STANDARDS Overview Context: Your firm sells a product that is part - PowerPoint PPT Presentation

STANDARDS

Overview • Context: Your firm sells a product that is part of a network of products and consumers. What design should you choose? • Concepts: network effects, critical mass, excess inertia, path dependence, compatibility. • Economic principle: in some markets, the winner takes all, sometimes by luck, sometimes by skill.

Outline • Standards wars • Compatibility decisions • Public policy and standards: the government as a strategic player

Outline • Standards wars • Compatibility decisions • Public policy and standards: the government as a strategic player

Video Cassette Recorders (VCR) Market share (%) Installed Base (million units) 100 250 80 200 Betamax market share Total units sold 60 150 40 100 20 50 Year 0 1975 1980 1985

Standards wars: a stochastic model • Motivating example: VHS vs Betamax • Two versions of a new technology: V and B • Case 1: each adopter chooses favorite version (each design is chosen with probability 50%) − dynamics governed by law of large number − market shares converge to 50% almost surely • Case 2: each adopter inquires from 3 previous adopters and chooses the “majority” design (i.e., design chosen by 2 or 3 of the inquired previous adopters) − dynamics highly path dependent − market shares converge to 0 or 100% almost surely

Stochastic dynamics without network effects Market share 1.0 0.5 Time 0.0 0 50 100

Stochastic dynamics with network effects Market share 1.0 0.5 Time 0.0 0 50 100

Standards wars • Eventually, one design takes over the entire market, while the other is “orphaned:” self-reinforcing dynamics, snow-ball effects. • The winning technology is not necessarily the best or the one preferred by most consumers; the fittest does not necessarily survive. • The ultimate outcome of the battle depends on a series of “small historical events;” the outcome is path dependent.

Examples • Videocassette recorder • gasoline engine • QWERTY keyboard • NB: interpretation of these examples highly controversial

Bund futures market • Bund: long-term German government bonds • Until 1997, mostly traded at Liffe exchange • Exchanges supply liquidity, clearing house services, and data • Eurex: electronic exchange formed by the merger of the Deutsche Terminborse and Soffex in 1998 • Initial market share shift motivated by special deals; eventually, by transactions costs

Tipping in the Bund futures’ market Eurex’s market share (%) 100 75 50 25 Year 0 1990 1995 2000 Eurex based in Frankfurt; competing exchange in London.

Outline • Standards wars • Compatibility decisions • Public policy and standards: the government as a strategic player

The standard setting game Firm 2 Design 1 Design 2 0 b Design 1 0 a Firm 1 0 a Design 2 0 b • If a > b > 0, then Firm i prefers standard i to standard j � = i • Both firms prefer a standard to no standard

Quadraphonic sound: promising launch • Def: audio with 4 independent channels • 1971: Columbia launches SQ system (a.k.a. matrix; simpler version) • 1971 JVC (Japan) launches CD-4 system (a.k.a. discrete system: “real” quad) • Systems are backward compatible but mutually incompatible • 1972 (Columbia’s competitor in U.S.) announces support for JVC’s system

Quadraphonic sound: competing standards • Fierce competition in − Product improvement − Complementary products − Influencing expectations • Expectations − “RCA is acting as a spoiler . . . Discrete is premature” − “Matrix is Mickey Mouse quad” • Albums sold − Matrix (by 1973): 160 albums, 2m copies − Discrete (by March 74): 25 albums, 860K copies

Quadraphonic sound: splintering and demise • Hardware sales − By beginning of 1974, 25–30% of dollar sales • Sales slowed down in 1974. Consumer/retailer complaints − Confusion regarding standards − Software library − Recording quality • 1976: new product sales entirely stereo • Digression: How does this bear on Sony’s decision to add “software” to its “hardware” business?

Compatibility decisions • A proprietary standard can be very profitable (Windows, Palm OS, CDMA). • But often two or more standards compete for a market. • If the network effects are strong enough, people may abandon one standard when the other gets a substantial installed base (a critical mass, one might say). • Should a firm choose to be compatible or incompatible with rivals’ products?

Compatibility decisions • Incompatibility: there is a chance I will end empty-handed, but upside is also promising. There may also be significant costs from a “standardization war.” • Compatibility: no standardization war, but tougher competition in the product market (I will never be a monopolist). • Trade-off also depends on my relative strength.

Compatibility decisions: examples • Betamax vs VHS. • MacOS vs DOS. • DVDs. • Third-generation wireless: Ericsson, Nokia and Qualcomm.

Bue-Ray and HD-DVD • HD players followed HDTV

Outline • Standards wars • Compatibility decisions • Public policy and standards: the government as a strategic player

Public policy • Dilemma #1: Influencing the choice between alternative technologies: narrow windows. • Moving too early implies deciding with little information − Light-water nuclear reactors − Japan’s HDTV standard • Moving too late implies paying high costs of switching − Driving on the right in Sweden − Dvorak keyboard

Driving conventions • September 3, 1967 (Dagen H): Sweden switches from driving on the left to driving on the right − Dagen H logo on milk cartons, underwear, etc − TV song contest; winner: H˚ all dig till h¨ oger, Svensson ( Keep To The Right, Svensson ), by Rock-Boris. • Change widely unpopular — and costly − reconfigure exit lanes, bus stops (one-way streets) − buy or retrofit buses (doors on right) − extra set of traffic signals, painted lines − all non-essential traffic banned from 1–6am − crazy traffic jams − temporary reduction in # traffic accidents

Public policy • Dilemma #2: Market v government standard setting. The trade-offs: − speed of standardization − technological competition − price competition • Example: Second and third generation wireless communications: − Europe: ETSI ⇒ GSM − US: ◦ / ⇒ TDMA, CDMA, etc.

Public policy • Dilemma #3: Antitrust policy. Favouring compatibility may lead to market power; but encouraging competition may lead to incompatibility problems. • Examples: − Microsoft − ATMs in Portugal

Takeaways • Network effects crop up everywhere. They can lead to excess inertia, and may allow small seemingly random events to control the outcome. • Compatibility can be a critical decision: whether to maintain a proprietary standard and risk losing, or to cooperate and face greater price competition. • Policy is a challenge, because the quantity-restricting social cost of monopoly is balanced by the benefit to consumers of using the same product.