Networks and Positive Feedback

1. Networks and Positive Feedback John Morgan

2. Important Ideas • Positive feedback • Network effects • Returns to scale • Demand side • Supply side

3. Positive Feedback • How system adjusts to perturbations • Negative feedback: stabilizing • Positive feedback: destabilizing • Positive feedback makes a market “tippy” – winner take all • Examples: VHS v. Beta, Wintel v. Apple, 56k modems, DVD v DivX • “Winner-take-all markets”

4. Sources of Positive Feedback • Supply side economies of scale • Declining unit cost of supply • Marginal cost less than average cost • Example: information goods are all fixed cost • Demand side economies of scale • Increasing value to users as market share increases • A single standard: fax, email, Web • Competing standards: VHS v. Beta, Wintel v. Apple, 56k modems, Codec “standards” in Digital Audio

5. Color fax machine • You have a new technology for color fax machines • License it to many sellers • Technology can only be used by sender if receiver has color fax machine • So there is a strong network effect---value to user of technology depends on number of adopters

6. Setup • Indicate your adoption of the technology by standing up • The number on your card shows that value v (to you) of adopting if you are the only adopter • In n people (including you) adopt, your value is nv • I will write the price of the fax machine on the board • Adopt when your value (strictly) exceeds the price.

7. Analysis • Standalone values were 10,9,8,…,1

8. Analysis • vn = p : marginal user wants to adopt • n=10-v :everyone with greater value than marginal user adopts • Combine to give demand=supply condition • (10-n)n=p • n=1, (10-1)1=9 • n=2, (10-2)2=16 • n=3, (10-3)3=21… n=9, (10-9)9=9 • Takeoff occurs when p=9

9. Adoption Dynamics Saturation Number of Users Takeoff Launch Time

10. Network Effects • Demand side economies of scale often referred to as network effects • Real networks – telecom • Virtual networks – network of users • Metcalfe’s Law: Value of network of size n proportional to n2 • Experiment is an example of this

11. Expectations Matter • What is the difference between success and failure in tippy markets? • Expectations Matter: • I want to join network that I expect to succeed • Central part of successful marketing is setting appropriate expectations • Commitment can help • Old economy example: Banks • New economy example: Microsoft version 1.0 products

12. Virtuous Cycles and Death Spirals: 1-2-3 v Visicalc Value to User Virtuous cycle “Death spiral” Number of Users

13. Direct and indirect Network Effects • Value to me depends directly on number of adopters • Fax machine, telephone, email • Value to me depends on adoption of some complementary product • DVD player/ DVD disks • eBook reader + content • Palms and software

14. Are All Information Markets “Tippy”? • AOL • Dell • Google • What are the key drivers of network effects?

15. Network Effects–Likelihood of Tipping

16. Chicken & Eggs • Fax and fax machines • VCRs and tapes • DVDs: A more complicated problem • Online dating

17. Igniting Positive Feedback • Evolution • Give up some performance to ensure compatibility, thus easing consumer adoption • Revolution • Wipe the slate clean and come up with the best product possible

18. Compatibility versus Performance Compatibility Evolution Revolution Performance

19. Evolution • Offer a migration path • Examples • Microsoft Windows • Intel • Borland v Lotus • Build new network by links to old one

20. Important Considerations • Use creative design for migration • Think in terms of whole system

21. Compatibility versus Performance Compatibility Migration “sweet spot” Evolution Revolution Performance

22. Technical Obstacles • Converters and bridge technologies • One-way compatibility or two way? • Windows for Wordperfect users • Importance of UI

23. Legal Obstacles • May need IP licensing • Example: Sony and Philips had advantage since they held the patents on CDs • DVD players usually play CDs as well

24. Revolution • Grove’s law: “10X rule” • But depends on switching costs • Examples: Nintendo, Iomega Zip, DVD, CD

25. Openness v. Control • Your reward = Total added to industry x your share • Value added to industry • Depends on product and • Size of network • Your share • Depends on how open technology is

26. Openness • Full openness • Anybody can make the product • Problem: no champion • Unix v BSD v Linux • Alliance • Only members of alliance can use • Problem: holding alliance together • Conflicting incentives: China and DVDs

27. Control • Control the standard and go it alone • If several try this strategy, may lead to standards wars • iPod/iTunes v MP3 players

28. Generic Strategies

29. Lessons • Positive feedback means strong get stronger and weak get weaker • Consumers value size of network • Works for large networks, against small ones • Consumer expectations are critical • Fundamental tradeoff: performance and compatibility

30. Lessons, continued • Fundamental tradeoff: openness and control • Generic strategies • Performance play • Controlled Migration • Open Migration • Discontinuity • Lessons of history