Lab 5: Modeling Network Effects 1

INT XXX – Business Dynamics and System Modeling Pard Teekasap (DBA Candidate, MM, BEng)

Lab 5: Modeling Network Effects1 10 Points

Assigned: Nov 21, 2009; Due: Nov 28, 2009

denotes a question for which you must hand in an answer, a model, or a plot

denotes a fact that you will want to include in the model under discussion

denotes a tip to help you build the model or answer the question

Based on the previous lab assignments, you should understand the effect of positive and negative feedback loop on the behavior of the system and able to create a basic model to represent the systems with those feedback. In this lab assignment, you will be able to illustrate the path dependency phenomenon by putting multiple positive and negative loops together. Path dependency is situation when small difference or microscopic noise creates winners and losers of the game. We will start with the basic network effects model and then apply it to the case of VHS and Betamax.

A. Model of Network Effects

The simple network effects model shown in section 10.8 of the Business Dynamics book is one example of the path dependency model. In this lab, you will test the behavior of the system under different condition.

The model shown in Figure 10-23 is in the CD that comes with the textbook. You can choose to use the built model or create it yourself. Although the last option is the most

                                                            1 Developed from the Challenge section at the end of Chapter 10 of “Business Dynamics: Systems Thinking and Modeling for a Complex World” by John Sterman

Lab 5: Modeling Network Effects 2

time-consuming, it can also be the most valuable as going through the model-building process enables you to better understand the model and its formulations. If you choose the build-from-scratch approach, you must compare your model listing with that of the model in the CD before you proceed with the assignment in order to make sure you have the complete and correct version of the model, with the identical variable names and formulations that appear in the original model.

Start the simulation at time 0

The parameters for the model are presented in Table 10-2. However, you should eliminate the random shocks by setting the stand deviation of random effects on attractiveness to zero

A1. (1 point) Suppose firm 1 attempts to gain initial advantage by seeding the marketplace with some free units, so that at the start of the simulation the installed base of firm 1 is 10,000 units, while firm 2’s initial installed base remains 1 unit.

a. Hand in the simulation plot for Product 1 and Product 2

b. What is the initial market share of firm 1?

c. What happens to market share over time, and why?

A2. (1 point) Suppose firm 2 attempts to counter firm 1’s effort to win the market by doing out 10,000 free units of its own product. However, it takes time for firm 2 to react, so the free units of firm 2’s product don’t begin to reach the market until 6 months have passed. Suppose further that it takes 1 year to distribute all 10,000 units.

To implement this policy, modify the equation for Sales of Product 2 as follow: Sales of Product 2 = Total Demand * Market Share Product 2 + Extra Sales of Product 2 *

PULSE(Extra Sales Start Time, Duration of Extra Sales) Extra Sales Start Time = 0.5 Duration of Extra Sales = 1 The PULSE function is zero until the Start Time, then takes a value of 1 for Duration time units, and return to zero thereafter.

a. Hand in the simulation plot for Product 1 and Product 2 and briefly describe the model behavior

b. Does firm 2’s policy of seeding the market with 10,000 extra units to counter firm 1’s initial 10,000 unit advantage work? Why/why not?

c. How many units must firm 2 add to its sales rate over the course of a year starting at time 0.5 to overcome firm 1’s initial advantage and win the market? Estimating this quantity to the nearest 1000 units/year is sufficient precision

Lab 5: Modeling Network Effects 3

A3. (1 point) Suppose firm 2 waits until year 5 to counter firm 1’s advantage (firm 1 starts with an initial installed base of 10,000 units and firm 2 starts with 1 unit). How many units must firm 2 now add to its installed base over the course of 1 year to overcome the lead of firm 1 and capture the market? Why? Estimating the quantity to the nearest of 10,000 units per year is sufficient precision.

A4. (1 point) What do you conclude about the optimal strategy for a firm in markets characterized by strong positive network effects? How would you implement the winning strategy? What considerations might temper or reverse this conclusion?

A5. (1 point) What other strategies besides free distribution of product might a firm use to counter the initial advantage of a rival? Give examples.

B. VHS VS Betamax

The competition between VHS and Betamax format for the market share of videocassette recorders (VCRs) is the classic example of the path dependency phenomenon. The brief situation during the fight is in section 10.3. In this assignment, you will apply the case of VHS and Betamax to the simple network effects model.

In the simple model, there is no outflow from the installed base of product. In reality, products such as VCRs and computers wear out or are replaced by improved products. Revise the model to include product discards and turnover of the installed based:

Assume the average lifetime of both products is the same and equal to 5 years. Also assume the discard process if first-order, that is, that the discard rate equals the installed base of each product divided by the average lifetime

Assume every person or household discarding the product purchase a replacement. You will therefore need to modify the equation for total demand to include the replacement demand, consisting of the sum of individual discard rates

Turn off the random shock by setting the stand deviation of random effects on attractiveness to zero

Explore the behavior of the revised model for different values of the product lifetime

B1. (1 point) Hand in the plot of the market share of firm 1, share of installed base for firm 1, and the volume of installed base for firm 2 and describe the model behavior

B2. (2 points.) What is the effect of discards on the rate at which the system locks into a standard? Explain in terms of the feedback structure

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B3. (2 points) If Firm 1 gain initial advantage (firm 1 starts with an initial installed base of 10,000 units and firm 2 starts with 1 unit), what is the effect of product lifetime on the rate at which the system locks into a standard? Explain in terms of the feedback structure