1. Slide 1 © Carliss Y. Baldwin and Kim B. Clark, 2004 Insights from Agency Theory into User Innovation Carliss Y. Baldwin Harvard Business School LMU-MIT International Workshop on User Innovation and Open Source Software Munich, Germany, EU June 21, 2004

2. Slide 2 © Carliss Y. Baldwin and Kim B. Clark, 2004 Institutions of Innovation—Agenda  Goals of our research –Derive “Institutions of Innovation” from the basic properties of designs –Users are principals, designers are agents –What do the designs and the users need from the economic system?  Definitions and Basic properties of designs  The Problem Domain  Agency alternatives –“Employment” –“Outsourcing”  Conclusions and next steps

3. Slide 3 © Carliss Y. Baldwin and Kim B. Clark, 2004 First, some definitions/axioms

4. Slide 4 © Carliss Y. Baldwin and Kim B. Clark, 2004 Designs  Instructions that turn knowledge into things  Span all artifacts and human activities –Tangible, intangible –Transacting, contracting, dispute resolution –Government  The wealth of an economy inheres in its designs

5. Slide 5 © Carliss Y. Baldwin and Kim B. Clark, 2004 The Great Chain of Design and Production Finance lives here! Must value everything that is made, including designs Designs are the start of everything that is made

6. Slide 6 © Carliss Y. Baldwin and Kim B. Clark, 2004 Design Architecture  Small designs “just get done” by one person or a small team  Large designs require architecture –“The design of the design process” –Forward-looking, future oriented –Analogous to physical architectures »Create and constrain” movement and search  Major social technology, but not much studied –In engineering or the social sciences

7. Slide 7 © Carliss Y. Baldwin and Kim B. Clark, 2004 Innovations are NEW Designs Ex ante: a problem = “the design problem” Ex post: a solution = “the design”

8. Slide 8 © Carliss Y. Baldwin and Kim B. Clark, 2004 Users are Principals  Users willingness to pay determines value of a new design

9. Slide 9 © Carliss Y. Baldwin and Kim B. Clark, 2004 Designers are Agents  A designer may also be a user,  But one user-designer can’t solve all problems! –Remember Wedgwood!

10. Slide 10 © Carliss Y. Baldwin and Kim B. Clark, 2004 Institutions of Innovation  Aoki => Institutions are equilibrium patterns of interaction  Function is to bring User-Principals and Designer-Agents into a voluntary, productive relationship –User-designers are excluded from this analysis (will be dealt with later)  Institutions are costly—in a free economy, they must “pay for themsselves”

11. Slide 11 © Carliss Y. Baldwin and Kim B. Clark, 2004 Our goal  Derive candidate institutions from basic properties of designs;  Compare institutions with different cost structures;  Predict which institutions will be seen in which problem domains

12. Slide 12 © Carliss Y. Baldwin and Kim B. Clark, 2004 Basic Properties of Designs  Designs are –non-rival »My use does not prevent yours –ex ante uncertain; –ex post rankable by outcome; –ex post contingent; –have an architecture »Modular/integral »indivisible at module level; –costly

13. Slide 13 © Carliss Y. Baldwin and Kim B. Clark, 2004 Basic Properties of Designs  Designs are –non-rival (non-exclusive use); –ex ante uncertain; –ex post rankable by outcome; –ex post contingent; –have an architecture »Modular/integral »indivisible at module level; –costly

14. Slide 14 © Carliss Y. Baldwin and Kim B. Clark, 2004 The Problem Domain

15. Slide 15 © Carliss Y. Baldwin and Kim B. Clark, 2004 Isoquants in the Domain Increasing Social Value

16. Slide 16 © Carliss Y. Baldwin and Kim B. Clark, 2004 Two Agency Alternatives

17. Slide 17 © Carliss Y. Baldwin and Kim B. Clark, 2004 Coase Theorem—  Frictionless Economy  No Transactions or Agency Costs  ALL institutions (agency alternatives) are equivalent  Assume Cost per Solution, C = 5

18. Slide 18 © Carliss Y. Baldwin and Kim B. Clark, 2004 Under the Coase Theorem

19. Slide 19 © Carliss Y. Baldwin and Kim B. Clark, 2004 First thought experiment— Robinson Crusoe  Every user hires designers  Cost of hiring =.2*C –Includes search, mundane, and opportunistic transaction costs

20. Slide 20 © Carliss Y. Baldwin and Kim B. Clark, 2004 Employment by Robinson Crusoe Users

21. Slide 21 © Carliss Y. Baldwin and Kim B. Clark, 2004 Second thought experiment— Specialist Manufacturers  Upstream Mfrs offer solutions to some problems  Cannot charge more than Users would pay under the alternative employment scenario  Mfrs have costs: –Variable cost per transaction =.2*C –Fixed cost for setup and data = 15*C

22. Slide 22 © Carliss Y. Baldwin and Kim B. Clark, 2004 Upstream Manufacturers will efficiently solve some problems

23. Slide 23 © Carliss Y. Baldwin and Kim B. Clark, 2004 Third thought experiment— Two Types of Manufacturer  Blue Type has costs (as before): –Variable cost per transaction =.2*C –Fixed cost for setup and data = 15*C  Green Type has lower variable and higher fixed costs –Variable cost per transaction =.01*C –Fixed cost for setup and data = 90*C

24. Slide 24 © Carliss Y. Baldwin and Kim B. Clark, 2004 Two Mfrs with Different Cost Structures

25. Slide 25 © Carliss Y. Baldwin and Kim B. Clark, 2004 New Scale

26. Slide 26 © Carliss Y. Baldwin and Kim B. Clark, 2004 Thank you!