TUM Management Insights

IP Modularity: Profiting from open innovation through IP-oriented modularization

Firms seeking to take advantage of open innovation and outsourcing often face a tension between value creation and value capture. Openness facilitates distributed value creation, but may make it difficult to appropriate this value and thus profit from innovation. In an article published in the California Management Review, TUM professor Joachim Henkel and professors Carliss Y. Baldwin and Willy Shih from Harvard Business School introduce the concept of “IP modularity” to address this tension.

Success with an IP-modular product is illustrated by the case of Valve Software, which released the game “Half-Life” in 1998. Code for the game was divided into two modules: the source engine and the game code. Valve kept the source engine proprietary, but published the game code and granted users a broad license to modify and share it. Within eight months of release, users had built a modified game, “Counter-Strike,” which became hugely popular. However, to play Counter-Strike, players had to license the source engine from Valve, and thus Counter-Strike increased total demand for Valve’s product.

Established rationales for modularization are, among others, distributed development and production, component reuse, and platform strategies. The central idea of IP modularity is that innovators also need to take intellectual property (IP) aspects into account when designing modular systems. A system is “IP-modular” if its technical modular structure is aligned with its IP structure. In other words, parts of the system that shall be treated differently with respect to IP – e.g., be made public, kept secret, or licensed under certain conditions – constitute separate modules. By designing the modular structure in such a way that “open” and “proprietary” parts are clearly separated, innovators can reconcile distributed value creation and value capture.

The article defines what it means for a system to be “IP-modular,” illustrates the application of this concept in a number of practical situations, and presents a comprehensive framework that can be used to design and evaluate value capture strategies for modular systems.

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