Co-Creation with Production Externalities

Co-creation, the participation of customers in the design and production of goods and services, has been gaining popularity in recent years. In this research we incorporate firm pricing into the joint production process allowing us to study (1) production externalities between firm and customers, (2) production externalities among customers, and (3) optimal pricing by firms. We show that given a choice, a monopoly firm will opt for co-creation with customers rather than deal with passive price-taking consumers. Furthermore, the firm will increase the effort it devotes to co-creation as the number of potential co-creating customers increases. We show that the profit of a firm facing a centralized pattern of externalities among customers (with an expert, or lead user, in the center) can be higher than its profit when facing a decentralized pattern of externalities among customers and clearly dominates its profit when customers do not have any cross externalities. Thus, we provide a different justification for the use of lead users, one that depends on their network centrality and not on having lower cost, more information, or greater ability than the firm. Because the decentralized pattern has more links than the centralized pattern, our results demonstrate the importance of the pattern of links between customers, and not just their number, in determining the profitability of co-creation. Furthermore, we find that the lead user's externality spillover to other connected users, her neighbors, acts as a force multiplier on the efforts exerted by all participants in equilibrium. Specifically, a higher spillover from the lead user increases the efforts of the firm, the neighbors, and the lead user herself, and this may lead to beneficial outcomes for all. Finally, we show that in co-creation environments, a monopolist firm may benefit by committing to a single price rather than exercising price discrimination. This is because the pricing structure affects customers' incentive to invest effort in the innovation-production stage.