Transcript NFRS Seminar - Harvard Business School

The Institutions of Innovation
Carliss Y. Baldwin
ITM Seminar
April 16, 2004
Slide 1
© Carliss Y. Baldwin and Kim B. Clark, 2004
The Institutions of Innovation
The Great Chain of Design and Production
Architecture
+ Design
Procurement
+ Production
Product
Use
Users' Willingness to Pay
Competition +
Market Structure
Price * Quantity
– Cost
– Investment
"Free Cash Flow "
Discount for
Time and Risk
Value
$$$
Rational Investment in New Products and Design Architectures
Slide 2
© Carliss Y. Baldwin and Kim B. Clark, 2004
The Institutions of Innovation
Neoclassical Economics
Architecture
+ Design
Procurement
+ Production
Product
Use
Users' Willingness to Pay
Competition +
Market Structure
Price * Quantity
– Cost
– Investment
"Free Cash Flow "
Discount for
Time and Risk
Value
$$$
Rational Investment in New Products and Design Architectures
Slide 3
© Carliss Y. Baldwin and Kim B. Clark, 2004
The Institutions of Innovation
Neoclassical Financial Economics
Architecture
+ Design
Procurement
+ Production
Product
Use
Users' Willingness to Pay
Competition +
Market Structure
Price * Quantity
– Cost
– Investment
"Free Cash Flow "
Discount for
Time and Risk
Value
$$$
Rational Valuation of an Existing Enterprise
Slide 4
© Carliss Y. Baldwin and Kim B. Clark, 2004
The Institutions of Innovation
Management Studies
Architecture
+ Design
Procurement
+ Production
"Marketing"
Product
"Operations"
Use
Users' Willingness to Pay
Competition +
Market Structure
Price * Quantity
– Cost
– Investment
"Strategy" +
I-O Economics
"Free Cash Flow "
Rational Investment in New Products and Design Architectures
Slide 5
Discount for
Time and Risk
Value
$$$
"Finance"
© Carliss Y. Baldwin and Kim B. Clark, 2004
The Institutions of Innovation
New Product Development
Architecture
+ Design
Procurement
+ Production
Product
Use
Finally,
Designs +
Architecture
matter to
someone!
Users' Willingness to Pay
Competition +
Market Structure
Price * Quantity
– Cost
– Investment
"Free Cash Flow "
Discount for
Time and Risk
Value
$$$
"Semi-Rational" Investment in New Products and Design Architectures
(can select for effective and efficient practices)
Slide 6
© Carliss Y. Baldwin and Kim B. Clark, 2004
The Institutions of Innovation
Design Rules, Volume 1
Architecture
+ Design
Procurement
+ Production
Product
Economic Institutions
Use
Users' Willingness to Pay
"We can't model this part yet"
"Stay Tuned for DR2!"
Competition +
Market Structure
Price * Quantity
– Cost
– Investment
"Free Cash Flow "
Discount for
Time and Risk
Value
$$$
More Rational Investment in New Products and Design Architectures
"Pow er of Modularity" Results
Designs are options
Modular architectures multiply options
Modules and Experiments are complementary
Modular designs evolve in a semi-structured w ay via modular operators.
Slide 7
© Carliss Y. Baldwin and Kim B. Clark, 2004
The Institutions of Innovation
Unfortunately, Economic Institutions have
first-order effects on Value!
Architecture
+ Design
Procurement
+ Production
Product
Use
Users' Willingness to Pay
Competition +
Market Structure
Can't Retire Yet!
Price * Quantity
– Cost
– Investment
"Free Cash Flow "
Discount for
Time and Risk
Value
$$$
Rational Investment in New Products and Design Architectures
"Pow er of Modularity" Results
Designs are options
Modular architectures multiply options
Modules and Experiments are complementary
Modular designs evolve in a semi-structured w ay via modular operators.
Slide 8
Institutions of Innovation
Architecture = a Production Function for Designs
Institutions are equilibria of sets of linked games
What institutions do the designs "need" to evolve?
What does competition do to payoffs?
Can competitive effects be predicted ex ante?
Cui bono? Who benefits?
© Carliss Y. Baldwin and Kim B. Clark, 2004
The Institutions of Innovation
Open Source Development is one of the "Institutions"
Architecture
+ Design
Procurement
+ Production
Product
Use
Users' Willingness to Pay
Competition +
Market Structure
Price * Quantity
– Cost
– Investment
"Free Cash Flow "
Discount for
Time and Risk
Value
$$$
Rational Investment in a New Open Source Architecture
"Pow er of Modularity" Results
Designs are options
Modular architectures multiply options
Modules and Experiments are complementary
Modular designs evolve in a semi-structured w ay via modular operators.
Slide 9
Institutions of Innovation
Architecture = a Production Function for Designs
Institutions are equilibria of sets of linked games
What institutions do the designs "need" to evolve?
What does competition do to payoffs?
Can competitive effects be predicted ex ante?
Cui bono? Who benefits?
© Carliss Y. Baldwin and Kim B. Clark, 2004
What this paper does
Characterizes software as a “non-rival” good
 Characterizes Open Source Development in terms
of two linked games with three stages (join, work,
reveal)
 Interacts games with code architecture
 Looks at Nash equilibria vs. “Robinson Crusoe”
alternative (coding alone)
 Defines a voluntary collective development
process as sustainable if the equilibrium payoff to
Workers is greater than Robinson Crusoe payoff

Slide 10
© Carliss Y. Baldwin and Kim B. Clark, 2004
Open Source is—
New System of
Property Rights
Complementary
Institutional
Structure(s)
GNU GPL
Many Software
Development
Processes—
Social
Movement
Free Software
One Method?
A Bunch of
Organizations +
Governance
Structures
Slide 11
© Carliss Y. Baldwin and Kim B. Clark, 2004
Related Literature—Vast

Eric Raymond
–
–
–
–






Software is a non-rival good; cost of revelation
“Scratching an itch”
“Reputation game”
“Enough eyeballs”
Rishab Ghosh (“cooking pot”, generalized exchange)
Lerner and Tirole (simple economics, reputation=>Wealth)
Justin Pappas Johnson (“public provision of private goods”)
Harhoff, Henkel and von Hippel (“free revelation”)
James Bessen (users benefit from a customizable codebase)
Von Hippel and von Krogh, O’Mahony, Benkler (this is a
new institutional/organizational form)
Slide 12
© Carliss Y. Baldwin and Kim B. Clark, 2004
We position our work in a different
economics literature
We start with a (specific) production process and
a related (non-arbitrary) production function
 Go on to derive/deduce the institutional
structures that can support the production
process, hence “deliver the value” of the
production function

– “New Institutional Economics”
» “Institutional Structure of Production” or ISP

Aoki-Hurwicz-Greif institutions
– An institution is an equilibrium of a set of linked
games, plus summary beliefs that are self-confirming
as the play unfolds.
Slide 13
© Carliss Y. Baldwin and Kim B. Clark, 2004
A production function for design processes
We assert— The production function of any design
process can be written as:
V = I(t){V(Min) + S max Vj(kj ; sj )} – Costs
j
Thresholds
A Minimal System
kj
Costs
Modules/Options
The specifics of this function are determined by the architecture
of the design = architecture of the system
Vs are often recursive—> modules within modules
Process/function can be extensive, but IS MAPPABLE
Slide 14
© Carliss Y. Baldwin and Kim B. Clark, 2004
If this function is descriptively true, we should
be able to derive the institutions needed to
sustain design processes as equilibria of
linked games (plus summary beliefs) about
instances of this function
An Instance = An Architecture
Slide 15
© Carliss Y. Baldwin and Kim B. Clark, 2004
Software Development Processes
Are Design Processes
New System of
Property Rights
GNU GPL
Social
Movement
Design
Processes
Many Software
Development
Processes —
Free Software
One Method?
A Bunch of
Organizations +
Governance
Structures
Slide 16
© Carliss Y. Baldwin and Kim B. Clark, 2004
Open Source is a set of complementary institutional
structures that sustain lots of design processes—
=> A “test” of our production function thesis
=>Prediction:
Open Source institutional structures should arise as
equilibria of some specifications of our function, ie,
for some architectures of codebases.
Slide 17
© Carliss Y. Baldwin and Kim B. Clark, 2004
Two Properties of
Code Architecture
Modular Structure
Option Value
Slide 18
© Carliss Y. Baldwin and Kim B. Clark, 2004
Modularity
 Module
–
–
–
–
= a set of tasks
separable from others;
with additive incremental value
Unit of design substitution
No. of modules = j
Global Design Rules
Module A
Slide 19
Module B
Module C
Module D
© Carliss Y. Baldwin and Kim B. Clark, 2004
Modularity
 Applies
to groups of tasks.
 Modular in design ≠ Modular at runtime
– Linux is modular in design but monolithic at
runtime.
» So is Unix
– Minix is modular at runtime, but (arguably)
monolithic in design.
Slide 20
© Carliss Y. Baldwin and Kim B. Clark, 2004
Option Value
 Design
process is a search under uncertainty
 Design substitution is optional
 Versions are evidence of option values
being realized over time
Global Design Rules v.1
Version 1.0
Version 1.2
Version 1.5
Version 1.8
Slide 21
© Carliss Y. Baldwin and Kim B. Clark, 2004
Modularity and Option Values are
“architectural properties” because
(1) They are observable in early and
incomplete code releases; and
(2) They affect the way the codebase
evolves, ie., gets built out
Slide 22
© Carliss Y. Baldwin and Kim B. Clark, 2004
How Modularity and Option Value
Work — Intuition/Analogy
 Cooking
dinner (Rival good: lot size = 12 portions)
– One big stew = Not modular, no option value
» A cook has no incentive to join with other cooks
– Meat, salad, dessert = Modular, j=3
» Three cooks have incentives to get together
– Two different stew recipes = Option value, s > 0
» Two cooks, pick the best recipe after the fact
– Three courses, two recipes per course = Modules with
option value
» Six cooks will voluntarily join up, cook, and feed each other
» May feed an additional 6-18 people (free riders)
 Collective
Church recipe book (Non-rival good)
– Contributions = #courses x #recipes per course
Slide 23
© Carliss Y. Baldwin and Kim B. Clark, 2004
Open Source Development Process
1
Design
2
Contribute
3
Code
4
Post
5
Integrate
6
Test
7
Report Bugs
8
Patch
This paper looks at the early stages, only.
Suggests that those stages of the process can
be characterized in terms of two linked games.
“Involuntary
Altruism”
Decision to join
and work or
free-ride
Slide 24
+
“Voluntary
Revelation”
Decision to
publish code,
comments, etc.
© Carliss Y. Baldwin and Kim B. Clark, 2004
The Two Linked Games

Work (write code,
patch, etc.)

Reveal (publish code,
comments, etc.)
/* bitmap.c contains the code that handles
the inode and block bitmaps */
#include <string.h>
#include <linux/sched.h>
#include <linux/kernel.h>
#define clear_block(addr) \
__asm__("cld\n\t" \
"rep\n\t" \
"stosl" \
::"a" (0),"c"
(BLOCK_SIZE/4),"D" ((long)
(addr)):"cx","di")
Slide 25
© Carliss Y. Baldwin and Kim B. Clark, 2004
First game—“Involuntary Altruism”

Decision 1:
– Join a collective development process; or
– Code in isolation
If a developer joins and works, his/her work product
will automatically benefit other joiners (who may
be free-riding). Standard, convenient assumption.
 Decision 2: Within collective,
– Work; or
– Free-ride
“Private provision of public goods” game
Slide 26
© Carliss Y. Baldwin and Kim B. Clark, 2004
First Game—Formal Setup


Non-rival good—agents’ outside alternative is to code
alone, involuntary revelation=>free-riding
Two-stage (join/work), one round. Work interval equals the
time needed to code one module; All work synchronous.
– Or endogenous sequences to exhaust modules/option value

Subgame perfect Nash equilibrium
– Sequential or simultaneous entry
– Pure, mixed and evolutionarily stable strategies

Code Architecture visible to agents
–
–
–
–
Some number of symmetric modules, j ≥ 1
Value per module = v/j; Cost per module = c/j
Some option value per module (s ≥ 0)
“Perfect” and “imperfect” information
Slide 27
Number of
workers is the
outcome of
equilibrium
© Carliss Y. Baldwin and Kim B. Clark, 2004
First Game—Results

If codebase is NOT modular and has NO option value, a
working developer does just as well coding in isolation as
joining the collective.

If codebase is modular OR has option value, working
developers do better in the collective than coding
alone.

Modularity and option value are economic complements:
more of one makes more of the other more valuable
(Baldwin and Clark, Design Rules, 2000)
Slide 28
© Carliss Y. Baldwin and Kim B. Clark, 2004
The Equilibrium Number of Working Developers in a Game of
Involuntary Beneficence as a Function of Cost-to-Value Ratio, c/v,
and Number of Modules, j (Imperfect Information, Redundant Effort)
No. of
Modul es
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
Slide 29
Cost/Value per Module
10%
1
4
6
9
11
13
15
18
20
22
25
27
29
32
34
36
38
41
43
45
20%
1
3
4
6
8
9
11
13
14
16
17
19
21
22
24
25
27
29
30
32
30%
1
2
3
5
6
7
8
10
11
12
13
14
16
17
18
19
20
22
23
24
40%
1
2
3
4
5
6
6
7
8
9
10
11
12
13
14
15
16
17
17
18
50%
1
1
2
3
4
4
5
6
6
7
8
8
9
10
11
11
12
13
13
14
60%
1
1
2
2
3
3
4
4
5
5
6
6
7
7
8
8
9
9
10
10
70%
1
1
1
2
2
2
3
3
4
4
4
5
5
5
6
6
6
7
7
7
80%
1
1
1
1
1
2
2
2
2
3
3
3
3
4
4
4
4
4
5
5
90%
1
1
1
1
1
1
1
1
1
1
2
2
2
2
2
2
2
2
2
3
100%
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
© Carliss Y. Baldwin and Kim B. Clark, 2004
The Number of Developers Working in Equilibrium, nj*, as a
Function of the Cost-to-Technical-Potential Ratio, c/s, and the
Number of Modules, j (Perfect Information, Option-driven Effort)
No . of
Mo d ul es
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
Slide 30
Co st/Tech n ical Po ten ti al
25%
2
6
12
16
25
30
42
48
54
70
77
84
104
112
120
128
153
162
171
180
189
220
230
240
250
50%
0
2
3
8
10
18
21
24
27
30
44
48
52
56
60
64
85
90
95
100
105
110
115
120
150
75%
0
0
0
4
5
6
7
16
18
20
22
24
26
42
45
48
51
54
57
60
63
66
92
96
100
100%
0
0
0
0
0
0
7
8
9
10
11
12
26
28
30
32
34
36
38
40
42
44
46
72
75
150%
0
0
0
0
0
0
0
0
0
0
0
0
0
0
15
16
17
18
19
20
21
22
23
24
25
Note: E(v) =.399s
Ten
developers on
each module
© Carliss Y. Baldwin and Kim B. Clark, 2004
Second Game—“Voluntary Revelation”
In real life, developers do not have to reveal their
code to one another
 Suppose two developers each have coded a
module (sunk cost)
 Can send it to the other, but communication is
costly
 One bears a cost to benefit the other
 This is a canonical Prisoners’ Dilemma game

Slide 31
© Carliss Y. Baldwin and Kim B. Clark, 2004
There are many ways to encourage cooperation in a
Prisoners’ Dilemma game (Axelrod)

Reduce the cost of communicating
– Internet, email, newgroups

Increase the rewards
– Desire to reciprocate (Ernst Fehr)
– Feelings of altruism (Benkler)
– The “Reputation Game” (Lerner-Tirole)

Create a repeated game
– Contingent strategies (eg. Tit-for-Tat)
– Can support cooperation in equilibrium
Slide 32
© Carliss Y. Baldwin and Kim B. Clark, 2004
Code Architecture interacts with the
Prisoners’ Dilemma Game

Modularity
–
–
–
–

reduces the cost of a unit of contribution
creates opportunity for reciprocation
creates many different “chunks of reputation”
creates larger “space” of repeatable games
Option value
– provides improvable modules, thus creates “contests
with winners” (reputation)
– makes the arrival of the end-game a surprise
Slide 33
© Carliss Y. Baldwin and Kim B. Clark, 2004
The effect of linking the two games
 Reputation/repetition
only has to overcome
the cost of communicating (r/j)
 “Work” motivated by the value of own
code:
– v/j > c/j for the developer
 “Joining”
motivated by access to others’
code (non-rival good)
 Potentially very large continuation value:
V – c/j – r/j + Rj for each developer
Slide 34
© Carliss Y. Baldwin and Kim B. Clark, 2004
Conclusions: A Voluntary, Collective Design
Process Requires—

For existence:
–
–
–
–
–

Designer-users
Non-rivalrous goods
A design architecture with modules and/or options
Communication speeds matching the design interval for one module
Methods of SYSTEM INTEGRATION AND TESTING (omitted
here—see DR1 and Bessen)
For efficiency:
– Ways to know who’s working on what
– Ways to know which module design is better or best (Module-level
testing—see DR1, contrast to Bessen)

For robustness (to solve the Prisoners’ Dilemma game):
– Rewards for communication
– Iteration with an indeterminate horizon (not strict repetition)
Slide 35
© Carliss Y. Baldwin and Kim B. Clark, 2004
A theoretical horse race:
Microsoft vs. Linux







Assume: one firm, one collective, j modules
Equal quality output
Developer-users will purchase proprietary system instead
of coding modules for a collective system if the price of
proprietary system < their cost of coding
Cost per developer of collective system with j modules
= c/j (for Workers, 0 for free-riders)
So Max proprietary system price = c/j
So Max revenue = Nc/j (N is number of customers)
Cost of creating proprietary system comparable to
collective system
= c if no option value;
= kj*c if option value (we show this…)
Slide 36
© Carliss Y. Baldwin and Kim B. Clark, 2004
Horse race
 Under
these assumptions, we show:
 NPV of the proprietary codebase
= Nc/j – c
= Nc/j – kj*c
 If
N ≤ kj*j
kj* and j are consequences
of code architecture; kj* is
increasing, concave in j
Slide 37
if codebase is modular
if codebase is modular and
has option value; and
no commercial
opportunity exists (though
sunk cost assets may
survive)
© Carliss Y. Baldwin and Kim B. Clark, 2004
Thank you!
Slide 38
© Carliss Y. Baldwin and Kim B. Clark, 2004