Chapter 4 STANDARDS BATTLES AND DESIGN DOMINANCE Strategic Management of Technological Innovation Melissa Schilling Chapter 4 STANDARDS BATTLES AND DESIGN DOMINANCE

The Rise of Microsoft In 1980, Microsoft didn’t even have a personal computer (PC) operating system – the dominant operating system was CP/M written and sold by Gary Kildall through his company Digital Research As the market for personal computers grew and IBM realized they were missing out on what might be a significant industry, they rushed to get a PC to market. Kildall, for some unclear reason, did not get back to IBM fast enough so they turned to Bill Gates who was already writing software for IBM. Gates bought an operating system from Seattle Computer Company and called it MS DOS. It was a clone of CP/M. The success of the IBM PCs (and clones of IBM PCs) resulted in the rapid spread of MS DOS, and an even more rapid proliferation of software applications designed to run on MS DOS. Microsoft’s Windows was later bundled with (and eventually replaced) MS DOS. Had Gary Kildall signed with IBM, or had other companies not been able to clone the IBM PC, the software industry might look very different today!

The Rise of Microsoft Discussion Questions: What factors led to Microsoft's emergence as the dominant personal computer operating system provider? Is Microsoft's dominance due to luck, skill, or some combination of both? How might the computing industry look different if Gary Kildall had signed with IBM? Does having a dominant standard in operating systems benefit or hurt consumers? Does it benefit or hurt computer hardware producers?

Overview Many industries experience strong pressure to select a single (or few) dominant design(s). Once selected, producers and customers focus their efforts on improving their efficiency in manufacturing, delivering, marketing or deploying this dominant design rather than continue to develop and consider alternatives There are multiple dimensions of value that shape which technology rises to the position of the dominant design. The strategies of firms can influence several of these dimensions, enhancing the likelihood of their technologies rising to dominance.

Why Dominant Designs Are Selected Increasing returns to adoption When a technology becomes more valuable the more it is adopted. The more they are used, the more they are understood and thus improved Revenues generated can be used to further develop and refine the technology As a technology becomes more widely adopted, complementary assets are often developed that are specialized to operate with the technology This results in a self-reinforcing mechanism that increases the dominance of a technology regardless of its superiority or inferiority to competing technologies

Why Dominant Designs Are Selected Two primary sources of increasing returns to adoption are learning effects and network externalities. The Learning Curve: As a technology is used, producers learn to make it more efficient and effective often with reduced input costs or waste rates The cost of producing a unit falls as the number of units produced increases. This pattern has been found to be consistent across a wide range of products and services including automobiles, ships, semiconductors, drugs and even heart surgery techniques

Why Dominant Designs Are Selected Prior Learning and Absorptive Capacity A firm’s prior experience influences its ability to recognize and utilize new information. Use of a particular technology builds knowledge base about that technology Even failures can provide a useful learning experience and build a base of knowledge for future use The knowledge base helps firms use and improve the technology Suggests that technologies adopted earlier than others are likely to become better developed, making it difficult for other technologies to catch up. As a technology becomes more widely adopted, complementary assets are often developed that are specialized to operate with the technology This results in a self-reinforcing mechanism that increases the dominance of a technology regardless of its superiority or inferiority to competing technologies

Why Dominant Designs Are Selected Network or Positive Consumption Externalities In markets with network externalities, the benefit from using a good increases with the number of other users of the same good. Network externalities are common in industries that are physically networked e.g., railroads, telecommunications Network externalities also arise when compatibility or complementary goods are important e.g., many people choose to use Windows in order to maximize the number of people their files are compatible with, and the range of software applications they can use.

Why Dominant Designs Are Selected A technology with a large installed base attracts developers of complementary goods; a technology with a wide range of complementary goods attracts users, increasing the installed base. A self-reinforcing cycle ensues Example of the cycle: Microsoft’s dominance of the OS market and GUI market is due to the early adoption of their product which led to a large installed base and the development of complementary products. This further increased the installed base and reinforced the cycle.

A Standards Battles in Digital Audio Formats Theory In Action A Standards Battles in Digital Audio Formats 1982:Sony and Phillips jointly developed the CD that replaced the vinyl LP and split the royalties Late 1990s: CD market was saturated, looking for new audio format for continued growth of the market and prevent music piracy 1996: record companies and electronics companies joined together to form the DVD Audio Consortium to create a new high-fidelity audio format. 1999: Sony and Philips unveiled their own high-fidelity audio format, Super Audio CD, setting the stage for a standards battle similar to the VHS versus Beta battle in video recorders. Fearing a format war that would select one standard as dominant (and one as failed), many manufacturers decided to bear the extra cost of producing “Universal players” that would support both formats. Neither format has been extremely successful, and popularity of MP3 format may further dampen demand.

Why Dominant Designs Are Selected Government Regulation Sometimes the consumer welfare benefits of having a single dominant design prompts government organizations to intervene, imposing a standard. 1953: FCC approved the NTSC color standard in television broadcasting to ensure compatibility to monochrome TV sets broadcasting in the U.S. 1998: EU adopted a single wireless telephone standard the general standard for mobile communications (GSM) to avoid proliferation of incompatible standards and facilitate exchnage within and between members countries The Result: Winner-Take-All Markets Natural monopolies Firms supporting winning technologies earn huge rewards; others may be locked out.

Why Dominant Designs Are Selected Increasing returns to adoption indicate that technology trajectories are characterized by path dependency: End results depend greatly on the events that took place leading up to the outcome. Early technology offerings may become entrenched and block subsequent superior technologies from being accepted Aggressive sponsorship by a large and powerful firm may ensure acceptance but lock out alternatives A dominant design can have far-reaching influence; it shapes future technological inquiry in the area. Firms will tend to use and build on their existing knowledge base rather than enter unfamiliar areas Winner-take-all markets can have very different competitive dynamics than other markets. Technologically superior products do not always win. Such markets require different firm strategies for success than markets with less pressure for a single dominant design. Winners know how to manage the multiple dimensions of value that shape design selection

Multiple Dimensions of Value In many increasing returns industries (the rate of return from a product or process increases with the size of it’s installed base), the value of a technology is strongly influenced by both: Technology’s Standalone Value Network Externality Value A Technology’s Stand-alone Value Includes such factors as: The functions the technology enables customers to perform Its aesthetic qualities Its ease of use, etc. Kim and Mauborgne developed a “Buyer Utility Map” that provides a guide for managewrs to consider multiple dimensions of technological value and multiple stages of the customer experience The benefits have to be considered with respect to the cost to the customer of obtaining or using the technology – the benefits to cost ratio determines value

Multiple Dimensions of Value

Multiple Dimensions of Value Network Externality Value In industries characterized by network externalities, the value of technological innovation to users will be a function not only of its stand-alone benefits and cost, but also of the value created by: The size of the technology’s installed base The availability of complementary goods A new technology that has significantly more standalone functionality than the incumbent technology may offer less overall value because it has a smaller installed base or poor availability of complementary goods. Value to customers of Windows OS is due to stand-alone value (makes it easy use computer), the installed base (number of users you can interact with) and availability of compatible software. This is what makes it difficult for OSs that are better than Windows to gain a foothold in the market NeXT Computers were extremely advanced technologically, but could not compete with the installed base value and complementary good value of Windows-based personal computers. They were not compatible with Wintel machines which had become the standard.

Multiple Dimensions of Value To successfully overthrow an existing dominant technology, new technology often must either offer: Dramatic technological improvement (e.g., in videogame consoles, it has taken 3X performance of incumbent) Greater stand-alone value is not enough, needs greater overall value see Fig 4.4(b) Compatibility with existing installed base and complements see 4.4(c) Super Audio CD (SACD) from Sony and Philips is a new audio format based on Direct Stream Digital technology. It is much better than standard CD technology but they made it backward compatible so that people would not have to throw out their existing CDs when they buy the new player and the new disks can be played on old CD players as well Thus they maintained compatibility with the existing installed base and complementary goods

Multiple Dimensions of Value

Multiple Dimensions of Value When comparing the value of a new technology to an existing one, users are weighing a combination of: Objective information; actual benefits, installed base and complementary goods Subjective information: perceived benefits, base and complementary goods Expectations: anticipated benefits, base and complementary goods These three may be proportional or not For example, perceived installed base may be greater than actual. How is this accomplished? Marketing, stretching the truth, vaporware When Sega and Sony introduced their 32-bit video game consoles, Nintendo was far from having one in production. Instead, Nintendo began promoting the development of a 64-bit system in 1994 even though it didn’t appear until 1996. But many customers believed Nintendo and held off buying the 32-bit systems. Post mortem: Sony developed the PlayStation2 with more than 2x the processing power of the Nintendo 64, made it backward compatible, made sure there was a large supply of game titles available at launch, marketed it as if it would the product everyone would by and sold it at a very low price. Nintendo never regained market dominance

Multiple Dimensions of Value Actual, Perceived and Expected Components of Value

Multiple Dimensions of Value When customer requirements for network externality value are satiated at lower levels of market share, more than one dominant design may thrive. This may be the case in the video game console industry. While a larger market share may increase network externalities so that customers have more games and more people to play against, those benefits can be achieved without attaining a majority of the market Sony has a majority share of the US video game market and neither Nintendo’s GameCube nor Microsoft’s Xbox has greater than a 20% market share Yet, there is still an abundance of game titles for all three consoles and a significant pool of people to play games against Such markets may not experience great pressure to select a single dominant design; ,multiple platforms may successfully exist

Are Winner-Take-All Markets Good for Consumers? Economics emphasizes the benefits of competition. However, network externalities suggest users sometimes get more value when one technology dominates. Some would argue that Microsoft has clearly engaged in anticompetitive behavior in its quest to dominate the PC operating system market, others would counter that it’s overwhelming market share has created greater compatibility among computers and software applications. How can a regulatory board determine if a firm has become too dominant? One way is to compare the network externality returns to market share (value customers reap by more people using the same product) with corresponding monopoly costs (benefits form gets when their product is dominant)

Are Winner-Take-All Markets Good for Consumers? Network externality benefits to customers rise with cumulative market share Greater availability of complementary goods More compatibility among users More revenues that can be channeled into further developing the technology Monopoly costs to customers also rise with cumulative market share Price gouging Restricted product variety Product innovation may be stifled or purposely delayed

Are Winner-Take-All Markets Good for Consumers? Network externality returns to market share often exhibit an s-shaped curve Monopoly costs to market share are exponentially increasing The two costs trade off against each other Where monopoly costs exceed network externality benefits, intervention may be warranted. Optimal market share is at point where lines cross. A firm can choose not to charge the highest price the market will bear – some say that Microsoft does not charge the maximum price for Windows OS but they are able to control the evolution of the market by selectively aiding some suppliers or complementors more than others

Discussion Questions 1.   What are some of the sources of increasing returns to adoption? 2.   What are some examples of industries not mentioned in the chapter that demonstrate increasing returns to adoption? 3.   What are some of the ways a firm can try to increase the overall value of its technology, and its likelihood of becoming the dominant design? 4.   What determines whether an industry is likely to have one or a few dominant designs? 5.   Are dominant designs good for consumers? Competitors? Complementors? Suppliers?