Invisible Engines: How Software Platforms Drive Innovation and Transform Industries

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  1. “By focusing on the software platform we hope to offer the reader a perspective on the business dynamics and strategies of industries, old and new, that have been powered by these invisible engines…All of us quickly recognized that software platform businesses have at least two sides. Software platforms consist of services that are often made available to developers through APIs. They are also made available to computer users, but those computer users typically avail themselves of API-based services by buying applications that in turn use APIs. It is only a slight exaggeration to say that all software platform makers all the time invest in getting both developers and users to use their platforms. The developers/users are like the men/women, cards/merchants, advertisers/eyeballs, and buyers/sellers that we mentioned above. In fact, software platforms sometimes appeal to more than two distinct groups—including hardware makers and content providers. The economics of two-sided platforms provides a number of insights into pricing, design, organization, and governance of platform-based businesses. We were interested in understanding how this new economic learning could help shed light on the strategies followed by software platforms. On the flip side, we were interested in understanding how a diverse set of industries based on software platforms could be probed to provide insights for students of this new economics. This book is the result. It blends economics, history, and business analysis. It is intended for anyone who wants to better understand the business strategies that have been followed in industries based on software platforms. We focus on pricing, product design, and integration into downstream or upstream suppliers.”

Key Takeaways

  1. Most successful software platforms have exploited positive feedbacks (or network effects) between applications and users: more applications attract more users, and more users attract more applications. Nurturing both sides of the market helped Microsoft garner thousands of applications and hundreds of millions of users for its Windows platform.
  2. The modular approach has numerous advantages. If a new program (or other complex system) can be specified as N modules, N teams can work in parallel. Moreover, individual modules can subsequently be improved without touching other parts of the overall program, and they can be used in other programs.
  3. Operating systems provide services to applications through Application Programming Interfaces (APIs). These services range from rudimentary hardware services, such as moving a cursor on a monitor, to sophisticated software services, such as drawing and rotating three-dimensional objects. The APIs serve as interfaces between these services and applications…It is easy to see why application developers find the ability to access system services through APIs appealing. Rather than every application developer writing hundreds of lines of code to allocate memory to an object, to take the example above, the operating system developer writes 116 lines of code and makes the system services this code provides available to all application developers through the API.
  4. Software platforms make services available through APIs. Developers benefit from these because they avoid having to write some of their own code. Users benefit from a greater variety of and lower prices for applications. The economics of multisided platforms provides a set of tools for understanding the past, present, and future of software platforms.
  5. Multisided businesses can generate profits for themselves and benefits for their customers if they can figure out ways to increase and then capture indirect network externalities. There are three major ways in which they do this. First, they serve as matchmakers. Second, they build audiences. Advertising-supported media do mainly that: they use content to attract eyeballs and then sell access to those eyeballs to advertisers. Third, they reduce costs by providing shared facilities for the customers on each side. That’s the shopping mall case with which we began.
  6. Businesses in multisided markets often subsidize one side of the market to get the other side on board—sometimes explicitly by charging low or negative prices. A dating club may charge men a higher price just because they have more inelastic demand and because it is easy to identify that group of consumers. But businesses in multisided markets have an additional reason to price discriminate: by charging one group a lower price the business can charge another group a higher price; and unless prices are low enough to attract sufficient numbers of the former group, the business cannot obtain any sales at all. In contrast, economic analyses of multisided platforms, along with the industry case studies discussed in the following chapters, show that successful multisided platform businesses must pay careful attention to all relevant groups, and typically must worry more about balance among them than about building share with one of them. Getting the balance right seems to be more important than building shares. Platform markets do not tip quickly because as a practical matter, it takes time to get things right. And the first entrant often does not win in the end: many other firms may come in and successfully tweak the pricing structure, product design, or business model. The businesses that participate in such industries have to figure out ways to get both sides on board. One way to do this is to obtain a critical mass of users on one side of the market by giving them the service for free or even paying them to take it. Especially at the entry phase of firms in multisided markets, it is not uncommon to see precisely this strategy. Another way to solve the problem of getting the two sides on board simultaneously is to invest to lower the costs of consumers on one side of the market. As we saw earlier, for instance, Microsoft invests in the creation of software tools that make it easier for application developers to write application software for Microsoft operating systems and provides other assistance that makes developers’ jobs easier. In some cases, firms may initially take over one side of the business in order to get the market going.
  7. The copyleft provision means that if people choose to distribute software that is based in part on other software covered by the GPL, they must distribute their new software under the GPL. GPL software thereby propagates itself.
  8. Bundling features into the software platform is often efficient for the platform producer and for end users, as it is for most information goods, because it lowers distribution costs and expands demand.
  9. Multisided platforms must consider marginal costs and price sensitivity in pricing, like single-sided businesses, but they must also consider which side values the other side more. Software platforms generally charge low prices on one side in order to attract customers who can then be made available to the other side. Getting the balance right among all sides is more important than building market share.
  10. Per-copy charges also helped Microsoft capitalize on its investment in programming languages in the face of great uncertainty as to which computer makers would succeed. A flat fee would have earned less from the top sellers and would have discouraged other makers from even trying. Microsoft retained this basic pricing model when it went into the operating system business.
  11. In retrospect, having multiple operating systems run on a hardware platform is a poor strategy. The idea, of course, was to ensure that the hardware, not the operating system, became the standard that defined the platform and determined its evolution. Indeed, IBM followed an important economic principle for traditional industries: all firms would like everyone else in the supply chain to be competitive. IBM didn’t seem to recognize that this was far from a traditional industry. If IBM’s strategy had worked, and if several operating systems had been installed on substantial numbers of IBM PCs, what would have happened? Most likely, having multiple operating systems would have made the hardware platform less popular than having a single operating system. Applications are generally written for software platforms, not the underlying hardware. The more fragmented the installed base of operating systems, the less attractive it is to write an application for any one of them.
  12. Four key strategies helped Microsoft obtain the leading position in personal computers: (1) offering lower prices to users than its competitors; (2) intensely promoting API-based software services to developers; (3) promoting the development of peripherals, sometimes through direct subsidies, in order to increase the value of the Windows platform to developers and users; and (4) continually developing software services that provide value to developers directly and to end users indirectly.
  13. Technically, this is a two-part tariff, consisting of an access fee (the price of the razor) plus a usage fee (the price of the blade). Here the blade can be thought of as having two related roles. It meters the use of the durable good, and it sorts customers into those who are willing to pay more and those who are willing to pay less. These metering devices tend to increase profits and help companies better recover their fixed costs of investment. Because it is particularly attractive to make money on the blades, it is especially attractive to reduce the price of the razor, perhaps to below cost, or perhaps even to zero in extreme cases. For video game console makers this razorblade strategy made a lot of sense. Getting the console into the hands of many people increased the demand for the games it could play. Moreover, it made buying a console less risky for households, who had no good way of knowing how valuable the console would be until they saw the games produced for it. The game-console company, which was in the best position to forecast the quality of those games, took the risk: it lost money if consumers didn’t buy many games, and it made money if they did. The people who ultimately bought a lot of games were those who valued the console the most, so making profits mainly or even entirely on games enabled the console makers to earn the most from those willing to pay the most for their system.
  14. When consumers value product differentiation and platforms can offer innovative and unique features, multiple platforms can coexist despite indirect network effects that make bigger better.
  15. The console video gaming industry operates a radically different business model from other software platform industries. Game manufacturers tightly integrate hardware and software systems; they offer consoles to consumers at less than manufacturing cost, and they earn profits by developing games and charging third-party game developers for access to their platforms.
  16. Palm, on the other hand, regrouped. It surveyed Zoomer buyers to find out what they liked and didn’t like, what they used and didn’t use: What these people said opened the company’s eyes. More than 90% of Zoomer owners also owned a PC. More than half of them bought Zoomer because of software (offered as an add-on) that transferred data to and from a PC. These were business users, not retail consumers. And they didn’t want to replace their PCs—they wanted to complement them. People weren’t asking for a PDA that was smart enough to compete with a computer. They wanted a PDA that was simple enough to compete with paper.
  17. When you’re playing Bobby Fischer—and you want to win—don’t play chess. Make sure whatever game you’re playing—be it network delivery of media vs. stand-alone PC, whatever you’re in—that you’re not playing a game someone else has mastered when you have an option to play another game. —Rob Glaser, Founder of RealNetworks, May 20011
  18. Interestingly, many are made by Microsoft, which integrated into mouse production in 1983 mainly to be sure that the sort of mouse specified by its nascent Windows system would be available in the marketplace. Microsoft developed and patented a mouse that could connect to a PC through an existing serial port rather than to a special card installed within the computer. This innovation reduced the cost of the mouse and thus of mouse-using computers running Windows. Apple as a vertically integrated hardware and software platform maker has always produced its own mice.
  19. What is the cure? From A’s point of view, one cure is to have many competing producers of good b. Competition will then hold the price of b close to cost (including a reasonable return on capital) regardless of A’s pricing, so that A both effectively determines the system price (via the price of a) and captures all the economic profit. Generally, it is more attractive to rely on others to supply a complement (instead of buying it or making it), all else equal, if there are many producers of that complement who compete intensely. Hence the common strategic advice, “Commoditize the complements.”
  20. In a famous 1951 paper, Nobel Laureate George Stigler argued that this proposition implies that “vertical disintegration is the typical development in growing industries, vertical integration in declining industries.”
  21. Interestingly, we are aware of no examples of software platforms that initially integrated into the applications/games/content that subsequently exited that business entirely. On the other hand, almost all such platforms have adopted a two-sided strategy and made significant investments in attracting third-party suppliers. Partial integration is the norm. The only exceptions are those successful software platform vendors that launched without integration; they have remained out of the applications business. The tendency of computer-based industries to disintegrate over time is even clearer—with interesting exceptions—when we consider integration with the supply of basic hardware and peripherals. The Microsoft strategy of having the hardware complement its operating system produced by a competitive, technologically dynamic industry has served to make its operating systems more valuable and to speed their market penetration. Microsoft is not above using integration on occasion to stimulate important markets for complements, as its entry into mouse production, discussed earlier, illustrates.
  22. In a rephrasing of Mr. Katz’s words, Michael Dell told Microsoft upon refusing the Xbox deal offered to him: When Sony cuts the prices on their PlayStations, their stock price goes up. Every time I cut prices, my stock price goes down. If you don’t understand why that happens, you don’t understand the console business. I understand why this is strategic to Microsoft. I don’t understand why this is strategic to Dell.
  23. “Oh, ‘tanstaafl.’ Means ‘There ain’t no such thing as a free lunch.’ And isn’t,” I added, pointing to a FREE LUNCH sign across room, “or these drinks would cost half as much. Was reminding her that anything free costs twice as much in the long run or turns out worthless.” —Robert Heinlein
  24. In practice, it generally does matter which side pays, because two key assumptions made in the textbook discussion don’t apply. First, there are often significant transactions costs that prevent the customers on the two sides of most markets from just “sorting it out” themselves. Take the payment card example. Although most card systems prohibit merchant surcharging because it degrades the value of their product to cardholders, several countries have barred card systems from imposing such a no-surcharge rule. In those countries, however, most merchants don’t surcharge. One reason is that it is costly to impose small charges on customers. Those merchants that do surcharge often charge more than they are charged by the card system—an indication that they are using the fact that a customer wants to use her card as a basis for groupwise price discrimination.
  25. When balance matters in a mature two-sided business, the pricing problem is much more complex than in a single-sided business. Marginal cost and price responsiveness on both sides matter for both prices, and so does the pattern of indirect network effects. In general, if side A cares more about side B than B cares about A, then, all else equal, A will contribute more total revenue. Thus, newspapers make their money from selling advertising, not from selling papers. The textbook pricing formula for a single-sided market gives the optimal markup over marginal cost as 1 over a measure of price responsiveness (the price elasticity of demand), so low price responsiveness implies high markups. The corresponding formula for a two-sided business involves marginal costs on both sides, price responsiveness on both sides, and measures of the strength of indirect network effects in both directions. In particular, balance may require charging a price below marginal cost to a group with low price responsiveness, something a singlesided business would never do, if it is critical to attract members of that group in order to get members of the other group on board.
  26. The idea is initially to subsidize one side (or, more generally, to do whatever it takes) in order to get it on board even though the other side is not yet on board, and to use the presence of the subsidized side to attract the other side.6 This differs from the single-sided penetration pricing strategy discussed above because the key here is to generate indirect network effects, to use the subsidized side as a magnet to attract the other side. After entry has been successfully effected and both sides are on board, of course, the rationale for the initial subsidy vanishes, and one would expect to see a corresponding shift in pricing policy. One of the regularities we discuss below, however, is that pricing structures—the relative amounts paid by the various sides—appear fairly robust over time; there are not many examples of pricing low to one side at first and then raising prices significantly later.
  27. A fundamental decision facing all multisided platform businesses is choice of a price structure: How much should the platform vendor charge each side relative to the others? Since transactions involving some sides may have significant associated variable costs (the production and distribution costs of video game consoles, for instance), the most illuminating way to analyze observed price structures is to look at the contributions of each side to gross margin or variable profits: revenue minus side-specific variable cost. Should a two-sided platform derive most of its gross margin from one side of the market, and if so, which side, or should it choose a more balanced structure, with both sides making significant contributions to gross margin?
  28. Like all multisided platforms, the pricing structures of the software platforms we have encountered in this book reflect the need to get all unintegrated sides on board: end users, application/game/content developers, and manufacturers of hardware and peripheral equipment. The structures we have examined have three remarkable features. First, all of them are extremely skewed: almost all earn a disproportionate share of their variable profits on only one side of the market, either end users or developers. Second, for all but video games, the platform earns the bulk of its net revenues from end users. The third remarkable feature, which we consider in the next section, is that these structures have been stable over time.
  29. Components selling occurs when the firm offers A and B separately (cars and bicycle racks). • Pure bundling occurs when the firm only offers A and B together as a single bundled product, AB (men’s laced shoes). • Mixed bundling occurs when the firm offers the bundle AB and either or both of its components, A and B (such as the Sunday New York Times and the New York Times Book Review).
  30. It is common to bundle together products that are complements, such as automobiles and tires, but firms may find that it pays to bundle products that aren’t complements. We already saw an example of this above. Bundling persuaded two consumers to buy a product even though each wanted only a single component. This saved the manufacturer costs. The idea that bundling of noncomplements can be used to enhance profits goes back to a classic paper by Nobel Prize winning economist George Stigler. Stigler tried to explain why movie distributors at one time required theaters to take bundles of pictures. Bundling can be used in a different way to facilitate price discrimination, which we discussed in the preceding chapter. That is, if different groups of consumers place different values on groups of components, bundles can be designed so that those with stronger demand pay more. The idea is possible to design bundles of components that cause consumers to sort themselves by the bundles they choose into groups with different willingness to pay. (Marketers call this “segmentation.”) In the case of autos, some will want the car with the sports package, while others will want only the basic package. The seller can then charge a premium to groups that have a particularly high demand for a particular package and offer an especially aggressive price to consumers that are very sensitive to price but are also willing to take the no-frills deal. For this to work, there must be a predictable correlation between combinations of components and demand (for example, price-sensitive consumers generally have a low demand for frills). A number of studies have found, for example, that automobile companies have much higher markups on luxury models than on base models. Bundling drives innovation and creates industries.
  31. The ability to select bundles of features to sell helps firms segment their customers, control costs, and enhance profits. Bundled products offer consumers convenience, lower costs, and products tailored to their needs and wants.
  32. Bundling decisions by multisided platforms, such as software platforms, are more complex since they must take into account the effect on all customer groups. Multisided businesses must consider both the additional customers they get on one side as a result of including a new feature and the additional customers they will get on the other side from having those additional customers. They may also include features that harm one side directly but benefit the platform overall by getting more customers on board on another side.
  33. Bundling makes sense for businesses whenever the cost of adding additional features is lower than the additional sales generated thereby—even if most purchasers do not value or use all the features in a product bundle.
  34. Creative destruction has been a hallmark of economic progress for millennia, but it has proceeded at a glacial pace for most of history. The Industrial Revolution sped this process up. Even so, it took decades for change to filter through the economy following innovations such as the spinning jenny, steam engine, and electric generator. The information technology revolution has quickened the pace of industrial change greatly. The plummeting costs of computer processing and storage make it possible to create products and industries that were not only infeasible but also unimaginable a few years earlier. Software platforms further accelerate the process of creative destruction, mainly because code is digital and malleable. Think how easy it is to add a new feature to a software platform and distribute that change electronically over the Internet to potentially billions of computing devices around the world.
  35. One is familiar: developers. TiVo is evangelizing its software platform by providing tools and offering prizes for the best applications in several categories, including games, music, and photos.
  36. History teaches us that it takes decades for technological changes to work their way through the economy, destroying, creating, and transforming industries. The third industrial revolution got off to a quick start. We suspect that it will continue through at least the first few decades of the twenty-first century and that our invisible engines will ultimately touch most aspects of our business and personal lives.

What I got out of it

  1. Some of the examples are a bit outdated but the principles are just as valuable as ever – how to think about multisided markets, pricing, positioning, and so much more

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