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Chapter 8 – Understanding Network Effects: Strategies for Competing in a PlatformCentric, Winner-Take-All World John Gallaugher - Information Systems: A Manager's Guide to Harnessing Technology, version 4.0

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Chapter 8 Understanding Network Effects: Strategies for Competing in a Platform-Centric, Winner-Take-All World Section 8.1 True/False Questions 1. In the context of network effects, the term “network” refers to either wired or wireless systems that connect computing components. False; Easy 2. In the absence of network effects, the value of a product or service increases as the number of users grows. False; Easy 3. Network effects do not influence all consumer products or services. True; Easy Multiple Choice Questions 1. Metcalfe’s Law is also known as: a. systemic events. b. cluster effects. c. group impressions. d. herd instincts. e. network externalities. e; Easy 2. Which of the following products or services is not subject to network effects? a. Banking services b. Snack chip manufacturing c. Video game consoles d. Social networks e. Cell phone services b; Easy Essay Questions 1. What are “network effects”? Define the term and briefly explain the relevance they hold in an economic context. Network effects are sometimes referred to as “Metcalfe’s Law” or “network externalities.” In this context, a network refers to a common user base that is able to communicate and share with one another. When network effects are present, the value of a product or service increases as the number of users grows. Network effects are the most important reasons why users pick one product or service over another. They are among the most powerful strategic resources that can be created by technology-based innovation. Many category-dominating organizations and technologies owe their success to network effects, including Microsoft, Apple, NASDAQ, eBay, Facebook, and Visa. Network effects are also behind the establishment of most standards, including Blu-ray DVD, Wifi, and Bluetooth. Moderate Fill-in-the-Blank Questions

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1. Network effects are also known as _____ Law or Network ____________. Metcalfe’s, Externalities; Medium Section 8.2 True/False Questions 1. Every product or service subject to network effects fosters some kind of exchange. True; Easy 2. High switching costs serve to weaken the value of network effects as a value asset. False; Moderate 3. The higher the value of a user’s overall investment, the more they are likely to consider the staying power of any offering before choosing to adopt it. True; Moderate 4. Staying power is important for consumers of technology products because investment over time usually greatly exceeds the initial price paid for a product or service True; Easy 5. Many firms attempt to enhance their network effects by creating a platform for the development of third-party products and services that enhance the primary offering. True; Easy Multiple Choice Questions 1. Which of the following factors represents one of the sources of value derived from network effects? a. Congestion b. Price transparency c. Information symmetry d. Staying power e. Complementary costs d; Easy 2. Staying power refers to the: a. relative abilities of parties in a situation to exert influence over each other. b. energy demands required to run a product or service. c. ability of a firm to produce a good or service at a lower opportunity cost than a rival. d. long-term viability of a product or service. e. ability to take advantage of complementary products developed for a prior generation of technology. d; Easy 3. Which of the following terms is used as an alternative to switching costs? a. Lock-in b. Complementary benefits c. Exchange benefits d. Straddling costs e. Network impedance a; Moderate

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4. _____ are products or services that add additional value to the primary product or service that makes up a network. a. Quantum efforts b. Substitute components c. Complementary benefits d. Orthogonal gains e. Standby additions c; Easy 5. Windows OS, the iPhone, the Wii, and Facebook’s application programming interfaces allow for the development and integration of complementary goods by third parties. Based on this evidence, all these products or services are said to be _____. a. pure plays b. coopetitors c. adaptors d. platforms e. venture capitalists d; Easy 6. A firm can spend no money and time, yet expect to enhance its offerings, by: a. allowing other firms to contribute to its platform. b. going public through an initial public stock offering. c. outsourcing critical processes to third parties. d. adopting an envelopment strategy. e. preannouncing a forthcoming product to lower sales of current offerings. a; Moderate Essay Questions 1. What are the primary sources of value for network effects? Give a brief description of how each of these factors provides value for network effects. The value derived from network effects comes from three sources: exchange, staying power, and complementary benefits. Exchange: Every product or service subject to network effects fosters some kind of exchange. Just about any standard that allows things to plug into one another, interconnect, or otherwise communicate will live or die based on its ability to snare network effects. Staying power: Staying power refers to the long-term viability of a product or service. Networks with greater numbers of users suggest a stronger staying power. Complementary benefits: Complementary benefits are those products or services that add additional value to the network. These products might include “how-to” books, software add-ons, even labor. These three value-adding sources—exchange, staying power, and complementary benefits —often work together to reinforce one another in a way that makes the network effect even stronger. When users exchanging information attract more users, they can also attract firms offering complementary products. When developers of complementary products invest time writing software—and users install, learn, and customize these products—switching costs are created that enhance the staying power of a given network. From a strategist’s perspective this can be great news for dominant firms in markets where network effects exist. The larger a firm’s network, the more difficult it becomes for rivals to challenge its leadership position. Moderate Fill-in-the-Blank Questions

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1. _____ are products and services that allow for the development and integration of complementary goods. Platforms; Easy 2. One way firms seek to strengthen their platforms and encourage third parties to develop complementary goods is by offering ___________. APIs or Application Programming Interfaces; Easy 3. Sure, network effects are valuable, but why? List the three sources of the value (cited in our textbook & in class) that fuel the competitive advantage of network effects. Exchange, Staying Power, Complementary Benefits; Moderate Section 8.3 True/False Questions 1. Almost all networks derive most of their value from a single class of users. False; Easy 2. An instant-messaging standard is an example of a one-sided market. True; Easy 3. Cross-side benefits arise due to interaction among members of a single class of participant. False; Easy Multiple Choice Questions 1. A market is said to be _____ if it derives most of its value from a single class of users. a. a pure play b. a long tail c. core competent d. one-sided e. convergent d; Easy Essay Questions 1. Distinguish between one-sided and two-sided markets. Provide examples for each and mention the benefits derived from these markets. A one-sided market is a network market that derives most of its value from a single class of users is often referred to as a one-sided market. In one-sided markets, users gain benefits from interacting with a similar category of users (for example, instant messaging, where everyone can send and receive messages to one another). The network effects derived from a one-sided market are referred to as same-side exchange benefits. A two-sided market is a network market comprised of two distinct categories of participants, both of which are needed to deliver value for the network to work. In twosided markets, users gain benefits from interacting with a separate, complementary class of users (for example, in the video game industry, console owners are attracted to platforms with the most games, while innovative developers are attracted to platforms that have the most users). When an increase in the number of users on one side of the market (say console owners) creates a rise in the other side (software developers), that’s called a cross-side exchange benefit. Easy

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2. Are the markets for mobile payments one-sided or two-sided? Describe why you chose your answer. Mobile payment efforts like Square and Google Wallet, however, are considered to be two-sided markets, where significant benefits come from two distinct classes of users that add value by attracting each other. In the case of mobile payments, the more people that use a given payment platform, the more attractive that platform will be to storefronts and other businesses, and if more businesses accept these forms of mobile payment, then this in turn should attract more end consumers (and so on). Moderate Section 8.4 True/False Questions 1. The natural state of a market where network effects are present is for there to be intense competition between several rivals that come to an equalibrium where their respective market shares are roughly identical. False; Moderate 2. In a market influenced by network effects, the winning product or service is often determined by its technical superiority, with technically strong newcommers able to unseat the dominant incumbents. False; Moderate 3. Mobile software developers often find iOS more attractive than the Android operating system, because Android runs on many more types devices than iOS and the Android operating system is fragmented into differnet versions, each combination of which needs to be tested. True; Easy Multiple Choice Questions 1. Apple, which controls over 75 percent of digital music sales, was able to dictate song pricing for years, despite the tremendous protests of the record labels. This implies that: a. despite the presence of network effects, the music industry is not dominated by any single leader. b. the presence of multiple new entrants forces leading firms to drop prices of their offerings. c. firms with strong market dominance can enjoy substantial bargaining power over partners. d. a dominant market share does not necessarily translate to greater profitability for a firm. e. there were cross-side network effects between the various music labels. c; Moderate 2. A market dominated by a small number of powerful sellers is known as a(n) _____ a. oligopoly b. pure play c. short tail d. blue ocean e. greenfield a; Easy

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3. The video game console market offers important lessons for the strategist. The video game console market is a network market in which Sony’s PlayStation 2 (PS2) dominated over Microsoft’s Xbox offering. This has been possible due to: a. the low pricing of Xbox which eroded users’ confidence in the product. b. game developers favoring PS2 for its larger user base obtained because the PS2 was launched months before the Xbox. c. the presence of several cheap, rival imitations which ate into Xbox’s market share. d. PS2’s technical superiority over the Xbox. e. the straddling strategy adopted by Microsoft to expand in both video game and DVD player markets. b; Moderate 4. Which statement best describes the relationship between network effects and innovation? a. Network effects decrease innovation within a standard but increase the number of innovative offerings that compete against a strongly established standard. b. Network effects increase innovation within a standard but decrease the number of innovative offerings that compete against a strongly established standard. c. More often than not, network effects foster innovation d. More often than not, network effects limit innovation b; Moderate Essay Questions 1. Explain the nature of competition in markets influenced heavily by network effects. When network effects play a starring role, competition in an industry can be fundamentally different than in conventional, nonnetwork industries. First, network markets experience early, fierce competition. The positive-feedback loop inherent in network effects—where the biggest networks become even bigger—causes this. Firms are very aggressive in the early stages of these industries because once a leader becomes clear, bandwagons form, and new adopters begin to overwhelmingly favor the leading product over rivals, tipping the market in favor of one dominant firm or standard. These markets are also often winner-take-all or winner-take-most, exhibiting monopolistic tendencies where one firm dominates all rivals. The natural state of a market where network effects are present is for there to be one major player. Since bigger networks offer more value, they can charge customers more. Firms with a commanding network effects advantage may also enjoy substantial bargaining power over partners. Moderate 2. Markets where strong network effects are present often exhibit a winner-take-all or winner-take-most dynamic. What network effects-related advantages can a dominant incumbent enjoy that help it repell rivals, and why is it so difficult for a newcommer to displace the dominant player in these markets? Winning customers away from a dominant player in a network industry is not as easy as offering a product or service that is better. Any product that is incompatible with the dominant network has to exceed the value of the technical features of the leading player, plus (since the newcomer likely starts without any users or third-party product complements) the value of the incumbent’s exchange, switching cost, and complementary product benefit. And the incumbent must not be able to easily copy any of the newcomer’s valuable new innovations; otherwise the dominant firm will quickly match any valuable improvements made by rivals. As such, technological leapfrogging, or competing by offering a superior generation of technology, can be really tough. Moderate Fill-in-the-Blank Questions

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1. A market where there are many buyers but only one dominant seller is known as a(n) _____. monopoly; Easy 2. _____ involves competing by offering a new technology that is so superior to existing offerings that the value overcomes the total resistance that older technologies might enjoy via exchange, switching cost, and complementary benefits. Technological leapfrogging; Easy Section 8.5 True/False Questions 1. Moving first plays a significant role in markets influenced by network effects. True; Easy 2. A Blue Ocean strategy often works best when combined with operational effectiveness. False; Hard 3. Envelopment is a management strategy where a dominant firm acquires all the layers in its value chain to increase profitability. False; Moderate 4. Regional anti-trust authorities may consider product bundling by dominant firms to be anticompetitive. True; Moderate 5. Firms that constantly innovate do so to develop open standards for competitors to become compatible. False; Easy 6. Startup firms that find new markets attractive but do not yet have products ready for delivery preannounce efforts causing potential adaptors to delay a purchasing decision until the new effort rolls out. False; Moderate 7. Congestion effects often result when a key resource becomes increasingly scarce with the arrivals of more and more users. True; Moderate Multiple Choice Questions 1. Worldwide auction leader eBay started operations in Japan 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. This example shows that: a. online auction markets are characterized by constant shifts in market dominance. b. market dominance in the global marketplace translates to an equivalent position in national markets. c. national markets tend to be influenced by factors that are not necessarily localized. d. it’s imperative to move first in markets influenced by network effects. e. firms should always subsidize initial adoption of their products and make them cheaper than their competitor’s products. d; Easy

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2. Cisco purchased Pure Digital, maker of the Flip video recorder, but ended up shutting the unit down a little over two years later. The reason for Cisco’s failure was: a. Envelopment. Smartphone manufacturers and music players began to offer video recording features, enveloping the benefit provided by Pure’s gear in their offerings. b. Network effects. Late-arriving Cisco could not compete against the dominance of existing, incompatible standards created by early-moving incumbents. c. The Osbour Effect. Cisco preannounced a product and no one wanted its current offerings. d. Staying power. Consumers weren’t convinced a small firm like Cisco could win in the market. a; Moderate 3. Viral promotion involves: a. offering rebates and incentives to customers for adopting a product or service. b. paying celebrities to use a product visibly to lure customers into unwittingly buying the product. c. emphasizing customer retention and satisfaction, rather than a dominant focus on sales transactions. d. leveraging a firm’s customers to promote a product or service. e. sending a pre-written set of messages to customers or prospects over time. d; Moderate 4. 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 violent games. The strategy adopted by Nintendo in this example is the _____ strategy. a. straddling b. customer engagement c. Blue Ocean d. mass customization e. convergence c; Moderate 5. Two distinctly separate markets are said to undergo convergence when they: a. are dominated by a small group of powerful sellers. b. derive most of their value from two distinct categories of participants. c. offer products and services designed to target a specific industry. d. are characterized by many buyers, but a single, dominant seller. e. begin to offer similar features and capabilities. e; Moderate 6. Uber and PayPal used similar strategies when trying to jumpstart network effects that were vital in creating their dominance. What did each do? a) Leveraged viral customer promotions by giving incentives to consumers who helped recruit friends to the servcie. b) Operated in “Blue Ocean” that, to this day, remains free of competitors c) Preannoucned their products, discouraging rivals from entering with competing offerings d) Created services that were backward-compatible with rivals, reducing switching costs for anyone interested inleaving incumbents for their services. a; Easy 7. _____ is said to occur when one market attempts to conquer a new market by making it a subset, component, or feature of its primary offering. a. Acquisition

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b. Greenfield investment c. Envelopment d. Market leapfrogging e. Monopolization c; Easy 8. Nokia is a cell phone brand that offers digital cameras as part of its cell phone products. It is now in direct competition with camera brands such as Canon and Sony, an...