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INFORMATION
TECHNOLOGY IN
BUSINESS AND
SOCIETY

SESSION 23


NETWORK EFFECTS & POSITIVE FEEDBACK

SEAN J.
TAYLOR

ADMINISTRATIVIA


G1:
G
reat 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


Historical examples



Railroad gauges, AC versus DC power,

telephone networks

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 (demand
-
side 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


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


Expectations matter!

Users want to join the network of winners!

number of compatible users

value to

user

virtuous

vicious

DOCTOR
CRAZIE

http://www.youtube.com/watch?v=utHAlHDXKms

NETWORK EFFECTS

Network Externalities

Positive

Negative

“the less the better”

“the more the better”

Telephone service

Computer software

User
-
generated content

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 B
1
, ..., B
n
, thereby increasing the value of
components of type A


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

NETWORK EFFECTS: SOURCES


TYPES OF NETWORK EFFECTS


1.
Positive & Negative Network Effects
-



2.
Direct Network Effects

-



3.
Indirect Network Effects





4.
Local Network Effects

-


NETWORK EFFECTS: TIPPING






number of users

value to

each user


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:



Z
t

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)

a

b

a+ct

t

0

Value

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.



What happens if B is compatible with A?


a

b

b+ct

t

0

Value

Time

Q: What’s the network size of B at time t? Why?



a+ct

NETWORK MARKETS:
COMPATIBILITY
MATTERS

AN ECONOMIC MODEL IN A
PICTURE (ARTHUR, 1989)






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)

Performance (quality)

Compatibility

(value carried over

from an existing

network)

Evolution:

Lower
performance, but backward
compatibility provides easy
migration path

Revolution:

Offers radically
superior performance, but
creates the need to build an
installed base from scratch

STRATEGY: COMPATIBILITY






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


Total value added to industry

Your share of

industry value

Control:

Ensure high profit
margins, face an uphill task
of getting to critical mass

Openness:

Facilitate rapid
adoption, but face difficulty in
keeping margins high

The place to be?

TRADEOFF: OPENNESS VERSUS CONTROL






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


Total value added to industry

Your share of

industry value

Control:

Ensure high profit
margins, face an uphill task
of getting to critical mass

Openness:

Facilitate rapid
adoption, but face difficulty in
keeping margins high

The place to be?

STRATEGY: OPENNESS






Total value added to industry

Your share of

industry value

Control:

Ensure high profit
margins, face an uphill task
of getting to critical mass

Openness:

Facilitate rapid
adoption, but face difficulty in
keeping margins high

The place to be?

STRATEGY: CONTROL

Possible only when:


Technology is clearly superior


Firm has enough power to control standards


Standards still have to be sensible


FOUR GENERIC NETWORK
STRATEGIES


Controlled
Migration

Discontinuity


Open
Migration


Performance
Play


Compatibility


Performance


Control


Openness

Licensing patents, etc.


Provide

converters
etc.


efficient
manufacturing


technological

advantage

NEXT CLASS:

SWITCHING COSTS / LOCK
-
IN