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)

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

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

50 100 0.0 0.5 1.0 Market share Time

Stochastic dynamics with network effects

50 100 0.0 0.5 1.0 Market share Time

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
• f “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

25 50 75 100 1990 1995 2000 Year Eurex’s market share (%)

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 Firm 1 Design 1 Design 2 Design 1 b a Design 2 a 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¨

• ger, 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
• f monopoly is balanced by the benefit to consumers of using the

same product.