2. The Pricing and Profitability of Modular Clusters Carliss Y. Baldwin Modularity Mini-Conference London Business School October 2, 2003

3. Slide 2 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 This is an emergent modular cluster

4. Slide 3 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 Another View Showing Dramatic Increases in Aggregate Market Value even as the Number of Firms Grows

5. Slide 4 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 Can it last?  Chandler-Abernathy-Utterback-Klepper theory of industry evolution says “no”  Predictions of consolidation have occurred in every downturn since 1980 –Larry Ellison of Oracle in 2003  Is the Modular Cluster form of industrial organization sustainable as a long-term equilibrium? –Pricing holds the key –If firms kill each other in product markets, consolidation will occur

6. Slide 5 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 Quick review of price theory  Price competition among imperfect substitutes –Prices go down as number of firms goes up –Cournot quantities, Hotelling beach…  Vertical price externality among complements –Prices go up as number of firms in a vertical supply chain or a system of complements goes up –“Double marginalization”—Intuition

7. Slide 6 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 Yes How? Read the paper! Executive Summary Can imperfect price competition and the vertical pricing externality offset one another in a large cluster?

8. Slide 7 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 Our Thought Experiment  Beach resort vacation –Travel, hotel, restaurants, sports, tours, taxis… –Equipment supply, laundry, maid service, furniture, food wholesale… –Hospital, police, roads, buildings, electricity…  Large number of primitive production components— –All essential to the system –Many variants of each

9. Slide 8 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 Our Thought Experiment  Symmetric modular partitions  Divide the complements and variants up in different ways –1x1 = One Big Firm –Jx1 = J Module Monopolies –1xN = N Full-span Oligopolies –JxN = N firms competing in J module markets

10. Slide 9 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 Our Thought Experiment  Our model aims to look at an unlimited number of alternate “configurations”

11. Slide 10 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 The Key Assumption  The representative firm perceives its demand function to be: q i =  i (p i ; …) Q[P(p i ; …)] where p i is its own price.   i (p i ; …) is “market share” and depends on the prices in its “own market”.  Q[P(p i ; …)] is “system demand” and depends on the average prices of goods in the other “module markets”.  This decomposition makes analysis of symmetric JxN clusters feasible. Otherwise, combinatorial explosion!

12. Slide 11 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 The “array of configurations”  We solve for the pricing equilibrium in each cell and compute aggregate profit

13. Slide 12 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 Results—Prices  Along the edges of the array

14. Slide 13 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 Results—Aggregate Profit  Along the edges of the array

15. Slide 14 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 Results—Prices  Full array

16. Slide 15 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 Results—Aggregate Profit  Full array, reverse view—Note “sweet spots”

17. Slide 16 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 Implications for strategy  Cluster form is sustainable in theory  Financiers’ payoff vs. a firm’s payoff  Disintegration can pay…  Financiers can use M&A to approach the industry sweet spot, but…  Can a decentralized cluster find the pricing equilibrium at the sweet spot?

18. Slide 17 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003 Further implications for strategy  Two kinds of clusters –“Federated” clusters: all modules compatible –“Portal” clusters: Platform firms with captive module complementary module suppliers –Both appear to exist in the real world  Portal clusters price as 1xN, need small numbers  Can a cluster evolve from “portal” to “federated” by increasing the technical compatibility amongst modules?

19. Thank you!