Information Rules Chapter 7 Networks and Positive Feedback CMIS 520 April 11, 2005

Overview Positive Feedback Demand Side Economies of Scale Network Externalities Collective Switching Costs Is your industry subject to positive feedback Igniting positive feedback Evolution: offer a migration strategy Revolution: offer compelling performance Generic Strategies in Network Market Lessons

Positive Feedback Difference between old economies and new economies Economies of Scale vs. Economies of Networks The value of connecting to a network depends on the number of people on the network

Positive Feedback Positive feedback allows the strong to get stronger and the weak to get weaker Negative feedback allows the strong to get weaker and weak get stronger When two firms compete in a market where there is positive feedback only one winner can emerge This is driven by the fact that users want to be connected to the network that has (or will have) the most users

Positive Feedback The positive feedback system follows a predictable S-Shaped curve Flat during launch A steep rise during takeoff as positive feedback kicks in Leveling off

Supply/Demand-Side Economies of Scale Supply-Side Economies of Scale Declining average unit cost (ex: cars) As quantity increases marginal unit cost < average unit costs (ex: information goods) Demand Side Economies of Scale Value to the user increases as the number of compatible user increases Network effect Examples cellular phones

Demand-Side Economies of Scale Value to User Number of Compatible Users Vicious Cycle Virtuous Cycle Popularity Adds Value in a Network Industry

Demand-Side Economies of Scale Supply-side and demand-side economies of scale combine to make positive feedback in the network economy specially strong. Example: cellular phones Marketing (demand-side) Strategy

Network Externalities The term that describes the effect that large networks are more attractive to users than small ones are Network: view info technologies in terms of virtual networks, which share many properties with real networks such as communications and transportation networks

Network Externalities Externalities: arise when one market participant affects others without compensation being paid Like feedback, externalities come in 2 flavors: negative & positive Negative externality is pollution my sewage ruins your pool or drinking water Normally externalities are positive I join your network & it gets bigger and better to your benefit

Network Externalities Positive externalities give rise to positive feedback when I buy a fax machine, the value of your fax machine is enhanced since you can now send faxes to me and receive faxes from me

Network Externalities Metcalfe’s Law: named after the inventor of Ethernet The value of a network goes up as the square of the number of users If there are “N” number of people in a network, and the value of the network to each of them is proportional to the number of other users, then the total value of the network is proportional to N x (N-1) = N^2 – N

Network Externalities Metcalfe’s Law Continued If the value of a network to a single user is $1 for each other user on the network, then a network of size 10 has a total value of roughly $100. In contrast, a network of size 100 has a total value of roughly $10,000. A tenfold increase in the size of the network leads to a hundredfold increase in its value.

Collective Switching Costs Network externalities make it virtually impossible for a small network to thrive Every network has to start from scratch The challenge to companies seeking to introduce new but incompatible technology into the market is to build network size by overcoming COLLETIVE SWITCHING COSTS (the combined switching costs of all users)

Collective Switching Costs In many information industries, these are the biggest single force working in favor of incumbents They work in a non-linear way, convincing 10 people connected in a network to switch to your incompatible network is more than 10 times as hard as getting one customer to switch But you need all 10, or most of them: no one will want to be the first to give up the network externalities and risk being stranded Because various users find it so difficult to coordinate to switch to an incompatible technology, control over a large installed base of users can be the greatest asset you can have

Collective Switching Costs: Example QWERTY Keyboard (1870s : Type Writer brand of machines) Awkward configuration of letters, mainly to slow down typists and reduce incidence of jamming of the machines. Dovark Layout (patented 1932) Much superior .. All vowels on the same row Why, then, are we still using QWERTY keyboard (computer Keyboards rarely jam) ?

Positive Feedback Not all information infrastructure markets are dominated by the forces of positive feedback EX: Internet Service Providers A high tech industry that currently does not experience large network effects At one time, were attempts by ISPs for proprietary systems Changed by the commercialization and standardization of the Internet

Positive Feedback Think carefully about the magnitude and significance of network externalities in your industry Don’t let the idea of positive feedback carry you away; not every market tips Will your market tip toward a single dominant technology or vendor? Depends on the balance between two fundamental forces: economies of scale & variety

Not every market tips! Likelihood of Market Tipping to a Single Technology Low Economies of Scale High Economies of Scale Low Demand for Variety Unlikely High High Demand for Variety Low Depends

Igniting Positive Feedback: Performance Vs. Compatibility What does it take for a new technology to succeed in the market? Building your own base of users for a new technology in the face of an established network can be daunting

Igniting Positive Feedback: Performance Vs. Compatibility Two approaches for dealing with the problem of consumer inertia 1) Evolution strategy of compatibility 2) Revolution strategy of compelling performance Evolution strategy offers a smooth migration path Revolution strategy offers compelling performance

Igniting Positive Feedback: Performance Vs. Compatibility Evolution Improved Design or Adaptors Compatibility Performance Performance

Evolution: Offer a Migration Path Reducing switching costs to entice customers to try your new technology Requires compatibility with existing products Two Obstacles Technical Obstacles Legal Obstacles

Technical Obstacles Develop a technology that is both Compatible with existing technology Superior to existing technology Keeps switching costs low with backward compatibility and improved performance Compatibility/Performance Tradeoff 3 Strategies to combat tradeoff Use creative design Think in terms of the system Consider converters and bridge technologies

Legal Obstacles Need to obtain the legal right to sell products that are compatible with existing products Intellectual Property Rights over older generation technology Incumbents may use property rights to block competition or to license product

Revolution: Offer Compelling Performance Offer a superior product to persuade enough users to switch to it Revolution Strategy Challenges Revolution Strategy is risky Andy Grove’s ’10X’ rule of thumb

Igniting Positive Feedback: Openness Vs. Control Anyone launching a new technology must face a fundamental control/openness trade off. Open: Offering to make the necessary interfaces and specifications available to others. Control: Maintain control by keeping your system Proprietary.

Igniting Positive Feedback: Openness Vs. Control Proprietary control will be exceedingly valuable if your product or system takes off. Your network will be more valuable if you can control the ability of others to interconnect with you.

Igniting Positive Feedback: Openness Vs. Control Failure to open your technology can spell its demise. If customers fear lock-in or if you face a strong rival whose system offers comparable performance but is non-proprietary. Openness ups your chance of success by attracting allies and assuring customers that they can turn to other suppliers down the road.

Igniting Positive Feedback: Openness Vs. Control Which route is best? There is no right or wrong choice. The answer depend on the market and your position in the market. Ultimate goal is to maximize the value of your technology, not your control over it.

Igniting Positive Feedback: Openness Vs. Control Your Reward = Total value added to Industry X Your share of industry value Total value added to the industry depends on the inherent value of the technology and how widely the technology is adopted.

Openness The openness strategy is critical when no one firm is strong enough to dictate technology standards. Openness also arises naturally when multiple products must work together, making coordination in product design essential. Openness is more cautious than control. Idea is to forsake control to get the bandwagon rolling.

Generic Strategies in Network Markets 4 Generic strategies for companies seeking to introduce new technologies into the market place. These strategies follow logically from the two basic trade-offs Performance/Compatibility trade off Openness/Control trade off

Generic Strategies in Network Markets   Control Openness Compatibility Controlled migration Open migration Performance Performance play Discontinuity

Generic Strategies in Network Markets Controlled Migration Consumers are offered a new and improved technology that is compatible with their existing technology, but is proprietary. Upgrades and updates of software programs tend to fall into this category.

Generic Strategies in Network Markets Controlled Migration Cont. If you have secure domination in your market, you can introduce the new technology as a premium version of the old technology. Thus, controlled migration often is a dynamic form of the versioning strategy described in chapter 3.

Generic Strategies in Network Markets Open Migration The new product is supplied by many vendors and requires few switching costs. Open migration makes the most sense if your advantage is primarily based on manufacturing capabilities. You will benefit from a large total market and an agreed upon set of specifications.

Generic Strategies in Network Markets Discontinuity A new product or technology is incompatible with existing technology but is available from multiple suppliers. Ex.- introduction of CD audio systems, 3 ½ floppy disks Like the open migration strategy, discontinuity favors suppliers that are efficient manufacturers.

Generic Strategies in Network Markets Performance Play Boldest and riskiest of the four strategies. Involves the introduction of a new, incompatible technology over which the vendor retains strong proprietary control. Makes the most sense if your advantage is primarily based on the development of a striking new technology that offers advantages over existing technology. Examples – Nintendo, Palm pilot, Zip Drive How about Google?

Lessons Positive Feedback - The Dynamic Process by which the Strong get Stronger and Weak get Weaker. Adoption Dynamics – In the Presence of Positive Feedback tend to follow a predictable “S” pattern, or logistic growth path (slow start, rapid growth, the saturation)

Lessons Consumers Value Information Technologies that are widely used, just as they value communications networks with broad reach. Positive Feedback works to the advantage of large networks and against small networks. Consumer Expectations are vital to obtaining the critical mass necessary to fuel growth. The resulting demand-side economies of scale, or network externalities, are a major cause of positive feedback in the information economy.

Lessons Firms introducing new products and technologies face a fundamental trade-off between performance and compatibility. Firms Introducing new products and technologies also face a fundamental trade-off between openness and control. Many of the tactics for dealing with positive feedback and network externalities have been used in the past.

Lessons There are four generic strategies for innovators in network markets Performance Play Controlled Migration Open Migration Discontinuity

Discussion Questions Can Microsoft be considered a ‘growth’ company today? Where would you put Microsoft on the S-shaped curve (in terms of Revenue or profit) How would you characterize Google against the backdrop of the four generic strategies that we talked about? CMIS 520 April 11, 2005