Modularity and Intellectual Property Protection

Modularity is a means of partitioning technical knowledge about a product or process. The authors investigate the impact of modularity on intellectual property protection by formally modeling the threat of expropriation by agents. The principal has three options to address this threat: doing nothing, licensing the focal IP ex ante, and paying agents to prevent their defection. The principal can influence the value of these options by modularizing the technical system and by hiring clans of agents, thus exploiting relationships among them. The paper also gives examples of how managers arrive at a strategy in practice. Overall, the study contributes to the theory of profiting from innovation in three ways: First, it shows how the innovator's best choice of action against expropriation by agents-doing nothing, licensing, or paying agents-derives from the characteristics of the system, i.e., the share of trustworthy agents, the number of agents, the intensity of competition, the size of clans, the number of modules, and the degree of complementarity. Second, the innovator can use clans and modularity to increase profits, and the paper shows how clans and the modular architecture of the system interact to either reinforce or mitigate each other. Third, social relationships and norms of fairness affect the normative implications of an analysis based on rational choice theory. Implications for managers are also discussed. Key concepts include:

• Modularity is a means of partitioning technical knowledge about a product or process.
• Modularity can be used reduce the cost and/or risk of agents' expropriating valuable IP.
• The authors' model can be used to understand the effects of, for example, screening and signaling in the hiring process, legal protection of intellectual property, and social norms of fairness.
• Managers' fundamental choices are (1) to protect the knowledge or not; and (2) to trust the agents or not.
• Relational contracts, that is, paying selected agents not to defect, makes it possible to protect knowledge and maintain a monopoly when agents are relatively untrustworthy.
• Trusting one's agents-what the authors have called "doing nothing"-is the most valuable course of action if it works, but is a risky strategy because trust can always be betrayed. Better screening and signaling technologies make it easier for the principal to trust his agents, but some residual risk always remains.