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The paper describes a conceptual approach for a next-generation innovation paradigm in the Digital Economy called “Embedded Innovation” (Innovation 3.0). The notion of “embeddedness” is introduced to mark the increasing challenge of integrating firms into their surrounding communities to assure the absorption of exploitable knowledge. In the paper the evolutionary steps from Closed via Open to Embedded Innovation in small and medium sized companies (SME) are described. On the basis of the firm’s different relationships and knowledge flows with respect to its surrounding communities different modes of how and what to learn from communities are defined and how this may unfold leverage effects for the innovation process. Finally, we present empirical innovation case studies on how to embed the firm into communities with the aim of ensuring knowledge absorption and collaborative learning.JEL Codes: L17, O31, O32, O33