Products with so-called networks effects get more valuable when more people use them. Famous examples are telephones and social networks.
“Complementary network effects” refer to situations where a product gets more valuable as more people use the product’s complement(s). Two products are complementary when they are more (or only) useful together – for example, a video game and video game console, or an OS and an application for that OS. Microsoft Windows gets more valuable the more apps are made for it, which in turn makes Windows more popular, which in turn leads to more apps, and so on. Microsoft Windows is not more valuable simply because there are more copies of Microsoft Windows in the world, but because there are more complements to Windows in the world.
Network effects can be your friend or your enemy depending on whether your product has reached critical mass. Getting to critical mass in complementary network effect markets is sometimes called overcoming the “chicken and egg problem.” Back in graduate school (2003), my friend Jeff Rhodes and I wrote a paper titled “Six Strategies for Overcoming the ‘Chicken and Egg’ Problem in Complement-Based Network Effects Markets.” This is a frequent challenge when launching technology products, yet at least at the time we had seen very few people try to systematically document strategies for overcoming it. Some of our examples are a bit dated now, but if you are interested in this topic you might like the full paper.
Here is a high level summary of the 6 strategies we describe with a few updated examples. I’d love to hear from any readers who have more strategies and/or example products.
1. Signal long-term commitment to platform success and competitive pricing. When Microsoft launched the original Xbox, they made a big deal of publicly committing to spending $500M promoting the platform, thereby signalling that they were fully committed for the long haul and giving comfort to 3rd party game developers. Another way to give comfort that your platform isn’t going away is to open source it – this way third parties know that even if the company stops supporting the product, independent developers can continue to do so (e.g. Google Android and Chrome). Open sourcing also gives comfort that the company isn’t going to raise prices once they’ve reached critical mass.
2. Use backwards and sideways compatibility to benefit from existing complements. Microsoft of course has used backward compatibility very successfully for decades with DOS and then Windows, as have many game console makers. In our paper we argue that the successful early bill pay (“bill presentment”) companies provided backward compatibility by sending snail mail checks to merchants who had yet to sign on to their electronic platform.
Virtual machines and Bootcamp gave Apple’s hardware some sideways compatibility with Windows. Sun’s invention of Java could be seen as an attempt to introduce sideways compatibility between its shrinking server market and its competitors (Windows, Linux) by introducing a new, cross-platform programming layer.
3. Exploit irregular network topologies. In the last 90s, most people assumed that dating websites was a “winner take all market” and Match.com had won it, until a swath of niche competitors arose (e.g. Jdate) that succeeded because certain groups of people tend to date others from that same group. Real-life networks are often very different from the idealized, uniformly distributed networks pictured in economics textbooks. Facebook exploited the fact that social connections are highly clustered at colleges as a “beachhead” to challenge much bigger incumbents (Friendster). By finding clusters in the network smaller companies can reach critical mass within those sub-clusters and then expand beyond.
4. Influence the firms that produce vital complements. Sony and Philips, the companies that oversaw the successful launch of the compact disc technology in the early 1980′s, followed the CD launch with the introduction of the digital audiotape (DAT) in 1987. The DAT offered CD sound quality and, in a significant improvement over CD technology, it also offered the ability to record music. Despite these improvements, the DAT never gained significant consumer adoption and ended as an embarrassing failure for Sony and Philips. DAT failed because Sony and Philips failed to reassure record companies who were concerned that the recording capabilities of DAT would lead to widespread piracy. Sony finally reached an anti-piracy agreement with record companies in 1992, but by that time consumer expectations for the DAT platform were dampened sufficiently to doom the platform.
On the other hand, when Sony and Philips launched the CD, they succeeded because they did a significantly better job influencing complement producers. Most importantly, they addressed the record companies’ primary concern by making CDs piracy resistant (or so it seemed at the time). In addition, Philips was able to influence Polygram, a major record label, to release music in the CD format because Philips owned a 50 percent stake in Polygram. Finally, Sony and Philips provided the record companies with access to their manufacturing technology and plant in order to ensure an adequate supply of complementary products. As a result, nearly 650 music titles were available in CD format when the first CD players were released and the CD format went on to become the most popular music format.
5. Provide standalone value for the base product. Philips introduced the videodisc player (VDP) in 1979 as a competitor to the VCR. VDPs had slightly better picture quality than VCRs and had potentially lower hardware and software costs, owing to a simpler manufacturing process. However, the VCR had a 3-4 year head start on the VDP and had already developed an installed base of over one million units.
Providing a stand-alone use is the strategy that VCR producers used to achieve a successful launch and avoid fighting the difficult chicken and egg startup problem. Unlike the VDP, the VCR offered the ability to time-shift television programming. In fact, when the VCR was launched this was the only application available because the market for pre-recorded videocassettes had not yet developed. The standalone value for the VCR “time-shifting television programming” was sufficiently strong to get over a million people to purchase the product in the first 3-4 years after its launch. This installed user base of the VCR as a base product was sufficient to entice entrepreneurs to develop a market for pre-recorded videocassettes as complementary products in the late 1970′s. The complement-based network effect that resulted improved the value of the base product, increased sales velocity for the base and complementary products, and ensured that the VCR would be a common feature in most American homes.
A good modern example of this would be del.icio.us, which had stand alone value by storing your bookmarks in the cloud, and also had network effects with its social features.
6. Integrate vertically into critical complements when supply is not certain. To overcome the chicken and egg problem, companies must find a way to ensure an adequate supply, variety, and quality of complementary goods. By vertically integrating into the complement product as well as the base product, a company can attempt to ensure an adequate supply of both goods. Nintendo is the leading developer of games for its consoles, and Microsoft and Sony fund many of their most popular games.
Vertical integration is risky – as witnessed by the Apple computer in the late 80s and early 90s. By remaining tightly integrated, Apple precluded market competition from providing the necessary variety of price-competitive complements and base products.
Many of the above strategies (especially 3 & 5) apply to regular (non-complementary) network effect products.