Want to Enhance an Innovation’s Value? Consider Indirect Network Externalities

This content relates to : NEW PRODUCT & SERVICE DEVELOPMENT

HIGHLIGHTS

The value added by a new product’s features is enhanced by indirect network externalities; for example, the value of the GPU in a PC increases with the number of games and graphics apps available.

Product designers should consider such externalities when deciding which new product features to incorporate. 

The appropriate launch timing and pricing of new products can also benefit from paying attention to relevant indirect network externalities.
 

Amiya Basu

Syracuse University

The value of a product to a customer and the price the customer is ready to pay for the product often depends not only on the features of the product itself, but also on factors external to the product. One example of such external factors, called externalities, is network externality. Network externality may be direct where the value of a product increases with the number of people who use the product. For instance, Microsoft Word is a universally accepted word processor even though rivals such as Latex offer more sophisticated features when preparing scientific documents. 

Clearly, a larger platform of users that can use and share Word documents enhances the value of Microsoft Word. Network externality may also be indirect, where the value of a product increases with the availability of other products that can be used with it. For example, Apple iPod had a wealth of music titles available on its platform which rivals such as Rio lacked. The value of personal computers clearly increased with the availability of killer applications such as Lotus. More currently, the adoption of electric cars will definitely depend on the number of charging stations available to the driver. Or the number of drivers using an app such as Waze adds to the value of the app. 

The present article examines how indirect network externality affects the price of a product offering. The unique offering of the article is that it explores how the presence of contingent products affects the value added by different features of a product and shows that some attributes are influenced by indirect network externality while others are not. 

As a specific example, the product category of CD players is selected. There are two reasons for this choice. First, unlike many other products, CD players offered a stable set of standardized features from the beginning. Second, data on product features, price, and the network externality — number of CD titles available — were available from secondary sources. 

The article uses the hedonic pricing model, where price, as a proxy to value, is expressed as a simple function of product features. With this model, it is easy to examine how changes in individual attributes affect the price of a product. In the case of CD players, it is found that the number of CD titles available increases the value of the changer capacity, that is, the number of discs the player can hold. That is, as more titles become available larger capacity is more valuable. However, the value of a CD player’s quality of low-end frequency response is not affected by how many titles are available. 

The article confirms the role of indirect network externality and extends the basic premise of the model to show that the values added by different attributes are affected differentially by the availability of contingent products. There are two clear managerial implications of the research for new product marketing. 

First, by noting the role of indirect network externality, a marketer can determine the right time to introduce a product to the market and avoid the mistake of introducing a product too early before contingent products are available to customers. A marketer may also adopt strategies to build indirect network externalities that uniquely benefit its product offering. The more relaxed licensing agreements adopted by Philips attracted more titles to the VHS format and helped compensate for the superior quality of Sony Betamax. In the intensely competitive market for video game consoles, Nintendo has been able to leverage its wide collection of exclusive titles to fend off Microsoft Xbox and Sony PlayStation, competitors with superior raw computing power. 

Second, the relative importance of product features may change over time due to indirect network externality. For instance, the range of an electric car based on battery capacity is currently a very important factor in the decision as to which model to purchase or whether to purchase an electric vehicle at all. This is especially the case for long distance driving. However, with the proliferation of charging stations, the range capability of the battery may become less important over time. Similarly, graphics processing unit (GPU) attribute of a PC has become enormously valuable in PCs with the proliferation of computer games and Ethereum mining. By identifying which product features are affected by contingent products, an astute manager can plan product design and promotional activities and offer greater value to customers by focusing on the right product attributes. 

Author: 

Amiya Basu 

Professor of Marketing, Whitman School of Management, Syracuse University 

https://whitman.syr.edu/directory/showInfo.aspx?nid=abasu

To learn more, read

Amiya Basu, Tridib Mazumdar, and S.P. Raj (2003), “Indirect Network Externality Effects on Product Attributes,” Marketing Science, 22 (2), 209-221.