The last 20 years have witnessed the rise of disaggregated "clusters," "networks," or "ecosystems" of firms in a number of industries, including computers, telecommunications, and pharmaceuticals. In these clusters, different firms design and produce the various components of a complex artifact (such as the processor, peripherals, and software of a computer system), and different firms specialize in the various stages of a complex production process. This paper considers the pricing behavior and profitability of these so-called modular clusters. Baldwin and Woodard isolate the offsetting price effects in a model, and show how they might operate in large as well as in small clusters. Key concepts include:
* Clusters operating under open, public standards may have higher prices and profits than those operating under closed, proprietary standards.
* Cluster forms of industrial organization may not be conducive to all kinds of innovation. In particular, innovations that add new layers of functionality to the system, and thus increase total demand, will not be adequately rewarded relative to the value they create.
* It is important to learn how cluster configurations affect incentives to supply different forms of innovation, and how firms respond to these cross-layer dependencies in formulating their long-term strategies.
