Strategy for Information Markets/Network Externalities

Network externalities and demand

Network externalities (also known as network effects) are demand-side economies of scale. Usually we think of economies of scale as a supply-side phenomenon. On the supply-side, economies of scale mean that a good becomes less costly to produce when more of it is produced. On the demand side, network externalities mean that a good becomes more valuable as more people use it. Many traditional products can have a small amount of network externalities, for one reason or another, which we usually ignore. When network externalities are strong, however, they can radically affect the way a market behaves, and they cannot be ignored.

The following chapter will develop the working body that creates network effects. Expectations management and positive feedback both work as forces from a consumer or supply end that drive the direction of network effects (which can be negative). The Demand Structure with Network Externalities will show the importance the prior sections play in a network reaching "critical mass", that allows a network to be successful. Finally in the Networks and Network Structure section, we will analyze the structure of networks themselves and end with a discussion of two-sided-platforms.

• Demand Structure with Network Effects
• Two-sided Platforms
• Networks and Network Structure
• Diamond coconut model

Extent of externalities

When someone reads a novel, they most likely get enjoyment from the experience of reading in and of itself. Perhaps they would enjoy the novel even more, however, if they knew they had friends who had also read it and could discuss it with them. When someone chooses to purchase a particular model of car, they might benefit by choosing a popular model, since that will also make it easier to find expert mechanics and spare parts.

Neither novels nor cars fall clearly into the category of products which have strong network externalities. We would default to thinking of them as products which a consumer purchases for their own sake, and not particularly valuing what other people do. However, as the above examples show, it is easy to come up with stories which attribute network externalities to a wide variety of products. Sometimes these effects can be very strong. While there may be many books as enjoyable as the Harry Potter series and movies as much fun as Star Wars, being familiar with such popular works is part of participating in modern culture.

One thing which must be considered, then, is how strong network externalities are compared to the individual value placed on a product. A product may have some network externalities but be valued highly enough in its own right that many consumers would purchase it, even believing they were the only ones.

Game theory: Coordination games

If you haven't already, now is a good time to look at the background material on Nash equilibrium and coordination games.

Positive feedback

Positive feedback, sometimes referred to as "cumulative causation", refers to a situation where some effect causes more of itself. A system undergoing positive feedback is unstable. That is, it will tend to spiral out of control as the effect amplifies itself.

Negative feedback occurs when the output of a system acts to oppose changes to the input of the system; with the result that the changes are attenuated. If the overall feedback of the system is negative, then the system will tend to be stable.

The effect of a positive feedback loop is not necessarily "positive" in the sense of it being desirable. Positive refers to the direction of change rather than the desirability of the outcome. A negative feedback loop tends to reduce or inhibit a process, while a positive feedback loop tends to expand or promote it.

Positive feedback and high definition discs

An example of positive feedback lies in the current age of larger television sets with higher resolution where the battle between the two television technologies, HD DVD and Blu-Ray, began to face-off. For over a year, large corporations have been choosing sides between either HD-DVD or Blu-Ray, leaving cautious consumers slow to buy because of the fear of choosing a technology that will become either obsolete or extinct. HD-DVD initially seemed to have an advantage because it was very cheap, the disks were easy to produce, and the machines on which they ran cost much less. Although HD-DVD had this battle won based on their cost of production, it seems HD-DVD has lost most of its market share to Blu-Ray because of the media production companies leaving HD-DVD to pursue ventures with Blu-Ray. Initially, Warner and Paramount left HD-DVD to back ranks the Blue-Ray technology, and within a month, Toshiba (HD-DVD's largest supporter) migrated as well. The main reason for this wave of media companies is the presence of the Blu-Ray technology on the Playstation 3 gaming console. Although this is not a definitive win for the Blu-Ray team, there is wide speculation that the Playstation 3 will bring their technology into the market faster than the competing HD-DVD.

Tippy markets

When battling for this positive feedback, the market can be considered to be “tippy” when it can just as easily tip in the favor of one firm over the others. Positive feedback in part can begin as expectations from consumers arise, possibly from advertisement or the idea of vaporware, "inevitability, standards bodies, partnerships, openness. When this happens, the market has the potential to be locked-in on that product or technology.

As a starter, examine the graph to the right.

Graph of market share in a tippy market.

Consider the point at which two competing networks(the winner and loser) hold approximately 50% of the market share near time = 0. At this point both networks may, on their own be past the critical mass point and be moving towards a stable equilibrium (see previous section for explanation). However, in this case we are going to assume that due to feedback, the market is tippy and that either the winner or loser will eventually take almost 100% of the market share.

Back to the graph above. As time elapses, expectations provide a strong positive feedback effect in which the "winner"'s share of the market climbs towards 100% and, conversely, the "loser" essentially loses all market share. The point in which both networks slopes are very steep is when the critical mass point plays a role for both. At this point the "loser" falls below the critical mass point and, as seen above, essentially falls out of the market. As the two networks level off, the idea of systemic lock-in is at play. You can read about systemic lock-in further in the book.

One example of a tippy market is within the digital audio player industry. The first companies to enter the market were Digital Media and Eiger Lab with their two products, the Rio PMP300 and the MPMan F10. With a huge influx of users into the digital media market and the introduction of the file-sharing program Napster, the technology of digital audio players began to expand to other manufacturers such as Apple's Ipod and Microsoft's Zune. But when Napster faced legal challenges for copyright infringement, it was forced to shutdown putting a small hiccup in the digital audio player market. At this point, with the backing of the music industry, Apple stepped in and seized the market with the now even more popular Ipod, which also supported its own proprietary digital audio format: MP4. Apple helped secure their position by permitting users of iTunes to convert music files from MP3 to MP4, which allowed them to upload these files to their Ipods regardless of whether or not they were downloaded by iTunes.

What makes a market tippy

Shapiro and Varian attribute the tippiness of a market to the balance of the overall economies of scale in the market versus the consumers' taste for variety:

	Low economies of scale	High economies of scale
Low demand for variety	Unlikely to tip	Tippy
High demand for variety	Not tippy	Depends

References

Classroom exercises

• Classroom Experiments for Two Bandwagons