Network Effects May Affect a Company or Organization’s Value Creation,

Value Capture, Operating Model and How it Can Take Advantage of

Network Effects to Grow Its Business

E-Marketing and E-Commerce

Lecturer: Hanif Adinugroho Widyanto

Created By: Group 2

Aries Saputra (Student ID: 014201900078)
Ayu Sinthya (Student ID: 014201900095)
Dita Bunga (Student ID: 014201900028)
Hongleichen (Student ID: 014201900194)
Fauzan Fernando (Student ID: 014201900147)
Zaenur Ismail Widyatmoko (Student ID: 001201900035)

Faculty of Business Major Management

PRESIDENT UNIVERSITY
2020
 Network Effects and Efficiencies in Multisided Markets

Why Value Capture is the Most Important Business Idea?

Great businesses don’t have to be big and big businesses can be awful. The measure
of the quality of a business is all about Value Creation and Value Capture. Value Capture (a
business’s ability to create profit from it’s transactions) is one of the most interesting and
under-studied areas of business. In my reading and research I’ve seen material on it, though
rarely with the same terminology. We’re earning substandard returns and keeping it open just
to be nice to the elderly workers. But we’re not going to put huge amounts of new capital into
a lousy business. That the huge productivity increases that would come from a better machine
introduced into the production of a commodity product would all go to the benefit of the
buyers of the textiles. Nothing was going to stick to our ribs as owners. Business begins with
value creation. It is the purpose of the institution: to create and deliver value in an efficient
enough way that it will generate profit after cost. Because value creation is the starting point
for all businesses, successful or not, it’s a fundamental concept to understand. Here’s what is
to come in this collection of wisdom about value creation:
The value of products and services today is based more and more on creativity the
innovative ways that they take advantage of new materials, technologies, and processes. Value
creation in the past was a function of economies of industrial scale: mass production and the
high efficiency of repeatable tasks. Value creation in the future will be based on economies of
creativity: mass customization and the high value of bringing a new product or service
improvement to market; the ability to find a solution to a vexing customer problem; or, the
way a new product or service is sold and delivered. That’s such an obvious concept that there
are all kinds of wonderful new inventions that give you nothing as owners except the
opportunity to spend a lot more money in a business that’s still going to be lousy. The money
still won’t come to you. All of the advantages from great improvements are going to flow
through to the customers.
Conversely, if you own the only newspaper in Oshkosh and they were to invent more
efficient ways of composing the whole newspaper, then when you got rid of the old
technology and got new fancy computers and so forth, all of the savings would come right
through to the bottom line.
In all cases, the people who sell the machinery and, by and large, even the internal
bureaucrats urging you to buy the equipment show you projections with the amount you’ll
save at current prices with the new technology. However, they don’t do the second step of the
analysis which is to determine how much is going stay home and how much is just going to
flow through to the customer. I’ve never seen a single projection incorporating that second
step in my life. And I see them all the time. Rather, they always read: “This capital outlay will
save you so much money that it will pay for itself in three years.”

How to scale up businesses that exhibit Direct and Indirect Network Effects?
The simplest network effects are direct: increases in usage lead to direct increases in
value. The original example of telephone service is a good illustration of a product that
displays direct network effects.
 Network effects may also be indirect, where increased in usage of the product spawns
the production of increasingly valuable complementary goods, and this results in an increase
in the value of the original product. For instance, while there are some direct network effects
associated with Windows, the indirect network effects that arise from the increased quality
and availability of complementary applications software are probably much more important.
Products with indirect network effects such as marketplaces may not grow virally. In
such cases, network effects are a result of aggregation of the two sides and while each side can
be brought on virally through some incentive, it’s very difficult to leverage the indirect
network effect to get users on one side to come on through invitations or interactions from the
other side. Network effects can also be two-sided: increases in usage by one set of users
increases the value of a complementary product to another distinct set of users, and vice
versa. In many cases, one may think of indirect network effects as a one-directional version
of two-sided network effects.

Cross-Platform Network Effects.

The different sides of a platform market are interdependent to the extent their
decisions affect each other, even indirectly. Network effects are the cross-platform
externalities that result when the actions of participants on any side of the platform, or of the
platform itself, affect participants on other sides of the platform (or the functioning of the
platform itself). The externality can be direct, as when an increase in content providers makes
the platform more valuable to content consumers, or indirect, as when a platform’s provision
of better terms for users makes the platform more attractive to content or service providers
and to advertisers. For ease of exposition, this paper will refer to all cross-platform
externalities simply as “network effects.”
A positive network effect occurs when “the value that a customer on one side realizes
from the platform increases with the number of customers on the other side.” For example,
eBay—through which individuals can buy and sell goods on line—becomes more valuable to
buyers as the number of sellers increases because there are more items available for sale. At
the same time, eBay becomes more valuable to sellers as the number of buyers increases
because there are more potential customers available. Network effects need not be symmetric
or even run in the same direction between two sides of a market. Advertisers probably benefit
from an increase in users more than users benefit from an increase in advertisers, and in some
cases users may even suffer detriment from increased advertising.
Because network effects create interdependencies among the groups on a multisided
platform, a feedback loop may develop when membership of one side of the platform grows
or shrinks. To illustrate, assume a platform raises the price of platform access for suppliers of
some good or service. If some of those suppliers leave, the platform becomes less valuable to
customers on the other side of the market, who in turn also leave, further reducing the
platform’s value to the remaining suppliers, and so forth. These dynamics need not be
perpetual or irreversible, but at some point they can go far enough to tip a platform market
toward failure or dominance. As discussed below, the effects of this feedback loop may have
important implications for both conduct and merger analyses.
How should incumbent firms compete when their industries become susceptible to
network effects?
It is incumbent upon the merging firms to substantiate efficiency claims so that the
Agencies can verify by reasonable means the likelihood and magnitude of each asserted
efficiency, how and when each would be achieved (and any costs of doing so), how each
would enhance the merged firm’s ability and incentive to compete, and why each would be
merger-specific” points out that if an incumbent has a big advantage due to a wide variety of
available applications, a potential rival even with a significant cost or quality advantage
should nevertheless not enter the market since the incumbent’s installed-base advantage
outweighs the cost and quality advantage of the potential entrant.
In addition, contrary to the popular belief that indirect network effects protect
incumbents and are the source of market inefficiency, we find that under certain conditions,
indirect network effects could enhance entrants’ quality advantage and market outcomes
hence could be more efficient with stronger indirect network effects. We empirically examine
the competition between the Xbox and PlayStation 2 consoles. We find that Xbox has a small
quality advantage over PlayStation 2. In addition, the strength of indirect network effects and
consumers’ discount factor in this market are within the range in which platform success is
driven by quality advantage and the market is potentially efficient. Counterfactual
experiments suggest that PlayStation 2 could have driven Xbox out of the market had the
strength of indirect network effects more than doubled or had consumers’ discount factor
increased by fifty percent.

Competition between PlayStation 2 and Xbox

We study the competition between Sony’s PlayStation 2 and Microsoft’s Xbox
consoles between November 2001 and October 2005. PlayStation 2 was introduced in
October 2000 and is backward compatible with PlayStation 1. Xbox was introduced a year
later. While previous entrants to this market often came with next generation technology,
Xbox technology belongs to the same generation as PlayStation 2 (128 bits generation). Table
3 compares the features of the two consoles. The only differences are in the clock speed and
the amount of memory. PlayStation 2 had a significant lead in installed base and availability
of games: By the time Xbox was introduced, more than 4.5 million PlayStation 2 consoles
had been sold in the United States and more than 1000 compatible game titles were available
for PlayStation 2.
Although many industry experts and scholars cast doubt on Xbox’s ability to seize a
significant market share, Xbox made successful entry to this market. Table 4 shows the
market shares of the installed base, the total number of games, the new console sales and the
number of new game releases for each console over time. We compute these market shares
by dividing the number for each console by the sum of the two consoles in each year. As the
numbers indicate, Xbox has been very successful in growing its market shares on both sides.
Its shares of installed base and associated games increased over years. In 2004, Xbox had
more than 40% shares in both new console sales and new game releases. While the share of
its new game releases increased to 45% in 2005, Xbox sales slowed down in 2005, most
likely due to the anticipated release of the next generation system, Xbox 360. We also
compute the percentage of PlayStation 2 games provided by Sony and the percentage of
Xbox games supplied by Microsoft. The data suggest that console providers only produced a
very small number of game titles and third party game publishers are the major supplies of
games.
The competition between the two consoles provides an ideal setting for our empirical
analysis for two reasons. First, as both consoles target adults between 18 and 34, they
position themselves in direct competition with each other. While several other consoles were
also available on the market during this period, they were either targeted at different
demographics or were obsolete. PlayStation 2 and Xbox together accounted for more than
80% of new console sales in 2005.
Second, our theoretical model assumes that platforms are priced at the same level.
The pricing strategies of Microsoft and Sony fit this assumption well. Figure 6 shows price
differences between Xbox and PlayStation 2 consoles since the entry of Xbox in November
2001. PlayStation 2 had been priced at $299 before the release of Xbox. Since the release of
Xbox, both console providers have dropped console prices over time. The price differences
are less than ten dollars in all months except March 2004 and April 2004. This pattern
suggests that the two console providers quickly matched each other’s price over time. For
example, in May 2002 Microsoft was forced to cut the price of Xbox by $100 in response to a
similar price reduction of PlayStation 2. As the consoles were offered at similar prices in each
period, we expect that consumers made their purchase decisions based on the quality of the
consoles and the variety of associated games.

How can an entrant take over market leadership when competing with an incumbent in
a networked industry?
Both the strength of indirect network effects and consumers’ discount factor of future
applications determine the extent to which consumers value future applications. When
consumers place a relatively small value on future applications (i.e., small indirect network
effects and consumers’ discount factor of future applications), their beliefs about the
evolution of the market have little impact on their adoption decisions and hence their pattern
of adoption is close to that of the myopic case. When indirect network effects and consumers’
discount factor of future applications become larger, we find that the market starts to tip the
incumbent. In this case, future application provision becomes an important factor in
consumers’ adoption decisions. When consumers’ discount factor of future applications is not
very large, consumers only value applications in the near future and are not patient enough to
wait for the entrant to take over the leadership. Hence, the only self-consistent equilibrium
path is the one in which the market tips the incumbent. When e increases, the installed-base
advantage becomes more pronounced.
Our results indicate that a huge quality advantage may not be necessary for success.
When market dynamics are driven by quality, a platform with a small quality advantage can
also be successful, as in this case both indirect network effects and forward-looking behavior
enhance quality advantage. Installed-base advantages thus do not necessarily provide a safety
shield for the incumbent. To defend its leadership position, the incumbent needs to constantly
enhance its quality.
How can product-centric firms grow into platform-centric firms?
Platform-based markets are often characterized by significant indirect network effects
because of an inter-dependence between demands for platforms and demands for their
associated applications: having more applications on a platform leads to greater demand for
that platform; at the same time, a larger installed base of consumers leads to a larger supply
of applications. As a result of indirect network effects, a platform that has a small lead on
both sides of the market is likely to take over the entire market even if its quality is inferior to
its rivals’, thereby leading to an inefficient outcome.
In addition, most existing empirical studies focus on detecting the presence of indirect
network effects in specific markets. The relative importance of installed base, platform
quality and consumer expectations in the evolution of platform-based markets has not been
explored sufficiently. Our primary interest in conducting the empirical analysis is to find
empirical support for our theoretical model. Policy makers and platform providers could
apply the same approach to new situations to gain insights into market outcomes, and design
optimal strategies accordingly.
A market with indirect network effects could be more efficient than it would be
without indirect network effects. Government intervention may be counter-productive in this
case. On the other hand, when a market is installed-base driven, an inefficient outcome will
occur. In this case, government intervention such as enforcing standardization and
interoperability can help rescue the market from an inefficient outcome. Finally, in the
expectations driven scenario, government support of the superior platform may help it gain
favorable expectations and hence market dominance.

Conclusion
In this Essay, we develop a dynamic model to examine the evolution of platform-
based markets. We find that market dynamics depend critically on the strength of indirect
network effects and consumers’ discount factor of future applications. Using data from the
video game industry, we analyze the competition between Xbox and PlayStation 2. We find
that Xbox has a small quality advantage and the market dynamics are quality driven. These
results help explain the successful entry of the Xbox console into this market and provide
support for our theoretical model.
Reference

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