MIT641 Information Economics session 8 Network Externality

MIT641 Information Economics

session 8Network ExternalityNetwork Externality

Dr Sittiphol Viboonthanakul

Business for Rural Education and Development

[email protected]

1

Network Externalities

• What are externalities?

• Externalities are common in every area of

economic activity.

• They are defined as third party (or spill-• They are defined as third party (or spill-

over) effects arising from

the production and/or consumption of goods

and services for which no appropriate

compensation is paid.

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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 • 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

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Externalities

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

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E.G. Negative Externalities

• โรงงานอตุสาหกรรมก่อมลพิษ

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E.G. Positive Externalities

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Industry Economics vs Information Economics

• Oligopolies: A few large firms dominated their

market.

• Concentration ratio or Herfindahl-Hirschman Index (HHI)Index (HHI)

• Driven by economies of scale.

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Industry Economics vs Information

Economics

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UK industries with the highest five-firm concentration ratios include the following:• Sugar: 99%

• Tobacco products: 99%

• Gas distribution: 82%

UK industries with the lowest five-firm concentration ratios include the following• Metal forging, pressing etc.: 4%

• Plastic products: 4%

• Furniture: 5%• 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%

• Furniture: 5%

• Construction: 5%

• Structural metal products: 6%

• Wholesale distribution: 6%

• General purpose machinery: 8%

• Wood and wood products: 9%

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C4 Scores for the Search Engines, 2004 – 2011

Source: Experien Hitwise Canada. “Main Data Centre: Top 20 Sites & Engines.” last Accessed October 11, 2012. http://www.hitwise.com/ca/datacenter/main/dashboard-10557.htm

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• Information economy: temporary monopolies

• Driven by economies of networks.

• Economies of networks create market

dynamics and competitive strategy.dynamics and competitive strategy.

• Key concept: positive feedback

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Networks and Positive Feedback

• Why is positive feedback so important in high-

technology industries?

• Positive feedback makes the strong grow

stronger, and the weak grow weaker.stronger, and the weak grow weaker.

– Network of ATM, E-mail users, game

– Similar to physical network, e.g airport

– Same computer network: use the same software

and share the same files

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• 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 scaleDemand-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.

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More popular

More new Bigger More new people using

Attract new customer

No out of date, always

have new version

Bigger network

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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 • 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.

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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 1985

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Positive Feedback

• Positive feedback systems follow a predictable

pattern.

– Flat during launch

– A steep rise during positive feedback takes off

Saturation is reached– Saturation is reached

• Same to the spread of

viruses.

• Fax machine, colour TV, EMAIL.

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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.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.

http://blogs.wsj.com/, 2012

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• Small cost of development compared to the network

value.

• Demand-side economies of scale works when

markets get large enough.markets get large enough.

Feedback and Expectation work.

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• In the information economy, the lion’s share of

the rewards go to the winner, not the number

two player.

• “Double Whammy”• “Double Whammy”

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• Positive network externalities give rise to

positive feedback

• Fax machine: when I buy fax machine � your

fax machine value?fax machine value?

• Matcalfe’s Law: The value of a network goes

up as the square of the number of users

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• Matcalfe’s Law:

• n = number of people in a network

• The value of network to each person is

proportional to the number of other usersproportional to the number of other users

• Then, the total value of the network equals

nnnn −=−×2)1(

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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 • 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.

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Collective Switching Cost

• QWERTY keyboard (Type Writer Brand, 1870s)

• AOEUIDHTNS keyboard (Dvorak layout, 1932)

• Individual switching cost vs Collective

switching costswitching cost

• Coordination cost

• Which one will you buy? Why?

– Human component

– To acquire marketable skill

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Is your industry subject to positive feedback?

• Is your industry subject to positive feedback?

• HDTV

• IBM-compatible personal computers.

• Digital Goods

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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 for you to launch a new product or

technology?

• How can you overcome collective switching

cost and build a new network of users?

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• Two approaches

• Evolution strategy of compatibility

• Revolution strategy of compelling

performanceperformance

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Evolution

• Evolution

– When compatible is critical

– Offer customers an easy migration path

– Reduce switching cost– Reduce switching cost

– Risk: leave an opening for a competitor to come in

• Two Obstacles

– Technical

– Legal

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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 itto it

• Letter � Fax � email

• 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

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Openness versus Control

• Open approach: offering to make the

necessary interfaces and specification

available to others

• Control approach: keeping your system • Control approach: keeping your system

proprietary

• Which one is better?

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• Openness or Control

• Depends on whether you are strong enough

to ignite positive feedback on your own.

• Strength in network• Strength in network

– Existing market position

– Technical capabilities

– Control of intellectual property

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• Goal: to maximize the value of your

technology, not your control over it.

Your reward = Total value added to industryx Your share of industry valuex Your share of industry value

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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


• 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.

• 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

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• Control

• Only those is the strongest position who can

strongly control.

• Market leader• Market leader

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Generic Strategies in Network Market

• For companies seeking to introduce new

information technology into marketplace

• Two basic trade-off

• Trade-off between performance and • Trade-off between performance and

compatibility (Revolution and Evolution)

• Trade-off between openness and control

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Generic Network Strategies

Control Openness

Compatibility Controlledmigration

Open migration

Performance Performance play DiscontinuityPerformance Performance play Discontinuity

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Performance Play

• Boldest and riskiest

• Introduce a new, incompatible technology

over which the vendor retains strong

proprietary control.proprietary control.

• Technology has to offer users substantial

advantages over existing technology.

• Nintendo (vs Palm Pilot)

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Controlled migration

• Offer a new and improved technology that is

compatible with their existing technology, but

under controlled.

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Open migration

• Very friendly to consumers

• Little switching costs

• Each new generation conforms to an agreed-

upon standard and link smoothly with earlier upon standard and link smoothly with earlier

generations of machines.

• Fax machines, Modems

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Open migration

• Open migration makes the most sense if your

advantage is primarily based on

manufacturing capabilities

• You get benefit from the larger total market • You get benefit from the larger total market

and an agreed upon set of specifications.

• Allow your manufacturing skills and scale

economies to shine.

• Hewlett-Packard, Hua-wei

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Discontinuity

• A new product or technology is incompatible

with existing technology

• But available from multisuppliers

• CD audio system, and the 3 ” floppy disk• CD audio system, and the 31/2” floppy disk

• Similar to open migration, suppliers of

technology should be efficient manufacturers

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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 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)

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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)

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• Positive feedback

• A predictable pattern

• Value of network depends on the number of users � positive feedback and expectation 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

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Documents

MIT641 Information Economics session 8 Network Externality