Information technology in business and society

1. Information technology in business and society Session 23 – Network Effects & Positive Feedback Sean J. taylor

2. Administrativia • G1: Great job! • G1: Submit group feedback forms • G2: Posted

3. 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

4. Historical examples What is positive feedback? When does this happen? Possible consequences of positive feedback • Railroad gauges, AC versus DC power, telephone networks • 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…’ • 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) • 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 Positive feedback: Overview

5. Supply-side economies of scale (Traditional markets) Demand-side economies of scale (Digital 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 • 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 valueConsumer expectations are key! Sources of Positive Feedback

6. value to user number of compatible users Virtuous vs. Vicious Cycle virtuous • Expectations matter! • Users want to join the network of winners! vicious

7. Doctor Crazie • http://www.youtube.com/watch?v=utHAlHDXKms

8. Network Effects Network Externalities Negative Positive “the more the better” “the less the better” Telephone service Computer software User-generated content Highway traffic Internet congestion Radio frequency interference

9. Markets With Network Effects • A market exhibits network effects (also known as “increasing returns to scale” in consumption) when the valueto 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

10. Person-to-person communication feature Value from trading volume, number of partners Value from more nodes in a network Value from user-generated ‘content’ Value from complementary assets • Telephones, fax machines, email, Instant Messenger • eBay, B2B exchanges • BitTorrent, P2P Networks • Web 2.0, Wikipedia, online communities, … • Software -> System: Windows, PlayStation • Medium -> Device: HD-DVD vs BlueRay player • Training -> Complex software: Oracle, WebLogic Network effects: sources

11. Types of Network Effects • Positive & Negative Network Effects - • Direct Network Effects - • Indirect Network Effects – • Local Network Effects -

12. Network effects: Tipping • 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 value to each user number of users

13. The Model • Value of a product in a market with network effects is given by: Zt is the size of the network at time t, a represents the value without network effects g represents value from network effects.

14. 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

15. Network Markets: History Matters (II) Value a+ct b a Time 0 t Q: Which product will a new customer at time t adopt? Why?

16. 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.

17. Network Markets: Compatibility Matters • What happens if B is compatible with A? Value b+ct a+ct b a Time 0 t Q: What’s the network size of B at time t? Why?

18. An economic Model in a picture (Arthur, 1989)

19. Strategy: Compatibility 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) • 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)

20. Tradeoff: Openness versus Control Control: Ensure high profit margins, face an uphill task of getting to critical mass The place to be? Your share of industry value Openness: Facilitate rapid adoption, but face difficulty in keeping margins high Total value added to industry • 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

21. Strategy: Openness Control: Ensure high profit margins, face an uphill task of getting to critical mass The place to be? Your share of industry value Openness: Facilitate rapid adoption, but face difficulty in keeping margins high Total value added to industry • 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

22. Strategy: Control Control: Ensure high profit margins, face an uphill task of getting to critical mass The place to be? Your share of industry value Openness: Facilitate rapid adoption, but face difficulty in keeping margins high Total value added to industry • Possible only when: • Technology is clearly superior • Firm has enough power to control standards • Standards still have to be sensible

23. Four Generic Network Strategies Licensing patents, etc. Control Openness Controlled Migration Open Migration Compatibility Provide converters etc. Performance Play Discontinuity Performance technologicaladvantage efficient manufacturing

24. Next Class:Switching Costs / Lock-In