Structural Change and Economic Dynamics 12 2001 29 – 57
Technological choice and network externalities: a catastrophe model analysis of firm software
adoption for competing operating systems
Rense Lange
a
, Sean McDade
b
, Terence A. Oliva
c,
a
Illinois Department of Education, Springfield, Illinois, USA
b
Managing Consulting Director, Gallup Organization, Princeton, New Jersey, USA
c
Department of Marketing, School of Business, Temple Uni6ersity,
1810
N.
13
th Street, Philadelphia, PA
19122
-
6038
, USA Received 6 February 2000; received in revised form 23 June 2000; accepted 8 September 2000
Abstract
This paper presents an empirical estimation of a catastrophe model of organizational adoptions of a high technology product when network externalities are present. As such, it
integrates work from the economics literature and the catastrophe literature to provide a broader look adoptions issues. Additionally, it is one of the few empirical studies we are
aware of that attempt to model organizational adoption of high-technology products ‘for use’ rather than ‘for manufacture’. © 2001 Elsevier Science B.V. All rights reserved.
JEL classification: D23, O33, L15, C19
Keywords
:
Nonlinear dynamics; Network externalities; Organizational adoption; High-technology prod- ucts; Bandwagons
www.elsevier.nllocateeconbase
1. Introduction
Modern economies can be called network economies in at least two ways. Firstly, in dealing with new technologies and innovation, most firms are dependent on third
parties with which they have to interact to network in order to obtain necessary resources. Secondly, in addition to this, more or less, intangible part of the network
Corresponding author. Tel.: + 1-215-2048150; fax: + 1-215-7267808. E-mail address
:
olivasbm.temple.edu T.A. Oliva. 0954-349X01 - see front matter © 2001 Elsevier Science B.V. All rights reserved.
PII: S 0 9 5 4 - 3 4 9 X 0 0 0 0 0 2 8 - X
economy, more and more products and technologies can be seen as important and form the tangible part of the modern network economy. Hence, high technology
and its associated products have become increasingly more important to organiza- tions seeking to gain an edge in today’s competitive environment. It is often critical
for these organizations that the products they adopt are capable of interfacing with other internal and external organizational systems, have complementary additional
products available, and have high levels of support available. In such situations, a community of users develops around the technology or product which provides
increased benefits to the members of the community. The added benefits which can accrue to organizations affect the way that they adopt such high-technology
products. In particular, firms will tend to switch from one high-technology product standard or innovation only if they believe that other firms will switch as well.
Hence, and organization’s own high-technology preferences may be outweighed by their expectations concerning what other firms might do. This desire for community
creates a market that is characterized as having network externalities.
Understanding the nature of organization adoptions when network externalities are present will continue to increase. Unfortunately, to date relatively little empiri-
cal research has been done to examine this issue. Part of the reason for this dearth of research is due to the inherent complexity of modeling the organization adoption
process when network externalities are present. In particular, since the adoption by firms is influenced by the tradeoffs between the anticipated benefits and the
likelihood others will adopt, the market is characterized by bandwagons as firms move from the old product to the new product. This creates a discontinuity in the
market adoption curve, and makes the modeling efforts using more traditional techniques difficult e.g. Norton and Bass, 1987, 1992.
The research issue addressed in this paper is to examining the market-adoption dynamic for high-technology products when network externalities are present using
a catastrophe model Thom, 1975 to handle the discontinuity issue mentioned above. The application used for this study is derived from panel data on purchases
of Lotus Freelance Graphics software as the DOS and Windows operating systems compete for dominance. In this context, the paper provides empirically-based
information on the issue organizational adoption when network externalities are present, an area in which relatively little empirical work has been done. Further-
more, by using a nonlinear technique we are able to overcome some limitations of more traditional approaches to the research problem. The result is that the paper
both supports and extends the current literature on adoption when network externalities, and provides additional insight into the organizational adoption
dynamic.
In summary, the main contributions of this paper are threefold: 1 Normally, high externalities are assumed in models of network externalities. In this paper we
propose a model in which high as well as low levels of externalities are possible. In this way developing markets can be also analyzed; 2 The technique used allows us
to model jump processes. Traditional techniques have difficulties dealing with non-smooth processes which usually violate their core assumptions; 3 Because
little empirical work is done in this field the model is tested with panel data from the Techtel, Inc. database.
1
.
1
. Rele6ant literature In terms of the literature, relatively consistent descriptions of technological
choice when network externalities are important have been developed by different researchers Farrell and Saloner, 1985; Katz and Shapiro, 1985; Farrell and
Saloner, 1986; Xie and Sirbu, 1995; Brynjolfsson and Kemerer, 1996. One impor- tant characteristic of such situations is that when firms switch from one product,
standard, or innovation to another they tend to move in a bandwagon from the old choice to the new one. From an observer’s standpoint there is a discontinuity in the
market as firms move in unison from the current standard to another. While the models developed have provided interesting observations regarding firm behavior,
modeling efforts often had to rely on somewhat restrictive assumptions. For example, Farrell and Saloner 1985 assume high network externalities are present
and technological choice is irreversible. The assumption of ‘high’ network external- ities in the market means that the market has already developed. Hence, this
assumption precludes researchers from using the Farrell and Saloner 1985 model for newly evolving markets where externalities are nascent. Additionally, modeling
of jump processes when the underlying processes are not smooth is difficult for most traditional techniques. Further limiting the impact of this research is that
there has been a relative dearth of empirical support for the models that have been developed. Given the increasing economic importance of technological products in
the market whose success often is dependent on the development of a network much more work in the area is needed. Toward this end, we propose to use a
catastrophe model Thom, 1975; Zeeman, 1976 to deal with the problem of describing discontinuous jumps in market behavior. Such models allow us to relax
the typical assumptions so we can consider both developing and currently existing high network externality situations.
The specific application examines a sample of firm adoptions of PC presentation software Lotus Freelance for competing operating-system standards DOS versus
Windows drawn from a panel of firms in 14 industries. Data cover the years from 1987 to 1995, which is the most dynamic time frame for the DOS versus Windows
wars. To economize the effort and justification needed for the variables used in the study, three key indicators identified in the literature Farrell and Saloner, 1985
were used. Specifically, we assume that firm adoption behavior is primarily driven by the expected discounted costbenefits due to switching from one product
standard to another, which are conditional on the level of network externalities present Farrell and Saloner, 1985. Since our intent is to look at the adoption
process over time, we depart from the literature and allow network externalities to vary from low to high. This is reasonable given that nascent markets often have
only limited externalities as various technological formats compete for dominance. For example, in the beginning, numerous VCR formats were considered before the
market resolved into the dichotomous BETA versus VHS battle, eventually won by VHS. Similar examples abound for competing PC operating systems during the
early 1980s which continue until today e.g. LINUX and UNIX. Oliva 1994 argues that for technological products the level of network externalities can change
as products move through the stages of the product life-cycle Kotler, 1997. He argues that this is the result of different adopter types, with different characteristics,
entering the market at different times Oliva, 1994. Initially, ‘innovative adopters’
1
pay a premium to be first and help firms recover their development costs. But innovators often use different versions of the formats offered. Given their small
numbers, they do not determine the standard by themselves. Also, complementary goods and post-purchase support is limited, since vendors have no real incentive to
join the technological community given the small installed base Teece, 1986; Rosenkopf and Tushman, 1994; Wade, 1995. However, as the product life-cycle
progresses, subsequently larger adopter segments enter the market picking the product that is perceived to be better. Over time a standard is settled on by the
newly evolving technological community
2
. At this point new adopters will join the network, thereby strengthening the hold of the standard.
In time, a challenger may emerge that promises better benefits. The decision to stay with the current standard or switch to a new standard will become inherently
risky for firms. This choice introduces chaos into the structure of the technological community because it creates a dilemma for organizations as they struggle to
answer two crucial questions identified by Rosenkopf and Tushman 1994. They argue that adopting firms must worry about the following: 1 ‘What if we adopt
or switch to a new standard and no one else does?’; and, 2 ‘What if we do not adopt or switch to the new standard and everyone else does?’ Hence, when
externalities are large, the competing standard choice becomes a sort of zero-sum game. This produces an instability in the market that can result in a sudden
bandwagon shift to the new standard if the benefits for making the switch are significant enough.
Using the firm adoptions, costbenefits to switch, and network externalities, it is possible to conceptualize the situation in the form of a catastrophe model of firms’
adoption behavior market behavior. In the sections that follow we present the description of the model, the approach used to estimate the model, a description of
the data, how the variables were operationalized, and an analysis of the findings with conclusions.
2. The catastrophe model
