13 Jan 2012Working Paper Summaries

The Impact of Modularity on Intellectual Property and Value Appropriation

by Carliss Y. Baldwin and Joachim Henkel

Distributed innovation in open systems is an important trend in the modern global economy. In general, distributed innovation in open systems is made possible by the modularity of the underlying product or process. Carliss Y. Baldwin and Joachim Henkel provide a systematic analysis of value appropriation in closed and open modular systems, with implications for managers. Modular systems are made up of components that are highly interdependent within sub-blocks, called modules, and largely independent across those sub-blocks. Despite the technical benefits of modularity, history shows that it is not always straightforward for firms to capture value in a modular system. The paper argues that strategies for capturing value in an open, modular system must be formulated at the module level. But modularity is not a single strategy: it is rather a large set of strategic options and related tactics that can be deployed in different ways depending on the interplay of countervailing forces. Key concepts include:

Special attention should always be paid to essential modules, which have the capacity to capture a portion of total system value.
The IP related to some modules can and should be given away, although care must be taken not to let essential modules fall into the wrong hands.
Other modules can be protected via state-sanctioned IP rights and/or agent payments under a relational contract.
The modular architecture of the system should not be cast in stone until its IP dimensions are understood.
After IP issues have been analyzed, some modules may need to be split further to concentrate agents' knowledge or reduce payments to outside owners of knowledge. Others may need to be made larger to make imitation and substitution more difficult.

Author Abstract

Distributed innovation in open systems is an important trend in the modern global economy. In general, distributed innovation is made possible by the modularity of the underlying product or process. But despite the documented technical benefits of modularity, history shows that it is not always straightforward for firms to capture value in a modular system. This paper brings together the theory of modularity from the engineering and management literatures with the modern economic theory of property rights and relational contracts to address the question of value appropriation. It defines three generic threats to intellectual property (IP) and models the interactive impact of modularity and state-sanctioned IP rights on these threats. It identifies strategies for capturing value in so-called "open systems" in which IP is distributed among several parties. It shows why open systems should be designed as modular systems. Finally, it analyzes in detail the strategy of capturing value by maintaining exclusive control of an essential module in an open system.