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Abstract:
Competitive maneuvering in the information economy has raised a pressing question: how can firms raise profits by giving away products for free? This paper provides a possible answer and articulates a strategy space for information product design. Free strategic complements can raise a firm's own profits while free strategic substitutes can lower profits for competitors.

We introduce a formal model of two-sided market externalities based in textbook economics -- a mix of Katz & Shapiro network effects, price discrimination, and product differentiation -- that leads to novel strategies such as an eagerness to enter into Bertrand price competition. This combination helps to explain many recent firm strategies such as those of Microsoft, Netscape (AOL), Sun, Adobe, and ID.

The model presented here argues for three simple and intuitive results. First, a firm can rationally invest in a product it intends to give away into perpetuity even in the absence of competition. Second, we identify distinct markets for content-providers and end-consumers and show that either can be a candidate for the free good. Third, a firm can use strategic product design to penetrate a market that becomes competitive post-entry. The model therefore helps to explain several interesting market behaviors such as free goods, upgrade paths, split versioning, and strategic information substitutes.

free information, complements, substitutes, network effects, network externality, pricing, bundling, two-sided markets, two sided networks

Abstract:
In this paper, we develop an economic rationale for a the following stylized facts: Web-based firms command high (and highly volatile) valuations relative to earnings, spend profligately on advertising and marketing, and usually lose money. Our rationale is based on the winner-take-all structure of high-fixed-cost, low-marginal-cost, markets for information goods. This market structure ensures that market participation and the investment strategy are highly stochastic. Moreover, if a firm chooses to participate in a web market, it is optimal to act very aggressively through saturation advertising. While increases in advertising costs reduce the probability of entry, once the decision to enter is made, firm strategies are insensitive to advertising price. These competitive strategies generate returns that are highly positively skewed, following a Pareto-like distribution. Thus, firms have a small chance of huge gains combined with a large probability of ruin. In dynamic competition, firms weakened by early rounds are is less likely to challenge in subsequent rounds. However, when a challenge is attempted, it is always aggressive. In addition, since large expenditures in the first period produce valuable strategic real options in later periods, which are treated as expenses using traditional accounting methodology, the financial valuation of internet firms may actually be negatively related to performance using standard accounting measures of profitability that fail to capitalize these strategic real options.

Abstract:
We consider openness in private and socially optimal licenses under conditions where network effects and multiperiod innovation are both possible. For private firms, we model a variety of possible business models from completely closed to fully open, and find that opening a platform can increase profits based on network effects exclusively, innovation exclusively, or both. A firm's ability to control downstream innovation gives it reaon to rationally behave more like a social planner and even tolerate limited levels of piracy, interpreted as free user access. Further, open contracts with modest royalties offered to all developers can dominate closed Nash bargaining subcontracts with lead developers. We also find conditions when firms choose proprietary licenses despite innovation and network effects.

In social planning terms, we find that optimal protection for reusable information is not arbitrarily long. Overlong protection interferes the inputs to downstream innovation. Further, licenses must enforce shorter-than-privately-optimal disclosure terms. Otherwise, a prisoner's dilemma in private incentives limits free access to derivative work, essential for decentralized innovation. In modeling terms, we add to the recent literature on two-sided network effects by incorporating a production function on one side of the market. We also contribute a framing innovation that places several existing license types in a space suggesting that socially optimal but unexplored licenses might exist.

Innovation, Free Software, Open Source, Lead Users, Two-Sided Markets, Platform Goods, Copyright Length, CopyFlex, Network Effects, Network Externalities, Intellectual Property Rights

Abstract:
How can firms profitably give away free products? This paper provides a novel answer and articulates tradeoffs in a space of information product design. We introduce a formal model of two-sided network externalities based in textbook economics - a mix of Katz & Shapiro network effects, price discrimination, and product differentiation. Externality-based complements, however, exploit a different mechanism than either tying or lock-in even as they help to explain many recent strategies such as those of firms selling operating systems, Internet browsers, games, music, and video.

The model presented here argues for three simple but useful results. First, even in the absence of competition, a firm can rationally invest in a product it intends to give away into perpetuity. Second, we identify distinct markets for content providers and end consumers and show that either can be a candidate for a free good. Third, product coupling across markets can increase consumer welfare even as it increases firm profits.

The model also generates testable hypotheses on the size and direction of network effects while offering insights to regulators seeking to apply antitrust law to network markets.

Two Sided Markets, Network Externalities, Network Effects, Antitrust, Information Pricing, Cross-Subsidy

Abstract:
Due to network effects and switching costs, platform providers often become entrenched. To dislodge them, entrants generally must offer revolutionary products. We explore a second path to platform leadership change that does not rely on Schumpeterian creative destruction: platform envelopment. By leveraging common components and shared user relationships, one platform provider can move into another's market, combining its own functionality with the target's in a multi-platform bundle. Dominant firms otherwise sheltered from entry by standalone rivals may be vulnerable to an adjacent platform provider's envelopment attack. We analyze conditions under which envelopment strategies are likely to succeed.

Platforms, network effects, bundling, two-sided markets, convergence

Abstract:
We present a general model of project sourcing that includes the effects of integration costs and learning over time on both the execution of projects and the integration of project output into complete products and services. We demonstrate that myopic decisions can create path-dependent traps where firms that outsource to gain short term advantage can experience higher long-run costs. We describe conditions under which insourcing a small fraction of project activity may dominate either complete insourcing or complete outsourcing. Further, we show that very rapid rates of technological change are likely to be associated with outsourcing only if underlying supplier factor inputs, such as labor costs, are lower. Finally, we show that firms can rationally cycle back and forth between subcontracting project activities and performing them in-house.

Product Development, Integration, Learning Curve, Learning, Vertical Integration, Sourcing, Technological Change

Abstract:
In platform markets, with applications ecosystems and sequential innovation, we examine the decisions to open the platform and to bundle downstream products. We find that competition among application developers reduces openness and innovation while competition among platforms has the opposite effect. Developers can also be better off producing for proprietary platforms as opposed to completely open standards. Although a social planner would open a platform sooner and to a greater degree than would a private platform sponsor, a platform sponsor's ability to control downstream innovation gives it reason to behave more like a social planner than it otherwise would. However, if platforms are to perform this role, platform sponsors need longer duration rights than application developers. Results can inform antitrust and intellectual property regulation, innovation and competition policy, and intellectual property strategy.

Sequential Innovation, Platforms, Copyright and Patent Length, Technological Uncertainty, Information Systems, Network Effects, Network Externalities

Abstract:
Platform-mediated networks encompass several distinct types of participants, including end users, complementors, platform providers who facilitate users' access to complements, and sponsors who develop platform technologies. Each of these roles can be opened - that is, structured to encourage participation - or closed. This paper reviews factors that motivate decisions to open or close mature platforms. At the platform provider and sponsor levels, these decisions entail: 1) interoperating with established rival platforms; 2) licensing additional platform providers; or 3) broadening sponsorship. With respect to end users and complementors, decisions to open or close a mature platform involve: 1) backward compatibility with prior platform generations; 2) securing exclusive rights to certain complements; or 3) absorbing complements into the core platform. Over time, forces tend to push both proprietary and shared platforms toward hybrid governance models characterized by centralized control over platform technology (i.e., closed sponsorship) and shared responsibility for serving users (i.e., an open provider role).

platforms, network effects, open innovation, standards, two-sided networks

Abstract:
Outsourcing arrangements continue to evolve from peripheral activities, such as food services and back office transaction processing, to encompass more core activities such as new product development. Some arrangements maintain a clear lead organization while others, such as open source networks, are less centralized. We develop a framework identify the specific impact of different outsourcing arrangements on the search, selection, transformation, and coordination processes involved in new product development new product development.

outsourcing, offshoring, product development, distributed product development, modularity, product design

Abstract:
Using case study data, we describe how a large personal computer manufacturer changed its supply-chain management strategy after outsourcing the majority of its design and manufacturing activities to a network of focused suppliers. To cope with this new structure, the firm created highly skilled generalists, "supply-chain integrators," who coordinate product development, marketing, production, and logistics from product concept to delivery across firm boundaries. We particularly focus on the skill-set that characterizes these integrators. Finally, we use the case evidence, combined with previous theory, to suggest a specific program of research into coordinating product development across disaggregated supply chains.

Supply Chains, New Product Development, Integration, Outsourcing, Organization Design, Interface