1 / 18

The Network Effect

The Network Effect. The Network Effect. When a network effect is present, the value of a product or service is dependent on the number of others using it. Introduction. Archetype 1: Direct Network Effect. Consider the first and only person to have a FAX machine

kaseem-burgess
Download Presentation

The Network Effect

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. The Network Effect

  2. The Network Effect When a network effect is present, the value of a product or service is dependent on the number of others using it.

  3. Introduction

  4. Archetype 1: Direct Network Effect • Consider the first and only person to have a FAX machine • While nobody else had a fax, the machine was useless • The second FAX created value, because these two could communicate • The third FAX allowed the three members of this network to communicate • So, each new FAX added value to the existing FAX machines – the value of the product was dependent of the number of others using it

  5. Archetype 2: Indirect Network Effect • Consider the early days of Microsoft’s OPERATING SYSTEM • It had few users • Little reason for developers to create applications • When the OPERATING SYSTEM became popular • Developers created many applications, because there was a large market for their applications • These applications made the OPERATING SYSTEM more valuable to users who preferred it to other OPERATING SYSTEMs • So, each new user was an incentive to develop new applications, that created more value, that attracted more users . . . – the value of the product was (indirectly) dependent of the number of others using it

  6. Practical Implications • The network effect creates economies of scale on the demand side • Technologies (FAX machines, OPERATING SYSTEMS) which have many users are more valuable and attract even more users • Strong get stronger, weak get weaker • “Winner take all” markets • Successful Strategies: • Companies try to tie-in to existing networks to ease the adoption by consumers of their new technologies • Only rarely new technologies that are not compatible with old networks succeed

  7. Algebraic Formulations

  8. An Algebraic Formulation of the Network Effect–Metcalfe’s Law • The value of a communication network is: • value of connection with one other user: v • value of a network of n users for a single user: v*(n-1) • value of a network to all n users: n* [ v*(n-1) ] = v*(n2 - n) • For standard products and services • Given that the value of a product for a single user is v, then for n users it is usually n*v

  9. Background: The Demand Curve • The demand curvedepicts the relationship between the price of a certain product or service and the amount of it that consumers are willing and able to purchase at that given price. • The demand curve for all consumers is calculated by adding the individual demands. • The convention is to have • Price on the vertical axis • Quantity on the horizontal axis (following Alfred Marshal’s Principles of Economics ,1890) • The demand curve usually slopes downwards from left to right; which means people will buy more as its price falls.

  10. Background: The Supply Curve • A supply curve is a graph that illustrates that relationship between the price of a good and the quantity supplied • Under the assumption of perfect competition, firms will produce additional output as long as the cost of producing an extra unit of output is less than the price they will receive • The market supply curve is obtained by summing the quantities supplied by all suppliers at each potential price

  11. Demand and Supply Curves for Information Goods with Network Effect • 1000 people in a market for some good • index the people by v = 1, . . . , 1000 • v is the willingness to pay by person v • If p is the price of the good, then the number of people who are willing to pay at least p is 1000 − p • Let’s assume that the value of the good to person v is v*n • Let u denote the index of the person who is indifferent between buying the good and not buying it • p = u*n • The number of people who want to buy the good is n = 1000 − u • p = n(1000 − n) = 1000*n – n2 Source: Shapiro and Varian, Information Rules, A Strategic Guide to the Network Economy, Harvard Business School Press, 1999

  12. Social Networks Effect? Reed’s Law • The value of a social network is proportional to the number of sub-groups in the network • For n users of the network, there are 2n subgroups • (for 2 users, there are these groups 0,0; 1,0; 0,1; 1,1) • see demand curve 3 Three Demand Curves Price 3 1 2 Quantity

  13. Implications

  14. Collective Switching Costs • Success and failure are driven as much by consumer expectationsand luck as by the underlying value of the product • Network effects lead to substantial collective switching costs • It is the Biggest force working for incumbents • Example: QWERTY • created in the 1870s by Christopher Latham Sholes, a newspaper editor from Milwaukee, USA • Keys were arranged on diagonal columns, to give space for the levers • In 1873 manufacturing rights sold to E. Remington and Sons • Several alternatives have been developed, claimed to be more efficient, intuitive and ergonomic • Failed due to the dominance of available keyboards and training

  15. Standards • Standards expand network effects • Share with larger network • Attracts more users • Standards reduced uncertainty • No need to wait • In a standard war, neither side may win • Change the nature of Competition • Competition for the market v. competition in the market • Competition on price v. features • Competition to offer proprietary extensions • Component v systems competition

  16. Standard Wars • Standard wars are unique to network markets • Adoption is difficult when multiple groups of buyers need to co-ordinate • Key Assets • Control over an installed base • Intellectual property rights • Ability to innovate • First-mover advantages (learning) • Manufacturing ability • Strength in complements • Reputation and brand name

  17. DVD vs. DIVX • In September 1996, the DVD forum published the DVD open specifications as a replacement for video cassettes • Studios: • Committed – Warner Home Video, Columbia Tri-Star, MGM/UA, and Polygram, Universal, Disney • Skeptical – Paramount, 20th Century Fox (unclear if the technology will succeed, piracy danger) • Retailers: • Best Buy fully support DVD with special instore displays, wide selections of hardware and software at discounted prices, and heavy advertising • Circuit City, September 1997 – • DIVX would play all DVD discs, and would also play special DIVX discs that are unlocked when the user starts playing them, and remain unlocked for 48 hours • However, • Throughout the Christmas 1997 season, DIVX players were nowhere to be seen • DVD installed base of at least 1.9 million through mid-1999 • The DIVX installed base through that time was at most 165,000. • There were 3,317 titles available on the DVD • Only 471 titles available on DIVX • June, 1999, Circuit City pulled the plug on the DIVX format

  18. The Network Effect When a network effect is present, the value of a product or service is dependent on the number of others using it.

More Related