Leveraging Network Effects
and Competing Without
DSC340
Mike Pangburn
Agenda
 Understand meaning of network effects (“positive network
externalities”)
 1-sided and 2-sided examples
 Implications for competition
 Discuss competing without network-effects advantage
 Need for superior operations, not superior technology
 Need for superior use of information
 Consider case of Zara
Network Effects
Network effects
 When network effects are present, the value of
a product or service increases as the number of
users grows
 Most products aren’t subject to network effects
 “you probably don’t care if someone wears the same
socks, uses the same pancake syrup, or buys the same
trash bags as you” -- J. Gallaugher
 As a manager, it’s critically important to recognize
when a product does exhibit network effects
More users = More value
 Where does that value come from?
 Exchange
 Interact with others. The value isn’t typically $.
 Switching costs
 Save ($ or time) by sticking with initial choice
 Are your customers “barnacles” or “butterflies?”
 Complementary products
 Associated products that develop
“Exchange” examples?
 Telephone / Skype / fax
 Local “exchange value” example(s)?
Switching costs example
 “It is this switching cost that has given our customers the
patience to stick with Windows through all our mistakes,
our buggy drivers, our high TCO, our lack of a sexy vision
at times, and many other difficulties…. it would be so
much work to move over that they hope we just improve
Windows rather than force them to move…. without this
… we would have been dead a long time ago.”
 Comments from a Microsoft General Manager in a
memo to Bill Gates
 Local “switching cost” example(s)?
Switching costs recap
 The core “switching cost” idea isn’t that customers have
already invested $ in some past product/service
 A past/irrecoverable investment is sometimes referred to as a
sunk cost, which we should, as rational decision makers, ignore
 The core switching cost idea is that moving to the new
product or service will imply some new investment in time or
$.
Complementary products
 Example: iPod related
products
??
 90 brands selling some
280 models of iPod
speakers systems
 34 auto manufacturers
now trumpet their cars as
being iPod-ready
 Each enhances the value
of choosing an iPod over
a rival like the Microsoft
Zune.
 Local (UofO / Eugene)
“complementary products”
example(s)?
How do network effects change
competition?
 Network markets experience early, fierce competition.
 Often winner-take-all environments.
 Examples:
 Apple -- controls over 75% of digital music sales.
 Football?
 Best product or service doesn’t win.
 Example: Xbox 360 was earlier than Playstation 3, gained
early success due to inferior specs
Want to compete against an incumbent firm?
…High hurdle to clear!
Facing an incumbent enjoying networking
effects
 Subsidize new adoptions
 Example: PayPal gave $15 off $30 to each new customer to
promote its service. eBay was less generous but then ended up
later buying PayPal for $15 * 100,000,000
 Counterexample: Bing!
 Move early
 If you don’t? Consider that eBay waited 5 months after Yahoo!
to start auctions in Japan… never recovered in that market
 Redefine the market
 Look for “blue ocean” (W. Chan Kim and Renée Mauborgne)
 Example: Nintendo’s Wii strategy
 Encourage complementary products
 Example: Facebook’s fbFund: up to $250,000 funding per firm
writing apps
Network effects and IT
 Savvy managers look for ways to design-in network effects
 E.g., Facebook
 Exchange value, Switching cost, Complementary products
 Thus, Information Technology can establish competitive
advantage via network effects with your firm’s product
 The strategic role of IT is not limited to tech products with
network effects
 IT as product versus IT as enabler
 The latter applies even for non-tech products
 Zara provides a powerful example of leveraging IT as
strategic enabler
Agenda
 Understand meaning of network effects (“positive network
externalities”)
 1-sided and 2-sided examples
 Implications for competition
 Discuss competing without network-effects advantage
 Need for superior operations, not superior technology
 Need for superior use of information
 Consider case of Zara
Consider Zara
 What?
 Most successful apparel company on the planet
 Where?
 Based in the ship-building town of La Coruña, Spain
 Who?
 Founded by Amancio Ortega, the world's 3rd richest man
with assets worth more than $50 billion
 Not much of a marketeer, has more a product/process
focus
Network effects and Zara
 For the type of products that Zara sells, why might network
effects not be very strong?
 Generally speaking, network effects (“network
externalities”) can be either positive or negative
 When a product exhibits negative network externalities, the
resulting challenge for a firm a severe
 What product-line management strategy would you
recommend to a manager facing that challenge?
Core aspect of Zara’s strategy
“If you see something and
don’t buy it, you can
forget about coming back
for it because it will be
gone.”
-- 20-something Zara shopper
Consider this tension (challenge)
Accounting rule
Inventory = an asset
 Retailing adage
“Inventory equals death”
Use of technology
As a manager, your focus should not be on
having better technology
Focus on having better information and
processes, with minimal technology costs
Zara is information/process focused, not
tech focused
 “Whether measured by IT workers as a
percentage of total employees or total
spending as a percentage of sales, Zara’s IT
expenditure is less than one-fourth the fashion
industry average.”
Technology ≠ Effective Processes
Just Ask Prada
 Contrast with Prada’s “Manhattan project” to
create the ultimate fashion store
 PDAs would let staff check inventory immediately
 glass dressing room foot pedals would allow customers to
turn walls opaque, into a combination mirror and headsup display
 dressing room computer would recommend matching
accessories
 How did it turn out?
Technology ≠ Effective Processes
 An information system (IS) is much more than just
hardware and software.
 An IS also includes data used or created by the system,
as well as the procedures and the people who interact
with the system
 Successful information systems (IS) must
integrate these 5 critically-important
components: hardware, software, data,
procedures, and people.
Zara, the new Dell?
 Dell was the low-inventory, short lead-time, high
product variety competition-killer of the 90’s
 Dell is facing more heat now from its
competitors.
 Is Zara “the new Dell”?
 How do they differ?