteristics of the product whereas environmental R&D is dedicated to the improvement of environmental characteristics.

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firm specialised in price and product performance. This case is characterised by a strong heterogeneity across firms in terms of R&D sharing between productive R&D and environmental R&D (cf. figure 3). DeltaI stands for the share of R&D investment dedicated to clean technologies (process and product) over the total amount of R&D investment. We observe that firms investing strongly in environmental characteristics (DeltaI superior to 80%) hold a market share inferior to 20%. Such firms coexist with firms whose environmental R&D rate does not exceed 30%, but are dominating the market in terms of market share.

Figure 3 : Market shares and share of environmental R&D in the scenario MS

2.2.2 Emergent properties of the industrial dynamics The evolution of the market structure is linked to the process of product differentiation exerted by firms in the market to meet heterogeneous needs related to different groups of clients. Firms orient their R&D efforts in a targeted way so as to improve the characteristics that benefit from a strong pressure from demand and that allow them to gain technological lead compared to rivals, likely to be further exploited. Since neither of firms is able to initially meet the requirements of minimum performance, the first moment of competition are featured by a "compliance stage" during which clients make defection after each period of product use. Such instability in the suppliers-users relationships favours technological progress for the characteristics initially below minimum requirements. Once compliance achieved, firms focus on the characteristics that the clients weight the most strongly and that give them the opportunity to reinforce their lead compared to the rivals. This evolution leads to a specialisation of firms that increase the differences across the performances of products characteristics. As quality deviation increase, clients can choose products more consistently with their preferences. Indeed, the selection made by client is based on the global performance of a supplier according to a merit function that depends upon each characteristic weighted by the subjective preference of the client, and also on the supplier's market share. Given that selection process, specialised firms progressively attract the corresponding clients. The process of adaptation of clients' requirements according to technological progress achieved in the whole industry contributes to amplify the pressure that clients exert on the firms that need to take into account the rise in the requirement levels. So, the process of firms specialisation lead, through a self reinforcing effect, to the rise in the requirement levels of clients. In the long run, technological potential is exploited asymmetrically by firms according to their specialisation. This is particularly true in the scenario MS where a polarization between

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productive and environmental firms occurs due to a market segmentation. For scenario HO, given the relatively homogeneous market structure constituted by firms that focus on economic competitiveness, there is a low diversity across the products offered. This feature is such that firms succeed in meeting jointly the needs of both groups of clients. This is due to the weakness of opportunities for improving environmental quality of the production process that prevail in the first paradigm in which firms specialised in economic competitiveness are developing. Moreover, the comparison between scenario HO (homogeneous oligopoly) and scenario MS (market segmentation) shows a) a strong positive correlation between productive efficiency and market share and also between product performance and market share (cf. Appendix A1, figures 1 and 3); b) an inverse trend concerning the link between environmental quality of process and market share (c,f. Appendix A1, figure 2); c) a blurred relation between environmental quality of product and market share (cf. Appendix A1, figure 4), so that the economic characteristics are mainly determining the market share of firms in the long term. Concerning the features of demand in the long run, we observe the constitution of heterogeneous requirements of minimum performance across both groups of clients and also a decrease in the difference of reservation price between these two groups compared to the initial difference (equals to 3). We observe a decrease in the maximum price at the last period for the groups G1 and G2 and also the persistence of a price deviation between both groups (Cf. Appendix A2, figure 1). Figure 2 in Appendix A2 shows, at the last period, a very high rise in the levels of requirements of product performance by group G2, compared to initial thresholds (2), whereas group G1 aspires to relatively low levels and close to those initially set. Figures 3 and 4 in Appendix A2 show some differences in the levels of requirements of minimum environmental performance of process and product across the groups G1 and G2. We observe that group G2 keeps levels of requirement close to those initially imposed by regulation (1.5 for the process and 2 for the product) whereas group G1 aspires to levels of environmental performances set beyond regulatory compliance. Moreover group G1 with environmental position tends to be more demanding in the long run on environmental quality of process in the scenario MS than in the scenario HO. This property results from very high performances achieved for this characteristic by the firm betting on environment that succeeds in constituting a market niche. Indeed the strong specialisation of such a firm enables it to access paradigm with high potential for improving environmental quality of the process, which contributes to pull minimum requirements of clients up, especially of group G1 characterised by a strong attention to environmental criteria. The evolution of reservation price and requirements of minimum performance is linked to the specialisation process of firms in competition. Given that clients progressively update their requirement thresholds according to the deviation between progress achieved in average in the industry and their initial pretension -deviation all the more taken into account as the characteristic matters for the client (high weighting)-, clients tend to revise down their budgetary constraint and revise up their minimum quality requirements according to the average performances of industry. But the average performances of industry depend on innovative activities of firms which are determined by the orientation of R&D activities that found their specialisation. Consequently, specialisation of firms pull maximum price down and pull requirements of minimum economic and environmental performances up. Proposition 1 : Endogenous interactions between suppliers and clients subject to environmental quality constraints implies :

14

- A high industrial concentration related to the firms specialisation on a low number of product characteristics;

- The leadership of firms specialised on economic characteristics and selected by clients whose levels of environmental requirement are just equivalent to those imposed initially by regulation;

- The conditional appearance of a green market niche dominated by a firm specialised on the improvement of environmental characteristics of the product. This niche relies upon the capture of the clients with high environmental ranking, willing to pay a relatively high price and characterised by lower requirements in terms of product performance. The firm with a local monopoly on environment-friendlier products is able to go beyond the regulatory compliance in relation with the evolution of requirements of the green clients.

In order to explain in details the mode of market evolution in the case of the emergence of a green market niche, we proceed to the analysis of the coevolution of firms strategies and clients' requirements by facing the two scenarios HO and MS. Results originate from specific simulation runs that are representative of these two cases.

2.3 The detailed analysis of the coevolutionary dynamics of suppliers and users For each scenario, surviving firms at the last period are represented with thick lines whereas dying firms are represented with thin gray lines.

2.3.1 The detailed analysis of scenario "Market Segmentation" The detailed analysis of scenario MS shows the great specialisation of firms F1 and F2 on different characteristics that enable them to gain a local monopoly. F1 is leader on price and product performance whereas F2 is leader on environmental characteristics. These differences in specialisation are reflected in firms R&D investment rates. firm F1 succeeds in dominating the market in the long run with 90% of market shares against 10% for firm F2.

Figures 4 to 7 to insert Until period 96, firm F2 orients its R&D expenses in a relatively balanced way toward product performance (Am) and environmental characteristics (Ip and Im) at the expense of the decrease in production costs. This strategy enables it to hold, during this period, the most important market share (almost 20%, cf. figure 4). At period 96, firm F2 changes paradigm since it reaches, thanks to its innovative activities, a level of environmental performance for the process superior to 3 (cf. figure 5). This paradigmatic change leads to a drop in the firm's market shares (cf. figure) due to the simultaneous decrease in product performance Am (cf. figure 6) and in cumulated experience on each characteristic. The falling down of product performance consecutive to the change of paradigm of firm F2 lead to defections of clients. Indeed, the firm F2's product is no longer able to meet minimum requirements of clients which thus leave the firm. Defections involve a decrease in the firm's market share, which -jointly with the falling down of product performance- affects negatively the possibility to be selected by potential clients. On the base of information gathered beside new clients, firm F2 is induced to recover the level over the deficient characteristics as regard to minimum requirements of clients. Therefore, this firm proceeds to a reorientation of its R&D expenses so that it increases transitorily its rate of productive R&D investment dedicated to the improvement of productive efficiency (Ap) and product performance (Am). This leads to give satisfaction to clients with low levels of requirements in terms of price and product

15

performance, which corresponds to the green clients. So, firm F2 ends in specialising only in environmental characteristics (Ip and Im) from which it can consolidate its lead compared to the rivals and capture the clients that strongly weight these characteristics. Such clients renew the purchase among F2 since this firm meets the whole of their requirement criteria. The firm's product is then characterised by a high price, a low level of product performance (Am) and very high levels of environmental quality. Such product is destined for clients demanding on environment protection, willing to pay a relatively high price and to have a product at one's disposal which is much less efficient than the one offered by firm F1. We observe that firm F1 evolves in the paradigm with low environmental potential after compliance with levels of minimum environmental performance initially set (cf. figures 5 and 7). The firm F1 succeeds in dominating the market thanks to its competitive advantage on price and product performance, these two characteristics being the most demanded in the market. The costs domination of firm F1 leads to an increase in intensity of requirements of the whole clients in terms of willingness to pay the product. The point is that group G1 of clients with environmental position is subordinate from the first periods to process innovations of firms that lead to improvement of productivity gains and so, to reductions in the products price. Price requirements of group G2 are so strong that any firm is able to meet them immediately, which make them unchanged until period 136. From period 136, clients of group G2 are also induced to revise their reservation price down under the influence of decrease in average price in industry. However, a deviation of reservation price still persists across both groups of clients which is enough important to allow firm F2 to capture clients with environmental positioning and to constitute a green market niche. Likewise, technological lead acquired by firm F1 on product performance is associated with a rise in the corresponding minimum requirements of the whole clients. However, this rise in the requirement level is more manifest for group G2 which favours economic characteristics of product, than for group G1 with environmental positioning.

2.3.2 The detailed analysis of scenario "Homogeneous Oligopoly" The detailed analysis of scenario HO shows the domination in the long run of three firms specialised on economic characteristics of product. Market is relatively equally shared between these firms since they respectively gain 37%, 35% and 28% of market shares (cf. figure 8).

Figures 8 to 11 to insert The three firms exhibit relatively homogeneous performances over the four product characteristics. Hence, each of them succeeds in achieving high levels of productive efficiency and product performance close to their maximum limit set to 14 (cf. figures 8 and 10). Concerning environmental quality of process (Ip), the three firms succeed in reaching levels inferior to 3 in the long run, which corresponds to the development of trajectories of clean technologies within the paradigm with low environmental potential. As to environmental quality of product (Im), two firms get a level close to 4 and one firm reaches a level close to 7 so that they situate in a corridor of performances whose maximum values are achieved by competing firms specialised in environment and whose minimum values are established by initial regulatory requirements (cf. figure 11). The result is that average environmental performance of product at the industry level obtained in scenario HO is equivalent in the long run to the one obtained in scenario MS although we could have expected a more important difference in favour of the MS case.

16

So in the scenario HO the three surviving firms offer very efficient products that are also relatively clean for use, based on efficient production processes and on incremental improvements of environmental quality of these processes. Specialisation of firms are reflected in R&D expenses they allocate to the characteristics.

2.3.3 The emergence of market niche : some generic properties In both scenarios MS and HO, industrial dynamics essentially lies upon the combination of two mutually related processes : first, a progressive specialisation of suppliers on a low number of characteristics following demand impulse and second, the adaptation of clients' requirements following average performances of industry. Indeed, R&D orientation is dependent on demand pressure (weighting and minimum requirements) and on lead regarding the rivals. This process determines the innovative capacity of a supplier over the various characteristics. At the same time, the intensity of minimum requirements claimed by clients depends on average performance of industry weighted by firms market shares. Since R&D investments dedicated to the improvement of product characteristics influence minimum requirements of clients, their rise, linked to innovative activities of firms, tend to reinforce the R&D intensity assigned to the characteristics whose requirement level has risen. Thus, this process favours not only the domination of innovative and specialised firms on these fields, but imposes also to level the characteristics subject to requirements of minimum performance. Compared to scenario MS, the low diversity across firms that features the scenario HO does not lead to high individual environmental performances, which has repercussions on the levels of requirement of environmental performance to which clients can pretend a minima. So group G1 is characterised by requirements of minimum environmental performance for the process lesser in the scenario HO than in the scenario MS in the long run. On that account, the intensity of competition that prevails across the firms leaders on the most demanded characteristics tend to condition the emergence and the survival of a green market niche. Indeed, given the low number of green clients initially willing to pay a higher price for a product meeting environmental criteria and given the specificity of the adaptive rule of minimum requirement thresholds, firms betting on improvements of environmental quality are penalised by the generalised diffusion of economic performances (productive efficiency and product performance) to the whole clients and also by the low intensity of requirements of environmental performances likely to emanate from a leader group of green clients. Competition may be -as in the scenario HO- sufficiently rapid and strong across firms betting on price and product performance so that average performances of industry achieved for the price affect noticeably budgetary requirements of green clients. The following decrease in reservation price creates a disadvantage for firms specialised on environmental quality and less efficient regarding price. On the contrary, the constitution of a green market niche requires to capture clients willing to pay a relatively high price for a product meeting environmental quality criteria. Hence, maximum price of clients that exert a strong pressure on environmental characteristics of product remains enough high so that the firm specialised in environment may benefit from a turnover enough high that enables it to invest in R&D and to meet the requirements of clients with environmental positioning. However persistence of relatively high level of maximum price for the group of green clients and persistence of price deviation between both groups are necessary but not sufficient conditions to the emergence and survival of a green market niche in the long run. It is also essential that a group with requirements of environmental performance going beyond regulatory compliance is developing, thus playing the role of pioneering users in environment.

17

Finally the emergence and survival of a green market niche depends on the conjunction of two processes that we can summarise with the following propositions : Proposition 3 : the growing intensity of the competition between firms betting on price competitiveness contributes to lower the price requirements of the whole clients and in particular the willingness to pay initially high of the green group of clients. This effect reduces the possibility for firms specialised in environment to benefit from a high monopoly rent. Proposition 4 : the pressure exerted on the economic characteristics by the firms betting on price competitiveness and product performance slows down the levelling up of the requirements of minimum environmental performance of the green group of clients, still able to reinforce the specialisation of the pioneering firms in environment and to contribute to the progress in the paradigm with high environmental potential. So price competition tends to prevent the green market niche to capture a group of green clients characterised by requirements of environmental quality that are ahead of those set by regulatory standards. This leads to the following proposition : Proposition 5 : the pressure exerted on the price by the clients and sustained by the upstream competition between suppliers can jeopardise the survival of a green market niche We note that survival of firms with good performances on environmental characteristics is more difficult because they have to overcome the effects of paradigmatic change linked in particular to the assumption of falling down in product performance (Am). Such falling down lead the firms that enter the new paradigm to offer a product whose performances are inferior to minimum requirements claimed by the whole clients and updated under the influence of performances achieved by competing firms with specialisation on economic characteristics. This leads to defections of clients which are often fatal to the firms that carry out them. This enables to explain the abrupt drop in market shares observed in most of the firms that change paradigm and that are unable to recover market shares. In the scenario MS, we observe that, in spite of entry of firm F2 in the paradigm with high environmental potential, this firm succeeds in recovering market shares and in capturing the green market niche unlike firms that change paradigm quite later. This result suggests that the falling down in product performance and market share supported by a firm with good performance in environment may be overcome provided that the change of paradigm occurs relatively early, in particular before few firms specialise in product performance and before too much important deviation grow between levels of requirement of minimum product performance across clients. This result is summarised through the following proposition : Proposition 6 : an early change in paradigm contributes to open a window of opportunity for the development of a green market niche so that pioneering firms in environment avoid disadvantage too much important regarding product performance with firms leaders on price and also avoid too much strong lag with levels of requirement in terms of minimum product performance. Finally, the set of results shows that the qualitative coordination that regulates vertical interfirm relationships is far from being sufficient to favour the development of radically new technologies.

18

Conclusions In this paper, the evolutionary type modelling we have adopted to examine the coevolutionary dynamics of a population of competing suppliers and a population of industrial clients has led to generate scenarios likely to emerge in the long term with different implications in terms of economic and environmental performances. The detailed analysis of scenarios has stressed the conjunction of two essential driving forces that explain the emergence and survival of a green market niche : the intensification of competitive pressure operated by firms leader on price and the capture of a lead group of green clients. Emulation across firms specialised on economic characteristics may jeopardise the survival of pioneering firm in environment. Hence competition between firms betting on economic competitiveness hangs over the evolution of budgetary constraints of the whole clients and in particular over the group of green clients which is a priori endowed with low budgetary constraint. Moreover, this effect slows down the rise in requirements of environmental performance that the green group may claim, and yet likely to reinforce the specialisation of the pioneering firms in environment and also to determine the performance level that needs be reached to change paradigm. Limits of the model mainly lie on the absence of price strategies by suppliers and on the absence of firms entry. These two simplistic assumptions can not be satisfactory if we intend to grasp the possible trade-off between cost competitiveness and rent seeking, and so the diversity of firms strategies. A further line of research should be aimed at endogenous mark-up rate over the production costs and at defining the conditions of entry. However such dynamic and coevolutionary view of inter-firm linkages may contribute to fruitfully enlighten public policy interventions. Due to the complexity that arises from stochastic processes, but also to the simultaneous existence of multiple interacting populations of agents, the model is analysed by means of computer simulations. Such methodological tool may be used to generate scenarios that enable to explore some alternative regulatory options and to visualise the effects of these options upon trajectories of firms. In this respect, the study of policy impacts upon scenarios can give a better understanding of the relationship between environmental regulation and innovation. So the analysis of implications of various policy instruments constitutes a relevant guideline to pursue in future research. REFERENCES Andersen E.S., Philipsen K., 1998, "The evolution of credence goods in customer markets :

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Appendix A1

Figure 1 : market shares at time t=500 according Figure 2 : market shares at time t=500 according to

to productive efficiency environmental quality of process

Figure 3 : market shares at time t=500 according Figure 4 : market shares at time t=500 according to

to product performance environmental quality of product

0%10%20%30%40%50%60%70%80%90%

100%

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

Productive efficiency (Ap)

Mar

ket s

hare

MS HO

0%

20%

40%

60%

80%

100%

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

Environm e ntal quality of proce ss (Ip)

Mar

ket s

hare

MS HO

0%

20%

40%

60%

80%

100%

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

Product performance (Am)

Mar

ket s

hare

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0%

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100%

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

Environmental quality of product (Im)

Mar

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NV MP

22

Appendix A2

Figure 1 : Maximum price required at time t=500 Figure 2 : Minimum requirement of environmental

for both groups of clients quality of process at time t=500 for both groups of clients

Figure 3 : Minimum requirement of product Figure 4 : Minimum requirement of environmental quality

performance at time t=500 for both groups of clients of product at time t=500 for both groups of clients

Maximum Price

MSHO

2,5

2,0

1,5

1,0

,5

0,0

G1

G2

Minimum requirement product performance

MSHO

12

10

8

6

4

2

G1

G2

Minimum requirement environmental quality process

MSHO

4,0

3,5

3,0

2,5

2,0

1,5

1,0

G1

G2

Minimum requirement environmental quality product

MSHO

7

6

5

4

3

2

1

G1

G2

Figures to insert in "Analysis of the coevolution of suppliers and users through an evolutionary modelling - The case of environmental innovations" Figure 4 : Evolution of firms market shares Figure 5 : Evolution of firms performances in the space in the scenario MS (Ap, Ip) in the scenario MS

0%

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Iterations

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F1 F2

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l qua

lity

of

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ess

(Ip)

F1 F2

Figures to insert in "Analysis of the coevolution of suppliers and users through an evolutionary modelling - The case of environmental innovations" Figure 6 : Evolution of product performance of firms Figure 7 : Evolution of environmental quality of product in the scenario MS of firms in the scenario MS

0

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)

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Figures to insert in "Analysis of the coevolution of suppliers and users through an evolutionary modelling - The case of environmental innovations". Figure 8 : Evolution of firms market shares Figure 9 : Evolution of firms performances in the in the scenario HO space (Ap, Ip) in the scenario HO

0%

10%

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30%

40%

0 100 200 300 400 500

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Mar

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s

F1 F2 F3

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(Ip)

F1 F2 F3

Figures to insert in "Analysis of the coevolution of suppliers and users through an evolutionary modelling - The case of environmental innovations". Figure 10 : Evolution of product performance of firms Figure 11 : Evolution of environmental quality of in the scenario HO product of firms in the scenario HO

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)

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F1 F2 F3