The Network Effect 1

2 When a network effect is present, the value of a product or service is dependent on the number of others using it.

Introduction

Consider the first and only person to have a FAX machine While nobody else had a fax, the machine was useless The second FAX created value, because these two could communicate The third FAX allowed the three members of this network to communicate So, each new FAX added value to the existing FAX machines – the value of the product was dependent of the number of others using it 4 Archetype 1: Direct Network Effect

Consider the early days of Microsoft’s OPERATING SYSTEM – It had few users – Little reason for developers to create applications When the OPERATING SYSTEM became popular – Developers created many applications, because there was a large market for their applications – These applications made the OPERATING SYSTEM more valuable to users who preferred it to other OPERATING SYSTEMs So, each new user was an incentive to develop new applications, that created more value, that attracted more users... – the value of the product was (indirectly) dependent of the number of others using it 5 Archetype 2: Indirect Network Effect

Practical Implications Successful Strategies: – Companies try to tie-in to existing networks to ease the adoption by consumers of their new technologies – Only rarely new technologies that are not compatible with old networks succeed 6 The network effect creates economies of scale on the demand side – Technologies (FAX machines, OPERATING SYSTEMS) which have many users are more valuable and attract even more users – Strong get stronger, weak get weaker – “Winner take all” markets

Algebraic Formulations

The value of a communication network is: – value of connection with one other user: v – value of a network of n users for a single user: v*(n-1) – value of a network to all n users: n* [ v*(n-1) ] = v*(n 2 - n) 8 An Algebraic Formulation of the Network Effect– Metcalfe’s Law For standard products and services Given that the value of a product for a single user is v, then for n users it is usually n*v

Background: The Demand Curve The demand curve depicts the relationship between the price of a certain product or service and the amount of it that consumers are willing and able to purchase at that given price. The demand curve for all consumers is calculated by adding the individual demands. The convention is to have – Price on the vertical axis – Quantity on the horizontal axis (following Alfred Marshal’s Principles of Economics,1890) The demand curve usually slopes downwards from left to right; which means people will buy more as its price falls. 9

Background: The Supply Curve A supply curve is a graph that illustrates that relationship between the price of a good and the quantity supplied Under the assumption of perfect competition, firms will produce additional output as long as the cost of producing an extra unit of output is less than the price they will receive The market supply curve is obtained by summing the quantities supplied by all suppliers at each potential price 10

11 Demand and Supply Curves for Information Goods with Network Effect 1000 people in a market for some good index the people by v = 1,..., 1000 v is the willingness to pay by person v If p is the price of the good, then the number of people who are willing to pay at least p is 1000 − p Let’s assume that the value of the good to person v is v*n Let u denote the index of the person who is indifferent between buying the good and not buying it p = u*n The number of people who want to buy the good is n = 1000 − u p = n(1000 − n) = 1000*n – n 2 Source: Shapiro and Varian, Information Rules, A Strategic Guide to the Network Economy, Harvard Business School Press, 1999

Social Networks Effect? 12 Reed’s Law The value of a social network is proportional to the number of sub-groups in the network For n users of the network, there are 2 n subgroups (for 2 users, there are these groups 0,0; 1,0; 0,1; 1,1) see demand curve 3 Quantity Price Three Demand Curves 1 3 2

Implications

Collective Switching Costs Success and failure are driven as much by consumer expectations and luck as by the underlying value of the product Network effects lead to substantial collective switching costs It is the Biggest force working for incumbents Example: QWERTY – created in the 1870s by Christopher Latham Sholes, a newspaper editor from Milwaukee, USA – Keys were arranged on diagonal columns, to give space for the levers – In 1873 manufacturing rights sold to E. Remington and Sons – Several alternatives have been developed, claimed to be more efficient, intuitive and ergonomic – Failed due to the dominance of available keyboards and training 14

Standards Standards expand network effects – Share with larger network – Attracts more users Standards reduced uncertainty – No need to wait – In a standard war, neither side may win Change the nature of Competition – Competition for the market v. competition in the market – Competition on price v. features – Competition to offer proprietary extensions – Component v systems competition 15

Standard Wars Standard wars are unique to network markets Adoption is difficult when multiple groups of buyers need to co- ordinate Key Assets –Control over an installed base –Intellectual property rights –Ability to innovate –First-mover advantages (learning) –Manufacturing ability –Strength in complements –Reputation and brand name 16

DVD vs. DIVX In September 1996, the DVD forum published the DVD open specifications as a replacement for video cassettes Studios: Committed – Warner Home Video, Columbia Tri-Star, MGM/UA, and Polygram, Universal, Disney Skeptical – Paramount, 20th Century Fox (unclear if the technology will succeed, piracy danger) Retailers: Best Buy fully support DVD with special instore displays, wide selections of hardware and software at discounted prices, and heavy advertising Circuit City, September 1997 – – DIVX would play all DVD discs, and would also play special DIVX discs that are unlocked when the user starts playing them, and remain unlocked for 48 hours However, – Throughout the Christmas 1997 season, DIVX players were nowhere to be seen – DVD installed base of at least 1.9 million through mid-1999 – The DIVX installed base through that time was at most 165,000. – There were 3,317 titles available on the DVD – Only 471 titles available on DIVX June, 1999, Circuit City pulled the plug on the DIVX format 17

18 The Network Effect When a network effect is present, the value of a product or service is dependent on the number of others using it.