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Article Excerpt
This paper examines four alternative product strategies available to an innovating firm in markets with network effects: single-product monopoly, technology licensing, product-line extension, and a combination of licensing and product-line extension. We address three questions. First, what factors affect the attractiveness of each of the four product strategies? Second, under what conditions will any particular strategy dominate the others? Third, what is the impact of licensing fees on the profitability of a licensing strategy? We show that offering a product line utilizes consumer heterogeneity to increase the total user base and is superior to free licensing when the innovator's cost of producing a low-quality product is low and network effects are weak. However, because of the advantage of licensing in generating a larger installed base, free licensing can dominate line extension when network effects are strong, even if the innovator suffers no cost disadvantage compared to the competitor. We also show that paid licensing trumps free licensing when the clone product has a high quality or a low cost, regardless of network effect. Finally, strong network effects make a lump-sum fee more profitable than a royalty fee (or a combination of both) because a royalty fee reduces the licensee's production.
Key words: network effects; new product strategy; innovation management; licensing; product line; competitive strategy; technological standards; installed base
History: This paper was received September 22, 2003, and was with the authors 1 month for 1 revision; processed by Eugene Anderson.
1. Introduction
Many industries are characterized by a network effect, under which the value of a product to each user increases with the number of users (Katz and Shapiro 1985, 1994; Farrell and Saloner 1985; Liebowitz and Margolis 1999; Shapiro and Varian 1999). Examples of markets with a network effect include communication devices (e.g., fax machines and modems), communication services (e.g., telephone, e-mail, and Internet online services), and complementary products (e.g., VCRs, PCs, video-game players, CD players, and DVD players). Several recent papers have addressed some important strategic issues involving the network effect, such as pricing (Dhebar and Oren 1985, Xie and Sirbu 1995), discontinuous innovation (Dhebar 1995), indirect network effects (Gupta et al. 1999, Basu et al. 2003), product upgrades (Padmanabhan et al. 1997), knowledge management (Ofek and Sarvary 2001), success of high-tech products (Yin 2001), advertising strategy in the presence of standards competition (Chakravarti and Xie 2004), asymmetric network effects (Shankar and Bayus 2003), cross-market network effects (Chen and Xie 2003), and effect of network effects on pioneer survival (Srinivasan et al. 2004). This paper addresses innovating firms' product strategies in the presence of a network effect.
In markets without network effects, innovating firms often use legal attacks or technological power to combat or deter imitation (Porter 1980, Teece 1986). However, in markets with a strong network effect, many firms that develop new products have lowered entry barriers by licensing their technologies to competitors or by making their design or system "open" (Graud and Kumaraswamy 1993). Several recent studies demonstrate the counterintuitive effect of encouraging compatible entries in markets with a network effect. For example, Conner (1995) finds that with a strong network effect, the innovator may benefit from having a clone competitor even if the innovator can (costlessly) foreclose such competition. By incorporating a network effect into a diffusion model, Xie and Sirbu (1995) show that an innovating firm can achieve faster diffusion of its product and gain a higher profit by having a compatible competitor enter the market at an early stage rather than by being a monopolist. Economides (1996) suggests that an innovator may have incentives to share or even subsidize its technology with competitors.
Building on this branch of research, this paper addresses some important unanswered questions. For example, if the innovator can benefit from the existence of a "clone" product, should the innovator produce the clone product internally via product-line extension (self-cloning) or externally via the licensing of its technology to competitors? Are external and internal cloning strategies substitutable? Is it possible for the innovator to achieve a higher profit by simultaneously pursuing both technology licensing and line-extension strategies than by pursuing each pure strategy alone? Different alternative strategies have frequently been observed in markets with network effects. For example, manufacturers of video game players have adopted a single-product-monopoly strategy--each generation of video game player (e.g., Microsoft's Xbox, Nintendo's N64) has been produced by only one manufacturer and offered in only one quality. Many software vendors, however, have adopted a line-extension strategy--introducing different versions of their application software that remain compatible but vary in quality. For example, TreeAge Software offers a full version of its decision-analysis software DATA at $495 and a student version that limits the size of models to 125 nodes at only $50. Some software vendors create multiple products to expand their installed base by separating their product's creation and consumption features (e.g., Adobe's free versions of Adobe Reader, a component of Adobe Acrobat). Finally, the combination strategy--simultaneously offering a product line and licensing technology--has been observed in markets with network effects, such as VCRs, CD players, PCs, and PDAs. For example, Palm licenses its operating system, Palm OS, to competitors such as Handspring, Sony, Nokia, Samsung, and Acer while at the same time offering a wide range of its own products. Given the array of feasible product strategies, it is important for innovating firms competing in markets with a network effect to understand the trade-offs between different product strategies along with their strategic implications.
Most of the past research on innovating firms' incentives to facilitate compatible entry (e.g., Baake and Boom 2001, Conner 1995, Esser and Leruth 1988, Katz and Shapiro 1985) has assumed a zero licensing fee. In markets with a network effect, however, we observe both free and paid licensing policies. For example, in the PDA industry, both Palm and Microsoft charge other manufacturers a per-unit licensing fee to use their operating system (Palm OS or Windows CE). The impact of a licensing fee is important because it can affect the size of the installed base of the clone products and, thus, the overall attractiveness of a technology-licensing strategy.
To better understand these issues, this paper examines four alternative product strategies available to an innovating firm: (1) a single-product-monopoly strategy, under which the innovator is the exclusive seller of the product based on its technological standard, (2) a technology-licensing strategy, under which the innovator creates compatible products externally by licensing its technology to competitors, (3) a product-line-extension strategy, under which the innovator internally creates compatible products with multiple qualities, and (4) a combination strategy, under which the innovator simultaneously licenses its technology and expands its product line. We address three specific questions. First, what factors affect the attractiveness of each of the four product strategies? Second, under what conditions will each of these strategies dominate? Third, what is the impact of licensing fees on the profitability of a licensing strategy? To answer these questions, we first develop a basic model to examine the innovator's optimal product strategy in markets with a network effect. Then, we generalize the basic model to allow different licensing-fee structures.
While previous research has analyzed the benefits of encouraging compatible entry, our results reveal that such a strategy is neither the only way nor always the best way for the innovator to realize a larger installed base and a higher profit. We show that, under some conditions, product-line extension can be the optimal strategy in the presence of a network effect. In the marketing literature, product-line decisions traditionally have been driven by consumer heterogeneity (Dobson and Kalish 1988, Lilien et al. 1992, Preyas 2001). We show that a network effect creates interdependence among consumers with different preferences because the valuation of their preferred product is determined by the joint demand for the full line. In the presence of a network effect, manufacturers that offer a product line not only tailor their products to consumers' preferences but also utilize consumer heterogeneity to increase the total user base. This, in turn, increases all buyers' consumption utility. We also show that while a licensing fee generates revenue for the innovator, a free-licensing contract can lead to a higher profit. With strong network effects, a lump-sum fee is more profitable for the innovating firm than a royalty fee or a combination of the two because a royalty fee increases the licensee's marginal cost and, thus, reduces its production. Furthermore, some of our results are counterintuitive. For example, we show that it is possible for a free-licensing strategy to generate a higher profit than a line-extension strategy even if internal and external clone production have the same costs. While a licensing lee generates revenue for the innovator, a free-licensing contract can lead to a higher profit. We also show that the strength of a network effect is not always the dominant factor in determining the superiority of a paid-licensing contract versus a free-licensing contract. Network effects become a key factor only when the value of the clone product is...
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