Networks and Positive Feedback

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Networks and Positive Feedback

• John Morgan

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Important Ideas

• Positive feedback
• Network effects
• Returns to scale
• Demand side
• Supply side

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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

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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

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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

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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.

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Analysis

• Standalone values were 10,9,8,,1

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Analysis

• vn p marginal user wants to adopt
• n10-v everyone with greater value than marginal
  user adopts
• Combine to give demandsupply condition
• (10-n)np
• n1, (10-1)19
• n2, (10-2)216
• n3, (10-3)321 n9, (10-9)99
• Takeoff occurs when p9

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Adoption Dynamics
Saturation
Number of Users
Takeoff
Launch
Time
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Network Effects

• Demand side economies of scale often referred to
  as network effects
• Real networks telecom
• Virtual networks network of users
• Metcalfes Law Value of network of size n
  proportional to n2
• Experiment is an example of this

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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

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Virtuous Cycles and Death Spirals 1-2-3 v
Visicalc
Value to User
Virtuous cycle
Death spiral
Number of Users
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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

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Are All Information Markets Tippy?

• AOL
• Dell
• Google
• What are the key drivers of network effects?

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Network EffectsLikelihood of Tipping
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Chicken Eggs

• Fax and fax machines
• VCRs and tapes
• DVDs A more complicated problem
• Online dating

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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

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Compatibility versus Performance
Compatibility
Evolution
Revolution
Performance
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Evolution

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

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Important Considerations

• Use creative design for migration
• Think in terms of whole system

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Compatibility versus Performance
Compatibility
Migration sweet spot
Evolution
Revolution
Performance
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Technical Obstacles

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

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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

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Revolution

• Groves law 10X rule
• But depends on switching costs
• Examples Nintendo, Iomega Zip, DVD, CD

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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

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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

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Control

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

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Generic Strategies
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Performance Play

• Introduce new, incompatible technology
• Examples
• Palm Pilot
• Iomega Zip
• Your examples
• Attractive if
• Great technology
• Outsider with no installed base nothing to
  cannibalize

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Controlled Migration

• Compatible, but proprietary
• Examples
• Windows 98
• Pentium
• Upgrades to every product
• Your examples
• Some vulnerability to entry since have to pay
  switching cost anyway

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Open Migration

• Many vendors, compatible technology
• Examples
• Fax machines
• Some modems
• Your examples

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Discontinuity

• Many vendors, new technology
• Examples
• CD audio
• 3 1/2 disks
• Your examples

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Historical Examples ofPositive Feedback Effects

• RR gauges
• AC v. DC
• Telephone networks
• Color TV

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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

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Lessons, continued

• Fundamental tradeoff openness and control
• Generic strategies
• Performance play
• Controlled Migration
• Open Migration
• Discontinuity
• Lessons of history