Competitive strategy for open and user innovation

• Author: Gastón Llanes
• Date: 01 April 2019
• Published date: 01 April 2019
• DOI: http://doi.org/10.1111/jems.12282

Received: 2 December 2016

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Revised: 28 March 2018

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Accepted: 10 July 2018

DOI: 10.1111/jems.12282

ORIGINAL ARTICLE

Competitive strategy for open and user innovation

Gastón Llanes

Pontificia Universidad Católica de Chile,

School of Business, Santiago, Chile

Correspondence

Gastón Llanes, Escuela de

Administración, Pontificia Universidad

Católica de Chile, Vicuña Mackenna 4860,

Macul, Santiago, Chile.

Email: gaston@llanes.com.ar

Funding information

Institute for Research in Market

Imperfections and Public Policy, MIPP,

Grant/Award Number: ICM IS130002;

Comisión Nacional de Investigación

Científica y Tecnológica, Grant/Award

Number: Fondecyt 1150326

Abstract

I study the incentives to open technologies in imperfectly competitive markets

with user innovation. Firms may choose to open part of their knowledge or

private information so that it becomes freely accessible to users. Openness

decisions are governed by a trade‐off between collaboration and appropriability:

by becoming more open, a firm encourages user innovation but hampers its

ability to capture value. I find that large firms are less open and invest more in

product development than small firms, and that firms react to greater openness

from rivals by becoming more open. I also show that compatibility and

spillovers have a negative effect on openness, and that firms become more open

as the number of competitors increases.

KEYWORDS

asymmetric equilibria, compatibility choice, open innovation, openness choice, open standards,

open‐source software, spillovers, network effects, user innovation

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INTRODUCTION

An important question for competitive and technology strategy is whether firms should follow open or closed

approaches to product development and intellectual‐property management. In this paper, I study the incentives to open

technologies in imperfectly competitive markets with user innovation.

Openness enables and facilitates user innovation (von Hippel, 1988, 2005) but may lower a firm’s ability to capture

value (Arrow, 1962).

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For example, IBM’s creation of an open standard around the PC allowed third‐party suppliers of

peripheral devices, expansion cards, and software to develop PC‐compatible products, but also led to the entry of a

myriad of clone manufacturers that eroded IBM’s market dominance. Likewise, releasing software under an open‐

source license allows users to contribute code and provide valuable feedback, but may also cannibalize sales of the

firm’s proprietary offerings.

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Thus, openness leads to a trade‐off between collaboration and appropriability, which

affects firms’decisions to open technologies (West, 2003; Henkel, 2006; Henkel, Schöberl, & Alexy, 2014).

In a competitive environment, firms’openness decisions are also affected by strategic considerations. In the mid

2000s, IBM’s proprietary product WebSphere Application Server was facing strong competition from the open‐source

product JBoss Application Server in the middleware market. IBM reacted by buying JBoss’s main rival (a developer

named Gluecode) and releasing its source code under an open‐source license. JBoss’s CEO, Marc Fleury, complained at

the time that IBM’s intention was to “kill JBoss,”and warned that Gluecode would hurt sales of IBM’s WebSphere as

much as JBoss’s.

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J Econ Manage Strat. 2019;28:280–297.wileyonlinelibrary.com/journal/jems280

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© 2018 Wiley Periodicals, Inc.

I am grateful to Roberto Allende, Francisco Ruiz‐Aliseda, the editors, and two referees for useful comments and suggestions. I gratefully acknowledge

financial support from Conicyt (Fondecyt No. 1150326) and from the Institute for Research in Market Imperfections and Public Policy, MIPP (ICM

IS130002).

In this example, IBM responded to competition from a firm that was more open by becoming more open, even

though doing so meant creating competition for its own proprietary product. Likewise, Facebook decided to open

part of its platform’s source code as a response to OpenSocial–an open‐source platform used by Google, MySpace,

and LinkedIn

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–and Microsoft became more open after the success of open‐source products such as Linux and

Chrome.

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Extant papers on open and user innovation focus on understanding individual developers’incentives (Johnson,

2002; Polanski, 2007), or study competition between a for‐profit firm and a community of nonstrategic developers

(Casadesus‐Masanell & Ghemawat, 2006; Athey & Ellison, 2014; Casadesus‐Masanell & Llanes, 2011). In this paper, I

contribute to the literature by studying the incentives to open part of a firm’s knowledge in a market with imperfectly

competitive for‐profit firms and user innovators.

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From a methodological point of view, the paper links open and user innovation to the literature on network effects.

Users provide innovations that benefit other consumers, so the willingness to adopt a firm’s product depends on its

expected number of users.

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Given that users can innovate more when they access more knowledge, the choice of

openness determines the intensity of network effects. This mechanism is absent in previous works studying network

effects.

The paper has two main results. First, I show that large firms are less open and invest more in product development

than small firms. If users expect a firm to have a larger user base, they expect it to benefit more from user innovation.

Thus, the firm can lower its openness degree and increase its price without losing too many customers. Returns to

investment, on the other hand, increase with firm size, because large firms enjoy larger product‐market revenues (they

set higher prices and have a larger market share), and because user investments increase with the number of users and

are complementary to firm investments.

This result explains the general observation that firms with a large market share, such as IBM in the middleware

market, tend to be less open and invest more in product development than small firms, such as JBoss. Similarly,

Microsoft is larger, less open, and has a higher investment than Novell and Red Hat in the server operating systems

market; and Nvidia is larger, less open, and has a higher investment than ATI/AMD in the graphics processing units

market.

The result is also consistent with the findings of Bonaccorsi, Giannangeli, and Rossi (2006), who show that firm size

is negatively correlated with openness. To the best of my knowledge, this paper is the first to provide a formal link

between firm size and openness.

Second, I show that firms react to greater openness from rivals by becoming more open. This result is consistent with

the examples of IBM, Facebook, and Microsoft mentioned above. In a similar vein, Toyota responded to Tesla’s decision

to release its electric‐car patents by releasing its patents on the competing fuel‐cell technology, and Microsoft opened up

Azure to respond to competition from Amazon Web Services, which was more open.

I also show that spillovers have a negative effect on openness, and that firms become more open as the number of

competitors increases. Spillovers imply that the knowledge a firm discloses can be accessed by its rivals. As the intensity

of spillovers increases, firms become less open and equilibrium profits increase. Therefore, firms may benefit from

coordinating on a high level of spillovers (for example, by making their products more compatible) to induce an

equilibrium with a smaller openness degree. The result that firms react to entry by competitors by becoming more open

explains Apple’s decision to open Swift after the entry of cross‐platform solutions for developing smartphone

applications, such as Microsoft’s Xamarin and Adobe’s Cordova.

The main contribution of this paper is to clarify the role of strategic and competitive factors on openness decisions.

Its results have direct managerial implications. In particular, the paper shows the best openness and investment

strategies for small and large firms, and explains how to respond to increases in openness by rival firms. In Section 10, I

discuss real‐world examples to illustrate the paper’s findings. In the conclusion, I discuss the limitations of the model

and present ideas for further research.

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THE MODEL

Two firms,

i

=1,

2

, develop and sell products to a continuum of users with unit mass. User demands depend on prices

and knowledge investments. Firms can protect their knowledge with intellectual‐property rights or secrecy, but they

can also choose to disclose (open) part of their knowledge so that it becomes freely accessible to users.

LLANES

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