This paper characterizes and explores a corporate strategy in which downstream firms collaborate to develop open substitute designs for proprietary hardware they would otherwise purchase from upstream suppliers. This strategy centrally involves the downstream firms distributing design costs over multiple downstream firms – a strategy that is routine to producers selling to multiple downstream firms, but which has been in the past typically not practical for coalitions of downstream firms. Today, downstream firms find it increasingly feasible to co-design products they may all purchase due to two technological trends. First, CAD-CAM and other design technologies are lowering downstream firms’ costs to develop designs for purchased hardware inputs. Second, better communication technologies are lowering the costs of doing such projects collaboratively, even among large groups of downstream customer firms.
Downstream firms collaborating to develop a design for a hardware input they all purchase could in principle choose to protect their design as a club good. However, opening up collaboratively-created designs to free riders can increase the profits of the contributing firms for several reasons we explore and model. Important among these is that free revealing draws free riders away from purchases of proprietary software or hardware to customer-developed free substitutes. This “scale stealing” mechanism reduces the markets of upstream suppliers of competing proprietary inputs. In the case of hardware only, free riders also contribute to reducing the average manufacturing costs of the open hardware by increasing purchase volumes and so creating increased economies of scale. Resulting reduced unit purchase costs benefit downstream firms contributing to the free design as well as free riders.
Abstract: Innovation has traditionally been seen as the province of producers. However, theoretical and empirical research now shows that individual users – consumers – are also a major and increasingly important source of new product and service designs. In this paper, we build a microeconomic model of a market that incorporates demand-side innovation and competition. We explain the conditions under which firms find it beneficial to invest in supporting and harvesting users’ innovations, and show that social welfare rises when firms utilize this source of innovation. Overall, our results explain when and how the proliferation of innovating users leads to a superior division of innovative labor involving complementary investments by users and producers, both benefitting producers and increasing social welfare.
Baldwin, Carliss Y., Christoph Hienerth, and Eric von Hippel. “How User Innovations Become Commercial Products: A Theoretical Investigation and Case Study.” Research Policy 35, no. 9 (2006): 1291–1313.
Abstract: In this paper we model the pathways commonly traversed as user innovations are transformed into commercial products. First, one or more users recognize a new set of design possibilities and begin to innovate. They then join into communities, motivated by the increased efficiency of collective innovation. User-manufacturers then emerge, using high-variable/low-capital cost production methods. Finally, as user innovation slows, the market stabilizes enough for high-capital, low-variable cost manufacturing to enter. We test the model against the history of the rodeo kayak industry and find it supported. We discuss implications for “dominant design” theory and for innovation practice.
Baldwin, Carliss, and Eric von Hippel. “Modeling a Paradigm Shift: From Producer Innovation to User and Open Collaborative Innovation.” Organization Science 22, no. 6 (December 2011): 1399 –1417. doi:10.1287/orsc.1100.0618.
Abstract: In this paper we assess the economic viability of innovation by producers relative to two increasingly important alternative models: innovations by single user individuals or firms, and open collaborative innovation projects. We analyze the design costs and architectures and communication costs associated with each model. We conclude that innovation by individual users and also open collaborative innovation increasingly compete with – and may displace – producer innovation in many parts of the economy. We argue that a transition from producer innovation to open single user and open collaborative innovation is desirable in terms of social welfare, and so worthy of support by policymakers.
Abstract: There are two ways to diffuse innovations: for “free” via peer-to-peer channels, and at a price via market channels. Economic scholarship and policymaking have traditionally focused upon marketplace diffusion. In this paper, we also consider peer-to-peer diffusion, and so are able to consider the effects of rivalry and complementarity between these two important innovation diffusion channels.
When innovations that are close substitutes are being diffused via both channels, producers face a rival that has rarely been considered in competitive analyses: the option for users to self-supply independent of the market. We show that this additional option for adopters – a “user-contested market” – exerts price discipline on producers, and also increases social welfare. We also find that users can, under some conditions, exert greater competitive pressure than can rival producers.
It is also the case that innovations diffused peer-to-peer are often useful or essential complements to products diffused via the market – a “user-complemented market.” For example, a product may be sold on the market, while techniques for operating that product may largely or entirely be diffused peer-to-peer. We show that producers of essential components can extract value from complements created and diffused by users. Producers will often prefer their complementors to be users rather than other producers. User-complemented markets may even give producers higher profit than a vertically integrated monopoly. We also find that the producer’s preference for user complementors may be too strong from the perspective of social welfare.
We argue that producer-contested and producer-complemented markets are quite common as well as important for theorizing market outcomes. We consider implications for producer firms active in such markets. We also explain that benefits from peer-to-peer diffusion of user innovations are largely an externality from the point of view of innovating users. This market failure may require attention from policymakers.
Raasch, Christiana, and Eric von Hippel (2012), “Innovation Effort as ‘Productive Consumption:’ The Power of Participation Benefits to Amplify Innovation” MIT Sloan School of Management Working Paper (October)
Abstract: When economists and innovation practitioners think about whether developing an innovation will be worthwhile, they tend to think exclusively about the economic value of the outcome of the innovation process. In this article, we develop and explore the idea that innovators can also gain significant benefits from participation in a development process as well as or even instead of benefits from using or selling the innovation created. When this is the case, the net cost of innovation projects can be much lower for developers – in effect, a portion of project development costs becomes “productive consumption.”
We draw on the findings of empirical studies to document that a significant fraction of the benefits that individuals obtain from engaging in innovation projects can consist of benefits derived from participation. We offer an “innovation amplification” metric to quantify the associated cost reductions for project sponsors, and discuss implications for innovation research and practice.