1. Networks and Positive Feedback John Morgan

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

3. Positive Feedback How system adjusts to perturbations Negative feedback: stabilizing Positive feedback: destabilizing Positive feedback makes a market “tippy” – winner take all Examples: VHS v. Beta, Wintel v. Apple, 56k modems, DVD v DivX “Winner-take-all markets”

4. Sources of Positive Feedback Supply side economies of scale Declining unit cost of supply Marginal cost less than average cost Example: information goods are all fixed cost Demand side economies of scale Increasing value to users as market share increases A single standard: fax, email, Web Competing standards: VHS v. Beta, Wintel v. Apple, 56k modems, Codec “standards” in Digital Audio

5. Color fax machine You have a new technology for color fax machines License it to many sellers Technology can only be used by sender if receiver has color fax machine So there is a strong network effect--- value to user of technology depends on number of adopters

6. Setup Indicate your adoption of the technology by standing up The number on your card shows that value v (to you) of adopting if you are the only adopter In n people (including you) adopt, your value is nv I will write the price of the fax machine on the board Adopt when your value (strictly) exceeds the price.

7. Analysis Standalone values were 10,9,8,…,1

8. Analysis vn = p : marginal user wants to adopt n=10-v :everyone with greater value than marginal user adopts Combine to give demand=supply condition (10-n)n=p n=1, (10-1)1=9 n=2, (10-2)2=16 n=3, (10-3)3=21… n=9, (10-9)9=9 Takeoff occurs when p=9

9. Adoption Dynamics Number of Users Time Launch Takeoff Saturation

10. Network Effects Demand side economies of scale often referred to as network effects Real networks – telecom Virtual networks – network of users Metcalfe’s Law: Value of network of size n proportional to n 2 Experiment is an example of this

11. Expectations Matter What is the difference between success and failure in tippy markets? Expectations Matter: I want to join network that I expect to succeed Central part of successful marketing is setting appropriate expectations Commitment can help Old economy example: Banks New economy example: Microsoft version 1.0 products

12. Virtuous Cycles and Death Spirals: 1-2-3 v Visicalc “Death spiral” Virtuous cycle Value to User Number of Users

13. Direct and indirect Network Effects Value to me depends directly on number of adopters Fax machine, telephone, email Value to me depends on adoption of some complementary product DVD player/ DVD disks eBook reader + content Palms and software

14. Are All Information Markets “Tippy”? AOL Dell Google What are the key drivers of network effects?

15. Network Effects–Likelihood of Tipping

16. Chicken & Eggs Fax and fax machines VCRs and tapes DVDs: A more complicated problem Online dating

17. Igniting Positive Feedback 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

18. Compatibility versus Performance Performance Compatibility Evolution Revolution

19. Evolution Offer a migration path Examples Microsoft Windows Intel Borland v Lotus Build new network by links to old one

20. Important Considerations Use creative design for migration Think in terms of whole system

21. Compatibility versus Performance Performance Compatibility Evolution Revolution Migration “sweet spot”

22. Technical Obstacles Converters and bridge technologies One-way compatibility or two way? Windows for Wordperfect users Importance of UI

23. Legal Obstacles May need IP licensing Example: Sony and Philips had advantage since they held the patents on CDs DVD players usually play CDs as well

24. Revolution Grove’s law: “10X rule” But depends on switching costs Examples: Nintendo, Iomega Zip, DVD, CD

25. Openness v. Control Your reward = Total added to industry x your share Value added to industry Depends on product and Size of network Your share Depends on how open technology is

26. Openness Full openness Anybody can make the product Problem: no champion Unix v BSD v Linux Alliance Only members of alliance can use Problem: holding alliance together Conflicting incentives: China and DVDs

27. Control Control the standard and go it alone If several try this strategy, may lead to standards wars iPod/iTunes v MP3 players

28. Generic Strategies

29. Performance Play Introduce new, incompatible technology Examples Palm Pilot Iomega Zip Your examples… Attractive if Great technology Outsider with no installed base: nothing to cannibalize

30. Controlled Migration Compatible, but proprietary Examples Windows 98 Pentium Upgrades to every product Your examples… Some vulnerability to entry since have to pay switching cost anyway

31. Open Migration Many vendors, compatible technology Examples Fax machines Some modems Your examples…

32. Discontinuity Many vendors, new technology Examples CD audio 3 1/2” disks Your examples…

33. Historical Examples of Positive Feedback Effects RR gauges AC v. DC Telephone networks Color TV

34. Lessons 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

35. Lessons, continued Fundamental tradeoff: openness and control Generic strategies Performance play Controlled Migration Open Migration Discontinuity Lessons of history