Winning the Hardware Software Game Winning the Hardware-Software Game - 2nd Edition

Using Game Theory to Optimize the Pace of New Technology Adoption
  • How do you encourage speedier adoption of your product or service?
  • How do you increase the value your product or service creates for your customers?
  • How do you extract more of the value created by your product or service for yourself?

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The purpose of this analysis is to better understand the dynamics of internet platforms. The analysis considers the three basic types of platforms:

  • Vendors (WalMart, Apple, Pandora, etc.)
  • Social Media (Facebook, LinkedIn, YouTube, etc.)
  • Matchmakers (eBay, Uber, etc.)

And will seek to address such issues as

  • Who are the different players in each type of platform game? 
  • How do the players' actions combine to generate value in each type of game?
  • Who extracts what value?
  • Which types of platforms and configurations have the greatest value potential? 

Platform: Definition and Types

Definition of Platform

Let’s start with a more precise description of what I mean by platform. I’m actually focusing on a subset of computing platforms, economic catalysts, also known as two-sided markets. David Evans and Richard Schmalensee defined the term economic catalyst.

An economic catalyst is an entrepreneur or company that precipitates a fundamental change in business or technology. A more precise definition of a catalyst is based on the new economics of multi-sided platforms. In this literature an "economic catalyst" is an entity that has (a) two or more groups of customers; (b) who need each other in some way; but (c) can't capture the value from their mutual attraction on their own; and (d) rely on the catalyst to facilitate value-reaction reactions between them.

For the rest of the analysis, when I use the term platform, I’m actually referring to the subset of platforms, economic catalysts.

Types of Platforms

I distinguish three basic types of platforms on the internet, vendors, social media, and matchmakers.

Vendor Platforms

I define vendor platforms at technology systems that are hosted by a Vendor, such as WalMart, Costco, or Amazon. The Host Vendor sells products and services to Users. Host Vendor offerings are fulfilled by the Host Vendors.

Vendor platforms may also include offerings by Third-Party Vendors. Third-Party Vendors provide products or services listed on the Host Vendor sites for sale to Users. Third-Party Vendor offerings are fulfilled by the Third-Party Vendors. Some of the offerings provided by Third-Party Vendors (e.g., by Developers) enhance Users’ customer experience on the site. For example, Third-Party Vendors provide apps on eBay to help Users track auctions and be notified when they’ve been outbid.

The Users of vendor platforms are the customers who visit the sites to purchase products and services.

The Vendor Platform Game is displayed in Figure 1.

Figure 1

1 vendor platform 

Social Media Platforms

Social media platforms are hosted by Platform Owners, such as Facebook, LinkedIn, or YouTube. I define social media platforms as those systems that (i) host (and filter) user-generated content, (ii) may sell premium subscription services to Users, (iii) generally sell advertising services to Advertisers, and (iv) may sell third-party products and services provided by Third-Party Vendors.

Social media platforms generally sell ad space to Advertisers, to be viewed by Users.

Social media platforms may also include offerings by Third-Party Vendors. Third-Party Vendors provide products or services listed on Platform Owners’ sites and sold to Users.

The Users of social media sites are the customers who visit the sites to view and post user-generated content.

The Social Media Platform Game is displayed in Figure 2.

Figure 2

2 social media platform 

Matchmaker Platforms

Matchmaker platforms are hosted by a Platform Owner, such as eBay, Uber, or Match.com. I define matchmaker platforms as those systems that (i) match Buyers/Users to Sellers/Users, (ii) may sell premium subscription services to Users, (iii) generally sell advertising services provided by Advertisers, and (iv) may sell third-party products and services provided by Third-Party Vendors.

Matchmaker platforms generally sell ad space to Advertisers, to be viewed by Users.

Matchmaker platforms may also include offerings by Third-Party Vendors. Third-Party Vendors provide products or services listed on Matchmakers’ sites and sold to Users.

The Users of Matchmaker sites are the customers who visit the sites to be matched either to Sellers or to other Users.

The Matchmaker Platform Game is displayed in Figure 3.

Figure 3

3 matchmaker platform 

 

What Players Want

Platform Hosts

In addition to providing the main content, to Users, Platform Hosts also generally provide:

  • Online payment of purchases from Platform Owner, Third-Party Vendors, and/or Sellers/Users.

Platform Hosts may also provide any of the following types of services for Users:

  • Ratings and/or reputation systems;
  • Recommendation engines and/or matchmaking services;
  • Background checks on Third-Party Vendors and Sellers/Users;
  • Online scheduling of purchases from Platform Owner, Third-Party Vendors, and/or Sellers/Users;
  • On-demand availability of content; and/or
  • Product or service insurance or guarantees.

Platform Hosts generally want to make as much money from their platforms as possible. They accomplish this by:

  • Attracting as many Users as possible to visit the site,
  • Who visit the site as often as possible, and
  • Who spend as much time and/or money on the site while they’re there.

Users will visit the site more often and spend more time there when:

  • There is a lot of high quality content – products, services/content, apps, user-generated content, etc. –provided by Hosts, Third-Party Sellers, and other Users;
  • There is a lot of custom, site-specific content (i.e., content that can’t be found anywhere else);
  • The price of the content is low; and/or
  • The content variety changes often.

Sellers and Third-Party Vendors

Sellers and Third-Party Vendors want:

  • A lot of potential Users,
  • Users who visit the platform often,
  • Users who spend a lot of time on the site, and
  • Users who are willing to pay high prices for content.

Users

Users want the Platform Host to provide:

  • A large volume and/or variety of content,
  • At a low price, and
  • That matches their needs and preferences.

 

Insights

Platform Types with Greatest Value Potential

I cover this issue extensively in my book, Winning the Hardware Software Game (2nd Edition coming soon!). Platforms in which (i) Users value interacting with other Users (direct network effects are large) and (ii) Users value third-party content provides (indirect network effects are large) tend to provide larger profit opportunities.

Tensions

Tension 1:  Low vs. High Royalties for Third-Party Content

The availability of content by Third-Party Vendors increases the value of the platform to Users. However, Platform Hosts face a tension:

  • Platform Hosts want to make the content on their platform low-priced to attract a lot of Users. This suggests Platform Hosts should (only be able to afford to) pay low royalties for content supplied by Third-Party Vendors.

For the logic here, consider payments exchanged for sales of Third-Party content to Users through the Platform Host

Users pay Platform Host Price

Platform Host retains Royalty from Price

Platform remits Price – Royalty to Third-Party

If Price is low, then Royalty must be low for Price – Royalty > 0

  • Platform Hosts want to attract a lot of high quality content from Third-Party Vendors to enhance the value of the platform to Users. This suggests Platform Hosts should pay high royalties for content supplied by Third-Party Vendors.

Tension 2:  Custom vs. Generic Third-Party Content

The availability of custom, site-specific content by Third-Party Vendors increases the value of the platform to Users. However, Platform Hosts face a tension:

  • Platform Hosts want to make the content on their platform low-priced to attract a lot of Users. This suggests Platform Hosts should pay low royalties for content supplied by Third-Party Vendors. But Third-Party Vendors won’t provide custom, site-specific content for low prices.
  • Platform Hosts want to attract a lot of custom, site-specific content from Third-Party Vendors to enhance the value of the platform to Users. This suggests Platform Hosts should pay high royalties for content supplied by Third-Party Vendors.

Resolution to Tensions 1 and 2

Platform Hosts will optimize the provision of content on their site by Third-Party Vendors if:

  • Platform Hosts pay Third-Party Vendors of generic content — content that is available or can be provided elsewhere —low prices (royalties).
  • Platform Hosts pay Third-Party Vendors of custom, site-specific content — content that is exclusive to the Platform Host’s platform —high prices (royalties).

This is precisely what’s been happening.

  • Creators of generic (non-platform specific) content, such as books, music, and videos have seen their payments plummet as Platform Hosts (e.g., Amazon, iTunes, Netflix) force them to accept low royalties for sales of their content.
  • Creators of custom, site-specific content (e.g., apps) generate higher prices from their content than do producers of generic content.
  • Platforms (Amazon, Netflix, etc.) have been increasingly investing in creating their own content, which is then made available exclusively on their own platform. The next section describes this last point in more detail.

Third-Party Content: Own Platform vs. Host Platform

Platform Hosts capture value generated by Third-Party Vendors through two distinct routes:

  1. In the form of a royalty payment to Platform Hosts on sales made by Third-Party Vendors.

The greater the royalty payment from Third-Party Vendors to Platform Hosts, the lower the incentive Third-Party Vendors have to generate (custom, site-specific) content. So Platform Hosts want to minimize royalty payments from Third-Party Vendors to encourage them to provide as much (custom, site-specific) content as possible.

  1. In the form of greater platform value to Users.

Platforms with more (custom, site-specific) content create greater value for Users. Content provided by Third-Party Vendors thus enhances the value to Users of platforms owned by Platform Hosts. Platform Hosts extract value from content provided by Third-Party Vendors by attracting more Users and/or by charging Users higher prices for content.

Consider the case when Third-Party content creates a lot of value for the Platform Host (i.e., 2. Is large relative to 1.). In this case a lot of value being generated by Third-Party Vendors is being extracted by the Platform Host. That is, Third-Party Vendors are unable to capture a lot of the value they’re creating. So how can Third-Party Vendors capture more of the value they create? By selling their content exclusively on their own platforms – assuming their own platforms will attract similar volumes of Users as do Host Platforms.

This is exactly what been happening. In August, Disney announced it was pulling its content off of Netflix and providing it on the Disney platform. And then in September, Fox also announced it was pulling content from Netflix and Amazon to host on its own platform. For the same reason, many luxury brands won’t list their products on other (non-Brand-owned) platforms. For example, Swatch won’t sell its products on Amazon.

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