CHAPTER 4. Standards Battles and Design Dominance

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1 CHAPTER 4 Standards Battles and Design Dominance SYNOPSIS OF CHAPTER The focus of this chapter is on identifying the reasons why most industries adopt a dominant design and why a particular firms technology is adopted as the dominant design. The key factors driving industries to adopt a dominant design include increasing returns to adoption, path dependency and government regulation. The role of network externalities in the pressure to adopt a dominant design is also explored. Network externalities often arise when compatibility, complementary goods and investments in training are important to customers. The chapter then investigates why some firms learn faster than others. Prior learning and absorptive capacity are found to be large contributors to the variance in learning rates between firms. To answer the question concerning why one firms technology is adopted as the dominant design and not others the chapter explores 1) the nature of value creation in technology based products and 2) the specific actions a firm can take to encourage the adoption of its technology as the dominant design. Value is created in two ways. The first way a technology creates value is in the functionality it provides the customer and is referred to as its standalone value. The second way a technology creates value is through the network externalities associated with the technology. Technologies accepted as the dominant design deliver the greatest total value, standalone plus network externalities. This, in part, explains why it is not always the superior product that is adopted as the dominant design. Firms can sponsor their technology with the goal of gaining a controlling share of market and locking out potential competitors and they can enter early in an effort to become so entrenched that potential competitors may not be able to gain a foothold in the industry. The chapter concludes by considering how the level of market share at which consumer network externality benefits are attained drive the adoption of single or multiple dominant designs in an industry. LEARNING OBJECTIVES 1. Explain why a dominant design emerges and why it is not always the most technological superior design that becomes dominant. 2. Identify the primary sources of increasing returns and network externalities. 3. Argue both sides of the statement A winner-take-all markets are good for consumers. 4. Be able to employ a multidimensional model for assessing the value of a technology to buyers.

2 CHAPTER OUTLINE I. Overview II. A. Why do industries experience pressure to select a dominant design? Market forces (e.g. increasing returns to adoption, the importance of complementary products, etc.) and government regulatory action are the two primary sources of pressure to select a dominant design. B. Why do some technologies become dominant designs and others do not? Generally, one design is selected over another because the total value it offers customers (standalone value plus network externality value) is greater than the total value offered by other technologies. The chapter explores consider the multiple dimensions of value that will shape which technology design s rise to dominance. Why Dominant Designs are Selected A. Why do many markets coalesce around a single dominant design rather than supporting a variety of technological options? There are many factors that drive a market to coalesce around a dominant design. These factors often result in a self-reinforcing process that continues to increase a technology s dominance even if it is inferior to competing technologies. These factors include: 1. Learning affects the improvement rate of a technology. Greater use of the technology leads to greater knowledge accumulation. Greater knowledge accumulation enables the improvement of the technology. 2. Network externalities that result when there are increasing returns to adoption (i.e. a technology becomes more valuable to customers as more and more customers adopt the technology). 3. Complementary product creation often occurs at a faster rate as adoption becomes more widespread. B. Learning Effects evidence shows that the more a technology is used the more developed, effective and efficient it becomes. Learning effects have been demonstrated in a wide variety of industries including automobiles, ships, semiconductors, pharmaceuticals, and even heart surgery techniques. C. Learning curves represent the cumulative impact of learning on production costs and productivity. Organizational learning scholars typically model the learning curve as a function of cumulative output: performance increases, or cost decreases, with the number of units of production. The learning curve is formulated as y = ax -b, where y is the number of direct labor hours required to produce the xth unit, a is the number of direct labor hours required to produce the first unit, x is the cumulative number of units produced, and b is the learning rate.

3 D. Organizations learn at very different rates. Firms learn at different rates because their levels of prior learning and absorptive capacity differ. Learning rates also differ with the nature of the task and firm strategy. 1. Absorptive Capacity refers to the phenomenon whereby as individuals or firms learn, they also increase their future ability to learn. For example, the development of a new technology requires experimentation. Experimentation helps build a knowledge base that allows the individual or firm to identify what alternatives are most likely to be successful in the future. Firms that do not invest in technology development may not develop the absorptive capacity need to recognize or develop a new technology in the future. 2. Absorptive capacity also has effects at the industry level. As the number of firms learning about a technology increases and/or the number of firms creating complementary technologies increases the more effective and efficient the original technology will become. E. Network Externalities, or positive consumption externalities affect the adoption of a dominant design because a user s benefit from using a good increases as the installed base increases (e.g. railroads, telecommunications, communities of practice, computer platforms). For example, many people choose a computer that uses the Windows operating system and an Intel microprocessor because the Wintel platform has the largest installed base, thus maximizing the number of people with which the user s files will be compatible. 1. Network externalities arise when compatibility (e.g. exchanging computer files) and the availability of complementary goods (e.g. movies for a VCR; film for cameras) are important and when investments in training are high (e.g Qwerty). 2. For example, as Windows installed base increased developers became more likely to expend their efforts on developing products compatible with Windows rather than the MAC. Thus a virtuous cycle (at least from Microsoft s perspective) begins. An increasing installed base attracts complementary goods developers and the availability of complementary goods increases the installed base, and so on. F. Path dependency often characterizes technology trajectories with increasing returns to adoption. Path dependency means that small historical events may have a large effect on the form of the technology adopted as the dominant design. For example, 1. early entrants and their technology may become so entrenched that subsequent, superior technologies, may be unable to gain a foothold in the market. 2. sponsorship by a large powerful firm can help a technology gain a controlling share of the market, locking out alternative and potentially superior technologies.

4 G. Coalitions have proven to be an effective strategy for firms trying to affect the selection of a dominant design. 1. For example, in the early 1980 s Sony & Philips worked together to develop and bring to market the CD (replacing vinyl LP s). Recently, the stranglehold these two firms have on the market has been attacked by another consortium formed to develop and market the DVD. This consortium includes Hitachi, JVC, Matsushita, Mitsubishi, Pioneer, Seagram's Universal Music Group, Time Warner, and others. The goal of this group was to replace the CD standard with a DVD standard. Sony & Philips continued to work together and have responded by introducing a high-fidelity CD that is backwards compatible. This has enabled them to continue to control the royalties for the new disks and players. H. Government Regulation in addition to the market forces that encourage the adoption of a dominant design sometimes government regulation plays a role in the selection of a dominant design. Governments are most likely to intervene when there is a societal or consumer welfare benefit to having compatible technologies. This has often been the case for the utilities, telecommunications and television industries. For example, 1. in 1953 the FCC approved the National Television Systems Committee color standard in television broadcasting to ensure that individuals with monochrome television sets would be able to receive the color television programs broadcast by networks. 2. in 1998, the European Union adopted a single wireless telephone standard to avoid the proliferation of incompatible standards and to facilitate exchange both within and across national borders. I. The most superior products do not necessarily win. When all of the above forces are at work, the result can be a natural monopoly (though some alternatives may survive in niche markets) and winner-take-all markets. 1. The winning firm enjoys high returns and is well positioned to affect the development trajectory of the technology thereby further enhancing its dominant position in the industry. 2. Losing firms, not only have to play catch up after they adopt the dominant design they also lose the capital, learning and brand equity invested in their original technology. J. The influence of a dominant design can be far reaching. Dominant designs affect knowledge accumulation after their adoption primarily because firms have a tendency to build on their existing knowledge base rather than build new ones. This means that a dominant design will influence the technological discontinuity that will replace it. K. Are winner-take-all markets good for consumers? This is a complex question, made more complicated by traditional economics emphasis on the advantages of competitive markets. What makes this a complex question is the issue of

5 III increasing returns (of course the antitrust suits brought against Microsoft are a good example to use here). To answer this question the benefits accrued by customers when a larger portion of the market adopts the same technology (scurve) must be compared with the corresponding monopoly (exponentially increasing) costs (e.g. higher prices, less product variety, flatter technology improvement trajectory, etc.) Multiple Dimensions of Value A. So if technological superior products don t always win, what determines which technology and which firm wins? The company that wins usually is able to effectively manage the multiple dimensions that comprise total customer value. Customers compare the value of two or more competing technologies based on each technologies standalone and network externality value. B. Standalone Value Chan Kim and Renee Mauborgne developed the Buyer Utility Map to help managers determine what aspects of a new technology will be valued by potential customers (e.g. the functions it enables the customer to perform, its aesthetic qualities, its ease of use, etc.). They recommend considering six utility levers and the six stages of a buyers experience cycle (purchase, delivery, use, supplements, maintenance, and disposal) in order to fully understand a new technologies standalone value to a customer. Of course, each benefit has to be considered in light of its cost. For example, a new online ordering system alters the value proposition offered to the customer by simplifying the purchasing process (i.e. a change in a single cell) while the Honda Insight hybrid-electric vehicle offered customers greater benefits in the use and maintenance stages of the buyers experience cycle (i.e. change in multiple cells). C. Network Externality Value is a function of the size of the installed base and the availability of complementary goods. 1. The value of the Windows operating system, for example is due to the ability of the system to make it easy for consumers to use the computer (standalone value) plus two sources of network externality value: 1) its large installed base which translates into a large number of computers with which the user can easily interact, and 2) the availability of compatible software developed for Windows as its installed base increased. 2. An incumbent technology may thwart the adoption of a new technologically superior technology because the total value (standalone + network externalities) it offers is higher (NeXT computers are a good example to use here). 3. In order for a new technology to compete on only standalone value, that value must exceed the total value offered by the incumbent technology or the new technology must be compatible with the incumbent s installed base and complementary goods (Sony & Philips new SuperAudio CD is a good example of the compatibility effect).

6 D. All of the above has been based on the consumer s reliance on objective information. But consumer choice is also affected by subjective information (i.e. perceptions of value). So each value component has a corresponding perceived or anticipated value component that can be considerably different from the actual value. E. Firms can take advantage of consumer reliance on perceptions by creating a large mindshare through heavy advertising that makes the installed base appear larger than it actually is and/or make the availability of complementary goods appear greater than they actually are (Sega and Nintendo s battle for dominance in the 16-bit video game console market is a great example to use here). F. Another tactic firms use to capitalize on consumer reliance on perceptions is preadvertising. Preadvertising markets vaporware (a product that is not yet on the market and may not even exist) in an attempt to persuade customers to wait for the new product instead of buying a competitor s product that is already available (here again the game console industry is a good example to use with your students). G. Competing for Design Dominance in Markets with Network Externalities_Do network externalities create pressure for a dominant design or a few dominant designs? How large of an installed base is necessary before most of the network externality benefits are captured? The answers to these questions can be demonstrated to your students by examining the graphs in transparency seven. 1. Consider the rate at which value increases with the size of the installed base, and how large of an installed base is necessary before most of the network externality benefits are achieved. These graphs are usually characterized by a threshold level of adoption below which the externality benefits are very low and above which the benefits increase significantly. This type of graph shifts up when the base level value of a technology is greater. 2. Now you can show students transparency eight that compares the effects of relative market share on two competing technologies with the same base value. This graph shows that at every point where A has less than 50% market share (and thus B has greater than 50% market share), B will yield greater overall value, making B more attractive to customers and vice versa. However, when one technology offers greater standalone value the indifference point is shifted in its favor. 3. What is the competitive landscape like when customers attain their desired level of network externality benefits at low levels of market share? The customer has a greater region of indifference between the two technologies (a good example here are video game consoles) and firms in these markets may compete very successfully with multiple dominant designs.