1. ©2009 Prentice Hall 12-1 MGMT 738 Management of Technology Lecture 6 Technical Standards and Network Externalities

2. Overview Many industries experience strong pressure to select a single (or few) dominant design(s). There are multiple dimensions shaping which technology rises to the position of the dominant design. Firm strategies can influence several of these dimensions, enhancing the likelihood of their technologies rising to dominance.

3. ©2009 Prentice Hall 12-3 Technical Standards Specifications that ensure that different components are compatible Permit independent companies to produce different components for the same product Standards are of particular importance to start-up firms, which generally cannot, due to capital, produce all of the components needed to make a product

4. ©2009 Prentice Hall 12-4 The Development of Technical Standards and Dominant Designs Technical standards develop because:  Of chance occurrence  One technology is superior to another  Governments mandate them  Industry trade associations or standards- setting bodies establish them  Companies take strategic action

5. ©2009 Prentice Hall 12-5 Not Always the Best Technology Industries sometimes converge on standards that are technically inferior to other alternative Often because a technology achieves a large installed base and the cost to change is too high

6. ©2009 Prentice Hall 12-6 Technical Standards and Customer Adoption Technical standards influence customer adoption because:  Customers don’t want to adopt products that might be abandoned  Customers desire compatibility, particularly for systemic products  Makes products more functional  Facilitates creation of complementary products

7. ©2009 Prentice Hall 12-7 Standards Battles Companies often battle to control technical standards because:  Products that conform to the technical standard can be sold at a premium therefore create a higher profit margin  Suppliers will have to adhere to the company’s technology, giving leverage over them, and allowing to capture a large portion of industry profits  Competitors will have to adopt the technology if it is the industry standard, which puts them at a competitive disadvantage

8. ©2009 Prentice Hall 13-8 Increasing Returns Businesses Some industries, particularly knowledge- intensive ones, are subject to increasing returns, which means that profit margins increase with the volume of production

9. ©2009 Prentice Hall 13-9 Direct Network Effects

10. Metcalfe’s Law

11. ©2009 Prentice Hall 13-11 Increasing Versus Decreasing Returns

12. ©2009 Prentice Hall 13-12 Increasing Returns at eBay

13. ©2009 Prentice Hall 13-13 Why Industries Display Increasing Returns Industries display increasing returns when:  They have high up-front costs and low marginal costs  Producer learning is high  Network externalities, when the purchase of a product by a new customer creates additional value for existing customers

14. Positive Feedback in Demand

15. ©2009 Prentice Hall 12-15 Positive Feedback in the Development of Linux

16. Theory in Action A Standards Battles in Digital Audio Formats  In 1996, record companies and electronics companies joined together to form the DVD Audio Consortium to create a new high-fidelity audio format.  In 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.

17. ©2009 Prentice Hall 12-17 Technical Standards and Competition Between Systems Technical standards often lead to competition between systems of companies, rather than between individual organizations Must decide to support one standard or all standards

18. ©2009 Prentice Hall 12-18 Open Versus Closed Standards Open standard: a standard for which specifications are known by other companies Closed standard: a system for which those specifications are not known by other companies Open systems are valuable because they:  Facilitate the availability of complementary products that create a positive feedback effect  Encourage other companies to adopt your technology  Permit the rapid creation of a large installed base

19. ©2009 Prentice Hall 12-19 Open Standard Disadvantages The loss of control over the technology, which could lead to a loss in sales That licensees might change your technology in a way that makes it unnecessary for them to pay you royalties An open standard demonstrates to competitors how the technology works, making it easier for them to imitate it

20. ©2009 Prentice Hall 12-20 Types of Open Systems Proprietary – help providers by reducing competition, giving them control over the development of the technology, and providing a strong incentive to support the system Non-proprietary – have the advantage of being more attractive to customers; they are neutral, don’t require royalty payments, and are easier for customers to use

21. Why Dominant Designs Are Selected Increasing returns to adoption occurs when a technology becomes more valuable the more it is adopted. Two primary sources are: Learning Effects The Learning Curve: As a technology is used, producers learn to make it more efficient and effective.

22. Experience and Learning Curves

23. 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. –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.

24. Why Dominant Designs Are Selected Network 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.

25. 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:

26. 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. E.g., the NTSC color standard in television broadcasting in the U.S.; the general standard for mobile communications (GSM) in the European Union. The Result: Winner-Take-All Markets  Natural monopolies Firms supporting winning technologies earn huge rewards; others may be locked out.

27. Why Dominant Designs Are Selected  Increasing returns indicate that technology trajectories are characterized by path dependency: End results depend greatly on the events that took place leading up to the outcome.  A dominant design can have far-reaching influence; it shapes future technological inquiry in the area.  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.

28. Multiple Dimensions of Value In many increasing returns industries, 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.

29. Multiple Dimensions of Value Kim and Mauborgne developed a “Buyer Utility Map” that is useful for identifying elements of a technology’s stand-alone value:

30. Buyer Utility Map

31. Multiple Dimensions of Value  Network Externality Value Includes 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. –E.g., NeXT Computers were extremely advanced technologically, but could not compete with the installed base value and complementary good value of Windows- based personal computers.

32. 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) »Compatibility with existing installed base and complements

33. Components of Utility

34. Multiple Dimensions of Value Subjective information (perceptions and expectations) can matter as much as objective information (actual numbers) Value attributed to each dimension may be disproportional

35. Actual and Perceived Utility

36. Multiple Dimensions of Value Competing for Design Dominance in Markets with Network Externalities  We can graph the value a technology offers in both standalone value and network externality value:

37. Multiple Dimensions of Value  We can compare the graphs of two competing technologies, and identify cumulative market share levels (installed base) that determine which technology yields more value.

38. 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.

39. ©2009 Prentice Hall 13-39 Types of Network Effects Network externalities come in two varieties: direct effects and indirect effects Direct network effects are network externalities that come from the direct interaction of users Metcalfe's law: the value of a network is proportional to the square of the number of devices in it Indirect network effects are network externalities that develop when the presence of complementary goods – products that are used along with the focal product – increases a product’s value

40. ©2009 Prentice Hall 13-40 Strategic Issues with Networked Industries Industries subject to network effects face important strategic issues that do not confront other industries, including:  The maintenance of the network  The possibility of sustaining more than one network  The use of strategic action to exploit network effects  Competition from other networks

41. ©2009 Prentice Hall 13-41 Multiple Networks?

42. ©2009 Prentice Hall 12-42 How to Win a Standards Battle To win a standard battle, companies may:  Gain the support of producers of complementary products  Have a complementary “killer application” making one technology much more attractive than another  Make the product backward compatible so that it works with a previous generation of products  Manage customer and competitor expectations

43. ©2009 Prentice Hall 12-43 Defending a Technology Standard Defend against the efforts of other firms by keeping customer switching costs high:  Make the products more functional, by adding features, or by making peripheral components available  Set up long-term supply of complementary products or services  Make future generations of the product backward compatible  Make the products or services incompatible with the alternatives offered by competitors

44. ©2009 Prentice Hall 13-44 Strategy for Increasing Returns In increasing returns industries, you need to:  Establish large-scale operations  Build your installed base quickly  Create customer lock-in  Be a first mover

45. ©2009 Prentice Hall 13-45 Start Large Because increasing returns businesses are winner-take-all, firms need to make large bets

46. ©2009 Prentice Hall 13-46 Amount Raised and Ownership in Biotechnology

47. ©2009 Prentice Hall 13-47 Build a Large Installed Base Quickly Firms in increasing returns industries need to build a large installed base, the number of current users of a product or service, quickly because customer adoption decisions are affected by the size of the installed base A large installed base:  Helps to make the product the industry standard, which gives long-lasting leverage over other firms in the value chain  Makes the product more attractive to the providers of complementary products  Pushes the company down the learning curve  Improves the economics of developing new technologies  Will keep out competition by creating a positive feedback loop that is hard for competitors to break

48. ©2009 Prentice Hall 13-48 How to Build an Installed Base Quickly Penetrating pricing – but it comes at the risk of lack of profitability Bundling the product with other products that are already popular with customers Targeting the mass market

49. ©2009 Prentice Hall 13-49 The Effect of a Big Initial Installed Base

50. ©2009 Prentice Hall 13-50 Get Customers to Ignore Lock-in Customer lock-in occurs when customers view the costs of switching suppliers as too high to justify doing so Firms in increasing returns industries use the razor-razor blade model to minimize customer lock-in to attract customers

51. ©2009 Prentice Hall 13-51 Be a First Mover First mover advantages are large in industries subject to increasing returns because the likelihood of new customer adoption increases with the size of the installed base Getting to market quickly is more important than having superior technology in industries subject to increasing returns because customers will not switch products to superior technology if the inferior technology has already been adopted by a large installed base Contracting, rather than owning the different parts of the value chain, facilitates getting to market quickly, and is a valuable approach in industries based on increasing returns

52. ©2009 Prentice Hall 13-52 Limitations to a Strategy Based on Increasing Returns Companies have to evaluate whether increasing returns are really present in their industry before they set their strategy because industries do not always show increasing returns when theory says that they should

53. Theory in Action 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.  Should the government intervene when network externalities create a natural monopoly?

54. Theory in Action  Network externality benefits to customers rise with cumulative market share  Potential for monopoly costs to customers (e.g., price gouging, restricted product variety, etc.) also rise with cumulative market share.

55. Network Externality Benefits versus Monopoly Costs Curve shapes are different; Network externality benefits likely to grow logistically, while potential monopoly costs likely to grow exponentially. Where monopoly costs exceed network externality benefits, intervention may be warranted. Optimal market share is at point where lines cross.

56. The Rise of Microsoft In 1980, Microsoft didn’t even have a personal computer (PC) operating system – the dominant operating system was CP/M. However, in IBM’s rush to bring a PC to market, they turned to Microsoft for an operating system and Microsoft produced a clone of CP/M called “MS DOS.” 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!

57. ©2009 Prentice Hall 12-57 Complementary Products in the High-Definition DVD War

58. ©2009 Prentice Hall 12-58 What If You Lose? If a standards battle is lost:  Companies can exit the market  Conform to the standard and compete on another dimension  Focus on a niche and meet its needs without conforming to the standard

59. ©2009 Prentice Hall 12-59 Fighting A Standard