Transcript File - Information Technology Management

The Network Effect
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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.
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Introduction
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
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Archetype 2: Indirect Network Effect
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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
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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
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Algebraic Formulations
An Algebraic Formulation of the Network Effect–
Metcalfe’s Law
• 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
• 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)
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Background: The Demand Curve
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The demand curve depicts 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.
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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
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Demand and Supply Curves for Information Goods
with Network Effect
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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
Source: Shapiro and Varian, Information Rules,
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p = n(1000 − n) = 1000*n – n
A Strategic Guide to the Network Economy,
Harvard Business School Press, 1999
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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
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1
2
Quantity
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Implications
Collective Switching Costs
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Success and failure are driven as much by
consumer expectations and luck as by the
underlying value of the product
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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
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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
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Standard Wars
• Standard wars are unique to
network markets
• Adoption is difficult when multiple
groups of buyers need to coordinate
• Key Assets
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Control over an installed base
Intellectual property rights
Ability to innovate
First-mover advantages (learning)
Manufacturing ability
Strength in complements
Reputation and brand name
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DVD vs. DIVX
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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
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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
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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.
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