NETWORK EFFECTS, SWITCHING COSTS, AND COMPETITION IN UNIFIED COMMUNICATIONS

Michael L. Katz and Bryan Keating*

November 5, 2012

* This paper was commissioned by Cisco Systems Inc. The views expressed are those of the authors and do not necessarily reflect the views of Cisco Systems Inc.

CONTENTS

I. INTRODUCTION AND OVERVIEW ...... 1

II. BACKGROUND ON COMPETITION AND PUBLIC POLICY ...... 9

III. NETWORK EFFECTS , SWITCHING COSTS, AND MULTI-HOMING COSTS ...... 11 A. DEFINITION AND SOURCES OF NETWORKS EFFECTS ...... 11 1. Direct Network Effects ...... 11 2. Indirect Network Effects ...... 12 B. DEFINITION AND SOURCES OF SWITCHING COSTS AND MULTI-HOMING COSTS ...... 13 C. IMPLICATIONS FOR COMPETITION ...... 16 1. Proprietary v. Shared Network Effects ...... 16 2. Competitive Dynamics ...... 18 D. THERE CAN BE MARKET FAILURE IN INDUSTRY ADOPTION OF INTEROPERABILITY STANDARDS...... 23

IV. APPLICATION TO VIDEO CALLING AND UNIFIED COMMUNICATIONS ...... 25 A. INDUSTRY BACKGROUND ...... 26 1. Suites and Component Applications ...... 28 2. Major Competitors ...... 30 3. The Rise of the Cloud ...... 31 B. STANDARDS EXIST, BUT FULL INTEROPERABILITY HAS NOT BEEN ACHIEVED...... 33 1. Overview of Key Standards ...... 34 (a) Call Control and Signaling ...... 34 (b) Presence and Messaging ...... 37 (c) Data Encoding and Decoding...... 39 2. Standards and Gateways ...... 41

C. THE UC INDUSTRY IS CHARACTERIZED BY CONDITIONS THAT RAISE COMPETITIVE CONCERNS WITH RESPECT TO STRATEGIC OPPOSITION TO INTEROPERABILITY ...... 42 1. Network effects, switching costs and single-homing in UC ...... 42 2. Asymmetric Vendor Positions ...... 44 3. Evidence of strategic behavior in the UC industry ...... 46

V. THE ROLE OF COMPETITION POLICY ...... 50 A. THE COSTS AND BENEFITS OF GOVERNMENTAL INTERVENTION ...... 50 B. CONDUCT RAISING POTENTIAL COMPETITION CONCERNS ...... 53 C. POTENTIAL REMEDIES IN THE EVENT THAT ANTICOMPETITIVE CONDUCT IS FOUND ...... 57

VI. CONCLUSION ...... 59

APPENDIX: QUALIFICATIONS ...... 61 A. MICHAEL L. KATZ ...... 61 B. BRYAN KEATING ...... 62

I. INTRODUCTION AND OVERVIEW

1. Historically, enterprises have used separate systems for voice, data, and video communications. These communications systems were not integrated within an enterprise and were often supplied by different vendors.1 Unlike traditional communications, Unified

Communications (UC) integrates a variety of communications methods, including voice, data, and video into a single user interface generally available across multiple communications devices.2 UC also typically incorporates real-time presence information, which allows a user to determine whether other users are available. For example, Cisco describes its Jabber UC application as follows:3

Cisco Jabber lets you access presence, instant messaging (IM), voice, video, voice messaging, desktop sharing, and conferencing. Now you can find the right people, see if and how they are available, and collaborate using your preferred method.

Similarly, Microsoft’s UC application, Lync, allows users to “keep track of their contacts’ availability; send an IM; start or join an audio, video, or web conference; or make a phone call—all through a consistent, familiar interface.”4

2. By integrating different communications applications into a unified interface, UC applications offer users the ability to transfer data and information across applications and

1 These are sometimes referred to as “silos” in the industry. 2 See, e.g., Frost & Sullivan, “World Unified Communications Markets: Competitive Landscape and Lean Enterprise Budgets Spur UC Solutions Innovation,” Report N8C0-64, May 2011 (hereinafter FSN8C0-64) at 9-11; Gartner, “Avoiding the UC Mirage,” Report G00227220, 14 February 2012 (hereinafter G00227220) at 5 and 6. There is no commonly agreed upon definition of UC, but analysts and industry participants agree that it includes these basic elements. 3 Cisco Systems, Inc., Cisco Jabber, available at http://www.cisco.com/web/products/voice/jabber.html, site visited September 4, 2012. 4 Microsoft, Inc., “What is Lync,” available at http://lync.microsoft.com/en-us/what-is- lync/Pages/what-is-lync.aspx, site visited September 4, 2012.

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devices in real time. At the enterprise level, UC capabilities potentially allow firms to operate more efficiently and more effectively by enabling employees to work and communicate more flexibly and at lower cost.5 For example, a recent study listed the top driver of enterprise video adoption as “[r]educ[ing] travel budget,” followed by “[i]mprove[ing] collaboration,”

“[b]oost[ing] productivity,” “[e]nable[ing] video training,” and “[s]upporting green IT.”6

3. At the macroeconomic level, economic research has demonstrated a clear relationship between investment in Information and Communications Technology (ICT) and productivity growth. For example, a recent survey article published by the Organisation for Economic Co- operation and Development (OECD) found that “there is broad evidence that over the last two decades an increase of ICT by 10 % translated into higher productivity growth of 0.5 to

0.6 %.”7 Moreover, the same study noted that “ICT facilitates communication and the creation of new knowledge through more efficient processes of collaboration and information processing.”8 Because a primary benefit of UC is to enable efficient collaboration, it is reasonable to expect that UC, if widely adopted, could lead to significant gains in productivity.

4. UC is not just for business and governmental enterprises. Consumers, too, can benefit from UC. For example, one promising application of UC is to allow business enterprises to communicate flexibly and seamlessly with their customers, whether other businesses or

5 See, e.g., G00227220 at 3. 6 Zeus Kerravala, “Standardization is the Key to Pervasive Video,” ZK Research, July 2012 at 3. 7 Tobias Kretschmer (2012), “Information and Communication Technology and Productivity Growth: A Survey of the Literature,” OECD Digital Economy Papers, No. 195 at 6. 8 Kretschmer (2012) at 8.

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household consumers. Indeed, one industry analyst predicts that “[t]he value of video as a sales and support tool will drive demand to improve [business-to-business] and [business-to- consumer] desktop videoconferencing capabilities.”9 And, as we note below, enhanced business-to-consumer communications is one of the main selling points for Microsoft’s new

UC platform.10

5. Despite its large potential benefits, the adoption of UC has been relatively limited to date.11 Many enterprises have not adopted UC, and those that have adopted it generally have done so on a partial basis in the sense that they do not include the full range of applications and capabilities that UC can offer.12 Survey evidence indicates that the lack of interoperability among the products of different UC vendors is one of the major concerns of potential users and is one of the major factors hindering more widespread adoption of UC, generally, and video-to-video communications, specifically.13

6. Video calling presents a particularly important example of how the lack of interoperability can slow adoption and reduce the benefits users derive from UC.14 Video

9 Frost & Sullivan, “Global Desktop Videoconferencing Market: Desktop Applications Key to Pervasive Enterprise Videoconferencing,” Report 9847-64, December 2011 (hereinafter FS9847-64) at 49. 10 Microsoft Corp., “Lync 2013 Preview,” available at http://lync.microsoft.com/en- us/Pages/Lync-2013-Preview.aspx, site visited October 8, 2012. 11 FSN8C0-64 at 13; Ben Elliot and Steve Blood, “Magic Quadrant for Unified Communications,” August 27, 2012, Report G00232192 (hereinafter G00232192) at 12 (“The adoption of UC by enterprises continues to increase; however, actual penetration as a percentage of market, and, in some cases, usage rates across an enterprise, remain low.”) 12 FSN8C0-64 at 19. 13 G00227220 at 11-12; FS9847-64 at 28, 30, 47; Frost and Sullivan, “Federation in Enterprise Unified Communications,” 2012 (hereinafter FS Federation Report) at 2-3; Nemertes Research, “UC Implementation Strategies,” 2011 at 2. 14 Video calling is an increasingly important form of communications for businesses. For example, Frost and Sullivan projects that sales of desktop video-conferencing clients will

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calling is characterized by network effects. A network effect is present when the value of a good or service to a given user rises as the number of other users of that good or service rises.

A video-calling application (including the video-calling functionality contained in a UC application) is valuable to a user because he or she can use the application to reach other users, as long as those users have interoperable video-calling applications. Hence, the more people who are on a given network of interoperable, or compatible, video-calling applications, the more valuable that network is to any given user. Consequently, there is a positive feedback loop present: additional users attract still more users. This effect is present with video calling, specifically, and UC, more generally.

7. The scope of the network effects is determined by whether different vendors offer interoperable products. If all video applications are interoperable, then all video users constitute a single network. However, when two vendors have video applications that are not interoperable, the users of each application constitute a separate, proprietary network. This fact has several implications. One of them is that users do not enjoy the full benefits that video calling could potentially generate; rather than being able to make video calls with all other video users, a given user can make video calls only with those other users who are on the same proprietary network as is he or she. Another implication is that users risk being stranded if they pick a video calling application that turns out to be unpopular with other users and, thus, has a small network.

increase by approximately 16 percent per year between 2010 and 2015. In 2010, UC accounted for approximately half of desktop videoconferencing application sales, while web conferencing clients accounted for the other half. (FS9847-64 at 5. See also Infonetics Research, “Enterprise Telepresence and Video Conferencing,” March 16, 2011, showing that enterprise video grew strongly in 2010.)

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8. Video calling is also characterized by switching costs. Switching costs refer to the expenditures that a buyer making repeated purchases of a particular good or service has to incur in order to change from one supplier to another. For example, enterprise users may have to incur costs of retraining employees or installing new hardware in order to utilize a new video calling application. Switching costs create a hurdle for any supplier seeking to attract consumers away from their existing suppliers. In the presence of switching costs and network effects, a consumer may be especially reluctant to incur the costs of switching to a new network unless he or she is confident that other consumers will do so as well.

9. The increased difficulty of entry is not the only adverse consequence that the combination of significant switching costs and network effects can have for competition.

This combination also can lead customers to adopt a service more slowly or even not at all.

Specifically, there may be a chicken-and-egg problem: each potential user of a new network service may wait for other users to join before being will to join him or herself. Of course, if everyone waits, then the service will never get off of the ground. The chicken-and-egg problem can be particularly strong in the absence of industrywide interoperability standards.

Absent such standards, a potential user may have to choose among multiple proprietary networks, no one of which is clearly going to be the “winner.” A potential us