Innovation Process in Transition (2) – 22.04.2014

1. Innovation Process in Transition (2) – 22.04.2014 Dr. Hans Schaffers Director of Research, Centre for Knowledge and Innovation Research (CKIR), Aalto School of Business E-mail: hans.schaffers@aalto.fi

2. New forms and dynamics of disruptive innovation Dr. Hans Schaffers Director of Research, Centre for Knowledge and Innovation Research (CKIR), Aalto School of Business E-mail: hans.schaffers@aalto.fi

3. Goal: understanding new forms and dynamics of disruptive innovation and strategic implications Analysis of the innovation process, in particular the phenomenon of disruptive innovation. Some cases will help to understand better the process and context. Simple theoretical framework of disruptive innovation. The context of innovation: network markets and the forces shaping or affecting it. Network market phenomena such as lock in, positive feedback, strategic collaboration and other. We then look into strategies for network markets: collaboration and openness, compatibility How are these strategies relevant for innovation strategies.

4. Background literature C.M. Christensen and M.E. Raynor: The Innovator’s Solution, Harvard Business School Press, 2003 C. M. Christensen: The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail. Harvard Business School Press 1997 C. M. Christensen (a.o.), Disruptive Innovation for Social Change. Harvard Business Review. H. Chesbrough: Open Business Models, Harvard Business School Press, 2006 H.R. Varian, C. Shapiro: Information Rules. A Guide to the Network Economy. Harvard Business School Press, 1999. http://mbauninorte.files.wordpress.com/2009/08/information-rules.pdf

5. Logic of today’s course Phenomenon of disruptiveinnovation • Sustaining and disruptive innovation Disruptiveness and networkeconomies • Networkeffects and positive feedback • Lock-in • Networkstrategies • Platform economics (6th May) Management of innovation • Implications for innovation process and • Innovation management

6. Some key concepts in analysing innovation systems • Competitive forces and industry competition (Porter) • Analysing the attractiveness of an industry • Positioning within an industry (generic strategies: cost, differentiation) • Value chain model and strategy (Porter) • Value chain analysis and Identifying competitive advantage • Strategy development for exploiting advantages • National Innovation Systems: ‘diamond’ framework (Porter) • Sources of national advantages • Factor conditions, demand conditions, industry networks, strategies • Network effects and network markets (Varian / Shapiro) • Implications of network effects for strategies in network markets • Innovations and disruptive technologies (Christensen) • Disruptiveness vs sustainable technologies

7. Disruptive innovation (Christensen)

8. Examples of disruptiveness • These innovationschange business models and ways of life • Disruptiveinnovation – disruptive entrepreneurs – (Eric Ries, “The LeanStartup”; Eric von Hippel, “Democratizing Innovation”) • Tools to facilitatedemocraticinnovation: Open Data, 3D-printing, Open Source, … Personal computer Canon photocopiers Amazon.com Facebook Embedded sensors Google Mapsnavigation service Apple’siTunes digital music Tesla 3D printing Computationalbiology Autonomousvehicles

9. Big Bang disruption? Christensen’s view on disruptive innovation emphasizes the role of low-cost products or services to undermine existing markets; but incumbents still have opportunities to respond Does this view still hold when innovation is widespread / democratic, when the pace of renewal increases dramatically, and when business models have changed? • “Big Bang Disruption” promoted by Downes / Nunes, 2014 • Disruptors use different types of business models (e.g. Google’s free navigation service) Balanced view is needed looking at innovation’s reality Disruptors sometimes are one-hit and short lived What can be said is that a higher level of awareness of change is necessary

10. Disruptive innovation impacts the innovation ecosystem – and vice versa Disruptive innovation impacts the value network, the value created by the innovation ecosystem, the revenue model Disruption of the existing innovation ecosystem is followed by reconfiguration of the innovation ecosystem • Type and number of actors, entry of new actors / suppliers • Collaborative network • “Platform” changes, multisidedness of markets etc. Innovation ecosystems orchestration provides the conditions for innovation and disruptiveness • Innovation policies at city, region, national and EU level

11. Basic ideas disruptive innovation Objective • Analysis of innovation forces that influence industries • Develop a tool or framework to identify and understand the signals that unveil industry direction • Connection between network markets - innovation forces to better understand the impacts Messages • A framework is needed to understand industry changes through innovation forces, predict technologies with high potential of disruption • Importance of government policy in shaping opportunities (e.g. legal issues, competition policies) • Disruptive technologies are around but must overcome barriers (e.g. spectrum limitations, regulations, …)

12. Innovations undermining existing industry structure • In the past, innovation and change primarily in the voice telephony market (until deregulation a regulated monopoly controlled by AT&T) • Intensive deregulation in 1990s • New set of core technologies incubated in the data enterprise market is shaping new forces of change • LAN: simpler, more flexible enabled by IP en Ethernet standards resulted in innovations (multi-protocol router), disrupting a series of highly reliable but rigid incumbent technologies and accelerated the any-to-any networking paradigm • Voice over IP: enabling convergence (voice, video, data) • Convergence and decoupling of services from transport leads to Any-to-any computing paradigm

13. “Innovation failures” concept • Companies failing when confronted with disruptive technologies, even or because of their market orientation: sound decisions can lead to failures • There are situations when it is right not to listen to customers, invest in lower performance products that have lower margins etc • Difference between sustaining technologies and disruptive technologies

14. Disruptive and sustaining technologies • Sustaining technologies: • Foster improved product performance • Some can be radical / discontinuous, some incremental • Have sustaining technologies precipitated the failure of industries? • Disruptive technologies • Driver: “overshooting” the needs of mainstream customers • Result in worse product performance • Often precipitate leading firms’ failure • Bring to the market a very different value proposition • Underperform established products in mainstream markets • Cheaper, simpler, smaller, more convenient to use • Examples: PC, discount retailing, small motorcycles, transistors ... • Disruptiveness is relative: Internet retailing is disruptive for bricks-mortar retailers, but not disruptive for catalogue retailers

15. Technology and market demand • Technologies can progress faster than mainstream market demand is able to “absorb” • Suppliers often ‘overshoot’ the market • Microsoft Office cannot change the behaviour of business processes quickly enough to utilise all the enhancements (perhaps 5 % is used): thus an opportunity for simpler, cheaper, more flexible technology is created. • Customers question the value of “improvements” • Disruptive technologies that may under-perform today, relative to market demand (targeting low cost business models), may be fully performing / competitive tomorrow • Example: Mainframe versus PC, PC originally a ‘toy’ for mainstream users, then valuing ease of use instead of expert use

16. Impact of sustaining and disruptive technological change Progress due to sustaining technologies (incumbent innovators) Product performance Performance demanded at the high end (most demanding) of the market Most demanding customer absorption Average customer Least demanding customer Progress due to sustaining technologies Performance demanded at the low end (least demanding) of the market Disruptive technological innovation Disruptive Ideas Time Technologies can progress faster than market demand is able to absorb

17. Two types of disruption • Low-end disruption: address overserved customers with a lower cost business model • New-market disruption: create new value network, compete with non-consumption (e.g. PC, transistor pocket radio)

18. Disruptive litmus test, details 1. Does growth opportunity (niche market) exist? • New or unique application outside of the mainstream market • New business model targeted towards last demanding mainstream customers • Does it allow a larger number customers with relatively less expert knowledge to achieve a desired outcome? • Does it fit with existing patterns of behaviour? 2. Can it attract customers away from the core of the mainstream market? • Can it become good enough for the mainstream - are there barriers 3. Can the incumbent respond? • Is the option to respond unattractive or impossible? • Has the innovation developed an independent ‘value network’ comprised of component suppliers, retailers, other value chain participants?

19. 802.11 Amazon.com Barnes & Noble Bell Telephone Charles Schwab Cisco Dell Computer Digital animation Digital printing eBay E-mail Linux MCI, Sprint Microsoft Minicomputers Oracle Palm Pilot PC’s Sun microsystems Werelesstelephony Google Intel microprocessor Disruptivestrategies

20. (1): Voice telephony innovation in the US Cases: • 1968: opening the CPE market - almost displacing Western Electric • 1980s: from analog to digital services: discontinuous change; incumbent-led effort to upgrade the network • 1991: MCI, advanced billing system, tariff differentiation and innovative customer relations management • These are not really examples of disruption; that would be the case if the incumbent would not be able to respond against a business model associated with the technology. Sustaining innovations. Litmus test to recognise disruptive technologies: • Does a growth opportunity exist? • Can it attract customers away from the core of the mainstream market? • Can the incumbent respond?

21. Regulation and telecoms change • Profound changes in telecom industry, but no disruptive change • Competitive market for long distance services • PSTN backbone: analog digital - fibre • Role of regulation: distorting the disruptive process: • Regulation may stop innovations: creates artificial barriers, preventing innovations from finding the right group of customers. (example: control of spectrum allocation, makes it difficult for newcomers to target niche segments) • Regulation may force technologies to meet needs of most demanding customers • Regulation forces artifical interdependence or encourages inappropriate modularity

22. (2) Data communications • Disruptive innovations in enterprise data markets • low regulatory hurdles • high user value • Inter-office communication: LAN internetworking (Novell, Apple, 3COM) • disrupts: electronic processing, typing pools • Mission-critical data transport: Multi-protocol router (Cisco) • disrupts: SNA transport • Mission-critical applications: developer tools / applications (Microsoft, SUN) • disrupts: IBM mainframe value network • Business voice: VoIP, IP, VPN • disrupts: business voice & related service markets • VoIP case study

23. Factors determining disruptiveness • LAN internetworking, initial stages, advantages • decentralised scalability: open standards, to be purchased off the shelf • cost savings: sharing of peripherals as if directly attached • time savings: file sharing, enabling collaborative tools • LAN Disadvantages: • limited distance, network degradation with increasing number of users, lacking QoS, bandwidth requirements • IP networking disruptiveness (does it fulfil the Litmus tests): • IP networking: piece together departmental LANs, easily deployed, better functionality and flexibility • LAN technology could replace proprietary networking technologies; Cisco introduced SNA over IP (multi-protocol router) • IBM (circuit-switched world) could not compete effectively; multi-protocol router was part of an independent value network • 1999 IBM sold internetworking business to CISCO

24. (3) Mobile/wireless innovations: cellular telephone, wireless LAN • Wireless (cellular services) vs wired litmus tests: • Growth: Huge new growth; convenient, simple functionality • Core customers: Changing consumer demands makes it hard for wireless to cross over; some substitution of wireless voice for wired voice, but strongly increasing wired data demands; can they be met by 2,5G / 3G ? • Incumbent response: High degree of interdependence and overlap between wireless and wired value networks limits disruptive potential • Conclusion: limited disruptive potential • Wireless LAN (802.11x) vs 3G litmus tests: • Growth: big (departments, hotspots, home), cheap, simple • Core customers: Limits to improving 802.11: regulation, physics (power, spectrum, interference); government limitations on use of unlicensed spectrum. May keep WLAN out of mainstream market • Incumbent response: New data-based business models, potential independent value network • Conclusion: Limited disruptive potential WLAN, may depend on role of new CAPs. WLAN may end up to be complementary to 3G.

25. (4) Internet of Things Healthcare (remote monitoring), infrastructure (power grids), public services (smart cities), logistics (tracking) Create platforms to enable entrepreneurship and innovations Innovative business models Privacy and security concerns Disruptiveness related to industry and ecosystem change

26. (5) Cloud technology Core enabler of the Internet Disruptingexisting business models Cloud services boon for entrepreneurs and smallenterprises

27. (6) 3D printing Designers, engineers, architects and increasingly all Masscustomisation Living organs – biosystems – health Disruptiveness

28. (7) Renewableenergy Solar, wind, biofuels, oceanthermalenergyconversion, geothermal power Implicationsforenergyplayers and related industries, governments, citizens Innovators

29. Incumbents’ strategies in coping with disruption / performance oversupply • Push upmarket towards ever higher-end customers (ultimately abandoning lower-tier customers when simpler, more convenient etc. disruptive approaches emerge) • Absorb disruptive innovations / business models, incumbents controlling the improvement trajectory, introducing it to their mainstream markets • Incumbents may invest in small startups or set up external units following disruptive trajectories • Incumbents may exert influence to block the innovation; regulation may hinder disruptive innovations • Stay with customers in a given tier of the market. Is not a easy as seems; basis of competition shifts from performance – reliability – convenience – price. Dell and Gateway 2000 focusing on convenience, Compaq targeting needs of lower tiers of the PC market low price, modest functionality) • Use marketing to steepen the slope of the market trajectory so that customers demand the technologies that are provided (Intel, Microsoft ?)

30. Networkeconomy and disruptiveinnovationstrategies

31. Important Network Economy concepts • Business Design: totality of selection of customers, differentiation of products and services, strategic control (ability to protect profit stream), value capture (value creation model) • Business Model: architecture of product, service and information flows, and the sources of revenues and benefits for suppliers and customers • Value Migration: due to changing consumer behavior • Networks: new products require the existence of complementors; products are developend through networks (Microsoft, Apple, Facebook etc), value networks or platforms • Positive feedback, network externalities: product value depending on other users, making networks larger, leading to demand side economies of scale and positive feedback • Strategic control (i.e. through standardisation)

32. Disruptive innovation and the network economy • Christensen does not speak about ‘network markets’, but it is implicit in his theory. Also aspects like ‘interdependence’ and ‘modularity’ relate to the Varian-Shapiro analysis of strategies in network markets. • Christensen takes into account more factors than network effects: characterisation of growth opportunities, role of regulatory barriers, market power of incumbents, ‘value network’ • To understand why innovations become disruptive through attracting customers away from the core of the mainstream market, you need insight in network effects (switching costs, positive feedback)

33. Underlying economic principles • Old economy: ‘normal’ economics of scale • More production – lower average cost of production • Information economy: economics of networks • Positive feedback is key concept • More than economies of scale: - dominant component of fixed costs are sunk cost (nor recoverable if production is halted)- variable costs: nearly zero, independent of volume • Low incremental costs and very large scale of operation: Microsoft • Implications for pricing strategy; once costs are sunk, prices are driven down to marginal costs

34. Dynamics of networks and positive feedback Network economy Network effects Value of products/services (positive externalities) Criticalmass “Winner takes all”:de-facto standard Positive feedback Disruptive technologies Role ofstandards Number of users or Availabilityof software or content Techologies Products Markets Number ofcomplementaryproducts Formation of dominantconsortium standard Innovation -/+ Lock-in Switchingcosts Standards may hinder further innovation and entry

35. Two types of network effects: 1. direct and 2. indirect Source: Messerschmitt, Networked Applications, 1999

36. What is lock-in • Lock-in results from (high) switching costs to change to another (incompatible) technology; you can’t change a piece of a system easily • Switching costs in changing from Nissan to Ford are very low: no lock in • Switching cost in changing from Mackintosh to Windows are very high • Lock-in arises whenever users invest in multiple complementary and durable assets specific to a particular information technology system or brand • Lock in may bring suppliers in a dominant position versus customers, possibly charging higher prices, but lock-in can also apply to suppliers • Examples of lock-in: • LP + turntable vs CD + CD player vs DVD • Microsoft Windows operating system vs Mackintosh • Bell Atlantic investing in AT&T 5ESS digital switches (Shapiro, Varian) • Number portability (Shapiro, Varian)

37. Importance of lock-in and network effects • Networks give rise to network effects (positive network externalities) • The value of products and services increases with the number of adopters • Network effects affect the industry and marketplace through critical mass and positive feedback, this may result in ‘winner-takes-all’ markets (product tips to dominant supplier) • Strong network effects drive de-facto standards (example: IBM PC) • Suppliers also may form consortia defining a dominant technology to stimulate a market and avoid stranded investment, rather than wait for the market (many examples in Mobile communication; also: OMG, IETF, ..) • Switching cost in replacing technologies, applications, products (etc) result in lock-in, which might hinder new entrants and new technologies • Application providers have to choose complementary products (language, design tools, computer platform, software components etc); all these choices have the potential for switching costs and lock-in

38. Recognising lock-in • It is important to recognise lock-in, because lock-in involves costs and benefits and requires a strategic look • Lock-in may happen in the mass market (many customers, low switching costs per customer) as well in specialised markets (few customers, high switching costs per customer): you need to value the installed base • Examples of mass market lock-in: • number portability: switching costs of changing your telephone number • E-mail address lock-in when changing to another ISP • web presence dependency on ISP web hosting services • Dealing with lock-in requires as a first step identifying the switching costs • ISP’s need to value their installed customer base revenue stream in order to be able to set prices, design marketing strategies • Total cost of switching = customer costs + new supplier costs

39. What counts is total costs of switching • Customer C switches from ISP A ISP B • Customer C bears switching costs: 50 (time and effort) • ISP B bears switching costs: 25 (initial cost of set up of account) • Total switching costs: 75 • Benefits of switching should be > 75 (required compensation for all costs) • If switching benefits = 100, profit = 25 • Required: benefits of both: > 0 Benefits of switching, C: > 0 (= compensation - costs)Benefits of switching, ISP: > 0 (= future profit - initial costs - compensation to C) • Value of installed base = value of switching costs + value of competitive advantage (lower costs, superior product) • In a competitive market: value of installed base = value of switching costs • Number portability diminishes the value of installed base

40. Uses of switching cost valuation • How much to invest today to attract new customers • How to evaluate a target company with an installed base • How to make decisions affecting customers’ switching costs (product design, compatibility decisions)

41. Types of lock-in and sources of switching costs Today’s investments may limit tomorrow’s options

42. Sources of switching costs (1) 1. Contractual commitments • Even fixed prices may result in exploiting lock-in by reducing quality • Extent of lock-in depends on the nature of the contract • Anticipate your switching costs after the contract terminates • design the contract to minimize after-termination switching costs 2. Durable purchases • Economic lifetime and existence of market for used durable goods is critical factor • Lock-in tends to be self-limiting due to depreciation • Customers can reduce switching costs by renting or leasing • Key issue is amount of choice available, e.g. alternative suppliers of complementary products • Most durable equipment requires follow-on purchases (upgrades, improvements), very often owned by the original vendor, thus impeding acquiring aftermarket services of other vendors

43. Sources of switching costs (2) 3. Brand-specific training • Complementary products: durable product + brand-specific (not: general) training • Considerable time and effort required to learn to work with a new product • Switching costs tend to rise with time because of increasing familiarity with the system • Maintain switching costs through introduction of upgrades • Market entry by easy-to-learn products 4. Information and databases • Complementary products: hardware / software for data storage, and the information / database itself • Key question: portability of information to another system • Example: CD format • Switching costs tend to rise over time as more and more information comes to reside in historical database • Limit switching costs by using standardised formats and interfaces; if possible to let vendors publish interface specifications

44. Sources of switching costs (3) 5. Specialised suppliers • Current choices dictate tomorrows’ needs • With specialised equipment alternative suppliers will be difficult to find in the future • Procurement strategy: dual sourcing (for example: buyer IBM: Intel, AMD) 6. Search costs • Depend on time and effort in locating attractive new suppliers and cost of locating customers • reductions in search costs can threaten the value of established mass-market companies lacking truly superior products 7. Loyalty programs • Loyalty programs can create switching costs. - You may forfeit built-up credits if you stop buying from your regular supplier- You may forfeit benefits based on cumulative usage. • Traditional frictions such as search and distribution costs erode in the information economy, but also new frictions can be created (example: Amazon.com).

45. Managing lock-in • Lock-in is important from both perspectives • (1) Buyers: • Strategies to minimise lock-in, avoid monopoly exploitation • Even capitalise on own switching costs • (2) Suppliers • New entrant: identify customer’s switching costs, offensive • Established player: identify switching costs, defensive

46. Lock-in strategy: buyers perspective • Identify switching costs (i.e. how difficult to convert data into other formats in a few years, dependency on suppliers to make changes in the database etc) • Bargain for long term protection, before becoming locked-in • Initial sweeteners (discounts, support) • Consider the entire lock-in cycle • Keep options open, I.e. second sourcing, to minimise extent of lock-in • bargaining position will become weaker once you make sunk, supplier-specific investments. • Minimise switching costs throughout the lock-in cycle • Keep switching costs under control - maximise future options I.e. second source or pick an open system

47. Lock-in strategy: suppliers perspective • In how far a lock-in cycle is not a zero-sum game but can be win-win ? • Suppliers invest (in a customer relations process) - should expect a reasonable return, protected by switching costs (perspective: the whole lock-in cycle) • Three key principles: • 1. Invest in developing an installed base of customers • 2. Entrench customers over time • 3. Leverage by maximising the value of the installed base by selling complementary products and by selling access to these customers to other suppliers

48. Investing in an installed base • Investing in installed base: use customer profitability analysis over the lock-in cycle, look to total switching costs. • Locked-in customers are valuable assets; this guides promotional investments in new customers • Being first to market (timing advantage) can generate both differentiation and cost advantage (installed base before competition arrives) • Identify and exploit mutual gains

49. Examples • Iomega (Zip drives), example of strategy to build-up installed base • Netscape: ‘open’ strategy, low lock-in, different from Microsoft • Costs of switching to Explorer relatively low: eroding installed base when Explorer was given away for free and incorporating browser functions into the operating system • Microsoft: highly integrated, high switching costs, wants extended lock-in by integrating web-applications with desktop and local area applications • Cisco: value is not based on lock-in, uses open standards, vulnerable for competition

50. Customer entrenchment • Entrenchment by design • Offer value-added information services to deepen customer relationships • Loyalty programs and cumulative discounts • Loyalty programs will turn conventional markets into lock-in markets