Behavioral economics and crowdsourcing

Behavioral economics uses social, cognitive and emotional factors in understanding the economic decisions of consumers. It integrates insights from psychology with economic theory.

Social vs. market norms

Imagine you are at a dinner at your mother-in-law’s house. Try to answer the following question:

• Would paying be a good idea?

Answer to this questions seems to be pretty straightforward. It is simple, because we assume to apply social norms here. According to social norms, that are defined as derived from our social nature and our need for community, you wouldn't be required to pay for the meal.

However, from the market norms' perspective - based on costs and benefits - you would.

Working for a cause vs. working for money

In many cases people work more for a cause than for cash. Let's analyze the results from the AARP (American Association of Retired Persons) study. When lawyers were asked to offer less expensive services to needy retirees ($30 an hour) – they declined. However, when asked to offer free services – they agreed.

What does it tell us?

People act differently under social and market norms.

Do they also perform differently?

Performance under market vs. social norms

Let's now have a look at how working under social vs. market norms affects performance.

Case 1: Working for money
Students were asked to perform a boring task for 5 minutes

• Group 1 didn’t get paid
• Group 2 got 5$
• Group 3 got 50 cents

Results:

• Group 1: best performance
• Group 2: slightly worse
• Group 3: the worst 

Case 2: Working for a gift
The same experiment with gifts:

• Group 1: no gift
• Group 2: chocolate worth 5$
• Group 3: chocolate worth 50 cents

Results:

• All three groups had the same performance

Even small gifts keep us in the social exchange world – and away from market norms

Case 3: Work for an explicitly priced gift

• What about “50-cent snickers bar” and “five-dollar box of Godiva chocolates”?

Results:

• The same performance as with money: the students reacted to the explicitly priced gifts the same way they reacted to cash

Once market norms enter our considerations, the social norms are pushed out

Summary

Heyman and Ariely (2004) distinguish between monetary markets and social markets:

• Monetary markets are highly sensitive to the magnitude of compensation, whereas social markets are not
• Money market: effort depends on reciprocity, the amount of compensation directly influences individuals’ level of effort
• Social market: effort is shaped by altruism, the amount of compensation is irrelevant
• Explains a well established observation: people sometimes expend more effort for no payment (vs. low payment)
• Mixed markets closely resemble monetary market: signaling that a compensation is equivalent to money invoke market norms

Crowdsourcing and open source projects operate under social norms. As research shows merely activating the concept of money completely change the setting and heavily influence people's performance.

Next post will cover some other aspects of psychological concept of money. Stay tuned!

Source: Heyman, James, and Dan Ariely. "Effort for payment a tale of two markets."Psychological Science 15.11 (2004): 787-793.

Crowdsourcing: social phenomenon in monetary markets

Today, probably everybody has heard about crowdsourcing. However, do you know what is it? More importantly, do you know why do we do it? How do firms exploit it? And what are the implications for competition?

This post starts a short series on crowdsourcing. We will have a closer look both at psychological aspects and market consequences:

• How concept of money changes personal and interpersonal behavior?
• Enterprise 2.0 and social networking within corporation
• What drives people to contribute for free?

Today we start with general information about crowdsourcing, definition and examples.

What is crowdsourcing

—First time this term was coined by Jeff Howe in June 2006 in Wired. Howe presented crowdsourcing as a

"business model that leverages the power of online communities for profit". 

"Wired" cover: June 2006

It combines 

"the best aspects of open source production and outsourcing".

According to Wikipedia —

“crowdsourcing is defined as the act of taking a task traditionally performed by an employee or contractor, and outsourcing it to an undefined, generally large group of people, in the form of an open call.”

There are three main pillars of crowdsourcing:

• —Collective intelligence: a million heads are better than one 
• —Crowd wisdom: aggregating the individual solutions of many is often better than collaboration for problem solving 
• —New media technology (Internet): helps cast a wide net to harness this talent

The power of the crowd

Empire State Building

Facebook 1bn users spend on average 8 hours per month on the site

= 8 billion hours per month

= 266 million hours per day

Empire State Building took 7 million man hours to build. Time spend every day on Facebook is enough to build 38 new Empire State Buildings every day!

Why do users contribute?

They contribute for a sense of collaboration and trust. Below are the main drivers for users' contribution:

• Collect participants’ resources or data 
• To get a reasonably immediate rewards 
• Social rewards, being part of the community 
• Reputation 
• Self expression 
• Altruism 

If you are interested in how concept of money changes social behavior, stay tuned for the next post.

Source: Cook, Scott. "The contribution revolution: Letting volunteers build your business." Harvard Business Review 86.10 (2008): 60-69.

What are the advantages for companies?

1. —Cost advantage. These sites enjoy free “raw materials”, ex: eBay, an online store with no inventory 
2. —Scalability advantage. Contributions of countless people can be aggregated into vast compilations that surpass traditional offerings. Wikipedia has ten times as many articles as Britannica. 
3. —Competitive advantage. The network effect put in motion a spiral in which increasingly more people choose to use and contribute to it.

The Economics of Technology Sharing

In this post I will try to answer the question why programmers invest their own time in OS projects? What motivates them to contribute and what is in it for commercial companies?

Literature provides us with 6 possible reasons:

• Improve performance in paid work (e.g. system administrators looking for solutions for their companies) 
• Intrinsic pleasure (e.g. cool project) 
• Future job offers, shares in commercial open source based companies 
• Ego gratification from peer recognition 
• The promise of higher future earnings 
• Intellectual curiosity 

Signaling 

Other very important reason for investing programmers’ time in open source projects is signaling, i.e. proving high level of competence. Why this is important in OS? Because the ability to signal a high level of competence can be higher in an OS project. 

• Outsiders can see the contribution of each individual 
• The programmer takes full responsibility for a subproject 
• More knowledge can be transferred to new environments, because many elements of the source code shared across OS projects 

Let’s have a look at the Apache Project.

Instead of central leader they have a series of committees to resolve open issues. There are five levels of rank within the Apache Software Foundation (ASF): 

• Developer 
• Committer 
• Project management committee member 
• ASF member 
• ASF board member 

Advancement is made in recognition of an individual’s commitment and contribution to an Apache project. Empirical study (Hann et al 2004) showed that: 

• Sheer volume of contribution have little impact on salary 
• Moving into higher rank resulted in 14-29% increase 

Commercial Firms

Commercial firms may interact with open source projects in a number of ways:

• Benefit from complementary markets 
• Benefit from learning 
• Benefit from good public relations 
• Compete directly with open source providers 

Example: IBM and HP released codes to open source communities

Why?

Bait and hook: if the released code will be used more widely, profits in the complementary segment will grow (e.g. from consulting services)

Other very important reason is that many small developers are uncomfortable doing business with large firms, that may compete in the developers segment and reduce price in order to raise demand for the broad software platform.

By contrast, when a large firm makes its platform available on an open source basis, the small firm need no longer fear being squeezed.

However, we don’t know if the corporation will keep all source code in the public domain? Or if it will highlight important contributions adequately?

In this case important licensing plays important role.

Open source licenses

Permissive license

users retain the ability to use the code as they want. Common in projects with strong appeal to the community of contributors

Restrictive license 

common in projects geared for end users who are unlikely to appreciate the coding (e.g. computer games)

Quality

There is no consensus if open source software is superior to “off-the-shelf” commercial software. Advocates of OS code’s higher quality stress that:

• Users can enhance quality 
• Users can customize it to meet particular needs 
• There is a superior development process: 
• Workers in commercial firms may not report errors of fellow employees – however OS programmers do not have incentive to collude, and their project is more peer reviewed 
• Security flaws are more easily identified because many people are involved 

Counter arguments:

• The openness of the code allows hackers to figure out its weaknesses 
• Poorer documentation (due to the incentives structure) 
• Poorer user interface 

Public policy

Governments around the world encourage the development and use of open source projects. However, the impact on social welfare is not conclusive:

• OS projects have access to a larger talent pool 
• On the other hand: free riding problem 

According to static point of view, any potential user has access therefore OS increase social welfare.

Dynamic view states that developers may lack incentives to introduce new products therefore OS reduce social welfare.

Bibliography: Lerner, Josh, and Jean Tirole. The economics of technology sharing: Open source and beyond. No. w10956. National Bureau of Economic Research, 2004.

Innovation models

In organizational science there are two prevalent models of innovation:

(1) Private investment model
(2) Collective action model

Open source contains elements of both models, and represents private-collective model

The private investment model
In the private investment model an innovator earns from private goods thanks to intellectual property protection. Intellectual property laws are simply the innovators’ rights to their work. They are an incentive to create new knowledge for the innovators. However, intellectual property protection diminishes knowledge dissemination.

The collective action model
The collective action model works under conditions of market failure, where innovators collaborate in order to produce a public good.

Provision of public goods implies that if any user consumes it, it cannot be feasibly withheld from other users. This infers two main problems:

(1) Free riding problem
(2) Incentive problem

General solution to those problems is to provide monetary and reputation-based rewards to innovators.

Private-collective model
Private-collective model comprises of both models where incentives for private investment and collective action coexist.

First of all, software users rather than software manufacturers are the typical innovators; a fundamental incentive is using the software. Secondly, innovators freely reveal the proprietary code they developed. This implies (1) an increase of innovator benefits (e.g. sales of complementary goods) and (2) private losses will typically be quite low, rivalry with potential adopters is low – but the reward may be significant (e.g. reputation, reciprocity, building a community)

In private investment model it is assumed that free revealing of code leads to a loss of private profits. Conversely, in OS projects free revealing can result in net gains for the company. For example, free revealing can increase innovation diffusion and so increase an innovator’s profits through positive network effect.

Collective action model assumes a free rider can obtain equal benefits to those a contributor can obtain. Conversely, in OS projects contributors gain private benefits which are stronger than those available to free riders, e.g. learning and enjoyment, sense of ownership and control over the work, they can choose the project, the task and the technical approach to suit their own interest, and last but not least participating in a community. These rewards reduce the free riding problem.

It is worth noting, that free riders can be good for the company. There are two reasons for that (1) their adoption of the software increase its market share and help to set it as a standard in a marketplace, (2) some users do not write code – but contribute by reporting bugs.

Source: Eric von Hippel and Georg von Krogh (2003) "Open Source Software and the 'Private-Collective' Innovation Model: Issues for Organization Science" Organization Science 14, 209-223.

Open Source

What is open source?

Open source usually refers to software that is released with source code under a license that ensures that derivative works will also be available as source code, protects certain rights of the original authors, and prohibits restrictions on how the software can be used or who can use it.

You can find over 300k open software projects on Sourceforge.net - provider of free services to open source developer.

What is an open source project?

Open source project is a voluntarily collaboration of Internet-based communities of software developers to develop software that they or their organization need. Contributors agree to make all enhancements available to everybody. Many of contributors are not paid; the strucutre is often loosely structured, contributors are free to choose interest area.

Open Source is different from shareware, freeware and crowdsourcing. Shareware is a proprietary software provided for free (binary files), usually on a trial basis (the user pay for continued use/support). Freeware is a software provided for free (can be copyrighted or in the public domain). Crowdsourcing is basically an outsourcing of a task to a group of contributors.

Early history

1960s-1970s: sharing source code was commonplace (part of the research cultures). Software was mainly developed in academic and corporate labs by scientists and engineers

Early 1980’s: AT&T enforced its property rights of Linux, to which many academics and other corporate researchers contributed

1985: The Free Software Foundation was established by Richard Stallman, a programmer at MIT Artificial Intelligence Laboratory

"Software users should freely learn and create; software should be free to use, modify and distribute" The philosophy of The Free Software Foundation

1998: the Open Source Movement was founded by prominent hackers, replacing the term “free software”
and emphasizing the practical benefits of OS (economic and technological)

Watch a video of Richard Stallman talking about the open source:

How OS projects evolve?

A project is typically initiated by an individual or a small group having an idea, for an intellectual, personal or business reason. Anyone with the proper programming skills and motivation can use and modify any OS software written by anyone. The project initiators usually become the project “owners” taking responsibility for project management. Others can download, use and “play” with the code (most of them are free riders). However, some go on and modify the code and then they post it on the project website for others to use it and for feedback. In many projects the privilege of adding to the authorized code is restricted to only a few trusted developers a.k.a. “gate keepers”.

Who is using OS?

• 20% of Internet users use Firefox (source: www.statowl.com, 06-2012)
• Facebook uses PHP and MySQL and is the largest user in the world of memcached, an open-source caching system 
• Google has over one million servers running a customized Linux version as an operating system 
• 50% of web servers employ Apache 
• 60% of web servers use Linux as an operating system 
• PERL and PHP are the dominant scripting languages

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".

How do digital information good characteristics influence pace and modalities of international market entry?

As it was described in the previous post - Internationalization of Internet Companies - digital goods providers can deploy different internationalization strategies. In this post I will use eBay as a case, describing its internationalization process compared to three literature-streams: internationalization theory, internalization theory, and research on international new ventures.

The Internet allows small firms to become international via a website, and communication costs are reduced in international operations.

Digital information goods differ from other goods in several dimensions and their economic implication. These are:

a. experience good character
b. transportation costs
c. (re-) production costs
d. product adaptation costs 

Digital information good providers seek to enter foreign markets through entry modes that allow

a. control for branding and advertising strategies, and
b. gaining access to locked-in customer bases.