Biz model 5 standards

1. A/Prof Jeffrey FunkDivision of Engineering and TechnologyManagementNational University of SingaporeStandards, Network Effectsand Complex SystemsSources: Shapiro and Varian, Information Rules; Rohlfs, Bandwagon Technologies; Payingwith Plastic, Evans and Schmalensee

2. Business Model Value proposition: what to offer and how todifferentiate Customer selection: whom to serve and not serve Scope of activities: what activities to carry out andwhat relationships to haveThis partly depends on the existence ofstandards Value capture: dominant sources of revenue Strategic control: how to sustain profitability (e.g.,how to control architecture and standards)

3. Outline What are standards and complex systems? How are standards chosen? What are network effects? What is a critical mass of users? What are standards wars and what impact do theyhave on competition? Key issues: Performance vs. compatibility Open vs. closed Key tactics and assets Various examples

4. What are Standards A Standard is a set of technicalspecifications adhered to by a producer,either tacitly or as a result of a formalagreementSource: David and Greenstein, The Economics Of Compatibility Standards: An Introduction ToRecent Research, Economics of Innovation and New Technology, Volume 1, Issue 1-2, 1990

5. Types of Standards Reference and minimum quality standards Provides a signal that a given product conforms to thecontent and level of certain defined characteristics (e.g., ISO9000) Todays focus: Interface or compatibility standards Assures the user that an intermediate product or componentcan be successfully incorporated in a larger systemcomprised of closely specified inputs and outputs

6. Examples of Interface Standards Mobile phones: between Phones and base stations Operating systems and apps Music and video systems: between phonograph record and stylus, magnetic tape/disk and read-write head optical disk and read-write system (laser and photodiode) MP3 player and Internet Computer systems: between hardware, operating system andapplication programs Transportation systems: between train wheels and rail gauge Trading systems: money

7. Examples of Interface Standards (continued) Wireline Communication systems, between modems and computers facsimile machines and telephone system Broadcasting systems between transmitters and receiver (e.g., television, radio) Electric power: between power station, transmissionsystem, and home appliances Automobiles and fueling station between fuel source and method of propulsion between nozzle and fuel tank What about energy (e.g., smart grids), water, satellitesystems? in the future?

8. What do Interface Standards have todo with Business Models? Standards Impact on Vertical (Dis)integrationand Vertical (Dis)integration impacts on scopeof activities Open standards facilitate vertical disintegration Vertical disintegration enables smaller scope ofactivities And we want to understand the best scope ofactivities for firms

9. Vertical (Dis)integration Represents extent to which work is shared amongdifferent organizations Changes in vertical (dis)integration can come fromtechnological, institutional, or social changes In particular, reductions in transaction cost reduce costs of having work done by multiple agents importance of integrative capabilities and thus facilitate the emergence of vertical disintegration(and entrepreneurial opportunities) Standards are one way to reduce transaction costs

10. Source: Christensen & Raynor, 2003Vertical DisintegrationEmergence of Standards Drove:

11. When Do Standards Emerge? Emergence of standards depends on technological,institutional, and social factors Starting with technological factors, standards emerge when modular design is technically and economically feasible this depends on tradeoffs between integral and modular design Modular design leads to standards when firms agree to use the same modules and the same rules that defineinterfaces between standards Whether standards lead to vertical disintegration depends are standards are open? are different capabilities required in different activities? are there economies of scale or network effects in some activities? firm strategies

12. From Integral to Modular Design Often evolution from integral to modular design over time Integral design often has higher performance Improvements in performance often enable modular design Wireline and wireless telecommunication Broadcasting, music players, computer, and Internet Example of Internet compatible mobile phones Low processing power and memory capacity of first Internet-compatible mobile phones made integral design necessary Successful services designed and controlled by service providers Improvements in processing power and memory capacity enabledmodular design and phones that were capable of accessing PCInternet content with PC-compatible standards

14. Types of Interface Standards and How they areChosen 1. Unsponsored standards The originator nor any subsequent sponsoring agencyholds a proprietary interest (e.g., UNIX, Linux) 2. Sponsored standards Where one or more sponsoring entities holding a director indirect interest, creating incentives for other firms toadopt particular sets of technical specifications (e.g.,www consortium, CDs, DVDs, Wintel PCs, facsimiles)

15. Types of Standards and How they are Chosen 3. Standards agreements These are arrived at within and published by voluntarystandards-writing organizations (ANSI, ISO, IEEE, etc.) Sponsored standards (CDs, DVDs, and those for telecom,Internet) are sometimes addressed in these agreements 4. Mandated standards These are implemented by government agencies that have someregulatory authority (building, accounting, and sometelecommunication and broadcasting standards)

16. De facto and de Jure Standards (1) Defacto Both unsponsored (1) and sponsored (2) standards emergefrom market-mediated processes Dejure Both standards agreements (3) and mandated standards (4)are a consequence of political/committee deliberations oradministrative procedures which may be influenced marketprocesses without reflecting them in any simple way

17. De facto and de Jure Standards (2) De jure: created by the lawful exercise of power In the past, most broadcasting and telecom standards De facto: determined by a combination of betterperformance, network effects, openness, backwardcompatibility, and/or biz model. Examples include: PCs (Wintel), music (CDs) and movie (VHS, DVD) standards Distinctions between de jure, de facto are disappearing Power of national committees have declined But need for agreements on standards have increased, thusmaking committees more important (>1000 for mobile phones) Many standards are created in a committee but market determineswinner (e.g., many mobile phone standards)

19. What are Network Effects (NE)? Effect that one user of a good or service has on value ofthat product for other people Direct effects Value of product depends on number of users Examples: telephones, facsimile machines, Internet mail, SMS,Social Networking or Instant Messaging Sites Indirect effects Value of a product depends on number of complementaryproducts Software & hardware for computers, video games, music, video players Mobile phones and applications Note: number of complementary products often depends onnumber of users

20. Other Examples of Indirect Network Effects (NE)Industry Product Network EffectsRealEstateProperty sales Buyer, sellerRentals Renter, ownerMedia Newspapers, Magazines Reader, advertiserNetwork television Viewer, AdvertiserPortals and WebPublicationsWeb surfer,advertiserShopping Malls Merchant, shopperPaymentSystemCharge/debit card Cardholder,merchant

21. How do NEs Impact on Purchasing Decisions? Products competing inmarket segments withno NE Consumers/customersbase their purchasedecision on the intrinsicvalue and utility of theproduct to them Competition on thebasis of features, price,promotion, after salesservice, etc. Products competing in marketwith NE Consumers/customers basepurchase decisions on the size ofthe installed base and/or the(actual or projected) accessibility,quality, and functionality ofcomplementary products andservices Competition on the basis of thesize of the installed base,availability of complementaryproducts and their supplierscompetence and support

22. With Strong Network Effects, Market Share ItselfCreates ValueValue toconsumerActual (or anticipated) size of the installed baseValue of standardsDriven productConventional product (e.g.,automobile)

23. While the competing standard loses valueCompeti-tiveness ofcompetingstandardInstalled base of products that work with yourstandardStandards-Driven productConventional product

24. Winner Take-All from Network Effects1Probabilitynext consumer/producerchoosestechnology AAssumption:Only two technologies,A and B, and consumershave same needs0(1) When Asprobability ishigher than itsmarket share, Atends to convergeto 1 (winner-take-all)(2) When Asprobability is lower,it tends to convergeto 0 (loser-gets-nothing)(1)(2)As Market Share

25. When Network Effects are Strong,but not winner-take all strong1Probabilitynext consumer/producerchoosestechnology AAssumption:Only two technologies,A and B, and consumershave same needs0The result is aduopoly in whichtwo technologies/standards co-existAs Market Shareequilibrium

26. Small Change in Support, Large Change in Share Support by movie distributors in 2007 HD DVD: Paramount, Universal, Warner Brothers Blu-ray: Sony, Disney, MGM, Warner Brothers 50-50 split in hardware sales in 2007 Warner Broth removed support for HD on Jan. 4, 2008causing market share for Blu-ray hardware to jump to 90% in week of January 12 63% in week of January 19 despite heavy discounts by HDDVD suppliers (Source: NY Times, Feb. 5, 2008, HBS Case) By mid-February Toshiba stopped production of HD DVD Walmart and NetFlix would only supply Blu-ray

27. Many Winner Take all Markets for Standards/Firms (fora certain time period) Computers IBM System/360 in mainframes Wintel in PCs UNIX in workstations, Portable memory formats Internet HTML, URLs, etc. Ciscos IOS for operating systems in routers Paypal for online micropayments Documents e.g., Adobe Vector Graphics e.g., Flash

28. More Examples (2) Telecommunication GSM for second generation mobile phone systems WCDMA for third generation mobile phone systems Various facsimile and modem standards Transportation Railroad gauge Specific airports as airline hubs (not as much winner take all) Container sizes, Automobile fuels, i.e., gasoline Consumer Electronics B&W and Color Television standards Music: stereo records, cassette tapes, CDs, MP3 Movie/Video: VHS, DVD (both 1G and 2G) Video game consoles

29. Implications of Winner Take All You must be part of the winning standard If youre not, you wont be able to sell your product As user of wrong standard, it may be hard to purchase productsfor your standard or to work with other organizations or Winner take all phenomenon is particularly commonwhen there are high switching costs The costs that a user incurs when they change products highswitching costs can lead to lock-in Cant sell your product because users are locked in Cant use other products because you are locked in But some standards have low switching costs particularly whenthe software for the new standard can be quickly downloaded(e.g., instant messaging services)

30. Suppliers Shouldnt Overestimate Importance of NetworkEffects and Lock-In Internet Bubble broke in 2000 One reason bubble occurred isbecause firms thought that Network effects were very strong Users would be willing to paya higher price for the servicesfrom the leaders and thus would be locked-in to early leaders And thus firms needed to obtain market share quickly Lock-in hasnt occurred to this extent In fact, the leading Internet firm did not become successful untilafter the bubble had burstNASDAQComposite

31. Network Effects are Easy to Misunderstand! Even the experts make mistakes Just remember critical questions: What emphasis do consumers/customers base theirpurchase decision on the intrinsic value and utility of the product to them size of the installed base and/or the (actual orprojected) accessibility, quality, and functionality ofcomplementary products and services? What are the extent of the switching costs?

33. What is a Critical Mass of Users? The number of users that are needed for a product orservice to provide them with sufficient value so that theywill continue to use the product or service Products with strong network effects often require acritical mass of users before growth will occur

34. Industries for which a Critical Mass of Users orFirms was or is Required Direct Network Effects (number of users is key factor) Telephones; Fax machines; Internet mail Wireless (before connections with fixed line phones) Video phone/conferencing Social networking sites Indirect Network Effects (number of complementaryproducts is important) Broadcasting (local broadcasters, advertisers, programs) New music or video formats (hardware and content) Computer hardware and software Mobile Internet users, services, phones, and content

35. Consider Facebook Mark Zuckerberg first created a critical mass of users at asingle university and then expanded this critical mass ofusers to other schools before addressing mass market He created the first critical mass of users at Harvard Second, at other universities: Yale, Columbia, andStanford Third, High Schools Fourth, alumni for U.S. universities and high schools Fifth, foreign schools Sixth, began offering services that enabled people to makeconnections between networks

36. Similar things in other technologies Examples: Telephone,wireless, facsimile, Internetmail, video conferencing Technologies first diffused in small group of users (e.g.,intra-firm communication) that were only concernedwith these users This caused growth to occur primarily in the form offragmented networks Later these networks became interconnected

37. IndustryorProductDifferent Sub-Populations for which a criticalmass of users was createdProducts/Services thatConnected FragmentedSub-PopulationsTelephone 1. Intra-firm communication2. Local communication in cities3. Local communication in smaller cities and ruralareasMedium and long distancephone servicesWireless 1. Intra-firm wireless telegraph services2. Ham radio users (i.e., radio heads)3. Intra-organizational wireless communicationMobile phones andstandardsfor themFacsimile 1. Intra-firm communication2. Inter-firm and consumer communication throughfacsimile transmission servicesInexpensive fax machines& standards for themInternet mail 1. Communication among computer scientists andother univ. professors2. Intra-firm communication3. General business/consumersCommercial gateways,telecommunicationbackbones and standardsVideo telephone/conferencing1. Intra-firm video conferencing networks2. Inter-firm services3. General business/ consumersInternet, PCs, mobilephones, and standardsA Critical Mass of Users Was Created Multiple Times(for different sub-populations) in Many Industries in U.S.

38. Does a Critical Mass of Firms have to be CreatedMultiple Times for the Mobile Internet? Indirect network effects between services, phones, andcontent/applications Critical mass of services, phones, content for Messaging/Texting Ringing tone or music downloads Video downloads Game or other Java-based downloads GPS (global positioning system) 2D Bar Codes Payments and tickets (Wallet Phones) Infrared or Bluetooth Critical mass must be created for each standard

39. In summary Creating a critical mass of users is sometimesnecessary Strong network effects often means it is necessary tocreate a critical mass of users But not always: video cassette recorders When necessary, creating a critical mass of users isdifficult Must identify appropriate customers Convince multiple users to adopt the technology

40. Outline (and Learning Objectives) What are standards and complex systems? How are standards chosen? What are network effects? What is a critical mass of users? What are standards wars and what impact do theyhave on competition? Key issues: Performance vs. compatibility Open vs. closed Key tactics and assets Various examples

41. Standard Wars Battle between rival technologies to becomerecognized standard Winner-take all standards sometimes leads to winnertake all firms Large benefits to having your technology become astandard one key method of strategic control control how different products interact with each other Thus firms invest a lot of money and time to make (ortry to make) their technology a standard First key issue is performance vs. compatibility

42. CompatibilityPerformanceEvolutionRevolutionImproved designand adaptationPerformance/Price Versus Compatibility(as compared to existing technology)

43. Types of Standards Wars: Degree ofCompatibility with Existing TechnologyCompatibleIncompatibleCompatible IncompatibleRevolutionVersusEvolutionRivalRevolutionsEvolutionVersusRevolutionRivalEvolutionsRival TechnologyYourTechnologySource: Shapiroand Varian

44. Types of Standards WarsCompatibleIncompatibleCompatible IncompatibleNew versions ofmobile phonestandards (e.g.,4G), video gameplayers (until recently)Rival TechnologyYourTechnologyNew versions ofDVDs, modems,fax machinesNewVersions ofWindows vs.LinuxNewVersions ofWindows vs.Linux

46. Closed versus Open Strategy Closed Strategy Do not release specifications about interface standards Control everything about interface standards Open Strategy Release specifications about interface standards Work with other firms Tradeoff between degree of openness & control must be open to obtain users and obtain cooperation fromproducers of complementary products due to importance ofnetwork effects as degree of openness increases, unit profits may decline

47. Degree of Openness (Two Definitions)In Specifications Do not release any specificationsand make all hardware andsoftware (most closed) Only make software or hardware Release some information about keyinterfaces Release all information but controlupdates Fully open standard and standardsetting processNumber of Firms One firm controlsstandard (mostclosed) Members of alliancecontrol standard All firms have accessto standardIncreasing Openness

48. MerchantMerchant(98%)ConsumerVisa,MasterCardAcquirer(0.4%)ConsumerIssuer(e.g., Banks)AmericanExpress,Discover1 (Shop)2 33223Bill/Pay1 (Shop)3 2Bill/PayClosed-Loop SystemOpen-Loop System2: Authorization3: Settlement (interchange fee in this case is 1.4% and merchant discount is 1.8%)TogetherShare 1.4%Credit Cards(example of greater openness with more firms): Visa and Master Card enabledacquirers and issuers to sign up merchants and consumers, i.e., more open

50. Key Tactics in Standards Wars Preemption Announcing a product or service before it is ready in order toreduce interests in a competitors products or services Expectations management Assemble allies Convince large companies or governments to support yourservice and then everyone expects you to win Governments (e.g., European governments in case of GSM) Large corporations in case of video and software formats Discounting the service for a specific set of users or providers ofcomplementary services (previously discussed) Document readers (Adobe) Video and music players

51. Key Assets in Standards Wars For benefitting from network effects Control over an installed base of users Microsoft in operatingsystems First-mover advantages Apple, Google, Samsung For convincing other firms to align their technology withyour technology or users to adopt your technology Strength in complements Samsung, Apple Brand name and reputation Apple, Google, Samsung For benefiting from technology being part of standard Intellectual property rights Qualcomm in phones For reducing need to have your technology in standard Ability to innovate Apple Manufacturing capabilities Japanese firms previously hadadvantages

53. Standards Battle in the US Railroad Gauges Although some governments chose the width of the railroadgauge (e.g., Japan, Europe), the U.S. government did not By accident different size gauges (width of rail line) were usedin different parts of the U.S. In 1860 (beginning of U.S. North-South Civil War) 50% of rail gauge was 4 feet 8 inches (the northern states) 50% was 5 feet (the southern states) No real issues of openness (all were open) orcompatibility/performance comparison with previoustechnology Key issue was network effects and winner take all North built railroad to west during and after Civil War Network effects caused 4 feet 8 inch gauge to win and Southchanged all of its railroad lines to 4 feet 8 inches

54. Color Television U.S. Government chose RCAs (owned NBC) technology as black-and whitestandard in 1940 Initially chose CBSs technology as color standard in 1951 But CBS technology was not backward compatibilitywith B&W TVs And manufacturers refused to make color TVs RCA proposed color TV standard that was compatiblewith B&W TV U.S. government changed to RCA technology in mid-1950s But took many years (until 1968) for color TVs sales topass those of B&W TVs issue of critical mass

55. Color Television (continued) Openness versus control Both CBS and RCA licensed their technology (similaropenness) Choice of RCAs technology provided it with importantlicensing fees and temporary manufacturing advantages Compatibility and Performance Performance advantages of first color TVs did not make upfor lack of compatibility with B&W TVs

56. Video Cassette Recorders (VCRs) Ampex introduced first VCR in mid-1950s for broadcasters Many firms (including Japanese ones) introduced simpler andcheaper VCRs (Helical design) for training etc. in mid-1960s Reductions in price created consumer market in early 1970s Consumers used them to record television programs Pre-recorded movies did not have strong sales until early 1980s Sony and Matsushita/JVC introduced incompatible systems inmid-1970s Sonys (Betamax) system appeared first and achieved early lead in sales But Matsushita/JVCs system (VHS) had longer recording times and moremanufacturers Sales of VHS units passed Beta in 1977, Beta discontinued in mid-1980s

57. Video Cassette Recorders - continued Network Effects they emerged as pre-recorded movies became available; thiscaused winner take all for VHS However, since recording television programs drove diffusion ofVCR, network effects did not initially apply to VCRs Compatibility and Performance Backward compatibility with Ampex Quadruplex was irrelevantas only broadcasters used Quadruplex But many argue performance advantage of VHS (longerrecording time) led to its greater diffusion than Betamax Openness versus control Others argue that VHSs greater openness (JVC/Matsushitalicensed more producers of hardware) was key to success

58. Personal Computers Initial competition First PC released in 1975 Apple, Commodore, Tandy released PCs in 1977 Apple and CP/M compatible (OS) machines were leaders by1978 Apples machine used proprietary technology such as OS IBM PC IBM introduced open-modular product in 1981 that usedexternal technology (e.g., Microsoft and Intel) that issummarized on the next slide

59. IBMs PC included: Operating System from Microsoft Hybrid 8- and 16-bit microprocessor from Intel 8-bit capability provided compatibility with software writtenfor CP/M OS 16-bit capability enabled software superior to that used inApple computer: Word Perfect replaced Word Star in wordprocessing software, Lotus 1-2-3 replaced VisiCalc inspreadsheets But other manufacturers introduced clones Microsoft (and Intel) became big winners throughcontrol of key interfaces. Subsequently, they haveintroduced products that are backward compatible

60. Personal Computers - continued Network Effects Increased in importance following release of IBM PC Openness versus control Openness of IBM machine contributed to its success But openness enabled Microsoft, Intel to become big winners Lessons: IBM should have pursued more closed policy Apple should have pursued more open policy Compatibility and performance IBM PC was not compatible with previous generations ofcomputers (but compatible with some previous PCs) But for many users IBM PC was superior in terms ofperformance-price ratio to mainframe and mini-computers

61. Outline (and Learning Objectives) What are standards and complex systems? How are standards chosen? What are network effects? What is a critical mass of users? What are standards wars and what impact do theyhave on competition? Key issues: Performance vs. compatibility Open vs. closed Key tactics and assets Various examples (mobile phones)

62. Mobile Phones (1) First systems introduced in 1920s for police, taxi, fire,military, etc.; public systems introduced in 1950s Single transmitter/receiver restricted number of users Dividing system in cells and reusing frequencyspectrum in each cell increased system capacity andreduced the cost First cellular systems introduced in late 1970s inScandinavia and later in U.S. interface standards determined interaction between basestations and phones U.S. standard (AMPS) became global standard

63. Mobile Phones (2) Digital services first introduced in 1991 (GSMstandard) First successful mobile Internet service in 1999 inJapan required many different standard standards Compatibility between different standards and thus integraldesign As processing power and memory capacity increased, itbecame possible to design phone systems and phones in a modular way use interface standards from PC Internet and now we have the iPhone and the Google phone

64. Lets look at the history of the mobile phone industryin more detail

65. BatteriesKey Interface Standard in Mobile Phone IndustryPhoneManufacturersDisplaysInterface defined by air-interfacestandards such as GSM and CDMAChipsSoftwareOperatorsBase StationsSwitching EquipmentNetwork SoftwareRetail CustomerSource: Adapted from (Steinbock, 2003; Peppard and Rylander, 2006)

66. Type ofMobileDates Generation ofTechnologyGlobalStandard(s)Singletransmitter/receiverEarly 1900s Wireless Telegraph Not applicableFrom 1920s Wireless Voice(police, military)Not applicableCellular 1970s,1980s1GAnalogAMPS (U.S.)1980s, early1990s2G Digital GSM (Europe)Late 1990s 3G W-CDMA2000s Mobile Internet PC Internet-basedstandardsEvolution of Technology and Standards in Mobile Phones

67. Competition Between 2G Digital Phone Systems Europe Countries agreed to develop single standard in 1987 Began awarding new licenses in 1989 Non-European countries began adopting GSM in early 1990s Services started in 1992 U.S. Finalized specs for standard (D-AMPS) in 1989 But no new licenses! And incumbents didnt invest in digital Alternative from Qualcomm later emerged and U.S. governmentallowed service providers to use any standard Japan NTT DoCoMo created the Japanese standard in cooperation onlywith Japanese manufacturers (i.e., no openness!)

68. CompatibilityPerformanceEvolutionRevolutionImproved designand adaptationQualcomms Technology (CDMA) vs. GSM in late 1990sQualcommGSM updates

69. Qualcomms CDMA Technology Successful IP strategy Charges the same licensing fee for use of its patents in both its3G CDMA (e.g., cdma2000) technology and the most widelyused version of CDMA technology (W-CDMA) Qualcomm makes lots of money Unsuccessful standards strategy W-CDMA is much more widely used than Qualcomms 3Gtechnology Qualcomms partners (Motorola, Lucent, Nortel) have lostsignificant share of the infrastructure market because of the lackof success in Qualcomms 3G technology

70. New Standards Continue to Emerge Network standards (between base station and phone) 4G Cognitive Radio WiFi WLAN Content and Application related standards 2D Bar Codes Payments and tickets (Wallet Phones) 3D content Operating System (which connects applications with content) We will talk about operating systems next week

71. Conclusions (1) Interface standards technically define interfacesbetween different modules or building blocks incomplex systems Relatively open standards facilitate verticaldisintegration and thus new types of scope ofactivities But small amounts of control can lead to high profitsfor some firms Thus monitoring, participating and succeeding instandards are critical issues in defining businessmodels

72. Conclusions (2) The choice of standards is not just due to technicalperformance (intrinsic value) but also due to networkeffects (favors early installed base) Levels of openness and backward compatibility, andother tactics that lead to an early installed base (i.e.,network effects) are also important degree of network effects can differ dramatically among productsand systems strong network effects can lead to early leader becomingstandard very strong network effects can lead to high switching costs

73. Conclusions (3) Although different types of standards require differenttypes of strategies, degree of openness and compatibilityplay critical roles in all standard setting Openness increases chance of adoption but may decrease profits Backward compatibility also increases chances of adoption Performance advantages can overcome backwardincompatibility (i.e., there is a tradeoff between performanceand compatibility) Who pays and how much (methods of value capture) are criticalin building a critical mass of users for your system/product andthe standards included in the system/product