Managing innovations and change HOMEWORK DUE IN 6 HOURS

PART (1) ‘Laws’ in the digital economy

1. What is Moore’s Law?
2.  Metcalfe’s Law? 
3.  Reed’s Law? 
4.   Why is it important for managers and entrepreneurs to understand these laws?
5. Take a digital company of your choice. How any of these laws apply to this company?

PART  (2)  Network effects 

1. What are network effects? How many types of network effects exist?
2. How are they different from other economic laws, particularly traditional ‘economies of scale’?
3. What are ‘data network effects’? How are they different from traditional ‘network effects’? 
4. Provide examples of businesses with network effects. Explain how they apply to these businesses. 
5. Why is understanding ‘network effects’  important for managers? 

Chapter 2

Innovation & Economics

MGMT 461
Managing Change & Innovation

Topic 10: Platforms and ecosystems

A/Prof Tatiana Zalan

This presentation builds on the ideas and presentations by Profs Geoffrey Parker, Marshall von Alstyne and Thomas Eisenmann

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Where are we in the course?
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2
Foundations:
Introduction to Innovation (T1)
Innovation & Economics (T2)
Developing an
innovation strategy (T3)
Creativity and idea
generation (T4)
Selecting and managing
an innovation portfolio (T5)
Implementing
innovations (T6)
Creating an
innovative culture (T7)
Boosting
innovation
performance (T8)
Funding and fostering innovation (T9)
Platforms & ecosystems (T10)
Innovation & change (T11)

Agenda and objectives
To clarify / explain:
Growth of the digital economy and platform businesses
Economics of information goods
Economics of platforms
Innovation and change enabled by platforms

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“There is hardly an area of economic and, arguably, social interaction these days that is left untouched by platforms in some way”.
Martin Bailey, Leader of the European Commission, on efforts to create a single digital market, quoted in The Economist, 28 May, 2016
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platform Revolution

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“In 2015, Uber, the world’s largest taxi company owns no vehicles, Facebook the world’s most popular media owner creates no content, Alibaba the most valuable retailer has no inventory, and Airbnb the world’s largest hotelier owns no real estate.”
Tom Goodwin, Sr. VP of Strategy Havas Media
Source: Parker, van Alstyne & Choudary (2015)

platform Revolution

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Platforms are beating products

The digital / information age – Class activity
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Questions – for the entire class:
What is the difference between the digital economy and the traditional economy?
What is a “platform” (vs ‘product)?
Questions for each group:
How can you explain the success of these companies? And their dominance?
Why did they grow so fast?
Which technologies underlie their growth?
What is the downside of growth (if any)?

https://www.youtube.com/watch?v=
dqdF3p9PEpU

Scott Galloway
THE BOTTOM LINE: A market warning, the big bitcoin debate and a deep dive on tech heavyweights (about 8 min start).
Task: Form 4 groups – “The gang of Four” – Amazon, Facebook, Google / Alphabet and Apple

Scott Galloway
The Four Horsemenhttps
://www.youtube.com/watch?v=XCvwCcEP74Q
Gang of Four: Apple / Amazon / Facebook /Google (Scott Galloway, Founder of L2) | DLD16‬https://www.youtube.com/watch?v=jfjg0kGQFBY
‪
Douglas Rushkoff
‪Online Companies Like Facebook Have Created a Meaningless Economy, says Douglas Rushkoff‬ https://www.youtube.com/watch?v=6_n1Dro0Uec
The Growth Trap https://www.youtube.com/watch?v=yUGzUktP7jg

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the world looks different

what does the market say?

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Global Internet Market Leaders = Apple / Google / Amazon / Facebook / Tencent /
Alibaba … Flush with cash …Private companies well represented

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Current generation of internet leaders =
Growing faster than previous generations

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Source: Galloway (2016)
New economy firms are extremely productive

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Information goods are goods that have information embedded in them – books, databases, magazines, music, web pages, databases are all information goods.
Digitization has enabled the detachment of information goods from the medium of transfer, impacting the production, exchange and consumption of information.
Digital goods are real bits located on physical devices – computer software and various services ranging from Internet search engines and portals to online content.
Digital goods have unique properties:
Unique cost structure
Properties of public goods
Property of experience goods and other
Network effects
The abundance of information (information clutter) creates a paucity of attention.

Information and Digital Goods

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Information goods have high fixed costs of production but near-zero or zero marginal costs (i.e., costs of reproduction).
Developmental costs of producing the first unit of an information product are generally high, but producing each additional unit costs virtually nothing.
For example, the estimated costs of developing the popular computer game Gran Turismo 5 were around $80 million (DigitalBattle, 2010); the costs of replicating additional copy range from negligible (production of DVDs) to essentially zero (downloadable files).
Cost of storing and transmitting stored information is cheap (and continues to get cheaper); there are no effective capacity constraints on the production of digital goods.
Traditional product
Digital product
Unique cost structure

MSPs (multi-sided platforms) are intermediaries that reduce search costs and transaction costs.
Characteristics of Multi-Sided Platforms (MSPs):
The platforms provides infrastructure and governance rules;
Two or more user groups participating;
Direct and indirect network effects;
Non-neutrality of fees – one side is a money side, the other a subsidy side;
Enabling direct interaction between two or more distinct sides – the sides retain control over the key terms of the interaction (e.g., pricing, bundling, marketing and delivery of goods)
Each side is affiliated with the platform – users make platform-specific investments (e.g., an opportunity cost or spending time and money on learning how to develop apps).
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what is a platform?

Industry platforms are “core” to a technological system of use (essential to its function) as well as highly interdependent with other parts of the technological system. The organization of these ecosystems appears to follow a regular structure, with platform leaders acting as “keystone” members of the network of firms that are the platform complementors, with a dense set of interdependencies, both technological and strategic, between the “core” that is the platform and the other parts of the ecosystem/technological system. The complementors themselves occupy a peripheral position in the network, with fewer links between them (Gawer and Cusumano, 2008; Gawer, 2010).

2007
iPhone
2012
Coursera
2014
Apple Pay

2008
Runkeeper

Source: Mishra, Smithson, Kim, Smith & Toraty (2017), presentation at MBS, March
Apple

Positive Cross-side Network Effects
Multi-Sided Markets
CUSTOMER VALUE

?

Exercise / Health

iPhone

?
Insurance
Companies

Study
Universities

We took a closer look at a couple of the horseman starting with Apple
Apple released its iphone in 2007 and this started their network of people who use a phone to make calls go on the internet and down the track they strengthened this network with things like facetime where it paid to have an iphone… your standard network effect
They then introduced a whole bunch of apps – ive used health and well being as an example – which probably drew more users but more importantly it drew app developers creating a two sided market – the more users there were – the more it attracted developers and the more apps there were, the more it attracted users
Similarly – they create a market for peple who want to study a Mooc
And a network with financial institutions
Over time, apple has built up a huge network of customers who derive value from being “connected” and apple leveraged this customer base to launch the apple watch – for people who were willing to pay to wear this convenience!
But does the apple watch add value to the network the same way apple pay does? Or the app store does?
On the face of it – it might look like it doesn’t but it could easily provide a link to the insurance industry or even to Geoff’s point, connect to the medical community to develop something that tells you to pack your bags cos your about to have a heart attack!
What we can see here is customer value created by positive cross-side network effects.

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Network effects – demand-side economies of scale
Control of user interface and user experience
Control of the ecosystem
Data and algorithms for:
Matching
Pricing
Personalisation
Trust
McAfee & Brynjolfsson (2017)
platform advantages

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Network effects are demand-side economies of scale.
Note that ‘network effects’ are nothing new. What is new, however, is that the Internet has enabled network effects on a global scale.
Supply-side economies of scale (or simply economies of scale) is a function of production size, scale leads to lower costs per unit. They operate on the cost side, and while costs fall, they cannot fall indefinitely.
Demand-side economies of scale (aka network effects) is a function of users, so scale leads to higher utility for users. They operate on the customers’ willingness-to-pay side. At least theoretically, there is no upper bound to network effects.
They are both sources of competitive advantage, but network effects are thought to be stronger, as users have higher
switching costs.

Network effects

Members of each group exhibit preferences regarding the number of users in the other group (cross-side network effects) and / or regarding the number of users in their own group (same-side effects).
Network effects are demand-side economies of scale. Many large platforms also exhibit producer-side economies of scale.
Network effects create significant barriers to entry and exit in an industry.
Side 1
Side 2
Platform

A two-sided platform has FOUR network effects

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Three common “laws” for estimating network Value

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Zipf’s law
Metcalfe’s law is too optimistic, Zipf’s law is more accurate (according to mathematicians
Andrew Odlyzko, Benjamin Tilly & Bob Briscoe)
Facebook Values Itself Based on Metcalfe’s Law, But the Market Is Using Zipf’s
https://www.forbes.com/sites/anthonykosner/2012/05/31/facebook-values-itself-based-on-metcalfes-law-but-the-market-is-using-zipfs/#32d915d268f5
An example of the difference in valuation between Metcalfe’s law (n2) and Zipf’s law (n log (n)) is illustrated by Bob Briscoe:
Imagine a network of 100,000 members that we know brings in $1 million. We have to know this starting point in advance—none of the laws can help here, as they tell us only about growth. So if the network doubles its membership to 200,000, Metcalfe’s Law says its value grows by (200,0002/100,0002) times, quadrupling to $4 million, whereas the n log( n ) law says its value grows by 200,000 log(200,000)/100,000 log(100 ,000) times to only $2.1 million.”
A more robust way of estimating Network Value

Estimating Network Effects
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InterBrand: 2013 Best Global Brands

These Grew Fastest

Children say “Google it”
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These are platforms

Platform Examples
Desktop OS: Unix, Mac, Windows
PDAs: Palm, Psion, Newton
Game Consoles: Wii, Xbox, Playstation
Network Switches: Cisco, IBM, HP
Multimedia: Adobe/Flash, MS/Silverlight, Google-Apple/HTML5
Payment Systems: Paypal, Google Checkout, Visa, Apple, Mobile Felica
Mobile Devices: iPhone, Android, Symbian, Blackberry
Enterprise Systems: Salesforce, Oracle, i2, IBM, SAP
Social Networks: Facebook, MySpace, LinkedIn, Monster, Twitter
Batteries: Sony, Panasonic, Sanyo, A123
Web Search: Google, Bing+Yahoo!, Baidu
Ebooks: Amazon, iPad, Nook, Sony
Smart Grids: IBM etc.
Health Care: Microsoft, WebMD, IBM etc.

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eBay Example: The Miracle of Value Exchange and Creation
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Source: D. Evans (2012) Catalyst Code: How to ignite a platform business and rule a platform-centred ecosystem

In a traditional value chain, on the left is cost, on the right is revenue

Price consumers are Willing
To Pay for a product

Retail Price

Wholesale Price

Price to wholesaler

Price to manufacturer
Price of farming inputs
Consumer surplus

Cost – including risk-adjusted cost of capital
Producer profit

Consumer
Retailer
Wholesaler
Manufacturer
Primary
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Value added

Traditional Value Chain

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Apple as a standard linear value chain business
User matches MP3 player to library (Apple pre-iTunes)
Apple as a two-sided market
Apple matches users to content
In these markets, value / cost can be on the left or right
Source: Parker & Van Alstyne (2011)
Platform businesses are different

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Source: Hagiu & Wright (2015)
Note: becoming an MSP is a strategic choice, not an inherent characteristic of an industry!
MSPs vs alternative businesses

Innovation and change in platforms
Marketing and prices
Winner-take-all (WTA) dynamics
Openness (vs control)
Valuation and finance
Unlocking new value from spare resources
New forms of organization

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The platform may charge a side….
Example: Microsoft makes consumers pay for video games
…or subsidise a side
Example: YouTube finances video content providers
Who should you charge?
Who should be subsidised?
The answer depends on three considerations:
Ability to capture cross-side effects => if your network’s subsidy side can transact with a rival platform provider’s money side, your ‘giveaway’ will be wasted (e.g., Netscape)
User sensitivity to price => subsidise the price-sensitive side
User sensitivity to quality = > subsidise the quality-sensitive side
Source: Eisenmann et al. (2006)
The allocation of fees on one side of the platform will affect the total volume of transactions, hence many MSPs have a money side and a subsidy side [see next slide]
The most important decision is the pricing structure

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Price
Quantity
Market One
q1
p1

Price
Quantity
Market Two
q2
p2

Price
Market One
Quantity
q1
p1

p1
q1

Price
Market Two
Quantity
q2
p2

p2
q2
If markets are separate, collect profits in both
But if markets are interdependent, discounting one builds demand in the other
See “Two Sided Network Effects” (2006) Management Science, Parker & Van Alstyne
The economics of pricing in two-sided markets

Cross-side effects are positive and strong.

User groups do not require differentiated features.

Switching costs (from one offering to another) and multi-homing costs (costs of affiliation with multiple platforms) are high.
Winner
takes all!
Three conditions lead to a WTA dynamic:
Source: Eisenmann et al. (2006)
}
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… this is what underlies the success of Amazon, Microsoft, Uber, Google, Facebook…
Firms strive to be MSPs because they can become winners-take-all
(or most) in their respective industries

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Research shows that MSPs (“ecosystems”) have higher revenue growth (32%) and higher profit margins (27%) than industry average. Smaller companies are better at seizing disruption opportunities (Weill & Woerner, 2015).
There is evidence that MSPs outperform other types of firms

Corporate valuation models that underestimate market expansion due to network effects fail to invest

Platforms encourage openness in organizations

Platforms Open Themselves to Third Party Contributions

40
Openness vs. Control

Your Share
Industry Value Added
Open
Proprietary
Your reward = (Value added to industry) x (Your share)
Based on: Shapiro & Varian ‘99
Maximum protection ≠ Maximum Value

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41
Openness vs. Control

Your Share
Industry Value Added
Open
Proprietary
Linux is so open (viral GPL) it’s difficult to control and make money.
Maximum protection ≠ Maximum Value

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© 2011 Parker & Van Alstyne

42

Why platforms beat products
Consider product innovation alone
– Harnessing 3rd party resources, innovation occurs at a higher combined rate.
– Even if a platform starts behind, its value will overtake the product leader.

Time
Value Added

© 2011 Parker & Van Alstyne

Platforms, innovation and change – summary
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‘Free’ pricing is profitable
Who is the money side, and who is the subsidy side?
Platforms unlock new value from spare resources and user generated content
Instagram sold for $1B not because of contributions of 13 employees, but from 30M users (premium on the value of personal data?)
Platforms enable collaboration between teams across the organization and organizational boundaries
Amazon’s motto – all teams expose their data
Platforms promote Open Innovation – they open themselves to third party contributions
Innovation takes place at a higher rate

Uber live case study
Task 1:
Compare Uber with BMW
Consider: (1) year founded; (2) employees and (3) market cap
What conclusions do you make?
Task 2:
What is innovative about Uber?
What is the pain point they are addressing? What problem are they trying to solve?
How did they build the platform? How did they start? How did they overcome the chicken-and-egg problem?
How does Uber make money? And how much?
Is Uber vulnerable? What could go wrong?

Side A
DIRECT INTERACTIOINS

MSPs vs. Alternative Business Models

Side B

Side A Side B

Side A Side B

Side A Side B

MSP

RE-SELLER

AFFILIA
TION AFFILIATION

SALES OF GOODS
OR SERVICES

SALES OF GOODS
OR SERVICES

V.I. FIRM

SALES OF GOODS
OR SERVICES

OWNERSHIP OF SIDE A
(VERTICAL INTEGRATION)

INPUT
SUPPLIER

SALES OF GOODS
OR SERVICES SALE OF INPUT

Side A
DIRECT INTERACTIOINS
MSPs vs. Alternative Business Models
Side B
Side A Side B
Side A Side B
Side A Side B
MSP
RE-SELLER
A
F
F
I
L
I
A
T
I
O
N

A
F
F
I
L
I
A
T
I
O
N

SALES OF GOODS
OR SERVICES
SALES OF GOODS
OR SERVICES
V.I. FIRM
SALES OF GOODS
OR SERVICES
OWNERSHIP OF SIDE A
(VERTICAL INTEGRATION)
INPUT
SUPPLIER
SALES OF GOODS
OR SERVICES
SALE OF INPUT

© 2015 Parker, Van Alstyne & Choudary Twitter: @InfoEcon :: marshall@mit.edu :: PlatformEconomics.com

•  Estimate global taxi market
•  Estimate market share

•  Est. risk adjusted cash flow
•  Consider proprietary

methods, barriers to
competition

•  Value: $5.9 Billion

Aswath Damodaran: NYU Finance professor, Corporate
Valuation author, Herb Simon Prize.

© 2015 Parker, Van Alstyne & Choudary Twitter: @InfoEcon :: marshall@mit.edu :: PlatformEconomics.com
• Estimate global taxi market
• Estimate market share
• Est. risk adjusted cash flow
• Consider proprietary
methods, barriers to
competition
• Value: $5.9 Billion
Aswath Damodaran: NYU Finance professor, Corporate
Valuation author, Herb Simon Prize.

Bill Gurley: Venture Capitalist, OpenTable, Zillow, Uber

© 2015 Parker, Van Alstyne & Choudary Twitter: @InfoEcon :: marshall@mit.edu :: PlatformEconomics.com

•  All true but overlooking
network effects.

•  Prices decline expanding to
rental car market and car
replacement market and
delivery market.

•  Oh, BTW, already 3x size in
2009 when Uber started.

•  Value: $17 Billion

Source: David Sacks, COO PayPal, CEO Yammer

Bill Gurley: Venture Capitalist, OpenTable, Zillow, Uber
© 2015 Parker, Van Alstyne & Choudary Twitter: @InfoEcon :: marshall@mit.edu :: PlatformEconomics.com
• All true but overlooking
network effects.
• Prices decline expanding to
rental car market and car
replacement market and
delivery market.
• Oh, BTW, already 3x size in
2009 when Uber started.

• Value: $17 Billion
Source: David Sacks, COO PayPal, CEO Yammer

1.  All teams will expose their data…
2.  Teams must communicate

through interfaces.
3.  … no other form of interprocess

communication allowed
4.  Interfaces, without exception,

must be externalizable.
5.  Anyone who doesn’t do this will

be fired.

Bezos Platform Mandate

© 2015 Parker, Van Alstyne & Choudary Twitter: @InfoEcon :: marshall@mit.edu :: PlatformEconomics.com

Source: Yegge Rant

1. All teams will expose their data…
2. Teams must communicate
through interfaces.
3. … no other form of interprocess
communication allowed
4. Interfaces, without exception,
must be externalizable.
5. Anyone who doesn’t do this will
be fired.
Bezos Platform Mandate
© 2015 Parker, Van Alstyne & Choudary Twitter: @InfoEcon :: marshall@mit.edu :: PlatformEconomics.com
Source: Yegge Rant

A platform is a system that
can be… adapted to
countless needs and
niches that the platform’s
original developers could
not possibly have
contemplated…”

Mark Andreessen: Venture Capitalist, Netscape
Founder, Board HP, eBay © 2015 Parker, Van Alstyne & Choudary Twitter: @InfoEcon :: marshall@mit.edu :: PlatformEconomics.com

Source: “The 3 kinds of Platform you Meet on the Internet” – Sept 16, 2007.

A platform is a system that
can be… adapted to
countless needs and
niches that the platform’s
original developers could
not possibly have
contemplated…”
Mark Andreessen: Venture Capitalist, Netscape
Founder, Board HP, eBay
© 2015 Parker, Van Alstyne & Choudary Twitter: @InfoEcon :: marshall@mit.edu :: PlatformEconomics.com
Source: “The 3 kinds of Platform you Meet on the Internet” – Sept 16, 2007.

62 © 2015 Parker, Van Alstyne & Choudary Twitter: @InfoEcon :: marshall@mit.edu :: PlatformEconomics.com

− Open to .com”

Open to developers −

The Rise & Ignominius Fall of MySpace – Business Week 2011

Does Openness Work?

62
© 2015 Parker, Van Alstyne & Choudary Twitter: @InfoEcon :: marshall@mit.edu :: PlatformEconomics.com
− Open to .com”
Open to developers −
The Rise & Ignominius Fall of MySpace – Business Week 2011
Does Openness W ork?