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Network Externalities SI 646 Jeffrey K. MacKie-Mason
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Competing against, and planning for information technology is hard
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You want to make wise decisions about multi-million $ investments.
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How do you anticipate the pitfalls before committing?
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Anticipate by recognizing features common to many challenges
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Recognizing and understanding network externalities helps you plan, compete, evaluate.
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CHAPTER 1: What are network externalities?
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What are common features of CD (yay!) and DAT (boo!) problems for Sony & Philips?
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Network…
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Externalities…
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Why “network”? Source: Undetermined
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Networks offer substitutes composed of complements
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What is not a network? CC BY-NC abbyladybug (flickr) http://creativecommons.org/licenses/by-nc/2.0/ flickr
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Key: Strong complementarities. Tightly coupled Multilateral dependencies
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Externalities are…?
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Why “externalities”?
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What are examples of network externalities in… information technologies? Image CC BY mil8 (flickr) http://creativecommons.org/licenses/by/2.0/ flickr
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What are examples of network externalities in… information goods? Image CC BY laffy4k (flickr) http://creativecommons.org/licenses/by/2.0/ flickr
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What are examples of network externalities in… information distribution? Image CC BY-NC 19melissa68 (flickr) http://creativecommons.org/licenses/by-nc/2.0/ flickr
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CHAPTER 2: How do network externalities work?
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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:
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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
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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
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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
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Tipping: When successful, product penetration can be very fast Network effects Demand for Variety LowHigh Lowunlikelyhigh High very low depends Tipping likely?
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Excess inertia: Successful networks tend to be large, entry is tough
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Give an example of a standard that tends to promote excess inertia
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Natural monopoly: Network externalities push toward one supplier
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Supply-side natural monopoly: When cost of building an alternative is economically prohibitive
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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)
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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
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Should we do something about network externality natural monopolies? Liebowitz and Margolis: Usually no!
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CHAPTER 3: How do we play the game?
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Succeed by closing the platform Increases consumer switching costs Exploits coordination efficiencies Reduces consumer confusion, search costs, finger pointing, risk
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Succeed by opening the platform Encourages partners Stimulates innovation Reduces consumer risk
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Succeed by buying critical mass Use critical mass in one layer of a vertical chain of complements to grab critical mass in another layer
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Case discussion
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