Tipping the Balance: Indirect Network Effects and Market Concentration
he drawn-out fight between high-definition videodisc formats Blu-ray and HD-DVD ended in early 2008 when Warner Bros., a big Hollywood studio, announced that it would no longer release movies on HD-DVD. Warner Bros. felt it had to make a decision because the dueling formats were holding up the market. No one wants to own a video player that can't play the movies they want to watch. As a result, customers were on the fence about which standard to buy until they could see a clear winner.
In many high-technology markets, the success of a product largely depends on the availability of software titles that complement that product. When one studio after another said that it would stop producing movies on the HD-DVD format, the HD-DVD player became virtually worthless. This "indirect network effect" also appears in markets for video game consoles, devices that play movie downloads on television sets, and computer operating systems. One of the reasons why Microsoft's operating system holds such a commanding share of the market is the large number of software applications that can run on its platform.
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Image: Reuters Photographer / Reuter
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Sony's strategy from the start was to provide as many games as possible. In order to stimulate game development, Sony asked for only half of the game royalty fee that rival Nintendo charged. | |
When people care very much about how many software titles are available, it can set off a series of reactions, from consumers to software developers to hardware manufacturers that, makes one standard "tip" or pull away from the rest of the competition. For instance, the supply of software increases in the number of consumers that have adopted the hardware, but consumers will likely adopt that standard only if it has a bigger library of software titles. Thus, a small initial advantage can grow much larger over time. Far from being the result of "bad acts" by a company, a product can grab a very large share of the market simply because of indirect network effects.
The tipping phenomenon may be easy to spot, but it can be tricky to measure. In a new study, "Tipping and Concentration in Markets with Indirect Network Effects," University of Chicago Booth School of Business professors Jean- Pierre Dubé, Günter J. Hitsch, and Pradeep Chintagunta propose a modeling technique to analyze how indirect network effects can lead to success in hardware and software markets. One of the key findings is the crucial role that expectations play: Consumers' beliefs about the future evolution of the market can determine which product will emerge the winner.
The Fight for the Edge
The market for gadgets that allow consumers to watch movies downloaded from the internet on a television set can be used to illustrate how indirect network effects lead to tipping.
Consumers have a choice between two popular platforms today: the Apple TV or Netflix's player by Roku. If Netflix starts out with a larger movie library than Apple TV, then more consumers may buy the Netflix player because they value variety. But that's not all. If more people adopt the Netflix device, then film studios will have a bigger incentive to issue more movies for that specific platform. As a result, the Netflix library grows even larger and its player will attract more customers as it approaches the tipping point. "It's a feedback loop that makes an initial advantage grow stronger over time," Hitsch says.
In this example, one standard starts out with a small advantage. But what if both platforms have the same number of movie titles to begin with? The market can still tip in favor of one device, as long as consumers believe that one of the standards will eventually surpass the other.
For instance, if consumers think that Apple's recent string of high-profile successes with the iPod and the iPhone means that the Apple brand is going to be dominant in the long run, then it would be quite reasonable for them to believe that Apple TV also will be a success. Apple TV becomes more desirable than Netflix's device because consumers expect that more titles will be available for Apple TV in the future. Movie studios soon follow and the feedback loop sets in. "It's essentially a self-fulfilling expectation," says Hitsch. In that scenario, the sheer power of consumers' expectations drives the market to tip in favor of Apple TV.
While the story works out well in theory, the challenge lies in developing an approach that can compare what a product's market share would be with and without indirect network effects. No two products are exactly alike, and one can have a larger share of the market for many reasons. Thus, simply observing actual market shares does not reveal the importance of tipping.
To solve this problem, Dubé, Hitsch, and Chintagunta built a complex model that mimics the way firms compete and how customers adopt products in a market with indirect network effects. This model allows them to "shut down" the two main avenues of indirect network effects–the current and expected future supply of software–and then to look at the predicted market shares.
What sets this study apart is the fact that it is the first study to take into account that consumers are not myopic. Indeed, people form expectations about the future, whether it is the price of a device or the availability of titles when making a decision on which standard to adopt. "It is crucial to consider that consumers are trying to predict the future evolution of the market," says Hitsch. To assume that customers are not forward-looking may lead researchers to the wrong conclusion.
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