INFORMATION
TECHNOLOGY IN
BUSINESS AND
SOCIETY
SESSION 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
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 (demandside 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
Historical examples
•
Railroad gauges, AC versus DC power, telephone networks
SOURCES OF POSITIVE FEEDBACK
Supply-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 value
Consumer expectations are key!
VIRTUOUS VS. VICIOUS CYCLE
virtuous
value to
user
vicious
number of compatible users
Expectations matter!
Users want to join the network of winners!
DOCTOR CRAZIE
http://www.youtube.com/watch?v=utHAlHDXKms
NETWORK EFFECTS
Network Externalities
Positive
“the more the better”
Telephone service
Computer software
User-generated content
Negative
“the less the better”
Highway traffic
Internet congestion
Radio frequency interference
MARKETS WITH NETWORK EFFECTS
A 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
NETWORK EFFECTS: SOURCES
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
TYPES OF NETWORK EFFECTS
1. Positive & Negative Network Effects -
2. Direct Network Effects -
3. Indirect Network Effects –
4. Local Network Effects -
NETWORK EFFECTS: TIPPING
value to
each user
number of users
 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:
V  a  gZ t
Zt is the size of the network at time t,
a represents the value without network effects
g represents value from network effects.
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)
Value
a+ct
b
a
0
t
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.
NETWORK MARKETS:
COMPATIBILITY MATTERS
 What happens if B is compatible with A?
Value
b+ct
a+ct
b
a
0
t
Q: What’s the network size of B at time t? Why?
Time
AN ECONOMIC MODEL IN A
PICTURE (ARTHUR, 1989)
STRATEGY: COMPATIBILITY
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)
Evolution: Lower
performance, but backward
compatibility provides easy
migration path
Compatibility
(value carried over
from an existing
network)
Revolution: Offers radically
superior performance, but
creates the need to build an
installed base from scratch
Performance (quality)
TRADEOFF: OPENNESS VERSUS CONTROL
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
Control: Ensure high profit
margins, face an uphill task
of getting to critical mass
Your share of
industry value
The place to be?
Openness: Facilitate rapid
adoption, but face difficulty in
keeping margins high
Total value added to industry
STRATEGY: OPENNESS
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
Control: Ensure high profit
margins, face an uphill task
of getting to critical mass
Your share of
industry value
The place to be?
Openness: Facilitate rapid
adoption, but face difficulty in
keeping margins high
Total value added to industry
STRATEGY: CONTROL
Possible only when:
•
•
Technology is clearly superior
Firm has enough power to control standards
• Standards still have to be sensible
Control: Ensure high profit
margins, face an uphill task
of getting to critical mass
Your share of
industry value
The place to be?
Openness: Facilitate rapid
adoption, but face difficulty in
keeping margins high
Total value added to industry
FOUR GENERIC NETWORK
STRATEGIES
Licensing patents, etc.
Control
Compatibility
Openness
Controlled
Migration
Open
Migration
Performance
Play
Discontinuity
Provide
converters
etc.
Performance
technological
advantage
efficient
manufacturing
NEXT CLASS:
SWITCHING COSTS / LOCK-IN