Transcript NFRS Seminar - Harvard Business School

The Pricing and Profitability of
Modular Clusters
Carliss Y. Baldwin
Modularity Mini-Conference
London Business School
October 2, 2003
This is an emergent modular
cluster
Slide 2
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
Another View Showing Dramatic Increases in
Aggregate Market Value even as the Number of Firms
Grows
Slide 3
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
Can it last?
 Chandler-Abernathy-Utterback-Klepper
industry evolution says “no”
theory of
 Predictions
of consolidation have occurred in every
downturn since 1980
– Larry Ellison of Oracle in 2003
 Is
the Modular Cluster form of industrial
organization sustainable as a long-term equilibrium?
– Pricing holds the key
– If firms kill each other in product markets, consolidation
will occur
Slide 4
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
Quick review of price theory

Price competition among imperfect substitutes
– Prices go down as number of firms goes up
– Cournot quantities, Hotelling beach…

Vertical price externality among complements
– Prices go up as number of firms in a vertical supply
chain or a system of complements goes up
– “Double marginalization”—Intuition
Slide 5
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
Executive Summary
Can imperfect price competition and
the vertical pricing externality offset
one another in a large cluster?
Yes
How?
Read the paper!
Slide 6
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
Our Thought Experiment
 Beach
resort vacation
– Travel, hotel, restaurants, sports, tours, taxis…
– Equipment supply, laundry, maid service,
furniture, food wholesale…
– Hospital, police, roads, buildings, electricity…
 Large
number of primitive production
components—
– All essential to the system
– Many variants of each
Slide 7
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
Our Thought Experiment
Symmetric modular partitions
 Divide the complements and variants up in
different ways

–
–
–
–
1x1 = One Big Firm
Jx1 = J Module Monopolies
1xN = N Full-span Oligopolies
JxN = N firms competing in J module markets
One Big
Firm
One Big Firm
Slide 8
N
o
r
t
h
S
o
u
t
h
Full-span
Duopolists
Upstream
NU
SU
Dow nstream
ND
SD
Tw o M odule
M onopolists
M odular
Cluster
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
Our Thought Experiment
 Our
model aims to look at an unlimited
number of alternate “configurations”
One Big
Firm
One Big Firm
One Big Firm
Slide 9
N
o
r
t
h
S
o
u
t
h
Full-span
Duopolists
Five Full-Span
Oligopolists
Upstream
NU
SU
Dow nstream
ND
SD
Tw o M odule
M onopolists
Ten Module
Monopolists
M odular
Cluster
Fifty Firms in a
Modular Cluster
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
The Key Assumption

The representative firm perceives its demand
function to be:
qi = i(pi ; …) Q[P(pi ; …)]
where pi is its own price.

i(pi ; …) is “market share” and depends on the
prices in its “own market”.

Q[P(pi ; …)] is “system demand” and depends on the
average prices of goods in the other “module
markets”.

This decomposition makes analysis of symmetric
JxN clusters feasible. Otherwise, combinatorial
explosion!
Slide 10
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
The “array of configurations”

We solve for the pricing equilibrium in each cell
and compute aggregate profit
More Firms in Each Market
1x1
1x2
1x3
1x4
…
1xM
1xN
More
2x1
2x2
2x3
2x4
…
2xM
2xN
Module
3x1
3x2
3x3
3x4
…
3xM
3xN
Markets
4x1
4x2
4x3
4x4
…
4xM
4xN
Jx1
Jx2
Jx3
Jx4
…
JxM
JxN
Kx1
Kx2
Kx3
Kx4
…
KxM
KxN
…
…
…
Slide 11
…
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
Results—Prices
 Along
the edges of the array
One Big Firm
1x1 Conf igurat ion
Jx1
Conf igurat ions
1xN
Conf igurat ions
2000
1800
1600
1400
1200
Equilibrium
System
Price
1000
800
600
400
200
0
1
3
5
7
Number of Firms
Per Module Market
(N = 1 -20)
Slide 12
9
11
13
15
17
19
19
17
15
13
11
9
7
5
3
1
Number of Modules
(J =1 - 20)
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
Results—Aggregate Profit
 Along
the edges of the array
One Big Firm
1x1 Conf igurat ion
1xN
Conf igurat ions
Jx1 Conf igurat ions
1000
900
800
700
600
A ggregate
Prof it
500
400
300
200
100
0
1
3
5
7
Number of Firms
Per Module Market
(N = 1 -20)
Slide 13
9
11
13
15
17
19
19
17
15
13
11
9
7
5
3
1
Number of Modules
(J =1 - 20)
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
Results—Prices
 Full
array
2000
1800
1600
1400
Cluster
Syst em Price
Equals
One Big Firm
Syst em Price
1200
Equilibrium
1 0 0 0 Syst em
Price
800
600
400
200
1
Number of Firms
Per Module Market
(N = 1 -20)
Slide 14
3
5
7
0
9
11
13
15
17
19
19
17
15
13
11
9
7
5
3
1
Number of Modules
(J =1 - 20)
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
Results—Aggregate Profit

Full array, reverse view—Note “sweet spots”
1200
1000
800
A ggregate
600
Prof it
400
200
19
Number of Firms
Per Module Market
(N = 1 -20)
Slide 15
17
0
15
13
11
9
7
5
3
11
3
5
7
9
11
17 19
15
13
Number of Modules
(J =1 - 20)
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
Implications for strategy
Cluster form is sustainable in theory
 Financiers’ payoff vs. a firm’s payoff
 Disintegration can pay…
 Financiers can use M&A to approach the industry
sweet spot, but…
 Can a decentralized
cluster find the
pricing equilibrium
at the sweet spot?

1200
1000
800
A ggregate
600
Prof it
400
200
19
Number of Firms
Per Module Market
(N = 1 -20)
Slide 16
17
0
15
13
11
9
7
5
3
11
3
5
7
9
11
15
17
19
13
Number of Modules
(J =1 - 20)
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
Further implications for strategy

Two kinds of clusters
– “Federated” clusters: all modules compatible
– “Portal” clusters: Platform firms with captive module
complementary module suppliers
– Both appear to exist in the real world


Portal clusters price
as 1xN, need small
numbers
Can a cluster evolve
from “portal” to “federated”
by increasing the
technical compatibility
amongst modules?
Slide 17
1200
1000
800
A ggregate
600
Prof it
400
200
19
Number of Firms
Per Module Market
(N = 1 -20)
17
0
15
13
11
9
7
5
3
11
3
5
7
9
11
15
17
19
13
Number of Modules
(J =1 - 20)
© C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003
Thank you!