Network Economics - Class 4
Judith Molka-Danielsen
j.molka-danielsen@himolde.no
http://home.himolde.no/~molka
Reference: “Information Rules”, Carl Shapiro and
Hal R. Varian, Havard Business Sch. Press, 1999.
January 18, 2001
Overview
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Describe the New Information Economy
Discuss the factors in the Economics of
Networks
Define the terms: network effects and
network externaltities
Discuss the concept of Lock-in
The old industrial economy
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Dominated by Oligopolies
a few large firms
market share rose and fell slowly
lifetime employment
Industries that exhibited this:
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automobile
steel
aluminum
petrolium
chemical markets
economies of scale
The new information economy
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Dominated by temporary monopolies
dominate player based on the days leading
technology
short time on top
7 years average at one job
Industries: hardware and software
economies of networks
Types of Networks
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Physical networks
– telephone, electrical,
– railroad,
– airlines
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High Technology (real)
– computer, fax machine, compatible modems,
– email, ATMs, Internet
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High Technology (virtual)
– Macintosh users, CD readers-writers users,
– Nintendo 64 users, minidisc users
Important Concepts
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It is better to be connected to a bigger
network than to a smaller one.
Network effects
Positive Network Externalities
Companies compete by expanding their
networks, they increase the value by
interconnecting with other networks.
Positive Feedback
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Positive feedback - the strong get stronger
and the weak get weaker.
Speaking into a microphone, when the
amplified signals go back into the system,
you have repeated amplification. It gets
loud.
Negative feedback - when the strong get
weaker and the weak get stronger. Go to a
middle point. Industrial oligopolies exhibit.
In the industrial markets, attempts for
greater market share would trigger
respones by others towards efficiency, also
too large firms were too complex to
manage. The norm were oligopolies.
Positive feedback (cont.)
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Postitive feedback can contribute to
growth, but it is not the same thing. Ie.
Internet.
Virtuous cycle - success feeds itself.
Vicious cycle - product seen as failing,
the perception feeds the cycle, death
spiral, the weak get weaker. Ie. Apple
Macintosh.
Tippy market - two players compete,
one wins. (Video recorders - VHS v.
Beta) Winner take all.
Positive Feedback - example
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Nintendo - enters home video games in 1985
Other dominant player at the time (Atari,
Texas Instruments)
Christmas 1986, Nintendo Entertainment
System (NES) was hot. More game
developers begin to write games for them.
Game developers pay royalties to Nintendo
and agree to not share the game with other
systems for 2 years after release.
S-shaped curve
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Adoption of new technologies follow an Sshaped curve in three phases:
– flat during launch,
– steep rise during takeoff, positive feedback at
work,
– leveling off, saturation is reached.
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Seen in the adoption of: fax machine, CD,
color TV, video games, e-mail, and the
Internet.
Economies of Scale
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Economies of scale - is a source of positive
feedback. Larger firms tend to have lower unit
costs of productions. This is supply-side
economies of scale.
In manufacturing the benefits of scale are
usually exhausted before total market
dominance.
Demand side economies of scale - Microsoft
Windows 95 in 1998, widely used, de facto
industry standard. Some technologies go
head-to-head for years before a winner
emerges. Telephone netwk also showed this.
Network externalities
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Sponsor - of a net builds and hopes to profit from the
net.
– Apple controls interfaces, clone license terms, architecture
improvements, for the Mac. And influence supply of
complementary products. (Partners)
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externalities are positive and negative (pollution)
positive network externalities lead to positive
feedback
Metcalfe’s law: The value of the network goes up as
the square of the number of users. Total value of the
network to all users = n x (n-1) = n2 -n where n is the
number of users. If value=$1 for a single user, and
n=10, then network size 10 has 102-10=90 = $90.
Collective switching costs
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Switching costs - come from complementary assets,
hardware with software, IT systems with training. If I
learn to program in Access database language then
other access software and the language becomes
more valuable to those who are already users.
But it is hard to get people to switch, collective
switching costs. It is hard to coordinate users to
switch all at the same time, and they will not do so by
themselves. Therefore, the incumbents have the
advantage.
1870 QWERTY keyboard wins over the 1932 Dvorak
layout with home row AOEUIDHTNS that was proven
to be faster. We would collectively be better to switch
but the individual switching costs are too high. (Also
called technological Lock-in.)
Industry and positive feedback
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Not every market tips (Ford had a best-selling-car,
but who cares, you do not buy a car because others
have it. But you may avoid a car because no one has
it.)
There are no demand side economies of scale within
the IBM compatible PC market because standards
allow interoperability. Another example, Internet
service providers. (America Online, CompuServe,
Delphi, had separate discussion groups before
Internet. Now access can be from anyone, AOL,
IBM, ATT, etc.)
ISPs could differentiate access through QoS offers,
video conferencing, etc. Large ISPs have advantage
because it is easier to control QoS on a single
network.
Likelihood of a market tipping to one
technology
low economies of high economies
scale*
of scale
low demand for Unlikely
variety
High
high demand for Low - global
HDTV market**
variety
Depends
*sum of economies of scale - ie. There are supply
side eos for PC market where Compaq, Dell, HP and
IBM have 24%.
**standards reduce variety, but global HDTV
standards are not needed.
Performance v. compatibility
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How do you start the virtuous cycle? Philips and
Sony introduced the CD in the 1980s.
Philips offers digital compact cassette (DCC) in 1992
where DCC players can play regular cassettes,
backward compatible. But it didn’t catch on.
Consumer inertia approaches: the evolution strategy
of compatibility, and the revolution strategy of
performance.
Revolution - best performance to start over with a
new product, but high switching costs.
Evolution - give up some performance to allow
compatibility (lower switching costs).
Openness v. Control
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Is the second fundamental tradeoff.
Open - make interfaces and specifications available
to others. Consumers can fear lock-in, open raises
chances of success, attracks allies.
Control - keep your system proprietary. (This is
valuable if your system takes off.) Installed base is
more valuable if rivals cannot offer products to lockin customers. Control interconnection.
Existing market position, technical capabilities and
control of intellectual property rights are 3
dimensions of critical market strength.
Intel controls MMX multimedia specs for its Pentium
chips, but promote an open interface spec for graphic
controllers, the accelerated graphics port (AGP) to
increase demand for their microprocessors.
Openness v. Control
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Your Reward (total value to you) = Total value added
to the industry + Your share of the industry value.
Total value added to the industry = the value the
technology adds to the existing value + how widely
the technology is adopted (network size).
Your share of the industry value = your market share
+ your profits + your royalties + how the technology
effects your sale of other products (add to sales or
take away).
Openness v. Control
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Best Strategies: Have a large share of a small
market (small pie), or Have a small share of a large
market (Sun and Java).
The optimum point is where you maximize Total
Value.
Systems - are a cooperation of compoenets
To caputre value from one component requires
cooperation with those providing the other
components.
Suppliers will want a share of the rewards in retrurn
for cooperation.
Openness Strategy
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When no one firm is strong enough to dictate
technology standards.
When coordination is necessary.
To start the bandwagon rolling.
Full openness (ITU standards) v. Alliance Strategy
(member advantage, Microsoft developers)
Alliance types: special interest group, task forces,
groups of companies.
Alliances share: cross license patents,
manufacturing skills, improve time to market, share
designs.
Alliances coordinate: standards, interfaces,
protocols, specifications.
Control Strategy
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Central actor controls development
Sun sponsors Java, Apple sponsors Macintosh,
Ericson sponsors BlueTooth.
Companies that control product standards and
interfaces have power. But they can lose with poorly
conceived standards.
Generic Strategies for new Technology
Introduction.
Control
Openness
Compatibility
Controlled
migration
Open migration
Performance
Performance play Discontinuity
1. Performance Play - new, incompatible, strong
control, high risk, big technology advantage, new
entrants try with no base to worry about.
2. Controlled Migration - give up performance to
reduce customer switching costs, need allies,
backward compatible, but proprietary.
Generic Strategies for new Technology
Introduction.
Control
Openness
Compatibility
Controlled
migration
Open migration
Performance
Performance play Discontinuity
3. Open Migration - new product by many vendors,
low switching costs, good where there are only
manufacturing economies, want a big network.
4. Discontinuity - need allies, make system very
open, new product not compatible with old but
available from many suppliers, favor efficient
manufacturers.