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Network Effects. Increased market size makes product more valuable to consumers. This is just like an economy of scale in that it benefits large firms relative to small ones. Might lead to natural monopoly. Since demand increases for large networks, large networks should have higher prices.
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Network Effects • Increased market size makes product more valuable to consumers. • This is just like an economy of scale in that it benefits large firms relative to small ones. Might lead to natural monopoly. • Since demand increases for large networks, large networks should have higher prices. • In Microsoft case, judge decided that they were a barrier to entry, that incumbents were locked-in, or put another way, challengers were locked-out.
Network Effects • Definition: a product becomes more valuable to a consumer the more other consumers there are of the product. • Virtually identical theoretically to economies of scale • Markets will tend toward monopoly, winner-take-all result (in simple world). • Example: Fax machines, some software, languages, online networks, computer standards,. • Literal networks (physical connections, e.g., fax machines) and Virtual Networks (e.g., software)
Potential Problems Due to Network Effects • Traditional Problem: Network is the wrong size. Old fashioned negative externality. • This is just the inverse of the tragedy of the commons. Here the network is too small. There the network (commons) is too big (overused). • New Problem: Getting stuck with the wrong network—i.e., lock-in.
Effects versus Externalities • Where we have positive externalities, activity is too small (golf courses, research?). • Where we have negative externalities, activity is too big (e.g., air pollution, traffic). • One key element is whether external effects are internalized, or whether they are truly externalities.
Measuring Network Effects • Several attempts: • Gandal examined spreadsheet prices. • Examined whether Lotus file compatibility and ability to link to external databases were characteristics that led to higher prices. • Brynjolfsson and Kemerer examined spreadsheet prices • Examined whether Lotus menu structure and installed based lead to higher prices. • Literal networks: fax machines (Saloner and Shepard).
Tragedy of the Commons • Example of Negative Externality. • Common Property Resource – lake, forest, any productive resource that allows free use. • The tragedy is that the resource is overused. • Greater tragedy is that it is overused to the point where its entire value might be dissipated.
Business Applications • Should a firm have internal charges when one division helps another (e.g. technical support)? • The relationship to Network Effects.
Winner-take-all • Network effects give bigger networks advantages over smaller networks. • This is an ‘economy of scale’ on the demand side. • Many information products have old fashioned economies of scale since there is a large fixed cost and low variable cost. • Instant scalability: the ability to increase output extremely quickly. Requires non-specialized inputs. Not the same as zero marginal cost. • These factors tend toward the largest firm/network having two advantages over smaller competitors • Lower Costs. • Greater Willingness to Pay by consumers.
First Mover Wins? • Because of the advantages that seem to accrue to the large firms/networks, some thought that the key to success was to get to market first, since that would lead to the largest share, giving the firm a large advantage over competitors. • Marketing Professors thought they had evidence that first movers usually went on to dominate many industries in the past, and this should have been even stronger for high tech firms. • The theory of ‘lock-in’ provided new theoretical support for the idea that the first mover would win.
Lock-in • Claim: Markets do not adopt best products even when it is efficient to do so. • QWERTY, VHS-Beta are most common purported examples. • Story is one of coordination failure. • We all prefer Beta. But VHS dominates, and most movies are on VHS. Since we think that everyone else will get VHS, we get VHS too. • My work with Margolis has shown the key examples of lock-in to be false.
Lock-in Table • Technology B Wins although Technology A is better.
Assumption about different slopes? What does it really entail, and is it reasonable? • Assumption that consumers only look at their original payoff and not their final payoff is also unreasonable.
Support for Lock-In stories • First, we need to distinguish between strong and weak lock-in. • Strong lock-in: compatibility with others is so important that consumers would choose inferior product to be compatible with others. Coordination problem. • Weak lock-in: compatibility with one’s self, old habits and old work product (files) keeps one from switching. • The strong form leads to first-mover-wins because competitors can not just develop their products with the idea of making a switch easier, but they would need to coordinate consumers as well. • Weak lock-in is not a social problem. There are many examples of weak lock-in. Strong lock-in potentially leads to market inefficiencies. Are there any examples of Strong Lock-in?
Qwerty Story • Most famous case; • simple to identify ‘quality’ (speed of typing) • Consistent with chaos theories of unpredictable small events leading to big outcomes. • Usual Story: • Qwerty Keyboard was designed to slow down typing to keep keys from getting stuck. • In a famous typing contest in Cincinnati, pitting touch typist against ‘hunt-and-peck’ the touch typist used a Qwerty and won. This is the small accident leading to big outcomes, since people then associated Qwerty with speed. • Prof Dvorak designed a keyboard to speed things up in 1930s. • During WWII Navy tested new keyboard and found that speed increased 40% and cost of retraining was recouped within 10 days of completed switch. • Keyboard never adopted. End of war reduced Navy’s need for fast typists.
Qwerty Story • Actual Story • No evidence that Qwerty Keyboard was designed to slow down typing speed, and it wasn’t necessary to keep keys from getting stuck. • There were many other typing contest pitting touch typist against other touch typists on different keyboards and Qwerty won many of these. The point is that the Cincinnati contest was not crucial. • A highly publicized 1954 test of the Dvorak keyboard by the General Services Administration found no advantage in switching to Dvorak. • The WWII Navy study was biased in the way it calculated it results. All the biases were in favor of Dvorak. It also appears that the author of the study was probably Dr. Dvorak, the designer and patent holder of the keyboard. • Ergonomics studies on keyboard design confirm that Qwerty is a good design and not much different than Dvorak in terms of speed
Beta-VHS Story • Story • Beta was better than VHS. • VHS got an early lead and network effects allowed it to become dominant even though it was inferior. • Network effect was the fact that prerecorded tapes were available in VHS and people wishing to rent tapes would get a VHS machine to get a good selection of tapes. • Actual History • Beta started first, but could only tape for 1 hour. • Sony (Beta) and VHS (Matsushita) had a patent sharing agreement. • Only real difference was size of tape and how it was threaded. • VHS always had longer playing time which turned out to be decisive. • Beta had better editing and so it is used in professional equipment • VHS as good or better than Beta according to independent tests.
Other Stories • Quadraphonic sound • Railroad gauges • Macintosh versus dos • Internal combustion engine • Metric versus English measurement • Stereo AM • AC versus DC
Weaker forms of Lock-in • Decisions are often made that turn out to be incorrect yet not worth changing. This is a weaker form of lock-in. • There are at least two weaker forms that we can identify, called first and second degree in the literature.
Network Effects and Software • Standard Claims: • Winner-takes-all. • Market should gravitate toward a single winner. • Note that ‘instant scalability’ can also lead to winner-take-all type of result since market can follow preferences of consumers more strongly than would be typical. • Lock-In: Network effects presumably strengthen monopoly of leader. • Superior challengers can replace leader with built in network effects until difference in quality becomes • Tipping: At some point network effects support one firm or product so strongly that it becomes the standard and takes the market.
Methodology • We compare market share changes with product quality changes. • Quality measured by magazine reviews. • Magazines could be biased • Whether reviews are right or wrong, consumers have only this data and can interpret them the way they want. • 2 measures of quality: ‘wins’ and ratings. • ‘Wins’ is based on the top numerical score, Editors Choice, or some other indication that some product was the best in its class. • Many fewer reviews give numerical scores. When they did we set the top score to 10 and normalized the other scores to match.
Figure 9.5: Windows WP Ratings 10 2/25/92 PC Magazine 2/10/92 2/18/97 Infoworld PC Magazine 9 8/1/93 PC Computing Infoworld 1/7/91 PC Magazine 11/21/95 2/8/94 PC Magazine 5/24/93 ComputerWorld 8/1/90 Personal Computing 11/9/93 PC Magazine 8 PC Magazine 12/11/90 Ami Pro MS Word Windows WordPerfect for Windows 7
In 1994 Prodigy dropped its $14.95 unlimited use pricing and went to the same pricing as its competitors ($10 for 5 hours, $3/hr after).
Business Implications • First to market: How Important?? • How important is large market share early on? • If lock-in unimportant, then quality is more important than the order of entry. • So what should a firm do to succeed in information goods market?
