A few industries—media, telecom, and banking, among others—seem to stay above the competitive fray. Initially, these industries were well protected from the turbulence of emerging technologies, pure-play competitive startups, and global new entrants. Governmental regulations, high barriers to entry through committed investments in irreplaceable and costly infrastructure, complex contracting structures, and relationships combined with strong and enforceable property rights had, to this point, insulated them against the changing landscape.

Yet in erecting walls against all possible disruptors and competitors, while assuming away the option to become network partners and ecosystem allies, the companies in these protected and highly regulated industries may have been mistaking the good Dr. Jekyll for the evil Mr. Hyde.

In the early 1980s, during the advent of videocassette recorders, the movie studios fought major legal battles to try and stop home recording and video rentals. So, at first, studios priced their movies so that rental stores could afford to buy only a few copies, disappointing many customers who wanted new and popular releases. Of course, with the high video prices and artificial scarcity of video rentals, “cannibalism,” or eating into live-at-the-theater big-screen profits, was reduced. It took 15 years to see that the actual outcome of the new videocassette recorder technology was to enormously expand the entire market. In 1980, industry revenues from both big screen and video were $2.4 billion, by 1995, the market was $12.3 billion, with home video rentals bringing in $7 billion.

Figure 5-2 shows the multiple revenue streams and network effects that are now possible for movie studios with online and digital distribution. The challenge for the movie studios has changed from creating blockbuster movies and distributing them through a limited physical channel of distribution—the movie theater—toward more effective monetization and value capture of the expanded digital distribution market in cable pay-per-view, DVDs and rentals, network TV, video games, music soundtracks, and other potential syndication, licensing, and remixing opportunities.

Figure 5-2. Value chains deriving from a movie

Another example comes from e-commerce. It would be easy to see offline independent and chain bookstores as strict competitors of online booksellers like Amazon. However, just like the video story, sales in one domain seem to produce a “lift” in the other, and vice versa. The key to Netflix, Flickr, Amazon, and other online companies is that the sales of offline physical products can get online “buzz.” These online sales, referrals, rankings, and reviews enjoy a wider and more targeted word-of-mouth marketing, creating a chain reaction or critical mass of adoption and social influence.

Even when industry leaders recognize a potential network partner or ecosystem player, they will sometimes turn down the opportunity in order to protect their own cash cows or maintain control of their “walled garden.” In the financial world, this could be one of the explanations for why, of all the major retail banking centers in the world, only Japan had a different magnetic strip on its credit cards that made the cards usable only at Japanese ATMs. It certainly seems to have been why Citibank, the first bank to introduce and invest in the ATM infrastructure back in 1977, waited until 1991 to allow its ATM cards to work on other banks’ ATM networks. A simple analysis of indirect network effects would have shown that everyone’s ATM cards are more valuable when they work on all machines.

At least some of the explanation of Europe’s surprisingly strong recent economic health comes from both the European Union and the euro with its integration and positive network effects compared with the once-independent currencies and fragmented markets of the European nations.

PayPal’s person-to-person online payment system, piggybacking on the hypergrowth and the success of eBay’s online auction transactions, was viewed as a startup competitor rather than a potential ally by the major banks that wanted to protect their finely tuned and highly profitable SWIFT cross-border and inter-bank system for wire transfer of funds. (Several of them tried to develop their own person-to-person online payment systems.) PayPal’s system never reached a critical mass of networked online users because it lacked the visibility and daily volume of n-sided market transactions of an online partner like eBay. Not surprisingly, eBay acquired PayPal in 2002, listening to its customers who preferred it over eBay’s homegrown system.

The key is that allies and ecosystems can join forces in expanding and opening up markets to create a win-win situation. Competitors and a competitive perspective on innovation tend to divide markets and leave a lot of potential expanded network-effects value and opportunities on the table.

In the new-style online collaborative innovation, the entire perspective of innovation changes. We move away from a situation in which new and old companies compete in an industry for competitive advantage in capturing new and old markets using different kinds of innovative technologies. Instead, we have big and small companies whose users collaborate, often across industry boundaries, in innovative ways. So, the fundamental axes of the collaborative innovation matrix are different from those of the competitive innovation matrix.

The styles of collaborative innovation are distinguished by whether the collaborative interaction is between

Figure 5-3. Types of online collaborative innovation

Eric von Hippel’s book Democratizing Innovation (The MIT Press) observes that lead users often develop and modify products for themselves and freely reveal what they have done so that others can adopt the developed solutions. He calls the trend toward these primarily user-centered innovation systems the “democratization of innovation.”

As open source software projects show, horizontal or peer-to-peer innovation communities, consisting entirely of users, can function as self-organizing and regulating entities without manufacturer or corporate involvement. So, the keys to democratized innovation in the online collaborative world are the wide distribution, ease and low cost of tools for innovation, combined with the tools for interaction and communication. Peer interaction and recognition between users catalyze innovation, personal expression, and creativity. The Linux open source community is a good example, says Chris Hanson in Democratizing Innovation:

Web 2.0 technologies such as RSS, wikis, podcasting, and social networks increase the intensity, frequency, and ease of online collaboration and community-building.

Crowdsourcing or crowdcatching is a problem-solving and idea-generating process in which a company throws out a well-specified problem to a selected crowd or group of people for solution. Some well-known crowdcasts are in the form of competitions—prizes are used as an incentive, and the “winning” solutions are chosen by a set of judges. It provides a focal point for the “wisdom of the crowd” to emerge from unexpected and interdisciplinary sources and individuals.

Let’s start with a simple framework used by economists for analyzing knowledge as an economic good and apply it to the recent case of Goldcorp, a company in the “old-economy” mining industry. Rob McEwen had become the CEO of Goldcorp, a low-yield Canadian gold-mining operation, when the gold market was depressed, operating costs were high, and the miners were on strike. “Mining is one of humanity’s oldest industrial pursuits. This is old old economy. But a mineral discovery is like a technological discovery. There’s the same rapid creation of wealth as rising expectations improve profitability. If we could find gold faster, we could really improve the value of the company.”

McEwen realized that if he could speed up the “knowledge production” process—to find new ideas about where to dig for high-grade ore on his property faster—he could turn around his failing company. Most companies use three conventional forms of knowledge production:

McEwen needed results fast. He recalls that his “eureka” moment came as a result of a seminar at MIT in 1999, where he first heard about the impact of the Linux operating system and the open source revolution. Here was an unconventional and revolutionary approach to speeding up the “knowledge production” process without costly long investment cycles or big, risky bets. “I said, ‘Open source code! That’s what I want.’” After all, if Linux could attract world-class programmers to help make better software, maybe Goldcorp could attract world-class geologists to help find gold. McEwen issued the Goldcorp Challenge in March 2000—Goldcorp revealed all of its geological data regarding their Red Lake gold mine online, asking geologists to tell them where to find 6 million ounces of gold. The prize money totaled $575,000; the top award was $105,000.

More than 1,400 virtual “prospectors” joined the Goldcorp gold rush and downloaded company data. Like alchemists, many of the final contest winners turned Goldcorp’s raw information and data into actionable knowledge about where to dig for gold. McEwen says that the contest was a major success: “We have drilled four of the winners’ top five targets and have hit on all four.” Additionally, the discoveries have been high-grade and high-yielding ore deposits. “But what’s really important is that from a remote site, the winners were able to analyze a database and generate targets without ever visiting the property. It’s clear that this is part of the future.” Making the data available for download on the Web, allowed scientists, engineers, and geologists from 50 countries to participate, and the panel of 5 judges could evaluate and compare the creative approaches and targets of an astonishingly diverse set of submissions.

The numbers speak for themselves. In 1996, the Goldcorp Red Lake mine was producing at an annual rate of 53,000 ounces at a cost of $360 an ounce. After the contest and some modernizing in 2001, the mine was producing 504,000 ounces, about 10 times more, at a cost of $59 an ounce. With gold prices at $307 an ounce, that’s like $248 in profit per ounce rather than a $53 loss per ounce.

The mining industry as a whole has benefited. As Michael Polanyi pointed out in his book Personal Knowledge: Towards a Post-Critical Philosophy, personal knowledge or “tacit” knowledge such as riding a bike, scoring soccer goals, or intuiting where to dig in 55,000 acres of Red Lake property is usually hard to transfer or reproduce. But any of us can make the effort to deliberately share and transfer this kind of knowledge and skills to others by “codifying” it in a formula, script, program, model, expert system, demonstration, or recording.

The problem comes when the inventor or idea originator wants to get paid. Once knowledge is produced and codified, as in a mathematical formula or digital code on the Web or video, it becomes fluid (an economic good that is difficult for the creator to control privately), “infinitely expansible” (like the Energizer bunny, it doesn’t get depleted by usage), and cumulative—leading to a combinatorial explosion of social and public goods. This benefits many individuals and companies through knowledge “spillover,” but it may or may not result in profit or payment to the sponsoring company or to the generators of the idea and the knowledge. Thus the term “externality” applies when an economic good produces positive or negative effects (value or noise) that cannot be captured or “internalized.”

An online contest can turn out to be an unexpected solution to the externality problem. According to Ronald Coase in his article “The Problem of Social Cost,” in the Journal of Law and Economics, and explained in Dominique Foray’s The Economics of Knowledge (The MIT Press), the size of the externality can be reduced by expanding the area in which knowledge is voluntarily shared. So, the collective production of knowledge in technology consortiums, multicompany research centers, and R&D agreements can be used to “internalize externalities.” Before the Web, coordination and organization costs made a very large number of knowledge-sharing partners infeasible.

The Goldcorp contest was well organized to allow the company to immediately judge the value and quality of the submitted ideas and mining targets and then pay the contest winners a fixed amount for their contribution. In economic terms, this provided a fixed incentive for the contest participants as well as a way for Goldcorp to internalize or monetize the virtual gold rush through actual mining operations.

In the Goldcorp Challenge, the top contest winner was a partnership of two Australian groups (Fractal Graphics and Taylor Wall & Associates) that developed a powerful 3-D graphical model of the mine. Winning the prize gave publicity to the firms’ competence in 3-D models of mines, and according to Nick Archibald at Fractal Graphics, the industry now has a new way of doing exploration. “This has been a big change for mining. This has been like a beacon in a sea of darkness.”

In short, Goldcorp struck gold on the Web by:

The web sites of the Innovation Challenge, World Bank Development Marketplace, X PRIZE Foundation, Goldcorp Challenge, Bayer Material Science Prize, Netflix Prize, Ansari X PRIZE, Innocentive, and Red Hat Challenge illustrate the range of companies, industries, and technologies experimenting with crowdsourcing innovation.

It doesn’t even require a well-publicized contest. The blog Billions With Zero Knowledge (http://www.billionswithzeroknowledge.com/) uses the T-shirt company Threadless as an example of creative design-intensive community production that seems to be much more powerful and innovative than just “crowd-sourced manufacturing.”

Companies have adapted to user-centered innovation in different ways. Several authors have described how companies have innovated by providing platforms from which externally generated innovations can result, and where users—as well as ecosystems of affiliates, third-party developers, and service providers—can form innovative communities.

After reviewing some definitions and examples, we’ll discuss a more recent and wildly popular platform innovation: Apple’s iPod and the ecosystems that have developed around it. Although the iPod does not use a Web 2.0 business model, it illustrates how companies can capture and multiply network value from ecosystems and passionate, loyal users.

Steve Weber’s The Success of Open Source (Harvard University Press) explores how open source catalyzes innovation and enlarges the scope and scale of knowledge domains because “property in open source is configured fundamentally around the right to distribute, not the right to exclude.” He echoes Larry Lessig’s well-known argument that a “commons” functions as a “feedstock for economic innovation and creative activity.” But he adds a more nuanced innovation benefit: the importance of DIY participation in creative activity by individual users, simply for the sake and value of the individual or community creative act—even if this participation is not immediately measurable as an increase in knowledge stocks or directly related to a breakthrough innovation.

Marco Iansiti and Roy Levien’s The Keystone Advantage (Harvard Business School Press) argues that the very best companies are “keystones” or orchestrators of their ecosystem or “value network”—their large and distributed network of partner companies and customers. They use the examples of Wal-Mart, Microsoft, and Li & Fung to show how keystone companies provide “platforms” that other firms and users can leverage to spur innovation.

Geoff Moore, the best-selling author of Crossing the Chasm and recently Dealing with Darwin: How Great Companies Innovate at Every Phase of Their Evolution (Portfolio Hardcover), coined the term platform innovation. In his blog (http://geoffmoore.blogs.com/), he refers to Intel’s shift from microprocessor products to all-purpose mobile computing and communications platforms and devices as a good example of platform innovation. The key is to leverage a potentially ubiquitous product or device into a market-making, online distribution platform and channel.

The biggest challenge to companies innovating in this area is to convert from an engrained culture of competition to the collaborative culture necessary for creating trusting relationships and developing myriads of new partners and ecosystems. It’s not easy for a company like Intel—whose chairman and former CEO Andy Grove wrote a book titled Only the Paranoid Survive (Currency) and rose to power as a take-no-prisoners competitor—to turn around and preach “Give to get.”

The recombinant DNA techniques discovered in 1973 founded genetic engineering and sparked a biotechnology revolution. Recombinant DNA emerges from new combinations of DNA molecules that are not found together naturally and are derived from different biological sources. In an analogous way, innovation that shows recombination or new combinations of different companies’ technologies, processes, systems, and business models can be termed recombinant innovation to differentiate it from innovation that comes from only one company and source.

Rather than rebelling against or completely disrupting the old business order and replacing the infrastructure that took decades of development and investment, the new click-and-mortar, online-offline network partnerships are recombinant business model innovations. They focus on building new networks and business models based on collective user value and hypergrowth social network opportunities.

To create the iPod, Apple first assembled a production ecosystem—a group of companies all over the world that contributed to circuit design, chipsets, the hard drive, screens, the plastic shell, and other technologies, as well as assembly of the final device.

Although many people still think of the manufacturing process as the key place to capture added value, the iPod demonstrates that Apple—the creator, brand name, and orchestrator—has actually figured out how to capture the lion’s share of the value: 30%. The rest of the value is spread across a myriad of different contributions within the network of component providers and assemblers, none of them larger than 15%. Researchers, sponsored by the Sloan Foundation, developed an analytical framework for quantitatively calculating who captures the value from a successful global outsourced innovation like Apple’s iPod.

Their study (http://pcic.merage.uci.edu/papers/2007/AppleiPod.pdf) traced the 451 parts that go into the iPod. Attributing cost and value-capture to different companies and their home countries is relatively complex, as the iPod and its components—like many other products—are made in several countries by dozens of companies, with each stage of production contributing a different amount to the final value.

It turns out that $163 of the iPod’s $299 retail value is captured by American companies and workers, with $75 to distribution and retail, $80 to Apple, and $8 to various domestic component makers. Japan contributes about $26 of value added, Korea less than $1, and the final assembly in China adds somewhat less than $4 a unit. (The study’s purpose was to demonstrate that trade statistics can be misleading, as the U.S.-China trade deficit increases by $150—the factory cost—for every 30 GB video iPod unit, although the actual value added by assembly in China is a few dollars at most.)

Suppliers throughout the manufacturing chain benefit from sales of the product and may thrive as a result, but the main value of the iPod goes to its creator, Apple. As Hal Varian commented in the New York Times:^[32]

The iPod is also part of an ecosystem and contributes to the indirect network effects of Apple’s other key product: Macintosh computers. Even though iPods, and the iTunes software that supports them, were originally compatible with Macs only, the cachet of the iPod has continued to help sell Macs even after the iPod developed Windows support.

Beyond the iPod and iTunes, Apple’s creative and media ecosystem includes software such as iMovie, iDVD, Aperture, Final Cut, GarageBand, and QuickTime (a key technology for the video iPods). These are all Apple products, but many other companies also provide software and hardware for this space, notably Adobe and Quark.

As any visit to the local electronics (or even office supply) store will show, the iPod has inspired a blizzard of accessories. Bose, Monster Cable, Griffin Technologies, Belkin, and a wide variety of technology and audio companies provide iPod-specific devices, from chargers to speakers. Similarly, iPod fashion has brought designers, such as Kate Spade, into the market for iPod cases, along with an army of lesser-known contributors. Also, automobile companies and car audio system makers are adding iPod connectors, simplifying the task of connecting iPods to car stereo systems.

iPod accessories are a $1 billion business. In 2005, Apple sold 32 million iPods, or one every second. And for every $3 spent on an iPod, at least $1 is spent on an accessory, estimates NPD Group analyst Steve Baker. That means customers make three or four additional purchases per iPod.

Accessory makers are happy to sell their products, of course, but this ecosystem also supports retailers, which get a higher profit margin on the accessories than on the iPod (50% rather than 25%). It also reinforces the value of the iPod itself because the 2,000 different add-ons made exclusively for the iPod motivate customers to personalize their iPods. This sends a strong signal that the iPod is “way cooler” than other players offered by Creative and Toshiba, for which there are fewer accessories. The number of accessories is doubling each year, and that’s not including the docking stations that are available in a growing number of cars.

Most industry participants were surprised by the strength and growth of the accessory market. Although earlier products such as Disney’s Mickey Mouse or Mattel’s Barbie supported their own huge market for accessories, those were made by the company that created the original product or by its licensors. Apple has taken a very different path, encouraging a free-for-all; it accepts that its own share of the accessories market is small, knowing that the iPod market is growing.

Even before the iTunes music store opened, users who ripped their CDs to digital files in iTunes got more than just the contents of the CD. Most CDs contain only the music data, not information like song titles. Entering titles for a large library of music can be an enormous task, and users shouldn’t have to do it for every album.

This problem had been solved earlier by Gracenote, which is best known for its CDDB (CD database) technology. Every album has slightly different track lengths, and the set of lengths on a particular album is almost always unique. So, by combining that identification information with song titles entered by users only when they encountered a previously unknown CD, Gracenote made it much easier for users to digitize their library of CDs.

Rather than reinventing the wheel, Apple simply connected iTunes to CDDB, incorporating the same key feature that made CDDB work in the first place: user input. Whenever a user put in a CD that hadn’t previously been cataloged, iTunes would ask that user if he wanted to share the catalog.

Apple has no exclusive rights to CDDB, but it benefits from its existence nonetheless. Users get a much simpler process for moving their library to digital format, and contributing to CDDB requires only a decision, not any extra work.

The music industry is perhaps the most difficult ecosystem the iPod has to deal with—and the most frequently discussed. The music industry has dealt with the Web and the Internet broadly as a threat rather than an opportunity, as it saw its profits disappearing when the transaction costs of sharing music dropped precipitously. So, how did Steve Jobs get the record labels—which had been suing Napster and Kazaa—to sign up for the iTunes store to offer online, downloaded music?

Apple presented its proposal to the big four music companies—Universal, Sony BMG, EMI, and Warner—as a manageable risk. Apple’s control of the iPod gave it the tools it needed to create enough digital rights management (DRM)—limiting music to five computers—to convince the companies that this was a brighter opportunity for them than the completely open MP3 files that users created when they imported music from CDs. Jobs was actually able to leverage Apple’s small market share into a promising position:^[33]

Apple also played a key role in coordinating the pricing of songs among the big four music companies—99 cents a tune. This was a major step in weaning the music companies away from their high-priced retail distribution of prepackaged bundled digital goods— CDs—toward a digital distribution channel with a per-user/per-song revenue structure and potentially strong social-network effects. Downloads were also carefully priced to incentivize users who preferred having legal downloads and who trusted Apple and Steve Jobs to keep the price at that level despite the protests of the music labels.

After 18 months of negotiations, Apple was able to get started on its own platform, and later carry the DRM strategy to Windows. (One pleasant side effect for Apple of the DRM deal with the music companies is that it is difficult for Apple to license that DRM technology, preserving Apple’s monopoly there.)

Apple provided the music companies with a revenue stream built on an approach that would let them compete with pirated music, although the companies aren’t entirely excited about adapting to song-by-song models and the new distribution channels. However, EMI’s decision in April 2007 to start selling premium versions of its music without DRM—still through the iTunes store but also through other sellers—suggests that there is more to come in this developing relationship. Ecosystems evolve, and business ecosystems often evolve beyond their creators’ vision.

The Jajah calling experience is so convenient that 2 million users signed up for Jajah the first year, twice as many as Skype in its first year. There are more than 4 million users now worldwide. No special headset or phone equipment is required, and users are not tied to their computers or laptops. If you’re a frequent business traveler, you may have had the somewhat awkward experience of trying to have a Skype PC-to-PC call enroute to your gate while balancing your laptop on your carry-on luggage or a tiny telephone shelf. Like Flickr and other Web 2.0 companies, active, frequent users and independent bloggers created a critical mass and triggered a bandwagon effect. Interestingly enough, doing so little of its own marketing and advertising gave Jajah enormous credibility with users, both in the U.S. and overseas.

Jajah offers free calling between Jajah users. This provides a clear incentive for viral marketing—and encourages new users to bring their whole rolodex of friends on to the system. Soon IM (instant messenger) “buddy lists” will join as well.

Most frequently, a user will visit the company’s web site at http://www.jajah.com and schedule a Jajah call online, as shown in Figure 5-6. In a few minutes, or at the scheduled time, the user will receive a phone call on her phone or cell phone. When she picks up, a voice will greet her and inform her that Jajah is connecting her call. The caller should then hear the destination phone start to ring. During this call-ringing wait time, she may hear an ad message. As soon as the party at the other end picks up, the call is connected—for free if the destination phone is a Jajah user; for a minimal local charge if the destination phone is located in any of the 27 countries Jajah serves.

Figure 5-6. Scheduling a call using Jajah’s web interface

The web page also provides three-way calling, web-conferencing services, and the Jajah Direct feature. Blackberry and mobile phone users with Internet/broadband connections can call long distance and access Jajah phone services directly from their phones. Jajah also offers business services for operations like call centers.

Rather than promising to turn the telecom world upside down, Jajah worked together with large industry players that had already invested huge amounts in infrastructure, ecosystems, and customer relationships. This nonthreatening co-opetition approach avoids the backlash that occurs when entrenched or incumbent interests feel threatened by industry turbulence and disruptive technology.

Like with Apple and the major music labels, Jajah generates a new source of revenue for local carriers, rather than threatening to cut them out of the loop entirely, as Skype threatened to do. Deutsche Telekom, the owner of T-Mobile, has even invested capital in Jajah to grow and expand its Voice 2.0 services, along with Intel Capital.