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Information RulesChapter 7
Networks and Positive Feedback
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Overview

• Positive Feedback
• Demand Side Economies of Scale
• Network Externalities
• Collective Switching Costs
• Is your industry subject to positive feedback
• Igniting positive feedback
• Evolution offer a migration strategy
• Revolution offer compelling performance
• Generic Strategies in Network Market
• Lessons

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Positive Feedback

• Difference between old economies and new
  economies
• Economies of Scale vs. Economies of Networks
• The value of connecting to a network depends on
  the number of people on the network

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Positive Feedback

• Positive feedback allows the strong to get
  stronger and the weak to get weaker
• Negative feedback allows the strong to get weaker
  and weak get stronger
• When two firms compete in a market where there is
  positive feedback only one winner can emerge
• This is driven by the fact that users want to be
  connected to the network that has (or will have)
  the most users

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Positive Feedback

• The positive feedback system follows a
  predictable S-Shaped curve
• Flat during launch
• A steep rise during takeoff as positive feedback
  kicks in
• Leveling off

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Supply/Demand-Side Economies of Scale

• Supply-Side Economies of Scale
• Declining average unit cost (ex cars)
• As quantity increases marginal unit cost lt
  average unit costs (ex information goods)
• Demand Side Economies of Scale
• Value to the user increases as the number of
  compatible user increases
• Network effect
• Examples cellular phones

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Demand-Side Economies of Scale
Popularity Adds Value in a Network Industry
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Demand-Side Economies of Scale

• Supply-side and demand-side economies of scale
  combine to make positive feedback in the network
  economy specially strong.
• Example cellular phones
• Marketing (demand-side) Strategy

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Network Externalities

• The term that describes the effect that large
  networks are more attractive to users than small
  ones are
• Network view info technologies in terms of
  virtual networks, which share many properties
  with real networks such as communications and
  transportation networks

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Network Externalities

• Externalities arise when one market participant
  affects others without compensation being paid
• Like feedback, externalities come in 2 flavors
  negative positive
• Negative externality is pollution
• my sewage ruins your pool or drinking water
• Normally externalities are positive
• I join your network it gets bigger and better
  to your benefit

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Network Externalities

• Positive externalities give rise to positive
  feedback
• when I buy a fax machine, the value of your fax
  machine is enhanced since you can now send faxes
  to me and receive faxes from me

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Network Externalities

• Metcalfes Law named after the inventor of
  Ethernet
• The value of a network goes up as the square of
  the number of users
• If there are N number of people in a network,
  and the value of the network to each of them is
  proportional to the number of other users, then
  the total value of the network is proportional to
  N x (N-1) N2 N

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Network Externalities

• Metcalfes Law Continued
• If the value of a network to a single user is 1
  for each other user on the network, then a
  network of size 10 has a total value of roughly
  100.
• In contrast, a network of size 100 has a total
  value of roughly 10,000.
• A tenfold increase in the size of the network
  leads to a hundredfold increase in its value.

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Collective Switching Costs

• Network externalities make it virtually
  impossible for a small network to thrive
• Every network has to start from scratch
• The challenge to companies seeking to introduce
  new but incompatible technology into the market
  is to build network size by overcoming COLLETIVE
  SWITCHING COSTS (the combined switching costs of
  all users)

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Collective Switching Costs

• In many information industries, these are the
  biggest single force working in favor of
  incumbents
• They work in a non-linear way, convincing 10
  people connected in a network to switch to your
  incompatible network is more than 10 times as
  hard as getting one customer to switch
• But you need all 10, or most of them no one will
  want to be the first to give up the network
  externalities and risk being stranded
• Because various users find it so difficult to
  coordinate to switch to an incompatible
  technology, control over a large installed base
  of users can be the greatest asset you can have

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Collective Switching Costs Example

• QWERTY Keyboard (1870s Type Writer brand of
  machines)
• Awkward configuration of letters, mainly to slow
  down typists and reduce incidence of jamming of
  the machines.
• Dovark Layout (patented 1932)
• Much superior .. All vowels on the same row
• Why, then, are we still using QWERTY keyboard
  (computer Keyboards rarely jam) ?

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Positive Feedback

• Not all information infrastructure markets are
  dominated by the forces of positive feedback
• EX Internet Service Providers
• A high tech industry that currently does not
  experience large network effects
• At one time, were attempts by ISPs for
  proprietary systems
• Changed by the commercialization and
  standardization of the Internet

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Positive Feedback

• Think carefully about the magnitude and
  significance of network externalities in your
  industry
• Dont let the idea of positive feedback carry you
  away not every market tips
• Will your market tip toward a single dominant
  technology or vendor?
• Depends on the balance between two fundamental
  forces economies of scale variety

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Not every market tips!

• Likelihood of Market Tipping to a Single
  Technology

Low Economies of Scale
High Economies of Scale
Low Demand for Variety
Unlikely
High
High Demand for Variety
Low
Depends
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Igniting Positive Feedback Performance Vs.
Compatibility

• What does it take for a new technology to succeed
  in the market?
• Building your own base of users for a new
  technology in the face of an established network
  can be daunting

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Igniting Positive Feedback Performance Vs.
Compatibility

• Two approaches for dealing with the problem of
  consumer inertia
• 1) Evolution strategy of compatibility
• 2) Revolution strategy of compelling
• performance
• Evolution strategy offers a smooth migration path
• Revolution strategy offers compelling performance

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Igniting Positive Feedback Performance Vs.
Compatibility
Performance Vs. Compatibility
Evolution
Improved Design or Adaptors
Compatibility
Performance
Performance
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Evolution Offer a Migration Path

• Reducing switching costs to entice customers to
  try your new technology
• Requires compatibility with existing products
• Two Obstacles
• Technical Obstacles
• Legal Obstacles

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Technical Obstacles

• Develop a technology that is both
• Compatible with existing technology
• Superior to existing technology
• Keeps switching costs low with backward
  compatibility and improved performance
• Compatibility/Performance Tradeoff
• 3 Strategies to combat tradeoff
• Use creative design
• Think in terms of the system
• Consider converters and bridge technologies

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Legal Obstacles

• Need to obtain the legal right to sell products
  that are compatible with existing products
• Intellectual Property Rights over older
  generation technology
• Incumbents may use property rights to block
  competition or to license product

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Revolution Offer Compelling Performance

• Offer a superior product to persuade enough users
  to switch to it
• Revolution Strategy
• Challenges
• Revolution Strategy is risky
• Andy Groves 10X rule of thumb

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Igniting Positive Feedback Openness Vs. Control

• Anyone launching a new technology must face a
  fundamental control/openness trade off.
• Open Offering to make the necessary interfaces
  and specifications available to others.
• Control Maintain control by keeping your system
  Proprietary.

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Igniting Positive Feedback Openness Vs. Control

• Control
• Proprietary control will be exceedingly valuable
  if your product or system takes off.
• Your network will be more valuable if you can
  control the ability of others to interconnect
  with you.

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Igniting Positive Feedback Openness Vs. Control

• Openness
• Failure to open your technology can spell its
  demise.
• If customers fear lock-in or if you face a strong
  rival whose system offers comparable performance
  but is non-proprietary.
• Openness ups your chance of success by attracting
  allies and assuring customers that they can turn
  to other suppliers down the road.

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Igniting Positive Feedback Openness Vs. Control

• Which route is best?
• There is no right or wrong choice.
• The answer depend on the market and your position
  in the market.
• Ultimate goal is to maximize the value of your
  technology, not your control over it.

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Igniting Positive Feedback Openness Vs. Control

• Your Reward Total value added to Industry X
  Your share of industry value
• Total value added to the industry depends on the
  inherent value of the technology and how widely
  the technology is adopted.

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Openness

• The openness strategy is critical when no one
  firm is strong enough to dictate technology
  standards.
• Openness also arises naturally when multiple
  products must work together, making coordination
  in product design essential.
• Openness is more cautious than control. Idea is
  to forsake control to get the bandwagon rolling.

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Generic Strategies in Network Markets

• 4 Generic strategies for companies seeking to
  introduce new technologies into the market place.
• These strategies follow logically from the two
  basic trade-offs
• Performance/Compatibility trade off
• Openness/Control trade off

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Generic Strategies in Network Markets
    Control     Openness
Compatibility Controlled migration Open migration
Performance   Performance play     Discontinuity
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Generic Strategies in Network Markets

• Controlled Migration
• Consumers are offered a new and improved
  technology that is compatible with their existing
  technology, but is proprietary.
• Upgrades and updates of software programs tend to
  fall into this category.

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Generic Strategies in Network Markets

• Controlled Migration Cont.
• If you have secure domination in your market, you
  can introduce the new technology as a premium
  version of the old technology.
• Thus, controlled migration often is a dynamic
  form of the versioning strategy described in
  chapter 3.

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Generic Strategies in Network Markets

• Open Migration
• The new product is supplied by many vendors and
  requires few switching costs.
• Open migration makes the most sense if your
  advantage is primarily based on manufacturing
  capabilities.
• You will benefit from a large total market and an
  agreed upon set of specifications.

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Generic Strategies in Network Markets

• Discontinuity
• A new product or technology is incompatible with
  existing technology but is available from
  multiple suppliers.
• Ex.- introduction of CD audio systems, 3 ½
  floppy disks
• Like the open migration strategy, discontinuity
  favors suppliers that are efficient manufacturers.

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Generic Strategies in Network Markets

• Performance Play
• Boldest and riskiest of the four strategies.
• Involves the introduction of a new, incompatible
  technology over which the vendor retains strong
  proprietary control.
• Makes the most sense if your advantage is
  primarily based on the development of a striking
  new technology that offers advantages over
  existing technology.
• Examples Nintendo, Palm pilot, Zip Drive
• How about Google?

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Lessons

• Positive Feedback - The Dynamic Process by which
  the Strong get Stronger and Weak get Weaker.
• Adoption Dynamics In the Presence of Positive
  Feedback tend to follow a predictable S
  pattern, or logistic growth path (slow start,
  rapid growth, the saturation)

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Lessons

• Consumers Value Information Technologies that are
  widely used, just as they value communications
  networks with broad reach.
• Positive Feedback works to the advantage of
  large networks and against small networks.
• Consumer Expectations are vital to obtaining
  the critical mass necessary to fuel growth.

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Lessons

• Firms introducing new products and technologies
  face a fundamental trade-off between performance
  and compatibility.
• Firms Introducing new products and technologies
  also face a fundamental trade-off between
  openness and control.
• Many of the tactics for dealing with positive
  feedback and network externalities have been used
  in the past.

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Lessons

• There are four generic strategies for innovators
  in network markets
• Performance Play
• Controlled Migration
• Open Migration
• Discontinuity

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Discussion Questions

• Can Microsoft be considered a growth company
  today?
• Where would you put Microsoft on the S-shaped
  curve (in terms of Revenue or profit)
• How would you characterize Google against the
  backdrop of the four generic strategies that we
  talked about?