Durability of network effects – importance of multi-homing costs

In their recent HBR article, David Evans and Richard Schmalensee argue that winner takes all thinking does not apply to the platform economy. In the article, they cite instances of how popular multi-sided platforms like Facebook, Google, and Twitter haven’t won every market. In fact, in spite of being near monopolies social networking, internet search, and micro-blogging, they compete very hard for the advertisement revenue. They also posit that network effects are not durable enough in the case of digital goods, as compared to physical networks like railroads and telephones. In this blog post, I am going to discuss these two assertions.

In the meantime, I ordered their book, Matchmakers, and my favorite ecommerce bookseller just delivered it to my desk, as I begin writing this blog. Will read the book in the coming week, and possibly update the note; but for now this blog post is based on their HBR piece. Now, if you have not read their HBR post, please read it.

Winner-takes-all markets

In their very popular HBR article Eisenmann, Parker, and Van Alstyne elucidate three conditions for a market to exhibit winner-takes-all (WTA) conditions. One, the network effects should be strong and positive; two, multi-homing costs should be high; and three, there should not exist any special needs by the users.

Network effects

In the case of the three multi-sided platforms that Evans and Schmalensee quote, the network effects are very strong. You signed up to Facebook because all your friends, family, and acquaintances were on Facebook (same side network effects); you use Google search because Google has learnt enough about you and only pushes “relevant” advertisements to you (cross-side network effects); and you micro-blog using Twitter because everyone who you want to reach are already looking for you at Twitter, as well as everyone who you want to follow are micro-blogging using Twitter (a combination of same and cross-side network effects).

Multi-homing costs

Multi-homing costs imply the costs of affiliating/ maintaining presence on multiple platforms at the same time. My most popular example is the case of internet-based email services. Even though it is literally free for anyone with an internet to have an unlimited number of email accounts, most of us cannot really maintain more than three email accounts. The monetary costs of creating and operating multiple email accounts may be zero, but the effort required to remember passwords, periodic logins to each of the accounts, and ensuring that you are communicating using the right email account is too much for most people. These are multi-homing costs.

Multi-homing costs exist in all the three markets we are discussing – social networking, internet search, and micro-blogging. In the case of social networking, it is difficult to maintain multi-home as the updates that we are likely to share in multiple networks are likely to be the same. And, the strong network effects (all my friends are on Facebook) make sure that there is virtually no-one else who is active in any other competing social networking site who is reading my updates. Multi-homing costs in internet search manifest in the form of the search engine’s ability to customise its advertisements and offers to my preferences and behaviour, which is based on my behaviour over time – with my past preferences, I have actually trained the search engine to customise. Search on the same key words across different internet search engines are unlikely to provide different results, but it is the overall experience including advertisements and personalisation that matters in the case of Google. This is somewhat similar to being loyal to a particular airline and gaining miles in that frequent flyer program; as splitting one’s travel across multiple airlines’ loyalty programs would ensure that one does not remain a frequent flyer anywhere! Similarly, having invested sufficiently in training Google on my personal preferences, I would rather stick with Google search. Similar is the argument for Twitter – the network of micro-bloggers and followers exist on Twitter; and I have carefully curated the list of which micro-bloggers I want to follow. Multi-homing costs include creating multiple lists of people I want to follow, and getting others to follow me.

Special preferences

The third condition for a market to exhibit winner-takes-all characteristics is the absence of any special preferences. Let us take the case of social networking – when professional networking and sharing of professional thoughts is a special need, different from social networking, LinkedIn thrives. Most people with a need to separate out their personal networks from the professional networks will maintain a Facebook account, as well as LinkedIn account. And, when a LinkedIn user turns into an active job seeker (from being a passive expert), she would open an account with a focused careers site like Monster.com. Similarly, someone’s work/ passion may require sharing large sized file attachments over email, and therefore push her to open multiple accounts for different kinds of uses.

In sum, winner-takes-all markets are characterised by the presence of strong network effects, high multi-homing costs, and the absence of any special needs. What Evans and Schmalensee ignore in their HBR post is the presence of high multi-homing costs. Yes, these firms do contest in the market for advertising revenues, but in one side of their respective markets, their strategies have been to continuously raise multi-homing costs. Take Facebook’s acquisition of WhatsApp for example. When more and more people took to social networking using a mobile phone than the ubiquitous desktop, and were increasingly constraining the breadth of audience for their posts, it was important for Facebook to be present on the users’ mobile phones, not just enabling broadcast social networking (with its Facebook mobile App), but also including narrowcasting or unicasting social networking using WhatsApp. Same is with Google – over the years, Google has come to dominate the internet search in more ways than one – YouTube and Maps to name a few.

Durability of network effects

The second thesis of Evans and Schmalensee is that network effects in multi-sided platforms are not durable. They cite how easy for a new entrant to challenge these leaders with little or no physical investments. Digital goods like software have high fixed costs and almost zero marginal costs for every additional unit produced. Economics has taught us that in markets with near-zero marginal costs, prices will fall continuously to eventually make the product free. There are a variety of other goods where such cost structures prevail. Take for instance, news media. The cost of replicating (or is it plagiarising) a news article across multiple outlets is close to zero, and therefore news producers are under tremendous pressure from consumers to respond to the threat of potential new entrants to provide news at prices cheaper than free. Yes, cheaper than free, which means that you may actually be paid to consume news! Like what Google did to the handset makers to use its mobile OS (for more details, read here). In the initial days of building the platform, firms are under severe pressure to kick-in network effects, and adopt pricing strategies that are cheaper than free. For instance, the Indian cab aggregator OLA Cabs, incentivises drivers handsomely (as the markets mature, the incentive rates are falling) to undertake a certain number of rides per day. This is apart from the amounts they earn from the passengers. In the entire bargain, drivers get paid by both the riders and the aggregator, and OLA keeps the rider fare low to encourage more usage, leading to faster growth of network effects.

Evans and Schmalensee argue that faster the network effects grow, faster they will disappear. I contend that this may not be true in markets with higher multi-homing costs. Take the OLA Cabs business model for instance. At the rider’s side, there are no significant multi-homing costs; at best it is limited the real estate available for multiple apps on the rider’s smartphone. It is the drivers’ multi-homing costs that are of interest here. OLA Cabs and its primary competitor Uber, have been working hard on increasing the driver’s multi-homing costs by limiting the incentive payouts only when the driver completes a certain number of rides per day. And as the market grew, this number of rides required to earn incentives has risen sharply. That means, a multi-homing driver has to ensure that he completes at least the minimum number of rides on one of the aggregator platforms before accepting rides on another. And soon, drivers who cannot meet the minimum required for earning incentives on both platforms would choose one of the two, and those drivers who cannot even meet the requirements of one aggregator would leave the market. Even though the cost structure of cab aggregation is similar to digital goods (high fixed sunk costs incurred upfront) and close to zero marginal cost of adding a new driver/ cab to the fleet, these firms have sustained the winner-takes-all characteristics by increasing the multi-homing costs of the drivers.

To sum up, network effects are durable when the platforms invest in increasing multi-homing costs of at least one side of the platform. Better so, the money side (not the subsidy side) that has the highest switching costs. These multi-homing costs arise out of asset-specific investments that the participants make in affiliation with the platform. In the case of OLA Cabs, multi-homing costs do not arise out of having to carry multiple devices, but in ensuring minimum number of rides per day on a particular platform to earn incentives. And these incentives are significant proportion of the drivers’ earnings, as the aggregators keep the rider prices low.

The importance of multi-homing costs

Evans and Schmalensee write:

With low entry costs, trivial sunk capital, easy switching by consumers, and disruptive innovation showing no signs of tapering off, every internet-based business faces risk, even if it has temporarily achieved winner-takes-all status. The ones most at risk in our view are the ones that depend on advertising, because even if they dominate some method of delivering ads, they are competing with everyone who has or can develop a different method.

In this post, I argue that creation and maintenance of high multi-homing costs is an effective insurance against low entry costs, trivial sunk capital and easy switching by consumers. Fighting disruptive innovation requires platform firms to understand the economics of envelopment, which we will discuss next week.

Cheers