By: Gunjan Bhardwaj
Markets can be quite hostile to new products launched, and in fact they refuse most new products. This hostility to new products can even be stronger in network markets, where all players are interconnected. Read more about the challenges to be addressed when you enter into network markets in this third article in a series of five by Gunjan Bhardwaj, head of Ernst & Young´s Global Business Performance Think-tank.
Although often relatively risky, innovations can increase profitability, thus driving growth, and finally shareholder value. Markets can be quite hostile to new products launched, and in fact they refuse most new products. This hostility to new products can even be stronger in network markets, where all players are interconnected. Actually, to adopt a new product network market participants have to be convinced that the others will also adopt the same new product.
This hostility to new products can even be stronger in network markets, where all players are interconnected
Network markets identify totally different sources of value than traditional markets and require the use of new tools to market new, innovative products. Besides, an increasingly important number of markets now take on the characteristics of network markets. Reasons for this phenomenon are the improved communications technologies, the widely spread access to the Internet, but also the increasing reliance on the global market (Chakravorti, 2004).
A network market is a market for a certain product where the value of this product increases with the number of adopters (Sheremata, 2004: 359). Katz and Shapiro have defined network markets as markets where the benefit customers can derive from using a certain product depends on the number of other customers buying compatible items (Katz & Shapiro, 1986: 822). For instance, what is the use of a fax machine if there are no other users? Indeed the utility of the fax machine to a user increases as the number of users increases (Srinivasan et al., 2004: 43).
What is the use of a fax machine if there are no other users?
On the one hand network markets can facilitate the quick diffusion of new, innovative products, because once enough participants have decided to adopt the innovation, the motivation of other participants to do the same increases significantly. On the other hand network markets can also be enormous barriers to the adoption of innovations, since all market players are interconnected (Chakravorti, 2004).
In network markets, utility comes from 2 different sources: the attributes of the product and the size of its network (Sheremata, 2004: 361-362). Indeed the customer utility in network markets can be expressed as ? + ?xt, where ? represents the consumption benefits which are not related to the network and ?xt the network consumption benefits. This equation demonstrates that superior products can compensate for network benefits (Katz & Shapiro, 1992: 58-59).
There are positive network externalities when the customer’s utility for a product grows as the number of customers using the same or compatible product grows. Network externalities do affect customers’ behaviours (Srinivasan et al., 2004: 41). The network externalities are the positive external consumption benefits linked to the product’s network.
For instance, being able to use certain software on a computer is a network externality. Such network externalities are important in several major industries (Katz & Shapiro, 1986: 823).
Moreover, different network markets have different threshold with regards to their size. This means that each network market has a size at which network externalities cease. Thus, when this threshold is low, several networks can coexist. Network externalities do not always grow at a constant rate. (Sheremata, 2004: 366-376).
Positive Effects of Network Externalities
According to the network externalities theory, the size of the user network of a product is the key reason for adopting it. Having an important, installed base of customers can allow for a faster acceptance of an innovation by the market, through word-of-month or through the credibility that this network brings to the firm. Therefore, not only the current size of the network matters, but also expectations about future size.
A strong user network brings value to the product
A strong user network brings value to the product (Frels et al., 2003: 32-33). Besides giving positive feedback, a large network of users can lead to the development of more complementary or compatible products, thus improving the utility of a product and finally encouraging the adoption.
Moreover, customers adopting the product will invest money in learning how to use the product and in complementary products. This will result in lock-in, and represent switching costs, making the customers reluctant to change to a competitor product (Srinivasan et al., 2004: 43). The effects of network externalities are explained in the Metcalfe’s law, which says that the value of a network equals the square of the number of users. Ultimately, a standard can emerge, thus eliminating all uncertainties concerning the size of the network and encouraging early adoption.
Negative Effects of Network Externalities
This “wait-and-see” behaviour will then delay the adoption and can lead to inertia, since all participants are waiting for more participants to join the network
Network externalities can also have negative consequences. They can slow the diffusion of certain innovations because of the uncertainties linked to their utility when there are only few adopters. This “wait-and-see” behaviour will then delay the adoption and can lead to inertia, since all participants are waiting for more participants to join the network. Eventually this period of inertia can make the development costs excess the revenues of the company (Chakravorti, 2004: 62).
Often standards are created to favour compatibility. In market where network externalities are important, the advantages of offering compatible products are important as well, although this might increase production costs (Katz & Shapiro, 1986: 823).
Compatibility is definitely a source of value in network markets
Nevertheless, compatibility is definitely a source of value in network markets: if the network size matters, then compatibility matters too. Actually customers measure the network benefits from network size because they value compatibility. However, since compatibility allows customers to mix products from a larger pool, it also increases their expectations in terms of network benefits (Sheremata, 2004).
Lately Sony, Samsung and Matsushita, and Toshiba were competing with 2 different formats of DVD: respectively the Blu-Ray and the HD DVD. Last January however, Warner Bros. decided to back the Blu-Ray format and announced that it would only release Blu-Ray movies starting July.
This led to a huge enlargement of the Blu-Ray network, and contributed to the sales of Sony’s Play Station 3, since it uses this format (Hall, 2008a). After Warner Bros. decision to join the Blu-Ray camp, Toshiba surrendered and decided to give up its HD DVD technology (Hall, 2008b).
Concerning network markets, a lot has been said and written about the first mover or early entrant advantages. Nevertheless challengers may be forced, for instance to defend core businesses or for related diversification, to enter network markets, and can indeed win (Sheremata, 2004). The radicalness of the product, the technological intensity of the product, and the size of the pioneer company have strong impacts on its survival in a network market.
These impacts can either be positive or negative, thus making it possible for challengers to take advantage of some flaws of the first mover and to build a significant share in a network market (Srinivasan et al., 2004).
About the author
Gunjan Bhardwaj is coordinator of the Global Business Performance Think-tank of Ernst&Young. He is also the solution champion for Pricing strategy and effectiveness as well as Innovation management in the advisory services of Ernst & Young with a focus on Pharmaceutical and FMCG sector.
Gunjan is also a guest professor for Growth and Innovation management at European Business School (EBS) in Germany and a member of the scientific advisory board of Plexus Institute in the US which researches on complexity in health sciences
Gunjan Bhardwaj graduated from Indian Institute of Technology Bombay, India in Metallurgical Engineering and Material Sciences and then did his MBA in International Management and Marketing in Pforzheim University, Germany on a DAAD Scholarship.
Gunjan has published a number of papers and articles in various Journals and magazines and has been a frequent speaker in conferences on marketing and innovation related topics. He is also the chief editor of the quarterly journal of Ernst & Young’s advisory practice called Performance.
Chakravorti, B. (2004) The new rules for bringing innovations to market. Harvard Business Review, March, pp. 59-67.
Frels, J.K., Shervani, T. & Srivastava, R.K. (2003) The integrated networks model: explaining resource allocations in network markets.
Hall, K. (2008a) Sony’s Blu-Ray breakthrough. Business Week, January 8.
Hall, K. (2008b) DVD format war: Toshiba surrenders. Business Week, February 19.
Katz, M.L. & Shapiro, C. (1986) Technology adoption in the presence of network externalities. Journal of Political Economy, 94:4, pp.822-841.
Katz, M.L. & Shapiro, C. (1992) Product introduction with network externalities. Journal of Industrial Economics, 40, pp. 55-84.
Sheremata, W.A. (2004) Competing through innovation in network markets: strategies for challengers. Academy of Management Review, 29:3, pp. 359-377.
Srinivasan, R., Lilien, G.L. & Rangaswamy, A. (2004) First in, first out? The effects of network externalities on pioneer survival. Journal of Marketing, 68, pp.41-58.