1. Network Economics – for Lo205
Judith Molka-Danielsen
Reference: “Information Rules”, Carl Shapiro and Hal R. Varian, Havard Business Sch. Press, chapter 07, 1999.
March 01, 2002

2. Overview Describe the New Information Economy
Discuss the factors in the Economics of Networks
Define the terms: network effects and network externaltities
Discuss the concept of Lock-in

3. The old industrial economy
Dominated by Oligopolies
a few large firms
market share rose and fell slowly
lifetime employment
Industries that exhibited this:
automobile
steel
aluminum
petrolium
chemical markets
economies of scale

4. The new information economy
Dominated by temporary monopolies
dominate player based on the days leading technology
short time on top
7 years average at one job
Industries: hardware and software
economies of networks

5. Types of Networks Physical networks High Technology (real)
telephone, electrical,
railroad,
airlines
High Technology (real)
computer, fax machine, compatible modems,
, ATMs, Internet
High Technology (virtual)
Macintosh users, CD readers-writers users,
Nintendo 64 users, minidisc users

6. Important Concepts
It is better to be connected to a bigger network than to a smaller one.
Network effects
Positive Network Externalities
Companies compete by expanding their networks, they increase the value by interconnecting with other networks.

7. Positive Feedback
Positive feedback - the strong get stronger and the weak get weaker.
Speaking into a microphone, when the amplified signals go back into the system, you have repeated amplification. It gets loud.
Negative feedback - when the strong get weaker and the weak get stronger. Go to a middle point. Industrial oligopolies exhibit.
In the industrial markets, attempts for greater market share would trigger responses by others towards efficiency, also too large firms were too complex to manage. The norm were oligopolies.

8. Positive feedback (cont.)
Postitive feedback can contribute to growth, but it is not the same thing. Ie. Internet.
Virtuous cycle - success feeds itself.
Vicious cycle - product seen as failing, the perception feeds the cycle, death spiral, the weak get weaker. Ie. Apple Macintosh.
Tippy market - two players compete, one wins. (Video recorders - VHS v. Beta) Winner take all.

9. Positive Feedback - example
Nintendo - enters home video games in 1985
Other dominant player at the time (Atari, Texas Instruments)
Christmas 1986, Nintendo Entertainment System (NES) was hot. More game developers begin to write games for them.
Game developers pay royalties to Nintendo and agree to not share the game with other systems for 2 years after release.

10. Sources of Positive Feedback (V&S)
Supply side economies of scale
Declining average cost
Marginal cost less than average cost
Example: information goods
Demand side economies of scale
Network effects
In general: fax, , Web
In particular: Sony v. Beta, Wintel v. Apple

11. Chicken & Eggs (V&S) Fax and fax machines VCRs and tapes
Internet browsers and Java

12. S-shaped curve
Adoption of new technologies follow an S-shaped curve in three phases:
flat during launch,
steep rise during takeoff, positive feedback at work,
leveling off, saturation is reached.
Seen in the adoption of: fax machine, CD, color TV, video games, , and the Internet.

13. Economies of Scale
Economies of scale - is a source of positive feedback. Larger firms tend to have lower unit costs of productions. This is supply-side economies of scale.
In manufacturing the benefits of scale are usually exhausted before total market dominance.
Demand side economies of scale - Microsoft Windows 95 in 1998, widely used, de facto industry standard. Some technologies go head-to-head for years before a winner emerges. Telephone netwk also showed this.

14. Network externalities
Sponsor - of a net builds and hopes to profit from the net.
Apple controls interfaces, clone license terms, architecture improvements, for the Mac. And influence supply of complementary products. (Partners)
Recall externalities are positive and negative (pollution)
Positive network externalities lead to positive feedback
Metcalfe’s law: The value of the network goes up as the square of the number of users. Total value of the network to all users = n x (n-1) = n2 -n where n is the number of users. If value=$1 for a single user, and n=10, then network size 10 has =90 = $90.

15. Collective switching costs
Switching costs - come from complementary assets, hardware with software, IT systems with training. If I learn to program in Access db language other Access software and the language becomes more valuable to those who are already users.
But it is hard to get people to switch, collective switching costs. It is hard to coordinate users to switch all at the same time, and they will not do so by themselves. Therefore, the existing providers have the advantage.
1870 QWERTY keyboard wins over the 1932 Dvorak layout with home row AOEUIDHTNS that was proven to be faster. We would collectively be better to switch but the individual switching costs are too high. (Also called technological Lock-in.)

16. Summary on Lock-In and Switching Costs (V&S)
Network effects lead to substantial collective switching costs
Collective lock-in is even worse than individual lock-in
Due to coordination costs
Example: QWERTY

17. Don’t Get Carried Away (V&S)
Network externalities don’t always apply
ISPs (but watch out for QoS)
PC production (easy to produce)

18. Industry and positive feedback
Not every market tips (Ford had a best-selling-car, but who cares, you do not buy a car because others have it. But you may avoid a car because no one has it.)
There are no demand side economies of scale within the IBM compatible PC market because standards allow interoperability. Another example, Internet service providers. (America Online, CompuServe, Delphi, had separate discussion groups before Internet. Now access can be from anyone, AOL, IBM, ATT, etc.)
ISPs could differentiate access through QoS offers, video conferencing, etc. Large ISPs have advantage because it is easier to control QoS on a single network.

19. Likelihood of a market tipping to one technology
*sum of economies of scale - ie. There are supply side eos for PC market where Compaq, Dell, HP and IBM have 24%.
**standards reduce variety, but global HDTV standards are not needed.

20. Performance v. compatibility
How do you start the virtuous cycle? Philips and Sony introduced the CD in the 1980s.
Philips offers digital compact cassette (DCC) in where DCC players can play regular cassettes, backward compatible. But it didn’t catch on.
Consumer inertia approaches: the evolution strategy of compatibility, and the revolution strategy of performance.
Revolution - best performance to start over with a new product, but high switching costs.
Evolution - give up some performance to allow compatibility (lower switching costs).

21. Igniting Positive Feedback (V&S) (First fundamental tradeoff)
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

22. Evolution (V&S) Offer a migration path Examples
Microsoft
Intel
Borland v Lotus
Build new network by links to old one
Problems: technical and legal

23. Technical Obstacles to Evolution (V&S)
Use Creative design
Think in terms of system
Converters and bridge technologies
One-way compatibility

24. Legal Obstacles (V&S)
Need IP licensing
Example: Sony and Philips CDs

25. Openness v. Control Is the second fundamental tradeoff.
Open - make interfaces and specifications available to others. Consumers can fear lock-in, open raises chances of success, attracks allies.
Control - keep your system proprietary. (This is valuable if your system takes off.) Installed base is more valuable if rivals cannot offer products to lock-in customers. Control interconnection.
Existing market position, technical capabilities and control of intellectual property rights are 3 dimensions of critical market strength.
Intel controls MMX multimedia specs for its Pentium chips, but promote an open interface spec for graphic controllers, the accelerated graphics port (AGP) to increase demand for their microprocessors.

26. Openness v. Control (V&S)
Your reward (total value to you) = Total value added to industry x your share (in the market).
Total Value added to Industry (VI)
Depends on product and
Size of network
VI= the value the technology adds to the existing product value + how widely the technology is adopted (network size).
Your share (YS) of industry value
Depends on how open
YS= your market share + your profits + your royalties + how the technology effects your sale of other products (add to sales or take away).

27. Openness (V&S) Full openness Alliance Anybody can make the product
Problem: no champion
Alliance
Only members of alliance can use
Problem: holding alliance together

28. Control (V&S) Control standard and go it alone
If several try this strategy, may lead to standards wars

29. Openness v. Control Best Strategies:
Have a large share of a small market (small pie),
Have a small share of a large market (Sun and Java).
The optimal point is where you maximize Total Value to you.
Systems - are a cooperation of compoenets
To caputre value from one component requires cooperation with those providing the other components.
Suppliers will want a share of the rewards in retrurn for cooperation.

30. Openness Strategy
When no one firm is strong enough to dictate technology standards.
When coordination is necessary.
To start the bandwagon rolling.
Full openness (ITU standards) v. Alliance Strategy (member advantage, Microsoft developers)
Alliance types: special interest group, task forces, groups of companies.
Alliances share: cross license patents, manufacturing skills, improve time to market, share designs.
Alliances coordinate: standards, interfaces, protocols, specifications.

31. Control Strategy Central actor controls development
Sun sponsors Java, Apple sponsors Macintosh, Ericson sponsors BlueTooth.
Companies that control product standards and interfaces have power. But they can lose with poorly conceived standards.

32. Generic Strategies for new Technology Introduction.
1. Performance Play - new, incompatible, strong control, high risk, big technology advantage, new entrants try with no base to worry about.
2. Controlled Migration - give up performance to reduce customer switching costs, need allies, backward compatible, but proprietary.

33. Generic Strategies for new Technology Introduction.
3. Open Migration - new product by many vendors, low switching costs, good where there are only manufacturing economies, want a big network.
4. Discontinuity - need allies, make system very open, new product not compatible with old but available from many suppliers, favor efficient manufacturers.

34. Performance Play (V&S)
Introduce new, incompatible technology
Examples
Palm Pilot
Iomega Zip
Attractive if
Great technology
Outsider with no installed base

35. Controlled Migration (V&S)
Compatible, but proprietary
Examples
Windows 98
Pentium
Upgrades

36. Open Migration (V&S) Many vendors, compatible technology Examples
Fax machines
Some modems

37. Discontinuity (V&S) Many vendors, new technology Examples CD audio
3 1/2” disks

38. Summary of the lecture (V&S)
Positive feedback means strong get stronger and weak get weaker
Consumers value size of network
Works for large networks, against small ones
Consumer expectations are critical
Fundamental tradeoff: performance and compatibility

39. Summary on introducing services and products into markets (V&S)
Fundamental tradeoff: openness and control
Generic strategies
Performance play
Controlled Migration
Open Migration
Discontinuity
Look at lessons of history