72 6.5 Competing When Network Effects Matter

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.

Timing is often critical in the video game console wars, too. Sony’s PlayStation 2 enjoyed an eighteen-month lead over the technically superior Xbox (as well as Nintendo’s GameCube). That time lead helped to create what for years was the single most profitable division at Sony. By contrast, the technically superior PS3 showed up months after Xbox 360 and at roughly the same time as the Nintendo Wii, and has struggled in its early years, racking up multibillion-dollar losses for Sony (Null, 2008).

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.

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 has over five 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. Within Facebook, feeds help activities to spread virally (see Chapter 8 “Facebook: Building a Business from the Social Graph”). Feeds blast updates on user activities on the site, acting as a catalyst for friends to join groups and load applications that their buddies have already signed up for.

Expand by Redefining the Market

If a big market attracts more users (and in two-sided markets, more complements), why not redefine the space to bring in more users? Nintendo did this when launching the Wii. While Sony and Microsoft focused on the graphics and raw processing power favored by hard-core male gamers, Nintendo chose to develop a machine to appeal to families, women, and age groups that normally shunned alien shoot-’em ups. By going after a bigger, redefined market, Nintendo was able to rack up sales that exceeded the Xbox 360, even though it followed the system by twelve months (Sanchanta, 2007).

Market expansion sometimes puts rivals who previously did not compete on a collision course as markets undergo convergence (when two or more markets, once considered distinctly separate, begin to offer similar features and capabilities). Consider the market for portable electronic devices. Separate product categories for media players, cameras, gaming devices, phones, and global positioning systems (GPS) are all starting to merge. Rather than cede its dominance as a media player, Apple leveraged a strategy known as envelopment, where a firm seeks to make an existing market a subset of its product offering. Apple deftly morphed the iPod into the iPhone, a device that captures all of these product categories in one device. But the firm went further; the iPhone is Wi-Fi capable, offers browsing, e-mail, and an application platform based on a scaled-down version of the same OS X operating system used in Macintosh computers. As a “Pocket Mac,” the appeal of the device broadened beyond just the phone or music player markets, and within two quarters of launch, iPhone become the second-leading smartphone in North America—outpacing Palm, Microsoft, Motorola and every other rival, except RIM’s BlackBerry (Kim, 2007).

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 Chapter 8 “Facebook: Building a Business from the Social Graph”), while its Android open source mobile phone operating system has gained commitments from many handset makers that collectively compete with Apple’s iPhone.

Leverage Distribution Channels

Firms can also think about novel ways to distribute a product or service to consumers. Sun faced a challenge when launching the Java programming language—no computers could run it. In order for Java to work, computers need a little interpreter program called the Java Virtual Machine (JVM). Most users weren’t willing to download the JVM if there were no applications written in Java, and no developers were willing to write in Java if no one could run their code. Sun broke the logjam when it bundled the JVM with Netscape’s browser. When millions of users downloaded Netscape, Sun’s software snuck in, almost instantly creating a platform of millions for would-be Java developers. Today, even though Netscape has failed, Sun’s Java remains one of the world’s most popular programming languages. Indeed, Java was cited as one of the main reasons for Oracle’s 2009 acquisition of Sun, with Oracle’s CEO saying the language represented “the single most important software asset we have ever acquired” (Ricadela, 2009).

As mentioned in Chapter 2 “Strategy and Technology: Concepts and Frameworks for Understanding What Separates Winners from Losers”, Microsoft is in a particularly strong position to leverage this approach. The firm often bundles its new products into its operating systems, Office suite, Internet Explorer browser, and other offerings. The firm used this tactic to transform once market-leader Real Networks into an also-ran in streaming audio. Within a few years of bundling Windows Media Player (WMP) with its other products, WMP grabbed the majority of the market, while Real’s share had fallen to below 10 percent¹ (Eisenmann et. al., 2006).

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.

Seed the Market

When Sony launched the PS3, it subsidized each console by selling at a price estimated at three hundred dollars below unit cost (Null, 2008). Subsidizing consoles is a common practice in the video game industry—game player manufacturers usually make most of their money through royalties paid by game developers. But Sony’s subsidy had an additional benefit for the firm—it helped sneak a Blu-ray player into every home buying a PS3 (Sony was backing the Blu-ray standard over the rival HD DVD effort). Since Sony is also a movie studio and manufacturer of DVD players and other consumer electronics, it had a particularly strong set of assets to leverage to encourage the adoption of Blu-ray over rival HD DVD.

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

Those firms that control a standard would also be wise to ensure that new products have backward compatibility with earlier offerings. If not, they reenter a market at installed-base zero and give up a major source of advantage—the switching costs built up by prior customers. For example, when Nintendo introduced its 16-bit Super Nintendo system, it was incompatible with the firm’s highly successful prior generation 8-bit model. Rival Sega, which had entered the 16-bit market two years prior to Nintendo, had already built up a large library of 16-bit games for its system. Nintendo entered with only its debut titles, and no ability to play games owned by customers of its previous system, so there was little incentive for existing Nintendo fans to stick with the firm (Schilling, 2003).

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 adaptor, 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.

Even more significant, since Intel is the same standard used by Windows, Apple developed a free software adaptor called Boot Camp that allowed Windows to be installed on Macs. Boot Camp (and similar solutions by other vendors) dramatically lowered the cost for Windows users to switch to Macs. Within two years of making the switch, Mac sales skyrocketed to record levels. Apple now boasts a commanding lead in notebook sales to the education market (Seitz, 2008), and a survey by Yankee Group found that 87 percent of corporations were using at least some Macintosh computers, up from 48 percent at the end of the PowerPC era two years earlier (Burrows, 2008).

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. AOL has been reluctant to open up its instant messaging tool to rivals, and Skype for years had been similarly closed to non-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.

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!