Two-sided networks

What is a two-sided network?

Wikipedia defines them as:

"economic platforms having two distinct user groups that provide each other with network benefits". 

Two-sided networks can be found in many industries, sharing the space with traditional product and service offerings. They exist in both physical and digital markets. Example from the physical world can include newspapers where subscribers are connected with advertisers. In digital words the obvious example is Google connecting users and advertisers or eBay - connecting buyers and sellers.

Economic platform (as used in the definition above) is a product or service that brings together groups of users in two-sided networks. It provides an infrastructure and rules that facilitate the two groups’ transactions. It also Incur costs in serving both groups and can collect revenue from each.

Two sided network effect

The two groups attract each other and value for a given user depends on the number of users on the other side. Platforms in two-sided networks enjoy increasing returns to scale. Leaders can leverage their higher margins to invest more in R&D or to lower prices to grow further the platform and benefit further from increasing returns to scale. This is driving out weaker rivals and only few biggest players remain in the market.

The platform attract subsidy side users. Once the platform reaches the critical number of users the company starts to monetize the platform - money side users will pay to reach the critical mass of subsidy side users. The bigger the network the more users will pay to access it. Generally, margins improve as the user base grows.

Pricing the platform

One of the biggest challenges in the two-sided networks is how to choose a price for each side of the platform? What will be the impact on the other side’s growth and willingness to pay? In other words,  how much subsidy should one side get – and how much premium should the other side pay?

If the subsidy-side was an independent market it would have to pay more. In this scenario giveaway might be wasted if the network subsidy side can transact with rival platform’s money side.

Pricing is further complicated because of same side network effect. Bigger the network on either side - subsidy or money - attracts more users.

In a nutshell, there are couple factors to be considered:

• ability to capture cross-side network effect,
• user sensitivity to price, e.g. PDF readers are very sensitive about price and publishers will yield more revenue by reaching out to more users than charging less users premium price,
• user sensitivity to quality, e.g. gaming platforms are very sensitive about quality of games delivered by the developers, as one 'low-quality' game may disturb the whole reputation of the platform discouraging other developers and users.

When Apple launched Mac, it charged third party developers $10,000 for the software development kit. In the same time Microsoft gave the Windows kit for free. As a result, Windows had 3 times as many applications.

Winner-takes-all dynamics

A single platform is likely to control the market when:

1. Multi-homing costs are high for at least one user side (the cost of establishing and maintaining platform affiliation)
2. Network effects are positive and strong
3. Neither side’s users have a strong preferences for special features

Sony provides a classic case study example of failure of emerging network with  its Betamax videotape system introduced in 1974. In a nutshell, in mid 70s two platform emerged (1) Betamax, developed by Sony and VHS, developed by Matsushita. Although Sony had better product, in the end VHS was widely adopted mainly because of Matsushita's distribution partnerships that resulted in building the critical mass that enabled cross-side network effect.

How do imitations erode the benefits of first movers?

As we discussed in post Is it always better to be first in Internet space? first movers can benefits from:

• experience/learning curve effects: reduce manufacturing costs 
• secure supply of raw materials if scarce resources 
• establish preferential shelf space, distribution channels and product segment 
• create buyer awareness and high switching costs as entry barrier to imitators 

However, Lee et al (2000) researched that first mover advantages were completely eroded by early and late imitations. Even more interesting is that even late imitation had significant influence on first mover stock market performance.

Early and fast movers achieve greater gains than the late and slow companies. However, they often suffer from new product imitations. Sometimes a fast second move can produce superior results.

Early imitations can be a profitable alternative to moving first, because:

• imitator learns from the first mover’s experience, they can reduce the risk or avoid the mistakes 
• avoid pricing mistakes 
• limit risk exposure and cut developing costs by reverse engineering 

The faster a firm introduces a new product, the higher the abnormal returns; first & second movers will (on the average) report higher abnormal return than late movers.

At a tie of new product imitations, the abnormal returns will be negative for the first movers; the faster a firm imitates, the greater the negative abnormal returns for the first mover (or the less durable the first mover advantages)

Summing up, there are two important implications for the companies:

(1) the faster & earlier a firm introduces a new product, the greater the shareholder wealth effect
(2) imitations impact negatively first movers, even late imitations

Source: Lee, Smith, Grimm & Schomburg (2000): Timing, Order and Durability of New Product Advantages with Imitation, Strategic Management Journal, 21, 1, pp. 23-30.

Is it always better to be first in Internet space?

Remember the post Who is afraid of a bid bad wolf? It presented a hypothesis that the first mover doesn't always perform better. In some cases it is actually the second mover or the imitator who is winning over the market share.

As you will learn in this post, leaders are more likely to experience loss of market share when (relative to industry challengers) they are less competitively aggressive, carry out simpler repertoires of actions and carry out competitive actions slowly.

Market share leadership comes together with being more profitable that the competitors. Main reasons for that are economies of scale, market power, first mover & reputation advantages. You can read more about the in posts: Prawo rosnących przychodów (in Polish) and How do firm characteristics and behavior affect i18n?

Another important thing you need to remember is the market dynamics. According to Schumpeter dynamic market process by which market leaders & challengers are in an incessant race to get or to keep ahead of one another is the reason why companies and industries experience creative destruction. It is all about challenging the market status quo.

According to Ferrier et al (1999) leaders that carry out more competitive actions than challengers will have a lower rate of market share gap erosion and a lower rate of dethronement. They define total competitive activity as the total number of new competitive moves the firm carried out in given year.

Leaders are more likely to lose market share when they are

– less aggressive,
– carry out simpler repertoire,
– carry out competitive actions more slowly,

with relation to their competitors. Higher the industry rivalry or aggressiveness of one of the companies in the market increases higher the likelihood of market share gains. In Schumpeter's sense, competitive dynamics among market leaders affects their market position.

Managerial implications

What can we learn from the research that Ferrier and his colleagues did over 10 years ago? First of all companies need to try to understand and predict the move of rivals. Secondly, they should take more actions and undertake them more quickly than competitors. Finally, carry out a broader range of actions to confuse your rivals. 

These simple things that every company is capable of doing can increase their changes of gaining more market share (or reduce the risk of market share erosion or dethronement).

Bibliography: Ferrier, Smith and Grimm (1999): The Role of Competitive Action in Market Share Erosion and Industry Dethronement: a Study of Industry Leaders and Challengers, Academy of Management Journal, 42, 4, pp. 372-388.

How do firm characteristics and behavior affect i18n?

"Internet firms are born global" (Kotha et al, 2001)

There are four main factors that affect the i18n of the Internet company:

(1) Reputation (intangible asset): number of media articles

(2) Website traffic (intangible asset): unique monthly users

(3) Level of competitive activity: new products and features

(4) Level of cooperative activity: partnering agreements

In 2001 Kotha, Rindova and Rorhaerrnel researched that these 4 factors are positively related to the degree of i18n (number of foreign domain websites).

Who’s affraid of a big bad wolf? Introduction to Internet competition

Radical innovations create economic growth in the long term while some of the well established firms decline. In Internet world no leadership position is secure or sustainable.

Schumpeter & the Austrian school described the innovation as a process of creative destruction. Innovation is a dynamic market process by which firms engage in a race to get ahead of one another. Creative destruction imply that:

• innovative actions undermine the competitive advantage of established competitors 
• firms commit resources to develop new products, new technologies and distribution channels 
• the success of these innovations provokes competitive responses from existing firms and new entrants 

Competitive Actions

Are the primary mechanism that the firms deploy to establish and protect their advantage, as well as erode the advantage of competitors

Competitive action can be defined as all action that are taken in the pursuit of discovered profit opportunity

As a rule, a leader that carry out more actions will exploit more opportunities and, hence, close the potential for challengers. Firms undertaking more competitive actions have superior performance. Continous innovation may be more important to competitive advantage than protection of assets.

Competition

Internet market is always in disequilibrium. Large firms are swept into a turbulent competitive rivalry that creates winners and losers. We can observe an inevitable destruction of the competitive status quo through new competitive moves by rivals. They can embrace innovation or immitation. Either or, the leaders will lose to more aggresive rivals if they not undertake any aggressive actions of their own.

Hypercompetition

According to D’Aveni hypercompetition results from the dynamics of strategic maneuvering amongst competitors. It can easily be observed in a fast-paced industries. In hypercompetitive environment all advantages are temporary and no industry position is secure. Competitors can easily copy an advantage from the other firms; it simply becomes the cost and risk of doing business.

Firm performance is an outcome of a continous series of competitive actions. Speed allows companies to disrupt the status quo, because it creates new advantages before competitors are able to preempt these moves. Speed is negatively correlated with complexity, thus there is a danger of simplicity. Simple actions become predictable and can be easily immitated.

Successful firms ”hit” competitors from several different directions at once. Market-leader choosing a complacent strategy may lose its position, being vulnerable to more aggressive challengers.

Competitive Dynamics

The interplay of actions and response and their implications on firms’ performance is defined as competitive dynamics

Firm aggressiveness is the outcome of three factors:

• Timing/speed 
• Frequency 
• Range/complexity 

Timing of action

A company that is first to introduce a new product/service, or first to enter a market, may gain competitive advantage. The advantage may be derived from:

• Monopolistic profits 
• Technological leadership 
• Establishment of brand loyalty 
• Establishment of buyers’ switching costs 
• Economies of scale 
• Learning and experience 

The durability of such advantages is largely determined by the speed of imitation by the competitors. According to Lee et al (2000), "the faster a firm introduces a product, relatively to its rivals, the greater is the impact on shareholders’ wealth". However these advantages can be completely eroded by the sum effect of early and late imitations. Ferrier et al (1999) says that the "industry leaders were more likely to maintain their market share by acting fast against challenges". Challengers who act faster than leaders tend to gain market share.

What about the second mover?

In some cases it is actually the second mover or the imitator who has a better performance. The reason for that is the learning from the first mover mistakes and the ability to create a better product/service through reverse engineering or other methods.

It is very important to note that though the theory stresses the importance of quick reaction/imitation, it is undeceive regarding the benefits of being a pioneer.

Number of actions

Firms take actions in the pursuit of profits and untapped market opportunities. Generally, firms taking more actions are expected to exploit more opportunities and have better performance.

According to Ferrier et al (1999) "market-share leaders were more likely to be dethroned by challengers or to lose market share when they are less competitively aggressive". We expect aggressive firms, those carrying out more competitive actions than rivals, to have better performance than their competitors.

Competitive repertoire

To gain advantage, firms should constantly develop new types of actions. Firms carrying out a broader variety of actions are expected to perform better because they will be perceived as more capable and may be less predictable. On the other hand, a simple repertoire of actions may be too predictable and may erode a firm’s competitive position.

As Ferrier et al (1999) has found in his research "market leaders using a narrower set of actions (relatively to their challengers) experienced market share erosion and dethronement".