INFORMATION TECHNOLOGY IN BUSINESS AND SOCIETYSESSION 23 – NETWORK EFFECTS & POSITIVE FEEDBACK

SEAN J. TAYLOR

ADMINISTRATIVIA

• G1: Great job!

• G1: Submit group feedback forms

• G2: Posted

NETWORK EFFECTS: LEARNING OBJECTIVES• Understand the idea of positive feedback and describe the role it has

played in some prior technology industries (railroad, electricity, telephony)

• Define network effects (demand-side economies of scale) and understand how they lead to positive feedback

• Describe the difference between supply-side and demand-side economies of scale

• Understand the typical sources of network effects in information technology industries

• Be able to recognize these sources for specific technology products or in specific business contexts

• Understand the trade-offs between performance and compatibility, and between openness and proprietary control of a technology

POSITIVE FEEDBACK: OVERVIEW

Historical examples • Railroad gauges, AC versus DC power, telephone networks

What is positive feedback?

• when a firm becomes successful, its past and current success make it more likely to succeed in the future

• ‘…success feeds on itself, the strong get stronger…’

When does this happen?

• More customers lower unit cost (supply-side economies of scale)• More customers larger ‘network’ more valuable product (demand-side

economies of scale caused by network effects)

Possible consequences of positive feedback

• Dominance of a single firm or technology• Dominance of an inferior technology that got an early lead • Critical Mass: below the critical mass, few are willing to buy (inertia);

beyond the critical mass, the market takes off.• Introducing a new product is difficult because of collective switching costs

SOURCES OF POSITIVE FEEDBACKSupply-side economies of scale (Traditional markets)

• More customers more units produced lower average cost per unit

• Marginal cost less than average cost • Spreading fixed costs across more units

• Manufacturing efficiencies, learning by doing

Demand-side economies of scale (Digital markets)

• More units consumed higher value per unit

• The value of the good comes from the network of consumers who use it (at least in part)

• Most commonly caused by network effects (Microsoft, Playstation, Facebook)

• Positive relationship between popularity and valueConsumer expectations are key!

VIRTUOUS VS. VICIOUS CYCLE

Expectations matter!

Users want to join the network of winners!

number of compatible users

value to user

virtuous

vicious

DOCTOR CRAZIEhttp://www.youtube.com/watch?v=utHAlHDXKms

NETWORK EFFECTSNetwork Externalities

Positive Negative

“the less the better”“the more the better”

Telephone serviceComputer softwareUser-generated content

Highway trafficInternet congestionRadio frequency interference

MARKETS WITH NETWORK EFFECTSA market exhibits network effects (also known as “increasing returns to

scale” in consumption) when the value to a buyer of an extra unit is higher when more units are sold, everything else being equal

• A node can reach more nodes in a large network • Large sales of components of type A induce larger availability of

complementary components B1, ..., Bn, thereby increasing the value of components of type A

Person-to-person communication feature

• Telephones, fax machines, email, Instant Messenger

Value from trading volume, number of partners

• eBay, B2B exchanges

Value from more nodes in a network

• BitTorrent, P2P Networks

Value from user-generated ‘content’

• Web 2.0, Wikipedia, online communities, …

Value from complementary assets

• Software -> System: Windows, PlayStation• Medium -> Device: HD-DVD vs BlueRay player• Training -> Complex software: Oracle, WebLogic

NETWORK EFFECTS: SOURCES

TYPES OF NETWORK EFFECTS

1. Positive & Negative Network Effects -

2. Direct Network Effects -

3. Indirect Network Effects –

4. Local Network Effects -

NETWORK EFFECTS: TIPPING

number of users

value to each user

More units consumed –> higher value per unit Tipping: Success feeds on itself and strong positive feedback can

lead to a “winner-take-all” situation. (eg: Netscape vs. Mosaic, IE vs. Netscape, Wintel vs. Apple, Nintendo vs. Atari)

Inferior products that move first may dominate Product introduction is difficult, entry strategy is crucial

THE MODEL

Value of a product in a market with network effects is given by:

Zt is the size of the network at time t,

a represents the value without network effects

g represents value from network effects.

tZV

NETWORK MARKETS: HISTORY MATTERS (I)

A and B are incompatible but have the same price

A is available at time 0. B will be available at time t, but customers do not know its availability until t.

A and B have intrinsic values of a and b respectively

Network value is c per user for both products

Customer arrival rate is 1 per unit time

NETWORK MARKETS: HISTORY MATTERS (II)

a

b

a+ct

t0

Value

Time

Q: Which product will a new customer at time t adopt? Why?

NETWORK MARKETS: HISTORY MATTERS (III)

• The superior product, B, is not adopted.

• For network products, both intrinsic performance and installed base matter.

• A has an inferior performance, but has an installed-base advantage by time t, with total value a+ct>b.

• This is precisely why the inefficient QWERTY keyboard hasn’t been replaced.

What happens if B is compatible with A?

a

b

b+ct

t0

Value

Time

Q: What’s the network size of B at time t? Why?

a+ct

NETWORK MARKETS: COMPATIBILITY MATTERS

AN ECONOMIC MODEL IN A PICTURE (ARTHUR, 1989)

Taking the evolutionary path: • Offer migration path (see lock-in strategies)

• BW Color TV, MS Office upgrades, … (your examples?)• Converters

• Need good design/engineering to minimize disruption• Need to overcome possible legal problems (e.g., a new entrant may face

patents for existing technologies)

Performance (quality)

Compatibility(value carried overfrom an existing

network)

Evolution: Lower performance, but backward compatibility provides easy migration path

Revolution: Offers radically superior performance, but creates the need to build an installed base from scratch

STRATEGY: COMPATIBILITY

A firm benefits from generating network effects if it: • Is the only supplier of the product (control)• Tries to get a very large user base rapidly (openness)

However:• Adoption is more rapid with open standards• Profit margins are much higher with proprietary standards

Total value added to industry

Your share ofindustry value

Control: Ensure high profit margins, face an uphill task of getting to critical mass

Openness: Facilitate rapid adoption, but face difficulty in keeping margins high

The place to be?

TRADEOFF: OPENNESS VERSUS CONTROL

When no firm has enough power to dominate: • With openness, company tries to maximize the network• Standards: Allow anyone to join by following guidelines

• Important to influence standards early• Alliances: Give access to allies, charge rest

Total value added to industry

Your share ofindustry value

Control: Ensure high profit margins, face an uphill task of getting to critical mass

Openness: Facilitate rapid adoption, but face difficulty in keeping margins high

The place to be?

STRATEGY: OPENNESS

Total value added to industry

Your share ofindustry value

Control: Ensure high profit margins, face an uphill task of getting to critical mass

Openness: Facilitate rapid adoption, but face difficulty in keeping margins high

The place to be?

STRATEGY: CONTROL Possible only when:• Technology is clearly superior• Firm has enough power to control standards

• Standards still have to be sensible

FOUR GENERIC NETWORK STRATEGIES

Controlled Migration

Discontinuity

Open Migration

Performance Play

Compatibility

Performance

Control Openness

Licensing patents, etc.

Provide converters etc.

efficient manufacturing

technologicaladvantage

NEXT CLASS:SWITCHING COSTS / LOCK-IN