5.7 Network Effects

[5.2 Using Game Theory] [5.3 Classic Game Models] [5.4 Simultaneous Games]

Another prominent application of game theory is the study of network effects. Network effects arise in technology industries where the value of adopting a technology to an individual is related to other individual’s adoption decisions.

To see this, imagine that you are the only person in the world with a fax machine. How valuable would your fax machine be to you? Probably not very valuable. But if your friends, family, colleagues, and business contacts all had fax machines, then how valuable would your fax machine be? Probably much more valuable now that a large network of people also own and use fax machines.

The fax machine is a network good; it becomes more valuable as more and more people own or use it. When a technology increases in value as more people use it, that technology is said to exhibit network effects.

Network effects can be described as direct or indirect. Some technologies, such as e-mail and telephones, have a physical network of users, meaning that actual connections (phone calls and messages) exist among users. Goods in physical networks tend to experience direct network effects. Consider when users purchased telephones. The value of telephones to users was "directly" determined by the number of users who also owned telephones. Therefore, the phone was less valuable to users when few people used it and it became more and more valuable as the network of phone users grew. When a good's value increases as the number of users increases and decreases as the number of users decreases, that good is said to experience direct network effects.

Click on the link here for more information about network externalities.

However, some goods make up a "virtual" network of users, meaning that although actual connections do not exist among users, virtual connections (eg, information and complementary goods shared among product users) do exist. Goods in virtual networks tend to experience indirect network effects. For example, consumers don't value the Microsoft operating system just because a great number of people use it. However, as more people use Windows^®, more complementary goods become available (eg, software applications). As more complementary goods become available for Windows^®, users start to value Windows^® more. When a good's value to users is determined by its available complementary goods, it experiences indirect network effects.

To learn more about direct and indirect network effects, read the example in the following here.

Phenomena Caused by Network Effects

Network effects can cause the following phenomena in technology markets: positive feedback, tippy markets, lock-in and product success or failure based on consumer expectations. Any one of these phenomena can affect the type of strategy firms choose to implement.

The positive feedback process: As previously stated, as more users buy a particular network good, its value increases. As its value increases, even more people want to adopt that good. This starts a "bandwagon" effect, and the product's success builds on its success. This virtuous cycle is often called positive feedback.

DVD technology experienced positive feedback. As more people bought DVD players, more movie titles became available on DVD and more video stores started to offer DVDs. With more titles and more stores selling DVDs, even more buyers purchased DVDs.

Such positive feedback cycles can continue until the product reaches market saturation and a large array of complementary products are available for a technology.

Tippy markets: If positive feedback continues and consumers favour a single technology standard, the market can "tip" towards one technology, making other technologies obsolete. For this reason, markets with network effects are often "winner-takes-all" markets.

To understand how and why a market tips, think of the DVD market. If DVD players become increasingly popular because of positive feedback, video stores will eventually stop renting VCR tapes, which will dissuade users from buying VCRs. As a result, VCRs could eventually become obsolete and tip the market to DVDs as the video recording technology standard.

For more information on how markets tip, read this here.

Lock-in: Once a large installed base of customers begins to use one network good, users might face large costs (ie, switching costs) if they want to switch technologies. Switching costs can include the price of the new technology and all complementary products, the time to learn a new technology, and the risk that an insufficient number of users will adopt. When switching costs prevent users from changing technologies, users face lock-in. If users are locked into one established product, firms with new, noncompatible technologies may have to go to great lengths to encourage users to adopt.

Sony learnt the power of lock-in in 1992 when it launched its MiniDisc. The MiniDisc had all of the same features of the CD, but it was physically smaller and could record music. However, by offering only slight improvements with its MiniDisc, Sony could not convince users who were locked into CDs and CD players to throw away their CD collections and rebuy them on MiniDisc. So although positive feedback continues for CDs today, MiniDisc sales remain stagnant.

Consumer expectations: In markets with network effects, consumers often decide to buy the network good they perceive as potentially being the most widely adopted. Therefore, convincing consumers that a technology will be the most widely adopted in the market is often more important than convincing them that it is the best technology. A good strategy that manages consumer expectations can determine the winning product in a market with network effects. For example, Corel Corporation, creator of WordPerfect^®, filed suit to block Microsoft from claiming that Microsoft Word^® was the world's most popular word-processing software program. Corel clearly developed this strategy to try to prevent losing potential buyers (who could have been convinced that Microsoft Word^® would eventually have the bigger network of users).

A key strategic decision for firms in markets with network effects is whether to choose an open or closed technology standard. Sony and Philips adopted an open standard for their CD technology. Nintendo, on the other hand, used a proprietary (or closed) standard when developing its home video game system. Both companies achieved great success because they critically considered details about their business, the product, and the market before making their standard decisions.

What is an open standard?

When a technology sponsor adopts an open standard, it signs a licensing agreement that allows other firms to implement its technology, often for a nominal fee.

What is a closed standard?

When the sponsor chooses a closed standard, or proprietary standard, it denies other firms use of its technology and remains the sole technology provider.

The decision to adopt an open or closed strategy ultimately rests with the technology sponsor, assuming there is no government intervention. This decision will influence other network-related strategies the firm might consider.

Standards can be somewhat open or closed. For more information, read the following link about hybrid strategies.

Advantages and disadvantages of an open standard

An open standard may encourage users to adopt a technology. This is equivalent to increasing the size of the network. If many companies use one technology to make similar products, consumers are more likely to adopt that technology because they do not fear being locked-in to a single product. Also, the presence of competitors will probably lead to price reductions and frequent technical improvements.

However, enlisting the help of other companies comes at a cost; competition decreases the technology sponsor's share of the overall market and puts pressure on prices.

When to consider an open standard

If a firm alone cannot ignite positive feedback and encourage people to adopt its technology, it should consider an open standard and allow other companies to license and promote its technology.

Advantages and disadvantages of a closed standard

Adopting a closed standard is riskier than adopting an open standard. After all, to succeed with a closed standard, a technology sponsor must ignite positive feedback without the help of other firms and their influence on consumer expectations. In the case that it succeeds, however, the advantage is clear: The technology sponsor maintains complete market share in the technology it sponsors, although not necessarily in the market as a whole, and it does not share profits with a competitor.

When to consider a closed standard

Before a firm chooses a closed standard, it must evaluate the following criteria to determine its likelihood of success.

Does it have an installed base of customers?	A large and locked-in customer base from an earlier-generation technology can convince users to adopt a new (but "backwards-compatible") technology. For example, Microsoft's operating system (OS) draws its success from its loyal users of earlier, compatible generations of the Windows^® OS.
Can it protect its intellectual property?	A firm must be able to keep its intellectual property for its closed technology secret or legally protected from imitators in order to succeed. A closed standard is of little use if a firm cannot prevent imitators from producing compatible substitutes. A firm using a closed standard must be able to protect its intellectual property from theft or imitation. Unless it can do so, it cannot guarantee that it, and not its imitators, will be the one to profit from the innovation.
Does it have a first-mover advantage?	A first-mover advantage can help exploit network effects and lock-in future customers.
Is the product innovative?	A closed technology must offer innovative features, superior performance, and low cost to overcome consumers' fear of lock-in. Customers may be less likely to purchase from a firm using a closed standard because, with a single firm as their source, they fear the adverse future effects of lock-in. For example, Apple Computers forbade other firms to use its operating system and so customers feared that, after purchasing an Apple computer, they would only be able to purchase software made by Apple (whereas many software developers were encouraged to write software for the IBM PC). Nevertheless, Apple computers achieved initial success partly because its graphical user interface was easier to use than its competitors.
Is the sponsor in control of its complementary assets?	The control of complementary assets is crucial; a firm that controls these assets has an advantage over firms that do not.
Does the firm have brand recognition?	Brand recognition is important because it can convince users of a product's potential for success, which can ignite positive feedback.

The following illustration shows that, in most cases, firms using open technology strategies gain a smaller share of a large market, whereas firms using closed technology strategies gain a larger share of a small market.

Three Strategies for Igniting Positive Feedback

Firms can use the following strategies to ignite positive feedback: alliances, penetration pricing and product pre-announcements.

Forming alliances. By forming alliances with complementors, a firm can encourage users to adopt its technology. When a technology is based on an open standard, customers benefit from network effects. For example, alliances can encourage users to adopt a common technology, thereby enhancing demand for all partners' products. In the early 1990s, microchip manufacturers — such as Sun, MIPS and Motorola — formed alliances to promote their chips, set standards, and encourage other firms to write code for their chips.

Click on the link here for some reasons to ally with complementors

Using penetration pricing. Penetration pricing (selling a technology at low to no cost) can help a firm penetrate a market and establish a critical mass of users. Once a significant number of users buys a product, however, the technology sponsor must develop a strategy to profit off future sales of its product. Unfortunately, once a firm offers a product for free to consumers, it may be difficult to convince consumers to pay for it. Internet service provider NetZero experienced this challenge. After it initially offered free Internet access to consumers, it encountered great consumer resistance when it began charging for this service.

Making product pre-announcements. Managing expectations is key to success in markets with network effects. Pre-announcements (ie, announcing that a product will soon be available) can work to fight off competitors. After all, customers may not buy your competitors' products if they are waiting for your product. Pre-announcements in the software business are called vapourware and are common.

The link below shows an example of product pre-announcements:

For example, Microsoft first announced that Windows NT 5.0® would be released in 1998 and then delayed its release of the product so long that it renamed its product Windows 2000®. Competitors accused Microsoft of using vapourware tactics.

Note: The legality of product preannouncements and vapourware has been called into question, so although these strategies are common, they're not necessarily recommended.

The outcomes when there are network effects are related to the classic game of the Deer Hunt. When there are two individuals in that game, there were two equilibria involving the hunters choosing to go after deer or rabbit. Interestingly, one equilibrium was preferred by both individuals.

This type of game summarises the issues that arise for technology adoption in the face of network effects. That is, individual adopters may co-ordinate on a potentially inferior standard (such as the IBM PC, VHS videos or QWERTY keyboard) and be unable to change from that situation. When people foresee this type of game, however, they can undertake actions to change the game and co-ordinate on a preferred equilibrium. One example of this is the adoption of standards that we examined above.

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