Democratizing Innovation
for in-house use might feel it perfectly acceptable to install a pre-
regarded under US law as also providing an implied warranty of “fit-
cisely right and very cheap computer controller made and promi-
ness for the intended use.” If a product does not meet this criterion,
nently labeled by Lego, a manufacturer of children's toys. (Lego
and if a different, written warranty is not in place, manufacturers can
provides computer controllers for some of its children's building kit
be found liable for negligence with respect to providing a defective
products.) But if that same engineer saw a Lego controller in a
design and failure to warn buyers (Barnes and Ulin 1984). This sim-
million-dollar process machine his firm was purchasing from a spe-
ple difference can cause a large difference in exposure to liability by
cialist high-end manufacturer, he might not know enough about the
innovators and so can drive up the costs of manufacturer-provided
design details to know that the Lego controller was precisely right
solutions relative to user-provided ones.
for the application. In that case, the engineer and his managers
For example, a user firm that builds a novel process controller to
might well regard the seemingly inappropriate brand name as an
185
improve its plant operations must pay its own actual costs if the
indirect signal of bad quality.
self-built controller fails and ruins expensive materials being pro-
182
Manufacturers are often so concerned about a reputation for qual-
cessed. On the other hand, if a controller manufacturer designed
ity that they refuse to take shortcuts that a customer specifically
the novel controller product and sold it to customers, and a fail-
requests and that might make sense for a particular customer, lest
ure then occurred and could be traced back to a fault in the de-
others get wind of what was done and take it as a negative signal
sign, the controller manufacturer is potentially liable for actual user
about the general quality of the firm's products. For example, you
costs and punitive damages. It may also incur significant reputa-
may say to a maker of luxury custom cars: “I want to have a cus-
tional losses if the unhappy user broadcasts its complaints. The
tom car of your brand in my driveway---my friends will admire it.
logical response of a controller manufacturer to this higher risk is
But I only plan to drive it to the grocery store once in a while, so
to charge more and/or to be much more careful with respect to
I only want a cheap little engine. A luxury exterior combined with
running exhaustive, expensive, and lengthy tests before releasing
cheap parts is the best solution for me in this application---just slap
a new product. The resulting increase in cost and delay for obtain-
something together and keep the price low.” The maker is likely to
ing a manufacturer-developed product can tend to tip users toward
respond: “We understand your need, but we cannot be associated
building their own, in-house solutions.
with any product of low quality. Someone else may look under the
Net Result
hood some day, and that would damage our reputation as a maker
186
of fine cars. You must look elsewhere, or decide you are willing to
A net result of the foregoing considerations is that manufacturers
187
pay the price to keep one of our fine machines idle on your drive-
often find that developing a custom product for only one or a few
way.”
users will be unprofitable. In such cases, the transaction costs in-
volved can make it cheaper for users with appropriate capabilities
183
Differing Legal and Regulatory Requirements
to develop the product for themselves. In larger markets, in con-
184
Users that innovate do not generally face legal risk if the product
trast, fixed transaction costs will be spread over many customers,
they develop fails and causes costs to themselves but not to others.
and the economies of scale obtainable by producing for the whole
In contrast, manufacturers that develop and sell new products are
market may be substantial. In that case, it will likely be cheaper for
34
Democratizing Innovation
users to buy than to innovate. As a result, manufacturers, when
duce biased advice, they may attempt to shop around among a
contacted by a user with a very specific request, will be keenly in-
number of suppliers offering different solution types and/or develop
terested in how many others are likely to want this solution or ele-
internal expertise on solution possibilities and/or attempt to write
ments of it. If the answer is “few,” a custom manufacturer will be
better contracts. All these attempts to induce and guard against
unlikely to accept the project.
bias involve agency costs.
An Illustrative Case
190
188
Of course, manufacturers have an incentive to make markets at-
tractive from their point of view. This can be done by deviating from
A case study by Sarah Slaughter (1993) illustrates the impact of
191
precisely serving the needs of a specific custom client in order to
some of the transaction costs discussed above related to users'
create a solution that will be “good enough” for that client but at the
innovate-or-buy decisions. Slaughter studied patterns of innova-
same time of more interest to others. Manufacturers may do this
tion in stressed-skin panels, which are used in some housing con-
openly by arranging meetings among custom buyers with similar
struction. The aspects of the panels studied were related to instal-
needs, and then urging the group to come up with a common solu-
lation, and so the users of these features were home builders rather
tion that all will find acceptable. “After all,” as the representative will
than home owners. When Slaughter contrasted users' costs of in-
say, “it is clear that we cannot make a special product to suit each
novating versus buying, she found that it was always much cheaper
user, so all of you must be prepared to make really difficult compro-
for the builder to develop a solution for itself at a construction site
mises!” More covertly, manufacturers may simply ignore some of
than to ask a panel manufacturer to do so.
the specific requests of the specific user client and make something
A stressed-skin panel can be visualized as a large 4-by-8-foot
192
that they expect to be a more general solution instead.
sandwich consisting of two panels made of plywood with a layer
of plastic foam glued in between. The foam, about 4 inches thick,
189
The contrasting incentives of users and manufacturers with respect
strongly bonds the two panels together and also acts as a layer of
to generality of need being served---and also with respect to the
thermal insulation. In 1989, manufacturing of stressed-skin panels
solution choice issue discussed earlier---can result in a very frus-
was a relatively concentrated industry; the four largest manufactur-
trating and cloudy interaction in which each party hides its best
ers collectively having a 77 percent share of the market. The user
information and attempts to manipulate others to its own advan-
industry was much less concentrated: the four largest constructors
tage. With respect to generality of need, sophisticated users un-
of panelized housing together had only 1 percent of the market for
derstand custom suppliers' preference for a larger market and at-
such housing in 1989.
tempt to argue convincingly that “everyone will want precisely what
I am asking you for.” Manufacturers, in turn, know users have this
In housing construction, stressed-skin panels are generally at-
193
incentive and so will generally prefer to develop custom products
tached to strong timber frames to form the outer shell of a house
for which they themselves have a reasonable understanding of de-
and to resist shear loads (such as the force of the wind). To use
mand. Users are also aware of manufacturers' strong preference
the panels in this way, a number of subsidiary inventions are
for only producing products that embody their existing solution ex-
required. For example, one must find a practical, long-lasting way
pertise. To guard against the possibility that this incentive will pro-
to attach panels to each other and to the floors, the roof, and the
35
Democratizing Innovation
frame. Also, one has to find a new way to run pipes and wires from
A builder was faced with the immediate problem of how to route
197
place to place because there are no empty spaces in the walls to
wires through the foam interior of panels to wall switches located
put them---panel interiors are filled with foam.
in the middle of the panels. He did not want cut grooves or channels
through the surfaces of the panels to these locations---that would
194
Stressed-skin panels were introduced into housing construction
dangerously reduce the panels' structural strength. His inventive
after World War II. From then till 1989, the time of Slaughter's
solution was to mount an electrically heated wire on the tip of a long
study, 34 innovations were made in 12 functionally important ar-
pole and simply push the heated tip through the center insulation
eas to create a complete building system for this type of construc-
layer of the panel. As he pushed, the electrically heated tip quickly
tion. Slaughter studied the history of each of these innovations
melted a channel through the foam plastic insulation from the edge
and found that 82 percent had been developed by users of the
of the panel to the desired spot. Wires were then pulled through
stressed-skin panels---residential builders---and only 18 percent by
this channel.
manufacturers of stressed-skin panels. Sometimes more than one
user developed and implemented different approaches to the same
Table 4.1 Users would have found it much more costly to get cus-
198
functional problem (table 4.1). Builders freely revealed their in-
tom solutions from manufacturers. The costs of user-developed
novations rather than protecting them for proprietary advantage.
innovations in stressed-skin panels were very low.
They were passed from builder to builder by word of mouth, pub-
199
lished in trade magazines, and diffused widely. All were replicated
Function
Average
user
Average
user
N
Minimimum cost of
at building sites for years before any commercial panel manufac-
development
development
waiting for manu-
time (days)
cost
facturer to deliver
turer developed and sold a solution to accomplish the same func-
tion.
Framing of openings in panels
0.1
20
1
1 , 400
Structural connection between panels
0.1
30
2
1 , 400
195
Histories of the user-developed improvements to stressed-skin
Ventilation of panels on roof
0.1
32
2
28 , 000
panel construction showed that the user-innovator construction
Insulated connection between panels
0.1
41
3
2 , 800
firms did not engage in planned R&D projects.
Instead, each
Corner connection between panels
0.2
60
1
2 , 800
innovation was an immediate response to a problem encountered
Installation of HVAC in panels
0.2
60
2
2 , 800
in the course of a construction project.
Once a problem was
Installation of wiring in panels
0.2
79
7
2 , 800
encountered, the innovating builder typically developed and
Connection of panels to roof
0.2
80
1
2 , 800
fabricated a solution at great speed, using skills, materials, and
Add insect repellency to panels
0.4
123
3
70 , 000
equipment on hand at the construction site. Builders reported that
Connect panels to foundation
0.5
160
1
1 , 400
the average time from discovery of the problem to installation of
Connect panels to frames
1.2
377
3
2 , 800
the completed solution on the site was only half a day. The total
Development of curved panels
5.0
1,500
1
28 , 000
cost of each innovation, including time, equipment, and materials,
Average for all innovations
0.5
153
12 , 367
averaged $153.
196
Example: Installing Wiring in a Stressed-Skin Panel
36
Democratizing Innovation
200
N represents number of innovations developed by users to carry
above and below these windows, but panel manufacturers only
out each listed function. Source: Slaughter 1993, tables 4 and
sold flat panels at that time. The builder facing the problem could
5. Costs and times shown are averaged for all user-developed
not simply buy standard flat panels and bend them into curved ones
innovations in each functional category. (The six manufacturer-
at the construction site---completed panels are rigid by design.
developed innovations in Slaughter's sample are not included in
So he bought plywood and plastic foam at a local building supply
this table.)
house and slowly bent each panel component separately over a
curved frame quickly built at the construction site. He then bonded
201
The builder-innovator reported that the total time to develop the
all three elements together with glue to create strong curved panels
innovation was only an hour, and that the total cost for time and
that would maintain their shape over time.
materials equaled $40. How could it cost so little and take so little
time? The builder explained that using hot wires to slice sheets of
To determine whether users' decisions to innovate rather than
205
plastic foam insulation into pieces of a required length is a tech-
buy made economic sense for them, Slaughter calculated, in a
nique known to builders. His idea as to how to modify the slicing
very conservative way, what it would have cost users to buy a
technique to melt channels instead came to him quickly. To test the
manufacturer-developed solution embodied in a manufactured
idea, he immediately sent a worker to an electrical supply house to
panel rather than build a solution for themselves. Her estimates
get some nichrome wire (a type of high-resistance wire often used
included only the cost of the delay a user-builder would incur
as an electrical heating element), attached the wire to a tip of a
while waiting for delivery of a panel incorporating a manufacturer's
pole, and tried the solution on a panel at the building site---and it
solution. Delay in obtaining a solution to a problem encountered
worked!
at a construction site is costly for a builder, because the schedule
of deliveries, subcontractors, and other activities must then be
202
This solution was described in detail in an article in a builder's mag-
azine and was widely imitated. A panel manufacturer's eventual re-
altered. For example, if installation of a panel is delayed, one must
sponse (after the user solution had spread for a number of years)
also reschedule the arrival of the subcontractor hired to run wires
was to manufacture a panel with a channel for wires pre-molded
through it, the contractor hired to paint it, and so on. Slaughter
into the plastic foam interior of the panel. This solution is only
estimated the cost of delay to a builder at $280 per crew per day of
sometimes satisfactory. Builders often do not want to locate switch
delay (Means 1989). To compute delay times, she assumed that a
boxes at the height of the premolded channel. Also, sometimes
manufacturer would always be willing to supply the special item a
construction workers will install some panels upside down in error,
user requested. She also assumed that no time elapsed while the
and the preformed channels will then not be continuous between
manufacturer learned about the need, contracted to do the job,
one panel and the next. In such cases, the original, user-developed
designed a solution, and obtained needed regulatory approvals.
solution is again resorted to.
She then asked panel manufacturers to estimate how long it would
take them to simply construct a panel with the solution needed
203
Example: Creating a Curved Panel
and deliver it to the construction site. Delay times computed in this
204
A builder was constructing a custom house with large, curved win-
manner ranged from 5 days for some innovations to 250 days for
dows. Curved stressed-skin panels were needed to fill in the space
the longest-term one and averaged 44 days.
37
Democratizing Innovation
206
The conservative nature of this calculation is very clear. For ex-
user problem. We also assume that both user firms and manufac-
ample, Slaughter points out that the regulatory requirements for
turer firms will incur the same costs to solve a specific user problem.
building components, not included, are in fact much more strin-
For example, they will have the same costs to monitor the perfor-
gent for manufacturers than for user-builders in the field of res-
mance of the designer employees they hire. In this way we simplify
idential construction. Manufacturers delivering products can be
our innovate-or-buy problem to one of transaction costs only.
required to provide test data demonstrating compliance with local
If there are no transaction costs (for example, no costs to write
211
building codes for each locality served. Testing new products for
and enforce a contract), then by Coase's theorem a user will be
compliance in a locality can take from a month to several years,
indifferent between making or buying a solution to its problem. But
and explicit code approval often takes several additional years.
in the real world there are transaction costs, and so a user will
In contrast, a builder that innovates need only convince the lo-
generally prefer to either make or buy. Which, from the point of
cal building inspector that what he has done meets code or per-
view of minimizing overall costs of obtaining a problem solution, is
formance requirements--- often a much easier task (Ehrenkrantz
the better choice under any given circumstances?
Group 1979; Duke 1988).
Let Vij be the value of a solution to problem j for user i. Let Nj be the 212
207
Despite her very conservative method of calculation, Slaughter
number of users having problem j. Let Wh
found the costs to users of obtaining a builder solution to be at
j be the cost of solving
least 100 times the actual costs of developing a solution for them-
problem j, where W = hourly wage and hj = hours required to solve
selves (table 4.1). Clearly, users' decisions to innovate rather than
it. Let Pj be the price charged by a manufacturer for a solution
buy made economic sense in this case.
to problem j. Let T be fixed or “setup” transaction costs, such as
writing a general contract for buyers of a solution to problem j. Let
208
Modeling Users' Innovate-or-Buy Decisions
t be variable or “frictional” transaction costs, such as tailoring the
209
In this section I summarize the core of the argument discussed in
general contract to a specific customer.
this chapter via a simple quantitative model developed with Carliss
To explore this problem we make two assumptions. First, we as-
Baldwin. Our goal is to offer additional clarity by trading off the
213
sume that a user firm knows its own problems and the value of
richness of the qualitative argument for simplicity.
a solution to itself, Vij. Second, we assume that a manufacturer
210
Whether a user firm should innovate or buy is a variant of a well-
knows the number of users having each problem, Nj, and the value
known problem: where one should place an activity in a supply
of solutions for each problem for all users, V
chain. In any real-world case many complexities enter. In the
ij.
model that follows, Baldwin and I ignore most of these and consider
These assumptions are in line with real-world incentives of users
214
a simple base case focused on the impact of transaction costs on
and manufacturers, although information stickiness generally pre-
users' innovate-or-buy considerations. The model deals with man-
vents firms from getting full information. That is, users have a high
ufacturing firms and user firms rather than individual users. We
incentive to know their own problems and the value to them of a
assume that user firms and manufacturer firms both will hire de-
solution. Manufacturers, in turn, have an incentive to invest in un-
signers from the same homogeneous pool if they elect to solve a
derstanding the nature of problems faced by users in the target
38
Democratizing Innovation
market, the number of users affected, and the value that the users
Nj (Whj - t) - Whj > 0,
224
would attach to getting a solution in order to determine the potential
or equivalently (provided Wh
profitability of markets from their point of view.
j > t)
225
N
215
We first consider the user's payo