The Atomizing Hand The strategy and economics of peer production Umair Haque http://www.bubblegeneration.com Spring 2005

Intro

What is Peer Production? Communities of prosumers or amateurs who collaborate to make things Wikipedia Metafilter Flickr OhMyNews By… Sharing information about inputs and outputs… … which creates pooled knowledge ...which increases the efficiency of future production And having open access to the means of production

Communities of prosumers or amateurs who collaborate to make things

Wikipedia

Metafilter

Flickr

OhMyNews

By…

Sharing information about inputs and outputs…

… which creates pooled knowledge

...which increases the efficiency of future production

And having open access to the means of production

Why Share? Altruism Because we care Reputation Because there are spillover signalling effects Reciprocity Because of implicit or explicit social control Money Because there are explicit incentives Fun Because we derive social utility from doing so Etc… … .No definitive answer (yet). Empirical effects are unambiguous File-sharing, Wikipedia, threadless, etc demonstrate that peers do share

Altruism

Because we care

Reputation

Because there are spillover signalling effects

Reciprocity

Because of implicit or explicit social control

Money

Because there are explicit incentives

Fun

Because we derive social utility from doing so

Etc…

… .No definitive answer (yet).

Empirical effects are unambiguous

File-sharing, Wikipedia, threadless, etc demonstrate that peers do share

Why Join a PP Community? Simple answer: Because you can do stuff more efficiently than by yourself By taking advantage of others’ sharing? No! PP is not free riding – in fact, the opposite happens: increasing returns When you do & make stuff, new knowledge is a side-effect Knowledge in a peer production community is a public good New users are attracted in proportion to the size of the knowledge pool Because it’s the strongest signal of potential marginal productivity gains from joining that community And new users increase everyone else’s productivity, growing the knowledge pool

Simple answer:

Because you can do stuff more efficiently than by yourself

By taking advantage of others’ sharing?

No!

PP is not free riding – in fact, the opposite happens: increasing returns

When you do & make stuff, new knowledge is a side-effect

Knowledge in a peer production community is a public good

New users are attracted in proportion to the size of the knowledge pool

Because it’s the strongest signal of potential marginal productivity gains from joining that community

And new users increase everyone else’s productivity, growing the knowledge pool

Why is Peer Production Important? Peer production enjoys very special economics A new kind of scale economy which enables massively distributed and ultraspecialized microproduction… Distributed economies of scale Which lets knowledge about production pool within the community… Which creates sustainable supply-side increasing returns Under certain conditions, peer production communities will be more efficient than firms or markets To understand why, I’ll try and explain why peer production is really about cheap coordination atomizing production… … which makes it a fundamentally new mode of production Or at least one analogous to modes of production that disappeared a very long time ago, like the putting-out system … which makes it a great opportunity (or a great threat)

Peer production enjoys very special economics

A new kind of scale economy which enables massively distributed and ultraspecialized microproduction…

Distributed economies of scale

Which lets knowledge about production pool within the community…

Which creates sustainable supply-side increasing returns

Under certain conditions, peer production communities will be more efficient than firms or markets

To understand why, I’ll try and explain why peer production is really about cheap coordination atomizing production…

… which makes it a fundamentally new mode of production

Or at least one analogous to modes of production that disappeared a very long time ago, like the putting-out system

… which makes it a great opportunity (or a great threat)

Network Economics 1.0 and 2.0 Primer

Network Economics 1.0 Demand-side viral effects Massively decreases user acquisition cost Low-cost imitation barrier to protect early-mover advantage Demand-side network effects One key resource: consumption network “ Metcalfe’s law” – marginal utility increases in network size No upper bound factored in – misreading of econ lit. Switching costs rise nonlinearly with network size Increasing returns to adoption Strategic intent: scale – grow adoption Rapid growth of network size “ Demand-side economies of scale” Search economies dominate strategy How costly is it for you to find stuff on the network? Cheapest solution wins: utility of network bounded by search mechanism

Demand-side viral effects

Massively decreases user acquisition cost

Low-cost imitation barrier to protect early-mover advantage

Demand-side network effects

One key resource: consumption network

“ Metcalfe’s law” – marginal utility increases in network size

No upper bound factored in – misreading of econ lit.

Switching costs rise nonlinearly with network size

Increasing returns to adoption

Strategic intent: scale – grow adoption

Rapid growth of network size

“ Demand-side economies of scale”

Search economies dominate strategy

How costly is it for you to find stuff on the network?

Cheapest solution wins: utility of network bounded by search mechanism

Network Economics 2.0 Supply-side viral effects Massively reduces prosumer acquisition costs Low cost imitation barrier to protect early-mover advantage Supply-side network effects Two resources: producer network and knowledge pool “ Haque’s Law” – marginal productivity increases in network size Upper bound: diseconomies of scale – large user network size creates knowledge network coordination costs Switching costs rise nonlinearly with both Increasing returns to knowledge Strategic intent: speed – accumulate knowledge Rapid growth of knowledge pool Doing & making things faster than competitors Coordination economies dominate strategy How costly is it for you to make & do stuff on the network? Cheapest solution wins: network utility bounded by coordination

Supply-side viral effects

Massively reduces prosumer acquisition costs

Low cost imitation barrier to protect early-mover advantage

Supply-side network effects

Two resources: producer network and knowledge pool

“ Haque’s Law” – marginal productivity increases in network size

Upper bound: diseconomies of scale – large user network size creates knowledge network coordination costs

Switching costs rise nonlinearly with both

Increasing returns to knowledge

Strategic intent: speed – accumulate knowledge

Rapid growth of knowledge pool

Doing & making things faster than competitors

Coordination economies dominate strategy

How costly is it for you to make & do stuff on the network?

Cheapest solution wins: network utility bounded by coordination

Markets and Firms: Production 1.0

Apologies Five somewhat painful slides to follow Bear with me, because they’ll help us explain why and when firms are less efficient than peer communities This is the most complicated part of the presentation OK, I’m lying…  … skip to the Summary slide if (when) you can’t take it anymore

Five somewhat painful slides to follow

Bear with me, because they’ll help us explain why and when firms are less efficient than peer communities

This is the most complicated part of the presentation

OK, I’m lying… 

… skip to the Summary slide if (when) you can’t take it anymore

Property Rights Organize Production We will call 1 and 2 rights of coordination because they organize production Liquid markets for 3 and 4 are prevalent Equities, fixed income, options, futures Markets to assign coordination rights often fail because of relatively high transaction costs Copyright is the canonical example Firms coalesce to economize on transaction costs of coordination rights assignment when markets fail Right to use economic resources Right to modify form and substance of resources Right to benefit from use of resources Right to transfer resources

We will call 1 and 2 rights of coordination because they organize production

Liquid markets for 3 and 4 are prevalent

Equities, fixed income, options, futures

Markets to assign coordination rights often fail because of relatively high transaction costs

Copyright is the canonical example

Firms coalesce to economize on transaction costs of coordination rights assignment when markets fail

Right to use economic resources

Right to modify form and substance of resources

Right to benefit from use of resources

Right to transfer resources

Understanding Firms What do firms do? Coordinate: The most efficient way to turn inputs into outputs… … By internalizing the uncertainty inherent in risky transactions... But economizing on transactions isn’t costless… Firms replace transaction costs with coordination costs How are coordination rights distributed within the firm? Within the firm, who can access the means of production and key inputs? Costs of administrative overhead Internal transaction costs: negotiation, bargaining, and enforcement of coordination rights These are essentially costs of information sharing and processing – firms internalize information costs, where they can be ‘managed’ As long as coordination costs stay less costly than transaction costs of inputs, firm is an efficient way to produce But they don’t, because….

What do firms do?

Coordinate:

The most efficient way to turn inputs into outputs…

… By internalizing the uncertainty inherent in risky transactions...

But economizing on transactions isn’t costless…

Firms replace transaction costs with coordination costs

How are coordination rights distributed within the firm?

Within the firm, who can access the means of production and key inputs?

Costs of administrative overhead

Internal transaction costs: negotiation, bargaining, and enforcement of coordination rights

These are essentially costs of information sharing and processing – firms internalize information costs, where they can be ‘managed’

As long as coordination costs stay less costly than transaction costs of inputs, firm is an efficient way to produce

But they don’t, because….

Coordination & Hierarchy Negotiating for coordination rights becomes combinatorially costly I want a top engineer on my team I negotiate with 4 VPs Each VP negotiates with each other Coordination cost explosion in firm size – negotiation doesn’t scale How do we deal with this? Hierarchy – centralized decision-making Hierarchy is designed to minimize coordination costs In firms, coordination rights are governed by authority embedded in hierarchical implicit or explicit contracts You’re my boss, you choose the ‘best’ products and features I’m the product manager, so I get the top engineers Hierarchy minimizes coordination costs by economizing on information Managers and administrators collect and process information from subordinates

Negotiating for coordination rights becomes combinatorially costly

I want a top engineer on my team

I negotiate with 4 VPs

Each VP negotiates with each other

Coordination cost explosion in firm size – negotiation doesn’t scale

How do we deal with this? Hierarchy – centralized decision-making

Hierarchy is designed to minimize coordination costs

In firms, coordination rights are governed by authority embedded in hierarchical implicit or explicit contracts

You’re my boss, you choose the ‘best’ products and features

I’m the product manager, so I get the top engineers

Hierarchy minimizes coordination costs by economizing on information

Managers and administrators collect and process information from subordinates

Coordination Diseconomies Minimizing coordination costs by economizing on information creates a big problem… Private info is never made completely public Bosses, middle managers, bureaucracy, politics, bullsh*t, inertia all make revealing private info costly Memos, reports, and meetings lose tacit info Disutility: authority sucks In firms, we can’t know if efficient solutions to assigning coordination rights are reached Because information, expectations, and preferences about inputs and outputs are never fully revealed Coordination diseconomies (1): The efficiency loss of hierarchy in assigning the best coordination rights, due to information loss This is an opportunity cost of hierarchy – we may forego a better coordination rights assignment

Minimizing coordination costs by economizing on information creates a big problem…

Private info is never made completely public

Bosses, middle managers, bureaucracy, politics, bullsh*t, inertia all make revealing private info costly

Memos, reports, and meetings lose tacit info

Disutility: authority sucks

In firms, we can’t know if efficient solutions to assigning coordination rights are reached

Because information, expectations, and preferences about inputs and outputs are never fully revealed

Coordination diseconomies (1):

The efficiency loss of hierarchy in assigning the best coordination rights, due to information loss

This is an opportunity cost of hierarchy – we may forego a better coordination rights assignment

Coordination & Specialization And…hierarchy does not eliminate coordination costs It minimizes them Coordination costs still exist Direct costs Admininstration, middle managers, bureaucracy Indirect costs Agency and influence costs – politics! Incentives dulled Coordination bounds specialization It’s economical to coordinate activities until marginal cost of coordination exceeds marginal gain from specialization Intuition: even in firms, coordinating 10,000 microactivities isn’t economical Or: 10 managers can coordinate 1000 activities, 100 managers can’t coordinate 10,000 activities Marginal cost of coordination increases exponentially in firm size Coordination diseconomies (2): Specialization gains hits a coordination cost wall Implication: eliminating coordination costs can realize specialization gains

And…hierarchy does not eliminate coordination costs

It minimizes them

Coordination costs still exist

Direct costs

Admininstration, middle managers, bureaucracy

Indirect costs

Agency and influence costs – politics! Incentives dulled

Coordination bounds specialization

It’s economical to coordinate activities until marginal cost of coordination exceeds marginal gain from specialization

Intuition: even in firms, coordinating 10,000 microactivities isn’t economical

Or: 10 managers can coordinate 1000 activities, 100 managers can’t coordinate 10,000 activities

Marginal cost of coordination increases exponentially in firm size

Coordination diseconomies (2):

Specialization gains hits a coordination cost wall

Implication: eliminating coordination costs can realize specialization gains

Summary: Modes of Production Markets fail Because of high transaction costs Firms coalesce but value creation is bounded by High coordination costs, which limit any specialization gains Hierarchies coalesce but value creation is bounded by Coordination diseconomies Total cost of hierarchy is high Coordination costs bound specialization gains… … and opportunity cost is optimal coordination righst assignment Or: a trade-off between specialization gains and information loss The more you minimize coordination costs, the more information you lose… … but the more you minimize coordination costs, the greater specialization gains you realize A more efficient form of organization… … escapes the information loss vs specialization gains tradeoff, and realizes advantages in both Zero coordination costs wenable huge specialization gains Not having to economize on information means optimal assignment of coordination rights

Markets fail

Because of high transaction costs

Firms coalesce but value creation is bounded by

High coordination costs, which limit any specialization gains

Hierarchies coalesce but value creation is bounded by

Coordination diseconomies

Total cost of hierarchy is high

Coordination costs bound specialization gains…

… and opportunity cost is optimal coordination righst assignment

Or: a trade-off between specialization gains and information loss

The more you minimize coordination costs, the more information you lose…

… but the more you minimize coordination costs, the greater specialization gains you realize

A more efficient form of organization…

… escapes the information loss vs specialization gains tradeoff, and realizes advantages in both

Zero coordination costs wenable huge specialization gains

Not having to economize on information means optimal assignment of coordination rights

Coordination & Specialization Coordination costs Specialization gains Coordination costs bound specialization gains Size Value Coordination costs exceed specialization gains

Coordination Diseconomies Hierarchy costs Specialization gains Coordination diseconomy : total costs of hierarchy are coordination costs and opportunity cost: not choosing the best coordination rights assignment. Specialization is effectively bounded at a small maximum efficient scale. Can trade off by either coordinating more, and losing less information…or coordinating less, and realizing greater specialization gains. Size Value Opportunity cost – information loss – increases costs of hierarchy Total costs exceed specialization gains

Peer Communities: Production 2.0

Peer Production PP vaporizes the real-world costs of assigning coordination rights Information sharing mechanisms aggregate and reveal private information and preferences frictionlessly About inputs What are the most efficient ways to produce our good? About outputs What are our most successful goods likely to be? Using explicit mechanisms Voting, ranking, pricing Or Implicit mechanisms Tags, playlists, reputation Without coordination costs… … so there’s no efficiency loss of centralized decision-making like in firms How…?

PP vaporizes the real-world costs of assigning coordination rights

Information sharing mechanisms aggregate and reveal private information and preferences frictionlessly

About inputs

What are the most efficient ways to produce our good?

About outputs

What are our most successful goods likely to be?

Using explicit mechanisms

Voting, ranking, pricing

Or Implicit mechanisms

Tags, playlists, reputation

Without coordination costs…

… so there’s no efficiency loss of centralized decision-making like in firms

How…?

Coordination Economies Because information and preferences are public, most efficient coordination rights assignment is transparent Public information regulates which inputs… code, people, designs … are granted access to means of production… platform, community, architecture … to create the outputs predicted to be most successful. T-shirts, games, OS kernels, music Frictionless, hyperefficient assignment of coordination rights: coordination economies PP can assign more efficient coordination rights more cheaply than firms or markets And so can realize gains from ultraspecialized production Coordination economies are a significant source of strategic cost advantage

Because information and preferences are public, most efficient coordination rights assignment is transparent

Public information regulates which inputs…

code, people, designs

… are granted access to means of production…

platform, community, architecture

… to create the outputs predicted to be most successful.

T-shirts, games, OS kernels, music

Frictionless, hyperefficient assignment of coordination rights: coordination economies

PP can assign more efficient coordination rights more cheaply than firms or markets

And so can realize gains from ultraspecialized production

Coordination economies are a significant source of strategic cost advantage

Coordination Economies How does PP achieve hyperefficient assignment of coordination rights? PP model is an implicit or explicit auction for access to means of production Implicit or explicit price mechanisms combined with price or quantity auctions Generally: Peers self-select into activities – ex-post coordination Distributed local information is aggregated Implicit price of access to means of production is established Peers are granted access to means of production (or not) If peer activity value as measured by aggregate utility is greater than implicit price as measured by aggregate bid Production without coordination costs No need to economize on information – massively distributed info processing, just like in real-world markets Costs incurred are market costs

How does PP achieve hyperefficient assignment of coordination rights?

PP model is an implicit or explicit auction for access to means of production

Implicit or explicit price mechanisms combined with price or quantity auctions

Generally:

Peers self-select into activities – ex-post coordination

Distributed local information is aggregated

Implicit price of access to means of production is established

Peers are granted access to means of production (or not)

If peer activity value as measured by aggregate utility is greater than implicit price as measured by aggregate bid

Production without coordination costs

No need to economize on information – massively distributed info processing, just like in real-world markets

Costs incurred are market costs

Summary: Firms, Markets, and Communities PP Models combine the microeconomic DNA of markets and firms: Places where people can exchange decentralized information about preferences and utility (markets) In order to coordinate centralized actions of consumption and production (firms) Without the coordination costs of real-world firms … or transaction costs of real-world markets, which create firms Which scale combinatorially with firm size – cost explosions Which makes complete information revelation uneconomical in firms Which makes it impossible for firms to assign the most efficient coordination rights Peer production is theoretically hyperefficient It can assign the most efficient coordination rights more cheaply than real-world firms or markets Or: PP lets the most talented people make the coolest things

PP Models combine the microeconomic DNA of markets and firms:

Places where people can exchange decentralized information about preferences and utility (markets)

In order to coordinate centralized actions of consumption and production (firms)

Without the coordination costs of real-world firms

… or transaction costs of real-world markets, which create firms

Which scale combinatorially with firm size – cost explosions

Which makes complete information revelation uneconomical in firms

Which makes it impossible for firms to assign the most efficient coordination rights

Peer production is theoretically hyperefficient

It can assign the most efficient coordination rights more cheaply than real-world firms or markets

Or: PP lets the most talented people make the coolest things

Costs Shape Modes of Production Markets Transaction costs Firms Peers Coordination costs Information loss Hierarchies Market failure Sharing costs Corpocracy Growth failure Atomization Failure point Organization Type of failure

Coordination Arbitrage What’s the implication of coordination economies? Coordination arbitrage Entrepreneurs will begin to use coordination economies – PP’s natural cost advantage – to atomize value chains They will target industries with high coordination costs (and large efficiency losses due to information economization) The coordination economy-diseconomy differential is the largest here: coordination arbitrage Rents will be redistributed to peers as peer demand intensifies and outstrips supply Prizes on Yahoo Labs’ prediction market Firms will not disintegrate, they will move up and down the value chain Peer management Platform supply Goods for which means of production/inputs access is limited or protected

What’s the implication of coordination economies?

Coordination arbitrage

Entrepreneurs will begin to use coordination economies – PP’s natural cost advantage – to atomize value chains

They will target industries with high coordination costs (and large efficiency losses due to information economization)

The coordination economy-diseconomy differential is the largest here: coordination arbitrage

Rents will be redistributed to peers as peer demand intensifies and outstrips supply

Prizes on Yahoo Labs’ prediction market

Firms will not disintegrate, they will move up and down the value chain

Peer management

Platform supply

Goods for which means of production/inputs access is limited or protected

Peer Production Economics

…So What?! Where things get really interesting After all, firms can (to an extent) realize coordination economies by using sharing/internal market mechanisms PP redefines two economic orthodoxies Diminishing marginal productivity Resources become less efficient at the margin Marginal productivity of variable inputs declines as quantity increases Increasing returns Positive demand-side network externalities: Your joining the network increases it’s value to me Demand-side lock-in: My high up-front learning costs increase my switching costs … So what makes peer-production special?

Where things get really interesting

After all, firms can (to an extent) realize coordination economies by using sharing/internal market mechanisms

PP redefines two economic orthodoxies

Diminishing marginal productivity

Resources become less efficient at the margin

Marginal productivity of variable inputs declines as quantity increases

Increasing returns

Positive demand-side network externalities: Your joining the network increases it’s value to me

Demand-side lock-in: My high up-front learning costs increase my switching costs

PP Economics are Revolutionary PP models create increasing returns 2.0: Sustainable supply-side increasing returns How? 2 key mechanisms Distributed economies of scale create increasing marginal productivity Cars, computers, electronics, books, songs…. Many hands make light work at the margin Knowledge externalities create increasing returns to adoption My productivity increases in network size Your joining the network increases my value to it … because our knowledge in collaboration increases marginal productivity for lumpy goods Increasing marginal productivity of labor

PP models create increasing returns 2.0:

Sustainable supply-side increasing returns

How?

2 key mechanisms

Distributed economies of scale create increasing marginal productivity

Cars, computers, electronics, books, songs….

Many hands make light work at the margin

Knowledge externalities create increasing returns to adoption

My productivity increases in network size

Your joining the network increases my value to it

… because our knowledge in collaboration increases marginal productivity for lumpy goods

Peer Production Economics Distributed Economies of Scale and the Atomization of Production

Ultraspecialization and Microproduction Massively distributed ultraspecialization Doesn’t work in the real world… Tiny chunks of ultraspecialized activities are valueless in isolation Lumpy goods take time and collaboration to make Who will pay for 1/1000 th of one of the ten car production activities? Even less economical to assign coordination rights for ultraspecialization Hierarchy or markets can’t handle it How do you coordinate 10,000 tiny chunks of ultraspecialized activities in the RW? How do you contract/pay for 10,000 tiny chunks of ultraspecialization in the RW? Combinatorial cost explosions… Combining microchunks requires costly coordination, integration, contracting, payment relative to every other microchunk If 10,000 microchunks, 10,000 x 9999 coordination+transaction costs necessary Massive coordination diseconomies for ultraspecialized collaboration Result: market and firm failure for ultraspecialization in the real world

Massively distributed ultraspecialization

Doesn’t work in the real world…

Tiny chunks of ultraspecialized activities are valueless in isolation

Lumpy goods take time and collaboration to make

Who will pay for 1/1000 th of one of the ten car production activities?

Even less economical to assign coordination rights for ultraspecialization

Hierarchy or markets can’t handle it

How do you coordinate 10,000 tiny chunks of ultraspecialized activities in the RW? How do you contract/pay for 10,000 tiny chunks of ultraspecialization in the RW? Combinatorial cost explosions…

Combining microchunks requires costly coordination, integration, contracting, payment relative to every other microchunk

If 10,000 microchunks, 10,000 x 9999 coordination+transaction costs necessary

Massive coordination diseconomies for ultraspecialized collaboration

Result: market and firm failure for ultraspecialization in the real world

Distributed Economies of Scale But… PP enables cheap, optimal assignment of coordination rights at any level of divisibility Overcomes coordination diseconomies By leveraging cheap information sharing mechanisms to costlessly regulate access to inputs and means of production Coordination economies make organizing microproducers for ultraspecialized production viable Distributed economies of scale… … Yield specialization gains Finer and finer input divisibility lets us each specialize in our comparative advantage Not simply ‘many hands make light work’ – many specialized hands make production more efficient PP community can be a more efficient producer than firm at large scale If enough microproducers contribute enough microchunks

But…

PP enables cheap, optimal assignment of coordination rights at any level of divisibility

Overcomes coordination diseconomies

By leveraging cheap information sharing mechanisms to costlessly regulate access to inputs and means of production

Coordination economies make organizing microproducers for ultraspecialized production viable

Distributed economies of scale…

… Yield specialization gains

Finer and finer input divisibility lets us each specialize in our comparative advantage

Not simply ‘many hands make light work’ – many specialized hands make production more efficient

PP community can be a more efficient producer than firm at large scale

If enough microproducers contribute enough microchunks

Coordination & Specialization Firm coordination costs Specialization gains Size Value PP coordination Costs PP coordination costs exceed specialization gains Firm coordination costs exceed specialization gains Coordination costs bound specialization gains. Since peer community coordination costs scale linearly, peer communities realize more gains

Supply-Side Externalities What can an ultraspecialized network of microproducers do? Peers contribute ultraspecialized microchunks of value activities I can produce 1/100 th of a DAC and 1/50 th of a spreadsheet application These microchunks are combinatorial, not additive So… Network effect: positive supply-side externality My marginal social productivity > my marginal private productivity I can’t make lumpy goods efficiently by myself… … Your joining the network increases my value to it in 2 ways Microchunk modularity explodes production set Combinatorial explosion in feasible activities n^n-1 possibilities: 4 activities produce 64 possible combinations Microchunk reusability yields increasing marginal productivity I can reuse microchunks you’ve contributed in the past In econ-speak, microchunks are non-rival and non-excludable in production

What can an ultraspecialized network of microproducers do?

Peers contribute ultraspecialized microchunks of value activities

I can produce 1/100 th of a DAC and 1/50 th of a spreadsheet application

These microchunks are combinatorial, not additive

So…

Network effect: positive supply-side externality

My marginal social productivity > my marginal private productivity

I can’t make lumpy goods efficiently by myself…

… Your joining the network increases my value to it in 2 ways

Microchunk modularity explodes production set

Combinatorial explosion in feasible activities

n^n-1 possibilities: 4 activities produce 64 possible combinations

Microchunk reusability yields increasing marginal productivity

I can reuse microchunks you’ve contributed in the past

In econ-speak, microchunks are non-rival and non-excludable in production

Distributed Economies of Scale In general: Your activity set means my marginal productivity is enhanced Productivity increases in number of ultraspecialized microproducers Distributed economies of scale 10 specialized car activities become 1000 ultraspecialized car activities …… creating more ways to recombine activities to improve efficiency …allowing greater reusability of activities to improve efficiency Distributed economies of scale Recombining and reusing microchunks incurs massive coordination costs in the real world Not all activity combinations in exploded production set are valuable… … and dividing activities doesn’t always yield marginal productivity gains Finding beneficial combinations – assigning coordination rights efficiently – is costly But cheap information sharing makes searching for best coordination rights assignment frictionless

In general:

Your activity set means my marginal productivity is enhanced

Productivity increases in number of ultraspecialized microproducers

Distributed economies of scale

10 specialized car activities become 1000 ultraspecialized car activities

…… creating more ways to recombine activities to improve efficiency …allowing greater reusability of activities to improve efficiency

Distributed economies of scale

Recombining and reusing microchunks incurs massive coordination costs in the real world

Not all activity combinations in exploded production set are valuable…

… and dividing activities doesn’t always yield marginal productivity gains

Finding beneficial combinations – assigning coordination rights efficiently – is costly

But cheap information sharing makes searching for best coordination rights assignment frictionless

PP and Firm Production Functions Firm coordination costs Firm production function Labor/Network Size Output PP production function Firm is more efficient producer PP community is more efficient producer PP marginal productivity exceeds firm marginal productivity Distributed economies of scale mean that at large scale, peer communities enjoy a significant cost advantage over firms

Microproducers & Ultraspecialization Ultraspecialization examples Jane knows everything about ab exercises (consumption externality) Dave’s built replicas of every shoe since 1500 (production externality) Al knows everything about 80s Italo Disco (hobby) Trekkies, game mods, blogging, Why do microproducers ultraspecialize? Production or consumption externalities Hobbies Local effects: family, friends But mostly because they can : the Net’s slashed search costs – specialization is less costly than it used to be How did ultraspecialization evolve? …

Ultraspecialization examples

Jane knows everything about ab exercises (consumption externality)

Dave’s built replicas of every shoe since 1500 (production externality)

Al knows everything about 80s Italo Disco (hobby)

Trekkies, game mods, blogging,

Why do microproducers ultraspecialize?

Production or consumption externalities

Hobbies

Local effects: family, friends

But mostly because they can :

the Net’s slashed search costs – specialization is less costly than it used to be

How did ultraspecialization evolve?

…

Traditional Value Creation Publishing: finance, marketing, procurement Management mediates transactions between primary value activities Management coordinates and exploits complementaries between supporting value activities Traditionally, value activities were integrated because market transaction costs were high Production : creation, editing, finishing

Disintermediation: Integration to Disintegration Publishing : finance, marketing, procurement Management coordinates and exploits complementaries between supporting value activities Disintermediation: Markets mediate transactions between primary value activities Cheap information disintegrates traditional value chains: value activities rearrange in horizontal layers, yielding efficiency gains Production: creation, editing, finishing

Microproduction: Disintegration to Atomization Cheap coordination atomizes disintegrated value chains: value activities rearrange in microchunks, yielding efficiency gains Publishing : finance, marketing, procurement Community mediates transactions between primary value activities Community coordinates and exploits complementaries between supporting value activities Production : creation, editing, finishing

Microproduction: Distributed Economies of Scale Microchunks have a positive supply-side network externality: a peer’s private productivity is less than his social productivity Why? User N contributes green microchunk G . This microchunk is reusable . Microchunk reuse increases marginal productivity: G’s complementarity with other microchunks reduces the marginal cost of future productivity. This microchunk is modular . Microchunk modularity explodes production set. G’s complementarity with other microchunks creates explosion in product set possibilities.

Distributed Economies of Scale - Summary Coordination economies enable ultraspecialized production Ultraspecialized production realizes network FX from reusing and recombining activity microchunks Tiny bits of ultraspecialized knowledge can, aggregated across enough peers , make peer production economically advantageous, because of supply-side network effects Marginal productivity increases in network size 2 Mechanisms 1 Effect

Coordination economies enable ultraspecialized production

Ultraspecialized production realizes network FX from reusing and recombining activity microchunks

Condition: Lumpy Goods Distributed economies of scale obtain under 2 conditions Lumpy goods and divisible inputs Lumpy goods supply functionality in discrete bundles Computers, cars, runways, sunglasses They require specialized knowledge in multiple activities Coordination, learning, and switching costs of production are high Because opportunity cost of specialization is not knowing other activities 10 activities required to make a car: 10 workers/car - 1 activity each Each worker is specialized – gains to specialization 2 workers/car - 5 activities each Only 2 activities/worker are specialized, workers must still perform remaining 8 – relative productivity loss Marginal productivity increases in workers More activities/worker lower productivity

Distributed economies of scale obtain under 2 conditions

Lumpy goods and divisible inputs

Lumpy goods supply functionality in discrete bundles

Computers, cars, runways, sunglasses

They require specialized knowledge in multiple activities

Coordination, learning, and switching costs of production are high

Because opportunity cost of specialization is not knowing other activities

10 activities required to make a car:

10 workers/car - 1 activity each

Each worker is specialized – gains to specialization

2 workers/car - 5 activities each

Only 2 activities/worker are specialized, workers must still perform remaining 8 – relative productivity loss

Marginal productivity increases in workers

More activities/worker lower productivity

Condition: Divisible Inputs Divisible inputs Inputs must be able to be unbundled in arbitrarily fine increments by microproducers You can contribute a sentence, a paragraph, or an essay … a scene, a script, or a review … a playlist, a vocal track, or lyrics For some goods, this is not possible (yet) Inputs are indivisible – can’t be unbundled Because of cost, technology, regulation, or specialization Examples: cars, runways, oil rigs, MRI scanners Which goods have divisible inputs? Digital media: music, films, books Designs for low-complexity physical goods: T-shirts Knowledge resources: Wikipedia, journals, blogs, genes Without input divisibility, microproduction isn’t possible

Divisible inputs

Inputs must be able to be unbundled in arbitrarily fine increments by microproducers

You can contribute a sentence, a paragraph, or an essay

… a scene, a script, or a review

… a playlist, a vocal track, or lyrics

For some goods, this is not possible (yet)

Inputs are indivisible – can’t be unbundled

Because of cost, technology, regulation, or specialization

Examples: cars, runways, oil rigs, MRI scanners

Which goods have divisible inputs?

Digital media: music, films, books

Designs for low-complexity physical goods: T-shirts

Knowledge resources: Wikipedia, journals, blogs, genes

Without input divisibility, microproduction isn’t possible

Peer Production Economics Knowledge Externalities and Increasing Returns

Recap PP models create increasing returns 2.0: Sustainable supply-side increasing returns How? 2 key mechanisms Lumpy goods and distributed economies of scale Cars, computers, electronics, books, songs…. Many hands make light work at the margin Supply-side knowledge externalities My productivity increases in network size Your joining the network increases my value to it … because our knowledge in collaboration increases marginal productivity for lumpy goods Increasing marginal productivity of labor

PP models create increasing returns 2.0:

Sustainable supply-side increasing returns

How?

2 key mechanisms

Lumpy goods and distributed economies of scale

Cars, computers, electronics, books, songs….

Many hands make light work at the margin

Supply-side knowledge externalities

My productivity increases in network size

Your joining the network increases my value to it

… because our knowledge in collaboration increases marginal productivity for lumpy goods

Knowledge Pools Knowledge pools are repositories … for information sharing mechanisms about inputs and/or outputs They store the community’s aggregated preferences and expectations… To act as a collective memory for the PP community Examples: Product/feature reviews (Yahoo! Finance msg boards) Tutorials, guides, and walkthroughs (GameSpy walkthrus) User reputation systems (eBay seller feedback) Stored product rankings (Amazon product rankings) Archived playlists, tags, links (Blogdex archives) Metainfo about community production (Metatalk.metafilter) … Other metainfo

Knowledge pools are repositories

… for information sharing mechanisms about inputs and/or outputs

They store the community’s aggregated preferences and expectations…

To act as a collective memory for the PP community

Examples:

Product/feature reviews (Yahoo! Finance msg boards)

Tutorials, guides, and walkthroughs (GameSpy walkthrus)

User reputation systems (eBay seller feedback)

Stored product rankings (Amazon product rankings)

Archived playlists, tags, links (Blogdex archives)

Metainfo about community production (Metatalk.metafilter)

… Other metainfo

Knowledge Resources Why is knowledge important? Knowledge enhances productivity by more efficient use of inputs Intuition: algebra vs arithmetic Knowledge is an experience effect: a result of learning-by-doing Knowledge pool is the key resource for PP communities Users will select PP communities where they their marginal productivity is maximized Knowledge pool is strongest signal of potential productivity gains Signals potential productivity gains of joining community independent of network size Or: signals current productivity per peer And since microchunks are non-rival in production Knowledge resources don’t get exhausted – they grow Knowledge pool is a resource stock That accumulates according to flow of knowledge externalities

Why is knowledge important?

Knowledge enhances productivity by more efficient use of inputs

Intuition: algebra vs arithmetic

Knowledge is an experience effect: a result of learning-by-doing

Knowledge pool is the key resource for PP communities

Users will select PP communities where they their marginal productivity is maximized

Knowledge pool is strongest signal of potential productivity gains

Signals potential productivity gains of joining community independent of network size

Or: signals current productivity per peer

And since microchunks are non-rival in production

Knowledge resources don’t get exhausted – they grow

Knowledge pool is a resource stock

That accumulates according to flow of knowledge externalities

Knowledge Externalities Recap: private info and preferences about inputs and outputs is aggregated and made public This info sharing has a macro supply-side externality: Storing aggregated info creates a knowledge pool for the community to learn from/access/utilize Inputs become more efficient Output quality increases Knowledge pool is a public good which acts as an input to increase the efficiency of future inputs Initial knowledge pool is additive … My productivity increases when you join the network … Ongoing knowledge pool is cumulative Every time we collaborate to produce a good, new knowledge is produced

Recap: private info and preferences about inputs and outputs is aggregated and made public

This info sharing has a macro supply-side externality:

Storing aggregated info creates a knowledge pool for the community to learn from/access/utilize

Inputs become more efficient

Output quality increases

Knowledge pool is a public good which acts as an input to increase the efficiency of future inputs

Initial knowledge pool is additive …

My productivity increases when you join the network

… Ongoing knowledge pool is cumulative

Every time we collaborate to produce a good, new knowledge is produced

Knowledge Pool Knowledge is an externality of value activities: learning-by-doing Knowledge pools when information and preferences shared during peer production are stored This knowledge enhances future productivity by informing peers about how to most efficiently modify inputs in order to produce the most-desired outputs Value activities (brown) have a knowledge externality, which flows into knowledge pool (silver).

Knowledge & Increasing Returns Leveraging this externality creates increasing returns Positive feedback: Network size growth increases marginal productivity Increased productivity generates new knowledge faster … New knowledge attracts more users Or… Your adding knowledge to the network increases my value to it Positive feedback: Largest public knowledge pool attracts new users My marginal productivity increases in network size Public knowledge increases in my marginal productivity Your marginal productivity increases in public knowledge You join the network - my marginal productivity increases in network size Increasing returns – productivity creates new knowledge, which attracts users, which increase productivity, which creates new knowledge Knowledge within the PP network is a public good produced as an externality of learning by doing Because innovation is cheaper Because transaction and integration costs are vaporized Doing and making cool stuff makes doing and making cooler stuff more efficient

Leveraging this externality creates increasing returns

Positive feedback:

Network size growth increases marginal productivity

Increased productivity generates new knowledge faster

… New knowledge attracts more users

Or…

Your adding knowledge to the network increases my value to it

Positive feedback:

Largest public knowledge pool attracts new users

My marginal productivity increases in network size

Public knowledge increases in my marginal productivity

Your marginal productivity increases in public knowledge

You join the network - my marginal productivity increases in network size

Increasing returns – productivity creates new knowledge, which attracts users, which increase productivity, which creates new knowledge

Knowledge within the PP network is a public good produced as an externality of learning by doing

Because innovation is cheaper

Because transaction and integration costs are vaporized

Increasing Returns Overview Productivity Increase New users Which accelerates Information sharing which attracts ultraspecialized in different activities at the margin (distributed economies of scale) about inputs and outputs ultraspecialized in different activities … New users Public knowledge Which grows about the most efficient coordination rights

Knowledge & Community How is knowledge related to network size? Knowledge is an experience effect: learning by doing The more you do, the more you learn Productivity of users determines of knowledge growth Since marginal productivity increases in network size… Knowledge pool should explode in network size Identifying and managing this relationship is the key strategic challenge in peer production Because it’s the indicator (and driver) of increasing returns Speed economies become crucial Production throughput accelerates knowledge externalities… … which build critical mass in pool and accelerate network growth: increasing returns

How is knowledge related to network size?

Knowledge is an experience effect: learning by doing

The more you do, the more you learn

Productivity of users determines of knowledge growth

Since marginal productivity increases in network size…

Knowledge pool should explode in network size

Identifying and managing this relationship is the key strategic challenge in peer production

Because it’s the indicator (and driver) of increasing returns

Speed economies become crucial

Production throughput accelerates knowledge externalities…

… which build critical mass in pool and accelerate network growth: increasing returns

Increasing Returns Increasing returns means: PP communities will be winner-take-all markets The resource to which there are increasing returns is knowledge , not just network size The biggest network won’t win by default (like dot com 1.0) – the most efficient knowledge generator will. Knowledge and network size are necessary to create natural monopoly dynamics Dominant strategies leverage speed To build larger knowledge pools fast… Which attract new prosumers by offering discontinuous marginal productivity gains … And build scale

Increasing returns means:

PP communities will be winner-take-all markets

The resource to which there are increasing returns is knowledge , not just network size

The biggest network won’t win by default (like dot com 1.0) – the most efficient knowledge generator will.

Knowledge and network size are necessary to create natural monopoly dynamics

Dominant strategies leverage speed

To build larger knowledge pools fast…

Which attract new prosumers by offering discontinuous marginal productivity gains

… And build scale

Increasing Returns – A Short History Where else do we see supply-side increasing returns? Accelerating down the learning curve – BCG Which came from… Disembodied learning-by-doing knowledge as public good in production functions. Cumulative knowledge investment of all firms exponentially related to capital stock (Arrow) Capital growth and knowledge externalities: (Romer) AKA endogenous growth theory How do these two theories of supply side increasing returns differ from PP models? EGT assumes constant supply-side returns at the firm level, and increasing returns only at the industry/national level Increasing returns in the BCG model aren’t sustainable – the learning curve flattens out Supply side increasing returns in PP models are sustainable as long as knowledge pool grows .

Where else do we see supply-side increasing returns?

Accelerating down the learning curve – BCG

Which came from…

Disembodied learning-by-doing knowledge as public good in production functions. Cumulative knowledge investment of all firms exponentially related to capital stock (Arrow)

Capital growth and knowledge externalities: (Romer)

AKA endogenous growth theory

How do these two theories of supply side increasing returns differ from PP models?

EGT assumes constant supply-side returns at the firm level, and increasing returns only at the industry/national level

Increasing returns in the BCG model aren’t sustainable – the learning curve flattens out

Supply side increasing returns in PP models are sustainable as long as knowledge pool grows .

Peer Production Strategy Understanding Value Chain Evolution

Value Chain Evolution Peers Platform Peers Aggregator Inputs Manufacturer Marketer Distributor Retailer Cheap information disintegrates value chains, because segment consolidators realize specialization gains and economies of scope – integrated production becomes costly Cheap coordination atomizes disintegrated value chains and explodes value activities within layers, because microproducers realize distributed scale economies Inputs, Manufacturing, Marketing, Distribution, Retail Costly info and coordination integrates value activities – most economical way to produce Peers

Value Chains & Value Appropriation Infrastructure Content Search ISP Telco Inputs In disintegrated value chains, industry profitability migrates to the center (aka the ‘coordinator’) Manufacturer Marketer Distributor Retailer Creatives Producer Publisher Distributor Retailer 5% 20% 50% 20% 5% Why? Market power in horizontalized landscapes – layer dominance – flows from relative scope (t he center can realize the greatest marketing scope economies of scope via marketing, branding, and advertising), or relative specialization (the center can develop the most economically advantageous core competences) EG: Nike, EA, SeanJohn, Google

Value Chains & Value Appropriation Platform Peers Aggregator In atomized value chains, industry profitability will migrate to the edges 40% 20% 40% Inputs Platform Peers Aggregator Reconstructor 35% 10% 10% 10% 35% Why? Market power in atomized landscapes is a function of relative scale: the edges can realize the greatest relative economies of scale via demand and supply side network FX. The middle of the value chain explodes and can’t realize scale economies. Core competences for disintegrated value chain coordinators become core rigidities – value capture requires competences at both edges of the chain

The Explosion of the Middle Peers Peers Peers Platform Peers Aggregator In atomized value chains, industry profitability will migrate to the edges 40% 20% 40% Why? The center explodes and atomizes – hypercommoditization – and value shifts to adjacent segments , because they can realize scale economies from the exploded center’s output. Examples: Blogger, Bloglines, Flickr

The Commoditization of the Edge In atomized value chains, the same technology that explodes the middle commoditizes the old edges (example: cheap connectivity enables blogging). Industry profitability migrated to new edges. 40% 20% 40% Coordination Production Aggregation Blogger bloggers Bloglines AudBlog podcasters PodWorld Community Owners reviewers Become Connectivity 0-1% BitTorrent ISP

Value Appropriation Examples In atomized value chains, industry profitability will migrate to newer (and newer) edges Platform Peers Publisher Aggregator Reconstructor 35% 10% 5% 10% 35% Coordination Production Publishing Aggregation Filtering Laptop audio Artist Label Club DJ Blogger bloggers hosting search Bloglines MMOG Developer gamers Mods & plugins Community sites Gaming Open Market

PP Dominant Strategy: Vertical Integration The point: Peer production communities are vertically integrated atomized value chains… To capture the most value, integrate towards both edges … Plus knowledge pools Knowledge externalities don’t pool without integration 40% 20% 40% Coordination Production Aggregation Platform Peers Aggregator

The point:

Peer production communities are vertically integrated atomized value chains…

To capture the most value, integrate towards both edges

… Plus knowledge pools

Knowledge externalities don’t pool without integration

Peer Production Strategy Competitive Dynamics

Peer Production Model Inputs (Coordination) Means of Production Outputs (Aggregation) Explicitly modifiable by community Sell access to users Competition for access, prizes Wikipedia raw content Open or community regulated access Advertising and sponsorship % Ad revenue Wikipedia CMS Efficient information sharing % Sales revenue % Revenue from outputs Wikipedia entry Knowledge pool grows New aggregated public info Requirements Revenue stream Peer incentive Example Increasing Returns

PP Competitive Dynamics PP model competitive dynamics You own a successful PP community facing new competitor entry. What do you do? Positioning continuum Quality Operating model should be partly proprietary. Tight supplier relationships. New peer entry by invitation or referral. Quantity Operating model should be fully open. Loose supplier relationships. New peer entry open to public. What resources and capabilities drive competitive advantage?

PP model competitive dynamics

You own a successful PP community facing new competitor entry. What do you do?

Positioning continuum

Quality

Operating model should be partly proprietary.

Tight supplier relationships.

New peer entry by invitation or referral.

Quantity

Operating model should be fully open.

Loose supplier relationships.

New peer entry open to public.

What resources and capabilities drive competitive advantage?

PP Strategy Building Blocks Key capability: Market-making Engineers increasing returns by exploding knowledge pool as user base grows… … By creating efficient information-sharing mechanisms Which create coordination economies by vaporizing transaction and coordination costs of production Results in: Economies of speed New users are attracted… … by accelerating knowledge pool growth … which increases productivity Or: the faster your throughput is, the faster knowledge pools… And reduces unit cost as network grows

Key capability:

Market-making

Engineers increasing returns by exploding knowledge pool as user base grows…

… By creating efficient information-sharing mechanisms

Which create coordination economies by vaporizing transaction and coordination costs of production

Results in:

Economies of speed

New users are attracted…

… by accelerating knowledge pool growth

… which increases productivity

Or: the faster your throughput is, the faster knowledge pools…

And reduces unit cost as network grows

How to Make a Market Markets don’t become automatically efficient Efficiency emerges from: Liquidity : assets are theoretically tradable Low transaction costs : assets are actually tradable Implications: graininess of information sharing mechanisms is key to minimize information asymmetries between peer producers Profit maximizing traders Implications: must create incentives/gains for peer producers Peer producers must be able to internalize those gains Only way to avoid prisoner’s dilemma – everyone expects someone else to vote, Bush wins Goods traded can’t be purely public goods Implication: access to means of production must be restricted to highest valued peer producers: quasi-public goods What’s the desired result? Information about which inputs used by which means of production most efficiently produce the most desired outputs… … is traded and arbitraged, and the best solutions are revealed

Markets don’t become automatically efficient

Efficiency emerges from:

Liquidity : assets are theoretically tradable

Low transaction costs : assets are actually tradable

Implications: graininess of information sharing mechanisms is key to minimize information asymmetries between peer producers

Profit maximizing traders

Implications: must create incentives/gains for peer producers

Peer producers must be able to internalize those gains

Only way to avoid prisoner’s dilemma – everyone expects someone else to vote, Bush wins

Goods traded can’t be purely public goods

Implication: access to means of production must be restricted to highest valued peer producers: quasi-public goods

What’s the desired result?

Information about which inputs used by which means of production most efficiently produce the most desired outputs…

… is traded and arbitraged, and the best solutions are revealed

Making Markets: Efficient Information Sharing In the real world… How do you build efficient information sharing? By building incentives to leverage reputation and reciprocity By minimizing the risk of contribution By imposing punishment costs How?! By using an implicit or explicit currency Links are the currency for link aggregators Feedback points are the currency for eBay’s reputation system Ratings are the currency for Amazon’s book reviews Which is liquid and tradable Which creates incentives to profit To gain more links To get positive reputation feedback … and by eliminating transaction costs

In the real world…

How do you build efficient information sharing?

By building incentives to leverage reputation and reciprocity

By minimizing the risk of contribution

By imposing punishment costs

How?!

By using an implicit or explicit currency

Links are the currency for link aggregators

Feedback points are the currency for eBay’s reputation system

Ratings are the currency for Amazon’s book reviews

Which is liquid and tradable

Which creates incentives to profit

To gain more links

To get positive reputation feedback

… and by eliminating transaction costs

A Quick Currency Case Study What is a currency? Karma/rating is not an implicit currency It’s not tradable… … It has use value but no exchange value If I give you good karma, what does it cost me? Nothing – i have little incentive to reveal my true preferences Conversely, if I have good karma, what does it benefit me? Generally, I receive more privileges… But I can’t trade it to get what I really want So I have little incentive to reveal my true preferences Your currency has to be more than a ratings system… … but not so complicated that peers won’t use it What currencies have use and exchange values? Links – use value is linking from, exchange value is linking to Implication: Ratings and karma fail because exchange is unidirectional Real currencies succeed because exchange is bidirectional

What is a currency?

Karma/rating is not an implicit currency

It’s not tradable…

… It has use value but no exchange value

If I give you good karma, what does it cost me?

Nothing – i have little incentive to reveal my true preferences

Conversely, if I have good karma, what does it benefit me?

Generally, I receive more privileges…

But I can’t trade it to get what I really want

So I have little incentive to reveal my true preferences

Your currency has to be more than a ratings system…

… but not so complicated that peers won’t use it

What currencies have use and exchange values?

Links – use value is linking from, exchange value is linking to

Implication:

Ratings and karma fail because exchange is unidirectional

Real currencies succeed because exchange is bidirectional

Making Markets: Sources of Transaction Costs Asset specificity Make information sharing objects not specific Example: tags Frequency and duration Make information sharing either frequent and small, or infrequent and large Example: playlists (infrequent and large) vs tags (frequent and small) Complexity and uncertainty Make info sharing mechanisms easy to navigate and predictable in results Difficulty of measuring performance Connectedness to other transactions in system Interdependent transactions can require complex coordination

Asset specificity

Make information sharing objects not specific

Example: tags

Frequency and duration

Make information sharing either frequent and small, or infrequent and large

Example: playlists (infrequent and large) vs tags (frequent and small)

Complexity and uncertainty

Make info sharing mechanisms easy to navigate and predictable in results

Difficulty of measuring performance

Connectedness to other transactions in system

Interdependent transactions can require complex coordination

PP Strategy Building Blocks Key resource: Peer network Owning the largest user network realizes increasing returns … .but only when knowledge pool explodes, attracting even more new users, increasing productivity Knowledge pool explosion depends critically on market-making capability creating efficient information sharing Results in… Economies of scale Speed and scale are interdependent If you can build both, you will achieve increasing returns … efficient information sharing mechanisms drive speed… ..and supply-side viral and network effects turn speed into scale Unit cost falls as marginal productivity increases in network size many specialized hands make production more efficient

Key resource:

Peer network

Owning the largest user network realizes increasing returns

… .but only when knowledge pool explodes, attracting even more new users, increasing productivity

Knowledge pool explosion depends critically on market-making capability creating efficient information sharing

Results in…

Economies of scale

Speed and scale are interdependent

If you can build both, you will achieve increasing returns

… efficient information sharing mechanisms drive speed…

..and supply-side viral and network effects turn speed into scale

Unit cost falls as marginal productivity increases in network size

many specialized hands make production more efficient

PP Strategy Building Blocks And economies of scope: Scope is a secondary economy Production set explosion means unit costs can fall in network size… … but only if means of production are flexible … and inputs are tradable It’s no good having a community of diamond miners when DeBeers owns all the mines Drivers: Knowledge network size

And economies of scope:

Scope is a secondary economy

Production set explosion means unit costs can fall in network size…

… but only if means of production are flexible

… and inputs are tradable

It’s no good having a community of diamond miners when DeBeers owns all the mines

Drivers: Knowledge network size

Relative Advantages Efficient Info Sharing Peer Network Public Knowledge Productivity New Users Without a market making capability… … public knowledge doesn’t pool … new users aren’t attracted … marginal productivity doesn’t grow … increasing returns fail

Peer Production Revenue Sharing PP is not about getting others to make your stuff for ‘free’ PP is way to create more value via coordination arbitrage … But there’s no such thing as a free lunch Revenue sharing will emerge as supply-side price competition Peer producers will appropriate more value as communities grow Should you share revenues? Yes! Sharing creates incentives for productivity and knowledge growth But share strategically – not as margin-eroding price competition Strategic revenue sharing targets constant margins and revenue growth in network size Strategic revenue sharing What determines the peer producer revenue share? Rivalry for peer producers within your industry Pre-empt margin erosion… By limiting rivalry for peer producers The more effectively you limit rivalry, the more you can share without margin erosion What limits rivalry for peers?

PP is not about getting others to make your stuff for ‘free’

PP is way to create more value via coordination arbitrage

… But there’s no such thing as a free lunch

Revenue sharing will emerge as supply-side price competition

Peer producers will appropriate more value as communities grow

Should you share revenues? Yes!

Sharing creates incentives for productivity and knowledge growth

But share strategically – not as margin-eroding price competition

Strategic revenue sharing targets constant margins and revenue growth in network size

Strategic revenue sharing

What determines the peer producer revenue share?

Rivalry for peer producers within your industry

Pre-empt margin erosion…

By limiting rivalry for peer producers

The more effectively you limit rivalry, the more you can share without margin erosion

What limits rivalry for peers?

Peer Production Industry Structures & Rivalry Suppliers & Buyers: Control access to key technologies, inputs, and distribution channels – vertical integration Control buyer/supplier scope economies by controlling high-value complements Fragment/commoditize key technologies or inputs if you can’t control them Example: Amazon – Fedex deal

Peer Production Industry Structures & Rivalry Suppliers: Control access to key technologies or inputs – vertical integration Fragment/commoditize key technologies or inputs if you can’t control them EG: Complements: Create larger numbers of higher quality complements than competitors Raises switching costs by lowering relative value of substitutes Example: lightweight, open standards (RSS) drive cheap complementarity Anti-example: Apple closing off iPod/iTunes platform kills complementarity Buyers: Control distribution channels – vertical integration Fragment/commoditize distribution channels if you can’t control them EG: New Entrants: Vertical integration creates strong entry barriers Scale and speed economies in network markets create strong entry barriers Other sources: first-mover advantage, preemption, deterrence, complements, nonlinear pricing, differentiation Example: eBay’s user network

Where PP is Inferior PP is an inferior way to organize the production & design of goods For which access to means of production is unavailable Tightly controlled by suppliers Aggregate peer network learning costs higher than opportunity cost of production Capital and connectivity intensive For which sharing isn’t viable No learning externalities Connectivity issues Inherent properties of goods Goods not lumpy Durable goods These properties limit rate of knowledge pool growth and kill increasing returns… Or limit ultraspecialization gains and kill distributed economies of scale

PP is an inferior way to organize the production & design of goods

For which access to means of production is unavailable

Tightly controlled by suppliers

Aggregate peer network learning costs higher than opportunity cost of production

Capital and connectivity intensive

For which sharing isn’t viable

No learning externalities

Connectivity issues

Inherent properties of goods

Goods not lumpy

Durable goods

These properties limit rate of knowledge pool growth and kill increasing returns…

Or limit ultraspecialization gains and kill distributed economies of scale

Where PP is Superior PP is a superior way to organize the production & design of goods For which real-world production transaction costs are high For which real-world production coordination costs are high But for which , virtually, production and consumption information can be efficiently shared, realizing coordination economies For which ultraspecialized knowledge is dispersed throughout the larger population Which can realize distributed scale economies For which inputs are divisible For which the means of production are accessible

PP is a superior way to organize the production & design of goods

For which real-world production transaction costs are high

For which real-world production coordination costs are high

But for which , virtually, production and consumption information can be efficiently shared, realizing coordination economies

For which ultraspecialized knowledge is dispersed throughout the larger population

Which can realize distributed scale economies

For which inputs are divisible

For which the means of production are accessible

Summary: Peer Production Economics Assigning coordination rights is costly in the real world But virtually, coordination economies make atomized microproduction viable By efficiently sharing information about about who and what should have access the means of production Atomized microproduction… Yields ultraspecialization gains Reusing modular microchunks of production create increasing marginal productivity Distributed economies of scale result Knowledge pools When goods are produced, and new shared information is stored Increasing the future productivity of the community Attracting new users, who make it more efficient to produce more goods… … sustainable supply-side increasing returns

Assigning coordination rights is costly in the real world

But virtually, coordination economies make atomized microproduction viable

By efficiently sharing information about about who and what should have access the means of production

Atomized microproduction…

Yields ultraspecialization gains

Reusing modular microchunks of production create increasing marginal productivity

Distributed economies of scale result

Knowledge pools

When goods are produced, and new shared information is stored

Increasing the future productivity of the community

Attracting new users, who make it more efficient to produce more goods…

… sustainable supply-side increasing returns

Summary: Peer Production Economics Disintegrated value chains will atomize Cheap coordination will atomize and explode the center, where production of goods generally happens … and value will migrate to newer and newer edges The dominant peer production strategy Is to vertically integrate across the entire value chain To capture the most value by providing infrastructure, inputs, and marketing/aggregation/filtering of outputs This can be seen as a shift from goods to services in many industries In order to achieve this strategy, you need… Key resources and capabilities in market-making … In order to enable efficient info sharing and engineer increasing returns … and a sufficiently large and productive peer network… In order to realize distributed economies of scale

Disintegrated value chains will atomize

Cheap coordination will atomize and explode the center, where production of goods generally happens

… and value will migrate to newer and newer edges

The dominant peer production strategy

Is to vertically integrate across the entire value chain

To capture the most value by providing infrastructure, inputs, and marketing/aggregation/filtering of outputs

This can be seen as a shift from goods to services in many industries

In order to achieve this strategy, you need…

Key resources and capabilities in market-making …

In order to enable efficient info sharing and engineer increasing returns

… and a sufficiently large and productive peer network…

In order to realize distributed economies of scale

Summary: Peer Production Models Open or community-regulated access to the means of production Open or community-regulated access to modify inputs Low level inputs require little technical knowledge content, designs, ideas, proposals High level inputs require complex technical knowledge product architectures, interfaces, features The catch: Supply-side productivity gains depend critically on information sharing to create knowledge externalities. How do you know how to modify inputs? Without knowledge externalities, the PP model can’t reach hyperefficiency. Supply side effects alone are not enough

Open or community-regulated access to the means of production

Open or community-regulated access to modify inputs

Low level inputs require little technical knowledge

content, designs, ideas, proposals

High level inputs require complex technical knowledge

product architectures, interfaces, features

The catch:

Supply-side productivity gains depend critically on information sharing to create knowledge externalities.

How do you know how to modify inputs?

Without knowledge externalities, the PP model can’t reach hyperefficiency.

Supply side effects alone are not enough

Summary: Peer Production Models Demand-side sharing mechanisms make private info and preferences about inputs and outputs public Playlists, tags, votes, ranks, values, reputations… Aggregating sharing mechanisms reveals: Utility functions & preferences – most efficient outputs Private technical expertise & info – most efficient inputs The cream will rise to the top - the most efficient inputs and outputs become transparent Assuming search costs are low Efficent sharing pools knowledge Which creates sustainable supply-side increasing returns No sharing without market-marking Leverage implicit or explicit currencies to build incentives No productivity gains without sharing Knowledge must be a public good

Demand-side sharing mechanisms make private info and preferences about inputs and outputs public

Playlists, tags, votes, ranks, values, reputations…

Aggregating sharing mechanisms reveals:

Utility functions & preferences – most efficient outputs

Private technical expertise & info – most efficient inputs

The cream will rise to the top - the most efficient inputs and outputs become transparent

Assuming search costs are low

Efficent sharing pools knowledge

Which creates sustainable supply-side increasing returns

No sharing without market-marking

Leverage implicit or explicit currencies to build incentives

No productivity gains without sharing

Knowledge must be a public good

Thank You

Heuristics

Peer Production Advantage Dot Com 1.0: Search engines, portals, networking services Peer Production Yellow Pages Fabs Low Search Economies High Coordination Economies Low High

Coordination Arbitrage Criteria Hedge Funds, VC Ford, GM Lifestyle goods Peer Production Sweet Spot Media… Low Input Indivisbility High Coordination Diseconomies Low High

Relative Advantages in… Amazon Peer Production Community Out of the Game Vital point eBay No Community Size Yes Market Making Capability No Yes

Who’s Attracted? Slackers: Inefficient info-sharing Restrict peer entry by invitation/referral Shift to part-closed model Control quality of complements Everyone : Sweet spot No one: Vital point Geeks: Expand scope Shift to fully open-access model Leverage viral effects & complements to win peers Low Knowledge Pool Size High Knowledge Pool Quality Low High

Productivity Explosions Productivity Implosion Real-World Productivity Real-World Productivity Productivity Explosion Low Community Size High Knowledge Pool Size Low High

Peer Production Cost Advantage Disintegrated Gains to Specialization Size of Production Set Atomized Integrated

Notes

Peer Production - Resource & Capability Dynamics Speed Effects User network Knowledge pool Action Coordination Information Exchange Knowledge Externalities Increasing returns Productivity Output Scale & Scope Effects

Analyzing Network Economics 2.0 3 dimensions of next-gen b-models: Horizontal scope (products) Vertical scope (features) Peer productivity (knowledge network size vs user network size). 3 economic variables: Scale, scope, and speed drive positioning on the above dimensions.

3 dimensions of next-gen b-models:

Horizontal scope (products)

Vertical scope (features)

Peer productivity (knowledge network size vs user network size).

3 economic variables:

Scale, scope, and speed drive positioning on the above dimensions.

2.0 Strategy Space Vertical Scope (Product Depth) Horizontal Scope(Portfolio Breadth) Peer Productivity Scope Scale Speed

Scale, Scope, and Speed Economies Scale Reduction in unit costs due to increase in operational size Scope Reduction in unit costs due to increase in number of products marketed Speed Reduction in unit costs due to increase in number of products put through supply/demand chain

Scale

Reduction in unit costs due to increase in operational size

Scope

Reduction in unit costs due to increase in number of products marketed

Speed

Reduction in unit costs due to increase in number of products put through supply/demand chain

Coordination and Transaction Coordination Search Matching Transaction Negotiation Bargaining Enforcement

Coordination

Search

Matching

Transaction

Negotiation

Bargaining

Enforcement