MIT641 Information Economics session 8 Network Externality

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1 MIT641 Information Economics session 8 Network Externality Dr Sittiphol Viboonthanakul Business for Rural Education and Development shineallday@yahoo.com 1

2 Network Externalities What are externalities? Externalities are common in every area of economic activity. They are defined as third party (or spillover) effects arising from the production and/or consumption of goods and services for which no appropriate compensation is paid. 2

3 Externalities Externalities can cause market failure if the price mechanism does not take into account the full social costs and social benefits of production and consumption. The study of externalities has become extensive in recent years - because of concerns about the link between the economy and the environment. PRIVATE AND SOCIAL COSTS SOCIAL COST = PRIVATE COST + EXTERNALITY SOCIAL BENEFIT = PRIVATE BENEFIT + EXTERNALITY 3

4 Externalities Allocative inefficiency - market over allocates Negative Externality: Alcohol drinking, Smoking Positive Externality: Education, Security 4

5 E.G. Negative Externalities โรงงานอ ตสาหกรรมก อมลพ ษ 5

6 E.G. Positive Externalities 6

7 Industry Economics vs Information Economics Oligopolies: A few large firms dominated their market. Concentration ratio or Herfindahl-Hirschman Index (HHI) Driven by economies of scale. 7

8 Industry Economics vs Information Economics 8

9 Industry Economics vs Information Economics UK industries with the highest five-firm concentration ratios include the following: Sugar: 99% Tobacco products: 99% Gas distribution: 82% Oils and fats: 88% Confectionery: 81% Man-made fibres: 79% Coal extraction: 79% Soft drinks and mineral waters: 75% Pesticides: 75% Weapons and ammunition: 77% UK industries with the lowest five-firm concentration ratios include the following Metal forging, pressing etc.: 4% Plastic products: 4% Furniture: 5% Construction: 5% Structural metal products: 6% Wholesale distribution: 6% General purpose machinery: 8% Wood and wood products: 9% 9

10 C4 Scores for the Search Engines, Source: Experien Hitwise Canada. Main Data Centre: Top 20 Sites & Engines. last Accessed October 11,

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12 Industry Economics vs Information Economics Information economy: temporary monopolies Driven by economies of networks. Economies of networks create market dynamics and competitive strategy. Key concept: positive feedback 12

13 Networks and Positive Feedback Why is positive feedback so important in hightechnology industries? Positive feedback makes the strong grow stronger, and the weak grow weaker. Network of ATM, users, game Similar to physical network, e.g airport Same computer network: use the same software and share the same files 13

14 Networks and Positive Feedback The value of connecting to a network depends on the number of other people already connected to it. Network Externalities = Network Effect = Demand-side economies of scale Bigger is better: better to connected to a bigger network than a smaller one. The value of network depends on the number of people who connected, and interconnecting to other networks. 14

15 Networks and Positive Feedback More popular Bigger network More new people using No out of date, always have new version Attract new customer 15

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17 Positive Feedback The extreme: Dominance of the market by a single firm or technology Monopoly Virtuous Cycle vs Vicious Cycle If positive feedback does not feel very positive, the virtuous cycle of growth can easily change to a vicious cycle. Positive feedback can lead to winner-take-all market. 17

18 Positive Feedback Positive feedback is a more potent force in the network economy than ever before. Technology A starts at 60% of market, while technology B starts at 40% of the market. e.g. Nintendo: entered U.S. market home video games in

19 Positive Feedback Positive feedback systems follow a predictable pattern. Flat during launch A steep rise during positive feedback takes off Saturation is reached Same to the spread of viruses. Fax machine, colour TV, . 19

20 Demand-side Economies of Scale Supply-side economies of scale The market capitalization of IT companies e.g. Microsoft, Apple, Facebook, Google, do not based on just supply side. The stock recently rose 1.8% at $660, pushing Apple s market capitalization up to $619 billion. Now Apple holds the distinction as the most valuable company by market capitalization. Apple s market cap is also more than $200 billion greater than Exxon Mobil the second biggest company right now clocking in at $405 billion. Microsoft, Wal-Mart and IBM round out the top five

21 Demand-side Economies of Scale Small cost of development compared to the network value. Demand-side economies of scale works when markets get large enough. Feedback and Expectation work. 21

22 Demand-side Economies of Scale In the information economy, the lion s share of the rewards go to the winner, not the number two player. Double Whammy 22

23 Network Externalities Positive network externalities give rise to positive feedback Fax machine: when I buy fax machine your fax machine value? Matcalfe s Law: The value of a network goes up as the square of the number of users 23

24 Network Externalities Matcalfe s Law: n = number of people in a network The value of network to each person is proportional to the number of other users Then, the total value of the network equals n ( n 1) = n 2 n 24

25 Collective Switching Cost Collective switching cost = combined switching cost of all users To build a network size you need to overcome the collective switching cost Switching cost is non-linear: convincing ten people to connected in a network to switch to your incompatible network is more than ten times as hard as getting one customer to switch. No one want to be the first to give up the network externalities and risky. 25

26 Collective Switching Cost QWERTY keyboard (Type Writer Brand, 1870s) AOEUIDHTNS keyboard (Dvorak layout, 1932) Individual switching cost vs Collective switching cost Coordination cost Which one will you buy? Why? Human component To acquire marketable skill 26

27 Is your industry subject to positive feedback? Is your industry subject to positive feedback? HDTV IBM-compatible personal computers. Digital Goods 27

28 Performance vs Compatibility What does it take for a new technology to succeed? How can you make network externalities work for you to launch a new product or technology? How can you overcome collective switching cost and build a new network of users? 28

29 Performance vs Compatibility Two approaches Evolution strategy of compatibility Revolution strategy of compelling performance 29

30 Performance vs Compatibility 30

31 Evolution Evolution When compatible is critical Offer customers an easy migration path Reduce switching cost Risk: leave an opening for a competitor to come in Two Obstacles Technical Legal 31

32 Revolution Revolution Offering compelling perfomance A product that so much better than what people are using that enough users will bear the pain of switching to it Letter Fax Andy Grove 10X rule of thumb: you need to offer perfomance ten times better than the established technology to start a revolution. Risky: cannot work on a small scale, requires powerful allies, follow S-Shaped 32

33 Openness versus Control Open approach: offering to make the necessary interfaces and specification available to others Control approach: keeping your system proprietary Which one is better? 33

34 Openness versus Control Openness or Control Depends on whether you are strong enough to ignite positive feedback on your own. Strength in network Existing market position Technical capabilities Control of intellectual property 34

35 Openness versus Control Goal: to maximize the value of your technology, not your control over it. Your reward = Total value added to industry x Your share of industry value 35

36 Trade-off between openness and control Large share of small market Small share of large market This trade-off is fundamental in network market. 36

37 Openness versus Control Openness Alliances are increasing common place in the information economy A group of companies for the express purpose of promoting a specific technology or standard. Three key assets: control of the existing installed base, technical superiority, and intellectual property right Cable TV, 7 eleven 37

38 Openness versus Control Control Only those is the strongest position who can strongly control. Market leader 38

39 Generic Strategies in Network Market For companies seeking to introduce new information technology into marketplace Two basic trade-off Trade-off between performance and compatibility (Revolution and Evolution) Trade-off between openness and control 39

40 Generic Network Strategies Compatibility Performance Control Controlled migration Openness Open migration Performance play Discontinuity 40

41 Performance Play Boldest and riskiest Introduce a new, incompatible technology over which the vendor retains strong proprietary control. Technology has to offer users substantial advantages over existing technology. Nintendo (vs Palm Pilot) 41

42 Controlled migration Offer a new and improved technology that is compatible with their existing technology, but under controlled. 42

43 Open migration Very friendly to consumers Little switching costs Each new generation conforms to an agreedupon standard and link smoothly with earlier generations of machines. Fax machines, Modems 43

44 Discontinuity A new product or technology is incompatible with existing technology But available from multisuppliers CD audio system, and the 31/2 floppy disk Similar to open migration, suppliers of technology should be efficient manufacturers 44

45 World of Warcraft The "World of Warcraft" (WoW) game is a good example of how the network effect can positively increases players' performance through exchanging information and experiences. New players learn from their peers experience shared in forums, blogs, Wikis and high quality answers and instructional videos. "The more players participate and interact with WoW's knowledge economy, the more valuable its resources become, and the faster players increase their rate of performance improvement. Said more generally, the more participants--and interactions between those participants--you add to a carefully designed and nurtured environment, the more the rate of performance improvement goes up"(john Hagel III et al., 2009) 45

46 World of Warcraft The figure below presents performance of WOW new players. After the first 150 playing hours, players win on average two million points. After the next 150 hours they can win eight million points, though the next levels are more difficult. Learning curve of World of Warcraft players (derived from Hagel III et al., 2009) 46

47 Positive feedback A predictable pattern Value of network depends on the number of users positive feedback and expectation gain advantage to larger network more. Firms introducing new product or tech face two fundamentals Trade-off between Performance vs Compatibility Trade-off between openness and control 47