Chapter 9 PROTECTING INNOVATION

1. Strategic Management of Technological InnovationMelissa Schilling Chapter 9PROTECTING INNOVATION

2. The Digital Music Distribution Revolution • In 1991, Fraunhofer IIS of Germany invents the MP3 format; by late 1990’s the format is wildly popular. • Compressed digital audio to 1/10th the of the original size with minimal compromise in audible quality • A song was now a file that could be shared over the Internet • Franuhofer pursued a partially open licensing approach by partnering with Thomson Multimedia as the exclusive licensing representative of MP3 patents in 1995 • Thomson then negotiated agreements with Apple, Adobe, Creative Labs and Microsoft to name a few. • This gave consumers easy access to the technology • Other companies developed competing technologies Sonywith ATRAC and MS with WMA but MP3 was dominant • In 1999, Shawn Fanning releases Napster, a free software program that allows users to easily share MP3 files (“peer-to-peer”) • The RIAA starts to worry about illegal trade of copyrighted music. In 2001 it gets a court ruling against Napster, taking it offline. • However, new peer-to-peer music services began to sprout up to meet the demand of the large population of “music pirates.”

3. The Digital Music Distribution Revolution • Napster offered to partner with the RIAA and develop a legitimate digital distribution model. The RIAA turned down the offer, won the legal battle but were still challenged by a new business model that they were not prepared for. • Warner Music and Sony Entertainment developed their own subscription services but they used proprietary digital file formats and very restrictive digital rights management schemes that frustrated the users. They also had a limited selection of recordings. • In 2003, Apple opens its iTunes Music Store – a one-stop-shop for music files from the five major record labels. Now record industry is earning significant revenues from MP3s. • Began with a catalogue of 200,000 songs for 99 cents each. 50 million downloads the first year. • Built security features (Fairplay DRM - digital rights management)to prevent illegal sharing which was not as restrictive as the older model • A number of factors lead to iTunes success • “cool” image • Used MP3 format • Attractive price • Success of the iPod • Large selection of songs due to licensing agreements with all five major labels

4. The Digital Music Distribution Revolution • In 2006, France pushes Apple to loosen its restrictions on iTunes music and iPods and allow songs downloaded from the French iTunes Music Store to be played on non-iPod MP3 players and that iPods should play competing file formats. • May 2006, The French government reconsidered a proposal to force Apple Computer to make the songs it sells through its iTunes Music Store playable on devices that compete with its iPods. • Aug 4, 2006 Apple's rivals can now request information necessary to make their services and MP3 players interoperable with iTunes and iPods, but Apple must be compensated. (Cnet news.com) • Sept 2007 Amazon launches DRM free music store • March 4, 2008 Warner Music has signed a deal with media site 7digital.com to offer its music without copy protection. Apple’s Itunes Plus offers DRM free music but only EMI tracks (bbc news)

5. The Digital Music Distribution Revolution • Many independent musicians welcomed MP3 and digital distribution tools to promote their music • Previously, music distribution was costly and required capital, typically provided by record labels. It was difficult to get a record deal and the terms were not attractive to the artists • New models of digital distribution were emerging: • Creative Commons • License agreements to make files public, legal, and free • Musicians can advertise their music and sign away certain copyright privileges so that the music can be downloaded and distributed without risk of infringement suits • Podcasting • whole “shows” could be downloaded • Musicians pass up immediate potential revenue for the opportunity to gain exposure and a fan base • NPR introduced podcasts on Aug 31, 2005 and by Nov 8, 2005, there were 5 million downloads. As of Feb 2006, more than 13 million downloads have been generated • Forrester predicts podcasting will grow from 700,000 households in the US in 2006 to 12.3 million households in the US by 2010

6. The Digital Music Distribution Revolution April 4, 2008 Apple Inc. has surpassed Wal-Mart to become America's No. 1 music store, the first time that a seller of digital downloads has ever beaten the big CD retailers.Apple sold more albums in January and February than any other U.S. retailer, market research firm NPD Group said Thursday, underscoring how the music industry is on the front edge of a digital media shift that is upending businesses as diverse as bookstores and video game makers.U.S. consumers still buy more CDs than digital downloads, but the gulf is narrowing rapidly. Only five years after launching its iTunes digital store, Apple has dominated the fast-growing download market so completely that it jumped ahead of individual CD sellers such as Wal-Mart, Best Buy and Target.

7. Appropriability • Appropriability: The degree to which a firm is able to capture the rents from its innovation. • Appropriability is determined by how easily or quickly competitors can copy the innovation. • Some innovations are inherently difficult to copy • tacit: knowledge that cannot be readily codified or transferred in written form • socially complex: arises through complex interactions between people (team of uniquely talented research scientists); sum of group effort is greater than the individual contributions • Many innovations are relatively easy for competitors to imitate • Firms attempt to protect these innovations through patents, trademarks, copyrights or trade secrets.

8. Patents, Trademarks & Copyrights • Most sources attribute the origin of formalized protection of IP to 15th century England where the monarchy granted certain privileges to manufactureres abd traders as signified by “letters patent” which were marked by the king’s great seal • In 1449, Henry VI granted John Utynam a 20 year monopoly on a method of producing stained glass that was unknown in England • Copyright protection arrived in 1710 when Parliament gave protection to books and other written works

9. Patents, Trademarks & Copyrights • Trademarks (marks of ownership) can be traced back to 3500 BCE but trademark laws did not emerge until the 1700s • In 1791, Thomas Jefferson supported the requests of sailcloth makers by recommending the establishment of trademark protection based on the commerce clause of the constitution • The 1st internationational trademark agreement was reached in 1883 at the Paris Convention for the Protection of Industrial Property 9-9

10. Patents, Trademarks & Copyrights • Patents, trademarks and copyrights each protect different things. • Patents: rights granted by the government that excludes others from producing, using, or selling an invention. • Must be useful, novel, and not be obvious. • Utility patents protect new and useful processes, machines, manufactured items or combination of materials. • Design patents protect original and ornamental designs for manufactured items. • Plant patents protect distinct new varieties of plants. • In 1998, many software algorithms became eligible for patent protection, previously covered only under copyright laws • It unleashed a flood of applications for software patents 9-10

11. Patents, Trademarks & Copyrights • To apply for a patent, the inventor must explain how to make use of the invention and make claims about what it does that makes it a new invention • In the US, the patent is reviewed by an examiner who may make modifications to the scope of the claims of the patent • The patent is then published and can be challenged by other inventors (e.g., infringes on an existing patent) • If the standards are met, then the patent is issued • Patents are issued for 20 years 9-11

12. Patents, Trademarks & Copyrights • The patent process can take 2-5 years, and involves a number of costs. Fee Types ($US) Regular Fee Small Entity Fee Patent Filing Fees    Basic patent filing fee—utility 1000 500    Design patent filing fee 430 215    Plant patent filing fee 660 330 Patent Issuance Fees (paid after Patent Office approves patent)    Utility patent issue fee 1,400 700    Design patent issue fee 800 400    Plant patent issue fee 1100 550 Publication fee 300 300 Patent Maintenance Fees (to keep patent in force)    Due at 3.5 years after issuance of patent 900 450    Due at 7.5 years after issuance of patent 2,300 1,150    Due at 11.5 years after issuance of patent 3,800 1,900

13. Patents, Trademarks & Copyrights • Patent Laws Around the World • Countries have their own laws regarding patent protection. Some treaties seek to harmonize these laws. • Paris Convention for the Protection of Industrial Property • Foreign nationals can apply for the same patent rights in each member country as that country’s own citizens. • Provides right of “priority” – once inventor has applied for protection in one member country, they can (within certain time period) apply for protection in others and be treated as if they had applied on same date as first application. • Patent Cooperation Treaty (PCT) • Inventor can apply for patent in a single PCT receiving office and reserve right to apply in more than 100 countries for up to 2 ½ years. Establishes date of application in all member countries simultaneously. Also makes results of patent process more uniform.

14. Patents, Trademarks & Copyrights

15. Patents, Trademarks & Copyrights • Trademarks and Service Marks: a word, phrase, symbol, design, or other indicator that is used to distinguish the source of goods form one party from goods of another (e.g., Nike “swoosh” symbol) • Rights to trademark are established in legitimate use of mark; do not require registration. • However, marks must be registered before suit can be brought over use of the mark. • Registration can also be used to establish international rights over trademark. • Two treaties simplify registration of trademarks in multiple countries: Madrid Agreement Concerning the International Registration of Marks, and the Madrid Protocol. Countries that adhere to either or both are in Madrid Union (77 members)

16. Patents, Trademarks & Copyrights • Copyright: a form of protection granted to works of authorship. • Copyright prohibits others from: • Reproducing the work in copies or phonorecords • Preparing derivative works based on the work • Distributing copies or phonorecords for sale, rental, or lease • Performing the work publicly • Displaying the work publicly • Work that is not fixed in tangible form is not eligible. • Copyright is established in first legitimate use. • However, “doctrine of fair use” stipulates that others can typically use copyrighted material for purposes such as criticism, new reporting, teaching, research, etc. • Copyright for works created after 1978 have protection for author’s life plus 70 years.

17. Patents, Trademarks & Copyrights • Copyright Protection Around the World • Copyright law varies from country to country. • However, the Berne Union for the Protection of Literary and Artistic Property (“Berne Convention”) specifies a minimum level of protection for member countries. • Berne convention also eliminates differential rights to citizens versus foreign nationals.

18. Patents, Trademarks & Copyrights Wall Street Journal 4/18/2008 (Steve Vander Ark vs J.K. Rowling) 9-18

19. Trade Secrets • Trade Secret: information that belongs to a business that is generally unknown to others. • Firm can protect proprietary product or process as trade secret without disclosing detailed information that would be required in patent. • Enables broad class of assets and activities to be protectable. • To qualify: • Information must not be generally known or ascertainable. • Information must offer a distinctive advantage to the firm that is contingent upon its secrecy. • Trade secret holder must exercise reasonable measures to protect its secrecy.

20. The Effectiveness and Use of Protection Mechanisms • In some industries, legal protection mechanisms are more effective than others • e.g., in pharmaceutical patents are powerful; in electronics they might be easily invented around. • It is notoriously difficult to protect manufacturing processes and techniques. • Nov 2002, P&G sued Potlatch Corp for stealing trade secret methods for producing Bounty and Charmin products by hiring two of P&Gs paper manufacturing experts. Settled out of court • In some situations, diffusing a technology may be more valuable than protecting it (open source software) • However, once control is relinquished it is difficult to reclaim. Fragmentation of the technology may result

21. Theory In Action IBM and the Attack of the Clones • In 1980, IBM was in a hurry to introduce a personal computer (PC). It used off-the-shelf components such as Intel microprocessors an operating system from Microsoft, MS DOS. • It believed that its proprietary basic input/output system (BIOS) would protect the computer from being copied. • However, Compaq reverse engineered the BIOS in a matter of months without violating the copyright, and quickly introduced a computer that behaved like an IBM computer in every way. Compaq sold a record-breaking 47,000 IBM-compatible computers its first year, and other clones were quick to follow.

22. The Effectiveness and Use of Protection Mechanisms • Wholly Proprietary Systems vs. Wholly Open Systems • Wholly proprietary systems may be legally produced or augmented only by their developers. May not be adopted as readily due to higher costs and inability to mix and match components • Wholly open system may be freely accessed, augmented and distributed by anyone. Quickly commoditized and provide little appropriabiliy of rents to the developers • Many technologies lie somewhere between these extremes.

23. The Effectiveness and Use of Protection Mechanisms • Advantages of Protection • Proprietary systems offer greater rent appropriability. • Rents can be used to invest in further development, promotion, and distribution. • Give the firm control over the evolution of the technology and complements • Microsoft Windows (see next slide) • Advantages of Diffusion • May accrue more rapid adoptions if produced and promoted by multiple firms • Technology might be improved by other firms (though external development poses its own risks). • UNIX was first developed by AT&T in 1969 by Bell Labs • A Dept of Justice injunction forbade AT&T from selling software commercially but they made the source code available through licensing • Each licensee added their own features which led to incompatible versions • AT&T sold UNIX to Novell who eventually handed over the rights to the X/Open standards setting body

24. The Effectiveness and Use of Protection Mechanisms • Video game console producers use a wholly proprietary strategy for their consoles but a limited licensing policy for their games • This encourages developers to produce games for the systems while enables the console producers to maintain a great deal of control over the games produced • Xbox game developers must first apply and be accepted into one of the Xbox programs in order to receive development tools. The games are subject to a rigorous approval process • Microsoft Windows • Protected by copyright and only MS can augment the software • Does allow access to portions of the source code to facilitate development of complementary goods, licenses the rights to such providers to produce complementary applications and licenses OEMs to distribute the software by bundling it with hardware 9-24

25. Theory in Action Sun Microsystems and Java • In 1995, Sun developed a software programming language called Java that enabled programs to be run on any operating system (e.g., Windows, Macintosh). This would lessen pressure for one operating system to be dominant. • Members of the software community felt that Sun should make Java completely “open” – they argued that “Java is bigger than any one company.” • However, Sun was afraid that if Java were completely open, companies would begin to customize it in ways that would fragment it as a standard. • Sun decided to distribute Java under a “community source” program: no license fees, but all modifications to Java required compatibility tests performed by Java’s own standards body (Java Community Process)

26. Production Capabilities, Marketing Capabilities, and Capital • Factors influencing benefits of protection vs. diffusion • Can firm produce the technology at sufficient volume or quality levels? • When JVC was promoting VHS, they knew they were at a marketing and manufacturing disadvantage compared to Sony. They pursued OEM and licensing agreements with Hitachi, Matsushita, Mitsubishi and Sharp to boost the technology’s production rate • Are complements important? Are they available in sufficient range and quality? Can the firm afford to develop and produce them itself? • Is there industry opposition against sole source technology? • Sony and Philips jointly created the original CD format and split the royalties. The other leading consumer electronics producers and record producers joined forces to develop the DVD technology

27. Production Capabilities, Marketing Capabilities, and Capital • Can the firm improve the technology well enough and fast enough to compete with others? • Netscape couldn’t compete against MS so they gave access to their source code to the external development community and incorporated their improvements into the products • How important is it to prevent the technology from being altered in ways that fragment it as a standard? • If a technology needs standards, then retaining some degree of control is critical (Java) • How valuable is architectural control to the firm? Does it have a major stake in complements for the technology? • The ability of a firm to determine the structure, operation, compatibility and development of a technology is even more important when the firm is a significant producer of complements 9-27