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WorkingPaperSeriesNo.16

ProfitingfromInnovationintheDigitalEconomy:Standards,ComplementaryAssets,andBusinessModels

IntheWirelessWorld

DavidJ.Teece1

23August20161ThomasTusherProfessorofGlobalBusiness&Director,TusherCenteronIntellectualCapital,HaasSchoolofBusiness,,UniversityofCalifornia,Berkeley;Chairman;BerkeleyResearchGroup,LLC.Email:dteece@thinkbrg.com.IwishtothankAsishArora,GaryPisano,GregLinden,andBenoitReillierforhelpfulcommentsandvaluableinsights.

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TABLEOFCONTENTS

I.Introduction.............................................................................................................3

II.PFIRevisited............................................................................................................3

III.ExpandingthePFIFramework................................................................................5

A.GeneralPurposeTechnologies,EnablingTechnologies,&theAppropriabilityChallenge..5

1.GeneralPurposeTechnologies...........................................................................................5

2.EnablingTechnologies........................................................................................................6

4.Enablingtechnologiesinmobilecommunicationecosystems.........................................10

B.ComplementaryAssets..................................................................................................12

1.Varietiesofcomplementarity...........................................................................................12

2.PFIandcomplementarityreconsidered...........................................................................16

3.Platformsandecosystems................................................................................................18

C.Multi-levelPFI................................................................................................................20

D.ModularityandIndustryPerformance...........................................................................23

E.BusinessModelConfiguration:LicensingandAlternatives.............................................25

F.Standards.......................................................................................................................27

1.Standardsettingandstandardsdevelopment.................................................................27

2.Standardessentialpatents(SEPs)androyalties...............................................................29

IV.ManagementandPolicyConclusions....................................................................30

References.................................................................................................................33

Appendix:TheDigitalRevolutionanditsEffects.........................................................37

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I.IntroductionInthispaper,IlookanewattheProfitingfromInnovation(PFI)frameworklaidoutinTeece(1986,1988a,2006).Thequestionsaddressedintheearliertreatments—whatdetermineswhichfirmsprofitfromaninnovation,andwhichfirmsearnonlymeager(andpossiblynegative)returns—haveenduringrelevanceforbothmanagementandpublicpolicy.2Ifanything,theimportanceoftheissuesisamplifiedas“digitaldisruption”gainspaceandasthemannerofinnovationchanges.Inparticular,themega-convergenceofcertainindustriesthatisbeingdrivenbythemergingofwirelessandInternettechnologiesrequiresthatoneopentheapertureofbusinessandeconomicinquiryfromtheinnovationofindividualproductsandprocessestoinnovationwithinecosystemsandacrosstheupstreamanddownstreamlevelsofcompetitioninanindustrialsystem.ThewiderapertureofinquiryinthispaperturnsouttoreinforcethekeyelementsofPFI.Intellectualproperty,thenatureofknowledge,complementaryassets,standards,andtimingallremaincenterstage.Whatisbroughtintosharperfocusisadditionalgranularitywithrespecttodifferenttypesofcomplementaryassetsandthewaystheyimpactthecaptureofvaluefrominnovation.Additionalclarityisalsoprovidedwithrespecttohowacollaborativestandardsdevelopmentprocessenablesdownstreaminnovation,andhowstandards-basedbusinessecosystemsemergeandcompete.Inparticular,thechallengesofcapturingvaluefromenablingtechnologyarerecognized,andpolicyimplicationsareexplored.Thisessayconsiderstheimpactsofchangeswroughtbythedigitalrevolution,theactivityofstandardsorganizations,thepresenceofenablingtechnologies,andthegrowingimportanceofcomplementaryassetsandtechnologiesintheinformationandcommunicationtechnology(ICT)sectorsandbeyond.Thesephenomenahaveenhancedsalienceinthewakeofthedigitalrevolutionandtheassociatedconvergenceofindustriesthatisdescribedintheappendix.

II.PFIRevisitedTheProfitingfromInnovation(PFI)framework(Teece,1986)waslaunchedthirtyyearsagoinaverydifferenttechnologicalandbusinessenvironmentthanmostcompaniesfacetoday.SincePFIhasbecomeimportanttothetechnologymanagementandbusinessmanagementliteratures,itisworthrevisitingperiodicallyinordertoseewhatrevisionsmightbenecessary.Ifirstdidsotenyearsago(Teece,2006),whenIsketchedanumberofelaborationsandextensionsinresponsetoshiftsintheenvironmentsince1986.Theseincludedfurtherdevelopmentofthemulti-inventioncontextforinnovation,theincorporationofaricherunderstandingofnetworkeffects,andtheconsiderationofbusinessmodelsengenderedbythelaunchoftheInternet.IalsodiscussedthegrowingimportanceofcomplementarytechnologiesandbusinessecosystemsandtheirimpactonPFI.Intheinterveningdecade,asmentionedearlierandelaboratedintheappendix,thetechno-businessenvironmenthasshiftedstillfurther.TheInternetisnolongerautilityconsultedjustfromuserdesktops.Itisincreasinglypervasive,accessedinteractivelybyusersonthegoandextendedtosensor-equippedterminalsanywhereandeverywhere.Meansofcommunicationhavealsoevolved,fromphoneandemailtowardmessagingappsthatalsoserveasportalsforshoppingandahostofotherservices.2BeforePFI,capturingvaluewasoftenconsideredjustamatterofpricingstrategy.Settingpricesremainsimportant,butvaluecapturedependsonmorefundamentalconsiderations.

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PFladdressedapuzzlethathadnotbeenwellexplainedinthepreviousliterature,namely:whydohighlycreative,pioneeringfirmsoftenfailtocapturemuchoftheeconomicreturnsfrominnovation?Apple'siPodwasnotthefirstMP3player,butithasacommandingpositioninthecategorytoday.Merckwasapioneerincholesterol-loweringdrugs(Zocor),butPfizer,alateentrant,securedasuperiormarketpositionwithLipitor.Atfirstglance,itistemptingtosaythattheseexamplesreflecttheresultofSchumpeteriangalesofcreativedestructionwherewinnersareconstantlychallengedandoverturnedbyentrants.Butthecitedcasesandcountlessothersinvolvemostlyincremental/imitativeentrantsratherthantheradicalbreakthroughsofSchumpeteriancompetition.And,ofcourse,therearemanycaseswherefirstorearlymoverscapturedandsustainedsignificantcompetitiveadvantageovertime.Genentechwasapioneerinusingbiotechnologytodiscoveranddevelopdrugs,and30yearslaterwasthesecondlargestbiotechnologyfirm(and,themostproductiveinitsuseofresearchanddevelopmentdollars)rightuptoitsacquisitionbyHoffmann-LaRochein2009.Intelinventedthemicroprocessorandstillhasaleadingmarketpositionmorethan30yearslater.Thefocusofthe1986articlewasonasingle,autonomousinnovationthatwascommerciallyviable.Thepaperthusduckedonequestion—whyinventionssooftenfailtosucceedin(orevenreach)themarket—andfocusedinsteadonhowthespoilsaredividedoncepositivenetvalueiswithinsight.Thepaperalsofocusedonproductinnovationsratherthanprocessimprovements,creativeoutput,orothervaluableintellectualproperty.Theseandothersimplificationsmadetheanalysistractable.

ThePFIframeworkprovidesanexplanationastowhysomeinnovatorswininthemarketplacewhileothersloseout—oftentorankimitators—andwhyitisnotinevitablethatthepioneerswilllose.Thefundamentalimperativeforprofitingfromaninnovationisthatunlesstheinventor/innovatormovesdownanimprovementpathandenjoysstrongnaturalprotectionagainstimitationand/orstrongintellectualpropertyprotection,thenpotentialfuturestreamsofincomeareatrisk.Therelevantappropriabilityregimeisthuscriticaltoshapingthepossibleoutcomes.Appropriabilityregimescanbe"weak"(innovationsaredifficulttoprotectbecausetheycanbeeasilycodifiedandlegalprotectionofintellectualpropertyisineffective)or"strong"(innovationsareeasytoprotectbecauseknowledgeaboutthemistacitand/ortheyarewellprotectedlegally).Appropriabilityregimesformanydigitalbusinessesareoftenquiteweak.Businessmodelscannotrelyheavilyonintellectualproperty(IP)tocapturevaluebecauseIPisgenerallynotself-enforcing;ofinstancesofpatentinfringementandtradesecretmisappropriationmustbeidentifiedandnegotiatedorlitigated,oftenatgreatexpense.Evenpatentsrarely,ifever,conferstrongappropriability,outsideofspecialcasessuchasnewdrugs,chemicalproducts,andrathersimplemechanicalinventions(Levinetal.,1987).Manypatentscanbe"inventedaround"atmodestcosts(Mansfield,1985;Mansfieldetal.,1981).Oftenpatentsprovidelittleprotectionbecausethelegalandfinancialrequirementsforupholdingtheirvalidityorforprovingtheirinfringementarehigh,orbecause,inmanycountries,lawenforcementforintellectualpropertyisweakornonexistent.Intermsofpreventingimitationorbringinginfringersintolicensingarrangements,apatentismerelyapassporttoajourneydowntheroadtoenforcementandpotentialroyaltystreams.Ofcourse,alargeportfolioofpatentscanprovevaluableforcross-licensingdealswithrivalsthathelpreducethelikelihoodofcostlylitigation.Tohelpwithappropriability,theinventorofacoretechnologycanalsoseekcomplementarypatentsonnewfeaturesand/orprocesses,and,insomecases,ondesigns.

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TheoriginalPFIarticlealsodevelopedthelinkagesbetweencomplementaryassetsandprofitability.Thisincludednotonlythesupplychaininputsneededtoembodytheinnovationinaproductorservice,butalsootherproducts,technologies,andservicesneededtoproducevalueinconsumption.Insomecases,suchasmobilephonesneedingcellularnetworks,thecomplementisaninfrastructureelementthatisavailabletoallfirms.Inothercases,suchashardwareneedingsoftware,thecomplement(e.g.,anoperatingsystem)mightbesospecifictotheinnovationthattheinnovatorhadtoprovideitin-houseorriskbecomingover-reliantonacomplementor.Inafewothercases,suchastheneedofoperatingsystemsforapplications,theplatformconcept,inwhichsuccessinvolvesbringingalargenumberofcomplementorsintothefold,wasalreadypresent.Asuccessfulopenplatformavoidsthe“bottleneck”problemofallowingotherentitiestocontrolrequiredelementsofthesystem(e.g.,akeyproductivityapplication,orahitvideogame)byencouragingcompetitionamongthecomplementors.However,thePFIframeworknowneedsawideraperturetolookatissuesbeyondthesingleproduct,singlelevel(ofanindustry)innovationthatwasthefocusin1986.Thisisnotwithstandingtherobustnessoftheoriginalframework.Thereasonisthatadditionalcolorandexplanatorypowercanbeaddedthroughhighlightingissuesthatdigitalconvergenceispresenting.TheadditionsIwillsketchoutdonotinvalidatethelogicofthePFImodel.ThecoreindependentvariablesinthePFImodel—thestrengthoftheappropriabilityregimecomplementaryassets,complementarytechnologies,,standards(andassociatedinstalledbaseeffects),andtiming—aremorerelevantthaneverforaworldwherefirmsincreasinglyofferplatformstowhichcomplementorscanaddincrementalvaluewiththeirowninnovations.

III.ExpandingthePFIFrameworkThebriefdescriptionadvancedearlier(andexpandedintheappendix)ofthedigitalrevolutionhashighlightedelementsofPFIthatneedfurtherelaboration,andsuggestedtheneedtoalsolookatthelevelofindustryatwhichinnovationistakingplace.Theframeworkcanbeextendedtospeaktothespecialdifficultyassociatedwithappropriabilitywhenenablingtechnologiesand/orgeneral-purposetechnologiesarebeingdevelopedanddeployed.Amoregranularviewofstandardsandcomplementaryassetsisalsorequired,alongwiththeanalysisofrelatedbusinessecosystemandbusinessmodelissues.

I. A.GeneralPurposeTechnologies,EnablingTechnologies,&theAppropriabilityChallenge

1.GeneralPurposeTechnologiesBresnahanandTrajtenberg(1995)identifyaGPTbythefollowingthreecharacteristics:(1)Pervasiveness:aGPTisusedin—andimpacts—manydownstreamsectors;(2)TechnologicalDynamism:theGPThaspotentialforimprovementovertime;and(3)ResearchProductivity:theGPTshouldmakeiteasiertoinventnewproductsorprocessesindownstreamapplications.Inotherwords,GPTshaveeconomy-wideeffects,getevenbetter,andspawnotherinnovations.Whilesomenon-GPTtechnologiesmaypossesseachofthecharacteristicstosomeextent,aGPTwillbedistinguishedbyitscumulativeeconomicimpact(JovanovicandRousseau,2005).Theycanbeeitherendogenousorexogenoustotheeconomicsystem(Lipsey,Bekar,andCarlaw,1998).AGPTcanbeaproduct,aprocess,oranorganizationalsystem.ExamplesthatLipseyetal.(1998)consider“clearanddramatic”arelimitedto

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printing,bronze,made-to-ordermaterials,thewaterwheel,steampower,electricity,theinternalcombustionengine,railways,motorvehicles,lasers,andtheInternet.TheaggregateeffectofaGPToccursoveraprotractedlengthoftime.Itsinventionisoftentheresultofcollaborationbetweenindividualswithdisparateskills.TheinventionsmaynotbeimmediatelyidentifiableasGPTs;theymightbeenablingtechnologiesorlessuntilimprovementsoccurandnewusesarediscovered.Forexample,whenthelaserwasinventedaround1960,itwasofscientificinterestbuthadnoobviousapplication.Today,lasersareubiquitous,beingimplementedinapplicationsrangingfromsupermarketcheckoutstandstomilitarybattlefields,withotherusesinmedicine,telecommunications,manufacturing,entertainment,andmore.ThewidespreadapplicabilityofaGPTwilloftenrequireadecadeormoretobecomeevident,butovertimethecumulativeeffectscanbesignificant.TherehavebeenpioneeringcliometricstudiesonthesocialbenefitsofGPTssuchassteamengines(vonTunzelman,1978),Britishrailways(Hawke,1970),andAmericanrailroads(Fogel,1964;Fishlow,1965).Hawke(1970),showedthattherailroadssavedbetween7%and11%ofBritishnationalincomein1865.2.EnablingTechnologiesThethresholdforaGPTisveryhigh,butthere’sasimilarcategory,enablingtechnologies(presentbutnotwelldefinedintheliterature),thatcanbethoughtofasjuniorGPTs,meetingcriteria(2)and(3),above,butnotnecessarilyhavingmeasurableeconomy-wideimpacts.3WhilethelistofGPTsisrelativelyshort,therearehundreds,ifnotthousands,ofenablingtechnologies.Eachonemightnotbethoughtofasa“gamechanger”byeconomichistoriansendeavoringtounderstandeconomicgrowth,buttheyareneverthelessimportanttoparticularfirmsandindustries.Theycanoftenbedisruptivetothestatusquoandgenerateveryconsiderableeconomicbenefitandsocialsurplus.Insomecases,enablingtechnologiescanhavequitemassiveeffects.Containerizationofcargoshipping,whichgreatlyreducedthetransportationcostofmanytypesofproducts,hadalargeeconomicimpact,eventhoughcontainertechnologyhasnotadvancedmuchtechnologicallyovertheyears,whichpossiblydisqualifiesitasaGPTbutnotnecessarilyasanenablingtechnology.AneconometricstudybyBernhofen,El-Sahli,andKneller(2016)found,aftercontrollingfortheeffectoftradeliberalizationagreements,thattheadoptionofcontainershippingovertheperiod1967-1982byagroupof22OECDcountriesraisedthevalueoftradeby1,240%.Anenablingtechnologycanbeusedtodrivetechnologicalchangeinanindustry.Theutilityoftheenablingtechnologyisnotexhaustedbyembeddingitinasingleproductorevenasinglesystem;itcanbelicensedtoarangeofdownstreamcustomersfortheirownproductsandservices.EnablingtechnologieswerenotthefocusofPFI,whichlookedatcommerciallyviableproductinnovationsandimplicitlyassumedthatonlyanarrowrangeofinventionswasincorporatedintoasingleproduct.

3Enablingtechnologyiscloselyrelatedto“generictechnology,”which,accordingtoKeenan(2003:132)canhaveanyofthreemeaning:“(1)Aclassofcloselyrelatedtechnologies;(2)Atechnologythedevelopmentofwhichwillhaveimplicationsacrossarangeofothertechnologies;or(3)Atechnologytheexploitationofwhichwillyieldbenefitsforawiderangeofsectorsoftheeconomyand/orsociety."Thesearedistinctfrom“genericknowledge”(Nelson,1989).Genericknowledgecomesfromhands-onexperienceandisoftenabyproduct,ratherthanagoal,offormalinnovation;itiseasilydiscoveredbypeerprofessionalsandgenerallycannotbeprotectedasintellectualproperty.

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Oneenablingtechnology(whichmighteventuallybecomeaGPT)isartificialintelligence(AI).AIencompassesarangeofsoftwaretechniquesemployedtoteachcomputerstosense,reason,interpret,communicate,andmakedecisionsinahuman-likemanner.Itgainedcurrencyinthe1950s,butneededcheaperandfastercomputingpower,especiallydevelopmentsinthecomplementaryhardwaretechnologiesofprocessorsandmemory,tobecomecommerciallyinteresting.AI-basedtechnologiescanalreadyrecognizefaces,understandspeech,anddrivevehicles.RegulatorsuseAItosortInternetchatterandzeroinonfraud,illegalactivity,andterroristplots.TheapplicationsforAIarelimitedonlybyeconomicsandimagination,anditscostcontinuestofallasitbecomesavailableaspartofthecapabilitiesofferedforhirebytheprovidersof“cloud”(online)computing.Acloselyassociatedtechnologyismachinelearning,acategoryofsoftwaretoolswitharelativelynarrowgoaloflearningknownpropertiesfromdatawithaminimumofpre-programmedrules.Onesub-type,deeplearning,performsabstracttaskssuchasrecognizingimages,usingneuralnetworksandothertoolsthattrytomimictheoperationofthehumanbrain.DeeplearninghelpsGoogleimprovethesearchresultsitprovidesusersanddrivestherecommendationenginesusedbymanyonlineretailers.Themostviablebusinessmodelsforcapturingvaluefrommachinelearningarelikelytobefirm-specificbecauseanalgorithmislikelytolearnfasterandproducemoreaccurateoutputswhenitisnarrowlyfocused(Norton,2016).Enablingtechnologiesvarynotonlyintypebutinownership.Theymaybeownedorcontrolled(inpartorinwhole)byprivatecompanies,universities,orconsortia.Manysoftware-basedenablingtechnologies,suchasdeeplearning,areoftenavailableasopen-sourcesoftware.Theuseoftechnologyfromtheopensourcecommunity,whereappropriabilityisinherentlylimited,placesapremiumontheabilityofthelicenseetoapplyPFIprinciples,suchasbyassemblingvaluablecomplements.Inthecaseofdeeplearning,forexample,thisrequiresaccesstolargequantitiesofhigh-qualitydatafortrainingalongwithadistinctproductorservice.Intheremainderofthissection,however,Iwillfocusprimarilyoncaseswhereenablingtechnologyisowned,atleastinpart,bythefocalorganization.AcharacteristicofenablingtechnologiesandGPTsisthattherearelargepositivespillovereffectsoftwokinds:staticanddynamic(CarlawandLipsey,2002).Staticspilloversarestandardexternalitiesthatdon’tleadtoanychangeinbehaviorbyothereconomicagents,eitheratthetimeorinthefuture.Dynamicexternalitiesoccurwhentheinnovationaltersthecurrentandfuturevalueofexistingtechnologiesandalsoenablesfurthertechnologicalopportunitiesforotheragents.Spillovers,asdiscussedinthenextsection,implythatappropriabilityisespeciallyweakforenablingtechnologiesandGPTs.Thisimpliesthatprivateenterprisewilltendtounderinvestincreatingthem,absentgovernmentsupport.ItalsoimpliesthatthedesignersandenforcersofintellectualpropertyregimesneedtobesympathetictotheappropriabilitychallengesthatdevelopersofenablingtechnologiesandGPTsface.

3. Appropriability

EventhoughthesocialcontributionofGPTsandenablingtechnologiesisveryhigh,thepioneerscantypicallyextractonlyatinyfractionofthevalue.DespitetheflaggingofthisproblembyBresnahanandTrajtenberg(1995),therehasbeenlittleefforttounderstanditordeveloppoliciestomitigateit.BresnahanandTrajtenberg(1995)identifiedtwowaysinwhichthesocialbenefitsofaGPTmaybecurtailedbyappropriabilityissues.First,thecaptureofaGPT’svaluefromdownstreamsectorsmaybe

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limitedbybusinessorregulatorybarriers.Second,theuptakeoftheGPTbymultipledownstreamsectorsmaybetoolow,inthesensethatifthesesectorswerecoordinatingtheiractivity,theywouldseethatfasteruptakeofthetechnologywouldsupportitsmorerapidimprovementbytheupstreaminnovator.ThepracticalsignificanceofthissecondpointisthatGPTsdevelopfasterwhenthere’salarge,demandingapplicationsector(avoidingtheneedtocoordinatesmallerones),suchastheU.S.DefenseDepartment’searlypurchasesoftransistorsandmicroprocessors.Helpman(1998,p.4)characterizedtheundersupplyproblemsasfollows:

GPTs introduce two-types of externalities: one between the GPT and the application sectors; another across the application sectors. The former stems from the difficulties that a GPT inventor may have in appropriating the fruits of her invention. When institutional conditions prevent full appropriation, the GPT is effectively underpriced and therefore, undersupplied. The latter stems from the fact that, since the application sectors are not coordinated, each one conditions its expansion on the available general-purpose technology. But if they coordinated a joint expansion, they would raise the profitability of the GPT and encourage its improvement. A better GPT benefits them all.

Akey(policy)implicationisthatinventorsofGPTshavegreatdifficultyappropriatingthefruitsoftheirinvestment,andmanagementwillbechallengedinfindingworkablerevenuearchitectures.Ownersofenablingtechnologiesfacesimilarchallenges.Asaresult,underinvestmentinGPTsandenablingtechnologiesisanearcertainty.Publicpolicyneedstoredressthisinsomefashion.SeveralfactorsconspiretorestricttheabilityofownersofGPTsandenablingtechnologiestocapturevaluefromdownstreamimplementers.First,designingabusinessmodeland/orcontrollingthenecessarycomplementaryassetsandtechnologiestointernalizemoreofthespilloversistypicallybeyondthescopeofwhatasinglefirmcando.AcaseinpointisPilkingtonGlassanditsinventionoffloatglass,whichis,arguably,animportantenablingtechnology.Thefloatprocess,introducedin1959,hadreducedproductioncostversusthedominantplateglassprocessbymorethanathirdbythetimethefirstlicensewasgrantedin1962,andbyabout75%by1974(Teece,2000,AppendixTableB.2).Ithasalsofacilitateddownstreaminnovationssuchasflatpaneldisplays.DespitePilkington’sstrongintellectualpropertypositionandtheevidentandquitesubstantialvalueofitstechnology,Pilkingtonlicensedthefloatprocessonanexclusiveterritorialbasistoallcomersatamere6%ofrevenues.Thisreflectsthefactthattheinventionwassouniversalinitsattractiveness,andfamily-ownedPilkingtonsounpreparedandunabletoimplementthetechnologybyitselfonaworldwidebasis,thatwidespreadlicensingseemedthebestalternative.Asaresult,amodestroyaltyforPilkingtoneffectivelypassedmostofthebenefitstomanufacturersandconsumers;Pilkingtonwasabletogarneronlyatinyshareofthetotalreturntothetechnologyforitself.Second,thefuturevalueofaGPTorenablingtechnologymaynotbeclearattheoutset;andevenifitis,theremayberegulatoryconstraintsthatlimitvaluecapture.Thetransistor,developedbyAT&T’sBellLabs,wasprotectedbypatents,butAT&Tlicensedthetechnologywidelyandalmostroyaltyfree.AT&T’slogicappearedtobethat,asalarge-scalebuyeroftelecomequipment,itwouldbenefitfromthecompetitionamongitslicensees,astrategicperspectivethat,atminimum,missedcapturingvaluefromthetechnologybeyondthetelecomindustry(Levin,1982).AT&Twasalsohighlyregulated,whichraisedadditionalbarrierstocommercializationandvaluecapture.

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Third,enablingtechnologies,bytheirnature,areintermediateinputsinthevaluechain,whicharesoldorlicensedtodownstreamfirms.Designingabusinessmodeltocapturevaluemorecompletelyisfareasierinconsumerfinal-productsalesthanininterfirmintermediateproductmarkets.Althoughthereistheoreticallyonlyonemonopolyrenttocaptureinthevaluechain,thechanceoftheinnovatorbeingabletodesignandimplementanairtightbusinessmodeltodosoislow.Forexample,supposethereisapatentedtechnologythatwhenplacedonacommunicationschipinamobilephonewillcreate$100ofincrementalvalueintermsofaverageconsumerwillingnesstopay.Theabilitytoextractthisas“rent”fromtheselleroftheenhancedcomponentwillbecompromisedbyalicensingmodelandtheinabilitytoeffectivelypricediscriminate.Moreover,patentsarenotself-enforcing,sothevaluethatcanbecapturedbyalicenseisaffectedbythecostsassociatedwithlaunchingalicensingprogram,includingthelitigationcostsfromchallengingthepatentinfringersandtradesecretmisappropriators.Allowingalargersliceofeconomicvaluetoflowtothelicenseemayhelplaunchalicensingprogram,butthisinturnwillreducetheinnovator’sshareoftheprofits.Fourth,thebargainingpositionoftheinnovatorisunderminedwhenitlacksacrediblethreattoexclusivelycommercializethetechnologyandpracticethepatent(s)itselfbecauseitlackstherelevantassetsandcapabilities.Thiscanbetrueforanytechnology,butitisespeciallytrueforenablingtechnologywithapplicationsinseveraldifferentindustries.Hence,thebroadertheapplicabilityofanenablingtechnologyacrossindustries,thelesscompletetherentappropriationislikelytobe.TheoriginalPFIframeworkappliedtoadiscreteinnovationthatwasassumedtobecommerciallyviable.Licensingwastherecommendedstrategyiftherewasstrongintellectualpropertyprotection,althoughthiswassaidtobeararecircumstance.Withweakappropriability,thebasicideawastoattempttocapturevaluebyacquiringorcontrollingtherequiredcomplementaryassetsforin-housecommercializationoftheinnovation.Otherwise,theinnovatorwouldhavetoeither(1)buildthem,whichisslowandexpensive,or(2)formpartnerships.Eitherstrategywoulddrainsomeofthevalueawayfromtheinnovator.Theverynatureofenablingtechnologiestodayisthattheyarelikelytobeembeddedinmulti-inventioninnovationsforwhichotherfirmsalsoholdrelevantpatents,soappropriabilityisinherentlychallenging.Capturingmorevaluerequiresnotonlyapplyingthetechnologybutalsodrivingthetechnology’spathforwardandintoderivativeapplications.Thisinherentlyinvolvesengagingwithpartnersbecause,asdiscussedinthefourpointsabove,thepursuitoffullverticalintegrationand/orhorizontaldiversificationisunlikelytobeviablegivenexistingcapabilitiesandresources.Forexample,tomake3Dprinting(alsocalled“additivemanufacturing”)viableforindustrialmanufacturing,complementaryadvancesindesignsoftware,metallurgy,machinetools,andmorewillbeneeded.Formostinnovations,relevantcapabilitiesareoftenalreadyavailabletotapexternally.Outsourcingcanshortenthepathtosuccessfulcommercialization,butwillalsoincreasethelossofvaluefortheinnovator.Astart-upinnovatorwillalmostcertainlyneedtorelyonpartners,andevenmostincumbentfirmswilllacksomeoftherelevantcapabilitiestoderivefullvaluefromtheenablingtechnology.Inshort,capturingvaluefromenablingtechnologiesismorechallengingfromabusinessmodelstandpointthancapturingitfrommodestdiscreteinnovations.Teece(1986)wasveryclearthatiftheinnovatorhastorelyonpartnerstocommercializethetechnology,theprofitsfrominnovationwouldneedtobeshared.ThisisquintessentiallythecasewithenablingtechnologiesandGPTs.

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4.EnablingtechnologiesinmobilecommunicationecosystemsThePFIframeworkhastobeuptothetaskofaddressingthedistributionofprofitswithincomplexecosystemsifitistobeageneralframework.WhilePFItellsusthatprofitswillgotothebottleneckassets,thesearenotalwayseasytoidentify,andtheymayshiftovertime.Forexample,anincreaseindatarateswithanewgenerationoftechnologymayincreaseprofitstoprovidersofvideocontent(andtoadvertisingvendors)whileimposinggreatercapitalanddepreciationcostsonnetworkproviders.Andthefortunesofspecifictypesofvideoswillfacedifferentappropriabilityregimes,suchaswhethertheyaretreatedascopyrightprotected.InthestandardPFImodel,thedriversare(1)appropriabilityregime(i.e.,strengthofIPprotectionanddifficultyofimitation),(2)complementaryassetsandtechnologiesandrelatedbusinessmodelissues,(3)standardsandinstalledbaseeffects,and(4)timing.Forthemobileecosystem,however,onemustalsoinclude,inrecognitionofthemultipleecosystemsatwork,(5)ecosystemstrength.Asamatteroftheory,andassumingthattherearenoartificial(regulatory)barrierstoentry,thentheindustrylevel(i.e.,thelocationalongthevaluechain,suchascomponents,equipment,etc.)neednotbecriticalandtheabovedriversremainthemostpowerful.Thefatesofindividualfirmsandecosystemswillvarywiththesuccessoftheireffortstoexploittheopportunitiescreatedbyeachstep-changeintheenablingtechnology.Withinecosystems,valuecapturedbyindividualfirmswilldependonthescarcityofeachfirm’sresourcesandthebusinessmodelstheyadopt.Awell-functioningecosystemwillallowmultipleavenuesforearningprofits.InGoogle’secosystem,Googlesubsidizestheecosystem’stechnologybutprofitshandsomelyfromadvertisinglinkedtousersearches.InApple’secosystem,Appleprofitsfromsellingattractiveandeasy-to-usedevicesandfromtakingashareoftherevenuefromappsandcontentsoldbytheirproviders.Thewirelesscommunicationssectoraffordsnumerousexamplesthatilluminatetheissuesofvaluecaptureforalltypesofparticipants,includingtheprovidersofenablingtechnologies.Thekeyadvancesbehindthedigitalcommunicationsrevolutionbeganasproprietarytechnologiesthatweresubsequentlycodifiedinaseriesofwirelessstandards,eachofwhichprovidesastepchangeimprovementincommunicationperformance.Theimprovementsinmobiletelephonystandardsfrom2Gintheearly1990sthroughthecurrent4Ghavebeenmorethanincremental,witheachgenerationprovidingdramaticperformanceimprovementsintransmissioncapacity,servicequality,congestionmanagement,cellhandover,andsignalquality.5Gisonapathtoberolledoutin2020withyetfurtherbooststobandwidthandspeedthatwillseetheemergenceofnew,wireless-basedbusinessmodelsinindustriesdealingwithmassivequantitiesofdataormission-criticalprocessing.Eachgenerationaladvancemakesnewtypesofdataservicespossible,andwirelessisalreadyposingacompetitivechallengetofixedwirelineservices,whichhavehistoricallybeenacashcowforphonecompanies.Theinverseisalsotrue;ifenablingtechnologyfailstoadvance,orifnewenablingtechnologiesarenotdeveloped,thennewproductsandservicesarelesslikelytobedeveloped.Indeed,themostsignificanttechnologicalinnovationundergirdingthe“grandconvergence”isthisdramaticimprovementinmobilebroadbandcapacity,whichhashelpedfeedgrowingdemandasmorepeoplehavegonemobileandnew,bandwidth-hungryserviceslikelivevideostreamingaredeveloped.Akeyenablingtechnologysupporting3Gwas“CDMA,”a2Gtechnologythatwaspioneeredandpromotedinitiallyonlybyasinglefirm,Qualcomm.Afterspiritedcompetition,engineers(frommany

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companies)whowereparticipatinginestablishinga3GstandardatSDOsselectedCDMA-basedtechnologybecauseitofferedafarhigherincreaseinbandwidthefficiencythanwaspossiblewiththesuccessortoGSM,whichwasthedominant2Gtechnology.Inasimilarvein,“OFDMA”(anewer,non-Qualcommtechnology)wasselectedbystandard-settingbodiesaspartofthe4Gstandard,allowingfurtherincreasesinspeedandbandwidthformobilecommunications.Thesetechnicaldecisionsinvolveagreatdealofdiscussion,testingandnegotiation.EachnewgenerationofcommunicationtechnologyrequiresbillionsofR&Ddollarsandoveradecadeofelapsedtimetodevelopandformalizeinstandards.ThetechnologicaladvancesacrossthegenerationsofthesewirelessenablingtechnologieshavebeenhistoricallyenabledbyarmiesofengineersandbillionsofdollarsinR&Dinvestmentatnumerouscompanies,includingAT&T,IBM,TI,Motorola,Siemens,andEricsson.TheothercurrentmajorwirelesstechnologydevelopersareQualcomm,whichsellschipsusingitstechnology,Nokia,whichisnowalmostexclusivelyatelecomequipmentsupplier,andInterDigital,apurelicensingcompany.4Standardsarethusaprimeexampleofamulti-inventioncontextinwhichanyapplicationusesinnovationsfromnumerousfirmsspanningmultipledomainsofknowledge.Thecomplexityandinterdependenceofthecommunicationtechnologiesunderlyingthemobiledatarevolutionhavecausedmultiple,connectedbusinessecosystemstoemerge(Teece,2012).Specializedfirmsandevenverticallyintegratedcompaniesarenolongerislands(iftheyeverwere)connectedtoothersonlybymarkettransactions.Eachisnowpartofoneormoreconstellationsofbusinessentitiesandorganizationswhosefatesaretiedtechnologicallyand/orcompetitively.Ecosystemshavesprungupforarangeofnewservicesincludingstreamingmedia,cloudcomputing,theInternetofthings,andmobilepaymentsystems.Eachoftheseareashasmobilecommunicationsatitscore,enablingthepartsofthesystemtoworktogetherandenhancingitsavailabilityforendusers.Insomecases,technologiesspecifictoaparticularfunctionaredesignedintothewirelessstandardatanearlystage.Thisrequiresthatcompaniescontemplatingmajornewservicesformalliancesandparticipateinstandardsdevelopment.Buteachgenerationofthewirelessstandardalsoservesasanenablingtechnologyforservicesthathaveyettobedevised.Todaythemobileindustryincludes(1)dedicatedtechnologyandcomponentfirmslikeQualcomm;(2)implementersofstandards-compliantinfrastructureequipmentlikeEricsson;(3)networkserviceproviders,likeAT&T;(4)downstreamimplementersofstandards-compliantmobiledeviceslikeSamsung;(5)softwarevendorslikeAppleandGoogledevelopingoperatingsystemsandapps;and(6)contentproviders,fromindividualstomediaconglomerates.Manycompaniesspantwoormoreoftheselinksinthevaluechain.Thetotalsizeofthemobileecosystemin2014was,accordingtotheBostonConsultingGroup,around$3.3trillion.Table1showshowthisrevenuebreaksdownacrosseightcategories,includingtechnology,networks,hardware,software,andservices.Itismoredifficult,however,todeterminehowprofitsaredistributedamongthesegroups,andthefactorsdrivingthosereturns.

4Theprimaryconsumer-sideimplementersofthetechnology,AppleandSamsung,havenothistoricallybeenmajortechnologycontributorstowirelessstandards.

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Table 1: The Value of the Mobile Ecosystem, 2014 Category 2014 Revenue

Core Comms.Technologies $40 billion Mobile Infrastructure Eqpmt. $220 billion Mobile Site Operations $230 billion Mobile Operators $1,010 billion Components for Devices $260 billion Device Manufacturers $450 billion Device Retail $520 billion Mobile Content and Apps $530 billion Total $3,260 billion

Source: BCG (2015), p.11

II. B.ComplementaryAssets

WhilecomplementswerehighlightedintheoriginalPFIformulation,theanalysiswasbroadbrush.Forinstance,timewasignored.Withtheintroductionoftime,co-evolutionbecomesimportant.PFIimplicitlyrecognized“rents”(profits)asflowingtothebottleneckassets,andthatcouldbedifferentcomplementaryassetsatdifferentpointsintime.WhilebottleneckassetsloomlargeinPFIasamagnetforprofits,rentsalsoarisefromcombiningdifferenttechnologiesinunique,value-enhancingwaysthatleadtogainsexceedingtheadditivenatureofstandardcomplements,wherethedemandforoneproduct(e.g.,automobiles)candrivedemandforanother(e.g.,gasoline).Eventhoughthecombinationinagasolineautomobileengineinvolvescomplextechnicalinteractions,itdoesnotinvolvecomplexeconomicinteractions.Inmanyinstances,technologiesthatwerenotobviouslycomplementary,suchasmicrochipsandbiologicalmaterials,canbecombined(“orchestrated”)toproduceentirelynewproductsthatareuniqueandvaluabletousers.Thisisavalue-creatingformofcomplementarity;standardnotionsofcomplementsandscopeeconomiesfallfarshortintheinnovationcontext.TherefinementofthePFIframework,andabetterunderstandingofecosystems,beginsbymorecloselyexaminingthemultipletypesofcomplementarity.1.VarietiesofcomplementarityComplementsarepervasivethroughouttheeconomicsystem,andparticularlyintechnologydevelopmentandbusinesstransformation.Nevertheless,theyarefrequentlyignored.However,theyarecentralinPFI.PerhapstheirneglectcanbeblamedonSchumpeter(1942),whostressedthat“newcombinations”ofartifactsorganizedbytheentrepreneurbroughtgalesofcreativedestruction;buthenevermentionedthat,withcomplements,arisingtidecanliftmanyboats.InthePFIframework,complementsneedtobeconsideredwithmoregranularityinordertoilluminatevaluecaptureissues,particularlytheramificationsofdigitalconvergence.Attheheartofeconomicnotionsofcomplementarityisthenotion,duetoEdgeworth,thatthemarginalvalueofavariableincreaseswithanothervariable.Assimpleasitsounds,thereismuchcomplexitytotheconceptofcomplementarity,promptingNobelLaureatePaulSamuelsontosayin1974that:

The time is ripe for a fresh, modern look at the concept of complementarity … the last word has not yet been said on this ancient preoccupation of literary and mathematical

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economists. The simplest things are often the most complicated to understand fully. (Samuelson, 1974, p.1255)

Theliteratureoncomplementshasremainedconfused,andthissectionwillmakeanefforttobringsomeclarity.Itshouldbenotedattheoutsetthatitiscommonfortwoormoretechnologiesoftenturnouttoproducemuchmorewhenpracticedtogether.5Thefirststeamtrainsemergedwhenhigh-pressuresteamengineswereyokedtocoalcarsrunningoncoal-mininghandcartrails.Thelawnmowercamefromcouplingasmallgasolineenginetoaminiaturemechanicalreaper.Thelaserandthecomputerwerecapableofmuchtogether(e.g.,CDplayers);andofstillmorewhenopticalfiberwasaddedtothemix.Economiststendtothinkofcomplementarityintermsofitseffectonfactorpricesoronvaluefromuse(CarlawandLipsey,2002).Innovationstudieslookinsteadattechnologicalrelatednessandtheimpactofnewcombinationsofexistingtechnologies.However,thefulleconomicsignificanceofcomplementsliesnotjustwiththeirabilitytoimproveandsupportappropriability.Absentcomplementarytechnologies,manyproductssimplywon’tgetdevelopedandlaunched.Thiswasthecase,forexample,intheU.S.electricalsupplyindustryattheendofthe19thcentury.Theindustryhadakillerapp—lighting—butwasmiredina“warofthecurrents”betweenalternatinganddirectcurrent,eachofwhichhadcertaindeficiencies.Itwasonlywiththedevelopmentofrotaryconvertersthatonesystem(alternatingcurrent)wasabletodevelopadominantpositionandspurrapiddeployment(David,1992).NextIbrieflydescribemultiple(andcomplementary)typesofcomplementarity,summarizedinTable2:

(1) Hicksian(Production)Complementarity:FactorsofproductionareHicksian

complementswhenadecreaseinthepriceofonefactorleadstoanincreaseinthe

quantityusedofitscomplementsinproduction.Aninnovationthatreducesthecost

ofafactorisequivalenttoadeclineinthefactor’sprice.Thisofcoursepresupposes

anexistingprocessutilizingthetwofactors,whichmakesitsomewhatirrelevantfor

studyinginnovation.Yet,itgeneralizestotheinsightincludedintheoriginalPFI

frameworkthatthesuccessfulcommercializationofaninnovationwillaffect

demandforcomplementarygoodsandservices.

(2) Edgeworth/Pareto(Consumer)Complementarity:Twogoods,XandY,are

Edgeworthcomplementsinconsumptioniftheutilityofconsumingthemtogetheris

greaterthanthatofconsumingtheminisolation.Asaresult,thequantity

demandedofeithergoodisaffectedbyachangeinthequantitydemandedofthe

5Ifapieceoftechnologyisindependentofothersandofferslittlescopeforimprovement,wehavewhatMokyr(2002,p.19)callsa“singletontechnique”thatmightbediscoveredbychance,withlittleunderstandingoftheunderlyingmechanism.Whilethiswascommonbefore1800,itisrareintoday’scomplexknowledgedomains.

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other.Ifdemandisdownwardsloping,thenthisistheconsumption-sideequivalent

oftheproduction-sideHicksiancase.InEdgeworth’sbroaderconception,

complementscanincludenon-priceditemssuchasgovernmentpolicies,or

organizationalstructures.MilgromandRoberts(1994)formalizedthisforagroupof

activities,labelingthemasEdgeworthcomplementsifdoingmoreofanysubset

increasesthereturnstodoingmoreofanysubsetoftheremainingactivities.

(3) Hirshleifer(AssetPrice)Complementarity:Thisisafinancialperspectiveonthe

Hicksianinsightthatcan,atleastintheory,beusedtoprofitfromaninnovation.If

innovationislikelytomovepricesasdescribedabove,thentheinitialinvention

createsforeknowledgeabouthowassetpricesmightmoveinthefuture.An

economicallyrationalinventorwithfinancialmeansandthistypeofforeknowledge

couldgainadditionalvaluebygoinglonginassetmarketsthatwouldbepositively

impactedbytheinventionand/orshortinmarketsthatwouldbenegatively

impacted.Thismodelofanticipatedcomplementaritywasinfactinvokedinthe

originalPFIarticlebynotingthattheinnovatorcouldspeculate,wherefutures

marketswereavailable,oncomplementaryassetsthatwerelikelytoincreasein

value(Teece,1986,p.295).Hirshleifer(1971)illustratesthisprinciplewithan

analysisofEliWhitney,whoreceivedapatentforthecottonginin1794yetdied

poor30yearslaterafterdissipatinghisprofitsinlitigationoverpatentinfringement.

HirshleiferpointsoutthatWhitneycouldhaveforeseenthenegativeeffecthis

inventionwouldhaveonthepriceofcottonandthepositiveeffectonthepriceof

landandthenspeculatedaccordinglyoneitherorboth.

(4) Cournot(InputOligopoly)Complementarity:TwoproductsareCournot

complementsiftheyareusedtogetherbutsoldbyseparatecompanieswith

monopolypower.Consider,forexample,thecasewhereeachfirmhasamonopoly

overoneoftwoinputsusedtomakeaproduct.Ifthecompaniesareunableto

collude,theywillchargepricesthatmaximizetheirindividualprofitsconsideredin

isolationyetfailtomaximizetheircollectiveprofit.ThisproblemarisesinPFIwhen

therearetwoormorebottleneckassetsneededtoproduceaninnovativeproduct,

andtheyareownedbyseparateparties.Whereascommonownershipwouldleadto

chargingamonopolyprice,theseparatefirms,absentcollusion,mightchargea

higherpriceandlowertheirtotalprofit,harmingconsumersaswell.Thisisan

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interestingtheoreticalpuzzlebutnotlikelytobeofpracticalsignificancebecause

marketsareseldominequilibriumlongenoughtodeterminethe“right”price.A

real-worldexamplewouldbeIntelandMicrosoftinthePCindustry;their

dominanceofintermediategoodsdidnotharmconsumersbecausecompetitionin

thedownstreammarketdrovedownend-userprices.TheCournotmodelhasbeen

misappliedinthecontextofpatentswhereeconomictheoristshavepostulatedthat

ownersofstandardessentialpatentswillpursueself-interestedpricingstrategies

thatresultinhighcumulativeroyalties(GaletovicandGupta,2016)thatare

destructiveofthemarket.Inreality,wetendtoobservetheopposite,inpart

becausepatentsarenotself-enforcingandinpartbecauselicensingasabusiness

modelhashistoricallybeenweakinitsabilitytocaptureanythingbutatinyfraction

ofthesocialbenefitsfromenablingtechnology.FRANDlicensingregimeshavealso

limitedthebargainingpowerofpatentholdersstillfurther.6

(5) Teecian(Technological)Complementarity:Technologicalcomplementarityoccurs

whenthevalueofaninnovationdependsonalteringthenatureofoneormore

existingtechnologiesand/oroncreatingnewones.Thistypeofcomplementarity

hasnothingtodowithpricesandquantities.Itapplieswhenthefullbenefit(oreven

anybenefit)oftheinnovationcannotbeachieveduntilsomeother,complementary

technology(whichhasindependent,lowervalueusesonitsown)hasbeencreated

orre-engineered.Thisisinfacttypicalofenablingtechnologies.Forexample,

realizingthefullvaluefromtheintroductionofelectricityrequiredthecreationof

electricmotorsthatcouldbeattachedtomachines.Theintroductionofanew

generationofcellularnetworkrequiresnewmicrochipsandhandsetstoexploitit.

TechnologicalcomplementaritycanposeaPFIchallengeforaninnovatorifthe

complementiscreatedbyaseparatecompanyandbecomesabottleneckasset.One

solutionistocreatethecomplementin-house,buttheinnovatormaylackthe

capabilitiestodoso.

(6) BresnahanandTrajtenberg(Innovational)Complementarity:Improvementsina

general-purposetechnologywillincreasetheproductivityindownstreamsectors.

Forinstance,theimprovementofacellularnetworkopensnewinnovation

6FRANDisalegaltermthatstandsfor“fair,reasonable,andnon-discriminatory.”

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opportunitiesforfirmsmakingwirelessdatadevices.Thisisaspecialcaseof(5)

above.

Table 2: Types of Complementarity: Summary Type Representative Authors Description

Production Hicks (1970) A decrease in price of X leads to an increase in the quantity of Y

Consumption Edgeworth (1897/1925) An increase in the quantity demanded of X leads to increased demand for Y

Asset Price Hirshleifer (1971) Financial arbitrage opportunities are created by foreknowledge of the probable impact of an innovation.

Input Oligopoly Cournot (1838/1960) Inputs X and Y will be sold for less if the companies can collude to maximize profits.

Technological Teece (1986, 1988b, 2006) Unlocking the full value of an innovation requires additional innovation in one or more lateral or vertical complements.

Innovational Bresnahan & Trajtenberg (1995)

Improvements in a GPT increases the productivity of goods in downstream applications.

WhilecomplementswerehighlightedintheoriginalPFIformulation,theanalysiswasbroadbrush.Timewasignored.Withtheintroductionoftime,co-evolutionbecomesimportant.PFIimplicitlyrecognized“rents”(profits)asflowingtothebottleneckassets,andthatcouldbedifferentcomplementaryassetsatdifferentpointsintime.However,rentsaregeneratednotonlyfromexploitingbottleneckassets;theyalsoarisefromcombiningdifferenttechnologiesinunique,value-enhancingwaysthatleadtogainsexceedingtheadditivenatureofstandardEdgeworthcomplements.WithEdgeworthcomplements,thedemandforoneproduct,e.g.,automobilescandrivedemandforanother(e.g.,gasoline).Eventhoughthecombinationinagasolineautomobileengineinvolvescomplextechnicalinteractions,itdoesnotinvolvecomplexeconomicinteractions.EdgeworthcomplementsandCournotcomplementsarelargelyirrelevanttotheinnovationcontext.Systemsintegrationisonepointwhereinformationsharingcanoccurwithoutcollusiononprice.Inreality,ofcourse,complementarytechnologiescanbecombined(“orchestrated”)toproducenewproductsthatareuniqueandvaluabletousers.2.PFIandcomplementarityreconsideredThelinesbetweenthesevariousformsofcomplementarityareinsomecasesblurred,sincetwogoodscanfitseveralofthesecategoriesatthesametime.PFI(implicitly)embracedallofthemexceptCournot.Whatthesetypesofcomplementarityhaveincommonisthattheyallraisecomplexcoordinationissues,whichinturnrenderappropriabilitymoredifficult.Aninnovatorhasnoguaranteethatthedownstreamusersofthetechnology(andtheprovidersofcomplements)willmakethe

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investmentsneededtogeneratethelargestvalue.Pessimisticexpectationscanbecomeself-fulfilling,whichreducestheinnovator’sincentivesforinvestinginfutureresearchanddevelopment.7Inmostcases,technologicalandinnovationalcomplementaritiesimposecoordinationandcontrolchallengesthatimpairthealignmentofactivitiesacrossfirmsinamarketeconomy.8SuchissueswereraiseddecadesagobyMalmgren(1961)andRichardson(1972),wereechoedbyWilliamson(1975),remarkeduponbyTeece(1984),exploredempiricallybyArmourandTeece(1980)andHelfatandTeece(1987),butthendropped.Theeconomicsliteraturetendstoassumethatupstreamanddownstreaminvestmentexpectationswillconverge,whichseemsunlikelygiventheproprietary(andhencesecret)natureofmuchoftherequiredinnovationactivity.9Moreover,theimpositionof“reasonable”royaltyratesinthecaseofstandardessentialpatents(SEPs),ifinterpretedbythecourtstomean“low”rates,underminestheinnovator’sincentivetoinvestinimprovingthetechnologyfurther,compoundingtheproblemstillfurther.Thereisnomarketmechanismshortofvertical(andhorizontal)integrationthatcanensuresociallyoptimalinnovationandadoptionofenabling(andGPT)technologiesthatpermitfurther“addin”innovationbydownstreamimplementers.TheexploitationofHirshleifercomplementaritiescanpotentiallyeasetheproblembyemployingfinancialengineeringstrategiestohelpcapturespilloverbenefits.However,thesewillnotbefeasibleinmanysettings.Fromamanagerialperspective,someoftheseconcernsareaddressedundertheheadingofbusinessmodelissues(Teece,2010b),leavingittoentrepreneurstodesigncreativeorganizationalarrangementstohelpsolvethecoordinationandassociatedappropriabilitychallenges.Privateordering(contractual)solutionsarepossibleinmanycases.However,traditionalresponsestothecoordinationandappropriabilityissuesarelikelytobelessefficaciousthegreaterthegeneralityofthetechnologyandthesmallertheentitythatownsit.Thereasonsrelatetothesheerscopeandcomplexityoftheeconomicapplicationsofasignificantenablingtechnology.Whentheapplicationopportunitiesarenumerousanddiverse,jointactivityplacesheavydemandsonthemanagementresourcesoftheinnovator,leadingittofallbackonthelicensingoption.Licensing,however,isofteninadequate,especiallyininstanceswherecourtsarereluctant(orunable)toissueinjunctions.TheseissuesareexploredinmoredetailinSectionEbelow.

7Thesepointshavebeengivenonlycursorytreatmentintheeconomicsliterature.Malmgren(1961)andRichardson(1972)hadnotedtheissueingeneralbuttheprofessionhasignoredit,believingthatexpectationswithrespecttocomplementaryinvestmentssomehowconverge.8Technologicalcomplementaritiesarelargelyabsentfromeconomicanalysis.Infact,theycompletelyvitiatetheconceptofaproductionfunction,whichassumesthatafixedlistofinputsisusedtopracticeatechnologyknowntoallfirms.Inreality,productionfunctions,evenintheabsenceofamajorinnovation,areoftenfirm-specificandquiteproprietary.Schumpeter(1934)observednearlyacenturyagothattheveryessenceofinnovationistypically“newcombinations.”However,histheorybroughtnogranularitytotheanalysis.Nordidheconsidertheappropriabilityissuesaroundnewcombinationsbecausehismainfocuswasontheabilityofnewproductsandprocessestodisplaceexistingones.Thisspoketosubstitution,notcomplementarities.9Verticalintegrationcanpartiallymitigatecoordinationproblems.ArmourandTeece(1980)establishedthatR&Dlevelsinthepetroleumindustryweresensitivetotheextentofverticalintegrationinadirectionsuggestingthatintegrationcaneasethecoordinationissueswhennewtechnologyisdevelopedanddeployed.HelfatandTeece(1987)showedthatverticalintegrationreducedrisk,whichcanincludetheuncertaintythataccompaniescommercializationofnewtechnology.

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IntheoriginalPFIpaper’sdiscussionofbusinessmodelissues,thegreatestemphasiswasgiventoquestionsaroundvaluechainissues,namely,whetherthefirmreadyandabletoassemblethespecificandgenericassetsneededtobringtheinnovationtomarket.Sincethen,Iandothershaveexpandedthenotionofbusinessmodelstoencompassthearchitectureofthebusiness,includingcustomers,costs,andlikelycompetitorresponses(ChesbroughandRosenbloom,2002;Teece,2010b).Moreover,businessmodeldesignisaniterativeprocess.Thispointisparticularlyrelevantasmoreandmorebusinessesarebuiltaroundsoftware.Software-basedbusinessmodelsarerelativelyeasytomodifyinresponsetocustomerfeedback,changesintheuserbase,orotherevidenceofmissedopportunities.MysubsequentworkonPFIhasemphasizedtechnologicalaswellasvaluechaincomplementarity(SomayaandTeece,2006;Teece,2006;Somaya,Teece,andWakeman,2011).WhereasHicksianandEdgeworthcomplementaritiespresenttheinnovatorwithchallengesandopportunitiesthatcanbemitigatedorexploitedbythinkingaheadstrategically,technologicalandinnovationalcomplementaritiesplacealarge,short-termburdenontheinnovatortocoordinatewithallownersofrelevantintellectualproperty.IntheoriginalPFIframework,theimpliedadvicetotheinnovatorwastoown(orcontrol,orneutralize)anybottleneckasset(s).Inamulti-inventioncontextthebottleneckcouldbeatechnologyratherthanaconventionalasset.Theinnovatormusteitheracquire,license,orallywiththeownerofrelevanttechnologiesinordertoensureapredictablepathtofollowbothfortheinitialcommercializationoftheinnovationandforitsfuturedevelopment(ChesbroughandTeece,1996).Athoroughunderstandingofprofitdistributioninthevaluechainalsorequiresexaminationofrelevantecosystems,whichareinherentlycomposedofvarioustypesofcomplementarity.EcosystemswereabsentfromPFIin1986andonlymentionedinpassinginPFI-2006.3.PlatformsandecosystemsComplementarityisthehandmaidenofplatforms,andplatformspowerecosystems.Becauseoftheprogressanddiffusionofdigitaltechnologies,platformsarebecomingpervasive.Digitalplatformsusecommonstandardstointegrateproductsandservices—andcompanies—usingtheInternetorprivatenetworks.Integrateddigitalplatformsconcernmultiplebusinessfunctionsandenablebusinessecosystems.Whilevarioustypesofplatformscanberecognized(Gawer,2014;Hazlett,Teece,andWaverman,2011),thereisnonethelessconsiderableambiguityaboutwhatconstitutesaplatform—oranecosystem.Consider,forinstance,theautoindustry.Ithasfordecadesworkedwith“platforms”;buttheseareofadifferentkind.Anauto“platform”isasharedsetofcommondesigns,parts,andproductioneffortsarrangedaroundanumberof(whatappearedexternallytobe)differentmodels.ItperhapsbeganatGeneralMotorsinthe1960swhenGMusedthesameplatform(chassis)fortheBuickSkylark,ChevyChevelle,PontiacLeMans,andOldsmobileCutlass.Theplatformapproachlowerscostsbyreducingtheneedtodesignpartsthatarefunctionallyidenticalbutdifferentineachmodel.Inthedigitalworld,platformscanbesoftware-only,likeAlphabet’sAndroidoperatingsystem(OS),ortheycanbelinkedtohardware,likeApple’siPhoneandiPad,whicharetightlyintegratedwithApple’sproprietaryiOSsoftware.Platformsmayimpactconsumersdirectly,asinthecaseofthesesmartphonetechnologies,ortheycanbebehindthescenes,likethesoftwarethatamanufacturingcompanyusestocoordinateandmonitoritssuppliers.Eitherway,platformsintheICTworldaremoreattractivewhentheyallowuserstotapintoaricharrayofcomplementsandadd-ons,i.e.,whentheyhavestrongnetworkeffects.

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ConsiderfurthertheiOS(Apple)ecosystem.Applehas,toalargeextent,“solved”thecoordinationproblembyintegratingmostoftheinnovation-intensiveelementsofitsvaluechain—themicroprocessorandthehandsethardware.Asaconsumer-facingcompany,itdoesnothavetoworryaboutcoordinatingwithdownstreampartners.ThesaleofappsinitsappstoreandthesaleofmusicintheiTunesStorecanpotentiallyoffsetsomeoftheweakappropriabilityfortheoperatingsystem,whichmustcompetewithGoogle’sfreealternative,Android.Apple’scontentrevenuehasbeensteadilyincreasinginimportance,anditfinallybeganbreakingout“Services”revenue(mostlyappsales)inJanuary2016.Inthefirstquarterofthecalendaryear,Serviceswere$5.99billion,nearly12%oftotalrevenue,makingitthesecondlargestsegmentafterthe(muchlarger)iPhoneandslightlylargerthanrevenuefromMacsales.Alphabet’srivaloffering,GooglePlay,thecontentportalfortheAndroidecosystem,hasalsothrived.Therearetwobasictypesofdigitalplatform,withnumeroushybridcombinations(EvansandGawer,2016).Atransactionplatformfacilitatesexchangesbyotherwisefragmentedgroupsofconsumersand/orfirms.TheparadigmhereiseBay,whichallowshugenumbersofindividualsellersandbuyerslocatedanywhereintheworldtofindoneanotherwithaneasethatwaspreviouslyunimaginable.Whiledigitizationhasenabledtransactionplatformsinagrowingrangeofindustries,thistransactionaltypeofplatformisnotentirelynew.Forexample,thecreditcardindustryhaslongprovidedaviablepaymentoptionthatmerchantswillaccept,thatbankswilljoinbyissuingcardsandprocessingtransactions,andthatcardholdersfindofvalue.Aninnovationplatformprovidesabasetechnologyanddistributionsystemtowhichothercompaniescanaddtheirowninnovations,increasingthevalueforthesystemasawhole.Apple’s“app”ecosystemistheparadigmaticexampleofthis.InnovationplatformsfitperfectlywithintheoriginalPFIframework,whichemphasizedtheneedtoaccesscomplementors.Whiletherelationshipislessobviousinthecaseoftransactionplatforms,successfulexamplessuchasAmazonneedtoattracttransactors,e.g.,AmazonMarketplacevendors,inmuchthesamewaytheymustattractkeypartners,e.g.,thedeliveryservices,byprovidingasufficientlyattractiveplatformwhoseparticipantswillreachacriticalmassofbuyersandsellers.Inessence,adigitalplatformprovidesahubaroundwhichcompaniesanduserscan,jointlyorseparately,innovateandattractusersfarmoreproductivelythaniftheyweretotrytoachievethesamegoalsintheabsenceoftheplatform.Owningorcontrollingasuccessfulplatformuponwhichotherfirmserecttheirbusinessmodelcanprovideacommandingpositionfromwhichtoenhanceanecosystemandcapturevaluefromit.Thedynamiccapabilitiesframework(Teece,2007,2014)helpsexplainwhysomefirmssuccessfullycreateplatform-poweredecosystemsthatcombinemultiplebusinessmodels.FirmslikeAmazon,Apple,Facebook,Google,andMicrosofthavemanagedtosenseopportunitiesoutsideoftheiroriginalbusiness,seizethembymobilizingrelevantresourcesand,mostimportantly,transformingtheirorganizationsbyaddingplatformcapabilities,particularlythemanagementofcomplementsintheecosystem.Otherfirmsthathadmanyoftheassetstosucceed(e.g.,telecomsoperators,discussedbelow)mayhavelackedthestrongdynamiccapabilitiesthatwouldhavebeenrequiredforthemtocreateacompetitivealternative.10Itiscommontoassumethatplatformsareownedbyasinglefirm,butthisoftenisnotthecase.Thecompanyorcompaniesatthecentermustprovidecoordinatingmechanisms,rules,intellectual

10IthankBenoitReillier(emailcorrespondence,August3,2016)forthisinsightfulobservation.

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property,andfinancialcapitaltocreatestructureandmomentumforthemarketorecosystemitseekstocreate.Standardshelpdefineplatforms,andthesestandardsneednotbeproprietary.Forexample,theInternetitselfisaplatformandInternetprotocolsarenotproprietary.IntheICTindustry,manyunderlyingsoftwaretechnologiesarestackedoneuponanother,withdevicessuchassmartphonesontopofthestack.Althoughsomefirmstrytocontrolanentireverticalstack,theygenerallydonotsucceed.Becauseofthis,verticalcooperation(andhorizontalcompetition)isnecessaryandcommon.Platformleaderstakeresponsibilityforguidingtheongoingtechnologicalevolutionofthesystem(GawerandCusumano,2002).Creatingandcapturingvaluethereforerequiresamixofopenness(toattractcomplementors)andadegreeofcontrol(tocreateagooduserexperience).Oncecreated,theremaybeopportunitiestocapturevaluethroughdevicesalesandothermechanisms.Whenthereisplatform-to-platformcompetition,adoptionandcommercialsuccessislikelyafunctionofwhocanrecruitthemost(andthebest)complementors.Overtime,theadvantagebelongstotheplatformleadersthatsettherulesinthemannermostlikelytobenefitthesystemasawholeandnotjusttheirownshort-terminterests.

III. C.Multi-levelPFI11

Inplatform-basedecosystems,competitionoccursatthreelevels:(1)betweenoneplatformandanother,aswasthecaseforVHSversusBetamaxinthefightfortheVCRmarket,orthecurrentcaseofApple’siOSversusGoogle’sAndroidinthemobilesector;(2)betweenaplatformanditspartners,asoccurredwithMicrosoftcapturingapartofthevaluefrombrowsers,streamingmedia,andinstantmessagingapplicationsthatworkedonitsWindowsoperatingsystem;and(3)amongcomplementors,eachseekingapositionwithinaplatform-basedecosystem,asinthecaseoftwomobilegameseachchasingthesameconsumersegment.Withregardtocapturingvalue,“[s]trategybecomesvastlymorecomplexasfirmsconsiderdynamicinteractionsofamulti-layeredecosystem”(ParkerandVanAlstyne,2015:5).Notwithstandingthiscomplexity,onecandistillafewgeneralizationsfromtheliteratureandfromrecenthistory.First,competitionbetweenplatformstendstoproducewinner-take-alloutcomeswhentherearelargedemand-orsupply-sidescaleeconomies,multi-homingcosts,andnobenefitfromnichespecialization.Platform-to-platformcompetitionalsoleadstoopennessthatresultsfromeachplatformendeavoringtorecruitmoredevelopers;thegreatertheopenness,thelesstheopportunityfortheprovidertocapturevaluedirectly.Agoodvaluecapturestrategyistocourtwell-knownbrands/partnerswhocanbringlargeblocksofcustomerstotheplatform(CusumanoandGawer,2002).Expandingtheperspectivetomultiplelevels,managingpartner-to-platformcompetitionandpartner-to-partnercompetitionrequiresstrikingabalancebetweencooperationandcompetition.Throughoutanyanalysisofmulti-levelPFI,thefundamentalquestionisthefollowing:istherelikelytobeacompetitivebottleneck?Ifso,where;andwhenwillitbecomeapparentifitisnotcurrentlyso?Theastuteidentificationofafuturebottleneckisapotentialopportunitytobuildorbuythenecessaryresourcestobenefit(ornotsuffer)fromit.Thistakesstrongdynamiccapabilities,includingorganizationalskillsinsensingandseizing(Teece,2007).Inthecaseoftwo-sidedandmulti-sidedplatforms,theplatform

11ThissectionisbasedinpartonHazlett,Teece,andWaverman(2011).

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ownerwilltrytocapturevaluebyinternalizingthe(usuallypositive)externalities.Generally,itisdesirabletoworkthingsoutthroughwhatOliverWilliamson(1985)calls“privateordering”arrangementsinordertoreducethelikelihoodofastate-mandatedarrangement,whichislikelytoimposeanarbitrarysolutionthatlimitsoutcomesanddestroysvalueforconsumers,too.InordertoexploresomeofthePFIconsiderationswithinandacrossthelevelsofanindustry,Iwilluseexamplesfromdigitalcellulartelephony,anindustrythatdidnotexistin1986,theyearofthefirstPFIarticle.Themassivetransformationsthatithasenabledhaverapidlytakenholdduringthefirstdecadesofthenewmillennium.MobiletelephonyprovidesusefulillustrationsoftheadditionalgranularityprovidedbythebroaderapertureoftheexpandedPFImodel.TheoriginalTeece(1986)modelappliedwellenoughtofeaturephones.PriortotheintroductionoftheiPhone,thecellularhandsetmarketwasdominatedbyahandfuloffirmswithprodigioustechnologicalandmarketing(complementary)assets.TheTop-5listsoftheearly2000swereconsistentlydominatedbyNokia,Motorola,Samsung,Sony-Ericsson,andLGElectronics,whichcollectivelyaccountedfor70%to80%ofglobalmarketshare.12Theircollectivedominanceappearedunshakable;Nokiaalonecontinuouslyaccountedforathirdormoreofworldwidemobilephonesalesaslateas2010.Apple’siPhoneprovidedamorePC-likeexperiencethantheproto-smartphonesthenonthemarket,anditwassupportedbyagrowingmarketforcontentthroughtheiTunesStorethatApplehadestablishedforitsiPod.WithinayearoftheiPhone’slaunch,AppleintroducedtheAppStoretomake(Apple-vetted)third-partysoftwareavailable.Inadditiontoitsstrongpositioningwithregardtocomplements,theiPhonebenefittedfromApple’s(path-dependent)learningwiththeiPod,itspositiveconsumerimage,anditsabilitytointegratehardware,software,andservices.13Successwasrapidanddurable.Bytheendof2008,theiPhonedominatedthemarketforhigh-endphonesandsetthedominantdesignforrivalstoadopt.Theintroductionofsmartphonesandtheirassociatedplatformschangednotonlythehardwarebutalsothebusinessmodel.In2011,SteveElopatNokiatoldhisemployees“Ourcompetitorsaren’ttakingourmarketsharewithdevices;theyaretakingourmarketsharewithanentireecosystem.”14Toaccountforthischange,PFImustincreasinglybeappliedacrossmultiplelevels(upstreamanddownstream)ofanindustry,andcellulartelephonyisacaseinpoint.Muchoftheenablingtechnologygetsbuiltonto(communications)chips,whichareprovidedbyahandfuloffirmscompetingoncostandquality.Thechipsmustgointoinfrastructureequipmentandterminaldevices(primarilyhandsets).Thequalityoftheuserexperienceisdependentontheskillwithwhichthetechnologyisintegratedintoasystembymobilecarriersandhandsetmakersbecausetheperformancethatonecanachieveoutofcellnetworksisintimatelytiedtonetworkdesignandhandsetantennadesign.Eachoftheselevelscanbeviewedasanecosystem,theycanbegroupedtoincorporateinteractions.Indeed,theInternetitselfcanbethoughtofasanecosystem.Hazlett,Teece,andWaverman(2011)showthat,atleastintheearly

12Compiledfrompressreportsofthetimeonannualmarketshare.13AsTimCook,along-timeexecutiveatAppleanditscurrentCEO,saidin2013:“Applehastheabilitytoinnovatein[hardware,softwareandservices]andcreatemagic...Thisisn’tsomethingyoucanjustwriteacheckfor.Thisissomethingyoubuildoverdecades”(AFP,2013).14TheleakedNokiamemowaswidelyreproducedonline.Seehttp://www.engadget.com/2011/02/08/nokia-ceo-stephen-elop-rallies-troops-in-brutally-honest-burnin/(accessedJune7,2016).

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yearsofthesmartphoneeraintheU.S.market,thenetworkproviderswerethelosersandthehandsetprovidersthewinners(seeTable3).ThisisconsistentwithDedrick,Kraemer,andLinden(2011).Profitsaremadeandlostatmanylayersinthesystem.PFIpredictsthatthebottleneckassets,ifany,willearnthelion’sshareoftherents.InthePCecosystem,Microsoft’sownershipandcontroloftheWindowsoperatingsystemgaveit(alongwithIntelasthemainmicroprocessorprovider)aprivilegedpositionwithrespecttocapturingPCecosystemprofits.MicrosoftwasaidedinitsvaluecapturemissionbythebeneficiallinkagesitcreatedbetweentheWindowsoperatingsystemandpersonalproductivitysoftwaresuchasExcelandOutlook.Table 3. Q Ratios for Selected Wireless Ecosystem Players

Company 2008 1Q2009 2Q2009 Ratio to SP500 (2Q2009)

Enterprise Value ($bill. as of 5.4.10)

Sprint .6 .6 .5 0.68 28.9 Apple 2.6 2.5 3.1 4.25 212.2 RIM 5.0 4.6 6.2 8.49 ~38.5 Nokia 1.0 .9 1.2 1.64 ~41.5 Motorola .7 .5 .3 0.41 11.7 Qualcomm 2.5 2.7 3.2 4.38 50.7 S&P 500 .55 .61 .73 1.0

Source:ManualofIdeas(Sept.21,2009).NetworkproviderssuchasVerizon,AT&T,andVodafonefacemultiplechallenges.First,consumersseedifferentiationatthedevicelevel,notsomuchatthenetworklevel(althoughservicequalityvariesbylocation).Second,thesecarriersmustmakemassiveinvestmentinnetworkinfrastructurewitheachnewgenerationoftechnologyyetcompetefiercelyonprice.IntheUnitedStatesmarket,withmultiplenationwidenetworksinoperation,thenetworkisnotabottleneckasset.ForseveralyearsaftertheintroductionoftheiPhone,AT&TprofitedfromitsexclusivearrangementwithApple,butthatendedin2011whenAppleintroducedaphonethatworkedonthenetworkofAT&T’schiefrival,Verizon.ThevaluetoAppleofaccessingalargepoolofpotentialnewcustomersoutweighedthebenefitsitwasreceivingthroughtheAT&Tpartnership.TheendofthepartnershipoccurredatatimeofApple’schoosing.Third,Googlehasinvestedinprovidingacertainamountofopticalfiberfortransport,furtherreducingthebottleneckpotentialoftheoperators,whoalsosufferedablowfromtheriseofInternettelephony.Asthissuggests,thetruebottlenecks,i.e.,theassetsthatareinhighdemandbutnotcompetitivelysupplied,arethemobileoperatingsystemsofAppleandGoogle.Inaddition,Apple’siPhonehasproduct/featurepatentsthathaveprovenformidable.AlthoughthetwoOS-basedecosystemscompete,theyarenotviewedbyusersasdirectsubstitutes,inpartbecauseApple’shardwareandbrandimageareexclusivetotheiOSecosystembutalsobecauseusersfaceswitchingcostswhenmovingbetweenthetwoplatforms.Forseveralyears,thelion’sshareofprofitsinthecellularindustryhasgonetothesetwofirms,whicharecurrently(June2016)thetwomostvaluablepubliclylistedcompaniesintheU.S.WhiletheoperatingsystembottleneckinsmartphonesissimilartoMicrosoft’spositioninPCs,thereisnobottleneckforcellphoneprocessorsequivalenttothatofIntel.ThishastodowiththesuccessoftheopenecosystemcreatedbytheUK’sARMLtd.,inwhichmanylicensees,competingfiercelyagainsteach

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other,areabletoaccessthekeyintellectualpropertytodesignthechipsthatrunthephone’ssoftware.NearlyallsmartphonestodayuseprocessorchipsbuiltaroundoneofARM’sdesigns.15ARMreceivesaroyaltyfromeachprocessor,whichistypicallythesecondmostexpensivecomponentafterthedisplay.ARM’sextensiveportfolioofintellectualpropertyaroundpower-efficienthardwareandsoftwarecouldbeconsideredabottleneckbecauseitslicensees,suchasSamsungandQualcomm,wouldneedagreatdealoftimeandexpensetoreplaceit.However,ARMhaskeptitsroyaltyratesrelativelylow,recognizingthepricepressurefacedbyitslicensees.InthefirstyearsaftertheiPhoneappeared,otherhandsetsupplierslikeNokiaandRIM/BlackBerrystillearnedprofits.ThischangedasthebusinessmodelsofAppleandGoogletookhold.Theirbusinessmodelsarequitedifferentandreflectthecapabilitiesthateachfirmbroughttothecellulartelephonyfield,inwhichneitheronehadpreviouslycompeted.Google’sbusinessmodelintheonlineworldhasbeenbasedsincenearitsbeginningonad-supportedtechnologydevelopment.Ithasnotechnicalormarketlock-in,justtheattractivenessofeasyaccesstolargequantitiesofwell-organizeddataandcontent.Ifbettersearch,mappingandemailsystemsemerged,itisnothardforuserstomigrate.Yahoo,anearlyleaderinthesamespace,sufferedfromthislackofanysignificantholdonitsusers,andwasleftbehindbyGoogle’ssuperiorabilitytosteadilyimproveandexpanditsoffering.Forcellularhandsets,GooglestructuredtheAndroidecosystemsothatGooglecapturestherentsfrommobileadstofunditscontinuedvaluecreationthroughimprovementofitsAndroidOS,whilethemakersofAndroiddevicesdissipatetheirprofitsbycompetingagainsteachother.Googlefocusesonsoftwareandleavesmosthardwaredevelopmenttopartnerfirms.Apple,ontheotherhand,hadalonghistorydevelopinghardwareaswellassoftwarepriortoenteringthecellphoneindustry.Apple’sprofitsfromtheiOSecosystemflowmostlyfromdevicesales,whichispossiblebecauseAppleistheirexclusivemanufacturer.Appleisstilllargelytheintegratedfirmithasalwaysbeen,inwhichhardwareandsoftwareintegrationisasourceofadvantage.Oneimportantcommonality(pioneeredbyApple)isthatbothAppleandGoogleofferaplatform(adigitalstorefrontforapplications)forindependentsoftwaredeveloperswhoaddvalue(whichtheymustsharewithAppleandGoogle)totheiOSandAndroidecosystems.Inthefirstinstance,thiswasprimarilyabouttheprovisionofcomplementaryassetstoenhancethenetworkeffectsthatattractandbinduserstoeachsystem.Asmentionedearlier,profitsfromthird-partysalesofcontentareonlyrecentlystartingtomakeasignificantcontributiontothefirm’sbottomline.Bothcompanieshavealsoexpandedtothepointthattheybenefitfromthetraditionaleconomiesofscaleandscope.

IV. D.ModularityandIndustryPerformance

WhilePFIisprimarilyatoolforthinkingaboutprofitabilitywithinindividualfirms,orintheecosystemsinwhichtheyparticipate,thelogicalsoappliestotheindustryasawhole.Justasaninnovatormustdesignaprofitablebusinessmodeltoensuretheabilitytoimprovethetechnologygoingforward,anindustry,althoughlackingacentralcoordinationmechanism,mustdothesame.Thefutureprogressmaybeindangerduetochangesinthewayappliedresearchintheseenablingtechnologiesisfunded.15Intelhastriedtoextenditsreachintothecellphone,atonepointevendesigningwithanARMlicenseithadacquired,butitscapabilitiesinlow-powercomputing,whereARMexcels,werelimitedduetoitshistoricalfocusonhighperformance.ARMisstartingtofacecompetitionfromseveralopen-sourcehardwareinitiatives,butthesearemorelikelytobeimportant,ifatall,inless-establishedmarkets,suchastheso-calledInternetofThings.

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Thesourcesofinventionintheelectronicsandcommunicationsindustrywasoncehighlyconsolidated.AT&T’sBellLabsinparticularwasthewellspringofmuchofthenewtechnologyforthetelecomandelectronicsindustry.Ithadlongpursuedeconomicallysignificantresearch,asrepresentedbytheinventionofthetransistor—thebasisfortheentirecomputerindustry—in1947.NTThasfulfilledasomewhatrelatedrole,providingresearch,equipmentmanufacture,andtelecomservicesinJapan.Sweden’sEricsson,aprivatefirm,wasalsointegratedfromresearchthroughtoequipmentdesignandmanufacture.Unfortunately,BellLabshasvirtuallyceasedtoexistinallbutname.Inplaceof“blue-sky”researchintotechnologieswithnoimmediateusethatlatergaverisetoinnovationsofgreatvaluetothetelecommunicationsindustry,researchtodayissmallscaleandveryproductdevelopmentfocused.Thedeclinebeganwiththe1982consentdecreepursuanttowhichAT&Twasbrokenupin1984andBellLabsmadevulnerable.BellLabshassincepassedthroughaseriesofsuccessorcompaniesandiscurrentlypartofNokia.ThelossofBellLabs’massivecontributionstoglobalscienceingeneral—andtocommunicationstechnologyinparticular—iscollateraldamagefromthebreakupofAT&T.Downstreamsectorshaveexperiencedmassivechangesaswell.Inearliergenerationsofthetechnology,companieslikeMotorolaandEricssonmadecomponents,infrastructureequipment,andconsumerdevices,followingamodelthathadbeenestablishedlongbeforebythestate-runmonopoliesinchargeoffixed-linetelephony.Thebreakdownofthisindustrystructureintoverticallyspecializedgroupsoffirmsresemblesthetrajectoryofthecomputerindustry,whereverticallyintegratedcompanieslikeDECthatmademidrangeandminicomputersgavewaytothespecialistcompaniesthatpopulatethemodularPCindustry.Themodularbusinessmodel,whenpresentattheindustrylevel,squeezesprofitoutofeachmoduleand“ownershipofcomplementaryassets”nolongerworksasacoreappropriabilitymechanism.Thiswasthecaseforpersonalcomputers,whereprofitforthemodules(harddrives,motherboards,finalassembly,etc.)becamevanishinglysmall.Yetthemicroprocessorandoperatingsystemprovedresistanttoimitationandcompetitionforavarietyofreasons,includingtechnologicalprowess,intellectualproperty,brandingand,especiallyinMicrosoft’scase,networkeffects.Themodularizationofthemobiletelephonyproductionsystemlimitsthefurtherprogressoftheindustry’senablingtechnologies.CompaniessuchasEricssonarefindingthemselvesforcedtode-verticalizeandspecializeinoneortwomodulestosurvive.However,modulesareinherentlycompetitive,makingithardtoearnsufficientprofitstofundR&Dthatislikelytobenefittheindustryasawhole.Thiseffectisexacerbatediftheprovidersofenablingtechnology(includingownersofstandardsessentialpatents)areunabletoreapareasonablereturnfortheirtechnologicalcontributorstostandardsdevelopment.Indigitalelectronicsystems,architecturalinnovationisoftendesirableandespeciallydifficult.Modularization,meanwhile,enablesautonomousinnovationtocontinueatarapidpace,butiteventuallyhaslimitedimpactunlesssystemicorarchitectureinnovation(involvingnewstandards)happenstoobecause,inmanycomplexsystems,itisinnovationinthesystem(and/orintheunderlyingenablingtechnology)thataffordsthegreatestbenefits.Itisalsosysteminnovationthatenablechangesinbusinessmodels.

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V. E.BusinessModelConfiguration:LicensingandAlternatives

Asalreadynoted,theoriginalPFIframeworkexploredonlyalimitedrepertoireofbusinessmodels;themainchoicesrecognizedwere(a)tolicenseand(b)toinvestinoneormorecomplementaryassetsand/ortechnologies.Jointventurearrangementswerealsoanalyzed,assomerewardwasconsideredbetterthannone.Theframeworkimplicitlyreliedonideasfrombargainingtheory,whichgenerallyshowedhowrentswouldbeshared.Itiscommonforeconomiststoassumethattechnologylicensingisastraightforwardwayforinnovatorstocapturevalue.Indeed,itisnotuncommonforthemtoassumethatapatentconveysanautomaticmonopoly,whichisfarfromthetruth.Notonlyisitrareforapatent,orevenapatentportfolio,tocoincidewitharelevant(inantitrustterms)market,itisalsounlikelythatacourtwillautomaticallygrantaninjunctionuponthemererequestofapatentowner.Thiswasnotthecaseinthepast,and,sincethe2006SupremeCourtdecisionineBayInc.v.MercExchange,L.L.C.,itisatmostaremotepossibility.TheseobservationshelpexplaintheconundrumthatNobellaureateKenArrowoutlinedhalfacenturyago,towhichscholarshaveyettorespondatall,letalonecomprehensively:

Patent royalties are generally so low that the profits from exploiting one’s own invention are not appreciably greater than those derived from the use of others’ knowledge. It really calls for some explanation, why the firm that has developed the knowledge cannot demand a greater share of the resulting profits” (Arrow, 1962, p 355)

TheexplanationthatArrowwaslookingforgoesbeyondthefactthecourtshaveoftensidedwithimplementersoverinventors.Itrelates,asdiscussedearlier,totheinherentinabilityoffirmsthatinventenablingtechnologiesandGPTstoattractandharnessthefinancialresourcesneededtoinvestinthecomplementaryassetsrequiredtoimplementappropriability-enhancingbusinessmodels.Asnoted,timingandstandardsmatter,alongwithwhatHelpman(1998,p.4)called“institutionalconditions.”Strategyshouldalsobeaddedtothelist,alongwithwhatevertalenttheinventorcanmustertosimultaneouslyinvent,beentrepreneurial,innovatebusinessmodelarchitectures,andorchestratecomplementarytechnologies.Asmentionedearlier,theidentificationandcontrolofkeycomplementsbothinsideandoutsideofecosystemsplayacentralroleinthePFIstoryandhelpsprovidetheexplanationthatArrowwassearchingfor.Ifthecomplementsarenotownedby,orcannoteasilybereplicatedby,theinventor,thenrentswilllikelybedrainedawaytowardthecomplementowner(s),andtheinnovatorwillbeinnobetterpositionthananimitatorwhocontrolsrelevantcomplements.PFIcouldeasilyhavecollapsedintoadiscourseonbargainingtheorytoexplainlikelyrentdivision,withappealstogame-theoreticmodelsdevelopedbyBertrand,Nash,Rubinsteinandothers.RatherthandoingsoIhavechosentofocusonframingthebroadersetofissuesratherthannarrowingthefocustothedivisionofrentsbetweencomplementorandinnovator.Thisfocusischosenbecausethecontextisnotstatic(asgame-theoreticmodelsassume),andtheinnovatorsometimeshasthetimetobuildand/oracquirerelevantcapabilities.However,thereareaplethoraofotherissuestoconsiderbesidescomplements.Forinstance,strategyanalysisisanessentialstepindesigningacompetitivelysubstantivebusinessmodelunlessthebusiness

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modedesignpassesthroughthefiltersofstrategyanalysis,itisunlikelytobeviable.Gettingthebusinessmodeldesignrightiscriticaltocapturingvalue.However,wemustrecognizethatitissometimesimpossibletodesignabusinessmodeltocapturevalueevenwhenvalueisbeinggenerated.Atextbookexampleistheprovisionoflighthouseservices.Itwasnotpracticaltolimitwhichshipswouldandwouldnotbenefit;ifsomepaid,theotherscouldfreeride.Society’ssolutioneverywhereistohaveagovernmentagency(intheU.S.,theCoastGuard)providetheservicesandtrytorecoupthecostthroughtaxationorimpositionofmandatoryfees.Suchservices/goodsarereferredtoaspublicgoodsinrecognitionofthedifficulty(ornearimpossibility)ofconstructingaviablebusinessmodel.Thereareofcourseexceptionstotherequirementtoinnovateinbusinessmodels.Forexample,smallimprovementsinamanufacturingprocess(evenifcumulativelylarge)willusuallynotrequirebusinessmodelinnovation.Butthemoreenablingtheinnovation,andthemorechallengingtherevenuearchitecture,thegreaterthechangeslikelytobeneededinstandardbusinessmodels(Teece2010,p.186).Thelifeandfortunesofinnovationsarecompromisedonaccountofthis,particularlywheninventorslackthewherewithaltoaccessthenecessaryresources.Moreover,designinganewbusinessmodelitselfrequirescreativity,insight,anddeepcustomerknowledge.TechnologicalDNAneedstobemarriedtobusiness/entrepreneurialDNAforinventorstosucceed.16Thisisatallorderformostinventors.EvenThomasEdisonwithhisportfolioof1,000+patentsfailedcommerciallyonmanyfronts,despitethefundamentalnatureofmanyofhistechnologicalcontributions.Heabandonedtherecordingbusinessafterarguablyfailingtogetitsbusinessmodelright(byofferingaclosedplatforminwhichonlyEdisondiscscouldworkonEdisonphonographs).Hislacklustercommercialresultswiththephonographwerealsoduetodeficienciesintheproduct(poorsoundreproduction,recordingsthatcouldonlysurviveafewplays).Othersmovedintofillthevoid,includingAlexanderGrahamBell,byusingwaxintheplaceoftinfoil(fortherecordingcylinder)andafloatingstylusinsteadofarigidneedlethatwouldincise.Inadditiontobeingagreatinventor,Edisonwasalsoverygoodatjudgingtheneedsofthemarket.Thismeantthatheandtheotherinventorsheworkedwithwereabletofocusoninventionsthatweretrulyusefulandhadachancetobecommerciallyviable.Hecreatedelectricityasasystemandpioneeredbusinessmethodssuchascriticalpathtechniques,engineeringstoryboards,andinterdisciplinaryproductdevelopment,centralstorerooms,andcorporatelibraries.WhileEdisondidnotdiepoor(apparentlyhewasworth$12millionin1932),hisnetworthwaspaltryinrelationtothevaluehecreatedforsociety.RemsenCrawford,Edison’sbiographerandclosefriend,hasendeavoredtoexplainEdison’sowninterpretationofhismodestfinancialsuccess(Crawford,1932).Edisonbynomeansreliedonpatentlicensingashisbusinessmodel.Hefoundedcommercialmanufacturingventures,includingseveralthatmergedtoformthecompanynowknownasGeneralElectric.Hewaswellawarethatthepatentsystemwasoftenquiteineffectualandoncerelatedhowhehadfoughtfor14yearsforhispatentontheincandescentbulbagainstinfringers,despairing(consistentwiththeArrowobservationcitedearlier)that:“myopponentswereabletokeepmeoutofprofitsofthatparticularpatentuntiltherightstoitwerewell-nighuseless”(citedinCrawford,1932,p.56).He

16ThisparaphrasesaconversationwiththeauthorandAndyBryant,ChairmanofIntel,2015.

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hadsimilarproblemsmonetizinghispatentsondevicesforcapturingandviewingmovingpicturesaswell.17Edison’sexperienceisnotuncommontoday.Theappropriabilityproblemforinnovatorsisalmostalwayssevere.Asaconsequence,technologicalinnovationneedstobematchedwithbusinessmodelinnovationtohelptheinventorcapturemorevalue.Nakedlicensingwillrarelysuffice.Thisisallthemoretrueifthecourtsfavorinfringers,whichtheyseemmoreandmoreinclinedtodo.ThePFIframeworkhelpsexplainwhyintellectualpropertylawandthecourtsshouldbemoreinventor-friendlyandintellectualpropertyrightsstrengthened.Holdouts(patentinfringersrefusingtotakealicenseevenafterthecreationofalicensingprogramsuggeststhatpatentvalidityislikelyhigh)needtobecurbed.Whileithaslongbeenrecognizedthatbasicresearchis,byitsnature,a“publicgood”intheeconomicsense,itisperhapsnecessarytorecognizethatothertypesofnewtechnologyhaveasubstantialpublicgoodcomponenttoo.Asapracticalmatter,GPTsandenablingtechnologieshaveappropriabilitycharacteristicsnotunlikebasicresearchforsomewhatdifferentreasons.Thelighthouseexample(ofapublicgood)ismuchmoregeneral(andalsoapplicabletoinnovation)thanpreviousscholarshaveperhapsrecognized.Itisnotjustthatfreeriders(e.g.,patentholdouts)arecommon;thephenomenonisamplifiedbythefactthatmanyinventions,especiallyofGPTsandenablingtechnologies,havesuchbroadapplicabilitythatdirectinvestmentbusinessmodelsdesignedtoexhaustthefullrangeofpossibilitiesaretooexpensiveformarketstofinance.Furthermore,theyoftentaketoolong.Theresultisthatimplementersindifferentindustriesoftenachievewindfallsfromtheinventor’stravails.Underinvestmentininventiveandinnovativeactivityisalikelyconsequence.Whileitishardtoprovethatinnovationwouldbemoreplentifulunderastrongerappropriabilityregime,weakinnovationcouldbeonecontributortothedecliningrateofU.S.productivitygrowthoverthepastdecade.

VI. F.Standards

AsshowninTable1,technologylicensingaccountedforamodest1.2percentshareoftotalwirelessrevenue.Thereareroughlyadozenmajorholdersof“essential”patentsthatanyimplementationofthetechnologyislikelytorequire.Despitetheoreticalfantasiesaboutpatenthold-up(i.e.,patentholderschangingtermstoextractmorevaluefromlicensees),itisneverobserved(Galetovic,Haber,andLevine,2015).Patentsarenotself-enforcing,sothatappropriabilityisfarfromperfectandpatenthold-out(i.e.,infringersfailingtopayroyalties)isarelativelyfrequentoccurrence.1.StandardsettingandstandardsdevelopmentTechnologicalstandardsprovidethefoundationontopofwhichrivalfirmsbuildtheirproductandserviceofferings.Thetimelycreationanddevelopmentofstandardsisimportantfortheabilityofnon-integratedfirmstooffersteadilyimprovinghardwareandsoftware.StandardsappearedintheoriginalPFIframeworkprimarilyintheformofdominantdesigns.Dominantdesigns(e.g.,HenryFord’sModelT,Apple’siPhone)emergeviamarketcompetitionandbecomedefactostandards,unlikethewirelesstelecomandothertypesofcomplexstandardsthatare

17Moreinterestingly,Edisonsawtheusurpationofprofitsbypiratesas“particularlyapttoresultinthecaseofsomeextraordinarypatents.Icouldinventanewmonkeywrenchwhichmightgowithoutinfringement,butthemomentItakecertainforcesandworkoutamovingpictureforthefirsttimeinthehistoryoftheworld,likethatproducedbytheKinetoscope,markyouhowthepiratesroseupandcallittheirown”(Crawford,1932,p.57).Thisisconsistentwiththeperspectiveadvancedearlier.

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cooperativelydeveloped.Standardsettingandstandardsdevelopmentareworthyoffurtherconsideration.Defactostandardswillcontinuetoplayarole.Asmobiletelephonymovesaheadto5G,thefieldofcompetitionwillwidenfromsmartphonestotheso-calledInternetofThings(IoT).The“things”willbevastnetworksofsensor-enabledsmartdevicesthatwillprovidedataandcontroltoconsumersandcompanies,enablingavastrangeofnewapplications,includingsmarthomes,smartcities,dynamicutilitypricing,mobilehealth,andautonomousvehicles.Whiletheunderlying5Gcommunicationstandardsarebeingdevelopedthroughaformalcollaborativemechanism,thestandardsforthecommunicationprotocolsamongdeviceswilllikelybesettledinthemarket.Competingconsortia,includingtheAllseenAllianceandtheOpenConnectivityFoundation,havepublishedopensourcecodefordeviceinteroperabilityattheapplicationlayer,andAlphabet’sNestLabsdecidedtofollowsuitwithitsequivalentsoftwareinordernottobestuckinaniche(Merritt,2016).Standardsforcomplexenablingtechnologiessuchas5Gcommunicationsrequirecollaborativedevelopmentiftheyaretoprovidefullinteroperabilityacrossecosystemsandindustries.Manyfirmshaveastakeincontributingtotheperformanceofthetechnology,whichtheywilluseasthebasisforlaunchingtheirownproductsinthemarket.Amongotherbenefits,standardsenablemodularization,whichallowsfirmstospecializewithintheecosystem,developingcomplementstotheplatformthatarecertaintoworkthroughthestandardinterface(seeLangloisandRobertson,1992).Modularityalsofacilitatescompetitionandentry.Forinstance,Wi-Fistandardshaveledtothedevelopmentofacompetitivemarketforsmall-networkwirelessgear.Ofcoursestandardsettingwasimportantintheoldindustrialworld,butthechallenge(andtheopportunity)fromstandardsinold-lineindustryisrelativelyminorcomparedtothedigitalworld.Theprocessbywhichatechnologyisselectedforinclusioninastandardtypicallyinvolvesinquiryandnegotiationwithinastandardsettingorganization(SSO)suchasSAEInternational,aU.S.-basedglobalSSOforthetransportindustries.ManystandardspromulgatedbySSOs,suchastheshapeofanelectricaloutletorthesideoftheroadonwhichtodrive,containlittleinthewayofnewtechnology.

Inothercases,standardsassembleandanointnewtechnologieswithstrongimplicationsfordownstreaminnovation.Insuchcases,thecomplextechnicaldetailsofastandardarelikelytobehammeredoutinastandarddevelopmentorganization(SDO),aforumthatallowsparticipatingfirmstocontributetechnologyandtoshapethestandard.Whilestandardsdevelopmentinvolvesquitealotoftechnologyexchange,actualR&DisdonenotbytheSDObutratherbackattheparticipatingcompanies.Oncethestandardisset,SDOparticipantsarefree(withincertainlimitsdiscussedbelow)topursuetheirownbusinessmodelsaroundtheirpatents.Muchoftheenablingtechnologygetsbuiltonto(communications)chips,whichareprovidedbyahandfuloffirmscompetingoncostandquality.Thechipsmustgointoinfrastructureequipmentandterminaldevices(primarilyphones).Themicroprocessorchipsthatenablethesoftwareapplicationsonsmartphonesmaybeseparateorintegratedwiththesemiconductorintellectualpropertyforthestandards-basedcommunicationprotocols.

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Whilesomescholarsmaytreatstandardsettingandstandardsdevelopmentinterchangeably,theprecedingdescriptionsmakeclearthattheyareverydifferent.Table4comparestheSSOandSDOmodels.Table4:StandardSettingversusStandardDevelopment

StandardSetting(SSO)

(ModelOne)StandardDevelopment(SDO)

(ModelTwo)

Process

Selectionamongstknownalternativesofferedbycontributors;choicesserendipitous…noclearwinner

Newtechnologiesdeveloped,oftenatgreatexpensetocontributors.Standardadoptedbecauseit'sofsuperiorperformance

Outcomes Uniformity,compatibility Innovation,uniformity,compatibility

Pricing Usuallyzero(patents&tradesecretsonlyrarelyimplicated)

FRAND(fair,reasonableandnon-discriminatory)

ExamplesLeft-vRight-handdriveautos,SAEcomponent;BritishvAmericanelectricaloutlets

3G,4G,LTE;802.11Wi-Fi(IEEE,ETSI)

AsubsetofpatentsrelevanttothestandarddevelopedinanSDOwillbedeemed“essential”foranyimplementationofthestandard.Aformaldeclarationofessentialityisaspecialtypeofcomplementaryassetforaninnovationthathelpsensurethatitwillearnaroyaltystreamoverthelifetimeofthestandard.A“standardessential”designationneednotimplytheharnessingofanenablingtechnology,butsometimesitdoes.2.Standardessentialpatents(SEPs)androyaltiesItisimportanttorecognizethatselectingstandardsisnotalwaysamatterofpickingamongstequallygoodalternatives.Insomecases,itinvolvesprivatepartiesinvestinghundredsofmillionsofdollarsinR&Dinordertoputforthtechnologythattheyhopewillbeadoptedindustry-wide.Inadditiontothepotentialforaroyaltystreamfromitsinnovations,aparticipatingfirmmayalsohopetoleveragecomplementaryintellectualpropertythatisseparatefromthestandardandtoleveragetheadvancedfamiliarityofitsengineerstostayaheadofitsrivals.Oncethecandidatetechnologieshavebeensubmitted,expertsattheSDOcollaboratetoevaluatecompetingpossibilitieswithaneyetowardproducingthehighest-performanceresultpossible.MostSDOsconsistofnumerousworkinggroupseachstrivingtofindthewaystoachievethegoalsthattheyhavebeenset.Nevertheless,what’sanimatingpublicpolicyintheU.S.istheDepartmentofJustice’sconcern“thatsometimestechnologyacquiresvalueonlybecauseitbecomesembeddedinastandard,”

30

i.e.,thatthecontentsofastandardmightbearbitraryratherthanobjectivelysuperiortoexistingalternatives.18Applyingthis“arbitrarystandard”assumptionwhenthe“enablinginnovation”paradigmisatworkharmsthevoluntaryresearchcooperationthathasemergedinrecentyears.Thelikelyconsequencesofpolicies/rulesthatassumetheworldisModelOne(SSO)whenit’sModelTwo(SDO)aredeleterious.Standardsdevelopmentorganizationshavemadearchitecturalinnovationpossiblesothatindustryandconsumersgetthebenefitofbothmodularizationandarchitecturalinnovation.Thisisanoteworthydevelopment.

Generally,standardsettingbodiesrecognizethat(patented)contributionstoastandardoughttoreceiverecognitionbybeingeligibleforroyaltiestobepaidbythosethatimplementthestandard.Themainreasonofcourseistocreateincentivesforcontributionstostandardssettingbodiesandforfutureimprovementstotheunderlyingtechnologies.Yetitisalsoimportantthatpatentholdersdonotover-claim,justasitisimportantthatuserstakealicense.MostSDOshavepoliciesthatadvanceandsupporttheideaoffair,reasonable,andnon-discriminatory(FRAND)licensingterms,particularlyforstandardessentialpatents(SEPs).Thetechnologyownersandimplementersmuststillnegotiatetodeterminefeesand/orroyaltiesforeachlicensorbasedonprojectedvolumes,creditworthiness,etc.Althoughthedefinitionof“reasonable”doesnothaveanengineer’sprecisionattachedtoit—withdisagreementsoccasionallyleadingtolitigation—theFRANDsystemhasworkedverywellforoverhalfacentury.19

IV.ManagementandPolicyConclusionsTeece(1986)endeavoredtoexplainhowtheprofitsflowingfrompreselected,commerciallyviableinnovationswouldlikelybedivided,basedonstructural,behavioral,andstrategicfactors.ThecoreinsightofthePFImodelisthatthedistributionoftheprofits(flowingfromaninnovation)amongtheinnovators,rivals,complementors,suppliers,andconsumersdependsprimarilyonthefeaturesoftheinnovationrelativetopossiblesubstitutes,theeaseofimitation,thecontrolofstandards,thedegreetowhichessentialcomplementaryassetsarecontrolledbyothers,andthevalue-capturebusinessmodelseffectivelyavailabletothepioneerand/orfollowers.Thevalue-maximizingstrategyandbusinessmodeloughttotakeintoaccounttheappropriabilityregime(thenatureoftheinnovation;thestrengthofthecorrespondingintellectualpropertyrights),complementaryassets(especiallyanybottleneckassetsthatare,orcouldbe,inlimitedsupply),andindustryevolution(includingwhetherstandardshavebeenestablishedandthepresenceorabsenceofnetworkeffects).WhiletheProfitingFromInnovationframeworkislooselygeneralizabletoothercontexts,theimplicit“onetechnology,onepatent,oneproduct”assumptioninTeece(1986)hasbecomelessandlessrealistic.Thirtyyearsago,R&Dexcellenceandcommercializationcapabilityresidedinmaybe50-100privatecorporationsworldwide(e.g.,IBM,TI,GE,Siemens,Roche,Exxon,Shell).Todaywehave100plusstrongtechnologyfirmsinalmosteveryfieldandhundredsofnewenterprises.PublicinstitutionanduniversitiesintheUS,EuropeandAsiaplaybigrolestoo.Thisdramaticshifttoarichplethoraof18DavidMeyer,DeputyAssistantAttorneyGeneral,DOJ,March26th2008.19TheIEEE,astandardsorganizationfortheelectronicsindustry,hasmadepolicyerrorsinrecentyearssuchasadoptingbylawsin2015thatpotentiallyallowthediscussionoflicensingtermswithinworkinggroupsthatconsistlargelyoffuturelicensees,essentiallyopeningthedoortobuyercartelsamongstimplementers.

31

partners—somenecessarymanyoptional—haschangedthemanagementlandscape,requiringspecificembellishmenttothePFIframework.Inparticular,complementaryassetsandcomplementarytechnologiesaremoresignificantthaneverinaworldofcompetingandintersectingplatforms,likelydwarfingtheinstalledbaseeffectsthatdroveprofitsinthePCera.Whilescale,scope,andinstalledbase/networkeffectsstillmatter,complementsarecenterstageinthewireless-enabledworldofdigitalconvergence.Thereare6groupsofembellishmentsaddedintotheframework:

1) Becauseoftheimportanceofcomplementaryassets,additionalgranularityhas

beenaddedtocomplements.Itisnolongerpossibletohavemeaningfuldiscussions

aboutcomplementaryassetswithoutaclearunderstandingofthenatureofthe

complementarityatissue.

2) Businessecosystemsareincreasinglytherelevantcompetitiveunit.Whenplatform-

poweredecosystemsareproperlymatchedtobusinessmodels,theycanhelpcreate

andcapturevalue.

3) Multi-inventioncontexts,inwhichindividualproductsdrawonmultipleinternaland

externalsourcesoftechnology(patentedandunpatented),arepervasive,andnow

assumedtobethenorminPFI.

4) Businessmodelchoicestoaidinvaluecreationandcapturearemuchmorecomplex

thanthesimplified“licensingversusin-houseproduction”businessmodelofPFI‘86.

Buildingplatformsandstrategicallymatchingbusinessmodelstothemrequires

strongdynamiccapabilities.

5) Byimplication,PFIhasmuchtodowithdynamiccapabilities(Teece,2014),because

oftheneedtoorchestratecomplementaryassets,designbusinessmodelsand

matchstrategyandcapabilities.

6) Itisveryhardforinnovatingenterprisestodesignabusinessmodelorcreatean

investmentstrategytocapturemorethanamodestamountoftheupside

associatedwithenablingandgeneralpurposetechnologies.Such

technologies/innovationsaredifficultforindividualinventorstocapturevaluefrom

32

unlesstheintellectualpropertysystemisworkingverywell.Publicpolicyshouldnot

onlyfavorinnovation,itshouldespeciallyfavorthosecompaniesandindividuals

thatcreateenablingtechnologies(andGPTs,oncetheyareevident).Theeconomic

systemneedstosupportthemintermsofbothvaluecaptureandvaluecreation.

Withtheseembellishments,theframeworkrespondstothequandariesadvancedbythetwoNobelLaureatesmentionedearlier:(1)Samuelson’scallforafreshlookatcomplementarities(atleastinthecontextofinnovation),and(2)Arrow’sconcernthatimitationisoftenasprofitableasinnovation.ThesuccessoftheoriginalPFImodelstemmedfromitsrathernarrowframe—widerthanmostexercisesinneoclassicaleconomics,butnarrowerthananecosystemorindustry-levelperspective.Whilethenarrowerframekepttheproblemtractable,itlimitedthemodel’sapplicabilityinmorecomplexsettings.Inthispaper,Ihaveopenedtheapertureanotch.Waysthattheaperturehasbeenwidenedincludeanalysesofenablingtechnology,multi-levelissues,andthedifferingtypesofcomplementarity.AlreadyinTeece(1986),complementaritywasrecognizedasvertical,lateral,andhorizontal,andeithertechnologicalorvaluechain-based,farbeyondwhat’senvisagedbystandardeconomicanalysis.Forexample,thebringingtogetherofelectronicsandmechanical/servotechnologiesledtothecreationofrobotics.Combinationslikethesegowellbeyondeconomiesofscopeorothereconomicnotionsofimprovedefficiency.AnotherpotentiallyusefulformofcomplementarityisthatofHirshleifercomplements.TheabilitytorecognizehowaninnovationwillaffectthevalueofcomplementarygoodscanbequiteimportantforcapturingvalueandcanbeexploitedatthesametimeastraditionalEdgeworthcomplementarity.Forinstance,Apple’sdecisiontoacquireprocessordesigncapabilitiesin2008(ayearafterthereleaseofthefirstiPhone,whichusedaSamsungprocessor)wasnotonlyareflectionofthepotentialbenefitsitcoulddrawfromtighthardwareintegrationbutalsoarecognitionthatrelianceonanoutsidechipsuppliersuchasSamsungorIntelfortheelectronicbraininfuturegenerationsofahitproductwoulddispersealotofthevaluethatApplehadgenerated.Complementarityliesatthecoreofecosystems.Today,mostecosystemsarestructuredaroundoneormoreplatforms.Platformsallowmodularization.Modularizationinturnallowscontributorsofautonomousinnovationfromcomponentandsubassembly(i.e.,module)supplierswithoutrequiringthemtocoordinatewiththerestofthevaluechainbeyondmeetingthestandardsfortheirmodularinterface,whichcanpotentiallyaccelerateinnovation.Ontheotherhand,modularitycanunderminetheabilityoftheecosystemtogeneratesystemic(orarchitectural)innovation(Teece,1984;HendersonandClark,1990).ThismayaccountwhyApple,averticallyintegratedproductdevelopmentcompany,hasexcelledatcreatingbreakthroughproductinnovations,whilethefullymodularecosystemthathasgrownuparoundGoogle’sAndroidOShasexcelledatimitationandincrementalinnovation.Themobilephonecasealsoshowsthatprofitscanbeearnedindifferentways.Asdiscussedabove,theplatformleadersAppleandGooglehavefoundcompletelydifferentbusinessmodelsforextractingvaluefromtheecosystem.InApple’secosysteminparticular,complementorsdon’tgetafreeride;theymustsharetherevenuetheyearnfromiOSappswithApple.

33

Long-termecosystemprosperityrequirescontinueddevelopmentofenablingtechnologies.Thisinturnrequiresthatdevelopersofthetechnologybeadequatelycompensated.Inthepast,whenthedeveloperswereverticallyintegratedand/ordiversified,theywereabletodesignbusinessmodelsthatkeptthetechnologyaffordablewhiletheyprofitedinwaysotherthanlicensing,althoughthiswasstillasmallfractionofthetotalsocialreturns.Now,whenmostdevelopersarenarrowlyspecialized,theincentivedesignchallengeisevengreater.Profitingfromenablingtechnologiesisdifficultoutsideofafullverticalintegrationmodelbecauseitimplicitlyinvolvesaplethoraoftransactionsandlicensingorjointventureactivitiesthatareinherentlydifficulttostructure,establish,andmanage.AftersomerecentU.S.courtdecisions,IquestionwhethertheFRANDlicensingrulesforstandardessentialpatentsprovidesufficientcompensationforcontributionstostandardsdevelopment.Thelicensingregimehasworkedwellinthepastformobiletelephony,balancingtheinterestsoftechnologycontributorsandtechnologyimplementers.However,theIEEEpatentrulechangesadoptedin2015areastepinthewrongdirectionandwilllikelycrippleinnovation,theIEEE,orboth(TeeceandSherry,2016).TheSDOsinwhichimportantenablingtechnologiesareco-developedarearelativelynewphenomenonandrequireunderstanding.LicensingregimeswithrespecttoSEPsaresomewhatfragile.Large-scalecooperationamongmultipleparticipantswithquitedifferentinterestsisalwayshardtoachieve.Thisisparticularlytruewhenthereareshort-termdifferencesinincentivesandtheplayersareheterogeneous.Policymakersandthecourtsneedtobekeenlyawareoftheappropriabilitychallengesfacedbythedevelopersofenablingtechnology.Otherwise,societywilldenyitselfthebenefitsofcriticalinventionsandinnovations.OpeningtheapertureofPFIfromanindividualinnovationtothebroaderindustrialecosystembringsincomplications.Butthebasicstoryisthesame.Appropriabilityisalwaysachallenge;conqueringitrequiresgood(strategic)managementandgoodbusinessmodeldesignalongwithasupportivepolicyenvironment.Atthebusinessecosystemlevel,itmayrequirebuildingandcontrollingaplatform.AdditionaladviceembeddedinPFIisformanagerstoalsoshapethebusinessenvironmenttotheextentpossible,inordertoprofitfromit.Managersmustrealizethatvaluecaptureshouldbepartofeveryexerciseinstrategy,businessmodeldesign,andinnovation.Merelybeingpioneerisnottheroadtoriches.Policymakersmustrecognizethechallengesthatinnovatorsfacewithrespecttocapturingenoughvaluetocontinueinnovatinginthefuture.Theproblemsareamplifiedforinventorsofenablingtechnologies.Tokeepasociety’sinnovationenginefueled,thegovernmentneedstojudiciouslysupportvaluecapture,notjustvaluecreation.Otherwise,incentivestoinnovatewillbecompromisedandfuturecitizenswillsuffer(Teece,Sherry,2016a).Themorefundamentalandenablingthetechnology,thegreatertheproblem.

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Appendix:TheDigitalRevolutionanditsEffectsThisappendixprovidesbackgroundinformationondigitaltechnologyanditsimpactonfirms,businessecosystems,andindustries.Themassproduction,ongoingenhancement,andwidespreaduseofdigitallogiccircuitshasledtorevolutionaryimprovementsinthetechnologiestheyenable,includingcomputers,telecommunicationsgear,theInternet,and,mostrecently,wirelessnetworksthatcan,formostpracticalpurposes,rivalwirednetworksforspeed.Advancesinwirelessbroadbandtechnologyhaveenablednotonlysmartphonesbutnowtheemerging“internetofthings”(IoT),inwhichanarrayofobjectsembeddedwithsensors,microprocessors,andwirelesscommunicationcanberemotelymonitoredandcontrolled,fromnannycamstodriverlesscarstofactories.Thedigitalrevolutionhassteadilyconvertedmoreandmoreanaloginformationintodigitalformats,makingitmoreamenabletoautomatedprocessing.Onceinformationisdigitized,itcaneasilymove

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betweenmedia,andacrossvastdistances,withreliablereproduction.Thishashadenormousengineeringandorganizationalconsequences.Forinstance,thewidespreadimplantationofdigitalsensorshashelpedblurthelinesbetweenmanufacturingandservices.RollsRoycenolongersellsengines;itsellshoursofthrustappliedtotheplaneinthesky(andontheground).Theimplicationsnotjustfortheperformanceofseparateproductsandsystemsbutforconnectednessandcomplementaritiesarepalpable.Theoldwayofmanufacturingandmarketinginvolvedmakingseveralpartsandwelding,screwing,orrivetingthemtogether.Nowagrowingnumberofproductscanbedesignedonadigitalcomputerandprintedona3Dprinterthatcreatesasolidobjectbyaddingsuccessivelayersofmaterial.Becausethesefactoriesneedfewerskilledmanualworkers,theycanbeanywhere,affectingthedistributionofreturnstoinnovation.Therelentlessminiaturizationofmicrochipcircuitryallowsonceunthinkablecomputingpowertobeembeddedintoalargerangeofobjectsfromcamerastoindustrialrobots.Industriesarebeingdigitizedtoo,mostnotablyretail,ledbyyoungbrandslikeeBayandAmazon,whiletechnologyismoreslowlyintegratedbythemostagileoftheoldermerchants(whilethelessagilefadeaway).Thedigitalrevolutioncreatesavirtuouscycle.Theengineeringofnext-generationcomponentsisaidedbytheadvancesofthepreviousgeneration.Evenfundamentalscientificresearchisbenefitingfromdigitallyenabledresearchtools,suchasthoseusedingenomics.Digitaltechnologiesalloweasyinter-operabilityconditionaloncommonstandards.Asaresult,productsthatwereonceseparatearemoreeasilyintegrated.Thedigitalrevolutionhasabolishedbordersbetweentelephones,musicplayers,theweb,TVs,cameras,andmore.Convergenceinthesmartphone,forexample,benefitsendusersbyallowingaccesstomultipleservicesfromasinglehandset.Thisoffersconveniencesandsimplificationsalongwithcostsaving.Atthesametime,itpushesprovidersofcontentandservicestowardshorizontalandverticalpartnershipstoleveragethepowerofbusinessecosystems.Digitalconvergencehasitsrootsinthe1980swhentelecomsandcomputingfirstconvergedwiththeintroductionofdigitalswitchinginthecentraloffice.The2Gcellularstandard,whichwasrolledoutworldwideinthe1990s,broughtthebenefitsofdigitaltelephonytoconsumerdevices.Whilealldigitalhandsetswereinsomesensecomputingdevices,itwasnotuntilthe2007introductionoftheiPhonethatPC-likefunctionalitygainedwidespreadpopularityinamobilephone.ThecapabilitiesofsmartphoneshavecontinuedtoadvancetothepointthatannualPCshipmentshavebeendecliningslightlysince2012,afterdecadesoffairlysteadygrowth.Inthecomputingerathatpredatedwireless-drivenconvergence,industryboundariesweresomewhatdistinct.Eventoday,whenanincreasingnumberoffirmsarepositionedacrossindustrylines,notallindustriesareseeingtheirboundariesbreached.Forinstance,eventhoughdigitaltechnologiesarebeingdeployedinfarming,theagriculturalsectorisnotconverging(yet)withanyother(althoughbiotechisapossiblecandidate).Thedriversofconvergenceare(1)acommon(0,1)baseforhandlingdiversetypesofinformation,includingwords,sounds,andimages;(2)widespreaduseofcommonstandards,whichallowsconnectivitybetweendiverseinformationdevices;and(3)theadvanceofenablingtechnologies,includingcomputers,datastorage,batteries,andwirelesscommunications.Theseforcesarepushingmultipleindustriestowarda“GrandConvergence”inafullydigitizedandintegratedswathoftheeconomythatencompassesbanking,computing,advertising,socialmedia,print,broadcast,camera,

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timekeeping,mapping,insurance,andeven,tosomeextent,education.Digitaltechnologieswillbenotjustastorefrontintheseindustriesbuttheirengine.Mobilewirelesswillintegratethesesectorsbyprovidingubiquitousandcontinuousconnectivitywithconsumersthroughdevicesthatwillgobeyondphonestoincludewearablesand,perhapsoneday,implants.Convergence-drivenecosystemshavedrasticallyenlargedthepartnershipnetworkswithwhichcompaniesmustengage.ARMisacompanythatprovidesaformofintellectualpropertyforthedesignofaprocessingunitthatisincorporatedbyitscustomersintotheirmicrochips,whichinturngointoelectronicdevicesinagrowingarrayofindustries(“verticals”)thatareaddingdigitalintelligencetotheequipmenttheyrelyon.InthewordsofARM’sCEO,SimonSegars:... Way back, our ecosystem was the semiconductor companies we were working with. We focused on working with our licensees.... Over time, we started working with more and more people up and down the supply chain. All that time we’ve been expanding that ecosystem as the use cases evolve and the range of the technology evolves. So we talk to more and more people, and when you get into IoT, there seems to be an almost limitless ecosystem you need to develop in these different verticals.20 ThedisastrouseffectsofafailuretoconnectwithecosystempartnersisdemonstratedbytheproblemsthataJapanesewirelesscarrier,NTTDocomo,hadwhenittriedtotakeitsdomesticsuccessoverseas.Docomo’si-modesystem,launchedin1999,becameoneofthefirstsuccessfulwirelessdataservices.Thei-modeservice,limitedbythe2Gcellulartechnologyofthetime,allowedkeypadphonestoaccessemailandcertainspeciallyredesignedwebpages.Italsoincludedasimplifiedversionofanappstorethroughwhichthirdpartiesprovidedi-modeuserswithpaidservicesandcontentandsharedtheprofitswithNTT.Althoughi-modewaswildlysuccessful—andprofitable—inJapan,effortstoexportitfailed.NTTinvestedheavilyinoverseaspartnershipswithfirmslikeAT&TWireless,butfailedtoconvincethemtoadopttheintegratedi-modebusinessmodel(Kushida,2011).NTTalsofacedanequipmentprobleminexportmarketsbecausetheJapanesecompaniesmakingi-modephoneshadnopresenceoutsideJapan,wherethewirelessstandardsatthetimewereincompatiblewiththoseofmostothercountries.NTThaddifficultyconvincingtheleadingnon-Japanesephonemanufacturers,particularlythen-dominantNokia,todevelopi-modecompatibledevices.Anotherelementoftheecosystem,i-modecompatiblecontent,wasalsoinshortsupply.In2002,NTT’spartnersintheUSandEuropebegantorollouti-mode-basedservices,buttheuptakebyconsumerswaspoorandDocomotookabigwrite-downonitsoverseasinvestments.Itwasnotuntil2007thatApplewouldcrackthewirelessdataecosystemchallengeoutsideJapan,inlargepartbyinternalizingthekeyelementsofhardwareandsoftwareandbyrelyingonstandardwebformatsratherthanrequiringspeciallydesignedcontent.Animportantcasedemonstratinghowdigitalconvergencecanimpactthenexusofprofitinand/oracrossindustriesiscameras.Kodakinventedamass-marketcamera(theBoxBrownie)intheearly1900sandrefineditsdesignsincrementallyoverdecadesasitmademostofitsmoneyfromsellingphotographicfilm.AlthoughaKodakengineerdemonstratedadigitalcameraprototypein1975,thecompany’sfilmbusinesswassoprofitablethatitonlyslowlyexploredthedigitalcameraopportunity,failingtorecognizethetechnology’sdisruptivepotential.ItcontinuedtoinvestinR&D,withresultsthatincludedthefirstmegapixelimagesensor.However,Kodak’smanagementhadnosenseofurgencyand

20Quotedin“ExecutiveInsight:SimonSegars,”June8,2016,http://semiengineering.com/executive-insight-simon-segars-2/

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digitalcameratechnologieswerecommercializedmosteffectivelybycompaniesotherthanKodak.Digitalcamerascametomarketinthe1990sandthereafterfollowedthesame“smaller,better,cheaper”trajectoryaspersonalcomputers.Inthe2000s,asKodakrespondedtothefaster-than-expecteddeclineofitsfilmbusinesswithentriesinthedigitalcameraandcolorprintermarkets,itlookedtoitspatentportfolioasasourceofadditionalrevenueandwasabletoearnmorethan$3billioninlicensingroyalties(Harris,2014).Bytheearly2010s,alltheworld’sleadingfilm-basedcameracompanieswereeitherindecline,or,inthecaseofbothKodakandPolaroid,bankrupt.CanonandNikon,whichwerebothalreadydiversifiedbeyondphotography,survivedascameravendorsbyretreatingtotheprofessionalandsemi-pronichemarkets.Kodakeventuallyattemptedtosellashareofitspatentsthathadbeenvaluedatwellover$1billion.Althoughotherdigitalpatentportfoliossoldaroundthistimeforfarmorethantheirinitialvaluations,Kodak’swentfor$94million,amerefractionofthepre-auctionestimate,inpartbecausethecompanywasclearlyteeteringontheedgeofbankruptcy(Harris,2014).TheKodakstoryclearlyshowsthedangerofunderestimatingtheriskofdigitaldisruption.Forreasonsmostlikelyassociatedwithmanagerialmyopia,Kodakwasslowtotakethedigitalthreattoitsfilmbusinessseriously,andthenwasslowtomonetizeitsintellectualproperty.Itwasalsoslowtorecognizethataconvergeddevice,thecamera-phone,wouldunderminethedigitalcameraandcolorprintermarkets.Inshort,timingremainsavitalelementofthePFItoolkit.Themusicindustrytellsasimilarstoryoffast-movingdisruption.Startinginthemid-1990s,musiccouldbedigitizedandcompressedbyconsumersusingaformalstandardthatwasillegallyreverseengineeredandspreadwidelywithoutcharge.Illegaldownloadingdevastatedrecordstores,musicalartists,andrecordlabels,whichwereslowtoofferlegalalternatives.AppleimprovedthesituationwiththeintroductionoftheiPod,followedbytheiTunesMusicStore,buttheabilitytobuyindividualsongsinsteadoffullalbumsshatteredtheoldbusinessmodelfortherecordindustry.Thesamedevastationwasvisitedonthemapindustry,oncedominatedbyRandMcNally,ShellOil,andNationalGeographic.MapsandroutingarenowprovidedfreebyGoogleandothers.Wirelesscommunicationsareatthecoreofthecurrentphaseofdigitalconvergence.Itisnotjustthatmobilephoneshaveevolvedfromfeaturephonestosmartphones(amergedmobilecommunicationandcomputingdevice),itisalsothatapplicationsaremovingtothecloud.Theconvergenceiscomingtogetherinthedatacenteraswellasinmobiledevices.Forexample,thevendingindustryisbeinganimatedbymobileapplicationsthatallowpaymentanddeliverybyUberdriversofitemsfromhigh-endautomatedvendingmachines,linkingtogetheraseriesofcloud-basedtransactionstoprovideconsumerconvenience.Asindustriesconvergearoundpowerfuldigitalplatforms,thedevelopmentandownershipand/orcontrolofcomplementaryassets/technologieswillbecentraltocompetitiveoutcomesandthedistributionofprofitsfrominnovation.