Important Elements of Value Creation in an Ecosystem

The rapidly changing business environment of businesses has given rise to a new name for the firm’s task environment, the “ecosystem” in some industries, particularly the technology-based. The ecosystem is an expanded name of an organization’s traditional task environment, which is typically the industry within which the firm is operating. The firm’s ecosystem broadly looks beyond the boundaries of the industry and includes suppliers of complementary products, the extended value chain, and other participants: organizations, individuals, and institutions to capture more opportunities and provide a better understanding of the competitive environment and the determinants of profitability. However, we should also look narrowly by disaggregating broad industry sectors to examine the competition within particular segments and groups of firms. Each element or group of the ecosystem affects the corporation and, in turn, is affected by it. Because of the intense interaction between the elements of the ecosystem, the ecosystem affects a firm’s decisions in crafting its business strategy, which in turn establishes new rules for the firm to generate a competitive advantage. However, the ecosystem-based strategy is not for every company. The ecosystem-based strategy can only be useful to companies that can generate network externalities successfully. The long-term advantage of network externalities is that it generates positive feedback. Once the system gains market leadership, it attracts a growing number of new customers.

Main Elements of Value Creation

The key elements that create additional value for the firm in an ecosystem are network externalities, complementary products and services, and the interaction among participants in the ecosystem. Additionally, the suppliers of complements can exercise their bargaining power in the industry. However, to make sound strategic decisions, an extended industry analysis will be needed that includes the role of complements, business ecosystems, and business models.

Network Externalities

When network externality is present in a product, the value of it to the owner of the product will depend on the number of other users of that product. Network externalities also exist when different products are compatible with each other through a common interface. Network externalities create network effects in the form of negative and positive feedback. In terms of value, positive feedback creates enormous value and negative feedback destroys firm value. Therefore, network-based products with positive feedback generate more return for the firm because it allows the firm to raise prices and sell more units. Thus, when a firm’s product gains market leadership, it attracts a growing number of customers. In contrast, when the firm loses market leadership, it loses customers due to negative feedback that eventually destroys firm value. Some markets which are subject to sufficient positive network externalities are normally dominated by a single supplier. For example, Microsoft is considered a leader in operating systems and office applications software, and eBay in internet auctions. Network externalities can originate from several sources. Network externalities are also known as network effects. According to network effect research, there are many types of network externalities, out of which few of them are described below:

Direct Network Effects

Direct network effects are generated through direct interaction among product users when they are linked to a network. The e-mail systems, railroad systems, social networking, and telephone systems are networks where product users are linked through a network. These types of networks produce direct network effects: the value of the network goes up as the number of users goes up. The advantage of this interaction is that the value of the network grows faster than its cost, resulting in higher profit margins for the owners of the network as it grows larger.

Indirect Network Effects

Complementary products and services produce indirect network effects: the value of the principal product or service depends on the sale of the complementary products that are used together with the principal product. In other words, when the sale of the number of products as a system increase, the production and supply of complementary products also increase. For example, the value of a video game console increases with the number of games played on it, and the value of DVD players increases with the number of movies that can be watched using it.

Two-sided (and Multi-sided) Network Effects

These network effects are based on the concept of indirect network effects. Two-sided (and multi-sided) network effects create platform-based markets in which customers and suppliers of complementary products are interconnected. For example, digital technologies, in conjunction with Internet and/or wireless connectivity, have created platform-based markets where two-sided network effects arise both from user connections and the availability of complements. Examples of two-sided network effects are hardware/software platforms, marketplace platform businesses, and product ecosystems.

Network Effects Reduces Switching Costs

Switching costs are costs that consumers incur when they switch products from one brand name to another. In platform-based markets, some products or services that are most widely used can lower the cost of switching to customers. An example of this is the smartphone operating system market, where Apple, Google, and Windows are the key players. Previously, customers switching from Android to Windows phones would incur migration costs (due to Windows phone weak applications library). However, now due to the improved Windows library (Windows 8 & 10: have more Android apps), the platform not only raises the utility to users but also lowers their switching costs in terms of data migration.

Now I will describe how the presence of network externalities is related to the platforms, standards, interrelationships, business models, and the ecosystem that can generate enormous value for the firm.

Controlling Standards

Achieving control over standards can become the main source of competitive advantage for firms when markets are influenced by network effects. When a standard is embedded into a platform, it can dominate the market and become a massive source of value creation. Therefore, companies should design platform-based winning strategies that incorporate network effects and standards, which will require a detailed analysis to identify the presence and sources of network effects.

Platforms

The term platform has been widely used for over 25 years in technology-based industries. This term, in conjunction with other terms such as product, technology, process, or a system, provides a base (for example product platform or technology platform) for launching several complementary products, services, or applications. A platform as part of an organization on the supply-side economies of scale when uses common components and subsystems to design, manufacture and market complementary products produces direct network effects. The use of common components and subsystems generates both scale and scope economies, resulting in lowering product cost to the organization. When a firm uses many platforms (a combination of product, technology, manufacturing, etc.), it produces a multiplication factor for value creation.

On the demand side economies of scale, the use of digital technologies in conjunction with Internet or wireless connectivity have created markets in which network effects are developed due to connectivity between suppliers of complements and product users. Therefore, these markets are called platform-based markets because they produce a two-sided link or interface between two groups of users: the customers and suppliers of complementary products. For example, operating systems such as Microsoft Windows, Google’s Android, and Apple’s iOS generate network effects among users (direct network effects) and the suppliers of applications (indirect network effects).

Business Models: To Manage the Business Ecosystem

A business model describes the core logic or architecture of value creation, value distribution, and capturing value. Historically, most businesses have used and operated with simple business models due to the existence of stable business environments. But because of the changing environment of today and the advent of digital technologies, for some businesses, old business models have become obsolete, and more complex business ecosystems have emerged that offer opportunities to design and select innovative business models. However, it is becoming a challenge for traditional firms to find new business models that incorporate network effects, platforms, interrelationships, and complementary products. As more and more established industries are being disrupted by digital technologies: their businesses are being rendered obsolete by competition, the challenge for traditional firms is to find new business models to replace the old ones.

To become successful using a new business model, a firm should be able to create initial leadership and maximize positive feedback effect to create enough value that can be appropriately shared with collaborators (customers, suppliers, and complementors). However, if the company attempts to capture a large share of value, then it may fail to build a big enough bandwagon to capture market leadership.

Business models are considered useful in managing ecosystems because strategy is often viewed too narrowly. Business models in context to an ecosystem allow us to consider more complex business scenarios and widely look for more opportunities.

Interrelationships

On the demand side economies of scale, two types of network externalities arise: from interrelationships due to the Internet or wireless connectivity with users (customers and suppliers of complementary products) and from the availability of complementary products. Here, the term “interrelationship” becomes the dominant factor that can generate a multiplication effect on value creation, and therefore, can confer a massive competitive advantage for the firm. This is because when users communicate within the network with each other, it generates a condition known as “virality.” Virality is a tendency that spreads or popularizes the product, service, or brand name rapidly and widely, from one user to the other through digital connectivity (particularly the internet). Virality can attract people to the network from both sides (customers and suppliers) and the positive feedback of the network effects keep them there. Virality is also about attracting people who are not on the platform and entices them to join it. Therefore, a major contribution to the competitive advantage comes from the presence of virality.

For the past two decades, large companies have been more dependent on the supply side of economies of scale to create value. Some large companies, such as Google, Facebook, Uber, and others, are valuable not because of their cost structure but are more valuable because of the communities that participate in their platforms.

Business Ecosystem

The most important aspects of managing the firm’s ecosystem of partners are in designing the value exchange among partners and capturing company value. However, to capture the value and achieve sustainable competitive advantage, the firm must evaluate the issues of value migration within its ecosystem. In a business system, value migrates between its different parts: between industries and companies, and within companies. This migration is due to the changing external forces, such as political, social, technological, and economic, over which the firm has no control. The value migration can also be influenced by the ecosystem partners: organizations, customers, and individuals. Changing customer needs due to changing customer preferences can move value within an ecosystem. The search for value creation requires identifying possible bottlenecks within the firm’s ecosystem: activities that create large amounts of value and determine if those activities can be controlled by the firm. If the firm fails to meet customer needs better than its competitors, then the firm can lose control over value creation, resulting in an outflow of value depriving the firm of sales, profitability, and market share.

To create and capture value, a firm must also have the organizational capability to manage partner relationships. Building relational capability requires building trust, defining value exchanges among partners, knowledge sharing, and establishing a mechanism for coordination. To successfully manage its ecosystem, a firm must also develop systems integration capability to coordinate and integrate dispersed activities, particularly when a firm intensifies its outsourcing of value chain activities to network partners. Apple’s incredible success with its iPod, iPhone, and iPad was not only due to its capabilities in designing, marketing, and integrating hardware and software, but also in managing the ecosystem of partners.

References and Further Reading

1. R. M. Grant, Contemporary Strategy Analysis (United Kingdom: John Wiley & Sons, Ltd., 2018), Chapters 4 and 9.
2. Julian Birkinshaw, Ecosystem Businesses Are Changing the Rules of Strategy (Boston: Harvard Business Review, August 08, 2019).
3. Scott Shane, Technology Strategy for Managers and Entrepreneurs (New Jersey: Prentice-Hall, 2009), Chapters 12 and 13.
4. Marko Karhiniemi, Creating and Sustaining Successful Business Ecosystems (Finland: Master’s Thesis, Helsinki School of Economics (HSE), 2009).
5. Ashok N., New Business Model Structure, Innovation Strategy, and Competitive Advantage, A&N Strategy Consulting (April 8, 2018).
6. Ravi Kumar, Understanding the basics of Network Effects—The Power of the Platform (https://medium.com), July 28, 2018.