Networks and Positive Feedback Carl Shapiro Hal R. Varian

Overview Chapter 7 (this chapter) illustrates the key concepts that underlie market dynamics and competitive strategy in both real and virtual networks. 4 strategies. History lessons. Chapter 8 discusses how to work with allies to establish a new technology – to launch a new network. Negotiations and standardization. Chapter 9 examines what happens if negotiations break down: how to fight a standard war.

Important Ideas Positive feedback Network effects Returns to scale Demand side Supply side

Positive Feedback(善歸還) cf. regression 回歸, cycle 循環 Mkt share PF: Strong gets stronger, weak gets weaker (from electronics term) Negative feedback: stabilizing  the strong gets weaker, the weak gets stronger PF makes a market “tippy” (쏠림) Examples: VHS v. Beta, Wintel v. Apple “Winner-take-all markets” 100% 50% 0% tippy

Sources of Positive Feedback Supply side economies of scale (ever) Declining average cost Marginal cost less than average cost Example: information goods, early US car industry Demand side economies of scale Network effects In general: fax, email, Web In particular: VHS v. Beta, Wintel v. Apple

Network Effects due to Positive Feedback Less value More value Network Effects due to Positive Feedback Real networks: telecommunication Virtual networks: iPhone Users Number of users Metcalfe’s Law: the inventor of Ethernet(LAN) Value of network of size n proportional to n2≈ n(n-1) Importance of expectations n Value to Users Virtuous Cycle Vicious

Lock-In and Switching Costs Keyboard array(천지인) for human Lock-In and Switching Costs Network effects lead to substantial collective switching costs b/c of the value of network s/he has to bear if switch Even worse than individual lock-in Due to coordination costs Example: QWERTY Keyboard array for machine August 드보락 1874(Type Writer) 1936, 속기사

Don’t Get Carried Away Network externalities (or tipping) don’t always apply AOL, Compuserv, Delphi (incompatible network services; 천리안, 코넷, 나우누리 PC통신, 90년대 중반부터 www) was going to tip the mkt but introduction of internet change all that  ISPs if with standard. No tipping. PC production (no PF within the mkt) Likelihood of tipping See next slide

Likelihood of Tipping due to Positive Feedback Scale Economy Effect > Demand for Variety Effect Low Scale Economies (low Network Effect) High Scale Economies (high Network Effect) Low Demand for Variety 다양성 필요 없는 상품 Ex) Rice Unlikely Ex) Computer OS High High Demand 다양성 요구되는 상품 Ex) Tennis Racket Low Ex) Mobile Phone Depends: w std, do not tip w/o std, tips. ③ ① ④ ② Chance of tipping increases: ④③②①

Chicken & Eggs Problem: which makes mkt tip? Bottle or Wine? The problem: wine without bottle or bottle without wine? Ex) Fax machines and fax, VCRs and tapes Internet browsers and Java: Internet provides the contents (wine) AND the viewer (bottle) at the same time Two strategies to ignite PF: 1) Performance vs. Compatibility 2) Openness vs. Control

Strategies to Ignite Positive Feedback 1: Performance vs. Compatibility 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 Compatibility Evolution Improved Design or adapters Revolution Performance

Evolution Strategy: Smooth Migration Offer a migration path Examples Microsoft (backward compatibility, Window XP vs. Windows 10) Ex) W8 써도 W10 쉽게 사용 Build new network (W10) by links to old one (W8) Problems: technical and legal (next) + slow consumer adoption Ex) 아직 W 8 사용? USB-C to USB

Technical Obstacles to Evolution Strategy Need creative product design: compatible but superior, Ex) B/W TV v. Color TV, NBC engineers in 1950s.  Color TV signal but watchable with B/W TV Need to think in terms of system: you may be making only one component, but the user care about the whole system. Ex) Broadcasting both conventional and HDTV digital signal, lessening switching cost. Analog vs. Digital broadcasting Need converters and bridge technologies One-way compatibility (ex: only analog to digital converter. XP to Win 8, not Win 8 to XP)

Legal Obstacles to Evolution Strategy Need IP licensing Example: IP of Sony and Philips on CDs  DVD makers needed Sony and Philips’ consent to make DVD read CDs.(as an evolution strategy) 10-31-18

Revolution Strategy: Compelling Performance Intel’s CEO Risky, need powerful allies, don’t know if the tech will take off or crash and burn even for great tech. Groves’s law: “10X rule”: need to be 10 times better to revolutionize. But depends on switching costs Example: Sega v. Nintendo: Sega 64 was not 10X better than Nintendo 32 but switching cost was low (new crop of ten-year-old boys every year)

Strategies to Ignite Positive Feedback 2: Openness v. Control Mkt Share CONTROL OPEN In choosing btwn them, your goal is to max Your reward (= Total value added to industry x your share), not control.  T&C control Value added to industry depends on; Product (what improvement, value of the tech) and Size of network (how widely adopted; more open  larger network) Your mkt share or installed base.(more open less share), Depends on how openly your tech used Total Value CONTROL OPEN Mkt Share Too Much control CONTROL MAX your reward Too open OPEN Total Value

Trade-off btwn Openness and Control Your share Proprietary = Control = std war (chapter 9) Optimum (largest area) Hardware + Software Your Reward Hardware Open = cooperation (chapter 8) Total Value added to industry ≒ network size Software Info tech is comprised of systems  as a system, more value  need cooperation of others  need to sacrifice mkt share to get them cooperate

Openness: emphasis on total value added to the industry Openness strategy: more details in chapter 8 When no one firm is strong enough to dictate tech standard, or when multiple products work together Full openness Anybody can make the product Problem: no champion, small mkt share Alliance Only members of alliance can use Problem: holding alliance together  small profit Emphasis on this

Control: emphasis on your share Control strategy: more details in chapter 9 For only those in the strongest position Ex) MS now, Sony and Philips before. Control standard and go it alone If several try this strategy, may lead to standards wars Emphasis on this

Generic Strategies: Combining the 2 Strategies to ignite PF One Vendor Many Vendors Strategies Control Openness Compatibility (evolution) Controlled migration Ex) Window 8  10 Open migration Ex) generations of fax machine Incompatibility (revolution) Performance play: Ex) Nintendo in mid-1980s. Discontinuity: new tech is incompatible but available from many suppliers Ex) 3.5 inch floppy New but Compatible Tech Chapter 8 (cooperation) 단종 전략 New and Incompatible Tech Chapter 9 (Std. War)

Controlled Migration Compatible, but proprietary Examples Windows 10 (from Window 8) 32bit CPU  64 bit CPU Upgrades The original Pentium processor was a 32-bit microprocessor produced by Intel. The first superscalar(parallel computing) x86 architecture processor

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

Open Migration Many vendors, compatible technology Examples Fax machines Some modems USB 2.0  3.0  4.0

Discontinuity (not continued from old tech) Many vendors, new(incompatible) technology Examples CD audio 3 1/2” disks HDMI

Historical Examples of Positive Feedback: Standard Battles 1 협궤(narrow; 1000~1372mm) 표준궤(std) 광궤(wide) 마차 폭 넓으면 똑바로 끌기 어려움. 너무 좁으면 물건 많이 못 실음 RR gauges: 5 foot (152.4cm; South) v. 4’8½” (148cm; North, Roman cart, most efficient for horse pulled cart)  3 diff. widths met at Erie  Westward expansion + Civil War  Standardized in 1860~1890: Penn. Porters’ Riots, insignificant historical events can lead to lasting technological lock-in Ex) Track gauge conversion

Lessons from Railroad Gauge Standard Battle Incompatibilities can arise almost by accident, yet persist for many years Network market tend to tip toward the leading player, unless the other players coordinate to act quickly and decisively Seceding from the standard-setting process can leave you in a weak market position in the future A large buyer(such as U.S. Gov’t) can have more influence than suppliers(sellers) in tipping the balance

Historical Examples of Positive Feedback: Standard Battles 2 DC AC AC v. DC (Thomas Edison Direct Current: 1 mile limit but efficient power generation, Westinghouse Alternating Current: efficient transmission) AC  transformer: allows power to be transmitted efficiently at high voltages and then stepped down to lower voltages for local distribution DC densely populated area, AC small, remote towns Edison electrocuted a dog with AC to show the danger of high voltage, but 1) AC got superior due to advances of polyphase 2) the rotary converter allowed DC stations integrated into AC stations 3) Edison established GE, supplying AC as well 11-2-18 Three-phase system transmits 73% more power but uses only 50% more wire.

Lessons from Electronic Industry Standard Battle Technologies can seek well-suited niches (battery) if the forces toward standardization are not overwhelming Ongoing innovation (polyphase AC ex: 3-phase, 공업용 전기, 380v) can lead to victory in a standard war A first-mover advantage (of DC) can be overcome by a superior tech (of AC) if the performance advantage is sufficient and users are not overly entrenched Adapters (rotary converter) can be the salvation of the losing tech and can help to ultimately defuse a standard war

Historical Examples of Positive Feedback: Standard Battles 3 Telephone networks Color TV HDTV 3D TV Samsung: Active Shutter LG: Passive Polarization

Lessons Positive feedback means strong get stronger and weak get weaker Consumers value size of network PF works for large networks(large gets larger), against small ones (small gets smaller) Consumer expectations are critical Fundamental trade-off 1  performance and compatibility

Lessons, continued Fundamental trade-off 2  openness and control Generic strategies (Trade-off 1 x Trade-off 2) Performance play Controlled Migration Open Migration Discontinuity Lessons of history

Feedback 피드백 한국: 되먹이기, 귀환(歸還), 중국: 反馈[fǎnkuì], 일본: フィードバック(휘도밧구), 反応(はんのうhannō) 전기용어: 입력신호와 동위상으로 귀환 (feedback) 하는 것을 <정귀환> (正歸還), 반대위상으로 귀환하는 것을 <부귀환> (負歸還)이라고 함. 정귀환 = positive feedback 전기용어에서 유래 : 자동 제어계나 증폭기 따위에서, 출력 회로의 전력 일부가 입력 회로에 대하여 그 입력 전력을 증가하도록 가하여지는 것. 이로 인하여 증폭 작용이 강화되고 결국은 발진(發振)이 생김 악순환惡循環=vicious cycle, 선순환善循環=virtuous cycle:

Track Gauge Conversion Bogies exchange operation in Ussuriisk (near Vladivostok) at the Chinese–Russian border Bogie change station at Chop, Ukraine station, Ukraine