Part VIII. Networks, standards and systems
Chapter 21. Strategies for network goods
Slides
Industrial Organization: Markets and Strategies
Paul Belleflamme and Martin Peitz
© Cambridge University Press 2010
Chapter 21 - Objectives
Chapter 21. Learning objectives
• Understand better the decision making on the
supply side of network markets.
• Analyze how firms choose whether to compete
‘for the market’ or ‘in the market’.
• Be able to describe and analyse a number of
strategic instruments that firms can resort to in
order to win a standards war.
• Understand why public interventions are fraught
with difficulties in network markets.
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Choosing how to compete
• Firms’ choices with respect to compatibility
• Simplification
• Compatibility is achieved through standardization (i.e., if firms
decide to produce the same good)
• Programme
• Typology of potential equilibria
• More precise characterization using the Katz-Shapiro model.
• 2 scenarios
 Asymmetric firms in terms of installed bases
 Symmetric firms but competition from an existing good
( collective switching costs)
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
A simple analysis of standardization
• Model
• 2 firms (1 & 2), 2 versions of a network good (A & B)
• Incompatible versions  compatibility is achieved only
if both firms adopt the same version.
• Payoffs
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Chapter 21 - Choosing how to compete
A simple analysis of standardization (cont’d)
• 4 combination of compatibility strategies
Straightforward standardization
“Battle of the sexes”
 1AA   1BA ,  2AA   2AB and
 1AA   1BA ,  2AA   2AB ,  1BB   1AB and  2BB   2BA
either  1AB   1BB or  2BA   2BB
  1AA   1BB and  2BB   2AA
“Pesky little brother”
Standards war
 1AB   1BB ,  2AB   2AA and
 1AA   1BA ,  1BB   1AB ,
either  1AA   1BA or  2BB   2BA
 2AB   2AA ,  2BA   2BB
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Chapter 21 - Choosing how to compete
Case. Standard battle for high-definition DVDs
• Early 21st century
STANDARDS WAR
+ 5 Hollywood studios
+ 1 Hollywood studio
Cooperative
standardization
Cooperative
standardization
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Chapter 21 - Choosing how to compete
Case. VirginMega vs Apple
• Digital Right Management (DRM) systems
• Enable copyright owners to specify what someone
else can do with the copyrighted product.
• Distribution of digital music
• Apple uses a DRM technology called Fairplay.
• Apple keeps Fairplay proprietary.
• 2004: Virgin-Mega claimed that Apple was guilty
of anticompetitive behaviour by refusing to
license its DRM technology.
•  ‘Pesky Little Brother’ attitude
• Ruled to be short of convincing evidence by the
French Competition Council.
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
A full analysis of standardization
• Reminder: Katz-Shapiro model
• 2 network goods, heterogeneous stand-alone benefits
• Surplus for new consumer of type  when
purchasing good of firm i at price pi
Ui ( )    gi  pi
• where gi  relevant expected network benefit from good i

 

gi    i  qie    j  q ej 
Strength of
network effects
“Installed bases”
Assumption:
<1/2
Past locked-in
consumers
Expected
numbers of new
consumers
© Cambridge University Press 2010
Level of
compatibility
between the 2
goods, 
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Chapter 21 - Choosing how to compete
A full analysis of standardization (cont’d)
• Reminder: Katz-Shapiro model (cont’d)
• Demand functions
pi  1  (qi  q j )  gi
 1   (i   j )  (1   )qi  (1   )q j
• Firm i chooses qi to maximize i (pi(qi,qj)  ci) qi
• Nash equilibrium
q 
*
i
2(1 ) 1ci  ( i   j ) (1  ) 1c j  (  j  i )
4(1 )2 (1  )2
 i*  (1  )(qi* )2
• As compatibility  (higher )
• Total equilibrium quantity  (Demand expansion effect)
• Advantage of dominant firm  (Quality differentiation effect)
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
A full analysis of standardization
• Two extensions
(cont’d)
• Common assumptions
• 2 firms (1 & 2), 2 incompatible goods (A & B).
• Firm 1 has a preference for good A, and firm 2 for good B.
• Firm i’s marginal cost of production,
 i adopts its most-preferred good  ci 
 i adopts its less-preferred good  ci c
• Compatibility can only be achieved through standardization
 Both firms choose good A or B  
 The two firms opt for different goods  
• To ease computations: , and c
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
A full analysis of standardization
• Two extensions (cont’d)
(cont’d)
• Installed bases  2 scenarios
• Only firm 1 enjoys the benefits of an installed base
 How does this asymmetry affect the equilibrium decisions
about standardization?
• Firms can benefit from a common installed base provided that
they choose standardization.
 If they opt for incompatibility, past users will stick to their
old network good and the market for goods A and B will
only be made of new users.
 Trade-off between compatibility and performance
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Scenario 1: choosing how to compete
• Model
• Installed base for firm 1 (large firm) but not for firm 2 (small
  and 
• Plug all values into Katz-Shapiro equilibrium profits:
firm)
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Scenario 1: choosing how to compete (cont’d)
• Characterization of equilibrium
Joint adoption of A
76
  174  17
c and    17  207 c
Joint adoption of B
80
  174  17
c and    17  197 c
Incompatibility (A,B)
Incompatibility (B,A)
80
  174  17
c and    17  207 c
Impossible
Intuition: When large firm adopts B, small
firm has all the reasons to do the same.
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Scenario 1: choosing how to compete (cont’d)
• Characterization of equilibrium (cont’d)
Both firms agree to standardize
on A. Small firm: ready to incur
c to take advantage of . Large
firm: demand expansion effect
dominates quality differentiation
effect
Low c but high 
 small firm prefers
compatibility more than
ever, but large firm prefers
incompatibility.
c sufficiently high
 both firms prefer to
compete to establish their
preferred technology as
the de facto standard.
Relatively low c and 
 both firms prefer to
adopt a common standard
to ‘going it alone’ but
preferences diverge.
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Scenario 1: choosing how to compete (cont’d)
• Lesson: Pre-market standardization is more
likely to emerge as an equilibrium when the
parties are relatively symmetric and do not have
marked preferences for a particular good. In
contrast, a standards war is more likely to
emerge as an equilibrium when the parties have
marked (and diverging) preferences for a
particular good.
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Scenario 2: overcoming collective switching costs
• Model
• Installed base (shared) only if standardization
• Idea: no migration from old technology if incompatibility
• (A,A) or (B,B)   and 
• (A,B) or (B,A)   and 
• Plug all values into Katz-Shapiro equilibrium profits:
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Scenario 2 (cont’d)
• Characterization of equilibrium
• Standardization prevails if and only if
 2AA  1BB  1AB   2AB    25  8c
• Consumers prefer standardization if and only if
CS AA  CS BB  CS AB    25  2c
• Lesson: Consumer and producer interests in
standardization may not be aligned because
consumers do not perceive the full cost of
standardization whereas firms cannot fully
appropriate the benefits from standardization.
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Strategies in network markets
• 2 specificities
• Firms have to factor in network effects in the formation
of their strategies.
• Multiple equilibria on the demand side
• Self-reinforcing effects
• Firms also develop specific strategic instruments.
• Strategic choice of compatibility
• Building an early installed base to preempt rivals
• Entry on network markets
 Trade-off between compatibility and performance
• Expectations management
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Building an installed base for preemption
• Motivation
• Previous models: exogenous installed base
• But, clear incentives to build installed base before
rivals
• Early-mover advantage because self-reinforcing power of
network effects
• 2-period model
• Period 1
• Only firm 1 is active with network good A
• Mass 1 of consumers
• Period 2
• Firm 2 has the possibility to enter with network good B
• Mass 1 of new consumers
• Locked-in old consumers of good A, 
• Marginal cost c , degree of compatibility 
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Building an installed base for preemption (cont’d)
• Nature of network effects
• ‘Intra-generation’  direct network effects
• ‘Inter-generation’  indirect network effects
• Learning, word-of-mouth  only from generation 1 to 2
• Complementary products  from 1 to 2 and from 2 to 1
• 1. Early users don’t benefit from later sales
• Equilibrium quantity in Katz-Shapiro model
q 
*
i
2(1 ) 1ci  ( i   j ) (1  ) 1c j  (  j  i )
4(1 )2 (1  )2
• For firm 2 in period 2 (c1  c2  c,  )
(1  2   )(1  c)   ( (2   )  1)1
q (1 ) 
4(1   )2  (1   )2
*
2
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Building an installed base for preemption (cont’d)
• 1. Early users don’t benefit from later sales (cont’d)
• 2 enters only if it can produce a positive quantity
• Always ok if goods are sufficiently compatible
• Otherwise, i.e. if  2 enters as long as 1 didn’t
build too large an installed base:
(1  2   )(1  c)
q2* (1 )  0  1 
 (1   (2   ))
•  2 stays out if the 3 following conditions are met
(1)  
1c
32c
, (2)  
 (32c)(1c)
 (3c )
, (3)
(12   )(1c)
 (1  (2 ))
 1  1
• Lesson: In the market with potentially 2 competing
networks, entry can be deterred if (1) network effects are
strong enough, (2) goods are incompatible enough, and
(3) the incumbent firm built a large enough installed base.
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Building an installed base for preemption (cont’d)
• 1. Early users don’t benefit from later sales (cont’d)
• If accommodation
• Firm 1 chooses  to maximize its
profit over the 2 periods:
*
m
1* ( )  1m  16 g( ) and pA1
( )  pA1
 18 g( )
Choices of a
myopic
monopolist
Decreasing
function of 
• Lesson: The less compatible the 2 network goods (i.e.,
the lower ), the larger the installed base built by the
incumbent and the lower the price of the network good in
the 1st period ( penetration pricing)
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Building an installed base for preemption (cont’d)
• 2. Early users benefit from later sales
• Analysis more involved (see details in book)
• Conflicting interests for firm 1
• Penetration pricing to reduce the profitability of entry
  Lower price in period 1 than in period 2
• Promise of a large future network to attract 1st generation
  Lower price in period 2 than in period 1
 Depends on firm 1’s capacity in period 1 to commit to low
prices in period 2 (How? See next case)
• Lesson: If the incumbent network can commit to
second-period price, it will set a higher first-period price
and a lower second-period price. This strategy deters
entry more effectively.
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Chapter 21 - Strategies in standards wars
Case. The VCR standards war
• 2 formats for video cassette recorders (VCR)
• Beta (sponsored by Sony) & VHS (sponsored by JVC)
• Importance of commitment in the standards war
• 1976: Start of the market, Beta dominates
• Sony started production on a very large scale.
• Motivation: to commit credibly to lower future prices by
immediately sinking part of the production costs.
• 1980: VHS installed base becomes larger in the US
• JVC had formed a large group of allies, aggressively pursuing
licensing agreements.
• Motivation: guarantee mass production and lower prices for
the technology in the future.
• 1989: Beta exits the consumer market.
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Backward compatibility and performance
• Trade-off
• Backward compatibility as a way to ease entry and
overcome collective switching costs.
• But, restricts the potential for horizontal and vertical
differentiation.
Case. Drupal backward compatible?
“Unfortunately, there is no right or wrong answer here: there are both
advantages and disadvantages to backward compatibility. As a result,
there will always be a tension between the need for hassle-free
upgrades and the desire to have fast, cruft-free code with clean and
flexible APIs. At the end of the day, we can’t make everybody happy
and it is very important that you realize that.”
(Dries Buytaert, lead of the Drupal Project, an open source content
management platform)
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Backward compatibility and performance
• Model
(cont’d)
• Same 2-period model as before
• Only firm 1 is active in period 1; it produces at cost c1  c ;
it builds an installed base  of users (locked in period 2)
• Firm 2 can enter in period 2.
• New feature
• Firm 2 can choose the degree of compatibility, , between its
network good (B) and firm 1’s network good (A)
• Conflicting effects of larger compatibility
• Easier entry
 2 benefits more from 1’s installed base
• Higher production costs
 Assumption: c2   c
 2’s cost advantage  with 
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Backward compatibility and performance
• Resolution
(cont’d)
• Key variable:  c  difference between
• ‘installed-base effect’ of full compatibility
• ‘performance effect’ of full incompatibility
• Optimal compatibility choice (see details in book)
   full compatibility
   full incompatibility
• Lesson: A firm that enters a network market with a
superior product makes this product incompatible with the
competitor’s existing inferior product only if what it gains
by selling a higher-quality product is sufficiently larger
than what it loses by not being compatible with the
incumbent’s installed base.
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Expectations management
• Intuition
• Expectations are crucial in network markets.
• They may determine the outcome of standards wars.
• Firms want to manipulate expectations in their favour.
• How?
• Advertising about the size of the network
• May become self-fulfilling if successful.  See Case 21.6
about high-definition DVDs
• ‘Fear Uncertainty and Doubt (FUD)’
• Disseminate negative information about rival products to
generate pessimistic expectations.  See Case 21.7 about
Microsoft’s ‘cereal box’ ad campaign against Novell
• Product preannouncement
• Announce a new product well in advance of actual market
availability to freeze sales of competing existing products
• If not credible: ‘vaporware’
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Chapter 21 - Public policy in network markets
Public policy in network markets
• Network effects create market failures
• Users may coordinate on inferior standards.
• Firms may provide lower compatibility than socially
optimal.
• Can public intervention correct (alleviate) them?
• 2 types of public interventions
• Ex ante interventions
• Public authorities take an active part in the competition
process among network goods, before standardization takes
place.
• Ex post interventions
• Public authorities don’t try to influence the competition
process, but aim at safeguarding it by controlling firms’
conduct.
• Both types are fraught with major difficulties.
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Chapter 21 - Public policy in network markets
Ex ante interventions
• 2 ways to reach a standard
• de facto: outcome of a standards war
• de jure: result of pre-market standardization agreement
• Public influence on de facto standardization
• Recall model with sequential adoption (Chapter 20)
• Path dependence
• Inflexibility (lock-in)
• Non predictability
• Potential inefficiency
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Chapter 21 - Public policy in network markets
Ex ante interventions (cont’d)
• Public influence on de facto standardization (cont’d)
• Path-dependence  3 generic problems (David, 1987)
• Narrow Policy Window Paradox
• “Window” for effective intervention: by influencing 1st users (by
taxes/subsidies), it is possible to influence the whole process.
• But the window may close very quickly.
• Blind Giant's Quandary
• Limited information during the window of intervention
• Possible strategy: "counter-action"
 Handicap the leader and favour other network goods that
remain behind in the competition for the market.
• Angry Technological Orphans
• Counter-action is socially costly
 Some network effects are not exploited.
 Creation of “angry technological orphans”
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Chapter 21 - Public policy in network markets
Ex ante interventions (cont’d)
• Public involvement in de jure standardization
• Many standards are selected by government agencies.
• Comparison
De jure standards
De facto standards
Legitimacy

They are developed through
agreed, open and transparent
procedures, based on a
consensus of all interested
parties.
Quick to emerge
Potential inefficiency

Slow to emerge
The market may adopt privately
profitable, but socially
undesirable, technologies.
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Chapter 21 - Public policy in network markets
Ex post interventions
• Application of competition (antitrust) policy
• Rather subtle in network markets
• Natural tendency to market share inequality and high
profitability of a top firm.
•  alleged anticompetitive conducts must be judged against
some ‘but for’ market structure with significant inequality and
profits.
• Conducts specific to network markets deserve careful scrutiny.
• Attitude towards cooperative standard-setting?
• Antitrust concerns have not prevented many cooperative
standard-setting efforts from proceeding.
• But neither is such activity immune from antitrust scrutiny.
• Basic issue: trade-off between ex ante and ex post
competition
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Chapter 21 - Public policy in network markets
Ex post interventions (cont’d)
• Ex ante vs. Ex post competition
• It is impossible to guarantee competition at all stages
of the life cycle of a network good.
• To have competition in the short term, cooperative standardsetting should not be allowed.
 a standards war would induce an intense ex ante
competition while cooperative standard-setting would mute it.
• To have competition in the long term, cooperative standardsetting should be allowed.
 a standards war would induce a winner-takes-all situation,
while ex ante cooperation would permit greater ex post
competition.
• Cooperation is certainly socially desirable when the
entire product category would fail to take off in the
absence of standardisation.
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Chapter 21 - Review questions
Review questions
• Discuss the conditions under which pre-market
standardization is more likely to emerge as an
equilibrium than a standards war.
• Explain why consumer and producer interests in
standardization may not be aligned.
• Explain why incumbent producers of network
goods may have an incentive to build an
installed base of consumers through penetration
pricing.
• Describe the trade-off between backward
compatibility and performance.
• Explain how and why firms try to influence
consumers’ expectations in a standards war?
© Cambridge University Press 2010
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