Section 5.1. Styles of Innovation

Chapter 5. New Recombines with Old

WEB 2.0 MAY APPEAR TO BE SOMETHING NEW, DIFFERENT, AND INCOMPATIBLE with business platforms that came before. Although much of the point of this book has been to show that Web 2.0 is different, that difference doesn't mean that the old world halts and a new world begins.

Web 2.0 strategies can be a component of other business models. One common option is to build communities on the basis of existing products and brands. Another is to build relationships between up-and-coming firms with new technologies and older companies with experience in a field and a strong user base. Along the way, businesses can explore new relationships with their customers and with each other.

5.1. Styles of Innovation

Even before economist Joseph Schumpeter described innovation as the "creative winds of destruction" back in 1942, businesses have feared the dark side of innovation. New technologies disrupt the old order and destroy the comfortable relationships, profitable markets, and leadership positions that current companies—called industry incumbents—have successfully carved out for themselves through years of investment and infrastructure. Clayton Christensen's bestseller, The Innovator's Dilemma (HarperBusiness), reminded even high-tech winners that innovation comes in disruptive waves from emerging technology niches and ignored market segments, making today's heroes next year's zeros.

Using the disk drive as an example, Christensen defines disruptive innovation as a "sleeper" technology that poses an unanticipated threat to industry incumbents, as the new entrants initially satisfy only the requirements of a niche or an emerging low-performance, low-end market. Thus, established firms—even those that are quite capable of the new technology—are led to complacency and inertia by their own mainstream and premium customers, until it's too late.

Of course, that is not quite the story in digital and online networked technologies or in disruptive business models that change the way businesses make money and cover costs in an increasingly connected online, mobile "flat world."

• Amazon.com certainly did not start with low performance when it immediately attacked the mainstream mass market for books and quickly moved to a range of retail products and affiliate storefronts.

• Digital cameras started out more expensive than film cameras of similar performance but held out the promise to all recreational photographers of lower lifetime usage costs because film and development could be replaced by digital images, distribution, sharing, and storage.

• Skype and peer-to-peer (p2p) architecture for Voice over Internet Protocol (VoIP) offered free basic or low-end service, but they targeted and reached a global mainstream and business market through viral marketing and distribution (allowing users themselves to be the routing hub for their international calling rolodex).

For the purposes of this chapter, we will start with a simplified 2 x 2 innovation typology, shown in Figure 5-1, that positions disruptive innovation (or, as it used to be called, "revolutionary innovation") along the axes of old-new markets and old-new technologies.

Figure 5-1. Categorizing different kinds of innovations

Clearly, new technologies that capture old or existing mainstream markets are disruptive—a bit like revolutionaries who turn the entire population against the old order. But for the mainstream market to move wholesale to a new way of doing things, a large population must believe that it's worth switching—and that the basis of competition and of how people are measuring and comparing value has changed.

It's easy to place incremental innovation and radical innovation in this matrix. Incremental innovation is old technology in old markets; radical innovation is new technology in new or emerging markets. Finally, we have architectural innovation, old technologies in new markets, recombining and repackaging existing technologies within redesigned system and product architectures to reach new market segments and niches. Scholars have used these terms for decades to categorize the kinds of technological innovations that cause shifts in the competitive landscape and the relative profitability and market share of incumbent firms compared with new entrants.

Of course, whether one views these innovations as "world-saving" or "creative destruction" depends on where she sits. Specifically, if any of these kinds of innovation or technologies is competence-enhancing and increases the value of the organizational and intellectual assets a company already has in-house, she is likely to be a cheerleader. However, if one of these technologies is competence-destroying and destroys the value of the organizational and intellectual assets a company possesses, she is likely to be a defender and will do her best to eliminate, strong-arm, or legally wipe out these threats. This is the typical zero-sum, win-loss battle between the incumbents, who have a lot at stake, and the new entrants, who have everything to gain.

However, Web 2.0 and its particular brand of collaborative, digital, and online networked/interactive user-led innovation doesn't fit neatly into this conventional 2 x 2 competitive innovation matrix. That isn't surprising, as these innovation categories were coined to describe technological breakthrough innovations in the physical world of disk drives, semiconductors, steel mini-mills, photolithography equipment, and manufacturing processes. In the following sections, we'll discuss some newer categories of online digital networked collaborative innovation that are breeding disruptive business models in high- and low-tech industries.

5.1.1. Competitive or Collaborative Innovation?

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.

5.1.2. Styles of Collaborative Innovation

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

• Crowds of users, called user-led or democratized innovation.

• Dissimilar companies, called recombinant innovation.

• Crowds collaborating to solve problems for companies, called crowdsourcing.

• Companies that provide new platforms on which innovation communities and ecosystems can form, including open source, ecosystem, and platform innovation. This yields a number of different paths for innovation, as shown in Figure 5-3.

Figure 5-3. Types of online collaborative innovation

5.1.3. Democratized 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:

Creation is unbelievably addictive. And programming, at least for skilled programmers, is highly creative.... Community standards encourage deep understanding.... For many, a free software project is the only context in which they can write a program that expresses their own vision, rather than implementing someone else's design or hacking together something that the marketing department insists on.... Unlike architecture, the expressive component of a program is inaccessible to non-programmers. A close analogy is to appreciate the artistic expression of a novel when you don't know the language in which it is written...this means that creative programmers want to associate with one another: only their peers are able to truly appreciate their art...it's also important that people want to share the beauty of what they have found....

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

5.1.4. Crowdsourcing Innovation

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:

• R&D knowledge production in company and academic labs focused on basic research or applied research

• Learning-by-doing, involving lead users and communities of practice

• Integrative or coordinative knowledge including standards and platforms

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:

• Accelerating relevant "knowledge production" (on where to dig for gold) by world-class experts at a relatively low fixed cost (total prize money was $575,000).

• Incentivizing "collective production of knowledge" by making its company-proprietary (but raw) data sets available to download for the contest, while maintaining sole rights to mine and exploit the knowledge generated about target sites.

• Capturing knowledge spillover and cumulative learning across a range of disciplines by reviewing, judging, and evaluating the diversity of approaches and then testing the target sites.

• Monetizing the winning models immediately by exploring the mining targets and paying, publicizing, and promoting the contest winners.

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."

5.1.5. Open Source, Ecosystem, and Platform Innovation

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."

5.1.6. Online Recombinant Innovation

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.

5.1.7. Bridging, Not Disrupting

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.