Dynamics of Platform Competition: Exploring the Role of Installed Base, Platform Quality and Consumer Expectations

by Feng Zhu & Marco Iansiti

Overview — What factors drive platform success, long-run market structure, and market efficiency? Conventional wisdom suggests that for a new platform to be successful, either it must make its technology compatible with the incumbent, or its technical advantage must offer so much value to consumers that it exceeds the combination of functionality, installed base, and complementary goods value offered by the incumbent. Zhu and Iansiti develop a dynamic model to examine the evolution of platform-based markets. They find that a huge quality advantage may not be necessary for an entrant to be successful. Using data from the video game industry, they find support for their theoretical predications. Key concepts include:

A huge quality advantage may not be necessary for success. When market dynamics are driven by quality, a platform with a small quality advantage can also be successful.
Xbox has a small quality advantage over Playstation 2 and the market dynamics are quality driven. These results help explain the successful entry of the Xbox console into this market and provide support for Zhu and Iansiti's theoretical model.
Installed-base advantages do not necessarily provide a safety shield for the incumbent. To defend its leadership position, the incumbent needs to constantly enhance its quality.

Author Abstract

This paper seeks to answer three questions. First, which drives the success of a platform, installed base, platform quality or consumer expectations? Second, when does a monopoly emerge in a platform-based market? Finally, when is a platform-based market socially efficient? We analyze a dynamic model where an entrant with superior quality competes with an incumbent platform, and examine long-run market outcomes. We find that the answers to these questions depend critically on two parameters: the strength of indirect network effects and consumers' discount factor of future applications. In addition, contrary to the popular belief that indirect network effects protect incumbents and are the source of market inefficiency, we find that under certain conditions, indirect network effects could enhance entrants' quality advantage and market outcomes hence could be more efficient with stronger indirect network effects. We empirically examine the competition between the Xbox and PlayStation 2 consoles. We find that Xbox has a small quality advantage over PlayStation 2. In addition, the strength of indirect network effects and consumers' discount factor in this market are within the range in which platform success is driven by quality advantage and the market is potentially efficient. Counterfactual experiments suggest that PlayStation 2 could have driven Xbox out of the market had the strength of indirect network effects more than doubled or had consumers' discount factor increased by fifty percent.