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Information Systems: A
Manager’s Guide to Harnessing
Technology, version 2.0
John Gallaugher
© 2013, published by Flat World Knowledge
6-1
Published by:
Flat World Knowledge, Inc.
© 2013 by Flat World Knowledge, Inc. All rights reserved. Your use of this work is subject to
the License Agreement available here http://www.flatworldknowledge.com/legal. No part of
this work may be used, modified, or reproduced in any form or by any means except as
expressly permitted under the License Agreement.
© 2013, published by Flat World Knowledge
6-2
Chapter 7
Understanding Network Effects:
Strategies for Competing in a
Platform-Centric, Winner-Take-All
World
© 2013, published by Flat World Knowledge
6-3
Section 1 - Learning Objectives
1. Define network effects
2. Recognize products and services that are
subject to network effects
3. Understand the factors that add value to
products and services subject to network
effects
© 2013, published by Flat World Knowledge
6-4
Network Effects
• When the value of a product or service increases as
its number of users expands
– Referred to as network externalities or Metcalfe’s Law
• Most products are not subject to network effects
• Presence of network effects influences the choice of
one product or service over another
© 2013, published by Flat World Knowledge
6-5
Section 2 - Learning Objectives
1. Identify the three primary sources of value for
network effects
2. Recognize factors that contribute to the staying
power and complementary benefits of a product or
service subject to network effects
3. Understand how firms like Microsoft and Apple
each benefit from strong network effects
© 2013, published by Flat World Knowledge
6-6
Where’s All That Value
Come From?
• Exchange
– Creates value
– Every product or service subject to network effects
fosters some kind of exchange
• Staying power: Long-term viability of a product or
service
– Suggested by networks with greater numbers of users
© 2013, published by Flat World Knowledge
6-7
Where’s All That Value
Come From?
– Switching costs: Consumer incurs when moving from
one product to another
• Directly related to staying power
• Strengthen the value of network effects as a strategic
asset
• Increases with the higher friction available to prevent
users from migrating to a rival
– Total cost of ownership (TCO): Economic measure of
the full cost of owning a product
© 2013, published by Flat World Knowledge
6-8
Where’s All That Value
Come From?
• Complementary benefits: Products or services that
add additional value to the primary product or
service that makes up a network
– Platforms: Allow for the development and integration
of software products and other complementary goods
© 2013, published by Flat World Knowledge
6-9
Where’s All That Value
Come From?
• Value-adding sources work together to reinforce one
another to make network effect even stronger
– Each add-on of an iOS product, like the iPod, enhances
the value of choosing it over a rival like the Microsoft
Zune
© 2013, published by Flat World Knowledge
6-10
Section 3 - Learning Objectives
1. Recognize and distinguish between one-sided
and two-sided markets
2. Understand same-side and cross-side
exchange benefits
© 2013, published by Flat World Knowledge
6-11
One-Sided or Two-Sided Markets?
One-sided market
Two-sided market
• Market that derives most of
its value from a single class of
users
• Same-side exchange
benefits: Benefits derived by
interaction among members
of a single class of participant
• Network markets comprised
of two distinct categories of
participant
• Needed to deliver value for
the network to work
• Cross-side exchange benefit:
An increase in the number of
users on one side of the
market
© 2013, published by Flat World Knowledge
6-12
Section 4 - Learning Objectives
1. Understand how competition in markets where
network effects are present differ from competition
in traditional markets
2. Understand the reasons why it is so difficult for latemoving, incompatible rivals to compete in markets
where a dominant, proprietary standard is present
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6-13
How Are These Markets Different?
• Network markets experience early, fierce
competition
– Caused by positive-feedback loop inherent in network
effects
• Firms are aggressive in the early stages because once
a leader becomes clear new adopters begin to favor
the leading product over rivals
– Tips the market in favor of one dominant firm or
standard
© 2013, published by Flat World Knowledge
6-14
How Are These Markets Different?
• Markets exhibit monopolistic tendencies
– One firm dominates all rivals
• Monopoly: Market where there are many buyers but
only one dominant seller
• Oligopoly: Market dominated by a small number of
powerful sellers
© 2013, published by Flat World Knowledge
6-15
Figure 5.1. Battling a Leader with Network
Effects is Tough
© 2013, published by Flat World Knowledge
6-16
Section 5 - Learning Objectives
1. Plot strategies for competing in markets where
network effects are present, both from the
perspective of the incumbent firm and the new
market entrant
2. Give examples of how firms have leveraged these
strategies to compete effectively
© 2013, published by Flat World Knowledge
6-17
Strategies for Competing in
Markets with Network Effects
• Move early
– Yahoo! Auctions in Japan
• Subsidize product adoption
– PayPal
• Leverage viral promotion
– Skype; Facebook feeds
• Expand by redefining the market to bring in new
categories of users or through convergence
– iPhone and Nintendo Wii
© 2013, published by Flat World Knowledge
6-18
Strategies for Competing in
Markets with Network Effects
– Convergence: When two or more markets, once
considered distinctly separate, begin to offer features
and capabilities
– Envelopment: When one market attempts to conquer
a new market by making it a subset, component, or
feature of its primary offering
• Form alliances and partnerships
– NYCE vs. Citibank
© 2013, published by Flat World Knowledge
6-19
Strategies for Competing in
Markets with Network Effects
• Establish distribution channels
– Java with Netscape
– Microsoft bundling Media Player with Windows
• Seed the market with complements
– Blu-ray
– Nintendo
• Encourage the development of complementary
goods
– Facebook fbFund
© 2013, published by Flat World Knowledge
6-20
Strategies for Competing in
Markets with Network Effects
• Maintain backward compatibility
– Apple’s Mac OS X Rosetta translation software for
PowerPC to Intel
– Backward compatibility: Ability to take advantage of
complementary products developed for a prior
generation of technology
– Adaptor: Product that allows a firm to tap into the
complementary products, data, or user base of
another product or service
© 2013, published by Flat World Knowledge
6-21
Strategies for Competing in
Markets with Network Effects
• Rivals - Be compatible with larger networks
– Apple’s move to Intel
• Incumbents - Close off rival access and constantly
innovate
– Apple’s efforts to block access to its own systems
• Large firms with well-known followers - Make
preannouncements
– Microsoft
© 2013, published by Flat World Knowledge
6-22
Strategies for Competing in
Markets with Network Effects
– The Osborne Effect: Firm experiencing a sharp and
detrimental drop in the sales of current offerings due
to its preannounces of forthcoming products
– Congestion effects: Increasing numbers of users to
lower the value of a product or service
© 2013, published by Flat World Knowledge
6-23
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