When network effects are present the value of a product or service increases?

Why do you care whether networks are one-sided, two-sided, or some sort of hybrid? Well, when crafting your plan for market dominance, it’s critical to know if network effects exist, how strong they might be, where they come from, and how they might be harnessed to your benefit. Here’s a quick rundown of the tools at your disposal when competing in the presence of network effects.

Strategies for Competing in Markets with Network Effects (Examples in Parentheses)

• Move early (Yahoo! Auctions in Japan)
• Subsidize product adoption (PayPal)
• Leverage viral promotion (Skype; Facebook feeds)
• Expand by redefining the market to bring in new categories of users (Nintendo Wii) or through convergence (iPhone).
• Form alliances and partnerships (NYCE vs. Citibank)
• Establish distribution channels (Java with Netscape; Microsoft bundling Media Player with Windows)
• Seed the market with complements (Blu-ray; Nintendo)
• Encourage the development of complementary goods—this can include offering resources, subsidies, reduced fees, market research, development kits, venture capital (Facebook fbFund).
• Maintain backward compatibility (Apple’s Mac OS X Rosetta translation software for PowerPC to Intel)
• For rivals, be compatible with larger networks (Apple’s move to Intel; Live Search Maps)
• For incumbents, constantly innovate to create a moving target and block rival efforts to access your network (Apple’s efforts to block access to its own systems)
• For large firms with well-known followers, make preannouncements (Microsoft)

Move Early

In the world of network effects, this is a biggie. Being first allows your firm to start the network effects snowball rolling in your direction. In Japan, worldwide auction leader eBay showed up just five months after Yahoo! launched its Japanese auction service. But eBay was never able to mount a credible threat and ended up pulling out of the market. Being just five months late cost eBay billions in lost sales, and the firm eventually retreated, acknowledging it could never unseat Yahoo!’s network effects lead.

Another key lesson from the loss of eBay Japan? Exchange depends on the ability to communicate! EBay’s huge network effects in the United States and elsewhere didn’t translate to Japan because most Japanese aren’t comfortable with English, and most English speakers don’t know Japanese. The language barrier made Japan a “greenfield” market with no dominant player, and Yahoo!’s early move provided the catalyst for victory.

What If Microsoft Threw a Party and No One Showed Up?

Subsidize Adoption

Starting a network effect can be tough—there’s little incentive to join a network if there’s no one in the system to communicate with. In one admittedly risky strategy, firms may offer to subsidize initial adoption in hopes that network effects might kick in shortly after. Subsidies to adopters might include a price reduction, rebate, or other giveaways. PayPal, a service that allows users to pay one another using credit cards, gave users a modest rebate as a sign-up incentive to encourage adoption of its new effort (in one early promotion, users got back fifteen dollars when spending their first thirty dollars). This brief subsidy paid to early adopters paid off handsomely. EBay later tried to enter the market with a rival effort, but as a late mover its effort was never able to overcome PayPal’s momentum. PayPal was eventually purchased by eBay for $1.5 billion, and the business unit is now considered one of eBay’s key drivers of growth and profit.

Figure 6.2 Gilt Groupe iPad App

Gilt’s ten-dollar iPad subsidy and instant membership offer helped fuel adoption of the iPad app. Mobile apps now account for 15 percent of the high-end fashion site’s sales.

When Even Free Isn’t Good Enough

Subsidizing adoption after a rival has achieved dominance can be an uphill battle, and sometimes even offering a service for free isn’t enough to combat the dominant firm. When Yahoo! introduced a U.S. auction service to compete with eBay, it initially didn’t charge sellers at all (sellers typically pay eBay a small percentage of each completed auction). The hope was that with the elimination of seller fees, enough sellers would jump from eBay to Yahoo! helping the late-mover catch up in the network effect game.

But eBay sellers were reluctant to leave for two reasons. First, there weren’t enough buyers on Yahoo! to match the high bids they earned on much-larger eBay. Some savvy sellers played an arbitrage game where they’d buy items on Yahoo!’s auction service at lower prices and resell them on eBay, where more users bid prices higher.

Second, any established seller leaving eBay would give up their valuable “seller ratings,” and would need to build their Yahoo! reputation from scratch. Seller ratings represent a critical switching cost, as many users view a high rating as a method for reducing the risk of getting scammed or receiving lower-quality goods.

Leverage Viral Promotion

Since all products and services foster some sort of exchange, it’s often possible to leverage a firm’s customers to promote the product or service. Internet calling service Skype (now owned by Microsoft) has over six hundred million registered users yet has spent almost nothing on advertising. Most Skype users were recruited by others who shared the word on free and low-cost Internet calls. And rise of social media has made viral promotion a tool that many firms can exploit. Facebook and Twitter act as a catalyst for friends to share deals, spread a good word, sign up for services, and load applications.

Expand by Redefining the Market

Seeking the Blue Ocean? Better Think Strategically

For Nintendo, the granny gamers, moms, and partygoers who flocked to the Wii represented an undiscovered feast in the Blue Ocean. Talk about new markets! Consider that the best-selling video game at the start of 2009 was Wii Fit—a genre-busting title that comes with a scale so you can weigh yourself each time you play. That’s a far cry from Grand Theft Auto IV, the title ranking fifth in 2008 sales, and trailing four Wii-only exclusives.

Alliances and Partnerships

Firms can also use partnerships to grow market share for a network. Sometimes these efforts bring rivals together to take out a leader. In a classic example, consider ATM networks. Citibank was the first major bank in New York City to offer a large ATM network. But the Citi network was initially proprietary, meaning customers of other banks couldn’t take advantage of Citi ATMs. Citi’s innovation was wildly popular and being a pioneer in rolling out cash machines helped the firm grow deposits fourfold in just a few years. Competitors responded with a partnership. Instead of each rival bank offering another incompatible network destined to trail Citi’s lead, competing banks agreed to share their ATM operations through NYCE (New York Cash Exchange). While Citi’s network was initially the biggest, after the NYCE launch a Chase bank customer could use ATMs at a host of other banks that covered a geography far greater than Citi offered alone. Network effects in ATMs shifted to the rival bank alliance, Citi eventually joined NYCE and today, nearly every ATM in the United States carries a NYCE sticker.

Google has often pushed an approach to encourage rivals to cooperate to challenge a leader. Its Open Social standard for social networking (endorsed by MySpace, LinkedIn, Bebo, Yahoo! and others) is targeted at offering a larger alternative to Facebook’s more closed efforts (see ), while its Android open source mobile phone operating system has gained commitments from many handset makers that collectively compete with Apple’s iPhone.

Share or Stay Proprietary?

Defensive moves like the ones above are often meant to diffuse the threat of a proprietary rival. Sometimes firms decide from the start to band together to create a new, more open standard, realizing that collective support is more likely to jumpstart a network than if one firm tried to act with a closed, proprietary offering. Examples of this include the coalitions of firms that have worked together to advance standards like Bluetooth and Wi-Fi. While no single member firm gains a direct profit from the sale of devices using these standards, the standard’s backers benefit when the market for devices expands as products become more useful because they are more interoperable.

Leverage Distribution Channels

Figure 6.3 Apple’s Retail Stores

Most pundits expected Apple retail to fail. Instead the stores provided a wildly successful channel to reach customers, explain products, and make sales. The Apple Store on Fifth Avenue in Manhattan was recently named the most photographed landmark in New York City.

Caution is advised, however. Regional antitrust authorities may consider product bundling by dominant firms to be anticompetitive. European regulators have forced Microsoft to unbundle Windows Media Player from its operating system and to provide a choice of browsers alongside Internet Explorer.

Antitrust: Real Versus Microsoft

Seed the Market

Giving away products for half of a two-sided market is an extreme example of this kind of behavior, but it’s often used. In two-sided markets, you charge the one who will pay. Adobe gives away the Acrobat reader to build a market for the sale of software that creates Acrobat files. Firms with Yellow Page directories give away countless copies of their products, delivered straight to your home, in order to create a market for selling advertising. And Google does much the same by providing free, ad-supported search.

Encourage the Development of Complementary Goods

There are several ways to motivate others to create complementary goods for your network. These efforts often involve some form of developer subsidy or other free or discounted service. A firm may charge lower royalties or offer a period of royalty-free licensing. It can also offer free software development kits (SDKs), training programs, co-marketing dollars, or even start-up capital to potential suppliers. Microsoft and Apple both allow developers to sell their products online through Xbox LIVE Marketplace and iTunes, respectively. This channel lowers developer expenses by eliminating costs associated with selling physical inventory in brick-and-mortar stores and can provide a free way to reach millions of potential consumers without significant promotional spending.

Venture funds can also prompt firms to create complementary goods. Facebook announced it would spur development for the site in part by administering the fbFund, which initially pledged $10 million in start-up funding (in allotments of up to $250,000 each) to firms writing applications for its platform.

Leverage Backward Compatibility

Backward compatibility was the centerpiece of Apple’s strategy to revitalize the Macintosh through its move to the Intel microprocessor. Intel chips aren’t compatible with the instruction set used by the PowerPC processor used in earlier Mac models. Think of this as two entirely different languages—Intel speaks French, PowerPC speaks Urdu. To ease the transition, Apple included a free software-based adaptorA product that allows a firm to tap into the complementary products, data, or user base of another product or service., called Rosetta, that automatically emulated the functionality of the old chip on all new Macs (a sort of Urdu to French translator). By doing so, all new Intel Macs could use the base of existing software written for the old chip; owners of PowerPC Macs were able to upgrade while preserving their investment in old software; and software firms could still sell older programs while they rewrote applications for new Intel-based Macs.

Rivals: Be Compatible with the Leading Network

Companies will want to consider making new products compatible with the leading standard. Microsoft’s Live Maps and Virtual Earth 3D arrived late to the Internet mapping game. Users had already put in countless hours building resources that meshed with Google Maps and Google Earth. But by adopting the same keyhole markup language (KML) standard used by Google, Microsoft could, as TechCrunch put it, “drink from Google’s milkshake.” Any work done by users for Google in KML could be used by Microsoft. Voilà, an instant base of add-on content!

Incumbents: Close Off Rival Access and Constantly Innovate

Oftentimes firms that control dominant networks will make compatibility difficult for rivals who try to connect with their systems. For example, while many firms offer video conferencing and Internet calling, the clear leader is Skype, a product that for years had been closed to unauthorized Skype clients.

Firms that constantly innovate make it particularly difficult for competitors to become compatible. Again, we can look to Apple as an example of these concepts in action. While Macs run Windows, Windows computers can’t run Mac programs. Apple has embedded key software in Mac hardware, making it tough for rivals to write a software emulator like Boot Camp that would let Windows PCs drink from the Mac milkshake. And if any firm gets close to cloning Mac hardware, Apple sues. The firm also modifies software on other products like the iPhone and iTunes each time wily hackers tap into closed aspects of its systems. And Apple has regularly moved to block third-party hardware, such as Palm’s mobile phones, from plugging into iTunes. Even if firms create adaptors that emulate a standard, a firm that constantly innovates creates a moving target that’s tough for others to keep up with.

Apple has been far more aggressive than Microsoft in introducing new versions of its software. Since the firm never stays still, would-be cloners never get enough time to create a reliable emulator that runs the latest Apple software.

Large, Well-Known Followers: Preannouncements

Large firms that find new markets attractive but don’t yet have products ready for delivery might preannounce efforts in order to cause potential adaptors to sit on the fence, delaying a purchasing decision until the new effort rolls out. Preannouncements only work if a firm is large enough to pose a credible threat to current market participants. Microsoft, for example, can cause potential customers to hold off on selecting a rival because users see that the firm has the resources to beat most players (suggesting staying power). Statements from start-ups, however, often lack credibility to delay user purchases. The tech industry acronym for the impact firms try to impart on markets through preannouncements is FUD for fear, uncertainty, and doubt.

Too Much of a Good Thing?

When network effects are present, more users attract more users. That’s a good thing as long as a firm can earn money from this virtuous cycle. But sometimes a network effect attracts too many users and a service can be so overwhelmed it becomes unusable. These so-called congestion effectsWhen increasing numbers of users lower the value of a product or service. occur when increasing numbers of users lower the value of a product or service. This most often happens when a key resource becomes increasingly scarce. Users of the game Ultima were disappointed in an early online version that launched without enough monsters to fight or server power to handle the crush of fans. Twitter’s early infrastructure was often unable to handle the demands of a service in hypergrowth (leading to the frequent appearance of a not-in-service graphic known in the Twitter community as the “fail whale”). Facebook users with a large number of friends may also find their attention is a limited resource, as feeds push so much content that it becomes difficult to separate interesting information from the noise of friend actions.

And while network effects can attract positive complementary products, a dominant standard may also be the first place where virus writers and malicious hackers choose to strike.

Figure 6.4 The Twitter Fail Whale

Feel confident! Now you’ve got a solid grounding in network effects, the key resource leveraged by some of the most dominant firms in technology. And these concepts apply beyond the realm of tech, too. Network effects can explain phenomena ranging from why some stock markets are more popular than others to why English is so widely spoken, even among groups of nonnative speakers. On top of that, the strategies explored in the last half of the chapter show how to use these principles to sniff out, create, and protect this key strategic asset. Go forth, tech pioneer—opportunity awaits!

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