Massive coordination games

Chapter 5: Massive Coordination Games
Overview
We look for opportunities with network externalities—where there are advantages to the
vast majority of consumers to share a common standard.
Bill Gates
[1]

In the last chapter, we discussed simultaneous games and learned about various
classifications of games. In this chapter we will focus on coordination games with millions
of players. Recall that in coordination games the players need to synchronize their
actions.
The introduction of the first telephones created a coordination game among its potential
customers. If everyone else was going to get one then it made sense for you to get one
too. If, however, no one you knew was planning to get a phone then it would be silly for
you to buy one. Telephones are valuable only when commonly owned since the benefits
of having a telephone are proportional to the number of your family members, friends,
and associates who are also on the telephone network. Telephones exhibit network
externalities because they become more valuable when more people own them. Network
externalities give rise to mass coordination games.
Network externalities—the more people who have the product, the more valuable the
product becomes.
You should buy a device that exhibits network externalities only if people you interact
with also have the product or plan to buy it soon. Many products other than telephones
exhibit network externalities. For example, no matter how much you might be impressed
by the technology underlying fax machines, the pleasure you would receive by faxing
yourself documents would probably not justify the machine’s cost.
Network externalities are the dominant strategic consideration in the computer industry.
Indeed, Microsoft owes its vast success to network externalities.
[1]
“Microsoft, 1995 (Abridged),” Harvard Business School Case No. 799–1003, 1.
Attack of the Clones: An Extremely Brief History of the

Personal Computer Industry
Before the personal computer, there were mainframes. IBM was the primary producer of
mainframe computers. Large companies, not individual consumers, bought mainframes.
Apple was the first company to sell easy-to-set-up computers to consumers and its early
success caused IBM to enter the desktop computer market.
IBM wanted to sell a desktop computer, but it didn't want to design all of the computer
parts itself, so IBM asked Microsoft to write an operating system for its personal
computer and asked Intel to manufacture its computer's microprocessor. IBM's personal
computer was a huge success and far more people bought personal computers from
IBM than Apple. Unfortunately for IBM, the sale of clones caused most of the profits from
the personal computer industry to go to other firms.
IBM clones worked almost exactly as an IBM-manufactured computer did. Most
importantly, they would run software that had been explicitly written for IBM personal
computers. These IBM clones still mostly used Microsoft operating systems and Intel
microprocessors. Microsoft and Intel made far more money from personal computers
than did IBM or Apple. The vast majority of the personal computers in use today have
Microsoft operating systems and Intel microprocessors-not necessarily because of these
products' quality, but rather because of network externalities and coordination games.
Success, Failure, and Network Externalities
Many people considered and still do consider Apple computer's operating system
superior to Microsoft's. Alas, Microsoft's operating system dominates the market while
Apple is a smaller (sometimes it seems dying) niche player. Network externalities caused
by compatibility problems are the reason that most everyone buys Microsoft operating
systems. Operating systems exhibit network externalities because software written for a
computer with one type of operating system will not easily run on a computer with a
different system. Thus, software written for Microsoft's operating system will not work on
an Apple computer or an IBM-compatible computer that has a non-Microsoft operating
system.
Software makers want to sell as many copies of their product as possible. Therefore,
most software makers devote the majority of their resources to writing software for the

type of computer that most people have. A consumer, therefore, benefits from having the
same operating system as most everyone else. As a result, the more people who use the
same type of operating system as you do, the more software there will be for you to use.
Microsoft's continuing popularity arises from a virtuous, network externality-driven cycle;
since most everyone uses Microsoft's operating system, most everyone else wants to
use Microsoft's operating system. Consumers play a coordination game with each other
where most people want to use the same kind of computer as everyone else does. For
whatever reason, consumers have chosen to coordinate on Microsoft-based personal
computers. As the game in Figure 28 shows, even if people prefer Apples, they might
end up buying Microsoft-based computers. In this game if each person expects the other
to buy a Microsoft-based computer, then they are better off getting one and receiving a
payoff of 9, rather than getting an Apple computer and possibly receiving a payoff of only
5. What a great situation for Microsoft: Its product stays popular because it is popular.

Figure 28
Apple lost a chance to take advantage of network externalities. Bill Gates, in 1985,
wanted to modify Macintosh's operating system (which required Motorola processors) so
it could be run on Intel processors. Apple refused to give him the necessary legal
permission.
[2]
Had Apple's operating system been made compatible with Intel chips, then
Apple would have benefited from the network externalities that made Gates so rich.
[3]

Microsoft understood what Apple didn't: Where network externalities are concerned, size
doesn't just matter, it's the dominating consideration.
Like Microsoft, Intel also benefits from network externalities. Since most computers run
on Intel microprocessors, software developers make most of their products compatible
with Intel microprocessors, which, of course, causes most consumers to want to buy
Intel-based computers. As with Microsoft's operating system, Intel microprocessors are

popular because a lot of people buy them.
[2]
Lessig, 63.
[3]
Ibid.
Competing Against Microsoft and Intel
How could a company compete against Intel or Microsoft? Ideally, the company would
sidestep the duo's network externalities by marketing a compatible product. Absent
compatibility, even if your company designed a cheaper and easier-to-use operating
system than Microsoft's, consumers would still be reluctant to purchase it because most
existing software would be incompatible with your operating system. If, however, your
operating system could run Microsoft-compatible software, then you could imperil
Microsoft's dominance.
AMD, in fact, has adopted such a strategy against the microprocessor maker Intel. AMD
makes microprocessors that, from the consumer's viewpoint at least, function almost
identically to Intel's. Consequently, AMD has been able to capture a small share of Intel's
market.
IBM, of course, did lose its dominance to competitors' compatible products. Since many
companies have made cheap IBM clones, IBM received no benefit from network
externalities. When a consumer decides whether to buy an IBM or a Dell personal
computer, his choice is based upon price or quality. This puts IBM and Dell on a level
playing field where the edge goes to the company with the superior manufacturing skills.
In contrast, network externalities protect Microsoft's market position, so even if another
company made a cheaper, better product, most consumers would still buy their operating
system from Microsoft.
In addition to making a compatible product, you could also compete against a company
with network externalities by selling to niche markets. For example, Apple has a large
share of the market for personal computers used in grade schools. Apple has the
advantage when selling to grade schools because its computers have historically been
easier to use than IBM-compatible computers. Furthermore, since so many grade

schools use Apple computers, much grade school-specific software is written for Apple
computers, and thus Apple enjoys network externalities in the grade school niche market.
For high technology products at least, perhaps the best way to attack a firm protected by
network externalities is to wait until the firm's consumers decide to play another mass
coordination game. High technology products quickly become obsolete. For example,
most software written today wouldn't run very well on a computer bought even seven
years ago because of the rapid increase in computer speed, graphics, and memory.
The quick obsolescence of computer products limits the benefits of network externalities.
To understand this, consider two types of software a consumer might want: (1) old
software that has already been written, and (2) new software the consumer hopes to buy
in the future. Microsoft and Intel have two advantages over potential competitors.
Because their products have dominated the computer market, there exists a large stock
of software compatible with their products. Furthermore, because people expect most
computers in the future to run on Microsoft's operating system and Intel's
microprocessors, consumers expect that most future software will be compatible with
these companies' products.
Now, imagine your company develops a new type of computer that won't run existing
software. Unfortunately, consumers will be reluctant to buy your computer when an IBM-
compatible computer (with a Microsoft operating system and an Intel microprocessor) will
run far more software. You can't do anything about the existing stock of software. If you
could convince software makers that your computer is going to be a big hit, however,
then they should be willing to write new software that runs on your computer. The
continual improvement in computer performance thus actually hurts Microsoft and Intel
because it reduces the benefit of the existing stock of software that is exclusively
compatible with their products.
Technological obsolescence and the challenges of achieving backward compatibility
gives competitors another advantage over Microsoft and Intel. Both of these companies
must continually improve their products as engineers figure out ways to make computers
better, faster, and cheaper. To preserve network externalities, however, Microsoft and
Intel desperately try to keep their new products compatible with old software, but it's

technologically difficult to make products backward compatible. It would be easier for
both Microsoft and Intel to design their products if they didn't have to worry about
compatibility. If your products won't run old software anyway, your engineers won't be
hindered by the limitations of backward compatibility. As a result, if your company has
the same level of engineering skills as Microsoft and Intel, you should be able to make a
better product. Of course, the superior quality of your product might not be sufficient to
overcome the benefits of network externalities that both Microsoft and Intel enjoy.
Java’s Threat to Microsoft
Microsoft’s Internet Explorer dominates the browser market. Although it appears that
Microsoft gives Internet Explorer away for free, it is actually a tremendous source of
profit for Microsoft. First, Microsoft bundles Internet Explorer with its operating system.
This bundling makes the operating system more valuable to consumers and
consequently raises the price that Microsoft can charge for Windows. Microsoft also
profits from having special knowledge about Internet Explorer’s workings.
Many types of Internet application software are written to be used by consumers running
Internet Explorer. The greater knowledge a company has about how Internet Explorer
works, the better they can make their application software. Since Microsoft knows more
about Internet Explorer than any other company, Microsoft has an advantage when
writing application software for its browser.
Java poses a threat to Internet Explorer’s network externalities. Java is an Internet-
friendly program that runs on top of Internet browsers and operating systems, and it was
designed to work with all major types of computers. The idea behind Java is that
programmers could write software specifically for it, and then these programs could run
on any computer, even if the computer was not running Microsoft software. If Java,
which was created by Sun Microsystems, fulfills its potential, then it, not Microsoft, will
reap the benefits from network externalities. If everyone used Java, then you wouldn’t
need to own Internet Explorer or even a Microsoft operating system to use most Internet
software applications. As of this writing, however, Java seems destined to become an
important, not critical, Internet programming language and consequently network
externalities will likely be a continuing source of riches for Microsoft.