Platform Envelopment and Network Effects

Absorbing functionality from another platform can help platforms solve the “chicken-and-egg” problem

This blog is written by B.J. Allen, Deepa Chandrasekaran, and Richard T. Gretz

Would you purchase a smartphone if it only offers a few compatible apps? Would you purchase a video game console if only a few games were available for the console? Is your answer ‘Probably not’?

Both these examples highlight an important relationship that characterizes hardware/software platform markets: The value of the platform (e.g., smart phone, video game console) increases as a larger amount of compatible software (e.g., mobile apps, video games) becomes available, also known as indirect network effects. Indirect network effects create a critical feedback loop: A platform with a greater amount of compatible software is attractive to consumers; more software becomes available as more consumers buy the platform.

This feedback loop creates a major challenge for new platform entrants and platforms with small networks in industries where these network effects are strong. It’s a classic chicken-and-egg problem: How can a platform grow their market if they lack sufficient quantities of related software? How can they attract software developers if they do not have enough adopters? Platforms in this position are dependent on software providers and possess low negotiating power.

So, what options does a new platform have in this scenario? It can try to build a stronger network, say by investing heavily in software provision (e.g., Nintendo making their own games). Or it can try to innovate radically to leapfrog the established competing platforms, which may be risky and difficult.

We propose a third strategy to compete effectively in these networked markets. In a new paper in the Journal of Product Innovation Management, we propose the use of platform envelopment in mitigating these indirect network effects. Platform envelopment is an innovation strategy, originally proposed by Eisenmann, Parker, and Van Alstyne (2011), wherein an existing platform absorbs the core technical features from another platform such that the functionalities of multiple platforms are combined. Envelopment involves more than just adding additional features; it is characterized by absorbing the core functionality of another platform. For example, a video game console absorbing the functionality to play DVD movies. We propose that platform envelopment can increase the stand-alone value of the platform, which should encourage consumer adoption even with limited software provision. This, in turn, decreases the platform’s reliance on software provision. Interestingly, platform envelopment has, thus far, largely been considered as a strategy for moving into an adjacent market. As a result, existing research has focused on how envelopment impacts performance in the enveloped industry (e.g., how a video game console offering DVD compatibility impacts the platform’s performance in the DVD market). In our paper, we look at the impact of platform envelopment on platform success in its original industry (e.g., how a video game console offering DVD compatibility impacts the platform’s performance in the gaming industry).

Platform envelopment offers two benefits to the platform. It makes the platform more attractive to the consumer (e.g., a video game console becomes more attractive with the ability to stream Netflix, Hulu, etc.). Critically, we propose that with envelopment, the amount of software becomes less important to overall platform performance. This is because envelopment attracts different segments of consumers who derive less value from the core functionality the hardware provides. Again, consider the example of video game consoles – consoles that only play games attract core gamers – all they care about are games. Core gamers value the console based on the available games. However, there is another segment out there – let’s call them novice gamers –who enjoy gaming but are on the fence of whether to buy the console because they are not sure if their novice interest is worth the investment. However, if the platform also doubles as a Blu-ray player, this might justify the purchase by novice gamers. These consumers, compared to core gamers, are not as influenced by the quantity of games available. Then, you have non-gamers who may purchase the console simply to use the Blu-ray player functionality; game provision is completely irrelevant for non-gamers. Importantly, our theory suggests that the net importance of software for the industry as a whole will decrease once these new consumers enter the market. Further, as the focal platform (e.g., video game console) is “borrowing” the network of the enveloped industry (e.g., Blu-rays), the marginal value of any one software supply is diminished. We call this phenomenon of weakening indirect network effects decreasing indirect network sensitivity.

We test our theory by examining the impact of platform envelopment on platform success in the video game industry with two studies. The first study looks at the relationship between hardware and software demand in the video game console industry in the US over several years and spanning several console generations. In the second study, we leverage data from several countries and consider this relationship in the context of a broad set of gaming platforms including gaming consoles, handheld devices (e.g., Gameboy), mobile phone gaming, online gaming, and PC gaming. Both studies find that platform envelopment increases the demand for the platform while simultaneously decreasing the importance of software supply on platform demand. Our findings suggest that a platform envelopment strategy can provide new entrants and firms with smaller networks a way to decrease their dependence on available software while increasing the platform’s stand-alone value, allowing them to better compete with larger platforms with established networks.

Can platform envelopment be an effective strategy in other industries? Let us consider video streaming. Compare the differences in strategy between Netflix and Amazon’s entertainment arm. Netflix relies mostly on third-party video content and is currently facing increasing costs for streaming rights. As Netflix offers no other functionality beyond streaming video content, it is dependent on content providers, which in turn leads it to raise the price charged to consumers. Netflix is now investing heavily in developing its own content to mitigate its reliance on movie providers. However, our research suggests that it could be beneficial for Netflix to consider streaming other content, such as music. Amazon’s entertainment arm utilizes this strategy by streaming both shows and music, making it less dependent on only one type of content provider.

This blog is based on BJ, Deepa and Rick’s research published in the Journal of Product Innovation Management which is included in the Platform Papers references dashboard:

Allen, B. J., Chandrasekaran, D., & Gretz, R. T. (2021). How can platforms decrease their dependence on traditional indirect network effects? Innovating using platform envelopment. Journal of Product Innovation Management, 38(5), 497-521.

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