Network Effects and Standards in Business
Network Effects and Standards
Network effects exist for good A if each user’s utility from A increases with the total number of users of A. There are two types:
- Direct: A user’s utility depends directly on the number of other users, without any other good involved.
- Indirect: A growing number of A-users leads to an increased offer of complements B, which indirectly increases each user’s utility.
Network Utility with N Users
- Cartier: Utility per user decreases with the increase of users; total utility increases weaker than linearly and may be falling.
- Telephone: Utility per user increases with the increase of users; total utility increases stronger than linearly.
Network externality: The larger the installed base of users, the more attractive the good is for prospective new users (positive feedback).
The Product Life-Cycle Curve
The life-cycle curve is a diffusion curve that relates to the life-cycle of the product. It relates sales or profit over time. The life cycle of a product has four phases:
- Introduction
- Growth
- Maturity
- Decline
It seems most attractive for firms to feature their products during the growth phase. The life-cycle may refer to a specific product or product category.
Problems:
- Little predictive power in the length of the phases.
- Competitive and market aspects are not taken into account.
Benefits:
- Illustrates market dynamics.
- Increases alertness to signals of phase changes.
The Role of Expectations
Managers’ expectations are important in product preannouncement. There is also a risk as products being announced but never, or later, reaching the market. Managers need to avoid coordination problems.
Standards
A standard is a set of specifications which products must satisfy in order to generate network effects. Products are compatible when they belong to the same standard. A system is a group of mutually compatible products.
Communication not standardized: Standardization cost = 0 + Conversion cost > 0
Communication standardized: Standardization cost > 0 + Conversion cost = 0
Proprietary vs. Open Standards
If Firm F has developed a new technology or standard, questions emerge:
- For control: Market power, lack of alternatives, products must be profitable. The risk is that it is a “big piece of a small cake.”
- For open standard: The product is complementary to other products, and fast and wide adoption is important. The risk is that it is a “small piece of a large cake.”
Other than Network Effects
Scale Effects
Positive feedback: The more buyers so far, the better for future buyers. A positive effect is the reduction of cost.
Lock-in
A situation where an investor is unwilling or unable to exit a position because of the regulations, taxes, or penalties associated with doing so. This may be an investment vehicle, such as a retirement plan, which can’t be accessed until a specified retirement date.
Market Entry
Get the bandwagon rolling through raising expectations, pushing initial adoption (discounting, advertising), and creating certainty regarding the standard.
Compatibility Play
An evolutionary strategy with limited improvement of performance, a large installed base to which a premium version of the product can be offered, ensures that the complements available can further be used, and high switching costs.
Performance Play
A revolutionary strategy with striking technological improvement, no large installed base needed, but many new customers expected, a weak competitive position, and pioneer advantages with a new standard.