When is an innovation opportunity viable for a producer?
Next, let us consider the space of innovation opportunities for which producer innovation is viable. Recall that a producer innovator is a single, non-collaborating firm that creates an innovation in order to sell it. Often producers can economically justify undertaking larger designs more easily than single individuals can, because they expect to spread their design costs over many purchasers.
Even though they are single organizations, producers, unlike single individuals, are affected by communication costs. They may use developers outside the firm, and then have to communicate with those outside individuals or organizations in order to coordinate. In addition, in order to justify investing in an innovation, they have to sell it. For that reason, they must invest in making potential buyers aware of what they have to sell via marketing communications. Such investments are often substantial, as the size of many producers' marketing budgets clearly attests.
Let us assume that a producer knows the development costs (dp) and communication costs (cp) that will be required to create the innovation and diffuse information about it to potential adopters. Let us also assume that the producer knows the value vi that each potential adopter places on that innovation, as well as the number of potential adopters who would drop out of the producer's list of potential customers because they can self-supply more cheaply—in other words, that the producer knows each customer's willingness to pay for the producer's version of the innovative product or service. Following standard reasoning in microeconomics, the producer innovator can convert this knowledge about customers into a demand function, Q(p), that relates each price it might charge to the number of units of the product or service it will be able to sell at that price. From the demand function, the producer innovator can solve for the price (p*) and the quantity (Q*) that maximize its expected revenues (net of production and transaction costs). Next, it can subtract its design (dp) and communication (cp) costs from this net revenue to calculate its expected maximum profit, P*:
If the producer anticipates positive profit for a specific innovation opportunity, then, as a rational actor, it will enter the market to supply the innovation. In other words, for that opportunity, the producer innovator model is viable. Conversely, if its anticipated profit is negative, the producer will not enter, and the producer model of innovation is not viable. As figure 3.3 shows, the zero profit line is a negative 45° line in the space of design and communication costs: p*Q* = dp + Cp. For innovation opportunities within the triangle created by that line, the producer can expect profits. Those opportunities are therefore "viable” for the producer. Outside that triangle, innovation opportunities are not viable (Baldwin and von Hippel 2011).
Adding a viability region for producer innovation.