ARE NETWORK EFFECTS REALLY ALL ABOUT SIZE? THE ROLE OF STRUCTURE AND CONDUCT - ALLAN AFUAH

1. ARE NETWORK EFFECTS REALLY ALL ABOUT SIZE? THE ROLE OF STRUCTURE AND CONDUCT - ALLAN AFUAH 기술경영학협동과정 박사과정 조인성

2. Contents 1. INTRODUCTION 2. THE ORIGINS OF SIZE’s DOMINANCE 3. STRUCTURE 4. CONDUCT WITHIN A NETWORK 5. BASIC CONDITIONS 6. SUMMARY AND DISCUSSION

3. 1. INTRODUCTION

4. Allan Afuah Associate Professor of Strategy EDUCATION PHD Massachusetts Institute Of Technology 1994 MS Massachusetts Institute Of Technology 1990 RESEARCH INTERESTS Arena: Value creation and capture in the face of technological innovation and globalization Perspective: Intersection of strategic management, and technology and innovation management Phenomena: Crowdsourcing, business model innovation, open innovation, disruptive technologies, social media, web 2.0, long tail, reverse innovations, strategic innovation, and firm boundaries in the face of change Approach: Multidisciplinary, drawing on economic theory, organizational theory and social network theory (e.g., RBV, TCE, SNT) Application: Goal is to contribute to an understanding of what drives firm performance, and wealth creation, especially in developing countries

5. Neoclassical economics Network effects • A product exhibits network effects if its value to users depends not only on benefits from the product itself but also on access to the network of people using that product or a compatible one • Neoclassical economics, focused on the role of network size Three definitions • ‘The benefit that a consumer derives from the use of a good often depends on the number of other consumers purchasing compatible items,’Katz and Shapiro, (1986: 822). • ‘A good is often more valuable to any user, the more others use compatible goods,’ Farrell and Saloner, (1986: 940); and • ‘A network externality exists when the value of consuming a particular product or service increases in the number of consumers that use compatible products or services,’ Gandal,(1994: 160; 1995: 599). Size에 대한 강조는 manager들에게 normative advice로 확장 Direct network effects; early lead in network size and pricing strategically Indirect network effects; boosting complements

6. Neoclassical economics 신고전파 경제학(新古典經濟學)는 경제 학파의 하나로, 시장이 어떻게 작동하는지를 설명하는 학문이다. 원래는 영국 고전파의 전통을 중시한 알프레드 마셜의 경제학을 일컫는 말로 여겨지지만, 일반적으로는 한계혁명 이후의 효용 이론과 시장균형 분석을 받아들인 경제학을 가리킨다. 현재 신고전파 경제학은 미시경제학의 주류 학파가 되었으며, 케인스 경제학과 함께 주류 경제학을 이루고 있다. Three central assumptions; • People have rational preferences between outcomes that can be identified and associated with values. • Individuals maximize utility and firms maximize profits. • People act independently on the basis of full and relevant information. 신고전파 경제학은 다음 3가지 가정에 기반을 두고 있다; • 완전한 계약의 가정(complete contracting assumption): 시장 거래의 핵심적인 조건이 계약 속에 포함되어 있다. • 규모에 대한 수익 체증(increasing return to scale)이 발생하지 않는다. • 모든 집단에 속한 집단원들이 그들의 집단을 위하여 일할 때 그 집단은 최대의 이익을 가진다.

7. Propositions of this paper Focusing on size alone can be misleading to both researchers and managers • First, products and services that exhibit network effects cut across all kinds of industries from health care (health maintenance organizations [HMOs]) to financial services, to high tech (computers and communications). • Second, over the past decade, social network theory (SNT) has been emerging as a theoretical perspective for exploring strategy questions. • Third, network effects are strategic resources(Shankar and Bayus, 2003). • Fourth, treating network size as the sole determinant of a network’s value to users is tantamount to omitting variables, which biases estimates and makes research results difficult to interpret. Network structure and network conduct

8. Background Information A firm creates value when the benefits it offers to customers exceed the cost of offering those benefits. It captures value when the price it obtains for the benefits exceeds the cost of offering them. Thus, a network contributes to a firm’s competitive advantage when it enhances value creation and/or capture. A network provider supplies a core component or subsystem of the infrastructure needed for network members to stay connected and undertake network transactions. Depending on the type of network, network providers have also been called network sponsors, network owners, platform sponsors or owners, and network suppliers (e.g., Rochet and Tirole, 2003). • “platform leader” (Gawer and Cusumano, 2002) • “keystone firm” (Iansiti and Levien, 2004) Of course, there are networks that have no ‘providers.’

9. 2. THE ORIGINS OF SIZE’s DOMINANCE

10. Four neoclassical economics assumptions Implied or explicitly stated in past network effects literature • 1. Every member of the network can transact with every other member and benefit equally from transacting with each member (Assumption 1 ). • 2. There is resource/capabilities homogeneity across network members and across network providers (Assumption 2 ). • 3. All network members are rational and have identical information about each other and about all possible transactions within the network (Assumption 3 ). • 4. Information flows seamlessly from member to member (Assumption 4 ). The value of network is proportional to the N(N-1) connections, The expected value each network user and provider from network effects increase with the square of network size.

11. Critical size and normative advice Early in the life of product, N^2 – N also very small  the benefits form the product가 중요 N^2 – N increase rapidly, Beyond some size, Nc (the critical size), network effects dominates • Network이 구식이 되거나 network size advantage를 뛰어넘는 product 출현 전까지 dominance 지속 • enabling the network provider(s) to dominate the market or win a standard, relegating competitors to niche markets or oblivion The normative advice (rooted in size hypothesis) • it has been suggested that early in the life of a network (before it reaches its critical network size), network providers are better off pursuing actions that would give their products an early lead in network size. (e.g., versioning, software piracy)

12. 3. STRUCTURE

13. Network’s Structure A network’s structure is the number of members, the relationships among them, and the heterogeneity and relative characteristics of members and their relationships Figure 2. Structure also determines value the four assumptions do not reflect the circumstances in most network industries and may be depriving researchers of paths to important constructs and solutions to interesting questions. In what follows, I relax the assumptions in search of other network insights, beyond the size hypothesis, that are potential sources of competitive advantage.

14. Network’s Structure - Transaction feasibility 1. Every member of the network can transact with every other member and benefit equally from transacting with each member (Assumption 1 ). Assumption 1: network phone number v.s. credit card network, Facebook • Fig. 2b: two-sided network, in which there two distinct groups that provide benefits to the other (e.g., Credit card network). • Fig. 2c: subnetworks with in a larger network (e.g., Facebook). • Networks value: 2a > 2b > 2d > 2c Proposition 1a: The more that each network member can transact with every other member, the more valuable the network is likely to be to each member and to the network provider(s).

15. Network’s Structure - Centrality and structural holes Because it is more centrally located than other members, L is said to have a high degree of centrality (Fig. 2d) More importantly, a centrally located member can create and/or capture more value from the network than a less centrally located one. If the bridge that it makes between the two subnetworks is nonredundant, the member is a monopoly as far as the bridge is concerned, and therefore has bargaining power during some transactions between the two subnetworks. Proposition 1b: The more central a non-opportunistic member’s position in a network, the more valuable the member is likely to be to other network members and the network provider(s). Proposition 1c: Members that bridge structural holes in a network are more likely to create and/or capture more value than members that do not.

16. Network’s Structure - Network ties 4. Information flows seamlessly from member to member (Assumption 4 ). v.s. Tacit information can be difficult and costly to transfer, Tacit knowledge is best transferred through strong ties (frequent and close relations) while explicit knowledge (such as information about where to find complex knowledge) is best transferred through weak ties (infrequent and distant relations). The frequent and close relationships of strong ties enable a firm to build a reputation or trust, both of which reduce transaction uncertainty about partners. Proposition 2: The more that the ratio of strong-to-weak ties matches the ratio of tacit-to-explicit knowledge, the more valuable the network is likely to be for members and the network provider(s).

17. Network’s Structure - Roles played by each network member 2N(N-1) v.s. N-1 v.s. (Nb)(Ns) Proposition 3: The more critical roles that each network member plays, the more valuable, on average, the network is likely to be to each member and to the network provider(s).

18. Network’s Structure - Heterogeneity of capabilities and the inverted U-shape of size 2. There is resource/capabilities homogeneity across network members and across network providers (Assumption 2 ). v.s. absorptive capability, nonredundant bridges to structural holes are likely to have some distinctive capabilities. However, if scalability of capabilities is limited—for example, because they are difficult to replicate—such a firm may be unable to obtain the additional capabilities it needs to manage exponential growth. After a certain network size, each new member is likely to have a negative effect on network value. Proposition 4a: A network is likely to be more valuable to members and providers that possess distinctive value-appropriating capabilities than to those that do not posses such capabilities. Proposition 4b: The lower the scalability of a firm’s resources for creating and/or capturing value in a network, the more that a plot of network value to the firm versus network size is likely to have an inverted U-shape.

19. 4. CONDUCT WITHIN A NETWORK

20. Conduct Within A Network - Opportunistic behavior 3. All network members are rational and have identical information about each other and about all possible transactions within the network (Assumption 3 ). Opportunistic behavior here refers to self-interest with guile, and ‘incomplete or distorted disclosure of information, especially to calculated efforts to mislead, distort, disguise, obfuscate or otherwise confuse’ The result is information asymmetry, which creates an opening for opportunistic behavior. Thus, each additional opportunistic member may make the network less valuable to other members and network provider(s). - lemons problem However, some researchers have argued that network members that are opportunistic in some activities may be good for the network provider(s). • software piracy the marginal cost of ‘supplying’ that extra stolen unit is zero • switching costs by learning how to use it, buy more compelling versions Proposition 5: The more opportunistic behavior there is in a network, the less valuable, on average, the network is likely to be to members and the network provider(s).

21. Conduct Within A Network - Reputation effects Network members can develop a reputation for retaliation, honesty, trustworthiness, and dependability. Members that want to develop such a reputation will be deterred from engaging in short-term opportunistic behavior by the fear of ruining their reputation and foregoing gains from future transactions. reputation mechanisms are designed to encourage more honest behavior by threatening actors with future punishment. - moral hazard Proposition 6a: The higher the reputation of network members for retaliation, honesty, trustworthiness, and dependability, the larger is the impact of network size on network value to its members and to the network provider(s).

22. Conduct Within A Network - Effect of trust Chiles and McMackin (1996: 85) defined trust as ‘the expectation that an exchange partner will not engage in opportunistic behavior, even in the face of countervailing short-term incentives. . . and uncertainty about long-term benefits.’ Transacting partners who believe they will engage in transactions again are less likely to be opportunistic in the short term if doing so reduces their opportunities for profitable future transactions In addition to reputation and trust, strong ties and the threat of social sanctioning can also reduce opportunism, thereby improving the value of a network to users and providers Proposition 6b: The greater the perception of trust in a network, the more valuable that network is likely to be to members and to the provider(s).

23. 5. BASIC CONDITIONS

24. Basic Conditions - Nature of transactions as antecedent and moderator A cell phone network, used for communications, is different from a credit card network used to mediate between cardholders and merchants. These differences often imply differences in infrastructures, feasibility of transactions, distinctive capabilities, levels of trust, structural holes, and other constructs. Effectively, the nature of transactions moderates the relationship between trust and the value of a network to members and the provider. Similar arguments can be made about the nature of the transactions that determine the other structure and conduct constructs, and the moderating effect on their impact on value.

25. Basic Conditions - Environment The other basic condition is the environment in which networks operate—in particular, the macro-environment made up of the political, economic, social/demographic, technological, and natural (PESTN) environments. Network externalities Technological discontinuity, standard or dominant design Centrally located firm Additionally, the fact that there are different technologies and their networks of backers competing for a standard or dominant design means there are likely to be structural holes between these networks. Effectively, the technological environment has both a direct and moderating effect on structure and conduct constructs.

26. Basic Conditions - Construct structure

27. 6. SUMMARY AND DISCUSSION

28. Strategic implications The goal of this paper is to show that factors beyond network size determine the value of a network to its members and provider(s). Focus on more than size • First, if members who are centrally located or who bridge structural holes add more value to a network (Propositions 1c), network providers might be wise to pursue such members first. • Second, because networks are more valuable when each member plays more than one role (Proposition 3), network providers may want to pursue activities that initially attract members who play more than one role in the network. • Third, since high levels of opportunism in a network can reduce the network’s value to members (Proposition 5), a primary goal should be to build one that has little or no opportunism. Timing • Firms use a product’s benefits to customers, pricing moves, alliances, and other measures to secure an early lead because, beyond Nc, such a lead becomes difficult to overcome (without riding a new technological trajectory or another discontinuity). • Many structural and conduct features -> leadership continue

29. Strategic implications

30. Discussion • Network Effects의 형태가 U-Shape 이외에 어떤 것이 있을 수 있을까? • Direct N.E와 Indirect N.E의 Type이나 Shape은 다른 점이 있을까? • 저자가 제시한 Structure와 Conduct 이외에 어떤 요인이 Network Effect에 중요할까? • Platform Provider가 제공하는 Core Component에 대한 사용에 대한 통제를 한다면? • Revenue sharing strategy • 두 Network(Platform) 간의 Competition이 있을 때, 혹은 신규로 시장 진입을 위해서 어떤 전략이 필요한가? • Platform Envelopment • 중요성이 시간의 흐름에 따라 변화 Product/Service -> Network Effect -> Product/Service • Network Effect가 발생하는 제품이나 서비스도Product Innovation -> Process Innovation 형태로 설명될 수 있을까? • Two-Sided Market에서 Critical size를 어떻게 정의할 수 있을까?