As introduced in the previous wrap up. We're going to look into how knowledge of complimentaritian standards can improve your business's performance. So how do firms compete in network industries? What are some of the strategies in network markets? Well, the first one. The first important strategic variable we have to think about is compatibility. So we can think of four types of compatibilities. We can think of full compatibility which means that brands are fully compatible if they operate on the same standard. As one example, we have T-Mobile and Vodafone which are completely technically compatible. So you can call a Vodafone number from a T-Mobile connection and vice versa. We can have backward compatibility, which means that two products are backward compatible if a newer model is compatible with an older model but not vice versa. So that means that for example, on a DVD player you can play CDs. But on a CD player you cannot play DVD's. The third type of compatibility is one way compatibility. And as the name suggests, this means that only one standard, or one technology can use the other one. But the other one cannot use the first one. So products are one-way compatible is one machine can read the files generated by a competing machine but not vice-versa. So music protected by digital rights management on iTunes would be a one-way compatibility story. And finally we can also have partial compatibility. And this actually refers to all three previous types of compatibility. Partial compatibility means that products are partially compatible if they're in too operable. So, if you can use one with the other. But, using software, or using files, or using machines that were initially designed for the other product, implies a decrease in performance or you have to incur some cost. So Microsoft Office and Open Office would be partially compatible because the performance of a Microsoft Office file on Open Office is not quite as good as if you had it on Microsoft office yourself. The second strategy I want to talk about is standardization. Which of course is sort of related to compatibility, but it's not exactly the same. So choosing a standard or choosing standardization, can take place in several forms. The first one is de jure standards. These are standards that have been established by law. They avoid uncertainty and confusion among consumers, which may actually help new technologies to get adopted. This implies that every firm gets access to the same standard and then these will then compete in the market. I should actually mention that the de jure standards also refers to standards that have been set by a standard setting organization. So that's not necessarily a legal requirement. But it's a requirement that an industry organization has set itself. De facto standards are standards that come about by one firm, or one standard having achieved a dominant position through market forces. So extensive usage, rather than approval by some standards organization, or by the government. This allows technologies to continue developing. So the story goes, the market is more likely to select a better technology. And then some de jure, some standardization organization, some law maker, that does it at the very beginning of the market. So the idea is that a de facto standard will mean completing for the market. So you compete with a competitor with a different standard. And if you're successful, you're actually successful taking the entire market. Rather than competing within that market. And we can actually generalize this a little bit by thinking about strategies in standardization, which gives you let's say a general problem here. The general problem is that firms in a network market will consider whether they would rather have inter-technology competition to become the standard. Or, if they would be happier with intra technology competition, if products are compatible. So, if we analyze the situation in a formal way. Just consider this two by two matrix below. Firm A and firm B, could sponsor, could choose technology one, or technology two. And the payoffs are gonna be A11 and B11 for firms A and B if both firms choose technology one. And so on and so forth. Firms can therefore adopt. Their strategies are to either adopt technology one or technology two. And the main assumption is that these two are incompatible. So if Firm A develops Technology one and Firm B, Technology two. The assumption is gonna be that Firm B would be happier with Technology two and Firm A would be happier choosing Technology one. And just by looking at this very simple matrix We can identify three forms of competition. And this depends of course, on the firm's compatibility strategies. We can have three combinations of strategies. First, we thank of the battle of the sexes which means that we want to choose a joint standard. But it's not clear if it's going to be the standard of technology one or the standard of technology two. We can have a standards battle, which we can formulate as Tweedledum and Tweedledee. So one of them is going to win and the other one is going to lose. And finally, we can have the strategy of the pesky little brother, where one of the firms prefers compatibility or standardization. The other firm does not. And so let's just have a look at how the payoffs would have to be and what the strategies would be that lead to these three compatibility, or standardization strategies. So in the battle of the sexes each firm favors compatibility. But each would prefer its own technology as the standard to be chosen. So this would be a payoff structure where you can see that, if Firm A chooses a different one to Firm B. Then we will have zero payoffs for both. Whereas if we standardize, both firms get positive payoffs. But what's important is that firm A prefers standardization on technology one, which is what they developed. And firm B prefers standardization on technology two, which is what they developed. Okay? And so the challenge here is to find out, and to convince the other firm to adopt your standard, rather than their own. In the situation of Tweedledum and Tweedledee. Firms will actually prefer to compete to determine what becomes the industry standard. So, here the payoffs are 300 and 205 for Firm A choosing their own technology. And for Firm B, it becomes 250 and 300, depending on what the other firm does. And what we can see is that for Firm A. It's actually a dominant strategy to choose your own technology. And for Firm B, it's also a dominant strategy to choose their own technology. Meaning that, in the end, the equilibrium. The Nash equilibrium, is going to be that each firm chooses their own standard. Finally, the third strategy we're gonna look at is the Pesky little brother strategy. Where Firm A prefers to have a joint standard. And we can think of this as the little brother who always wants to play with the big brother. Whereas Firm B, which we think of as the big brother, prefers two standards, prefers a different standard to the smaller one. So payoffs would have to be that Firm A will always want to choose technology one if Firm B also chooses technology one. They will choose technology two if firm two also choose technology two. However, Firm B will have as a dominant strategy to choose technology two. Right so in the end, what's going to be the equilibrium of this game is going to be that the firms standardize on the preferred standard by technology to. So how do you set a joint standard? How does joint standard setting actually happen? Well first it could happen by persuasion. So firms will simply try to persuade the others to agree on their own technology. So then it becomes a bargaining problem. It could happen by commitment, which means that firms involve, or choose actions that are visibly reducing the payoffs from agreeing to an outcome that they don't prefer. In other words, if I choose my own preferred technology. And there's no way back. Then I've committed to choosing that technology, to using that technology in the market. So you could build an installed base while still being engaged in negotiations. That makes it difficult to go back on your less preferred technology. You might want to invest in production capacity, or in R&D that will not be shared if the agreement is not reached. So another way of achieving a joint standard is by being soft, by making a concession. This might include agreeing to use the other firm's preferred technology as well as other actions that make it more attractive for the other firm to use your own technology. So for example, licensing again at a low cost makes it easier for people to join your standard. For example, using a hybrid standard, which takes in, on the one hand, elements of your own technology, and elements of the other technology. Committing to developing the standard jointly, rather than individually. Shifting the standards development to third parties, which is again one way of reducing your own power for the setting of the future standard. You might also promise timely information to rivals, which again is going to make it easier for them to agree to using your standard. But let's now assume that eventually you're just going to have to fight a standards battle, okay? So what do you do then? What are other strategies that you might want to choose? Well, as we all know and as we've sort of said more over and over again, establishing a large installed base is important. Making sure that you get enough consumers onto your network. So you have to do that quickly and visibly. Quickly because that drives out other firms from the market. Visibly because that's gonna raise the expectation of future consumers. So for example you might do that by dynamic or penetration pricing. Simply lowering prices. Charging prices low early on. That would then mean that you bring doctors early which is going to be useful at later stages of the market. Making public commitments to low prices in the long run. Managing the expectations of consumers. Pre announcing strategies. Pre announcing future new product introductions, for example will also be a way of fighting a battle. Of course, you want to improve the quality of your own technology. Because even though there might be some self sustaining some self perpetuating processes. It still pays to have a better technology. Offering a sufficient supply of complimentary goods is also important. So that actually speaks for vertical integration to some extent. That speaks for making it easy for suppliers of complimentary goods to join your standard. Pre emptying. So introducing a technology early, might allow you to build and install base that's not possible for the others. All though you have to be careful because the earlier you introduced a product. The lower the quality the more pre mature the technology might be. You might license to build up a critical mass of hard, and/or software. And simply acquiring a rival firm. In other words, fighting a standards battle by buying up the rival. Providing a competing standard, might also be a successful strategy. Now, assume that you've fought the standards battle, you've made sure that you were successful. How do you maintain the standard? Well, by staying on your guard. By making sure that others could come in. And they could make use of exactly the same techniques that you used to fight the standards battle in the first place. Commoditizing complementary products. Meaning that you secure a constant supply of complementary products because it's become a commodity. Competing with your own installed base by introducing a new technology. And finally, leveraging your installed base because your installed base. Remember, in network markets is one of your key assets, okay? That's an asset no one else has in the market if you are not compatible with your rivals. That was a lot of material. So do make sure you do the in video quiz. And then we'll see each other again. We'll next talk about why it is important to know the market you're operating in. And how you can make full use of this information.
