Open Source Strategy Research Blog

Updating business strategy for a world embracing open source

Tuesday, February 8, 2011

Make, Buy, or Open Source: Maximizing Appropriable Value by Reducing the Transaction Costs of Leveraging Knowledge Assets

This short paper begins by reviewing the papers on property rights and the phenomenon of open source from the economics and organization science perspectives. I then investigate the potential to extend the resource-based view and property rights economics perspective and the nature of make or buy decisions by highlighting the competitive advantage created by widely sharing property rights over knowledge-based resources in circumstances where both markets and hierarchies are suboptimal for the exploitation of these resources. I conclude with an example that suggests that the path to maximum value appropriation for a focal firm may sometimes be to allow as many outside actors as possible to exercise property rights over some of its resources.
Foss and Foss (2005) compare property rights economics to the resource-based view of the firm. They first extend the RBV definition of resource attributes to account for the property rights which may be held for each attribute of a resource at a firm’s disposal. They define these property rights as the “right to use, consume, obtain income from, and alienate” attributes of resources (Foss & Foss, 2005). Their major contribution to the strategy literature is the introduction of the notion that resource transactions involve the exchange of property rights over resources, not the exchange of resources per se, and that such transactions have transaction costs, the reducing of which can create capturable value for the firm that owns the property rights. The transaction costs that can be reduced are the costs of exchanging, defining and protecting the property rights. They further contribute by demonstrating how property rights can increase the demand curve for complementary goods that a firm offers, resulting in a net value capture that is independent of returns directly relating to the property rights (See figure 1, Foss & Foss, 2005). The scenario they present alludes to strategic implications surrounding circumstances where sharing property rights over resources without direct compensation for those rights might lead to increased value creation and capture by the firm. Foss & Foss (2005) conclude their paper with a call for future research examining exactly such a possibility.
Lerner and Tirole’s (2002) paper on the economics of open source examines the phenomenon in the software industry where skilled developers work to develop collective projects without obvious incentives or rewards. The major contribution of their paper is the examination of conditions where firms might wish to release their innovations as open source in order to increase their returns on the asset. They suggest that firms should open source resources when 1) the release of the property rights will lead to increased value acquisition in a complementary asset, and 2) this increase in value acquisition in complementary assets is larger than would have been possible directly through the selling of the property rights to the resource (Lerner & Tirole, 2002). They further argue that firms might benefit from a signalling advantage when they open source resources, similar to the advantage seen in joint ventures, because the adoption of an open source strategy is read by partners as a promise to not expropriate their complementary goods and services in the future (Lerner & Tirole, 2002). The net trust benefits increase cooperation in the ecosystem, and promote involvement between heterogeneous players, who support each other. Finally, they argue that the risk of imitation by competitors may be overstated due to the heterogeneity of firm capabilities (Lerner & Tirole, 2002). This assertion hints at situations where firms might be able to leverage the advantages of an open source strategy while minimizing the risks of loosening property rights restrictions.
In their paper, von Hippel and von Krogh (2003) contribute to the organization science and strategy literatures by suggesting that the open source phenomenon is an example of a novel “private-collective” innovation model. They propose that this mixed innovation model takes parts of both the traditional private and collective innovation models to maximize the advantages while minimizing the weaknesses inherent in the separate model. They make two major contributions. The first contribution is the description of the loss in value creation potential that arises when the “private-collective” innovation model is used by society to incentivize innovation. As they put it: “the monopoly control that society grants to innovators represents a loss to society relative to the free and unfettered use by all of the knowledge that the innovators have created”. In other words, the total value that the knowledge asset could have created is artificially constrained by the property rights protecting its use by others. The strategy implications of this circumstance is that the value that is lost may be of consequence to the firm that is protecting its rights by constraining use of their resources, as it could be value that the firm could have otherwise obtained itself. The second contribution is the challenging of the agency-theory-like assumptions that are implicit in the traditional innovation models, namely that innovators must be incentivized to innovate and that “free-riders” will extort benefits from collective innovations without contributing anything in return. Instead, von Hippel and von Krogh (2003) argue that by relaxing this assumption, the collective action innovation model “ceases to be a prisoner’s dilemma because members cease to regard participation as costly” (von Hippel & von Krogh, 2003). Participation becomes a benefit in itself, through learning effects, network effects, reputation effects, and positioning effects, leading to the formation and growth of an ecosystem centered on the shared resource. This change in paradigm suggests that there are certain benefits to reducing the constraint on the property rights to a resource that are only available to the focal form. These benefits act as a form of selective incentives that primarily increase the focal firm’s ability to appropriate the value created by the resource, even while that value is created by others.
All three of the papers previously discussed yield insights that have a strong commonality to each other: they all describe circumstances where conventional wisdom about property rights—i.e. that firms should hold tight to them, and that not protecting them leads to a loss of value through competitive imitation—may not hold true. Excluding non-owners from using and obtaining value from resources is costly, and provides no guarantees that the rights-owning firm can appropriate any of the value that the resources have the potential to create (Foss & Foss, 2005).
Barney (1991) argued regarding the strategic application of resources that sustainable competitive advantage is the result of “a value creating strategy not simultaneously being implemented by any current or potential competitors, [where] these other firms are unable to duplicate the benefits of this strategy”. Barney surely intended that the reason other firms were “unable to duplicate the benefits of this strategy” was due to their inability to access the benefits of the VRIN resources controlled by the firm; yet, the definition doesn’t preclude other explanations for why competitors can’t duplicate a strategy. It is entirely consistent with the resource-based view that competing firms might have access to resources but be unable to leverage them to obtain a competitive advantage. For example, a focal firm that has property rights to a resource may also have knowledge about how to best apply the resource to create value for a target customer base. Independent of that knowledge, the resource itself is less valuable. It is the knowledge that multiplies the value-creating properties of the resource. Said another way, resources have inherently different values to different firms due to heterogeneous firm capabilities. As such, freely granting property rights to a resource to a competitor may lead to low value dissipation for a focal firm if it has low rivalry in the ability to leverage that resource (von Hippel & von Krogh, 2003).
What then are the circumstances under which it may be advantageous to freely grant property rights over firm resources to other firms? Benkler (2002) suggests that it may be advantageous to do so when the joint production of firms in the ecosystem will more efficiently assign idiosyncratic human capital to information inputs than could be done either through purely market-based or hierarchical (intra-firm) means. This situation is often the case in the development of information assets, as the costs of information production and exchanges are rapidly declining in terms of physical capital, communications, and information input costs, leaving human capital costs as the remaining opportunity for cost optimization (Benkler, 2002). As Benkler (2002) put it: “markets and hierarchies are both relatively lossy media when applied to questions of human capital, primarily in terms of creativity, ability, motivation and focus. This information is uniquely in the knowledge of individuals and is immensely difficult to measure and specify in contracts for market clearance or for managerial allocation of resources”. A joint-production model, instead, allows firms to self-identify for tasks based on the talents of their employees, maximizing their productivity. The situations favouring different strategies of production organization are described in table 1.

In order for the open source strategy to be successfully executed, two additional conditions need to be met. The first condition is that the resource to which property rights are granted should be non-rival, i.e., using it does not diminish its utility to the subsequent user. It should also be non-excludable such that all potential actors can have simultaneous access to it. These properties are inherent to most knowledge-based resources. The second condition is that the focal firm that owns the property rights over the resource must focus its strategy on leveraging a complementary resource to the shared one in order to establish and maintain its competitive advantage in the ecosystem. This complementary resource might be knowledge or capability that enables it to utilize the shared resource in ways other firms cannot. Or, it may be brand, reputation, production, value-chain, or network effects that allow the focal firm to shape the industry in such a way that it is positioned to acquire the lion’s share of the value that is jointly created (Lecoq & Demil, 2006). This capture potential, itself, can act as an ex post barrier to competition (Peteraf, 1993), leading to increase rents for the focal firm.
The important strategy implication of this extension of existing theories can be summarized by the idea that an “effective open strategy balances value capture and value creation, instead of losing sight of value capture during the pursuit of innovation” (Chesbrough & Appleyard, 2007). In other words, property rights are an important part of strategic decisions about resources, but too much focus on rigidly protecting them can lead both to extensive transaction costs and loss of total capturable value. When asked about its investment into Linux, the freely available open source operating system, IBM’s VP of corporate strategy, Joel Cawley explained that “it takes $500M to create and sustain a commercially viable operating system” (Cawley, 2006 in: Chesbrough, 2006) on an annual basis. IBM invests about $100M per year and other commercial developers contribute $800-$900M per year. Even accounting for the portion of development that is exclusively for the specific needs of those companies, the net result is an extra $400M per year of cost-savings value that comes to IBM that was created through the joint development process. By allowing others unfettered access to its property rights over the resources related to the open source development, IBM has magnified the total value that is created to levels that it could not create on its own. IBM can then acquire much of this value by pairing the operating system with its server products and services and selling them as a bundle (Chesbrough & Appleyard, 2007).
The described IBM scenario is far from unique. Open strategies are presently being executed in various forms by large firms around the world, including Google, Facebook, Nokia, and even Microsoft. As Chesbrough and Appleyard (2007) point out, “if we are to make strategic sense of innovation communities, ecosystems, networks, and their implications for competitive advantage, we need a new approach to strategy – open strategy”. The literature needs to continue adapting the extant strategy theories to account for these circumstances. It is my hope that the present short paper has stimulated that effort.

References

Barney, J. B. 1991. Firm resources and sustained competitive advantage. Journal of Management. 17: 99-120.

Benkler, Y. 2002. Coase’s Penguin, or, Linux and the Nature of the Firm. Yale Law Journal. 112 (3): 369-446.

Chesbrough, H. W. 2006. Open Business Models: How to Thrive in the New Innovation Landscape. Harvard Business School Press: Boston, MA, USA.

Chesbrough, H. W., & Appleyard, M. M. 2007. Open Innovation and Strategy. California Management Review. 50 (1): 57-76.

Foss, K., & Foss, N. J. 2005. Resources and transaction costs: how property rights economics furthers the resource-based view. Strategic Management Journal. 26: 541-553.

Lecocq, X., & Demil, B. 2006. Strategizing industry structure: the case of open systems in a low-tech industry. Strategic Management Journal. 27: 891-898.

Lerner, J., & Tirole, J. 2002. Some Simple Economics of Open Source. The Journal of Industrial Economics. 50 (2): 197-234.

Peteraf, M. A., 1993. The cornerstones of competitive advantage: a resource-based view. Strategic Management Journal. 14 (3): 179-191.

von Hippel, E., & von Krogh, G. 2003. Open Source Software and the “Private-Collective” Innovation Model: Issues for Organization Science. Organization Science. 14 (2): 209-223.

posted by Mekki at 5:42 pm  

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