Transcript Network Economics

Network Economics – for Lo205
Judith Molka-Danielsen
[email protected]
http://home.himolde.no/~molka
Reference: “Information Rules”, Carl Shapiro and Hal R.
Varian, Havard Business Sch. Press, chapter 07, 1999.
March 01, 2002
Overview




Describe the New Information Economy
Discuss the factors in the Economics of
Networks
Define the terms: network effects and
network externaltities
Discuss the concept of Lock-in
The old industrial economy





Dominated by Oligopolies
a few large firms
market share rose and fell slowly
lifetime employment
Industries that exhibited this:
–
–
–
–
–

automobile
steel
aluminum
petrolium
chemical markets
economies of scale
The new information economy






Dominated by temporary monopolies
dominate player based on the days leading
technology
short time on top
7 years average at one job
Industries: hardware and software
economies of networks
Types of Networks

Physical networks
– telephone, electrical,
– railroad,
– airlines

High Technology (real)
– computer, fax machine, compatible modems,
– email, ATMs, Internet

High Technology (virtual)
– Macintosh users, CD readers-writers users,
– Nintendo 64 users, minidisc users
Important Concepts




It is better to be connected to a bigger
network than to a smaller one.
Network effects
Positive Network Externalities
Companies compete by expanding their
networks, they increase the value by
interconnecting with other networks.
Positive Feedback




Positive feedback - the strong get stronger
and the weak get weaker.
Speaking into a microphone, when the
amplified signals go back into the system,
you have repeated amplification. It gets
loud.
Negative feedback - when the strong get
weaker and the weak get stronger. Go to a
middle point. Industrial oligopolies exhibit.
In the industrial markets, attempts for
greater market share would trigger
responses by others towards efficiency,
also too large firms were too complex to
manage. The norm were oligopolies.
Positive feedback (cont.)




Postitive feedback can contribute to
growth, but it is not the same thing. Ie.
Internet.
Virtuous cycle - success feeds itself.
Vicious cycle - product seen as failing,
the perception feeds the cycle, death
spiral, the weak get weaker. Ie. Apple
Macintosh.
Tippy market - two players compete,
one wins. (Video recorders - VHS v.
Beta) Winner take all.
Positive Feedback - example




Nintendo - enters home video games in 1985
Other dominant player at the time (Atari,
Texas Instruments)
Christmas 1986, Nintendo Entertainment
System (NES) was hot. More game
developers begin to write games for them.
Game developers pay royalties to Nintendo
and agree to not share the game with other
systems for 2 years after release.
Sources of Positive Feedback (V&S)

Supply side economies of scale
– Declining average cost
– Marginal cost less than average cost
– Example: information goods

Demand side economies of scale
– Network effects
– In general: fax, email, Web
– In particular: Sony v. Beta, Wintel v. Apple
Chicken & Eggs (V&S)



Fax and fax machines
VCRs and tapes
Internet browsers and Java
S-shaped curve

Adoption of new technologies follow an Sshaped curve in three phases:
– flat during launch,
– steep rise during takeoff, positive feedback at
work,
– leveling off, saturation is reached.

Seen in the adoption of: fax machine, CD,
color TV, video games, e-mail, and the
Internet.
Economies of Scale



Economies of scale - is a source of positive
feedback. Larger firms tend to have lower unit
costs of productions. This is supply-side
economies of scale.
In manufacturing the benefits of scale are
usually exhausted before total market
dominance.
Demand side economies of scale - Microsoft
Windows 95 in 1998, widely used, de facto
industry standard. Some technologies go
head-to-head for years before a winner
emerges. Telephone netwk also showed this.
Network externalities

Sponsor - of a net builds and hopes to profit from the
net.
– Apple controls interfaces, clone license terms, architecture
improvements, for the Mac. And influence supply of
complementary products. (Partners)



Recall externalities are positive and negative
(pollution)
Positive network externalities lead to positive
feedback
Metcalfe’s law: The value of the network goes up as
the square of the number of users. Total value of the
network to all users = n x (n-1) = n2 -n where n is the
number of users. If value=$1 for a single user, and
n=10, then network size 10 has 102-10=90 = $90.
Collective switching costs



Switching costs - come from complementary
assets, hardware with software, IT systems with
training. If I learn to program in Access db language
other Access software and the language becomes
more valuable to those who are already users.
But it is hard to get people to switch, collective
switching costs. It is hard to coordinate users to
switch all at the same time, and they will not do so by
themselves. Therefore, the existing providers have
the advantage.
1870 QWERTY keyboard wins over the 1932 Dvorak
layout with home row AOEUIDHTNS that was proven
to be faster. We would collectively be better to switch
but the individual switching costs are too high. (Also
called technological Lock-in.)
Summary on Lock-In and Switching Costs
(V&S)




Network effects lead to substantial
collective switching costs
Collective lock-in is even worse than
individual lock-in
Due to coordination costs
Example: QWERTY
Don’t Get Carried Away (V&S)

Network externalities don’t always apply
– ISPs (but watch out for QoS)
– PC production (easy to produce)
Industry and positive feedback



Not every market tips (Ford had a best-selling-car,
but who cares, you do not buy a car because others
have it. But you may avoid a car because no one has
it.)
There are no demand side economies of scale
within the IBM compatible PC market because
standards allow interoperability. Another example,
Internet service providers. (America Online,
CompuServe, Delphi, had separate discussion
groups before Internet. Now access can be from
anyone, AOL, IBM, ATT, etc.)
ISPs could differentiate access through QoS offers,
video conferencing, etc. Large ISPs have advantage
because it is easier to control QoS on a single
network.
Likelihood of a market tipping to one
technology
low economies of high economies
scale*
of scale
low demand for Unlikely
variety
High
high demand for Low - global
HDTV market**
variety
Depends
*sum of economies of scale - ie. There are supply
side eos for PC market where Compaq, Dell, HP and
IBM have 24%.
**standards reduce variety, but global HDTV
standards are not needed.
Performance v. compatibility





How do you start the virtuous cycle? Philips and
Sony introduced the CD in the 1980s.
Philips offers digital compact cassette (DCC) in 1992
where DCC players can play regular cassettes,
backward compatible. But it didn’t catch on.
Consumer inertia approaches: the evolution strategy
of compatibility, and the revolution strategy of
performance.
Revolution - best performance to start over with a
new product, but high switching costs.
Evolution - give up some performance to allow
compatibility (lower switching costs).
Igniting Positive Feedback (V&S)
(First fundamental tradeoff)

Evolution
– Give up some performance to ensure
compatibility, thus easing consumer
adoption

Revolution
– Wipe the slate clean and come up with the
best product possible
Evolution (V&S)


Offer a migration path
Examples
– Microsoft
– Intel
– Borland v Lotus


Build new network by links to old one
Problems: technical and legal
Technical Obstacles to Evolution (V&S)



Use Creative design
Think in terms of system
Converters and bridge technologies
– One-way compatibility
Legal Obstacles (V&S)


Need IP licensing
Example: Sony and Philips CDs
Openness v. Control





Is the second fundamental tradeoff.
Open - make interfaces and specifications available
to others. Consumers can fear lock-in, open raises
chances of success, attracks allies.
Control - keep your system proprietary. (This is
valuable if your system takes off.) Installed base is
more valuable if rivals cannot offer products to lockin customers. Control interconnection.
Existing market position, technical capabilities and
control of intellectual property rights are 3
dimensions of critical market strength.
Intel controls MMX multimedia specs for its Pentium
chips, but promote an open interface spec for graphic
controllers, the accelerated graphics port (AGP) to
increase demand for their microprocessors.
Openness v. Control (V&S)


Your reward (total value to you) = Total value
added to industry x your share (in the market).
Total Value added to Industry (VI)
– Depends on product and
– Size of network
– VI= the value the technology adds to the existing
product value + how widely the technology is
adopted (network size).

Your share (YS) of industry value
– Depends on how open
– YS= your market share + your profits + your
royalties + how the technology effects your sale of
other products (add to sales or take away).
Openness (V&S)

Full openness
– Anybody can make the product
– Problem: no champion

Alliance
– Only members of alliance can use
– Problem: holding alliance together
Control (V&S)


Control standard and go it alone
If several try this strategy, may lead to
standards wars
Openness v. Control





Best Strategies:
– Have a large share of a small market (small pie),
– Have a small share of a large market (Sun and
Java).
The optimal point is where you maximize Total Value
to you.
Systems - are a cooperation of compoenets
To caputre value from one component requires
cooperation with those providing the other
components.
Suppliers will want a share of the rewards in retrurn
for cooperation.
Openness Strategy







When no one firm is strong enough to dictate
technology standards.
When coordination is necessary.
To start the bandwagon rolling.
Full openness (ITU standards) v. Alliance Strategy
(member advantage, Microsoft developers)
Alliance types: special interest group, task forces,
groups of companies.
Alliances share: cross license patents,
manufacturing skills, improve time to market, share
designs.
Alliances coordinate: standards, interfaces,
protocols, specifications.
Control Strategy



Central actor controls development
Sun sponsors Java, Apple sponsors Macintosh,
Ericson sponsors BlueTooth.
Companies that control product standards and
interfaces have power. But they can lose with poorly
conceived standards.
Generic Strategies for new Technology
Introduction.
Control
Openness
Compatibility
Controlled
migration
Open migration
Performance
Performance play Discontinuity
1. Performance Play - new, incompatible, strong
control, high risk, big technology advantage, new
entrants try with no base to worry about.
2. Controlled Migration - give up performance to
reduce customer switching costs, need allies,
backward compatible, but proprietary.
Generic Strategies for new Technology
Introduction.
Control
Openness
Compatibility
Controlled
migration
Open migration
Performance
Performance play Discontinuity
3. Open Migration - new product by many vendors,
low switching costs, good where there are only
manufacturing economies, want a big network.
4. Discontinuity - need allies, make system very
open, new product not compatible with old but
available from many suppliers, favor efficient
manufacturers.
Performance Play (V&S)


Introduce new, incompatible technology
Examples
– Palm Pilot
– Iomega Zip

Attractive if
– Great technology
– Outsider with no installed base
Controlled Migration (V&S)


Compatible, but proprietary
Examples
– Windows 98
– Pentium
– Upgrades
Open Migration (V&S)


Many vendors, compatible technology
Examples
– Fax machines
– Some modems
Discontinuity (V&S)


Many vendors, new technology
Examples
– CD audio
– 3 1/2” disks
Summary of the lecture (V&S)





Positive feedback means strong get
stronger and weak get weaker
Consumers value size of network
Works for large networks, against small
ones
Consumer expectations are critical
Fundamental tradeoff: performance and
compatibility
Summary on introducing services and
products into markets (V&S)


Fundamental tradeoff: openness and
control
Generic strategies
– Performance play
– Controlled Migration
– Open Migration
– Discontinuity

Look at lessons of history