How to Manage Outside Innovation

Should external innovators be organized in collaborative communities or competitive markets? The answer depends on three crucial issues.

The multibillion-dollar video game industry would not exist without a thriving market of third-party businesses to write game software for particular hardware platforms.

Image courtesy of Valve Corp.

To appreciate the important role that outside innovators can play, look no further than Apple Inc.’s wildly successful iPhone. Thousands of external software developers have written complementary applications for the iPhone that have greatly enhanced its value, transforming the product into a blockbuster that has become the center of a thriving business ecosystem. Of course, the fundamental concept of “open innovation” 1 — relying on outsiders both as a source of ideas and as a means to commercialize them — is hardly new, but companies have struggled with precisely how to open up their product development to the external world. For starters, many executives have little idea how to motivate and manage outside innovation. Specifically, should external innovators be organized as a collaborative community or as a competitive market? Collaborative communities are perhaps best known through the Linux Foundation’s Linux and through other open-source software efforts that are governed loosely by social norms and “soft” rules to encourage open access to information, transparency, joint development and the sharing of intellectual property. A remarkable aspect of communities is that members are often willing to work for free. 2 Competitive markets are strikingly different. Rather than collaborating, external innovators in a market will develop multiple competing varieties of complementary goods, components or services. Customers then choose from among the different offerings. The classic example here is the multibillion-dollar video game industry, where companies (Nintendo Co., for example) develop a hardware console (Wii) and encourage third-party businesses to write game software for that platform. In a market, external innovators are busy focusing on their own economic interests, which often results in fierce competition — and little cooperation — among them.

The leading question

Should companies organize outside innovation through collaborative communities or competitive markets?

Findings
  • Communities are useful when an innovation problem involves cumulative knowledge, continually building on past advances. Markets are effective when an innovation problem is best solved by broad experimentation.<

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References

1.Economist Friedrich Hayek’s longtime insight of distributed knowledge in the economy has been embraced and developed in modern research on open innovation. See, for example, E. von Hippel, “Democratizing Innovation” (Cambridge: MIT Press, 2005); and H. Chesbrough, W. Vanhaverbeke and J. West, eds., “Open Innovation: Researching a New Paradigm” (New York: Oxford University Press, 2006).

2.Lakhani and Wolf have shown that 60% of open-source software developers volunteer their time and efforts to the various projects. See K.R. Lakhani and R. Wolf, “Why Hackers Do What They Do: Understanding Motivation and Effort in Free/Open Source Software Projects” in “Perspectives on Free and Open Source Software,” ed. J. Feller, B. Fitzgerald, S.A. Hissam and K.R. Lakhani (Cambridge, Massachusetts: MIT Press, 2005), 3-22.

3.Pisano and Verganti discuss the trade-offs between various types of external collaborations, including working with a select set of elites. See G.P. Pisano and R. Verganti, “Which Kind of Collaboration Is Right for You?” Harvard Business Review 86, no. 12 (December 2008): 78-86.

4.See, for example, C.Y. Baldwin and K.B. Clark, “The Architecture of Participation: Does Code Architecture Mitigate Free Riding in the Open Source Development Model?” Management Science 52, no. 7 (July 2006): 1116-1127.

5.See S. O’Mahony and F. Ferraro, “The Emergence of Governance in an Open Source Community,” Academy of Management Journal 50, no. 5 (October 2007): 1079-1106.

6.Nuvolari has extensive examples of collective invention in a range of historic settings. See A. Nuvolari, “Collective Invention During the British Industrial Revolution: The Case of the Cornish Pumping Engine,” Cambridge Journal of Economics 28, no. 3 (May 2004): 347-363.

7.Boudreau, Lacetera and Lakhani discuss diversity in competitive markets around a platform. See K. Boudreau, N. Lacetera and K.R. Lakhani, “Parallel Search, Incentives and Problem Type: Revisiting the Competition and Innovation Link,” research paper no. 1264038, Harvard Business School Technology & Operations Management Unit, Boston, Massachusetts, September 2008, http://papers.ssrn.com.

8.See discussion of complementary innovation in A. Gawer and M.A. Cusumano, “Platform Leadership: How Intel, Microsoft and Cisco Drive Industry Innovation” (Boston: Harvard Business School Press, 2002).

9.Lakhani and Jeppesen discuss InnoCentive.com in K.R. Lakhani and L.B. Jeppesen, “Getting Unusual Suspects to Solve R&D Puzzles,” Harvard Business Review 85, no. 5 (May 2007): 30-32.

10.Von Hippel describes the role of users in the innovation process. See, for example, E. von Hippel, “Sources of Innovation” (New York: Oxford University Press, 1988).

11.For an overview of intrinsic motivations, see T.M. Amabile, “Creativity in Context” (Boulder, Colorado: Westview Press, 1996); M. Csikszentmihalyi, “Creativity: Flow and the Psychology of Discovery and Invention” (New York: HarperCollins, 1996); and E.L. Deci, R. Koestner and R.M. Ryan, “A Meta-Analytic Review of Experiments Examining the Effects of Extrinsic Rewards on Intrinsic Motivation,” Psychological Bulletin 125, no. 6 (November 1999): 627-668.

12.Belenzon and Schankerman show that altering details of how an open regime is governed affects the types of outsiders who participate in open innovation. See S. Belenzon and M.A. Schankerman, “Motivation and Sorting in Open Source Software Innovation,” CEPR discussion paper no. DP7012, Centre for Economic Policy Research, London, October 2008, http://papers.ssrn.com.

13.For an analysis of motivations in open source communities, see K.R. Lakhani and E. von Hippel, “How Open Source Software Works: ‘Free’ User-to-User Assistance,” Research Policy 32, no. 6 (June 2003): 923-943; and Lakhani and Wolf, “Hackers.”

14.Apple, for example, has been under significant pressure to limit the number of “free” or low-priced applications at the iTunes Store because many of the professional application developers are finding that they cannot economically compete with similar free applications.

15.Hagiu discusses the two-sided and integrator cases, referring to the latter as “merchants”; Rochet and Tirole provide a formal definition of two-sidedness. See A. Hagiu, “Merchant or Two-Sided Platform?,” Review of Network Economics 6, no. 2 (June 2007): 115-133; and J.C. Rochet and J. Tirole, “Two-Sided Markets: A Progress Report,” RAND Journal of Economics 37, no. 3 (autumn 2006): 645-667.

16.For extreme examples of “system integrators” who exert extensive controls, see M. Hobday, A. Davies and A. Prencipe, “Systems Integration: A Core Capability of the Modern Corporation,” Industrial and Corporate Change 14, no. 6 (2005): 1109-1143.

17.For a detailed discussion of the “regulatory” role played by multisided platforms, see K. Boudreau and A. Hagiu, “Platform Rules: Regulating the Ecosystem Around a Multi-Sided Platform,” chap. 3 in “Platforms, Markets and Innovation,” ed. A. Gawer (Northampton, Massachusetts: Edward Elgar, in press).

18.See J. Farrell and M.L. Katz, “Innovation, Rent Extraction and Integration in Systems Markets,” Journal of Industrial Economics 48, no. 4 (December 2000): 413-432.

19.As a matter of open community norms, community licenses such as the Berkeley Software Distribution, the General Public License or Creative Commons license tend to be applied broadly rather than as a matter of nuanced application of contracting instruments to attend to particular governance challenges.

20.See, for example, A. Gawer and R.M. Henderson, “Platform Owner Entry and Innovation in Complementary Markets: Evidence from Intel,” Journal of Economics & Management Strategy 16 (spring 2007): 1-34; and T.R. Eisenmann, G. Parker and M.W. Van Alstyne, “Opening Platforms: How, When and Why?” working paper 09-030, Harvard Business School Entrepreneurial Management, Boston, Massachusetts, Aug. 31, 2008, http://papers.ssrn.com.