We now deal with the Network Effect. Economists have studied similar effects for a generation and call them Externalities. These are the situations when production or consumption affect people who are not directly involved in these transactions. The classical examples were about pollution (a negative externality) and education (positive, I hope). Since the mid 1970s there is an interest in externalities in communication and technology networks. The first paper about this effect was published in 1974 by Jeffery Rohlfs from Bell Labs.
This paper from 1985 is the famous model of network externalities and competition by Katz and Shapiro from the University of California in Berkley. The paper presents the basis for our current business thinking about competition and compatibility in Information Technology.
Now it is clear that handling correctly the network effect is critical to success in technology markets. Apple is a good example. During the 1980s, Apple hesitated a long time between controlling and opening its Mac technology. Should it allow others to build and sell the hardware? Should it allow others to develop and sell software for the Macintosh? They had a few false starts with openness but finally chose a control strategy rather than letting go of control and letting the market create a much larger network. At the end of this period Apple's market share was 3% while the IBM compatible market held by Microsoft and Intel had the rest. Apple and Steve Jobs got an opportunity to rethink their network effect strategy with a hand held communication and computing devise they introduced six years ago. What strategy do you think they used? During the early 2000s it was clear that some openness is critical and we got the App Store and hundreds of thousands of applications for this technology.
These ideas are extremely practical and important for the management of technology but the paper is also important because it is analytical and applicable to your own organisations, for example understanding how to go about setting price to maximise profit. Thanks to Katz and Shapiro we can play with a mathematical model and experiment with pricing and network size. In this class we will limit ourselves to the problems of pricing and market expectation formation of a single supplier by building our own simple model of monopoly in a communication service.
If you wish to explore this paper and competition in markets with network externalities more deeply you should familiarise yourself with Cournot (en.wikipedia.org/wiki/Cournot_competition).
