Carl Shapiro Hal R. Varian Information Rules: A STRATEGIC GUIDE TO THE NETWORK ECONOMY Networks and Positive Feedback Carl Shapiro Hal R. Varian Modified by Ekaterina Shurkova and Gaurav Gupta

Important Ideas Positive feedback Network effects Economies of scale Demand side Supply side

Network Effects Real networks Virtual networks Number of users Adds value Metcalfe’s Law: Value of network of size n proportional to n2 Example: fax machine, Playstation Users

Positive Feedback Strong get stronger, weak get weaker Negative feedback Makes a market “tippy” Example: VHS v. Beta “Winner take all markets”

“Winner take all markets”- Positive Feedback 100 Winner Market Share (percent) 50 Battle Zone Loser Time

Positive Feedback (Example) Atari ↔ Nintendo

Adoption Dynamics Saturation Takeoff Number of users Launch Time

Adoption Dynamics (Examples) Biological world; Fax machine; E-mail; The Internet;

Sources of Positive Feedback Supply side economies of scale Declining average cost Marginal cost less than average cost Example: information goods

Sources of Positive Feedback Demand side economies of scale Based on number of users Does Not dissipate when the market grows Adds more value Example : MS Word

Popularity adds value in a Network industry Virtuous cycle Vicious cycle Value to user Number of compatible users

Lock-In and Switching Costs Network effects lead to substantial collective switching costs Even worse than individual lock-in Due to coordination costs Example: QWERTY Example: Metric System in the US Cell Phone Providers (free calls)

Don’t Get Carried Away Network externalities don’t always apply ISPs (but watch out for QoS) PC production DVD Players Likelihood of tipping See next slide

Likelihood of Tipping

Igniting Positive Feedback 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 Offer a migration path Examples Microsoft (WordPerfect) Borland copies from Lotus Apple (new Intel chip) Build new network by links to old one Problems: technical and legal

Technical Obstacles Use Creative design Think in terms of system Converters and bridge technologies One-way compatibility Office 97 as an upgrade of Office 95

Legal Obstacles Need IP licensing Example: Sony and Philips CDs

Revolution Groves’s law: “10X rule” But depends on switching costs Example: Records -> CDs DVD -> new format(?)

What To Choose Your reward = Total added to industry x your share Value added to industry Depends on kind of Product and Size of network Your share Royalty payments Proprietary Optimum Your share of industry value Your Reward Open Total value added to Industry

Openness v. Control Openness Control Make interfaces and specifications available to others Example Jabber Control Keeping the technology or system proprietary Example Skype

Openness Full openness Alliance Anybody can make the product Problem: no champion Alliance Only members of alliance can use Example SAE (Society Of Automotive Engineers) Technology - ESP Problem – holding the alliance together Example AIM (Apple/IBM/Motorola)

Control Control standard and go it alone Usually market leaders If several try this strategy, may lead to standards wars

Generic Strategies

Performance Play Introduce new, incompatible technology Examples Palm Pilot Iomega Zip Attractive if Great technology Outsider with no installed base

Controlled Migration Compatible, but proprietary Examples Windows Upgrades

Open Migration Many vendors, compatible technology Examples Fax machines

Discontinuity Many vendors, new technology Examples Satellite radio

Historical Example of Positive Feedback RR gauges