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2. Network Externalities SI 646 Jeffrey K. MacKie-Mason

3. Competing against, and planning for information technology is hard

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8. You want to make wise decisions about multi-million $ investments.

9. How do you anticipate the pitfalls before committing?

10. Anticipate by recognizing features common to many challenges

11. Recognizing and understanding network externalities helps you plan, compete, evaluate.

12. CHAPTER 1: What are network externalities?

13. What are common features of CD (yay!) and DAT (boo!) problems for Sony & Philips?

14. Network…

15. Externalities…

16. Why “network”? Source: Undetermined

17. Networks offer substitutes composed of complements

18. What is not a network? CC BY-NC abbyladybug (flickr) http://creativecommons.org/licenses/by-nc/2.0/ flickr

19. Key: Strong complementarities. Tightly coupled Multilateral dependencies

20. Externalities are…?

21. Why “externalities”?

22. What are examples of network externalities in… information technologies? Image CC BY mil8 (flickr) http://creativecommons.org/licenses/by/2.0/ flickr

23. What are examples of network externalities in… information goods? Image CC BY laffy4k (flickr) http://creativecommons.org/licenses/by/2.0/ flickr

24. What are examples of network externalities in… information distribution? Image CC BY-NC 19melissa68 (flickr) http://creativecommons.org/licenses/by-nc/2.0/ flickr

25. CHAPTER 2: How do network externalities work?

26. Defn: Value to a user increases in the number of other users Let p(i,n e ) be the amount the ith user is willing to pay when she expects n e other users Let p(i,n e ) be the amount the ith user is willing to pay when she expects n e other users p(i,n e ) is increasing in n e: p(i,n e ) is increasing in n e:

27. D 3 (n e 1 ) D 2 (n e 2 ) D 1 (n e 3 ) So, there’s a different demand curve for each level of expected usage p 1 mkt share

28. Market is in equilibrium when demand is based on expected usage equal to actual usage mkt share p 1 D 3 (n e 3 ) D 2 (n e 2 ) D 1 (n e 1 ) n2n2 n3n3 n1n1 p1p1 Fulfilled expectations: n = n e

29. Key feature in such markets is critical mass c0c0 n0n0 Region of successful networks c,p 1 share of users, n 0 small network large network critical mass c1c1 nLnL nHnH no network

30. Tipping: When successful, product penetration can be very fast Network effects Demand for Variety LowHigh Lowunlikelyhigh High very low depends Tipping likely?

31. Excess inertia: Successful networks tend to be large, entry is tough

32. Give an example of a standard that tends to promote excess inertia

33. Natural monopoly: Network externalities push toward one supplier

34. Supply-side natural monopoly: When cost of building an alternative is economically prohibitive

35. Supply-side natural monopoly If there are two sets of customers, A and B, and C(x) is the cost of providing service, then there is a natural monopoly if: C(A+B) < C(A) + C(B) (cost subadditivity)

36. Demand-side natural monopoly: Large user network benefits tendency to make small networks disappear, large networks emerge and survive c0c0 n0n0 Region of successful networks c,p 1 share of users, n 0 small network large network critical mass c1c1 nLnL nHnH no network

37. Should we do something about network externality natural monopolies? Liebowitz and Margolis: Usually no!

38. CHAPTER 3: How do we play the game?

39. Succeed by closing the platform Increases consumer switching costs Exploits coordination efficiencies Reduces consumer confusion, search costs, finger pointing, risk

40. Succeed by opening the platform Encourages partners Stimulates innovation Reduces consumer risk

41. Succeed by buying critical mass Use critical mass in one layer of a vertical chain of complements to grab critical mass in another layer

42. Case discussion