STEPHEN E. MARGOLIS
There has been a recent outpouring of research on the theory of standard setting. In economics, Farrell and Saloner (1985) and Katz and Shapiro (1986) made early contributions in the economics literature, each presenting arguments that there are interdependencies among consumers that are not fully internalized by markets and establishing the term "network externality."3 As we have noted in our earlier papers, the analysis of standards has emphasized the likelihood of a particular kind of trap: If there are only QWERTY typewriters, typists will only study QWERTY, but if there are only QWERTY typists, there well be only QWERTY typewriters.4 Such traps would be of considerable significance not only for public policy, but also for firms' competitive strategies. The results offer a pessimistic prognosis for firms that would attempt to displace an incumbent standard. It suggests great difficulty, for example, in replacing one generation of software with another. This would seem to promise great rewards for the firm that did manage to control a standard, suggesting that an entrenched standard might fall behind the capabilities of the best available technology without inviting a viable threat from a rival.
There are, however, important shortcomings with this "entrenched incumbents" view of standards.5 First, it leaves us without an explanation of the successful replacement of one technology with another. How did VHS displace Beta, or graphical user interfaces displace character based commands, or compact discs replace records, or automobiles replace horses and carriages? Second, the empirical support for such entrenchment is notably lacking. As we have shown elsewhere, the QWERTY versus Dvorak keyboard story, which is the most frequently cited support for the entrenched incumbents point of view, is largely a hoax.
This paper modifies the received model of standards in several ways that we believe incorporate reasonable characterizations of the production and purchase of goods that embody standards. The model that we develop allows separate consideration of the coordination advantage of standards (which we will call synchronization effects) and the production technology of these goods. The model also represents consumers as responding not only to the stock, or "installed base" of a standard but also to the latest news about the success of a standard. Further, it allows us to consider differences in tastes among consumers. With these departures in modeling come some important results, including these:
The expected effect of a "standards externality" is on the amount of the standard-using activity, not on choice of standard or the mix of standards.
Where there are differences in preferences regarding alternative standards, coexistence of standards is a likely outcome. Further, a single-standard equilibrium, if it is achieved, is more readily displaced by an alternative if preferences differ. This suggests that product strategies leading to strong allegiances of some customers are likely to be effective in the face of an incumbent standard.
Entrenched incumbents are seen as less entrenched within a model that acknowledges that consumers react to new sales, and not just accumulated stocks of goods that embody standards. In particular, a strategy that achieves a significant flow of adoptions for a challenging standard is shown to be viable. This contrasts with previous models in which a significant installed base gives the incumbent standard an insurmountable advantage.
We base our model on a fundamental function of standards: Standards facilitate interaction among individuals. We will use the term synchronization to refer to this effect.6 Synchronization is the benefit to the users of a standard from interaction with others who use the same standard. In general, synchronization effects will increase with the number of people using the same standard although it will often be the case that users benefit less from the total number of other users of a standard than they benefit from the number of users of a standard with whom they actually interact.
Synchronization is distinguished from the ordinary scale effects on production costs. Scale economies in the production are neither necessary nor sufficient for the existence of benefits of standardization, which is to say that synchronization effects may co-exist with increasing, decreasing or constant returns to scale.
It might seem natural to expect that goods that embody standards are subject to decreasing costs. After all, there are many examples where standardization is associated, rightly or wrongly, with lower prices. A number of the important technologies that have appeared in the last two decades seem to provide evidence that costs fall as a result of increases in the number of users of the technology. As we have seen decreases in the costs of computing power, telecommunications, and video-recording, accompanied by increases in the use of computer software, new methods of communications, and video recorders, theories that invoke economies of scale have had an easy time capturing our attention.
There is no reason to believe, however, that the goods referred to as "high-tech" are necessarily subject to increasing returns to scale. The technical advances associated with new technologies may easily disguise actual diseconomies of scale in production. Decreases in costs due to advances in technology are likely to lead to increases in output, but such movements of the average cost curve in response to changes in technology should not be confused with economies of scale in production.7 It is the old confusion of a shift in the curve with a movement along the curve.
These new high-technology goods are likely to be associated with unsettled format choices. The eventual adoption of a standard, which may take several years, or even decades, is likely to occur contemporaneously with improvements in technology, and the examination of correlations between time series of standardization efforts and production costs is likely to mislead, rather than inform. Certainly, an empirical association exists between the adoption of standards and decreases in costs: IBM enters the personal computer market, becomes the dominant format, and computer and software prices fall while the number of computers and programs rise; VHS wins the race with Beta while VCR costs fall;8 fax machines settle on a standard compression routine and prices fall dramatically. An appeal to the drop in costs associated with the standardization of many new technologies can not be taken as evidence in favor of an assumption of increasing returns, however, since the nature of new technologies is for rapid decreases in (quality adjusted) costs over time, with or without standardization.
The model that follows provides independent consideration of the impacts of synchronization effects and production costs. While the synchronization effect favors the domination of an industry by a single format, not unlike all other fixed costs of production, it is far from sufficient to guarantee such a result.9
Standards involve stock and flow dimensions. The total number of commitments in a particular format (e.g. English speakers, QWERTY keyboard users) is the stock; the number of new commitments per unit time is the flow. With respect to either of these, one can refer to either the scale or the share of a format. Scale is simply the number of commitments to a format. Share is the scale of a format divided by the total number of commitments to all formats (e.g. Beta share is Beta scale divided by the total number of VCR users).
The transformation of a format into a standard involves both scale and share effects. These two effects tend to move together in most real-world episodes of standardization, and so tend to confound observations of their separate manifestations. Yet share and scale can certainly move independently of one another, and each can have distinct effects on consumers.
If a consumer is interested, for example, in the very existence of a supply of products that embody a format, the absolute number of users of a format may be important. There may be an adequate supply of software for Macintosh computers as long as millions continue to be used and sold. On the other hand, decreases in the share of a format, holding constant the scale of the format, may worsen the circumstances of an adopter of that format. Macintosh owners may have greater sorting costs as the relative number of IBM compatible machines increases even as the absolute number of Macintosh machines increases.
For several reasons, we will treat consumers as making decisions on the basis of shares, not scales. First, there is the aforementioned issue of sorting costs. Second, for any given scale of the standards-using activity, relative share will determine relative scale. Finally, consumer choices of standards will often be one format versus another, so that it is the relative, not absolute, benefit of the standard that will affect consumer decisions.
Consumers are ultimately concerned with the number and identity of other consumers using a standard over the period during which they expect to use a standard. In making their decisions, however, they would quite reasonably look not only at the current stocks of commitments to competing formats but also to likely changes in these stocks for the time period in which they will use the standard. It seems only common sense, therefore, that consumers would be interested in the rate at which other consumers are making new commitments to a standard. A consumer contemplating the purchase of a PC in 1985 would probably not be satisfied to know that most of the machines in use were eight bit machines. He would also want to know whether these older machines still constituted a significant share of current sales. Similarly, sales of eight track tape recording equipment in the early 1970's were not much helped by the fact that there were more eight track machines in use than the soon to be popular four track cassette players. These examples could not have occurred if the status that consumers attributed to the format were based exclusively on the format's share of the stock and if compatibility were important. For this reason, we model consumers as reacting to both the current stock of commitments, and also the current flow of new commitments to the standards as a predictor of future stocks.
The operations of the share-scale and stock-flow concepts is illustrated nicely by the competition between Beta and VHS. During the 1980's, video recorders could be bought in either VHS or Beta format. The Beta format, created by Sony, was introduced first, generated much initial publicity, and its sales climbed quickly. Clearly, it had 100% of both stock and flow at this point. But shortly after Matsushita's VHS format was introduced (which was about a year and a half after Beta's introduction), the market share (flow, share) of Beta began to decline, though its sales (flow, scale) continued to grow.10 Sales of Beta peaked in 1984 and 1985. Yet, by 1984-5, the peak years in its sales, Beta had a fairly trivial role in the market, with a market share in the range of 10-15%. The changes in share of flow, naturally, preceded the changes in share of stock. Of course, it was the phenomenal growth of video recorders that accounts for the difference between scale and share.11
In the following, we consider a model in which two formats compete. Current consumer choices are affected by the share of each format in the stock of goods held by users. A consumer commits to a format, for at least a time, with the purchase of a good that embodies the standard. For concreteness and familiarity, the discussion is presented as a choice between Beta and VHS videotaping formats, in which commitment to a format occurs with the purchase of a VCR. But these names are merely convenient placeholders as the analysis applies equally well to any goods that embody standards.
The assertions about consumer values that are the basic building blocks of our model of standards are shown in figure 1. The horizontal axis shows, for a given time period, the stock of one format as a share of the total stock of all formats. In our example, the horizontal axis is the share of VHS VCR's in the stock of all VCR's. We define the autarky value of an individual's investment in a VHS video recorder to be its value with no interaction among VHS users. A VCR has value even if tapes are never rented or exchanged. A positive autarky value is not required for the model; in some activities, such as communication, it is reasonable to assume autarky value is zero.
The synchronization value is the additional value that results from the adoption of the format by other consumers.12 By assumption, the synchronization value of a format increases with the share in the stock of all commitments to a format: The synchronization value of VHS increases with its share. Total value is the autarky value plus the synchronization value, and will increase as the share of the format in the stock increases.
Figure 1 shows value of a format at a moment, the single period flow of benefits. Consumers will, of course, be interested in the benefits that they receive during their period of involvement with a standard. That is to say, consumers are not simply interested in the current stocks of a format, but also the stocks that will be in place over the consumer's horizon. Given flows, future stocks can be shown to develop in a very simple and predictable fashion.
Commitments to standards may be subject to depreciation. Goods wear out, technologies change, firms and people exit. In most durable goods contexts, the depreciation rate is simply the rate of depreciation of capital goods. In our model, depreciation has a somewhat different meaning. Some commitments to formats are associated with capital goods purchases. However, the commitments may not 'decay' at the same rate as the individual durable goods that embody them. For example, an owner of an MS-DOS or Windows compatible computer is likely to replace a depreciated computer with one that can use the same type of software. Commitments to a spoken language are not necessarily embodied in goods (although books and records may be examples in which they are), but nevertheless are quite durable. Nothing that follows requires a depreciation rate that is greater than zero, but important real world cases seem to exhibit positive depreciation rates.
Shares in the stock in period t are found by dividing equation 1 by equation 2. We obtain:
Thus the share of format a in period t is a weighted average of the share of format a in the previous period's stock and its share in the previous period's flow. The weight, , is simply the ratio of the gross flow to the stock in all formats. That, in turn, is the sum of the depreciation rate and the growth rate of the standard-using activity. Intuitively, one can think of high 's being generated in either immature markets where current sales are large relative to previous sales, or markets where stocks depreciate so rapidly that they have little influence on future stocks.
Equations 3 and 5 demonstrate, among other things, the reasonable result that the share in the stock is an increasing function of the share in the period flows. For any given stock, depreciation rate and growth rate, a format's share of the stock in all subsequent periods is an increasing function of its share of the flows. As a result, the synchronization value must increase with flow share, as shown in figure 2 (returning to our videorecorder example).
The synchronization value, however, need no longer go through the origin since the function shifts upward as a format's share in the current stock increases, ceteris paribus, since current stock share influences all subsequent stock shares, as in equation 5. Intuitively, for any given flow, the synchronization value of a format will be greater, the greater is the share of the format in the existing stock. The slope of the synchronization value function increases as increases, since is the weight of current flow in equation 5. As increases, flows have greater influence (relative to current stock) on the shares of the stock in subsequent periods.
For many standards, an individual's adoption of the standard occurs with the purchase of a single standard-embodying good; a computer, a camera, a typewriter, a videocassette recorder. For standards that are embodied in goods, the conditions of production will influence outcomes in social choices regarding standards.
Production of VCR's could be subject to increasing, decreasing or constant cost. For now, we will assume price taking behavior by producers. For a given quantity sold (flow) of VCR's the flow of a particular format will, of course, increase directly with the share. Figure 2 shows the supply price function under the assumption that VCR production involves increasing cost. (Other specifications of cost are allowed and discussed below. Here, the figure illustrates a single possible configuration.)
From these relationships, a net value function for videorecorder formats can be derived. The net value function is equal to the autarky value, plus the synchronization value, less supply price. The net value functions for machines with the Beta format can be constructed in the same fashion. Net value functions will be upward sloping if the supply price is less steeply upward sloping than the synchronization value. In other words, if decreasing returns in production overwhelm synchronization benefits, net value curves fall with market share. On the other hand, if synchronization benefits overpower decreasing returns in production, or if production exhibits increasing returns, then net value curves are upward sloping, as in figure 3.
As we shall see, it is only when the net value function is upward sloping that choices of standards are fundamentally different in character from choices of other goods (i.e. exhibit increasing returns instead of decreasing returns). We shall assume throughout the analysis that the slopes of the net value functions for all consumers have the same sign.13
The net value functions for Beta and VHS can be put in the same diagram, as in figure 3. As VHS share varies from 0% to 100%, Beta share varies from 100% to 0%. Where the two formats offer identical costs and benefits, the Beta net value curve is the mirror image of the VHS net value curve. The intersection of the two curves (if they intersect), labeled Di, represents the market shares in the current flows that would make the consumer indifferent between the two formats. This value plays a crucial role in our analysis. On either side of Di, the consumer will prefer one or the other of the formats depending on the slopes of these curves. For example, if the net value curves are upward sloping with respect to own market share, as in figure 3, the consumer will prefer VHS as its market share increases beyond Di. (VHS gets better, relative to Beta, as the VHS share increases beyond Di). (Should the two net value curves be downward sloping with respect to own market share, however, the consumer would prefer Beta as VHS share increases beyond Di.)
Note how the shares in existing stocks would influence Di. A larger stock of Beta machines would yield a higher net value curve for Beta and a Di that is closer to 100% VHS. Thus a format with a head start does have an advantage of sorts -- the 'trailing' format would require a greater current flow in order to equal the value of the leading format.
Notice also that the consumer is presumed not take into account the impact of his decisions on other consumers - i.e. he does not consider how his purchase of a video recorder will alter the valuation of other video recorder users. So the door is still left open for some sort of (network) externality, as we discuss below.
Each customer has an individual Di, a flow share at which the two formats are equally valuable. Accordingly, a population of customers will have a distribution of Di's. Let G(x) be the fraction of VCR purchasers with Di<x, that is, G(x) is the cumulative distribution function for Di. This distribution is a key to the selection of a standard.
Perhaps the most basic distribution would be one in which all consumers had the same tastes, so that Di is the same for all consumers. Call this common value Di*. This resulting cumulative distribution is shown in figure 4.
Returning to figure 4, we can now see that the candidates for equilibrium are A, B, and C. Points A and C are single format equilibria which are stable: for flows near 0% VHS all consumers still choose Beta, for flows near 100% VHS all consumers still choose VHS. In contrast, B is an unstable equilibrium. At flows near but to the left of Di* all consumers would choose Beta, at flows near but to the right of Di*, all consumers choose VHS. So, for the case of upward sloping net value curves, we do obtain an either/or choice that is often argued to be the expected outcome for standards.
The mere existence of synchronization effects is not sufficient, however, to establish the either/or choice with respect to standards. To see this, consider the outcome for downward sloping net value curves. In this case, all consumers with Di less than the prevailing flow choose Beta. The function G(x) thus reveals the fraction choosing Beta. The function 1-G(x), which is the fraction choosing VHS, is shown in figure 5. The only possible equilibrium is B, a stable equilibrium. At points near, but to the left of Di*, VHS machines are more advantageous than Beta machines (through effects on supply price) and more consumers would choose VHS. Similarly, displacements of equilibrium to the right of Di* would increase the relative advantage of Beta machines, moving the outcome back to the left.
Consumers split their purchases so that the marginal VHS purchase has identical net value to the marginal Beta purchase. This describes a circumstance in which the formats are subject to coexistence, at least in current flows. Note the significance of this result: even without differences in taste (which we will show favors coexistence) it is still possible for a mixed-format equilibrium to exist.
So far, we have considered the behavior of flows, while holding stocks constant. But these equilibrium flows will naturally influence long run equilibrium stocks. Where the net value curves are upward sloping, so that the equilibria are at the corners, the stocks must converge on the corresponding flow shares (100% VHS or 100% Beta). The all-of-one-kind flow can only reinforce the advantage of the preferred format.
Where the net value curves are downward sloping, providing a mixed format flow, the relationship between flows and stocks is somewhat more complicated. If the share of VHS in the flow is greater than the share of VHS in the stock, the share of VHS in the stock would increase over time and the share of Beta would fall. The net value curve for VHS would increase and the net value curve for Beta would decrease moving Di* to the right. This increase in Di* would feedback on itself, raising the current equilibrium flow of VHS, but as long as the impact of the changed stock was small relative to the impact of the flow this process would be expected to dampen itself out. If this process does not dampen itself out, the long-run equilibrium would be a corner solution at 100% VHS share.14 Alternatively, if Di* corresponds with the share in the stock, then that share is a long run equilibrium.
This model of the evolution of a standard, as simple as it is, provides some interesting insights. The nature of the equilibrium, either as a mixed format or as an either/or equilibrium, depends on the slopes of the net value curves, and synchronization effects are only part of the story. The slopes of the net value curves are not determined by the size or mere existence of synchronization effects. For example, upward sloping net value curves can occur when supply price falls, even when there is no synchronization effect. The existence of synchronization effects, the raison d'être of standardization, also does not rule out the possibility of downward sloping net value curves, and the resulting efficient coexistence of formats. Synchronization effects, therefore, are neither necessary nor sufficient conditions for an either/or equilibrium.
In fact, we would go so far as to argue that in the real world, either/or equilibria are mostly going to be driven by production costs and not network effects. So, for example, software categories may prove to be dominated by single entries because of the large fixed cost element in the production of software titles.15 But arguments that network effects might lead to software monopolies (as in Microsoft) miss the point. In other words, software creation may be just a newer version of a natural monopoly in terms of prosaic production costs, quite independent of any network effects.
Thus far, the model addresses only private valuations and their effects on outcomes. Since the literature has been preoccupied with how one consumer's choice of a format affects the values enjoyed by others, it is of interest to examine how internalizing this externality would affect standard choice.
To this point the net value curves represent private net benefit. Since the synchronization effect is always assumed to have a positive effect on other users of the same format, the social net value function will always lie above the private net value function, regardless of the slope of the private net value function.16 The difference in height depends on the relative strength of the synchronization effects and the market shares of the formats, in both stocks and flows. For example, at zero stock of VHS, the VHS private net value curve will intersect the VHS social net value curve at a zero flow of VHS. That is because, where there are no users of VHS to benefit from this individual's purchase, the private and social values must coincide. Where there is a positive stock of VHS, the social net value curve is everywhere above the private net value curve. This case is shown in figure 6. As the share of VHS in the flow increases, and the number of potential beneficiaries of this individual's VHS purchase increases, the difference between the social and private net value curves increases. The same would be true for Beta net value curves.17
Depending on the relative size of the synchronization effect on users of the two formats the intersection of social net value curves can be to the right or left of the intersections of the private net value curves. If the two formats attract users with the same levels of potential interaction, and if stocks of the formats are equal, internalizing the synchronization externality will have no effect on any individual's Di, and thus no effects on the potential equilibria.
If there is an asymmetric effect, such that the Di's move to the left or right, the cumulative distribution function would also move in the same direction. In that case, internalizing the synchronization externality may lead to a different equilibrium.
But even if the Di* in figure 4 moves left or right somewhat, when the market starts near point A, that will remain the equilibrium, and if it starts near point B, that will remain the equilibrium. Thus even if internalization of the externality changes Di's, the final market equilibrium need not change. Internalizing the synchronization effect thus might have no impact on the choice of format. We elaborate on this point in section 5.
There is one dimension where the internalization of the synchronization effect always has an impact, however. The private net value functions consistently undervalue videorecorders. Therefore, it is not the relative market shares, but rather, the size of the overall market that will be affected by this difference between private and social net value functions. Too few videorecorders of either type will be produced if the synchronization effect is not internalized by the market participants. Internalizing the externality enhances both VHS and Beta, causing consumption of VCR's to increase even if market shares remain constant.18 We would argue that this is the true impact of "network effects", although it has been largely ignored in the recent literature.
There are several natural extensions of this model. The assumption that all consumers have the same Di can easily be relaxed. Allowing consumers to differ in their Di's implies differences in tastes. These differences may reflect different assessments of the formats, or different synchronization values, or both.
Assume that the Di's for consumers range between 20% and 80% (VHS), and that within this range the distribution of Di's are uniform, as illustrated in figure 7. The height of the distribution of Di's indicates the slope of the cumulative distribution function. The cumulative distribution function, therefore, has a straight line segment between (20,0) and (80,100) as shown in figure 8, and intersects the 45 degree diagonal at points A, B, and C. If the net value functions are upward sloping with respect to own market share, A and C would be stable equilibria, B would not. Thus this type of uniform distribution of Di's gives the same general result as the assumption that all consumers had identical Di's. Thus, under these assumptions, we tend to get an either/or equilibrium.
If the net value function were falling with respect to own market share, the corresponding figure would be the vertical mirror image of figure 8. Point B would be the only stable equilibrium in flows. Consumers would buy the format that they most valued, unless it suffers a cost disadvantage due to its popularity. With decreasing returns, we expect many formats (brands, producers) in the market. Because this result is so standard, we focus our attention on the less standard case where net value rises with market share, i.e. where natural monopoly in production is a possible outcome.
Up to this point the results of the model indicate that when net value curves are upward sloping, the equilibrium will be of the either/or type. This need not be the case. Figure 9 shows a distribution of Di's representing the very reasonable case where each format has a fairly large number of adherents, with the rest of the population of Di's thinly (and uniformly) distributed between 20% and 80% VHS.
The distribution of Di's in figure 9 results in the cumulative distribution function shown in figure 10. The only stable equilibrium in this case is point B. The differences in tastes allow two standards to coexist in a stable equilibrium, even where net value curves are upward sloping. This is an important finding. In those instances in which each format offers some advantages to different groups of customers, we should expect to find that different formats appeal to different people. When this is so, we can expect formats to coexist in a market equilibrium, and individual consumers are not deprived of one of the choices.
We think it important to point out that this is the likely path that we would expect markets to follow when there are strong natural monopoly elements. Although a Hotelling model might predict that two firms will produce nearly identical products, we would expect (entrant) firms to try to specialize their products to appeal to particular groups of users. This is, after all, one simple way for firms to overcome any natural monopoly advantage that might exist in production costs of an incumbent. The incumbent firm, on the other hand, might do well creating products that appeal to the widest possible audience so as to foreclose this possibility.
There are some straightforward managerial implications here. First, even when there are economies of scale and/or network effects, the market can allow more than one format to survive. The key to success is to find a market niche and produce a product that is as close to the preferences of that market segment as possible. Unless the established firms are much larger and have much lower costs, the superior characteristics for the entrant's product, as viewed by the consumer niche, will provide sufficient advantage for the entrant to survive. If each producer can produce a product that appeals to a segment of the population, then the situation represented by figure 10 will prevail. That this advice is so straightforwardly compatible with common sense does not, to us, seem to diminish its value.
It is rather more complicated to define the meaning of a superior standard than might be thought. In the rather lopsided case of one format having higher net values than another by all consumers at all market shares, that format clearly would be superior. It is also not difficult to see that in this case, no Di would occur in the interior of 0-100%, and that the only equilibrium is at a share of 100% for the superior format. But it is not common to find such lopsided circumstances. Strongly held but divergent preferences lead to different results. If some individuals prefer format A, regardless of share, and others prefer format B, regardless of share, then it is not clear that either can be said to be superior.
For our purposes, however, we define standard A to be superior if, for all consumers and any market share X, the net value of A is higher than the net value of B with the same market share (e.g. if all consumers prefer A with 100% share to B with 100% share; similarly, all prefer A when both A and B share 50% of the market).
Assume that VHS is the superior standard and that there are no prior stocks of recorders. The Di's will then all be less than 50% since individuals would only choose Beta when it had the dominant market share. Assume that the Di's are uniformly distributed between 0% and 20%. Then the cumulative density function lies above the 45 degree line everywhere, as shown in figure 11. Figure 11 is the same as figure 8 except that the upward sloping segment is displaced to the left. A and C are the only two equilibrium points, but only C is a stable equilibrium. This analysis implies that if society starts at 100% Beta, it could get stuck at A, but only if no one ever purchases a single VHS machine. The trap at A, being an unstable equilibrium, is incredibly fragile.
In this case it is almost certain that the superior format dominates the market. If VHS is superior and both formats originate at the same time, VHS will win unless Beta, although inferior, can somehow capture and keep a market share of 100%. This would seem an almost impossible task for the Beta producers. It is unlikely, however, that both formats come to market at the same time. If VHS arrives first, Beta need not bother showing up. If Beta arrives first, as it in reality did, then it has a market share of 100% prior to the arrival of VHS. If the entrenched stock is large and exerts an important influence on new adoptions, the distribution of Di's would be shifted to the right. This implies the possibility of an equilibrium that is different from C. This is the instance of being 'stuck' in an inferior format, to which we now turn our attention.
It is not difficult to alter the previous example so that C becomes a stable equilibrium, even though VHS is preferred by all consumers. One simple alteration is merely to assume some minor changes from those conditions represented in figure 11. For example, as noted above, Beta might have an advantage in the existing stock. Let the Di's now range between 10% and 30%, instead of the former 0% and 20%. The market now can be represented by figure 12. Because all consumers prefer Beta when the share of Beta is greater than 90%, the cumulative distribution function is no longer always above the diagonal, and point A becomes a stable equilibrium in addition to point C. Point B, at 12.5% VHS, now is an unstable equilibrium.
Notice that the possibility of getting stuck does not require the existence of any synchronization (network) effect. Upward sloping net value curves are all that is necessary, and this can be achieved merely with old fashioned production economies.
Under these conditions, where the market settles at A, owners of the VHS format have an incentive to alter conditions to attempt to dislodge the market from A. One method might be to dump a large number of VHS machines on the market, perhaps by lowering the price, in order to generate an immediate 12.6% market share, driving the equilibrium to C.19
Producers of VHS can also try to prime the pump on sales by providing deals to the largest users, or distributors, or retailers (perhaps offering side payments) to convince them to switch to VHS.20 If this action can provide a market share of 12.5%, VHS can dislodge Beta [as of course it did]. Of course, if the VHS format were not owned, there would have been a potential free rider problem for the VHS producers to solve before these strategies could have been adopted.
There are other alternatives as well, including advertising, publicity, and services to allow partial or total compatibility. [VHS, with RCA's expertise, did put on a large publicity blitz in the US]. Interestingly, VHS, through a combination of lower prices, clever advertising, and most of all, a product considered superior by most consumers, had overtaken Beta within six months of introduction in the US.
It is important to note that the larger the difference between the two formats, the easier it is for the superior format to overcome any initial lead of an inferior standard. For truly large differentials, we should expect diagrams like figure 11, not figure 12. Thus, the greater the potential error in the choice of a standard, the less likely it is that an error would be made.
Further, though the trap remains a technical possibility within the model, its empirical relevance should not be overestimated. The importance of any theoretical possibility must be confirmed by empirical demonstration. The empirical support for the market failure of standards is extremely weak. Typewriter keyboards and videorecorders served for a time as the demonstration of existence of this market failure, as long as analysis remained at the level of casual empiricism. More detailed analysis is destructive to these claims as our 1990 and 1995a papers demonstrate. To date, we are not aware of any evidence of a single demonstration of a case in which a superior standard failed to dominate a market.
Firms often have to make decisions about which standard to choose, or whether to try to go forward with a new standard in the face of an entrenched incumbent. We have presented a model here in which we have shown that there are several conditions under which it makes sense for a firm to try to unseat an incumbent standard.
Foremost among these conditions is where a new standard is clearly superior to the old. In this case there is every reason to expect that the new standard will overtake the old and replace it.
Another condition enabling successful competition with entrenched standards is diversity in tastes among consumers. This allows firms to find market niches not well covered by the incumbent standard and use this market positioning to draw customers away from the incumbent.
These conclusions are at odds with the prevailing orthodoxy in the literature on standards. That literature has focused on logical possibility of getting stuck with an inefficient standard. In some models of standards, traps are presented as likely events. In our model, traps require far more stringent conditions and are far more easily evaded. And as we have argued elsewhere, a rival standard that does offer benefits in excess of costs will represent a profit opportunity for someone who can appropriate that gain. Thus we regard the persistence of an inferior standard to be an unlikely occurrence.
Yes, there is likely to be some inertia. And yes, the entrant may have to resort to clever marketing in order to rouse consumers from their slumbers. But these are not unusual problems for business firms, even when they compete in arenas where choices of standards play no role. Further, there is an enormous body of evidence in support of this proposition that market participants do find ways around the traps posed by entrenched standards and established technologies. For if they could not, we would still be riding horses, wearing animal skins, and living in caves.
1 See G. Reback, S. Creighton, D. Killam and N. Nathanson, with the assistance of G. Saloner and B. Arthur (1994) who argue that Microsoft's ownership of operating system standards will be leveraged into eventual domination of the entire information transmission mechanism of society. They state: "It is difficult to imagine that in an open society such as this one with multiple information sources, a single company could seize sufficient control of information transmission so as to constitute a threat to the underpinnings of a free society. But such a scenario is a realistic (and perhaps probable) outcome".
2 Standards arguments have been important in Judge Sporkin's decision to reject a settlement between Microsoft and the Justice Department. Microsoft's proposed acquisition of Intuit (the leader in personal finance software) has been blocked by the Justice Department, apparently for similar reasons.
3 We have argued that the term "network effect" is more appropriate, and this term seems to have been adopted by Katz and Shapiro (1994).
4 See our 1990 paper.
5 See Levinson and Coleman (1992) for a critique of the usefulness of these papers, Williamson (1993) for discussing the lack of remediable market failure in this literature, and our papers for both theoretical and historical critiques of this literature.
6 We have defined synchronization in a manner similar to what the literature has defined as 'compatibility'.
7 Some authors (e.g. Arthur, 1990) have gone as far as to claim that increasing returns is the norm for production of nonagricultural goods. These authors echo Marshall who thought that increasing returns were very common. According to Stigler (1941 pp. 68-76), however, Marshall's discussion of increasing returns indicates that he confused movements along the cost curves with movements of the cost curve. A similar point is made in Ellis and Fellner (1944). We examine this hypothesis in more detail in Liebowitz and Margolis, 1995b.
8 It is possible, and perhaps likely, that the competition between VHS and Beta enhanced the speed of innovation, as the formats fought for the market. Increased recording time, hi-fi sound, wireless remote controls, increased picture resolution, etc. all came about very quickly, with each format striving to keep ahead of the other. We are somewhat surprised that nowhere have we seen the suggestion that competition between formats might be beneficial in the same way that competition between producers is normally beneficial. Carlton and Klamer (1983) illustrates the traditional view of a tradeoff between competition and efficiency.
9 If there were production economies at the firm level, we should see many natural and entrenched monopolies. In fact, many early leaders of new technology industries are not those who now dominate their industries - e.g. Sony (Betamax) lost videorecorders, Digital Research lost operating systems (CPM), VisiCalc lost the spreadsheet standard to Lotus 1-2-3, which appears to have lost it to Excel, eight-track recorders lost to audiocassettes, and so forth.
10 We note that this contradicts the framework that it is supposed to support: Since Beta was first, it should have dominated even if moderately inferior.
11 See Liebowitz and Margolis, 1995a for a discussion of the Beta-VHS episode that provides evidence that VHS was superior to Beta in the dimension that counted to consumers (recording time), and that the two formats were virtually identical in almost all other respects. That discussion is based on Lardner (1987) and Klopfenstein (1989).
12 We assume that all members in the network are equally likely to interact with a user, so that the overall share of a standard represents the expected synchronization costs. If some members of the network were of more importance than others, i.e. greater likelihood of interaction, the overall shares would be less important than shares weighted by the importance of members in the network.
13 Of course, for any consumer, the two net value curves need not have the same sign. And different consumers need not have the same signs on their net value curves. In the latter case, there would be a group of customers with density functions like figure 4, and another group with density function like figure 5. The overall density function would be a mixture of these two. In the former case, if one format had a positive sloping (with respect to market share) net value curve, and the other a downward sloping net value curve, the relative size of the slopes in absolute terms would decide whether the result was a mixed-share, or a either/or equilibrium. If the upward sloping curve were steeper than the downward sloping curve, the result is identical to the case in which both curves are upward sloping, and the either/or result prevails. If the upward sloping curve were less steep, the results are the same as when both are downward sloping, and a mixed share equilibrium would prevail.
14 When the stock affects the net value curves, there are a family of these curves, one for each potential share of stock. When all consumers are the same, only one point on these net value curves is consistent with long run equilibrium (share of flow equal to share of stock). Connecting these points together creates a new curve which can be viewed as the long run net value curve, and is rotated counterclockwise from the slope of the short run net value curves. Thus the long run net value curves will be more upward sloping, and less downward sloping than their short run counterparts, regardless of the slope of the short run net value curves. These long run net value curves can be used to determine the long run market equilibria when all consumers are the same. Their intersection determines the long run Di, which allows a long run version of figure 4, and the long run solution will be determined by the slope of these long run net value curves, the same as in the text. The slope is affected by the same factors as the short run curves, namely the autarky value, supply price, and synchronization effect, but in addition, the slope is affected by the influence of the share of stock.
15 Even here we shouldn't let ourselves be seduced by the natural monopoly story. Yes, the (large ) fixed costs imply an element of natural monopoly, but after millions of copies have been sold, how steep is slope the average fixed cost curve? We suspect that for many software products the fixed costs are overwhelmed by variable costs at market output levels.
16 This discussion invokes the usual assumption that the supply function does not reflect a real or technological externality.
17 One possible consequences of internalizing the synchronization effect occurs where the sign of the slope of the social net value functions is different from the sign of the slope of the private net value functions. Since the social net value functions must have larger slopes than the private net value functions, this change in sign can only occur when the private net value functions are downward sloping, and the social net value functions are both upward sloping. In this case, the private net value functions would lead to a mixed-share equilibrium, but the social net value function implies that an either/or equilibrium would result if the externality were internalized.
18 Berg (1989) makes a similar point.
19 In fact, when VHS came to market, it significantly undercut the price of Beta although Beta almost immediately matched the price cut.
20 In fact, both VHS and Beta, aware of the need to generate market share, allowed other firms to put their brands on videorecorders. This was the first time that Sony was willing to allow another firm to put its name on a Sony produced product.
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