Network Effects: the Power of the Platform Platform Revolution: Making Networked Markets Work for You

Chapter 2 Network Effects: The Power of the Platform Platform Revolution: Making Networked Markets Work for You

Geoffrey Parker Marshall Van Alstyne Dartmouth College Boston University @g2parker @InfoEcon

Questrom School of Business with Sangeet Choudary Platformation Labs @sanguit 2016 Parker & Van Alstyne with Choudary – licensed under Creative Commons Attribution- ShareAlike 4.0 Int’l (CC BY-SA 4.0). Platform Revolution: Chapter 2 – Network Effects

1. Introduction: Welcome to Platform World 2. Network Effects: The Power of the Platform 3. Architecture: Basic Principles for Designing Successful Platforms 4. Disruption: How Platforms Conquer &Transform Traditional Industries 5. Launch: Chicken or Egg? 8 Ways To Launch Successful Platforms 6. Monetization: Capturing the Value Created by Network Effects 7. Openness: Defining What Platform Users/Partners Can &Cannot Do 8. Governance: Policies That Increase Value and Enhance Growth 9. Metrics: How Platform Managers Can Measure What Really Matters 10. Strategy: How Platforms Change Competition 11. Policy: How Platforms Should (and Should Not) Be Regulated 12. Future: Industries Facing Imminent Change

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(click to order on Amazon) 2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). A PLATFORM: • Is a nexus of rules and Elements of value exchange architecture • Is open, allowing regulated participation • Actively promotes (positive) PRODUCER CONSUMERS interactions among different partners in a multi-sided market • Scales much faster than a PLATFORM pipeline business because it does not necessarily bear the costs of external production.

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Source: Platform Revolution Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). PLATFORMS LEVERAGE NETWORK EFFECTS More users = more value = more users … 12 phones

5 phones

2 phones

1 10 66 interaction interactions interactions

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Source: Wikipedia.org Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). IT HELPS TO BREAK EACH INTERACTION INTO 2 SIDES

Phone Callers Phone Callees Uber Drivers Uber Riders eBay Sellers eBay Buyers Xbox Developers Xbox Gamers Amex Merchants Amex CardHolders Aga Khan Doctors Aga Khan Patients YouTube Videographers YouTube Viewers AirBnb Rooms AirBnb Renters Tesla Charge Stations Tesla Car Drivers Mechanical Turk Laborers Mechanical Turk Jobs LinkedIn Employers LinkedIn Employees Upwork Projects Upwork Freelancers Android Developers Android Users

This helps explain how attraction and feedback happen

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). Types of Network Effects

Explicit Implicit

Connectivity Magnetism Side Side 1 2

Ratings & User Generated Recommender Content Systems

How can users create value for other users? Distinctive Challenges • Businesses can be very complex • Rapid growth may preclude trial-and-error • Network effects = winner often takes most/all • Successes: Windows, Adobe, iPod/iPhone, Alibaba, LinkedIn, Facebook, etc. • Failures: Betamax, IBM OS/2, Amazon auctions, eBay Japan, MusicNet, N- Gage, Blackberry, etc.

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). Demand vs Supply-Side Scale Economies • Network effects are demand-side scale economies. Rising network effects increase existing and prospective users’ willingness-to-pay (willingness-to-participate) • Supply-side scale economies are realized when firms reduce unit costs by leveraging fixed costs or experience effects. With high fixed costs and low unit costs, average costs decline with volume. • Many businesses that exhibit network effects also enjoy strong supply-side scale economies • However, demand-side and supply-side economies are conceptually distinct: unit cost reductions that result from network growth should not be labeled network effects

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). STANDARD GOODS

Price Demand • Rising average costs Supply • Competitive supply • Soda, Eggs, Bread

Quantity

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). SUPPLY ECONOMY OF SCALE

Price Demand • Falling average costs • Monopolistic supply

Supply • Utilities, Semiconductors

Quantity

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). GIANTS OF SUPPLY SIDE ECONOMIES OF SCALE

Electric Acklam Ironworks Dynamo 1924 1893 Vanderbilt Colossus of (Rail) Roads Ford Model T 1908 Standard Oil 1909

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). DEMAND ECONOMY OF SCALE

Price Demand • Value grows with volume • Monopolistic Demand • Often falling average cost • Operating Systems, Instant Supply Messaging, Social Networks Quantity

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). GIANTS OF DEMAND SIDE ECONOMIES OF SCALE

Windows OS Mobile

Merchant Mkts Social Networks

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). TRADITIONAL LINEAR VALUE CHAIN

Stage 1 Stage 2 Stage 3

$ $ $ Value accumulates from stage to stage Minimal Network Effects

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). APPLE iPOD PRE-PLATFORM

Music Apple iPod Listener Retailer Producer

$ $ $

(1) Product First Thinking (2) Standard linear value chain (3) User bought music retail (or P2P) (4) Minimal network effects

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). APPLE iPOD COMBINED WITH iTUNES (AND APPLE MUSIC!)

Music Apple iPod Listener Retailer Producer

$ $ $

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). (1)Triangular platform supply network CONSUMER PRODUCER (2) Apple owns financial chokepoint (3) Apple helps users find content (4) Stronger network effects

APPLE

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). A TWO-SIDED NETWORK HAS FOUR NETWORK EFFECTS

• A same-side effect for each side, i.e., Side Side preference regarding number of other 1 2 users on own side • A cross-side effect in each direction, i.e., preference regarding number of users on other side

PLATFORM

Source: Eisenmann, Parker, Van Alstyne, 2006. “Strategies 2016 Parker & Van Alstyne, with Choudary – licensed under Creative for Two Sided Markets.” Harvard Business Review. Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). A TWO-SIDED NETWORK HAS FOUR NETWORK EFFECTS. THESE CAN BE POSITIVE OR NEGATIVE.

+ same-side : Player-to-player contact in Xbox MMOG, end-user PDF sharing.

+ cross-side : merchants & consumers for Visa, Side Side developers & end-users for Windows 1 2 - same-side : competing suppliers in Covisint auction, competing dates on Match.com

- cross-side : Digital Rights Management costs to consumers. Advertising clutter to PLATFORM viewers. You must manage all such interactions

Source: Eisenmann, Parker, Van Alstyne, 2006. “Strategies 2016 Parker & Van Alstyne, with Choudary – licensed under Creative for Two Sided Markets.” Harvard Business Review. Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). DAVID SACK’S (COO PAYPAL, CEO YAMMER) SKETCH SHOWS HOW POSITIVE FEEDBACK DROVE UBER GROWTH

MORE DEMAND Lower prices MORE Faster DRIVERS pickups Less driver downtime

MORE Geographic coverage, Saturation

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Source: David Sacks Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). ALL POSITIVE FEEDBACK LOOPS MEET NEGATIVE FEEDBACK LOOPS (ELSE THEY EXPLODE). MAKE SURE YOU FIND THEM AND MITIGATE THEM.

MORE DEMAND Lower prices MORE Faster DRIVERS pickups Less driver downtime

MORE Geographic coverage, Saturation

Source: Adapted from David Sacks 2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). HOMING AND SWITCHING COSTS

Mobile 1 SETUP + 1ONGOING Handsets Mono-homing Xbox 2 SETUPS + 1 TERMINATION + 1 ONGOING Xbox- Switching PS4

2 SETUPS + 2 ONGOING Credit Card Multi-homing Netflix/Hulu

Source: Eisenmann, Parker, Van Alstyne, 2006. “Strategies 2016 Parker & Van Alstyne, with Choudary – licensed under Creative for Two Sided Markets.” Harvard Business Review. Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). WHEN DO WINNER-TAKE-ALL MARKETS EMERGE? 1. Large Supply/Demand Effects (Utilities & Facebook vs Consulting). Costs fall or value rises with volume. 2. Large Multi-Homing Costs (OS vs credit cards). Consumers tend to choose just one 3. Niche specialization is low (geographically unrestricted courses vs geographically restricted courses). Differentiation creates protected markets not swamped by scale economies. More Likely Less Likely

Source: Eisenmann, Parker, Van Alstyne, 2006. “Strategies for Two Sided Markets.” Harvard Business Review. TO PRICE A PLATFORM WITH NETWORK EFFECTS, WHO GETS THE SUBSIDY?

Answer: The side that is the stronger attractant (or that creates more value)

Source: Parker & Van Alstyne, 2005. “Two Sided Network 2016 Parker & Van Alstyne, with Choudary – licensed under Creative Effects: A Theory of Information Product Design.” Mgmt Sci. Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). The Story of Acrobat Reader/Writer Adobe first tried to sell PDF readers and writers but no one wanted to buy readers when there was no content to read. And, no one wanted to buy writers when no one had readers. Adobe broke the logjam by giving PDF readers away.

Source: Tripsas “Adobe Systems Inc.” 2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). Harvard Business School case 801-19. Adobe Acrobat: SUBSIDIZE CONSUMERS

Making PDF readers free dramatically increased the value of PDF writers, shifting producer demand out and to the right. Here, Adobe subsidized consumers. Profit lost on one side of market is more than made up by profit gain on other side of market.

Source: Parker & Van Alstyne, 2000. “Information 2016 Parker & Van Alstyne, with Choudary – licensed under Creative Complements, Substitutes and Strategic Product Design” Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). Operating Systems: Subsidize Developers

Making System Development Toolkits (SDKs) free dramatically increased the value of operating systems, shifting consumer demand out and to the right. Here, Microsoft subsidized producers. Profit lost on one side of market is more than made up by profit gain on other side.

1) People understand the razors & blades strategy (same as cellphones & minutes, printers & ink) Give away one thing, charge for another The SAME person gets both items 2) People often misunderstand 2-sided network pricing Subsidize one party in order to attract then charge another party WRITERS READERS Subsidy side and money side of the market are DIFFERENT parties (like women & men on ladies’ nights) 3) Monetization is trickier for 2-sided networks Charging the wrong side (or both) reduces growth and network effects PLATFORM

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). ISSUES

Q: Why is price more important in network markets? A: The entire demand curve can change with price.

Q: Why is price more strategic in 2-sided networks? A: Imagine competing on the subsidy side – you need a source of subsidy at least as great.

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). TAKEAWAYS FROM CHAPTER TWO

Network effects are the main source of value creation and competitive advantage in a platform business—and, increasingly, in today’s economy. Whereas giant industrial-era firms were made possible by supply economies of scale, today’s giants are made possible by demand economies of scale—expressed as network effects.

Network effects are not the same as price effects, brand effects, or other familiar growth- building tools. Frictionless entry and other features of scalability maximize the value-building impact of network effects. A two-sided market (with both producers and consumers) gives rise to four kinds of network effects: same-side effects (consumer-to-consumer, producer-to-producer) and cross-side effects (consumer-to-producer, producer-to-consumer). Polarity on any of these can also be positive or negative. A growing platform business must manage all four. The key to minimizing most negative network effects is quality curation and minimizing congestion, which increases the chances of a happy match between producer and consumer. Winner Take All Markets (monopolies) tend to emerge from (1) large demand/supply economies of scale (2) large multihoming costs (3) more homogeneous / less niche markets

2016 Parker & Van Alstyne, with Choudary – licensed under Creative Source: Platform Revolution Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). Platform Revolution: Next Chapter 3 – Architecture

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(click to order on Amazon) 2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). For More Chapter 2 Information Suggested background: MBA Readings

1. Eisenmann, Parker & Van Alstyne, 2006. “Strategies for Two Sided Markets.” Harvard Business Review, 84, no. 10: 92–101 2. Tripsas “Adobe Systems Inc.” (2001) Harvard Business School case 801-19. 3. W. Brian Arthur, “Increasing Returns and the New World of Business,” Harvard Business Review 74, no. 4 (1996): 100–9 4. Bill Gurley, “How to Miss By a Mile: An Alternative Look at Uber’s Potential Market Size,” Above the Crowd, July 11, 2014 5. Miner, R., (2007) “Android: Building a Mobile Platform to Change the Industry,” Nov. 28, -- YouTube 6. Tiwana, A. (2013) “Core Concepts & Principles” Ch 2 – Platform Ecosystems: Newnes 7. Hagiu & Altman (2013) “Intuit Quickbooks: From Product to Platform” HBS Case N9- 714-433

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Geoffrey Parker Marshall Van Alstyne with Sangeet Choudary @g2parker @InfoEcon @sanguit (click to order on Amazon) 2016 Parker & Van Alstyne, with Choudary – licensed under Creative Commons Attribution-ShareAlike 4.0 International (CC BY-SA 4.0). For More Chapter 2 Information Suggested background: PhD Readings

1. Geoffrey Parker and Marshall Van Alstyne, 2000. “Internetwork externalities and free information goods.” Proceedings of the Second ACM conference on Electronic Commerce. Association for Computing Machinery, 107-116. 2. Jean-Charles Rochet and Jean Tirole, 2003. ``Platform Competition in Two-Sided Markets.’’ Journal of the European Economic Association. 3. Bernard Caillaud and Bruno Jullien, 2003. ``Chicken & Egg: Competing Matchmakers. Rand Journal of Economics. 4. Geoffrey Parker and Marshall Van Alstyne, 2005. ``Two-Sided Network Effects: A Theory of Information Product Design.” Management Science, 51 (10): 1494-1504. 5. Andrei Hagiu, 2006. ``Pricing and commitment by two‐sided platforms.’’ The RAND Journal of Economics. 6. Michael L. Katz and Carl Shapiro, “Network Externalities, Competition, and Compatibility,” American Economic Review 75, no. 3 (1985): 424–40

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