Chapter 6 Understanding Network Effects 6 1 Introduction Network effects aka Metcalfe s Law or network externalities when the value of a product service increases as the number of users grow 6 2 Where s All That Value Come From The value derived from network effects comes from 3 sources exchange staying power complementary benefits Staying power the long term viability of a product service Switching costs the cost a consumer incurs when moving from one product to another can strengthen the value of network effects as a strategic asset Complementary benefits are those products services that add additional value to the network Platforms products services that allow for the development and integration of software products and other complementary goods Windows iphone Wii are the standards that allow users to create facebook apps on different platforms Key Takeaways o Products and services subject to network effects get their value from exchange perceived staying power and complementary products and services Tech firms and services that gain the lead in these categories often dominate all rivals o Many firms attempt to enhance their network effects by creating a platform for the development of third party products and services that enhance the primary offering 6 3 One Sided or Two Sided Markets Some networks derive most of their value from a single class of users instant messaging no add ons one sided market a market that derives most of its value from a single class of users Same side exchange benefits benefits derived be interaction among members of a single class of participant Two sided market network markets comprised of 2 distinct categories of participant both of which that are needed to deliver value for the network to work video game software developer and console owners Groupon Cross side exchange benefit when an increase in the number of users on one side of the market creates a rise in the other side It is possible for a network to have both same side and cross side benefits Xbox 360 Key Takeaways o In one sided markets users gain benefits from interacting with a similar category of users think instant messaging where everyone can send and receive messages to one another o In two sided markets users gain benefits from interacting with a separate complementary class of users e g in Groupon s daily deal business deal subscribers are attracted to the platform because there are more vendors offering deals while vendors are attracted to Groupon because it has the most customers to receive the deals 6 4 How Are These Markets Different Network markets experience early fierce competition These markets are winner take all or winner take most exhibiting Monopoly a market where there are many buyers but only one dominant monopolistic tendencies seller Oligopoly a market dominated by a small number of powerful seller The best product service doesn t always win Technological leapfrogging competing by offering a new technology that is so superior to existing offerings that the value overcomes the resistance that older technologies might enjoy via exchange switching costs and complementary benefits While network effects limit competition against the dominant standard innovation within a standard may actually blossom Windows is a magnet for developers to innovate within the standard Key Takeaways o Unseating a firm that dominates with network effects can be extremely difficult especially if the newcomer is not compatible with the established leader Newcomers will find their technology will need to be so good that it must leapfrog not only the value of the established firm s tech but also the perceived stability of the dominant firm the exchange benefits provided by the existing user base and the benefits from any product complements For evidence just look at how difficult it s been for rivals to unseat the dominance of Windows o Because of this network effects might limit the number of rivals that challenge a dominant firm But the establishment of a dominant standard may actually encourage innovation within the standard since firms producing complements for the leader have faith the leader will have staying power in the market 6 5 Competing When Network Effects Matter Strategies for competing in markets with network effects o Move early Yahoo o Subsidize product adoption PayPal o Leverage viral promotion a firm s customers promote the product service Skype Facebook feeds o Expand by redefining the market to bring in new categories of users Wii or through convergence iPhone o Form alliances and partnerships NYCE vs Citibank o Establish distribution channels Java via Netscape o Seed the market with complements Blu ray Nintendo o Encourage the development of complementary goods offer resources subsidies reduced fees market research Facebook fbFund o Maintain backward compatibility Apple s Mac OS X Rosetta translation software for PowerPC to Intel Adaptor a product that allows a firm to tap into the complementary products data or user base of another product service o For rivals be compatible with larger networks Apple s move to Intel o For incumbents constantly innovate to create a moving target and bock rival efforts to access your network Apple s efforts to block access to its own systems o For large firms with well known followers make preannouncements Microsoft Large firms that find new markets attractive but don t yet have products ready for delivery might preannounce efforts in order to cause potential adaptors to sit on the fence delaying a purchasing decision until the new effort rolls out In Japan eBay showed up just 5 months after Yahoo launched its Japanese auction service in Japan eBay ended up having to retreat bc it moved in too late and communication was bad Blue ocean strategy an approach where firms seek to create and compete in uncontested blue waters market spaces rather than competing in spaces and ways that have attracted many similar rivals Convergence when two or more markets once considered distinctly separate begin to offer similar features and capabilities phones and media players Envelopment when one market attempts to conquer a new market by making it a subset component or feature of its primary offering Backward compatibility the ability to take advantage of complementary products developed for a prior generation of technology The Osborne Effect when a firm preannounces a forthcoming product service and experiences a sharp and detrimental drop in sales of
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