1 Network Effect The old industrial economy: Economies of scale. Declining average cost The new information economy: Economics of networks. The value of a network depends on the number of other people already connected to it. We are all familiar with physical networks, such as telephone network, railroad networks, and airline networks. But many other high-tech products reside in “virtual” networks: the network of Macintosh users, the network of CD machines, or the network of Nintendo 64 users.

2 Microsoft Case As of May 1998, Microsoft had a market capitalization of about $210 billion. Why do you use MS? Why do you develop programs for MS?

3 Software and Hardware The value of hardware depends on the prices and varieties of software products. The prices and varieties of software depend on how many consumers have the hardware platform. More use the same hardware, more software products will be supplied at lower prices

4 Positive Feedback The key concept of network economics is positive feedback. Positive feedback makes the strong get stronger and the weak get weaker. E.g: As Wintel’s share of PC market grew, uses found the Wintel more and more attractive. Success begat more success, which is the essence of positive feedback. Positive feedback can lead to a winner-take-all-market in which only one single firm or technology survives.

5 Positive Feedback

6 Collective Switching Cost Collective switching cost – the combined switching costs of all users. The Layout of the typewriter keyboard offers a fascinating example of collective switching costs and the difficulties of coordinating a move to superior technology. Suppose the computer lab has the QWERT keyboard. Which keyboard you will learn? Then, which keyboard the computer lab will has?

7 The QWERTY keyboard slows down typists and thus reduce the incidence of jamming. The problem of jamming was greatly reduced. Today, there is even no jamming of computer keyboards. Alternative, superior keyboards, the Dvorak layout, was developed.

8 Collective Switching Cost But then why are we all still using QWERTY keyboards? Collective switching cost – we would collectively be better off switching to the new layout, but no one is willing to lead the move. As coordination is so difficult, collective switching cost is far more higher than all of individual switching costs.

9 Apple Computer buyers are picking a network, not simply a product, They buy a Mac system, not only Mac computer. A firm must design its strategy accordingly. Building a network involves more than just building a product. complementary products such as software and peripheral devices. Finding partners, building strategic alliance, and knowing how to get the bandwagon rolling can be every bit as important as engineering design skills.

10 Compatibility: Telephone Network In mid-1890s, when several key Bell patents expired, several independent (non-Bell) companies entered the market. By 1903, Bell companies controlled less than half of the phones in America, while independents and rural cooperatives the other half. But what lead to the emergence of a dominant national telephone company, the Bell System?

11 Telephone Network In 1900, a mere 3% of all calls were long distance. Evidently, most people did not care much about long- distance service, and many telephone companies did not even offer long-distance service. The key is long-distance telephone service. The Bell System, with by far the most extensive long- distance network, thus faced a fundamental strategic issue: would it be better to restrict long-distance access to its affiliates or to open up its network to independents?

12 Telephone Network At last, Bell decided to open up to nonaffiliated companies that met Bell’s technical and operating standards and that were not direct local competitors. It denied local rivals access to its long-distance network, arguing that interconnection with independents with inferior standards (driven by competition) could compromise the integrity of its entire network It makes Bell stronger versus the independents. Soon, the Bell System’s advantage based on its long- distance network reversed the tide of competition.

13 Telephone Network These advantages allowed the Bell System to grow into the dominant local and long-distance carrier. Later, Bell System changed its name of AT&T. AT&T pushed for a natural monopoly model for the telephone system. After 1907, AT&T bought out many of its local competitors.

14 Telephone Network Lesson: If you control a key interface or bottleneck, you can leverage into the other market.