MT291.2

1
Session 16
An Introduction to Increasing Returns Markets
MT291.2 Introduction to Technology
Policy Vanderbilt University School of
Engineering
2
The Amplifying Effect of Path Dependence on
Dominant Designs Increasing Returns

• The bulk processing world diminishing returns
• saturation
• commoditization
• shake-outs
• stable shares
• zero-sum game

3
The Perfectly Efficient Market(a theoretical
ideal)

• Many buyers and sellers
• No buyer or seller is a price maker
• Products are interchangeable
• No entry or exit costs
• Perfect, universal knowledge among buyers and
  sellers

4
Deviation from Economic Ideal

• Insufficient Competition (too few competitors)
• Information Deficiencies
• Externalities (negative and positive)
• Public Goods
• High Entry Barriers

5
Insufficient Competition

• Ideal
• Many competitors
• Free entry and exit (perfect mobility)
• Deviations
• Monopolies
• Oligopolies
• Causes
• Tight patent protection
• Increasing returns markets
• Natural monopolies

6
Insufficient Competition (ctd)

• Results
• Overpricing
• Mediocre products and service
• Fewer choices for consumers
• Reduced incentives for efficiency, innovation

7
Insufficient Competition

• Ideal
• Many competitors
• Free entry and exit (perfect mobility)
• Deviations
• Monopolies
• Oligopolies
• Causes
• Tight patent protection
• Increasing returns markets
• Natural monopolies

8
The bulk processing world diminishing returns

• The world of natural, physical limits
• Manufacturing
• Mining/extraction
• Agriculture
• Services (travel, hospitality, professional
  services)

9
Evolution of an industryover the TLC -
diminishing returns world
Low
Competition based on value...
Differentiation
Value... Sustain a premium
High
10
Evolution of an industryover the TLC -
diminishing returns world
Low
The differentiated stage
Competition-based Moderate-margin Differentiated
Differentiation
New Entrants
Value-based High-margin Monopolistic
High
11
Evolution of an industryover the TLC -
diminishing returns world
The commodity stage
Survivors - cost/ volume leaders - niche players
Low
Shakeout
Competition-based Moderate-margin Differentiated
Differentiation
Value-based High-margin Monopolistic
High
12
Policy Result Good for society

• Market has done its job!
• Innovation brought to bear on a need
• Most effective solution emerges among
  alternatives
• Price driven down to lowest possible level

13
The World of Increasing Returns

• Positive Feedback
• value of product increases for each customer as
  customer base grows (network economics)
• telephone/video conferencing
• data networking
• communities of interest (Friends and Family)

14
Network Externalities(Also known as Metcalfes
Law)

• value of product increases for each customer as
  customer base grows
• telephone/video conferencing
• Internet
• communities of interest (Friends and Family)

15
Illustration of Effect of Network Externalities
subscribers to a network
2
3
4
5
Subscribers
12
20
2
6
Links
(n)x(n-1) n2
value of network (no. of subscribers)2
16
The World of Increasing Returns

• Positive Feedback
• value of product increases for each customer as
  customer base grows (network economics)
• Mutually reinforcing mini-ecology of complements

17
Complementary Products
Cars and Car Insurance

• When products are complementary, sales of one
  product generally pull through sales of its
  complements.

18
Specialized Complements

• Effect when complements are mutually specialized
  to each other... a closed-loop, self-reinforcing
  system
• DVD players - DVDs
• operating systems - application developers
• credit cards - merchants/customers
• portal websites - viewers/merchants
• On-line auctions buyers/sellers
• ticket outlets - patrons/entertainers

19
The World of Increasing Returns

• Positive Feedback
• High Switching Costs for Users

20
Buyer Switching Costs

• Retraining costs
• e.g., the Dvorak vs. QWERTY keyboards
• Potential write-offs of existing capital
  equipment
• Installation and set-up costs
• Customization costs
• e.g., application development
• Support costs
• e.g., renegotiating support contracts
• Transaction costs
• The (often hidden) costs that are incurred when a
  purchaser buys a product through an open market
  transaction with a seller

21
Transaction Costs Incurred When Switching
Suppliers

• Search costs
• buyers and sellers finding each other in an open
  market (e.g., advertising)
• Information costs
• costs to buyers and sellers of qualifying each
  other
• Bargaining costs
• communication and negotiating terms and
  conditions
• Decision costs
• evaluation of alternatives, reaching internal
  agreement, obtaining purchasing approval

22
The World of Increasing Returns

• Positive Feedback
• High Switching Costs for Users
• learning/training
• e.g., the Dvorak vs. QWERTY keyboards
• specialized complementary assets (support,
  repair, spare parts)
• e.g., aircraft (Air Force, Southwest Airlines)

23
The World of Increasing Returns

• Positive Feedback
• High Switching Costs for Users
• High Up-front or Fixed Costs for Supplier
• software developers
• airlines
• revenue from each new customer gtgt cost to serve

24
Result of Increasing Returns
Low

• Significant advantage to leader
• even if lead is only slight
• Market instability
• winner-take-most

Differentiation
High
25
Which World are These Industries In?
Increasing Returns
Diminishing Returns

• Regional Airports ___ ___
• HubAirports ___ ___
• Supermarkets ___ ___
• Outlet Malls ___ ___
• Movie Theaters ___ ___
• TicketMaster ___ ___
• Live Auction ___ ___
• On-line Auction ___ ___
• Banks ___ ___
• ATM Networks ___ ___

26
Implications for the Innovator in World of
Increasing Returns

• Know which world youre in!
• Identify/create positive feedback loops
• Position yourself relative to the platforms
  within your ecology
• Focus on market share over profitability
• Lock in your user base
• Leverage your initial position
• enter complementary businesses
• e.g., product -gt support services -gt custom
  software

27
Policy Implications of the Increasing Returns
Phenomenon

• Know which world the industry is in.
• Traditional antitrust sanctions often
  counterproductive in an increasing returns market
• Recognize that single-company dominance is
  increasingly temporary
• e.g., digital wireless technology, operating
  systems, cable systems
• Encourage market forces and further technological
  progress
• Reduce artificial entry barriers
• Intervene directly only when market forces fail.

28
Where were going

• Does Increasing Returns Explain These Natural
  Monopolies?
• PC Operating Systems
• Broadband Cable Networks
• Instant Messaging
• Digital Wireless Technology