STANDARDS

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Overview

• Context: Your firm sells a product that is part of a network ofproducts and consumers. What design should you choose?

• Concepts: network effects, critical mass, excess inertia, pathdependence, compatibility.

• Economic principle: in some markets, the winner takes all,sometimes by luck, sometimes by skill.

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Outline

• Standards wars

• Compatibility decisions

• Public policy and standards: the government as a strategic player

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Outline

• Standards wars

• Compatibility decisions

• Public policy and standards: the government as a strategic player

3

Video Cassette Recorders (VCR)

1975 1980 1985

0

20

40

60

80

100Market share (%) Installed Base (million units)

Year

Betamax market share

Total units sold

50

100

150

200

250

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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 ischosen 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 andchooses the “majority” design (i.e., design chosen by 2 or 3 of theinquired previous adopters)

− dynamics highly path dependent

− market shares converge to 0 or 100% almost surely

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Stochastic dynamics without network effects

0 50 100

0.0

0.5

1.0Market share

Time

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Stochastic dynamics with network effects

0 50 100

0.0

0.5

1.0Market share

Time

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Standards wars

• Eventually, one design takes over the entire market,while the other is “orphaned:” self-reinforcingdynamics, snow-ball effects.

• The winning technology is not necessarily the best orthe one preferred by most consumers; the fittest doesnot necessarily survive.

• The ultimate outcome of the battle depends on a seriesof “small historical events;” the outcome is pathdependent.

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Examples

• Videocassette recorder

• gasoline engine

• QWERTY keyboard

• NB: interpretation of these examples highlycontroversial

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Bund futures market

• Bund: long-term German government bonds

• Until 1997, mostly traded at Liffe exchange

• Exchanges supply liquidity, clearing house services, anddata

• Eurex: electronic exchange formed by the merger ofthe Deutsche Terminborse and Soffex in 1998

• Initial market share shift motivated by special deals;eventually, by transactions costs

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Tipping in the Bund futures’ market

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25

50

75

100

1990 1995 2000

Year

Eurex’s market share (%)

Eurex based in Frankfurt; competing exchange in London.

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Outline

• Standards wars

• Compatibility decisions

• Public policy and standards: the government as a strategic player

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The standard setting game

Firm 2

Firm 1

Design 1 Design 2

Design 1b

a0

0

Design 20

0a

b

• If a > b > 0, then Firm i prefers standard i to standard j 6= i

• Both firms prefer a standard to no standard

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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 mutuallyincompatible

• 1972 (Columbia’s competitor in U.S.) announcessupport for JVC’s system

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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

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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?

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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 onestandard when the other gets a substantial installed base (acritical mass, one might say).

• Should a firm choose to be compatible or incompatible with rivals’products?

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Compatibility decisions

• Incompatibility: there is a chance I will end empty-handed, butupside is also promising. There may also be significant costs froma “standardization war.”

• Compatibility: no standardization war, but tougher competition inthe product market (I will never be a monopolist).

• Trade-off also depends on my relative strength.

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Compatibility decisions: examples

• Betamax vs VHS.

• MacOS vs DOS.

• DVDs.

• Third-generation wireless: Ericsson, Nokia andQualcomm.

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Bue-Ray and HD-DVD

• HD players followed HDTV

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Outline

• Standards wars

• Compatibility decisions

• Public policy and standards: the government as a strategic player

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Public policy

• Dilemma #1: Influencing the choice between alternativetechnologies: 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

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Driving conventions

• September 3, 1967 (Dagen H): Sweden switches fromdriving on the left to driving on the right

− Dagen H logo on milk cartons, underwear, etc

− TV song contest; winner: Hall dig till hoger, 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

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Public policy

• Dilemma #2: Market v government standard setting. Thetrade-offs:

− speed of standardization

− technological competition

− price competition

• Example: Second and third generation wireless communications:

− Europe: ETSI ⇒ GSM

− US: ◦/ ⇒ TDMA, CDMA, etc.

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Public policy

• Dilemma #3: Antitrust policy. Favouring compatibility may leadto market power; but encouraging competition may lead toincompatibility problems.

• Examples:

− Microsoft

− ATMs in Portugal

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Takeaways

• Network effects crop up everywhere. They can lead to excessinertia, and may allow small seemingly random events to controlthe outcome.

• Compatibility can be a critical decision: whether to maintain aproprietary standard and risk losing, or to cooperate and facegreater price competition.

• Policy is a challenge, because the quantity-restricting social costof monopoly is balanced by the benefit to consumers of using thesame product.

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