# Network effects

Updated Wednesday, 26th October 2005

The interplay between products and markets is complex and further complicated by network effects, as explained in this OU Business School course extract.

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Markets are subject to network effects where the satisfaction that a user derives from consumption of an item or service increases with the number of other users. Network effects can be produced directly, such as with physical networks like the telephone and the railways. They can also be produced indirectly, such as where the buyer of a personal computer is concerned with the amount of compatible software available. Many technology-based products are subject to network effects.

A characteristic of markets subject to network effects is that any early lead gained by one product can be self-reinforcing. Network effects also exist in markets subject to increasing returns, and the advantage gained from an early lead in the number of users or customers reaches a point where it is effectively self-reinforcing and perhaps even becomes “unstoppable”.

Increasing returns
The expansion of production of a particular item typically runs into limitations in the form of rising costs or diminishing profits, that is, the notion of diminishing returns to scale. Increasing returns to scale tend to exist in industries, such as computer software, where the upfront or fixed costs are high and where the cost of producing one extra unit of a particular item tends to be low, perhaps even insignificant. Many firms that operate in the high technology sector are subject to increasing returns, where these markets exhibit any of the following characteristics:

• R&D costs are large relative to unit production costs. For example, the first version of a software package could cost $50 million to produce, while the second and subsequent copies could cost$3 each.
• Many high-tech products need to be compatible with a network of users. As with products subject to such “network effects”, the more the product gains prevalence, the more likely it will emerge as a standard.
• High-tech products are typically difficult to use and require customers to invest in training. Customers are, therefore, more likely to be “locked-in” to future versions of the product.

Standards and timing
Given that any early lead gained by one product can be self-reinforcing, the existence of network effects can produce a single winning standard dominating the market. A classic case is that of VHS vs. Betamax, where the former won the battle to establish the standard in video recording technology even though the underlying technology was widely acknowledged to be inferior to that of Betamax’s. The timing of market entry may also be important in order to establish the industry standard which, in turn, can act as a major barrier to entry.

The advantage of being an early entrant or first mover can be considered in terms of gaining pre-emptive resource advantages and the creation of barriers to entry. In industries subject to network effects, entry timing could be a key source of competitive advantage.

While technology is the focus of standards wars, the winner is more likely to be the one who has the best strategy rather than the best technology. In many technological markets, a first mover advantage can be overcome by a superior technology if the performance advantage of the late entrant product is significant and if the users of the existing product can be persuaded to use (and, hence, learn how to use) another 'superior' product.

Co-opetition and the Value Net Model
A framework that represents all the players in the market and the interdependencies between them is called a ‘Value Net’. The Value Net provides a framework with which to explore all the interdependencies in a market and, hence, an opportunity to examine how the market might be changed or even the players themselves. The Net includes an organisation’s customers and suppliers. It also includes other players with whom the organisation interacts but does not transact, such as its substitutors and complementors. Substitutors are alternative players from whom customers may buy products. Complementors are players from whom customers buy complementary products.

Hardware and software companies are a classic example of complementors. Implicit in the notion of complementors is the idea that the value of one company’s product or service is enhanced through the existence of the other company’s product or service, for example users may be more willing to buy Apple computers if Microsoft’s Office software is available for it. Central to this model is the idea of co-opetition, i.e. the co-existence of co-operative and competitive relationships. Relationships between any two of the players in the Value Net are rarely purely competitive or co-operative. Instead, relationships with substitutors need not always be competitive, while those with complementors need not always be co-operative. In the games market, Nintendo wanted to add value at the expense of the other players in its Value Net. In order to combat the power of its highly concentrated buyers such as Toys R Us (a toy retailer) and Wal-Mart (a general retailer), Nintendo changed the game by ensuring that it did not fill all the retailers’ orders to weaken the buyers’ power. The firm played a similar game with external software developers, its complementors. It weakened their power by (i) developing its own software in-house and (ii) restricting the number of software development licences it made available. Nintendo had no real substitutors since it already had the largest installed base of gaming systems, and Microsoft hadn’t entered the field yet.

Standards or incompatability
In technology industries many firms compete on the basis of establishing their product as the industry standard and, hence, highlight the importance of early mover advantage. However, this is not the only strategy possible. Competitive strategies that seek to develop a level of co-operation may sometimes be more suitable. If compatibility is overwhelmingly important, requiring vendors to agree on a standard, then it might not be preferable to spend potential profits on a standards battle. Low-cost licensing to permit use of each party’s technology or the development of a hybrid standard that combines the different technologies are two options.

When one firm is powerful, such as having a large customer or installed base, a particularly good technology or a powerful reputation for setting standards, it is more likely to prefer incompatibility than its smaller rivals. It can resist compatibility and imitation by asserting intellectual property rights or by changing technologies frequently. Although these approaches to competitive dynamics appear to be in conflict, the clash is more apparent than real.

• It is a matter of timing. At any one time, firms will be attempting to secure longer-term value-generating relationships with some market participants, while simultaneously pursuing short-term gains against others.
• It is also a matter of industry structure. Some industries offer considerable scope for value generation through co-operative relationships and partnerships, others offer little.

The complexity of modern networks
The lack of clarity about who are partners or collaborators is often compounded by the complexity of collaborative arrangements in practice. The sheer scale of networking activities is one aspect of this. Many organisations are involved in multiple alliances. One major electronics manufacturer, for example, is said to be involved in around 400 strategic alliances. Clearly, even with the most coherent alliance management practices, no individual manager is likely to know which partner organisations are involved. Obviously, multiple alliances must pull the organisation in a variety of different directions. As one senior manager in a division of a multinational computer hardware manufacturer put it:

"We have separate alliances with two companies (worldwide operating system providers) that are in direct competition with each other ... there is a lot of conflict within the company over these alliances ... the people involved try to raise the importance of theirs."

In addition to the volume of relationships, there is frequently complexity in the networks of relationships between organisations. For example, the complexity of interacting supply chain networks – in which every supplier has multiple customers, every customer has multiple suppliers, and suppliers have suppliers and customers have customers – is potentially infinite. Many networks of collaborations are, in addition, hierarchical in the sense that collaborations are members of other collaborations.

What is clear is that in the twenty first century, networks are a fact of life for many organisations. The successful ones use them as leverage to the achievement of organisational goals.