Networks and Positive Feedback

1
Networks and Positive Feedback

• Carl Shapiro
• Hal R. Varian

2
Important Ideas

• Positive feedback
• Network effects/externalities
• Returns to scale
• Demand side
• Supply side

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Positive Negative Feedback

• Strong get stronger, weak get weaker
• Negative feedback may occur beyond a point and
  helps stabilize markets
• Makes a market tippy (winner take all)
• Examples VHS v. Beta, Wintel v. Apple
• Successful E-Business companies have benefited
  from positive feedback (EBay,?.?)

4
Sources of Positive Feedback

• Supply side economies of scale
• Declining average cost
• Marginal cost less than average cost
• Example information goods
• Demand side economies of scale
• Network effects, spiralling demand
• In general fax, email, Web
• In particular VHS v. Beta, Wintel v. Apple

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Network Effects/ Externalities

• Real networks (Transportation,..)
• Smaller networks need connectivity to larger
  networks
• Virtual networks
• Number of users
• Metcalfes Law Value of network of size n
  proportional to n2
• Externality
• Value to a user depends on other users actions
  (/_) (e-mail, IM, congestion, industrial waste
  drinking water)
• Importance of expectations
• Positive and Negative Effects

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Lock-In and Switching Costs

• Network effects lead to substantial collective
  switching costs
• Compatibility Issues
• Even worse than individual lock-in
• Due to coordination costs
• Example QWERTY, Metric System?, Software?

7
Dont Get Carried Away

• Factors that lead to network externalities can
  become less important or disappear
• AOL Internet (Quality of Service)
• PC v. Mac (Interoperability)
• API/Interfaces for Software
• Supply side economies of scale may dissipate when
  size is too large and ve externalities set in
• E.g Ford, GM
• Larger size is unlikely to cause ve demand side
  externalities
• E.g., Microsoft
• Importance of network externalities depends on
  industry
• E.g. Are rebates to earn the title of best
  selling car worth it?
• Are rebates to earn the title of most popular
  OS worth it?

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Whats special about the Information Economy?

• Combination of supply side and demand side
  economies
• Supply side economies of scale may not erode due
  to size for some information products (software
  vs. cars, vs. network services)
• Reduced prices due to supply side economies of
  scale increase demand side economies
• Combined supply and demand side economies of
  scale can be very high for some companies
• The Internet reduces some network externalities
  by facilitation distribution and interoperability
  (eg. viewers)

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Likelihood of Tipping (Dominant player/technology)
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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

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Evolution

• Offer a migration path
• Examples
• Microsoft
• Borland v Lotus
• Build new network by links to old one
• Problems technical and legal
• Competitors may offer revolutionary products
  (dbase vs. paradox)

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Technical Obstacles

• Use Creative design
• Think in terms of system
• Converters and bridge technologies
• One-way compatibility
• Office 95 97
• Buy 97 read 95 97 files
• Delay adoption of 95

13
Legal Obstacles

• Need IP licensing
• Example Sony and Philips CDs

14
Revolution

• Grovess law 10X rule
• But depends on switching costs
• ExampleSega vs Nintendo
• Lots of customers with low switching costs
• New crop of 10 year old boys
• Growing vs. stagnant market
• Risky
• May require allies
• Difficult to forecast adoption (S-Curve)

15
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

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Openness

• Full openness
• Anybody can make the product
• Home networking
• Other factors such as brand
• Alliance
• Only members of alliance can use
• Problem holding alliance together

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Control

• Control standard and go it alone
• If several try this strategy, may lead to
  standards wars

18
Generic Strategies
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Performance Play

• Introduce new, incompatible technology
• Examples
• Nintendo, Others?
• Attractive if
• Great technology
• Outsider with no installed base
• Consider
• Controlled Migration
• Licencing key patents to help ignite positive
  feedback

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Controlled Migration

• Compatible, but proprietary
• Examples
• Windows 98
• Pentium
• Upgrades

21
Open Migration

• Many vendors, compatible technology
• Examples
• Fax machines
• Some modems
• Favors efficient vendors

22
Discontinuity

• Many vendors, new technology
• Examples
• CD audio
• -31/2 inch drive
• Favors Efficient vendors

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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

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Lessons, continued

• Fundamental tradeoff openness and control
• Generic strategies
• Performance play
• Controlled Migration
• Open Migration
• Discontinuity
• Are some of these lessons applicable to IT
  departments of large organizations offering
  in-house IT services?

25
Cooperation and Compatibility

• Carl Shapiro
• Hal R. Varian

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How Standards Change the Game

• Expanded network externalities
• Make network larger, increase value
• Share info with larger network
• Attracts more users
• ATM networks?
• Reduced uncertainty
• No need to wait
• In war, neither side may win
• Without standards customers may wait especially
  if a servicable older technology is available
• All players in a market may not be interested in
  standards
• Coopetition?

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Change Game, contd.

• Reduced consumer lock-in
• CD (modest licensing fee)
• IBM PC
• Reduces the chances of aggressive penetration
  pricing
• Competition for the market v. competition in the
  market
• Buy into an open standard, that becomes closed?
• DJIA

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Change Game, contd.

• Competition on price v features
• Commoditized products?
• Competition to offer proprietary extensions
• Extending a standard
• Home wireless (performance enhancer- CISCO)
• Component v systems competition
• With interconnection, can compete on components
• Specialists thrive on interface standards (HP
  Printers)
• Generalists and systems integrators thrive in the
  absence of compatibility

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Who Wins and Who Loses?

• Consumers
• Generally better off
• But variety may decrease
• Inferior technology (QWERTY)
• Software compatibility is still not satisfactory
• Complementors
• Generally better off (ISP and modem standards)
• May have conflicting impacts in some cases (DVD)
• DVD quality could increase demand
• DVD facilitates alternate channels of
  distribution

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Who Wins, contd.

• Incumbents
• May be a threat
• Strategies
• Deny backward compatibility (ATT- network access
  to devices)
• Introduce its own standard (Atari vs. Nintendo,
  backward compatibility)
• Ally itself with new technology (DVD, CD)
• Java?

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Who Wins, contd.

• Innovators
• Technology innovators collectively welcome
  standards
• If the group benefits, there should be some way
  to make members benefit
• Negotiation costs, opportunistic behavior

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Formal Standard Setting

• Essential patents must be licensed on fair,
  reasonable and non-discriminatory terms
• ITU
• 1865, now UN agency
• Notoriously slow
• ANSI and ISO
• 11,500 standards

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Tactics in Formal Standard Setting

• What is your goal?
• National or international?
• Protecting your interests?
• What are others goals?
• Do they really want a standard?

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List of Tactics

• Dont automatically participate
• If you do you have to license on fair and
  reasonable terms
• Consider organizing an alliance outside the
  standards process
• Keep up momentum
• Continue RD while negotiating
• Look for logrolling
• Trading technologies and votes

35
List of Tactics, contd.

• Be creative about deals
• Second sourcing, licensing, hybrids, etc.
• Search carefully for blocking patents
• Patents held by non-participants
• Preemptively build installed base

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Building Alliances

• Assembling allies
• Pivotal customers should get special deals
• But dont give your first customers too big an
  advantage
• Offer temporary price break

37
Building Alliances, contd.

• Who bears risk of failure?
• Usually ends up with large firms
• But bankruptcy favors small firms
• Government is even better!
• Smart cards in Europe
• EDI and small business administration
• Different stakeholders have different interests
• Consumer electronics manufacturers
• Content providers

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Interconnection Among Allies

• History of interconnection
• Post office, telephone, Apple, ATM network
• Internet?
• Offer Interconnection but negotiate terms
• Microsoft, Sun and Java
• Microsoft retained the right to make
  improvements that worked in a Windows
  environment
• Negotiating a truce
• Do the benefit cost calculation
• How to divide a larger pie?

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Maximizing Return

• Your reward Total value added x your share
• Cooperation between Netscape and Microsoft
• Open Profiling Standard
• VRML
• SET

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Alliance Examples

• Xerox and Ethernet
• Adobe PostScript
• Active X
• Giving away control to Open Group
• CORBA
• What is happening now?

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Managing Open Standards

• Standard is in danger if it lacks a sponsor
• Unix
• ATT invention by accident
• Gave away source code to EDU
• 1993 Coalition Novell purchased rights for 320
  million and gave name to X/Open
• Disagreement over Novells version
• Loss of market share to Windows NT
• SGML and XML

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Lessons

• Competition requires allies
• How does your standard affect competition?
• Expand nw externalities, reduce uncertainty,
  reduce lock-in,
• Move from winner-take all to conventional future
  struggle, features to price, systems to
  components
• Standards benefit consumers and suppliers, at
  expense of incumbents and sellers
• Formal standard setting adds credibility
• Find natural allies

43
Lessons, continued

• Before a battle, try to negotiate a truce
• Try to retain control over technology, even when
  establishing an open standard

44
Jamcracker -Application Service Providers
Aggregators

• Describe Jamcrackers Business model. Be sure to
  include costs, revenues, assets, and threats to
  the business model (10)
• Describe any four of Jamcrackers major
  capabilities including some that are based,
  in-part on IT (10)
• What kinds of supply and demand side economies of
  scale can Jamcracker hope to achieve.
  Explain.(15)
• Imagine you are a major software provider. How
  would you price software sold to an ASP?
  Explain.(10)
• What kinds of standards would benefit Jamcracker?
  Who are likely to be the parties involved in
  setting these standards and what reactions do you
  expect from them ? (10)
• You have been hired as a consultant to make a
  recommendation to the CEO of Jamcracker about
  what kinds of versioning and pricing strategies
  Jamcracker should use. Prepare a brief(2-3pages)
  summary of your recommendations. (15)
• You have been hired as a consultant to examine
  whether an organization should use Jamcrackers
  service. Write a memo to the CEO (2-4 pages)
  outlining the pros and cons of using an
  aggregator and any critical information that you
  would want to obtain in order to make a decision.
  (20) You can list any assumptions that you make
  on an extra page.
• Base your answers to the above questions on the
  case in the text book.
• Based on Jamcrackers web site how do you think
  Jamcrackers business model has evolved since the
  case was written ? Explain 10