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Online Services Change the Competition Equation

8/19/2011 --

Companies need to adjust their strategies when offering online services with network effects.

ANN ARBOR, Mich.—Companies that sell a product often offer their customers a service to go along with it: free maintenance, a newsletter, training, etc. As technology advances, a growing number of companies now offer online services such as blogs, online communities, and virtual forums. Dell, Oracle, and IBM all offer such complementary online services to customers who buy their products. The main difference between online services and traditional services is that, in addition to providing information and support, the online services allow customers to interact and share information with each other. Thus, the more consumers use the service the more valuable the service becomes, a phenomenon known as network effects.

It turns out these network effects create implications for competition and strategy in a way the non-network services don't, according to new research by Ross professor Hila Etzion. For example, if two companies that dominate a market both offer a high-quality online service, their profits actually will suffer long-term.

Likewise, if a company is considering offering an online service, it will need to look at its competitors, says Etzion, assistant professor of business information technology. If the company's main competitor offers a high-quality service with network effects, then the company may be better off not offering one. This first-mover phenomenon is not present with traditional services.

"The main takeaway for firms is that if you are considering offering online services, don't use models, insights, or market research derived from services that don't have network effects," she says. "You really have to take into consideration the fact that the value each consumer gets from your service will depend not only on the quality of the service you offer, but also on how many other people would be using your service."

The implications go beyond technology firms. Consider Webkinz, a child's plush toy that comes with an online code. That code allows customers to go onto the website, create a virtual animal that looks like the one purchased, and interact with other users.

Etzion's findings, based on models from game theory, are found in her paper "Complementary Online Services in Competitive Markets: How Firms Should Adjust Their Strategies Due to Network Effects." It's one of the first studies to consider how network effects influence strategy in the context of complementary services.

The reason online services with network effects change the equation is because of their nature. Each consumer derives more value as more people join the network.

While that's a positive for a company in a monopoly, it creates complications in a competitive market. Firms offering similar online services with network effects tend to lower prices and take other actions to fight harder for each customer. That lowers profits over time.

"It becomes so much more important to get those extra customers that you will cut your product's price to get them," Etzion says. "The price competition intensifies the stronger the network effects become. The competition becomes so intense that profits will go down compared to when neither firm offers a service. That's why companies that offer a similar service often find themselves in a prisoner's dilemma. They would be better off if neither offered the service, but since it is each firm's best response to offer the service, regardless what the competitor is doing, they end up both offering it. It's the consumers who win in this case."

But none of that is true with services that don't have network effects. In those cases, companies are not caught in a prisoner's dilemma, and the decision of whether or not to offer a service doesn't depend on what your competitor is doing. That's because it doesn't matter to the consumers how many others use the service.

"That turns out to be a major difference, these positive network effects," Etzion says. "It has a big effect on strategy and competition."

Terry Kosdrosky



For more information, contact:
Bernie DeGroat, (734) 647-1847, bernied@umich.edu