The Pricing and Profitability of Modular Clusters

Carliss Y. Baldwin

Modularity Mini-ConferenceLondon Business SchoolOctober 2, 2003

Slide 2 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003

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This is an emergent modular cluster

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

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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

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

Slide 6 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003

YesHow?

Read the paper!

Executive Summary

Can imperfect price competition and the vertical pricing externality offset one another in a large cluster?

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

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

One BigUpstream NU SU

FirmDownstream ND SD

One Big Firm Full-span Two Module ModularDuopolists Monopolists Cluster

North

South

Slide 9 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003

Our Thought Experiment

One BigUpstream NU SU

FirmDownstream ND SD

One Big Firm Full-span Two Module ModularDuopolists Monopolists Cluster

North

South

One Big Firm Five Full-Span Ten Module Fifty Firms in aOligopolists Monopolists Modular Cluster

Our model aims to look at an unlimited number of alternate “configurations”

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:qi = i(pi ; …) Q[P(pi ; …)]

where pi is its own price.

i(pi ; …) is “market share” and depends on the prices in its “own market”.

Q[P(pi ; …)] 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!

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 profitMore Firms in Each Market

1x1 1x2 1x3 1x4 … 1xM 1xN …

More 2x1 2x2 2x3 2x4 … 2xM 2xN

Module 3x1 3x2 3x3 3x4 … 3xM 3xN

Markets 4x1 4x2 4x3 4x4 … 4xM 4xN

…

Jx1 Jx2 Jx3 Jx4 … JxM JxN

Kx1 Kx2 Kx3 Kx4 … KxM KxN

… …

Slide 12 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003

Results—Prices Along the edges of the array

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Equilibrium System Price

Number of Modules (J =1 - 20)

Number of Firms Per Module Market

(N = 1 -20)

1xN Configurations

One Big Firm1x1 ConfigurationJx1

Configurations

Slide 13 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003

Results—Aggregate Profit Along the edges of the array

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AggregateProfit

Number of Modules (J =1 - 20)

Number of Firms Per Module Market

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Jx1 Configurations

One Big Firm1x1 Configuration 1xN

Configurations

Slide 14 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003

Results—Prices Full array

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Equilibrium System Price

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Number of Firms Per Module Market

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Cluster System Price EqualsOne Big Firm System Price

Slide 15 © C. Y. Baldwin, K. B. Clark, and C. J. Woodard 2003

Results—Aggregate Profit Full array, reverse view—Note “sweet spots”

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AggregateProfit

Number of Modules (J =1 - 20)

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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 thepricing equilibriumat the sweet spot?

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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 priceas 1xN, need smallnumbers

Can a cluster evolve from “portal” to “federated”by increasing thetechnical compatibilityamongst modules? 1

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Thank you!