Digital Economics - Overby and Audestad

Digital
Economics

How Information and Communication Technology
is Shaping Markets, Businesses, and Innovation
Harald Øverby

Jan A. Audestad

First Edition 2018

Copyright © 2018 by Harald Øverby and Jan A. Audestad

All rights reserved

ISBN-10: 1986751392
ISBN-13: 978-1986751391

Contents

Preface v
1. THE DIGITAL ECONOMY 1
2. FUNDAMENTALS 35
3. DIGITAL MARKETS 97
4. DIGITAL BUSINESS, STRATEGY, AND INNOVATION 131
5. ADVANCED DIGITAL ECONOMICS 173
Concluding Remarks 211
Notes 213
Comments on Activities 219
Index 231

iv DIGITAL ECONOMICS
Preface
Innovations and developments in Information and Communication Technology (ICT)

have laid the foundations for an economy based on digital goods and services—the
digital economy. Technologies such as social media, apps, cloud computing, mass
storage, cryptocurrencies, and sharing services have already shaped today’s business
landscape. There is a wave of “digitization” in many parts of the world as private
businesses, as well as the public sector, embrace ICT to achieve cost benefits,
efficiency, and competitive advantage. However, what we are witnessing is just the
beginning of an economic revolution as the full potential of the digital economy is
about to be harvested.
This book is about digital economics—the branch of economics studying digital
goods and services. The major goal of this book is to provide a theoretical basis for
digital economics and to show how these theories can be applied to the study of real-
world economics and business phenomena. The book also introduces models and tools
that are essential for analysis and better understanding of the digital economy.

Target Audience
This is an introductory textbook intended for undergraduate students in computer
science, economics, or business management. A broad range of professionals,
economists, business consultants, and computer scientists may also find this book
useful. The book contains one chapter with selected advanced topics in digital
economics (Chapter 5). However, other advanced—but still important—topics in the
field of digital economics have been left out for increased readability and compactness
of the book.
To fully comprehend the topics of this book, it is necessary to have a basic
background in either computer science or economics. Advanced topics in the book
(Chapter 5) require skills in mathematics—particularly, calculus and differential
equations.

vi DIGITAL ECONOMICS
Book Profile
This book provides a cross-disciplinary systems view of digital economics. It draws
upon knowledge from several academic areas, such as computer science, management
science, business modeling, economics, and mathematics to explain the digital
economy.
To fully comprehend digital economics, you need to understand the Information
and Communication Technology (ICT) underpinning digital businesses. This book
explains important innovations in telecommunications, information technology, and
ICT, and shows how these innovations impact the digital economy.
The field of digital economics is characterized by transient market behavior,
feedback mechanisms, international impact, many stakeholders, and technology
dependence. The book highlights this complex ecosystem.
Key tools to perform business modeling are presented in the book. The book also
discusses several business models available for the digital economy, including: Bitcoin,
Spotify, Wikipedia, World of Warcraft, Facebook, and Airbnb.
Several relevant business cases are discussed, as well as how digital economics may
be applied to real-world economics. The book introduces topics, such as:
Cryptocurrencies, financial technologies, crowdsourcing, and the sharing economy.
Finally, quantitative models useful for calculating value, consumer adoption, and
technology evolution are included for selected areas in the digital economy. These
models extend previous qualitative discussions on the topics.

Book and Chapter Design
The book is designed to motivate and support teaching by implementing the following
features:
Fact boxes provide additional knowledge and highlight selected topics.
Figures and tables are used extensively to explain topics in the book.
Activities are provided throughout the book. These activities are an essential
part of each chapter, with the intention of letting the reader reflect, analyze,
and apply the knowledge and tools presented in each chapter.
Learning goals are provided at the beginning of each chapter.
Definitions explain core concepts used throughout the book.
Suggestions for further reading are provided at the end of each chapter.
Comments on activities are provided by the authors at the end of the book.

Tools
The book introduces several tools that may be used to analyze various aspects of the
digital economy. These tools include:
The Layered Internet model in Section 3.6.
The Business Model Canvas (BMC) in Section 4.3.
The Stakeholder Relationship Model (SRM) in Section 4.4.
Preface vii
Network laws to calculate the value of networks in Section 5.1.

The Bass diffusion model in Section 5.2.
Quantitative long tail models in Section 5.4.

How to Use This Book
This textbook can be used as the basic curriculum for a full course on digital
economics. It is recommended to read the book from start to end. Such a course can
be offered at both the undergraduate and graduate levels. If offered at the
undergraduate level, we recommend using Chapters 1, 2, 3, and 4. If offered at the
graduate level, we recommend including Chapter 5 as well.
The book can also be used as the basic curriculum for a short course on digital
business, strategy, and innovation. For such a course, we recommend using Chapters
1, 2, and 4. Such a course can be offered at the undergraduate level.
Sample chapters from the book can also be used for shorter seminars and single
lectures on dedicated topics.
We further recommend using the included activities as a part of the teaching
process. The activities may be used as individual or group work, either as a part of the
class or between classes. The activities may also serve as the basis for minor reports,
assignments, and other coursework.
viii DIGITAL ECONOMICS

Book Profile
Cross-Disciplinary Systems View

This book provides a cross-disciplinary systems view of digital
economics and draws upon knowledge from several academic areas
to explain the digital economy, including: Management science,
innovation, computer science, economics, and mathematics.

Information and Communication Technology
To fully comprehend digital economics, you need to understand the
Information and Communication Technologies (ICTs) underpinning
digital businesses. The book presents important innovations in ICT
and shows how these innovations impact the digital economy.

Complexity of Digital Economics
The field of digital economics is characterized by transient market
behavior, feedback mechanisms, international impact, many
stakeholders, and technology dependence. The book highlights this
complex ecosystem.

Business cases
The book presents several relevant business cases and shows how
digital economics may be applied to real-world economics. Topics,
such as cryptocurrencies, financial technologies, crowdsourcing, and
the sharing economy, are discussed.

Quantitative Modeling
Quantitative models that are useful for calculating value, consumer
adoption, and technology evolution are introduced for selected
areas in the digital economy. These models extend previous
qualitative discussions on the topics.

Preface ix

The Chapters of the Book
Chapter 1 is an introduction to digital economics, discussing

the scope of digital economics, how digital economics is
related to other branches in economics, and how information
and communication technologies have shaped the digital
economy.

Chapter 2 deals with the fundamentals of digital economics.
The major part of this chapter discusses basic features of
digital goods and services, value models, multi-sided
platforms, network effects, positive feedback, lock-in, and the
long tail property.

Chapter 3 presents the markets where digital services are
traded; that is, the markets for network access, content,
services, and applications. The effect the protocol structure
of the Internet has on the business opportunities of the
Internet Service Providers is also explained.

Chapter 4 is about digital businesses, strategy, and
innovations with an emphasis on the Business Model Canvas
and the Stakeholder Relationship Model. Examples of
business models for several digital services are presented and
discussed.

Chapter 5 presents advanced topics in digital economics. This
chapter extends the theory and models presented in
Chapters 2 and 3. The chapter introduces the Bass diffusion
model for calculating the temporal market evolution for
digital services.

x DIGITAL ECONOMICS

About the Authors
Harald Øverby (born 1979) is a Professor at the Norwegian University of Science and
Technology (NTNU). He received his M.Sc. in Computer Science in 2002, a B.Sc. in
Economics in 2003, and a Ph.D. in Information and Communication Technology in
2005. Øverby has also studied law at the University of Oslo in Norway. Øverby has
published over 80 papers in international journals and conferences in the areas of
communication technology, digital economics, business modeling, data coding and
optical networking. He was the Head of Department of Telematics (NTNU) from
2013 through 2016. Øverby is a 1998 International Chemistry Olympiad bronze
medalist.
Jan A. Audestad (born 1942) is Professor Emeritus at the Norwegian University of

Science and Technology (NTNU). He received his M.Sc. in theoretical physics in 1965.
Audestad has more than 50 years of experience working in the telecommunication
industry, mainly as a researcher, research manager, and advisor to the top management
of Telenor. He has also been an Adjunct Professor at NTNU for 25 years, teaching in
the areas of communication networks, digital economics, strategy, and information
security. Audestad was one of the key scientists behind the standardization of the GSM
mobile communication system in the 1980s and intelligent networks and distributed
processing in the 1990s.

Preface xi

Acknowledgments
Writing a book is a considerable task. Over the years, we have taught several courses
and supervised students in the areas of digital economics, computer science, and
telecommunications. We felt that there was a need for a textbook in digital economics
with an emphasis on the technological basis of the digital economy, the unique
economic theories of digital goods and services, business modeling, and mathematical
modeling of markets. This book is a result of several years of teaching and research in
the area, as well as one year dedicated to writing the book.
We wish to thank the Norwegian University of Science and Technology (NTNU)
for granting us a sabbatical leave to complete this book. Without this support, we
believe this book would never have come to life.
We thank academic colleagues worldwide who provided valuable feedback,
discussions, and hosted us for shorter research stays. We are particularly grateful to
Professor Pietro Michiardi at EURECOM (France), Professor Moshe Zukerman at
Hong Kong City University, Professor Lee Andrew Bygrave at the University of Oslo,
and Professor Erik Bohlin at Chalmers University of Technology (Sweden). For
valuable feedback and fruitful discussions, we also thank Professor Ove Granstrand
and Maria Massaro at Chalmers University of Technology, and Professor Emeritus
Arild Jansen at the University of Oslo.
We acknowledge contributors of icons to flaticon.com for use in our figures
throughout the book. Many thanks to Janny Chen for advising on book design, Tanja
Russita for providing interior illustrations, and Abigail Stefaniak for proofreading the
manuscript.
Finally, we thank our family and friends who have supported us on this journey
and provided valuable feedback and support to our project.
Harald Øverby and Jan A. Audestad
Norway, 2018
xii DIGITAL ECONOMICS
Preface xiii

Detailed Table of Contents
PREFACE ................................................................................................................................... V
BOOK PROFILE ....................................................................................................................... VIII
THE CHAPTERS OF THE BOOK ..................................................................................................... IX
ABOUT THE AUTHORS ................................................................................................................ X
ACKNOWLEDGMENTS ............................................................................................................... XI
DETAILED TABLE OF CONTENTS ................................................................................................ XIII
LIST OF FIGURES .................................................................................................................... XVII
LIST OF TABLES ....................................................................................................................... XX
LIST OF ACTIVITIES .................................................................................................................. XXI
LIST OF DEFINITIONS .............................................................................................................. XXIII
ACRONYMS ......................................................................................................................... XXIV

CHAPTER 1. THE DIGITAL ECONOMY ...................................................................................... 1
1.1. INTRODUCTION ................................................................................................................. 2
BOX 1-1. Faces of the Digital Economy .................................................................................... 4
BOX 1-2. Recommendation Systems ............................................................................... 7
1.2. DIGITIZATION OF THE ECONOMY .......................................................................................... 8
1.3. DIGITAL ECONOMICS ....................................................................................................... 11
BOX 1-3. Moore’s law ................................................................................................. 12
BOX 1-4. Automation .................................................................................................. 13
1.4. THE DIGITAL ECONOMY ECOSYSTEM .................................................................................. 15
1.5. TECHNOLOGY EVOLUTION ................................................................................................ 20
BOX 1-5. The Transistor .............................................................................................. 22
BOX 1-6. The ARPANET ............................................................................................... 23
BOX 1-7. Cryptocurrencies .......................................................................................... 27
1.6. SERVICE CONVERGENCE ................................................................................................... 28
1.7. MARKET EVOLUTION IN TELECOMMUNICATIONS .................................................................. 30
SUMMARY AND KEY POINTS ..................................................................................................... 32
FURTHER READING ................................................................................................................. 32

CHAPTER 2. FUNDAMENTALS ................................................................................................ 35
2.1. DIGITAL GOODS AND SERVICES .......................................................................................... 36
BOX 2-1. Anything-as-a-Service ................................................................................... 38
2.1.1. Zero Marginal Cost ........................................................................................................... 39
xiv DIGITAL ECONOMICS
2.1.2. Public Good Features of Digital Services .......................................................................... 42

2.1.3. Zero Average Revenue Per User ....................................................................................... 45
BOX 2-2. Facebook and ARPU=0 .................................................................................. 45
2.1.4. Digital Commodities ......................................................................................................... 46
2.1.5. Transaction Costs .............................................................................................................. 47
2.1.6. Bundling ............................................................................................................................ 48
2.2. PRODUCTION OF DIGITAL SERVICES .................................................................................... 49
50
T
2.2.1. In-House Production .........................................................................................................
e
2.2.2. Commons-Based Peer Production ................................................................................... 50
x
t
2.2.3. Crowdsourcing .................................................................................................................. 51
2.2.4. Open-Source Software ..................................................................................................... 53
2.3. VALUE MODELS .............................................................................................................. 53
2.3.1. Value Chain ....................................................................................................................... 54
2.3.2. Value Shop ........................................................................................................................ 55
2.3.3. Value Network .................................................................................................................. 57
2.4. MULTI-SIDED PLATFORMS ................................................................................................ 61
2.5. NETWORK EFFECTS AND POSITIVE FEEDBACK ....................................................................... 64
2.5.1. Positive and Negative Network Effects ............................................................................ 65
2.5.2. Direct and Indirect Network Effects ................................................................................. 71
2.5.3. Same-Side and Cross-Side Network Effects ..................................................................... 71
2.6. PATH DEPENDENCE ......................................................................................................... 73
BOX 2-3. Videotape Format War ................................................................................. 76
BOX 2-4. The QWERTY Keyboard ................................................................................. 77
2.7. LOCK-IN AND SWITCHING COSTS ....................................................................................... 79
2.7.1. Switching Costs ................................................................................................................. 79
2.7.2. Lock-In Mechanisms ......................................................................................................... 80
2.8. FORMATION OF MONOPOLIES IN THE DIGITAL ECONOMY ...................................................... 82
2.9. MERGERS AND ACQUISITIONS ........................................................................................... 84
2.10. STANDARDS ................................................................................................................. 88
2.11. THE LONG TAIL ............................................................................................................. 90
SUMMARY AND KEY POINTS ..................................................................................................... 94
FURTHER READING ................................................................................................................. 95

CHAPTER 3. DIGITAL MARKETS .............................................................................................. 97
3.1. OVERVIEW OF DIGITAL MARKETS ....................................................................................... 98
3.2. STAKEHOLDERS AND RELATIONSHIPS IN DIGITAL MARKETS ..................................................... 99
BOX 3-1. Service Level Agreements ............................................................................ 101
3.3. E-COMMERCE MARKETS ................................................................................................ 102
BOX 3-2. The Sharing Economy .................................................................................. 105
3.4. NETWORK ACCESS MARKETS .......................................................................................... 106
3.5. INFORMATION SERVICE MARKETS .................................................................................... 109
3.6. THE LAYERED INTERNET MODEL ....................................................................................... 111
BOX 3-3. Skype and Over-the-Top Services ................................................................. 112
BOX 3-4. Net Neutrality ............................................................................................ 114
3.7. COST STRUCTURES OF IPS, ISPS, CPS, AND ASPS ............................................................... 115
3.8. MARKET EVOLUTION ..................................................................................................... 117
Preface xv
3.8.1. Initial Market Evolution .................................................................................................. 117

3.8.2. The S-Curve ..................................................................................................................... 118
3.8.3. Empirical Evidence for the S-Curve ................................................................................ 120
BOX 3-5. Diffusion of Innovations .............................................................................. 121
3.9. COMPETITION, COOPERATION, AND COOPETITION .............................................................. 123
BOX 3-6. E-banking .................................................................................................. 125
SUMMARY AND KEY POINTS ................................................................................................... 128
FURTHER READING ............................................................................................................... 129

CHAPTER 4. DIGITAL BUSINESS, STRATEGY, AND INNOVATION ......................................... 131
4.1. DIGITAL INNOVATIONS ................................................................................................... 132
BOX 4-1. Nordic Disruptions ...................................................................................... 136
BOX 4-2. Blue Ocean Strategy ................................................................................... 137
4.2. BUSINESS MODELS ........................................................................................................ 139
BOX 4-3. Funcom’s Business Model ............................................................................ 141
4.3. THE BUSINESS MODEL CANVAS ....................................................................................... 142
4.4. THE STAKEHOLDER RELATIONSHIP MODEL ........................................................................ 145
4.5. DIGITAL BUSINESS MODELS ............................................................................................ 147
4.5.1. World of Warcraft ........................................................................................................... 148
4.5.2. Spotify ............................................................................................................................. 150
4.5.3. Facebook ......................................................................................................................... 153
4.5.4. Wikipedia ........................................................................................................................ 155
4.5.5. Airbnb ............................................................................................................................. 157
4.5.6. Bitcoin ............................................................................................................................. 159
4.6. STRATEGIC POSITIONING ................................................................................................ 162
4.6.1. Assets .............................................................................................................................. 162
4.6.2. Core Competencies ........................................................................................................ 164
4.6.3. Competitive Forces ......................................................................................................... 166
BOX 4-4. Mobile Virtual Network Operator Entrants ................................................... 170
FURTHER READING ............................................................................................................... 172

CHAPTER 5. ADVANCED DIGITAL ECONOMICS ................................................................... 173
5.1. ESTIMATING THE VALUE OF NETWORKS ............................................................................ 174
5.1.1. Sarnoff’s law ................................................................................................................... 175
5.1.2. Metcalfe’s law and Odlyzko-Tilly’s law ........................................................................... 177
BOX 5-1. Six Degrees of Separation ............................................................................ 180
BOX 5-2. Dunbar’s Number ....................................................................................... 181
5.1.3. Reed’s law ....................................................................................................................... 182
5.1.4. Summary and Comparison of Network Laws ................................................................. 183
5.2. MODELING OF DIGITAL MARKETS .................................................................................... 185
5.2.1. The Bass Diffusion Model ............................................................................................... 186
5.2.2. Model for Markets with Competition and Churning ..................................................... 193
5.2.3. Models for Massive Multiplayer Online Games ............................................................. 195
BOX 5-3. System Dynamic Models ............................................................................. 196
xvi DIGITAL ECONOMICS
BOX 5-4. The SIR Model ............................................................................................ 198

5.3. EXPONENTIAL GROWTH ................................................................................................. 199
5.3.1. General Introduction ...................................................................................................... 199
5.3.2. Strategic Dilemmas of Exponential Growth ................................................................... 200
BOX 5-5. Viral Growth ............................................................................................... 204
5.4. THE QUANTITATIVE LONG TAIL MODEL ............................................................................ 205
FURTHER READING ............................................................................................................... 209
CONCLUDING REMARKS ...................................................................................................... 211
NOTES .................................................................................................................................. 213
COMMENTS ON ACTIVITIES ................................................................................................. 219
INDEX ................................................................................................................................... 231

Preface xvii

List of figures
FIGURE 1-1. WORLDWIDE ACCESS TO THE INTERNET AND CELLULAR AND BROADBAND MOBILE. ................. 3
FIGURE 1-2. TOP FIVE CORPORATIONS WORLDWIDE ACCORDING TO MARKET CAP. ................................... 5
FIGURE 1-3. DIGITIZATION OF DATA, INFRASTRUCTURES, PROCESSING, AND STORAGE. ............................. 8
FIGURE 1-4. ANALOG AND DIGITAL DATA. ......................................................................................... 9
FIGURE 1-5. EVOLUTION OF DIGITAL DATA STORAGE AND COMMUNICATION. ........................................ 10
FIGURE 1-6. THE DIGITAL ECONOMY ECOSYSTEM. ............................................................................ 16
FIGURE 1-7. DEPENDENCIES IN THE DIGITAL ECONOMY ECOSYSTEM. .................................................... 17
FIGURE 1-8. TRANSIENT AND STATIONARY STATES. ........................................................................... 19
FIGURE 1-9. TIMELINE OF ICT INNOVATIONS. .................................................................................. 21
FIGURE 1-10. SERVICE CONVERGENCE. .......................................................................................... 29
FIGURE 1-11. EVOLUTION OF THE TELECOMMUNICATIONS BUSINESS. .................................................. 31
FIGURE 2-1. THE AVERAGE COST AS A FUNCTION OF THE NUMBER OF UNITS PRODUCED. ......................... 41
FIGURE 2-2. CLASSIFICATION OF DIGITAL SERVICES. .......................................................................... 44
FIGURE 2-3. COMMODITIZATION OF DIGITAL SERVICES. ..................................................................... 46
FIGURE 2-4. THE IN-HOUSE PRODUCTION MODEL. ........................................................................... 49
FIGURE 2-5. THE COMMONS-BASED PEER PRODUCTION MODEL. ....................................................... 50
FIGURE 2-6. THE CROWDSOURCING PRODUCTION MODEL. ................................................................ 52
FIGURE 2-7. THE VALUE CHAIN. .................................................................................................... 54
FIGURE 2-8. THE VALUE SHOP. ..................................................................................................... 56
FIGURE 2-9. THE VALUE NETWORK. ............................................................................................... 57
FIGURE 2-10. EXAMPLES OF VALUE NETWORKS. .............................................................................. 58
FIGURE 2-11. NETWORK EFFECTS IN A TWO-SIDED PLATFORM. .......................................................... 62
FIGURE 2-12. TRADE PROCESS OF MULTI-SIDED PLATFORMS. ............................................................. 63
FIGURE 2-13. THE RESELLER. ........................................................................................................ 64
FIGURE 2-14. UNDIRECTED NETWORKS. ......................................................................................... 65
FIGURE 2-15. POSITIVE FEEDBACK. ................................................................................................ 66
FIGURE 2-16. ADDING A NEW NODE AND LINKS TO A NETWORK. ......................................................... 67
FIGURE 2-17. NETWORK EFFECTS IN SOCIAL NETWORK SERVICES. ....................................................... 68
FIGURE 2-18. MARKET EVOLUTION IF ALL CUSTOMERS ARE IMITATORS OR INNOVATORS. ........................ 69
FIGURE 2-19. FACEBOOK USERS IN THE PERIOD FROM 2004 TO 2015. ............................................... 70
FIGURE 2-20. PATH DEPENDENCE. ................................................................................................ 74
FIGURE 2-21. PATH DEPENDENT EVOLUTION WITH ONE POSITIVE FEEDBACK EVENT. ............................... 75
FIGURE 2-22. PATH DEPENDENT EVOLUTION WITH TWO POSITIVE FEEDBACK EVENTS ............................. 78
FIGURE 2-23. DIFFERENCE IN VALUE AS A FUNCTION OF UNITS PRODUCED. .......................................... 84
FIGURE 2-24. ORGANIC GROWTH. ................................................................................................ 85
FIGURE 2-25. MERGERS AND ACQUISITIONS. .................................................................................. 85
FIGURE 2-26. HORIZONTAL AND VERTICAL INTEGRATION OF A SOCIAL MEDIA SERVICE. ........................... 87
xviii DIGITAL ECONOMICS
FIGURE 2-27. THE LONG TAIL. ...................................................................................................... 91

FIGURE 2-28. AMAZON SALES. ..................................................................................................... 92
FIGURE 3-1. DIGITAL AND NON-DIGITAL MARKETS. ........................................................................... 98
FIGURE 3-2. STAKEHOLDERS AND RELATIONSHIPS IN DIGITAL MARKETS. ............................................. 100
FIGURE 3-3. E-COMMERCE TRADING. .......................................................................................... 102
FIGURE 3-4. CLASSIFICATION OF E-COMMERCE MARKETS. ............................................................... 104
FIGURE 3-5. VIRTUAL NETWORK OPERATOR. ................................................................................ 106
FIGURE 3-6. OVER-THE-TOP SERVICES. ........................................................................................ 107
FIGURE 3-7. DEVICE PROVIDERS IN DIGITAL MARKETS. .................................................................... 108
FIGURE 3-8. PROSUMERS IN DIGITAL MARKETS. ............................................................................. 111
FIGURE 3-9. THE LAYERED INTERNET MODEL. ................................................................................ 113
FIGURE 3-10. CAPEX AND OPEX FOR STAKEHOLDERS IN DIGITAL MARKETS. ........................................ 116
FIGURE 3-11. MARKET EVOLUTION FOR THREE DIGITAL SERVICES. ..................................................... 117
FIGURE 3-12. THE S-CURVE. ...................................................................................................... 119
FIGURE 3-13. EMPIRICAL MARKET EVOLUTION OF SELECTED ICT PRODUCTS. ...................................... 120
FIGURE 3-14. MOBILE PHONE SUBSCRIPTIONS IN NORWAY, CHINA, AND MALAWI. ............................. 122
FIGURE 3-15. COMPETITION, COOPERATION, AND COOPETITION IN DIGITAL MARKETS. ......................... 124
FIGURE 3-16. VERTICAL ORGANIZATIONS OF ISPS, ASPS, AND CPS. .................................................. 127
FIGURE 3-17. INTERNATIONAL COMPETITION BETWEEN ISPS. .......................................................... 127
FIGURE 4-1. PRODUCT LIFE CYCLE OF A SUCCESSFUL INNOVATION. .................................................... 133
FIGURE 4-2. PRODUCTIVITY OF SUSTAINING INNOVATIONS. .............................................................. 138
FIGURE 4-3. THE BUSINESS MODEL CANVAS. ................................................................................ 142
FIGURE 4-4. RELATIONSHIPS BETWEEN THE BUILDING BLOCKS IN THE BMC. ....................................... 144
FIGURE 4-5. NOTATIONS USED IN THE STAKEHOLDER RELATIONSHIP MODEL. ..................................... 146
FIGURE 4-6. WORLD OF WARCRAFT MODELED USING THE BMC. ..................................................... 149
FIGURE 4-7. WORLD OF WARCRAFT MODELED USING THE SRM. ..................................................... 150
FIGURE 4-8. SPOTIFY MODELED USING THE BMC. ......................................................................... 151
FIGURE 4-9. SPOTIFY MODELED USING THE SRM. .......................................................................... 152
FIGURE 4-10. FACEBOOK MODELED USING THE BMC. .................................................................... 153
FIGURE 4-11. FACEBOOK MODELED USING THE SRM. .................................................................... 154
FIGURE 4-12. WIKIPEDIA MODELED USING THE BMC. .................................................................... 155
FIGURE 4-13. WIKIPEDIA MODELED USING THE SRM. .................................................................... 156
FIGURE 4-14. AIRBNB MODELED USING THE BMC. ........................................................................ 158
FIGURE 4-15. AIRBNB MODELED USING THE SRM. ........................................................................ 159
FIGURE 4-16. BITCOIN MODELED USING THE BMC. ....................................................................... 159
FIGURE 4-17. BITCOIN MODELED USING THE SRM. ....................................................................... 160
FIGURE 4-18. COMPANY ASSETS. ................................................................................................ 163
FIGURE 4-19. CLASSIFICATION OF COMPETENCIES. ......................................................................... 165
FIGURE 4-20 FIVE FORCES MODEL OF PORTER. ............................................................................. 167
FIGURE 5-1. A NEW USER LINKS TO A NETWORK. ............................................................................ 175
FIGURE 5-2. A BROADCAST NETWORK. ......................................................................................... 176
FIGURE 5-3. A NETWORK WHERE ALL NODES CONNECT TO EACH OTHER. ............................................ 178
FIGURE 5-4. NUMERICAL EXAMPLES OF METCALFE’S, ODLYZKO-TILLY’S, AND SARNOFF’S LAW. ............. 184
FIGURE 5-5. THE BASS DIFFUSION MODEL. ................................................................................... 186
FIGURE 5-6. PLOT OF THE BASS DIFFUSION MODEL. ........................................................................ 189
FIGURE 5-7. THE BASS DIFFUSION MODEL WITH ONLY IMITATORS AND ONLY INNOVATORS. ................... 189
FIGURE 5-8. LATENCY TIME IN THE BASS DIFFUSION MODEL. ............................................................ 192
Preface xix
FIGURE 5-9. MODEL OF TWO COMPETING SUPPLIERS WITH CHURNING. ............................................. 193
FIGURE 5-10. MODEL OF A MASSIVE MULTIPLAYER ONLINE GAME. ................................................. 197
FIGURE 5-11. PLOT OF THE BPQ MODEL. ..................................................................................... 199
FIGURE 5-12. COMPARISON OF LINEAR AND EXPONENTIAL GROWTH. ................................................ 201
FIGURE 5-13. RELATIVE SIZE OF THE TAIL. ..................................................................................... 207

xx DIGITAL ECONOMICS

List of tables
TABLE 2-1. DIFFERENT TYPES OF GOODS AND SERVICES IN THE ECONOMY ............................................. 42
TABLE 2-2. EXAMPLES OF MSPS ................................................................................................... 62
TABLE 2-3. MERGERS AND ACQUISITIONS IN THE DIGITAL ECONOMY .................................................... 86
TABLE 3-1. EXAMPLES OF INFORMATION SERVICES ......................................................................... 109
TABLE 4-1. DISRUPTIVE INNOVATIONS IN THE DIGITAL ECONOMY ...................................................... 135
TABLE 4-2. THE NINE BUILDING BLOCKS OF THE BMC ..................................................................... 143
TABLE 4-3. LIST OF PRESENTED BUSINESS MODELS ......................................................................... 148
TABLE 4-4. COMPLEMENTORS AND COMPLEMENTARY PRODUCTS ..................................................... 169
TABLE 5-1. NETWORK LAWS ....................................................................................................... 184
TABLE 5-2. PARAMETERS IN THE BASS DIFFUSION MODEL ................................................................ 187
TABLE 5-3. LATENCY TIMES VS. INITIAL CUSTOMER BASE .................................................................. 191

Preface xxi

List of activities
ACTIVITY 1-1. DIGITIZATION ......................................................................................................... 11

ACTIVITY 1-2. DROPBOX .............................................................................................................. 20
ACTIVITY 1-3. ICT CONVERGENCE ................................................................................................. 30
ACTIVITY 2-1. DIGITAL SERVICES ................................................................................................... 39
ACTIVITY 2-2. COMPUTER GAME DEVELOPMENT ............................................................................. 42
ACTIVITY 2-3. DIGITAL COMMODITIES ............................................................................................ 47
ACTIVITY 2-4. BITCOIN TRANSACTION COSTS .................................................................................. 48
ACTIVITY 2-5. INTERNET EXPLORER ................................................................................................ 49
ACTIVITY 2-6. OWNERSHIP AND REVENUES OF A CBPP SERVICE ......................................................... 51
ACTIVITY 2-7. CROWDSOURCING .................................................................................................. 53
ACTIVITY 2-8. CHAINS, SHOPS, OR NETWORKS ................................................................................ 60
ACTIVITY 2-9. REVENUES IN VALUE NETWORKS ............................................................................... 61
ACTIVITY 2-10. NETWORK EFFECTS I: VALUE .................................................................................. 68
ACTIVITY 2-11. NETWORK EFFECTS II: WORLD OF WARCRAFT ........................................................... 72
ACTIVITY 2-12. NETWORK EFFECTS III: THREE-SIDED MARKETS ......................................................... 73
ACTIVITY 2-13. NETWORK EFFECTS IV: SNAPCHAT ........................................................................... 73
ACTIVITY 2-14. CRYPTOCURRENCIES AND PATH DEPENDENCE ............................................................ 79
ACTIVITY 2-15. ACQUISITIONS BY ALPHABET ................................................................................... 88
ACTIVITY 2-16. THE LONG TAIL IN SHARING SERVICES ...................................................................... 93
ACTIVITY 3-1. NETFLIX .............................................................................................................. 102
ACTIVITY 3-2. AMAZON AND ALIBABA .......................................................................................... 104
ACTIVITY 3-3. APPLE PAY ........................................................................................................... 110
ACTIVITY 3-4. APPLE APP STORE ................................................................................................. 115
ACTIVITY 3-5. CAPEX AND XAAS ................................................................................................. 116
ACTIVITY 3-6. MARKET EVOLUTION OF MOBILE PHONE SUBSCRIPTIONS ............................................ 123
ACTIVITY 3-7. VERTICAL COOPERATION ........................................................................................ 128
ACTIVITY 4-1. KODAK ................................................................................................................ 139
ACTIVITY 4-2. MASSIVE OPEN ONLINE COURSE ............................................................................. 145
ACTIVITY 4-3. POPCORN TIME AND NETFLIX .................................................................................. 147
ACTIVITY 4-4. SPOTIFY’S BUSINESS OPERATIONS ............................................................................ 152
ACTIVITY 4-5. WIKIPEDIA BUSINESS MODELS ................................................................................ 157
ACTIVITY 4-6. BLOCKCHAIN ........................................................................................................ 161
ACTIVITY 4-7. GOOGLE SEARCH .................................................................................................. 166
ACTIVITY 4-8. FINTECH ............................................................................................................. 171
ACTIVITY 5-1. INSTAGRAM ......................................................................................................... 177
ACTIVITY 5-2. FACEBOOK VALUE ................................................................................................. 178
ACTIVITY 5-3. SOCIAL MEDIA NETWORKS ..................................................................................... 182
xxii DIGITAL ECONOMICS
ACTIVITY 5-4. MULTI-SIDED PLATFORM LAWS .............................................................................. 182

ACTIVITY 5-5. NETWORK LAWS ................................................................................................... 183
ACTIVITY 5-6. THE NETWORK EFFECT .......................................................................................... 185
ACTIVITY 5-7. MERGERS ............................................................................................................ 185
ACTIVITY 5-8. THE BASS EQUATION I ........................................................................................... 190
ACTIVITY 5-9. THE BASS EQUATION II .......................................................................................... 193
ACTIVITY 5-10. CHURNING ........................................................................................................ 195
ACTIVITY 5-11. EXPONENTIAL GROWTH ....................................................................................... 200
ACTIVITY 5-12. NET PRESENT VALUE ........................................................................................... 203
ACTIVITY 5-13. EMPIRICAL EXPONENTIAL CASE STUDY .................................................................... 203
ACTIVITY 5-14. INTERNET ROUTER CONNECTIONS ......................................................................... 208

Preface xxiii

List of definitions
DEFINITION 1-1. THE DIGITAL ECONOMY ......................................................................................... 5

DEFINITION 1-2. DIGITAL ECONOMICS ........................................................................................... 14
DEFINITION 1-3. THE DIGITAL ECONOMY ECOSYSTEM ...................................................................... 18
DEFINITION 2-1. DIGITAL GOOD ................................................................................................... 36
DEFINITION 2-2. DIGITAL SERVICE ................................................................................................. 37
DEFINITION 2-3. MARGINAL COST ................................................................................................ 40
DEFINITION 2-4. NON-RIVALRY AND EXCLUDABILITY ......................................................................... 43
DEFINITION 2-5. MULTI-SIDED PLATFORM ..................................................................................... 61
DEFINITION 2-6. NETWORK EFFECTS ............................................................................................. 65
DEFINITION 2-7. SWITCHING COSTS .............................................................................................. 80
DEFINITION 2-8. THE LONG TAIL ................................................................................................... 93
DEFINITION 3-1. DIGITAL MARKET ................................................................................................ 99
DEFINITION 3-2. E-COMMERCE .................................................................................................. 103
DEFINITION 3-3. COMPETITION, COOPERATION, AND COOPETITION .................................................. 126
DEFINITION 4-1. INNOVATION .................................................................................................... 132
DEFINITION 4-2. BUSINESS MODEL ............................................................................................. 140
DEFINITION 4-3. DIGITAL BUSINESS MODEL .................................................................................. 147

xxiv DIGITAL ECONOMICS

Acronyms
3G Third generation mobile system

4G Fourth generation mobile system
5G Fifth generation mobile systems
AC Average Cost
ADSL Asymmetric Digital Subscriber Line
ARPU Average Revenue Per User
ASP Application Service Provider
B2B Business to Business
B2C Business to Consumer
BA Barabási-Albert
BMC Business Model Canvas
BPQ Buyer-Player-Quitter
C2B Consumer to Business
C2C Consumer to Consumer
CapEx Capital Expenditures
CBPP Commons-Based Peer Production
CP Content Provider
CPU Central Processing Unit
DAB Digital Audio Broadcasting
EDGE Enhanced Data rates for GSM Evolution
EEA European Economic Area
ER Erdös-Rényi
FinTech Financial Technologies
FTTH Fiber To The Home
GPRS General Packet Radio Service
GSM Global System for Mobile Communications
HTML Hypertext Markup Language
HTTP Hypertext Transfer Protocol
IaaS Infrastructure-as-a-Service
ICT Information and Communication Technology
IoT Internet of Things
IP* Internet Protocol
IP** Infrastructure Provider
ISP Internet Service Provider
ITS Intelligent Transport Systems
ITU International Telecommunication Union
LTE Long Term Evolution
M&A Mergers & Acquisitions
Preface xxv
MC Marginal Cost
MMOG Massive Multiplayer Online Game
MMS Multimedia Messaging Service
MOOC Massive Open Online Course
MSP Multi-Sided Platform
MVNO Mobile Virtual Network Operator
NFV Network Function Virtualization
NMT Nordic Mobile Telephone
NPV Net Present Value
O-T Odlyzko-Tilly
OpEx Operational Expenditures
OTT Over-the-Top services
PaaS Platform-as-a-Service
PC Personal Computer
PDF Portable Document Format
PLC Product Life Cycle
PSTN Public Switched Telephone Network
RPA Robotic Process Automation
SaaS Software-as-a-Service
SCTP Stream Control Transmission Protocol
SDN Software Defined Networking
SIR Susceptible-Infectious-Recovered
SLA Service Level Agreement
SMS Short Message Service
SOA Service Oriented Architecture
SRM Stakeholder Relationship Model
TCP Transmission Control Protocol
UDP User Datagram Protocol
URL Uniform Resource Locator
VCR Videocassette Recorder
VHS Video Home System
VNO Virtual Network Operator
VoIP Voice over IP
VoLTE Voice over LTE
WoW World of Warcraft
WWW Word Wide Web
XaaS Anything as a Service
*/** IP is abbreviated to both “Internet Protocol” and “Infrastructure Provider.” In the text, the
abbreviation is spelled out in case of potential misunderstanding.
xxvi DIGITAL ECONOMICS

Chapter 1
The Digital Economy

Learning Goals

After completing this chapter, you should understand:
The definition of the terms “digital economy” and “digital economics”
The scope and impact of the digital economy
How the digitization of the economy has led to the digital economy
How digital economics is related to other branches of economics
The complexities of the digital economy ecosystem
How the evolution of ICT impacts the digital economy
How service convergence has changed the ICT business landscape
How de-monopolization has changed the telecommunications industry

2 DIGITAL ECONOMICS
Information and Communication Technology (ICT) is everywhere around us—the

Internet, smartphones, laptops, wireless networks, apps, and online video services,
such as Netflix and HBO. ICT has become ubiquitous, at least in the developed world.
The pace of innovation in ICT is fast, and new technologies are emerging every year.
Over the last few decades, ICT has changed how we work, how we spend and invest
our money, and how we conduct our business. Telecommunications, finance, and
media are industries in which ICT has significantly changed the business landscape.
Spotify and other providers of online music services have radically changed the
business models of the music industry; particularly, revenue streams from CD retail.
Since an increasing amount of music is traded online, the need for physical stores
selling CDs has almost vanished. Worldwide sales of recorded music have decreased
by 45% from 1999 to 2014. The year 2014 also marked the first year in which online
traded music matched sales from physical formats, such as CDs.
E-banking has radically changed how we—as consumers—approach banks and
other financial institutions. Most activities involving personal finance are now
conducted over the Internet using smartphones or PCs. For active e-banking users,
there is no need to visit a physical bank to pay bills. Loans can be negotiated with the
bank over the Internet. Cash is no longer needed to pay for bus or train tickets, car
parking, or taxis.
At many airports, passengers check in automatically, put their baggage on the
baggage drop belt, and pass through the gate to the airplane without the involvement
of ground personnel. All passenger services are completely automatic, except for the
security control.
It is the increased use of digital goods and services, often as a replacement for
physical goods and non-digital services, that is responsible for this evolution. Digital
goods and services are the essential building blocks of the digital economy. Even
though digital goods and services have gradually changed the business world for some
time already, we are just now seeing the beginning of an economic revolution as the
full potential of the digital economy is about to be harvested.
This chapter introduces the digital economy (Section 1.1) and how it has been
shaped by the digitization of the economy (Section 1.2). In Section 1.3, the term “digital
economics” is defined. This is the essential topic of this book. Section 1.4 explores the
ecosystem of the digital economy. Sections 1.5–1.7 describe how technology, services,
and businesses have shaped the digital economy.
1.1. Introduction
The digital economy is an economy based on Information and Communication
Technology (ICT), such as the Internet, smartphones, mobile and wireless networks,
optical networks, Internet of Things (IoT), cloud storage and cloud computing, sharing
services, apps, and cryptocurrencies. The size and impact of the digital economy are
driven by people’s adoption of these technologies.
The Digital Economy 3
Worldwide Internet access Cellular and broadband mobile access

60 120
Cellular mobile
50 100 Broadband mobile
Subscriptions per 100 inhabitants

% of world population
40 80
30 60
20 40
10 20
0 0
2005 2007 2009 2011 2013 2015 2017 2007 2009 2011 2013 2015 2017
Year Year

Figure 1-1. Worldwide access to the Internet and cellular and broadband mobile.
Figure 1-1 shows (1) the number of Internet users worldwide for the period 2005–
2017 and (2) the number of cellular mobile and broadband mobile subscriptions per
100 inhabitants worldwide in the period 2007–2017 (numbers from 2017 are
predictions).1 In 2005, only 15% of the world’s population had access to the Internet.
Twelve years later, in 2017, about half of the world’s population had access to the
Internet. In all regions of the world over the last twelve years, access to the Internet
has increased. However, there are differences—a digital divide—in Internet adoption
between countries, regions, and within countries. While most of the western world is
connected to the Internet, large parts of Africa is lagging behind (some statistics are
presented in Figure 3-14).
Access to the Internet has been proposed as a basic human right, and in 2016, the
United Nations (UN) released a non-binding resolution condemning intentional
disruption to such access by governments.2 It is clear that access to the Internet has
changed the lives of people and the way businesses operate, and will increasingly do so
as the other half of the world’s population gets connected to the Internet.
Another important evolution in the digital economy is the number of people using
public narrowband and broadband mobile technologies. Cellular narrowband mobile
systems (2G) offer global services, such as telephone calls and SMS. Cellular broadband
mobile systems (3G, 4G, and 5G) support the use of smartphones to access the
Internet. These technologies also support telephony and SMS, phasing out the use of
2G systems. The number of users of public mobile networks has surpassed the number
of people in the world. The reason for this is that many people have access to more
than one device; for example, one private smartphone and one for work. Moreover,
mobile communications are used as local area routers and for connecting sensors and
other devices in the Internet of Things (IoT) and public infrastructures.
4 DIGITAL ECONOMICS
BOX 1-1. Faces of the Digital Economy

Digital goods and services are at the core of the digital economy. A few representable
examples of digital goods and services are presented below. This book investigates
these examples and many more in greater detail.

Facebook
There are over three billion people worldwide using a social media
service regularly. Facebook is the most popular of these services,
with approximately 2.2 billion users. Facebook has had a significant
impact on how people communicate and organize their social
lives. The advertising industry has been dramatically changed
because of the way social media advertisements can be tailored to match the
attitudes and preferences of the users. Because of the company's global impact,
Facebook founder, Mark Zuckerberg, was named “Person of the Year” by Time
Magazine in 2010. However, Facebook is not without controversies, as witnessed by
the Cambridge Analytica data scandal in 2018.

Airbnb
Established in 2008, Airbnb has grown to become one of the
biggest hospitality services worldwide. As of 2017, Airbnb has over
200 million users and offers over three million lodgings in 191
countries. Airbnb enables homeowners to rent out property to
registered guests and is one of the best examples of the expanding
sharing economy. Airbnb utilizes the concept of multi-sided
platforms (Section 2.4) and the long tail (Section 2.11) in its business operations. Key
enablers for Airbnb’s success are the widespread adoption of Internet access, high-
speed mobile networks, and smartphones. However, Airbnb has been blamed for
reducing attractiveness in the neighborhoods in which it operates, and has met
resistance from authorities in, e.g., Paris and New York.

Bitcoin
Bitcoin (BTC) was established in 2009 by the still-unknown person
or organization Satoshi Nakamoto. It has become the most
valuable and well-known cryptocurrency. Bitcoin utilizes the
blockchain technology to provide a distributed currency without
any involved third parties. Bitcoin has the potential to become a
true global currency. However, recent investigations have revealed several
weaknesses with Bitcoin, including long transaction times and high energy usage.
Other cryptocurrencies, such as Litecoin (LTC), Ethereum (ETH), and Ripple (XRP), may
overcome these challenges and turn out to be the dominant cryptocurrencies of the
future—if cryptocurrencies have any future at all.

The size of the digital economy is hard to estimate. This is because ICT is an industry
on its own (production of telecommunications, Internet equipment, mobile phones,
applications, and software), but also because ICT is integrated into almost all other
industries. ICT has enabled new business models, more efficient production, and new
ways of interacting with consumers in every other industry. An example is online
trading (e-commerce), where people can buy almost any kind of merchandise using the
Internet. We are experiencing a transition from the industrial economy to the digital
economy—from physical products to digital goods and services (see Sections 1.3
and 2.1 for an elaboration on the term “digital goods and services”).
Definition 1-1. The Digital Economy

The digital economy is an economy based on Information and Communication
Technology (ICT).

The world’s five largest corporations by market capitalization as of the beginning of

2018 (in descending order) are: Apple, Alphabet (Google), Microsoft, Amazon, and
Facebook.3 All of these companies produce digital goods and services, while also
conducting their businesses in the digital economy. Their combined market
capitalization totals over $3,400 billion. Figure 1-2 illustrates the market cap of these
companies for the period from 2008 to 2018. Note that Facebook entered the
NASDAQ stock exchange on May 18, 2012.
1000
900 Apple
Google
800
Microsoft
Market cap (billion USD)
700 Amazon
600 Facebook
500
400
300
200
100
0
2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Year

Figure 1-2. Top five corporations worldwide according to market cap.
6 DIGITAL ECONOMICS
These companies hold immense power in today’s business world due to their size, span
of operations, and international impact. They can be characterized as digital
conglomerates,4 as their business operations have expanded far beyond their original
business idea. Google, for example, started out as a company delivering search engine
services for Internet users. Today, Google offers, in addition to its search engine: Social
networking (Google+), e-mail (Gmail), instant messaging, and voice-over IP (Google
Hangouts), text editing (Google Docs), and cloud storage (Google Drive). Google has
expanded its business operations into many sectors of the digital economy by acquiring
competing companies and performing horizontal and vertical integration (see Section
2.9).
The main asset of these companies is the network of consumers who use the
digital goods and services they offer. These users give rise to network effects (see
Section 2.5) that provide huge value to these companies. Maybe the most striking fact
is that these companies have only needed twenty years to gain their current market
dominance. Looking ten years back (in 2008), the top five companies according to
market capitalization included PetroChina, Exxon Mobile, General Electric, China
Mobile, and Industrial and Commercial Bank of China (ICBC). Of these companies,
only China Mobile can be said to fully operate in the digital economy, providing
Internet and mobile access to consumers in China. How do companies in the digital
economy get so big? How is it possible for companies in the digital economy to
accumulate so much value in such a brief time? These are some of the questions we
will shed light on in this book.
Several disruptive innovations have contributed to the scope and size of the
digital economy.5 A disruptive innovation is an innovation that creates a new market,
often leading to a change in market leadership and the emergence of new companies
which become the dominant actors.
One of the most famous examples of disruptive innovations is the fall of the
photography company Kodak, which was one of the leading producers of chemical
photography and camera films. Kodak failed to embrace digital photography in the
1990s and 2000s and lost the competition with Asian producers. Kodak filed for
bankruptcy in 2012, and its patents were bought by a group of companies (including
Google and Apple) for $525 million in 2013. Later that year, Kodak emerged from
bankruptcy; however, with a very different market position compared to the market
leader it once was in the 1990s.
When ICT is at the core of a disruptive innovation, the market often changes from
producing physical products to producing digital goods and services. Market sectors
that have been significantly affected by ICT-based disruptive innovations are media,
telecommunications, and finance.6 Disruptive innovations are explored in more detail
in Section 4.1.
BOX 1-2. Recommendation Systems

Recommendation and consumer feedback are key features in the digital economy.
ICT enables retailers to harvest vast information about its consumers. This
information is used to refine business models. Feedback from consumers can either
be gathered directly or indirectly. One example of direct user feedback is when a
consumer is asked to rate or comment on a product or service after purchase.
Consumer ratings enable the retailer to select and recommend other products to
consumers (see figure).

Consumer buys
from a retailer
Similar products are The retailer identifies

recommended to the similar products
consumer for purchase

Reviews and feedback also serve another key role: They build trust in the shopping
experience, since the user can read reviews and feedback from other users. Such
feedback helps remove information asymmetries in the digital economy. Empowered
with feedback and reviews from previous customers, a potential new customer will
be better informed regarding the product they are about to buy. An example of
indirect user feedback is when Google is used for web browsing. Google may then
use the search results to build up a user profile so that more and more accurate
advertisements can be directed toward the user. This increases the value of Google
as a provider of advertisements.

User recommendations may result in data network effects (see Section 2.5). This is
the case when digital services are able to harvest and exploit users recommendations
to improve the service for other users. An example is Amazon, which recommends
other books for purchase based on the books a user has already bought. These
recommendations are based on sale statistics from purchases done by other users.
Another example of data network effects based on collected user behavior is real-
time traffic information in cars to help drivers navigate through congestion.

8 DIGITAL ECONOMICS
An important part of the digital economy is e-commerce. E-ecommerce is the online

trading of physical goods, digital goods, and services. Some of the largest companies
in the digital economy are in the business of e-commerce, such as Amazon, Alibaba,
and eBay. E-commerce is explored in more detail in Section 3.3. One important aspect
of e-commerce is user feedback and recommendations. Since e-commerce offers
consumers the ability to touch, feel, and test the merchandise to only a limited degree,
feedback and comments from other consumers may add trust to the shopping
experience.
1.2. Digitization of the Economy

The digital economy is triggered by three technological evolutions: The digitization of
data, the evolution of digital ICT infrastructures, and digital processing and storage.
All these technological evolutions have experienced significant breakthroughs and
growth in performance and user adoption in recent decades. Figure 1-3 shows how
these technological evolutions are related.
...01011011...
Digitization of data Digital ICT infrastructure Digital processing

and storage
Figure 1-3. Digitization of data, infrastructures, processing, and storage.
Data has historically been produced in analog formats, such as books, letters,
documents, photographs, tape recordings, and video cassettes. Today, however, an
increasing amount of data is produced and stored digitally. Digitization of data
means that the data can be coded as a sequence of bits (“0” or “1”). Examples of digital
data are: Music stored as files on a computer, books downloaded on a PC or a tablet,
bank account information in an e-bank application, e-mails, movies and music
streamed from the Internet, apps installed on smartphones, and instant messaging
conversations. Examples of analog and digital data are shown in Figure 1-4. Most
telephone services are also digitally encoded. That is, the voice from a user (which is
analog data) is coded into a sequence of digital bits before these bits are transported
over a digital ICT infrastructure to the receiving user(s). At the receiving end, the
sequence of bits is translated to analog voice. Cable television, and, to some extent,
radio (e.g., DAB), is also digitally coded and transported over a digital communication
network.
The share of data that has been produced and stored digitally has changed
significantly during the last 50 years. Prior to the invention of important ICTs, such as
the computer and digital storage, all data was stored in analog format. However,
inventions in ICT changed that. Figure 1-5 (top) shows how the share of the world’s
technological capacity to store digital data has changed from about 1% in 1986 to about
94% in 2007.7 Figure 1-5 (bottom) shows the world’s technological capacity of digital
communication. Almost all communication (including Internet, phone, and mobile
data) is now transmitted digitally. Within one generation, we have moved from an
analog world to a digital world.
Analog data Digital data

Video and audio cassettes, PC hard disks, DVD, Blueray, CD,
photos, vinyl LP, books, news videogames, e-mails, digital photos,
prints, letters videogames, smartphones, apps
Figure 1-4. Analog and digital data.
Today, an enormous amount of digital data is generated.8 For instance, in 2017, for
every minute that passed, 400 hours of video were uploaded on YouTube, fifteen-
million text messages were sent between mobile users, three million search queries
were handled by Google, 510,000 comments were posted on Facebook, and over
45,000 pictures were posted on Instagram.9 For every second that passed, more than
10,000 photos were shared on Snapchat. And this is just a small fraction of the total
data generated today. Data is not only generated directly by users, but also by sensor
devices connected to the Internet (e.g., weather sensors, wearable devices, and smart
watches). These sensors (also called Internet of Things) are becoming increasingly
cheaper and smaller, with the capabilities to communicate between themselves, as well
as store their gathered data in data storage facilities. There are also projects converting
huge amounts of historical analog data into digital data.
This amount of data vastly surpasses what any human mind can process. Data has
become abundant, whereas the human attention span to process this data is a scarce
resource. Since all this data is in a digital format, the data can be transmitted,
10 DIGITAL ECONOMICS
processed, and then stored extremely efficiently and at low costs. Companies and
governments apply Big Data techniques and artificial intelligence to analyze the data
for various purposes. Facebook, for example, analyzes data from its users to design
targeted advertisements.10
Notation
Storage
Digital data
Analog data
Communication
1986 1993 2000 2007
Figure 1-5. Evolution of digital data storage and communication.
Since the 1980s, there has been an extensive roll-out of a worldwide digital ICT
infrastructure. At the core of this infrastructure is the Internet. This digital
infrastructure encompasses wireless networks, mobile networks, satellite networks,
Fiber-To-The-Home (FTTH) networks, Asymmetric Digital Subscriber Line (ADSL)
on copper telephone lines, optical core networks, submarine optical cables, and
Internet of Things (IoT). This infrastructure has enabled worldwide communication
of digital data with high capacity, low latency, and high reliability. The most important
of these technologies are described in Section 1.5.
The advances in microprocessors and mass storage of digital data have resulted in
the evolution of digital devices with fast processing and cheap storage capabilities.
Today’s smartphones have the same processing power as supercomputers had twenty
years ago. While twenty megabytes was the standard storage capacity of home
computers in 1995, the storage capacity of smartphones twenty years later is more than
100 gigabytes; that is, 5,000 times bigger. The cost of storage has shown similar trends:
The cost of one gigabyte of storage in 1995 was about $1,000. Twenty years later, in
2015, the same amount of storage cost $0.02.11
It is the combination of digitized data, fast communication networks, and mass
storage that empowers the digitization of the economy. Most digital services rely on
advancements in all three technologies to operate effectively.
Facebook, for example, requires that data must be digital (text, images, and video),
there must be a worldwide communication network to enable communication between
Facebook users, and there must be mass storage capacities to store all user data. These
three types of digitization have developed exponentially, thereby quite accurately
following Moore’s law.12 This means that the amount of data created and the amount
of data processed, stored, and transmitted over these networks has followed Moore’s
law and increased exponentially. The doubling times for processing capacity, storage
capacity, and network capacity have typically been about one to two years. The costs
of these technologies have been reduced exponentially over the same time frames as
well—the quality and inflation adjusted price of information technology equipment has
decreased on average 16% per year over the five decades 1959–2009.
Currently, there is no end to the increase of data produced, stored, communicated,
and processed. Increased amounts of data are fueled by the new users who connect to
the Internet every day, since only about 50% of the world’s population currently has
access to the Internet. However, the most important increase is expected to arise from
IoT applications. By 2020, it is estimated that there will be more than 50 billion IoT
devices connected to the Internet—more than four times as many as today.13
Activity 1-1. Digitization

How will digitization of the economy impact the country you live
in? Search the web for news articles (two or three articles are
sufficient) and discuss how digitization influences the economy,
the public sector, and business domains.

1.3. Digital Economics

Digital economics is the branch of economics studying digital goods and services.
Hereafter, the term “digital services” is used when collectively referring to both “digital
goods and services.” This is because there is seldom a need to make the distinction
between “digital goods” and “digital services.” The full term is used when this
distinction is necessary.
Digital services comprise everything that is digital: Data produced by users, digital
applications and services provided over the Internet, and the storage and processing
of such data. A digital service can be:
Any kind of software
Files stored digitally
Smartphone apps
Websites
Text, video, and voice communication
The Internet service
Trade and bank transactions
BOX 1-3. Moore’s law

Moore’s law is one of the most well-known laws for technological evolution. It states
that the number of transistors in dense integrated circuits will double every two
years, thereby exhibiting exponential growth (see Section 5.3). Moore’s law is
applicable to data storage and communication network bandwidth as well, but with
different doubling times. Even though there are physical limits to the performance
of processing, communication network bandwidth, and data storage, we have not
reached these limits yet. In fact, new technological advances will most likely increase
the performance of ICT in terms of processing, storage, and communication network
bandwidth. This will open ICT for new innovations, taking advantage of this expected
performance increase. The challenges that need to be overcome for the long-term
evolution of ICT, according to Moore’s law are: Quantum effects if there are too few
atoms per transistor, overheating because of tight packaging, and thermal noise.

The number of transistors in various CPU generations
Source: Our World in Data. https://ourworldindata.org/wp-content/uploads/2013/05/Transistor-Count-over-
time.png

Moore’s law helps explain why ICT has become such an increasingly important part
of the economy. A $4,000 computer in 1987 would cost about $40 to purchase in
2007. That is a 100 times reduction in price for the same equipment. Very few similar
developments can be found in the non-digital economy, where prices normally
increase as a function of time (also called inflation). Computing, storage, and
communication have become exponentially faster and cheaper since they were first
brought to market, which has enabled new digital services and ICT and has fueled
innovation.

BOX 1-4. Automation

Automation is the use of technology to perform a process without human
assistance. Information and communication technologies provide significant
opportunities for automation, primarily due to the massive increase in computation,
storage capacities, and communication bandwidth following Moore’s law (see BOX
1-3). This has further lead to many digital innovations in cloud computing, machine
learning, Big Data, and Internet of Things (IoT). Automation seeks to reduce costs
and increase revenues, competitiveness, and customer satisfaction. It is a part of
the ongoing digitization of the economy and society at large. ICT-based automation
projects can be found in almost every business sector. Implications of automation
may be a widespread replacement of the human workforce by automated digital
services, robots, and algorithms. A big question for politicians and policy makers is
whether this wave of automation will destroy more jobs than it creates.

Financial Technologies (FinTech) is the use of new and
emerging ICT to deliver financial services; in many cases, as a
replacement for traditional financial services. Examples of
applications include: Mobile payment systems, crypto-
currencies, blockchain, crowdfunding, and smart contracts. A
major challenge associated with FinTech is data security.

Robotic Process Automation (RPA) is a form of business
process automation based on using software robots as
workers instead of humans. These robots can perform
repetitive tasks, such as updating websites, answering
customer questions, and sending e-mails. More advanced
robots, based on cognitive automation, are being developed.

In the manufacturing industry, automation is collectively
termed “Industry 4.0,” which is the use of ICT to create smart
factories based on industrial robots. 3D printing is an example
of an Industry 4.0 technology. Here, industrial products are
created on demand at customer premises outside the
traditional huge manufacturing plants.

Intelligent Transport Systems (ITS) is the use of ICT to
automate the road and transportation sector. Examples of ITS
applications include smart traffic signs and self-driving cars,
which both contribute to lower costs of transportation and
increased traffic safety.

Examples of digital services are: Facebook, YouTube, Microsoft software (e.g., Word,
Excel, and PowerPoint), Google, Netflix, Spotify, Uber, YouTube, mobile telephony,
Internet access, e-banking, and e-commerce (e.g., amazon.com and ebay.com). The
term “digital goods and services” is explained in more depth in Section 2.1. The
complement to digital goods and services is physical goods and non-digital services,
which comprises goods that can be touched and felt and have a physical presence (e.g.,
cars, books, computers, and furniture), and services that are not digital in nature (e.g.,
hairdressing, carpentry, and teaching).
Definition 1-2. Digital Economics

Digital economics is the branch of economics studying digital services.

The academic field of digital economics overlaps and relates to other fields of
economics. Digital economics is also known under different designations, each
designation having slightly a different focus and scope. Some of these are:
Network economy focuses on businesses in which much of the economic
value is generated by network effects (see Section 2.5). Network effects are
abundant in the digital economy and explain how value is generated in several,
but not all, digital businesses.
Platform economy focuses on businesses that act as platforms. The primary
business idea is to connect two or more user groups (two-sided or multi-sided
markets). Platform economy is closely related to network economics, since
network effects are also important drivers for platform businesses. However,
not all network economies are platform economies. Multi-sided platforms are
described in Section 2.4.
Information economy focuses on information products and how they are
produced and traded. The information economy is part of the digital economy,
in which the latter is broader in scope, since it also includes more than pure
information goods.
Data economy focuses on the business of harvesting and analyzing data. Data
is gathered from users or the environment and stored in large databases. Big
Data techniques and artificial intelligence are applied to analyze this data, in
which the purpose is to extract information of value to businesses or
governments. Such data may also be traded on the market; for example, as
input to statistics or as the basis for producing directed advertisements.
Virtual economy is the economy of virtual worlds, e.g., World of Warcraft and
Second Life. To some extent, virtual economies reflect the real economy
regarding the supply and demand of goods, trading, and network feedback.
Virtual economies are mostly disconnected from the real economy. However,
there are examples of virtual economies that can generate trade in the real
economy (e.g., gold farming in World of Warcraft).14
Internet economy comprises the economics of Internet goods and services.
Since most of the economic activity within the context of digital economics is
performed over the Internet, Internet economy is close in scope to digital
economics. One important digital market that is excluded in the Internet
economy, is the economics of telecommunications; that is, the market for
broadcast, Internet, and mobile and telephone subscriptions.
Attention economy is related to the value created by people’s attention. User
attention is an important element in many digital business models. The basis
for the attention economy is that data has become abundant, while people’s
attention span remain—and will always be—a scarce resource. There are
business models that exploits people’s attention span to generate revenue; the
most well-known are those based on advertisements. This business model is
considered in more detail in Section 4.5.3.
Sharing economy is the economy in which people or organizations share
goods and services, such as Airbnb and Uber. The sharing economy has also
been termed access economy, peer-economy, collaborative economy, and
crowdsourcing capitalism. See BOX 3-2 in Chapter 3 for an overview of
the sharing economy.
Abundance economy is the economy of goods and services that are
abundant; that is, they are close to unlimited in supply. Many digital services
exhibit abundance features, since they can be copied with zero marginal cost
(see Section 2.1.1). This challenges one of the most fundamental assumptions
in neo-classical economics; namely, that resources are scarce. In several digital
economies they are not!
Digital economics, as defined in this book, encompasses all or parts of the
terms explained above. It is important to point out that digital economics is a
young academic field of study. New terms are constantly appearing, and
descriptions of existing terms are revised as researchers gain an increased
understanding of the field, and as new technologies expand the boundaries of
the digital economy and enable new business opportunities.
1.4. The Digital Economy Ecosystem

The digital economy is based on ICT, such as the Internet, smartphones, data storage,
and processing. Put differently, digital services require ICT to manage and propagate
its value proposition to the consumers (for definition of the term “value proposition,”
see Sections 4.2 and 4.3). The interplay between digital services, information and
communication technologies, consumers, providers of digital services, digital markets,
and society at large, is the core feature shaping the digital economy. This interplay is
called the digital economy ecosystem.
Figure 1-6 illustrates the digital economy ecosystem, including the technologies
on which it depends. The global ICT infrastructure is the carrier of digital services.
This consists of interconnected networks of networks, including the Internet, mobile
networks, wireless networks, fiber networks, and broadband networks. It also includes
storage of data and computing facilities. A digital service may exploit one or several of
the ICT infrastructure components available. Users access digital services using the
ICT infrastructure. Internet Service Providers (ISPs) support the ICT infrastructure.
Application Service Providers (ASPs) offer digital services. ASPs trade their digital
services with consumers in the digital market (see Chapter 3). In addition to all this,
consumers and providers interact with society at large, adapting legal frameworks,
fighting against competing industries, and satisfying societal demands. To understand
the digital economy, it is necessary to first investigate how the different elements of
the digital ecosystem interact with one another.
Digital goods Digital markets

and services
Providers
Consumers
ICT infrastructure

Figure 1-6. The digital economy ecosystem.
Most digital services are dependent on other digital services to provide value to
consumers. Existing digital services are also the foundation for the development of
future digital services. For example, the business of Amazon is dependent on digital
payment services to offer e-commerce to consumers. Spotify depends on access to
digitized music to provide streaming services to consumers. These services may, in
turn, depend on various functionalities offered by several ICT providers and other
providers of hardware and software support functions. Together, these dependencies
make up the digital economy ecosystem. It is impossible to map all dependencies in
the digital economy ecosystem. However, an overview of these complexities is
obtained from studying digital services and the dependencies these services create. This
is exemplified in Figure 1-7, in which a digital Service A depends on two other digital
services (B and C), as well as the two ICTs (cloud storage and wireless access).
Furthermore, Service E depends on Service A, while Service D and Service A depends
on each other. Chapter 3 investigates how stakeholders create dependencies in the
digital economy.
Service D Service A Service E
Service B Service C Cloud storage Wireless

access
Notation
A B A B
A depends on B A and B depend on each other

Figure 1-7. Dependencies in the digital economy ecosystem.
Consumer adoption (or user adoption) of information and communication

technologies and digital services is a key element to apprehend the creation of
dependencies in the digital economy ecosystem. Consumer adoption is a measure of
how and at what rate consumers are adopting a specific ICT or digital service. Some
aspects concerning consumer adoption rate can be summarized as follows:
Obviously, the technology or digital service must be adopted by some initial
consumers to have any impact on the market evolution. If there are too few
initial consumers, then evolution may stagnate, and the technology or service
may disappear from the market. Examples of this are videophones only
enhancing ordinary telephony by showing videos of the speakers while talking,
and the Teletex service for transmitting documents over telephone networks.
Early market adoption is particularly important if the market growth depends
on network effects. Social services, such as Facebook, are examples of services
that are subject to strong network effects and have difficulty attracting early
users.
The adoption of a technology or digital service may depend on other
technologies or digital services to be widespread and fully-adopted by
consumers. For instance, Uber would have never become a success without
the high adoption rate of smartphones and wireless Internet access. The video-
on-demand service depends on optical network technologies for sufficient
traffic capacity in the network and for access to the database.
When a technology or digital service starts to attract consumers and the use
of it increases, it may trigger the evolution of new technologies or services.
The two most obvious examples are Internet and mobile networks prompting
the entire evolution of digital services. A less obvious example is touchscreens
for mobile terminals stimulating the development of apps.
New dependencies and entirely new stakeholders may appear as the digital
service evolves and gets adopted by even more users. Offline use of credit
cards prompted new operators to offer automatic card reader facilities for
direct payment in shops and hotels. This has further stimulated the evolution
of card readers in petrol pumps, parking meters, public toilet locks, and
payment automata in public transport. Apps on mobile phones are now taking
over several of the applications previously supported by credit cards.
Definition 1-3. The Digital Economy Ecosystem

The digital economy ecosystem describes the relations and dependencies between
digital services, ICT infrastructures, and digital markets in a socioeconomic context.

Hence, analyzing the targeted technology or digital service in isolation will not predict
how attractive it will be—several other services and functionalities needed for the
adoption of a technology or a digital service must also be considered. All these
interdependencies make up the ecosystem of the digital service. A qualitative
description of consumer adoption is presented in Section 3.8, and a quantitative
consumer adoption model based on the Bass equation is presented in Section 5.2.
The digital economy ecosystem also consists of social and legal aspects
concerning conditions for marketing and use of digital services, including how
technologies and digital services are regulated by the government. Legal regulations
of digital services may not only influence the content of these services but also how
they are adopted by the consumers. Such legal regulations may also have an impact on
the visibility, development, and use of related digital services. The main observation is
that the digital economy ecosystem is complex, cross-disciplinary, full of dependencies,
and has a great deal of impact on people’s lives, and even business operations, on a
global scale. Examples of how legal aspects impact the digital economy are the
regulations impacting cryptocurrencies15 and sharing services, such as Uber16 and
Airbnb.17 The decision by the European Court of Justice (ECJ) to classify Uber as a
transport company significantly impacts the business operations of Uber.
Process
Stationary state
Transient state
Time

Figure 1-8. Transient and stationary states.
The complexities and dependencies in the digital economy ecosystem result in a market
that is never the same from one day to the next. Changes, such as new stakeholders
entering the market, the evolution of new technologies, variations in consumer
adoption, competition, legal decisions, new regulations, and fluctuating dependencies,
all contribute to a market state that is more transient in nature than stationary. Figure
1-8 illustrates the difference between a transient and stationary state. The transient view
of the digital economy is consistent with the teachings in complexity economics. In
complexity economics, the basic argument is that the economy is ever-changing, and
will never reach a stationary state. The reasons for this are rooted in the digital
economy ecosystem and the rate of technological innovation. For a stationary
market to exist, most of these market aspects must be stable and unchanging. In the
digital economy, new technologies are, in contrast, developed and adopted at a rapid
rate. New technologies often lead to new business models, thereby causing changes in
the digital economy ecosystem. All this contributes to the transient nature of the digital
economy. Chapter 5 presents quantitative models for analyzing the transient nature of
the digital economy.
Activity 1-2. Dropbox

What ICTs and digital services does Dropbox depend on?
What digital services depend on Dropbox? Based on your
findings, sketch a figure illustrating the identified
dependencies.

1.5. Technology Evolution

The evolution of information and communication technologies has followed three
parallel timelines:
The innovation of technologies from simple telephone and telegraph
systems to the Internet, supporting social media, sensor networks, apps, and
many other digital services (Section 1.5).
The convergence of services in which the telephone and telegraph networks
are replaced by the Internet (Section 1.6).
The evolution of the telecommunications business itself from monopoly
to competitive markets (Section 1.7).
This is the evolution that has shaped the digital economy. One consequence of this
evolution is that the complexity of ICT systems probably has surpassed what humans
can conceive. Everything is connected, and everything we do depends on ICT. If ICT
stops, society stops. ICTs, along with electricity production and finance, are the most
important critical infrastructures of society. These infrastructures are tightly
interconnected and heavily interdependent. All other infrastructures depend critically
on them.
Figure 1-9 shows the timeline for selected key innovations that were essential for
the development of the digital economy and the year they became commercially
available or reached the mass market. The technologies listed in Figure 1-9 are
categorized as hardware, mobile/wireless, or software/services. A single technology
belongs to one or more of these categories. Prior to the commercialization of the
World Wide Web in 1993, key technologies were developed along two different paths:
Telecommunications and information technology.
Developments in telecommunications were led by the telecommunication
operators, focusing primarily on technology for long-distance voice communications.
Information technology developments were led by several companies, pioneering the
development of computers and communication between computers.
Optical Fiber GSM (1991) Notation
(1965)
Nordic Mobile
Hardware (bold)
Transistor radio Telephone
Mobile/wireless (underlined)
(1954) (1981) Software/services (italic)
World Wide Web (1993)
Mosaic (1993)
Telecommunications
Figure 1-9. Timeline of ICT innovations.

Information and Communication Technology (ICT)
WiFi (1997) 3G (2003) iPhone (2007) 4G (2009) 5G (2018)

Information Technology Bluetooth (1997) Android (2007)
Google (1998) Twitter (2006) Uber (2009) Snapchat (2011)

Ethernet (1974) MS-DOS (1981) Laptop (1985) Netflix (1998) YouTube (2005) Airbnb (2008) Bitcoin (2009)
TCP/IP (1974) Facebook (2004) Spotify (2008)
Skype (2003) Dropbox (2007)
Microprocessor PC (1977) SMTP (1982) Wikipedia (2001)
(1971)
BOX 1-5. The Transistor

The transistor is a semiconductor device used to switch and amplify electronic
signals. It effectively replaced vacuum tube technology and enabled the production
of cheap, low-powered, and small electronic devices. It is the basis for almost all ICT,
such as the microprocessor, PCs, smartphones, and other electronic devices. It may
be the most important invention of the 20th century.

Julius Edgar Lilienfeld had already filed a patent for the transistor in 1925. However,
because of the lack of high-quality semiconductor materials, it was impossible to
build a working transistor at that time. The first practical implementation of the
transistor was performed at Bell Labs, US, by John Bardeen, Walter Brattain, and
William Shockley in 1947. What they invented was the first point-contact transistor,
which they patented the year after. They received the Nobel Prize in Physics in 1956
for their research on semiconductors and their discovery of the transistor effect.

The vacuum tube radio (left) and the transistor radio (right). Source: Public domain.

The transistor radio was the first commercial device designed using transistors
(1954). In its early days, the transistor also found its use in pocket calculators, hearing
aids, telecommunication switching equipment, and then, finally, the computer.
Today, transistors are mostly used as a building block for integrated circuits, which,
in turn, are used to produce PCs, smartphones, and other electronic devices. In 2014,
more than 1018 transistors were produced. This is more than 100 million transistors
for each human being on Earth.

The size of a single transistor has continually gotten smaller since its inception in the
1950s, quite accurately following Moore's law. While the Intel 4004 microprocessor
released in 1971 had 2,300 transistors, each with a size of 10,000 nanometer, the
22-core Xeon Broadwell-E5 microprocessor released by Intel in 2016 has
7,200,000,000 transistors each with a size of 14 nanometer. More transistors means
in general more computing power. Whether or not the size of transistors can be
further reduced in the future according to Moore's law is an open issue. In the end,
quantum effects may limit the minimum size of a transistor.

BOX 1-6. The ARPANET

The ARPANET was a project with the major goal of building and demonstrating a data
communication network based on packet switching. It was also the first
communication network to implement the TCP/IP protocols. The ARPANET was
funded by the United States Department of Defense and launched in 1966. Packet
switching was a novel technology at that time, challenging the established circuit
switching technique used in telephone networks. The two key advantages of packet
switching over circuit switching were resource sharing and resilience against node
and link failures. Some scientists and engineers doubted packet switching could be
implemented due to its complexity.

The ARPANET in 1974. Note that the first node outside the US was at Kjeller in Norway.

In 1969, the ARPANET project built and demonstrated a packet switched network
covering parts of the US. The ARPANET originally connected nodes in the US, as
shown on the figure. In subsequent years, the ARPANET was refined and expanded.
The first international node in the ARPANET was to Norway via a satellite link in 1973.
The ARPANET was a predecessor to the Internet, since the key technologies in the
current Internet were developed and tested as a part of the ARPANET project. This
includes packet switching, layering, and the TCP/IP protocol suite. Many of the early
services of the Internet, such as e-mail and file transfers, were also first developed
and tested on the ARPANET. The ARPANET was decommissioned and replaced by
NSFNET in 1990, which turned out to be the first parts of the current Internet.

The two fields of information technology and telecommunications merged to

information and communications technology (ICT) after the World Wide Web was
commercialized in 1993. Since then, information technology cannot exist without
telecommunications, and vice versa.
The World Wide Web is enabled by the following technologies: Uniform Resource
Locator (URL), Hypertext Transfer Protocol (HTTP), and Hypertext Markup
Language (HTML). Together, these technologies allow users to access documents,
images, videos, and other information resources globally on the Internet. Mosaic (1993)
was the first graphical web browser which contributed to popularize the WWW and
the Internet. It was later followed by Netscape and Internet Explorer. The Internet is
a global system for interconnected computer networks based on technologies and
protocols such as Ethernet (1974) and TCP/IP (1974), allowing data to be transferred
between two or more computers. The TCP/IP protocol suite was developed and tested
as a part of the ARPANET project financed by the US Department of Defense, but it
is now a worldwide open standard for data transmission on the Internet.
Optical fibers, invented in 1965, provide a high-speed global ICT infrastructure
for the Internet. Most of the Internet backbones are built using optical fibers. A single
optical fiber, which is thinner than a human hair, can carry several hundred terabytes
of data per second. An optical cable, consisting of several (sometimes hundreds of)
optical fibers, can accommodate all traffic generated on the Internet today. With optical
fiber technology, the Internet can be built with abundant capacity for decades to come.
One of the first “killer applications” of the Internet was e-mail, which was
standardized in 1982 with the Simple Mail Transfer Protocol (SMTP). E-mail has been,
and still is, a widely-adopted and used digital service for exchanging messages. The first
commercially-available microprocessor was the Intel 4004, released in 1971. It was
based on the transistor technology that had been commercialized two decades earlier,
and it enabled reliable and low-cost digital computing. Today, microprocessors are
found in everything from PCs to smartphones, refrigerators, and cars. The Personal
Computer (PC) arrived in the early 1970s, but it did not reach the mass market until
1977 with the release of the Apple II and the Commodore PET.
The PC disrupted the existing time-sharing mainframe and minicomputer systems
by offering a dedicated low-cost multipurpose computing device for end-users. The
Microsoft Disk Operating System (MS-DOS) was released in 1981. It provided the
technological basis for Microsoft’s later products and dominance in the digital
economy. The first laptop available for the mass-market was the Toshiba T1100,
released in 1985. The laptop combined the PC with a display, keyboard, inputs,
outputs, and storage into a miniaturized package. In 2017, more than 160 million
laptops were sold. However, this number is small compared to the over 1.5 billion
smartphones sold the same year.
Nordic Mobile Telephone (NMT) was the world’s first automatic mobile
telephony system, released in 1981. It introduced automatic roaming and handover and
supported only voice communications. The Global System for Mobile

Communications (GSM) pioneered digital radio communication, supporting voice,
messaging, and data services. Initially, data communication was slow (less than 10
Kbit/s) and ineffective, but it increased with later developments (such as GPRS and
EDGE). High-speed data, particularly on the link from base station to mobile
(downlink), was introduced in 3G mobile systems (2003), and further developed with
increased bandwidth in 4G mobile systems, launched in 2009. The latest mobile
technology, 5G, was used at the 2018 Winter Olympics in South Korea and is about to
be rolled out on a large scale in the EU, the EEA, and the US. 5G will support the
Internet of Things (IoT).
Bluetooth (1997) interconnects devices over very short distances, while WiFi
(1997) offers local network access using packet radio. Both technologies are widely
employed today. Android (2007) and iPhone (2007) transformed smartphones into
advanced computers, and also enabled app ecosystems (Apple’s App Store and Google
Play). They are the main building blocks of the emerging location-based services, such
as Airbnb (2008) and Uber (2009), both of which are sharing services. Google (1998)
enables users to search the World Wide Web for information. When Google was
launched, there were several competing search engines; however, Google turned out
to be technologically superior to its competitors and captured most of the market.
Netflix (1998) started out renting and selling DVDs by mail, but now, it provides online
media streaming content to subscribers in over 190 countries.
When home computers and laptops became ubiquitous in the developed world,
Internet services, such as Wikipedia (2001), Skype (2003), Facebook (2004), YouTube
(2005), Twitter (2006), Dropbox (2007), and Spotify (2008), emerged. These services,
satisfying different user needs, were not the first in their respective service categories.
However, with a combination of technological superiority, smart design, and luck, they
managed to become the dominating services. With each new year, developments
emerge in different markets and fields. Bitcoin (2009) emerged with the idea of
disrupting the banking system by offering a cryptocurrency that enabled trade and
money transfers without third-party involvement. Likewise, Snapchat (2011) sought to
fill gaps in the social media market by enabling the private sharing of pictures and
videos via mobile devices.
This book is about the digital services and markets in Figure 1-6. However, digital
services cannot not exist without ICT. Enabling developments in hardware and
mobile/wireless technologies will give rise to new types and refined versions of
software and services, which, in turn, will have major impacts on the digital economy.
Note, also, that some of the basic technologies still in use, including TCP/IP, HTTP
(World Wide Web), Ethernet, and GSM, are now more than 25 years old. All these
technologies have been expanded and improved upon several times during their
lifetime. For example, IP exists in two versions (IPv4 and IPv6). GSM has generated a
whole new family of mobile communication systems—3G, 4G, and the upcoming
5G—all of them built on the basic principles of GSM. On the other hand, the basic
connection-oriented protocol on the Internet—TCP—has been unchanged since
1974.
Despite all these improvements, the original technologies are still widely used. For
example, IPv4 (42 years old) and GSM (26 years old) are still the dominating Internet
and mobile network technologies, respectively. Within industrialized countries, 3G and
4G technologies are rapidly replacing GSM, but still, all mobile networks must support
GSM. Any efforts to shut down GSM have, so far, failed. These technologies are
evolving slowly. The most important reason for this slow change is the huge
investments required for implementing them. Even a small improvement of a
technology is expensive to install, simply because of the vast volume of existing
equipment designed to the old standard.
Therefore, it may sometimes take more than ten years before the technology is
taken into use after it is specified and implemented. For example, it took more than
ten years from when the HTTPS specification was finalized until it was generally
implemented. IPv6 was ready for implementation in 1996. Nevertheless, in 2016, more
than 95% of the Internet traffic is still carried on IPv4 networks. This is because
Network Address Translation (NAT) has increased the available address space for IPv4
and hence, postponed the introduction of IPv6. On the other hand, both the
development time and adaptation time for many app-based digital services (such as
Airbnb and Uber) are very short. The reason is that many of them are simple software
packages—easy to develop, install, and use. The rapid evolution of apps took place
after iPhones and Android phones were marketed in 2008.
One important requirement for introducing a new technology is backward
compatibility; that is, the new technology should support equipment or software
designed to the old standard. One compatibility requirement is that new equipment
should be capable of operating in the old environment. This objective is fulfilled for
public mobile communication; a smartphone designed for 5G must also support 4G,
3G, and GSM so that it can be used everywhere. This implies that the smartphone
must support the radio interface for all mobile standards. In addition, it must support
WiFi and Bluetooth. This backward compatibility ensures that new families of mobile
systems can be introduced smoothly without needing to rebuild the network
completely.
Innovations in ICT will continue to impact the digital economy in the future.
Technologies such as machine learning, robotics, smart factories, smart cities, and 3D
printing all show great potential for disrupting existing business sectors and providing
the foundations for upcoming digital services. Machine learning techniques are already
utilized in several digital services. One example is online recommendation systems (see
BOX 1-2), which use machine learning to better recommend products to consumers.
Another example is voice recognition systems, such as Apple’s Siri.
BOX 1-7. Cryptocurrencies

Cryptocurrencies are a type of digital currency that uses cryptography to secure
transactions and generate new units. Transactions in cryptocurrencies are performed
without any centralized authority. They are based on the blockchain technology,
which is a public and decentralized database of encrypted records. Blockchain is a
versatile technology that can be used to design smart contracts as well as
cryptocurrencies. A general advantage of cryptocurrencies is their ability to perform
secure transactions of money without a third-party stakeholder involved, potentially
with reduced costs and lower transaction delays.

25 000
20 000
Bitcoin price in USD
15 000
10 000
5 000
0
January-16 July-16 January-17 July-17 January-18

The price of one BTC in US dollars from January 2016–March 2018.

Bitcoin (2009) was the first decentralized cryptocurrency and the first practical
implementation of the blockchain. Bitcoin involves many distributed miners that
confirm transactions between two parties. Transactions are recorded as a chain of
blocks (thereby the name “blockchain”) on a decentralized and distributed public
ledger. Bitcoin has the potential to become a true global digital currency. It can
currently be traded on international digital currency exchanges. However, the price
of Bitcoin has been extremely volatile compared to other currencies, such as the US
dollar and the Euro (see the figure above). Because of this, the use of Bitcoin in the
trading of goods and services has been limited. The development and popularity of
Bitcoin has also spurred the creation of many other cryptocurrencies, such as
Ethereum, Litecoin, Ripple, and IOTA. There are currently more than 3,400 different
cryptocurrencies in various stages of development. Cryptocurrencies in general,
including Bitcoin, have met recent criticism and have been compared to economic
bubbles, such as the tulip mania (1637). Cryptocurrencies have also been used in
money laundering and the funding of criminal activities.

1.6. Service Convergence

Service convergence means that digital services which once required a dedicated
network to support delivery to consumers can now be carried on the Internet. This is
shown in Figure 1-10. Historically, separate and dedicated networks were designed for
carrying different telecommunication services, such as:
Telephone networks for the telephone service
Public mobile networks for the mobile voice service
Audio broadcast networks for the radio service
Television broadcast over cable and satellite networks for television
Telex for low-speed text transmission
Dedicated data networks for various digital data services
All these networks, except the telex network and some early data networks, are still in
operation today. However, the services provided by these networks can also be
provided over the Internet. The evolution from transporting services over dedicated
networks to transporting them over the Internet is called convergence; that is, the
evolution from using multiple different networks for different services to a single
network supporting all of them—the Internet. This convergence started in 1993 with
the commercialization of the World Wide Web. The telegraphy service was closed in
2000 and is no longer offered. Hence, the world’s oldest telecommunications service
was then terminated after about 150 years in operation.
Audio broadcasts have been sent as analog signals over wireless networks since
the 1920s. From 1993, audio broadcasts have also been offered over the Internet
(Internet radio or web radio). Today, many radio broadcasters are moving from analog
to digital broadcast of radio signals (DAB), in addition to offering the same radio
channels over the Internet. Hence, for audio broadcast, there exists a separate radio
network (DAB network) and an equivalent digital service on the Internet (Internet
radio). TV channels have been broadcasted over dedicated cable or satellite networks
since the 1950s. From the early 2000s, TV channels have also been available over the
Internet. Some TV broadcasters, such as the BBC, offer their television programs on
web pages, in addition to broadcasting over cable or satellite networks. There are also
several pay-per-view Internet services, such as Netflix and HBO, which offer movies,
series, and other video content. Some TV channels are exclusively available over the
Internet.
The traditional fixed telephone service (PSTN) has been offered over a separate
dedicated network for more than 100 years. Voice-over IP (VoIP) enables voice
communications over the Internet. Examples of VoIP services include: Skype, Google
Hangouts, and WhatsApp. Even though traditional fixed telephony has been predicted
to be replaced by VoIP for many years, this service still exists and is offered alongside
VoIP. The situation for mobile telephony is similar to traditional fixed telephony. The
all-IP mobile technology 4G offers VoIP (also called VoLTE) to mobile terminals.
However, 4G systems must support fallback capabilities so that telephony and SMS
are offered over GSM or 3G. This is still the most common method for supporting
telephony in 4G.
VoIP Mobile VoIP
Mobile telephony
Fixed telephony
Type of network
Internet
Radio broadcast
TV Broadcast
Telegraphy
1990 2000 2010 2018
Internet radio Internet TV Full convergence

Figure 1-10. Service convergence.
To summarize, today, all services, such as audio broadcasts, television broadcasts, fixed
telephony, and mobile telephony, are still offered dedicated networks. These services
are also offered on the Internet. Hence, there is an ongoing convergence of services as
an increasing number of users switch from using a dedicated network to the Internet.
It is predicted that, at some time in the future, all telecommunications services will be
offered on the Internet exclusively, and the traditional networks will be shut down.
The convergence has been slower than expected, and we must wait to see whether
the full convergence to the Internet will ever happen or whether the Internet itself will
be replaced by a new technology. Existing communication networks are eventually
replaced by new and improved network technologies, however, this may take decades
or even centuries. The business implications of convergence are significant. When
services on dedicated networks can also be sent over the Internet, new forms of
competition arise. One general observation is that, in general, it is cheaper to offer
services over the Internet than over dedicated networks. Internet services can also be
targeted toward an international market at a lower cost, compared to traditional
delivery of the same services.
Activity 1-3. ICT Convergence

What are the major benefits and challenges of a fully-converged
ICT infrastructure? How will the cost of operating and managing
ICT infrastructures change due to convergence? Is it possible for
the Internet to accommodate all kinds of services offered on
current dedicated networks?
1.7. Market Evolution in Telecommunications

The telecommunications industry has undergone an evolution in market structure from
monopoly to competition market, as illustrated in Figure 1-11. Until about 1985, most
telecommunications enterprises were state-owned monopolies. Even in the US, the
telecommunications enterprises were monopolies—though privately-owned—each
with their own area of operation (cartels). The argument in favor of monopolies was
that it would be more expensive for the users if there were more than one telephone
operator in the region because of the large investments in ICT infrastructures required.
It was deemed inefficient to allow several telecommunications providers to build their
own communication networks which provided the same set of services.
Telecommunications was then regarded as a natural monopoly (see Section 2.8). The
state monopoly owned the network, offered the few services supported by the
network, and sold or rented out telephones, local switchboards, and data modems.
These telecommunications operators were called “vertically-integrated monopolies.”
Consumers usually had one choice regarding telecommunications service, dictating the
type of user equipment, network, and service the consumer had to use.
In the early 1980s, the first public data networks were put into operation and the
first automatic mobile networks (NMT) were up and running. The number of different
types of user equipment had exploded, and the monopolies were too bureaucratic and
too inexpert to handle this plethora of new paraphernalia. Responding to this, starting
from 1985, the authorities opened the sale of user equipment for free competition;
however, the type of equipment had to be approved by the telecom operator before
the new device could be connected to the network.
In 1981, the Nordic Mobile Telephone (NMT) had just been put into operation
in Nordic countries. Already in 1982, NMT was about to become the preferred
common European land mobile system. The UK participated in this project. In 1982,
Margaret Thatcher decided there should be full competition among mobile
communications in the UK with two independent operators. This implied that the UK
had to choose a system other than NMT; otherwise, one of the competitors would
have too big of an advantage. Europe was then left with four incompatible land mobile
systems: NMT in Norway, Finland, Sweden, Denmark, Iceland, Spain, Netherlands,
and Switzerland; TACS in the UK; C Netz in Germany; and Radiocom2000 in France.
This was, in fact, the major incentive for the Netherlands to suggest in 1982 that
Europe should develop a new pan-European digital mobile system—the Global
System for Mobile Communications (GSM). GSM was originally an abbreviation for
the name of the group developing the technology—Groupe Spécial Mobile. In 1992,
the GSM system was put into operation, and EU and EFTA decided that each country
should have at least two competing land mobile networks. The fixed network operators
would still remain monopolies. Hence, from 1992 onward, consumers could choose
between at least two providers of mobile telecommunications services.
< 1985 1985-1992 1992-1998 1998 >

Notation
User equipment Networks Applications
Figure 1-11. Evolution of the telecommunications business.
In 1998, the EU opened all aspects of telecommunications for full competition.

Anyone could now become a network operator, service provider, or retailer of user
equipment. However, the stakeholders in this market were subject to some regulatory
restrictions related to the competition between network operators—including virtual
network operators—on price, performance, customer care, and quality of service.
These regulations included mandatory cooperation between network operators to
ensure full connectivity between users of competing networks at reasonable prices and
quality of service, and non-discrimination of application service providers accessing
the network; in particular, preventing network operators from giving advantages to
application service providers owned by themselves.
These aspects are studied in more detail in Chapter 3. The driving force for the
de-monopolization of telecommunications was the political idea that a competitive
market would be more efficient and offer lower prices than the monopolies. A concern
for policy makers is that several companies in the data or Internet business have had a
tremendous increase in market value and revenues during the last ten years. Some of
these companies have also become ad hoc monopolies in their market segments (e.g.,
Google, Facebook, and Netflix) by acquisitions of competitors. These companies also
benefit from strong network effects, thereby resulting in robust lock-in barriers for
users (see section 2.7).
Summary and Key Points

Innovations and developments in ICT have laid the foundations for the digital
economy. A widespread digitization is observed, as a substantial and increasing part of
the economy is based on digital services. The most important technologies that have
formed the digital economy are the Internet and the WWW. Other factors contributing
to the evolution are the de-monopolization of the telecommunications industry
allowing for new types of competitive rivalry, miniaturization and increasing mass
storage and processing capacities of microprocessors, and ubiquitous availability of
cheap computing devices.
Key Points

The digital economy is an economy based on ICT.
Digital economics is the branch of economics studying digital services, such as
social media, sharing services, and e-commerce.
The digital economy is enabled by a digitization of the economy, which, in turn, is
triggered by three technological evolutions: The digitization of data, the evolution
of digital ICT infrastructures, and fast and cheap digital processing and storage
devices.
The digital economy ecosystem describes the relations and dependencies between
digital services, ICT infrastructures, and digital markets in a socioeconomic
context.
The evolution of ICT since the 1950s has enabled the digital economy—
particularly the World Wide Web—to trigger the enormous growth of the digital
economy during the last 25 years.
The digital economy has been shaped by the de-monopolization of the
telecommunications sector and the convergence of services since the 1980s.
Further Reading
Janet Abbate. Inventing the Internet. The MIT Press. 1999.

This book contains a detailed account of the history of the Internet from its early
inception in the 1960s to its worldwide adoption in the late 1990s. It not only describes
the evolution of the technologies forming the Internet—including packet switching,
layering, and the TCP/IP protocol suite—but it also describes how standardization
efforts have formed the current Internet and influenced the market for digital services.
Erik Brynjolfsson and Adam Saunders. Wired for innovation. The MIT Press. 2013.
This book discusses digital innovations and their impact on the digital economy. It also
raises topics such as organizational capital and consumer surplus. The book
emphasizes the exponential growth of information and communication technologies
as predicted by Moore’s law.

Martin Ford. The Rise of The Robots. Oneworld Publications. 2017.
This book draws upon digital economics theories to give the reader a description of
the potential socioeconomic consequences of emerging ICTs. The book discusses how
the evolution of robots and machine learning impacts the international job market.

Chapter 2
Fundamentals

Learning Goals

The definition of digital goods and services
Zero marginal cost, zero ARPU, commoditization, and bundling
Public good features of digital services
In-house production, commons-based peer production, and crowdsourcing
Value chains, value shops, and value networks
How multi-sided platforms may be exploited in digital businesses
Positive, negative, direct, and indirect network effects
Same-side and cross-side network effects
Positive feedback, path dependency, lock-in, and switching costs
How monopolies are formed in the digital economy
Mergers and acquisitions in the digital economy
The impact of standards on the digital economy
The long tail property and how it may be used in digital businesses
This chapter introduces the fundamentals of digital economics. These fundamentals

are essential for understanding the digital economy and why the digital economy is
different from the industrial economy, that is, economics for physical goods and non-
digital services. Section 2.1 defines and explains the properties of digital goods and
services, which are the basic building blocks of the digital economy. Then, the
fundamentals of digital economics are described, including production models (Section
2.2), value models (Section 2.3), multi-sided platforms (Section 2.4), and network
effects (Section 2.5). Path dependence is presented in Section 2.6, lock-in and switching
costs in Section 2.7, and the formation of natural monopolies in Section 2.8. Section
2.9 describes mergers and acquisitions in the digital economy. Finally, standards and
the long tail property are discussed in Sections 2.10 and 2.11, respectively. Chapter 5
provides more details concerning advanced quantitative and analytical models related
to some of the topics in this chapter.
2.1. Digital Goods and Services

The building blocks of the digital economy are digital goods and services. Everything
in the digital economy can be mapped down to the production, circulation, trade, and
use of digital goods and services. Even though digital goods and services are related
and sometimes overlapping concepts, they are also different in several aspects. A
digital good is defined as a networked zero marginal cost virtual object that has value
for individuals or organizations. A virtual object is intangible but can be stored as data
on a digital medium, such as a consumer’s hard disk or smartphone, or in the cloud.
Following our definition, the virtual object can be replicated without any incurred
costs—the marginal production cost of the object is zero (see Section 2.1.1). The
format of the virtual object must be such that it can be delivered to consumers over a
communication network, such as the Internet. That is, the virtual object is networked.
Finally, the virtual object must also have financial, psychological, or other value for
someone. Virtual objects without value for anyone are not included in our definition.1
Definition 2-1. Digital Good

A digital good is a networked zero marginal cost virtual object that has value for
individuals or organizations.
Examples of digital goods that satisfy this definition include: Microsoft Word
documents, music tracks on Spotify, web pages on the Internet, apps on iPhone,
Wikipedia articles, e-mails, data stored on electronic bank accounts, private data stored
on Dropbox accounts, and the list of apartments on an Airbnb web page. These are all
virtual objects; they have value for someone; they can be replicated without any cost;
and they can be delivered to consumers over a communication network. Examples of
Fundamentals 37
non-digital goods are: Computers, mobile phones, and mobile base stations. None of
these are virtual objects, they have non-zero marginal cost, and cannot be sent over a
communication network.
A digital service is a networked zero marginal cost service that has value for
individuals or organizations. Services are intangible by nature. Digital services include,
for instance: Social media, electronic banking, Internet access, multiplayer online
gaming, web browsing, and e-mail. The difference between a digital good and a digital
service is somewhat blurry. For example, the data on a Facebook account is a digital
good while the use of Facebook for any purpose is a digital service. Music tracks stored
on Spotify’s servers are digital goods, while the use of Spotify to listen to music is a
digital service.
Definition 2-2. Digital Service

A digital service is a networked zero marginal cost service that
has value for individuals or organizations.

The definition of digital services also includes network access; that is, the
transmission of data over fixed and mobile networks. Data storage and data processing
are also included in the definition of digital services. Network transmission and access,
storing, and processing of data are not only digital services in their own rights, but also
enablers for other digital goods and services, which make them enabling technologies
or foundational technologies. This means that other digital goods and services provide
the value proposition by building on the functionalities provided by the digital services
network access, data storage, and data processing. Such services harvest much of the
investments put into enabling services, for example, Facebook, which is totally
dependent on a worldwide Internet to provide its value proposition but have not
contributed to the development of the Internet as such.
Digital goods and services are different from physical products (tangible goods).
Physical products have presence in the physical domain, while digital goods are built
up by sequences of bits and exist only as pieces of software or data stored on computers
or other storage devices. Digital goods and services may be combined to form larger
and more complex digital goods and services before being offered to consumers. One
simple example is the use of the secure digital payment solution offered by Google
Play. A similar but more complex example is to use smartphones as authentication
tokens for secure access to bank accounts (see BOX 3-6). This case involves the
primary service provider (the bank), the authentication provider (the mobile operator),
and one or more clearinghouses which supervise and guarantee the validity of the
authentication process. Hence, a digital good or service may be built up by linking
several other digital goods and services, thereby forming its own ecosystem.
BOX 2-1. Anything-as-a-Service

To provide a digital service, it is necessary to set up a dedicated infrastructure which
supports the service. For example, the storage of data requires hard disks and
servers, data processing requires a large number of microprocessors, the e-mail
service requires an e-mail server, access to the Internet requires optical fibers and
Internet routers, and a wireless network service requires a network of wireless
routers and mobile base stations. With the Anything-as-a-Service (XaaS) concept, all
these services can be provided to a consumer without a dedicated infrastructure at
the consumer’s premises. The XaaS can be accessed in “the cloud”. A related term to
XaaS is “cloud computing”.

On-premises IaaS PaaS SaaS
Data Data Data Data
Applications Applications Applications Applications
O/S O/S O/S O/S
Infrastructure Infrastructure Infrastructure Infrastructure
XaaS provider managed Self-managed

Under the XaaS concept, several types of digital services can be delivered, such as
Software-as-a-Service (SaaS), Platform-as-a-Service (PaaS), and Infrastructure-as-a-
Service (IaaS). An example of IaaS is Dropbox offering storage of data in the cloud—
cloud storage—for consumers. Data stored using Dropbox’s service is stored in one
of their data centers. Using the Internet, a consumer can access their data stored on
Dropbox anytime and anywhere.

An example of SaaS is Vortex (https://vortex.gg/) offering cloud gaming services. A
user of Vortex’s services may access several games run on Vortex’s servers. There is
no need to store, install, or process the game in the user’s computer since all
processing is performed by Vortex.

Blockchain technology can also be offered as a service—Blockchain-as-a-Service.
Consumers or companies buy access to Blockchain-as-a-Service without installing the
infrastructure needed to support the service. Amazon, Oracle and IBM are examples
of companies offering Blockchain-as-a-Service. XaaS has changed how companies
invest in ICT. XaaS requires fast and reliable communication network, since huge
amounts of data are transported by the XaaS provider.

Fundamentals 39
Digital goods and services do not degrade as a function of time—they will continue to
exist far into the future with the same quality as when they were created because of
their digital nature. This is different from physical goods, which normally degrade over
time.
Digital goods and services are sometimes offered for free to the consumers. Such
free services challenge many businesses: How is it possible for companies offering free
services to have revenues? How can other goods and services that are traditionally not
offered for free compete with free digital goods and services? An example of free digital
services that compete with previously paid services include: WhatsApp vs. SMS and
online news vs. traditional newspapers.
As stated in Section 1.3, the term “digital service” is used when collectively
referring to both “digital goods and services.” This is because it is seldom necessary to
make a distinction between “digital goods” and “digital services.” We will write “digital
goods and services” when this distinction is necessary.
Activity 2-1. Digital Services

Which of the following is a digital service?
(1) the New York Times web page
(2) Internet access over a 4G mobile network
(3) a Compact Disc (CD)
(4) HBO subscription
(5) an Apple iPhone

Apply the definitions 2-1 and 2-2 and explain your answers.

2.1.1. Zero Marginal Cost

A key characteristic of digital services is that they have zero marginal cost. Marginal
cost is the cost of producing one additional unit of the service. Digital services can be
multiplied with no additional cost. An example of this is the cost of producing one
additional copy of an app. Let us consider a case in which an app has been downloaded
and installed 10,000 times on different smartphones. What is the cost of the next
download? In a networked system, a new copy of the app requires downloading the
app software from the app server, transmitting it via a communication network to the
smartphone, where it will be installed. The cost of these actions equals zero—or is, at
least, very close to zero. There are, however, certain costs associated with these
operations; for example, the use of electric power and communication network access
to download data. These costs are, in most practical settings, negligible and have,
therefore, no measureable influence on the economics of the operation, resulting in
zero marginal cost for all practical purposes. Another example is the cost of processing
one extra trade transaction on Amazon. As long as the infrastructure for trade is in
place, there is no additional cost of processing the extra transaction—the marginal cost
is zero.
On the other hand, the marginal cost is not zero for producing physical goods. The
cost of such production includes the cost of raw materials (e.g., steel or plastic),
workforce, and logistics. Note that some e-commerce businesses which sell physical
products online, such as Amazon, do not have a zero marginal cost because of the
shipping of physical goods. The business operation of e-commerce is examined in
Section 3.3.
Definition 2-3. Marginal Cost

Marginal cost is the cost of producing one additional unit of a good or service. Digital
services have zero marginal cost.

Digital services often have high fixed costs, since some of them are expensive to
develop, build, and operate. The development of software may cost millions of US
dollars, require development teams with hundreds of people, and take several years
from idea to finished product. For example, the development of the computer game,
Grand Theft Auto V (released in 2013) cost $265 million while Star Wars: The Old Republic
(released in 2011) cost $200+ million.2 These development projects are huge
undertakings, often backed by professional corporations. On the other hand, there are
examples of digital services with low fixed costs, such as the computer game Minecraft
and many apps for iPhone or Android. These are relatively simple digital services that
have been developed by a single person over a relatively brief time frame.
An interesting example is communication networks. It is very expensive to build
and run new communication networks, implying that the fixed costs are very high. This
is because communication networks consist of expensive equipment, such as cables,
mobile base stations, and switching and control centers. This equipment often spans
large geographical areas. Such equipment is also expensive to install and operate, and
requires often collaboration with local authorities to get the permission to dig trenches
for fiber optic cables or to install base stations on public buildings. On the other hand,
the marginal cost for producing their prime product—the transportation of bits—is
tiny and close to zero.
High fixed costs do not always mean that the consumer must pay for the good or
service. This depends on the business model of the company. Facebook and Google
have enormously high expenditures associated with running the company and
developing and extending their service offers to consumers. However, their costs are
not covered by direct payments from the consumers but indirectly, by selling
advertisement space. This is made possible by collecting huge amounts of personal
data from the users, and using this data to offer targeted advertisements, selling it to
Fundamentals 41
advertisers or other data processing corporations. Such business practices obviously

have privacy concerns. These business models are reviewed in Section 4.5.3.
The relative gap between the fixed costs and the marginal cost is descriptive for
digital services. For example, the major cost of an app is the development of the app.
The time taken to develop an app can be anything from a few days to several years. In
any case, the fixed costs associated with the development are several magnitudes larger
than the marginal cost associated with the production of the service itself.
Furthermore, since the marginal cost of a digital service is zero, there is no cost
associated with making a copy of it, which means that every new sale contributes
directly to revenue. Copies of the app can even be distributed for free without any
financial loss for the developer also because the production cost is zero. When total
sales have matched the costs of developing the app, the remaining sales are pure profit.
Under such conditions, the average cost of a copy of the digital service equals:
$ $
!" = + '" = ,
% %
where !" is the average cost, $ is the fixed costs, % is the number of copies of the
service produced during its lifetime, and '" is the marginal cost. Figure 2-1 shows the
average cost as a function of %.
MC=0
n
Figure 2-1. The average cost as a function of the number of units produced.
Economies of scale describe the cost advantages that companies achieve as the
number of units produced—the parameter %—increases. These cost advantages come
from an increased number of produced units to share the fixed costs of the company.
Many companies producing physical goods benefit from cost advantages as the
number of produced units increases, however, only until a certain point. This is because
expanding the production of physical goods beyond a certain limit requires building
new infrastructures in new regions, which increases the relative size of administration
and support functions of the company in such a way that the benefits from economies
of scale are marginalized. This is different in the digital economy—since the marginal
cost is zero, the cost advantages of increased production continue to benefit digital
companies apparently with no limits. This is one of the reasons why companies
producing digital goods and service get so big.
Activity 2-2. Computer Game Development

A computer game costs $100 million to develop (fixed costs),
with a selling price to consumers of $50 per copy. Assume that
the marginal cost is zero. How many copies must be sold to
cover the fixed costs? How many copies must be sold to cover
the fixed costs if the marginal cost of each copy is $10? Under
what condition is the marginal cost zero? Under what condition
is '" > 0?

2.1.2. Public Good Features of Digital Services
Goods and services, in general, can be classified as either private goods, public goods,
club goods, or common-pool resources.3 This classification depends on whether a
certain good or service is rival/non-rival or excludable/non-excludable. A good or
service is classified as rival if it is reduced in quantity after consumption, or if the usage
of the good or service prevents others from using it. A non-rival good or service is
the opposite of a rival good or service; it is neither reduced by consumption, nor does
the usage of the good or service prevent others from using it. An excludable good or
service is such that it is possible to prevent consumers from accessing or using the
good. A non-excludable good or service is such that consumers cannot be prevented
from accessing or using the good. A specific good or service can be either rival or non-
rival, and either excludable or non-excludable. From these characteristics, four
different combinations of goods and services arise, as shown in Table 2-1.
Table 2-1. Different types of goods and services in the economy

Type of good Characteristics Examples
Cars, food, clothes,
Private goods Rival and excludable
mobile phones.
Common-pool Fish, forests, wild
Rival and non-excludable
resources berries, pastures.
Cinemas, cable TV,
Club goods Non-rival and excludable
private parks.
Air, national defense,

Public goods Non-rival and non-excludable
knowledge.
Fundamentals 43
Digital services are non-rival by nature—the consumption of a digital service by a user

does not reduce the quantity available to other users of the same digital service. For
example, a user reading a web page does not reduce the availability of that web page
for other users. A Spotify subscription gives a user access to Spotify but this does not
prevent other users from accessing Spotify. A user accessing the Internet does not
reduce the availability or the quantity of the Internet for other users. The latter is true
with some limitations, since webservers and the Internet have a maximum capacity.
However, most computer and communication systems today are provisioned to handle
high demands. In this book, digital goods and services are assumed to be non-rival for
most practical examples.
Digital services can be either excludable or non-excludable. Excludability means
that access to the good or service can be regulated. On the other hand, if a service is
non-excludable, a user cannot be denied access to the service. Digital services that are
widespread on the Internet are non-excludable. Examples of this are: Free music, news,
and content on free web pages. Digital services that have restricted access are
excludable. Examples of this include: Access to specific magazines and journals,
copyrighted music and movies, and licensed software. Excludable services can be
accessed by, for example, accepting a paid subscription plan or enjoying a club
membership. The illegal copying of copyrighted material might result in excludable
content becoming non-excludable—copies become abundant and available for
everyone.
Definition 2-4. Non-Rivalry and Excludability

Digital services are non-rival by nature. Digital services can be either excludable or
non-excludable.
Figure 2-2 shows examples of digital services classified according to the type of good
defined in Table 2-1. Note that all the digital services in the example are non-rival.
Access to Wikipedia articles is non-excludable, since the website is open and available
for anyone. Gmail is an open and free service available for anyone who registers for an
account. Spotify is both excludable and non-excludable at the same time. Its basic
service is free for anyone registering for Spotify; however, Spotify’s premium service
is accessible only by paid subscription. Internet access is excludable, since the users
must pay for Internet access. However, Internet access may also be non-excludable;
access to the Internet may be free and open to anyone in airports and shopping malls.
Access to Netflix and World of Warcraft is excludable—a paid subscription plan is
required for using both these services.
If a digital good or service is both non-rival and non-excludable, it is classified as
a public good (or service). Public goods occupy a special place in economic theory.
They are often prone to market failure, resulting in governmental regulation or other
market interactions to make the market function properly. One of the reasons for
market failure is the free rider problem. Public goods can be accessed by anyone
without paying for it. There are, therefore, no incentives for private actors to provide
these goods or services; likewise, there are no incentives for users to pay for access or
usage to maintain and uphold the service. One example is Wikipedia offering a free
encyclopedia on the Internet. There are few or no incentives for private actors to
financially support or invest in Wikipedia. Wikipedia relies primarily on two sources of
income for sustaining its operations: Financial donations from benefactors and
voluntary work by authors who write and update articles.
Non-excludable
Wikipedia
Common-pool Public goods
resources Gmail
Spotify
Internet access
Excludable
Club goods
Netflix
Private goods
World of
Warcraft
Rival Non-rival
Figure 2-2. Classification of digital services.
A common-pool resource is prone to the tragedy of the commons, in which

common resources get overused and depleted. Even though individuals act in their
own self-interest, it is the collective behavior of all individuals that may lead to overuse
or depletion. Examples of the tragedy of the commons are overfishing in the seas and
air pollution. The tragedy of the commons also has impacts on the digital economy—
even though digital goods and services are not rival by nature. Since digital goods and
services have zero marginal cost and therefore, close to unlimited supply, the tragedy
of the commons takes different forms in the digital economy, such as the publishing
of unwanted and illegal information and content, spam, denial of service attacks, and
service abuse.4
Fundamentals 45
2.1.3. Zero Average Revenue Per User

Average Revenue Per User (ARPU) is an important financial indicator in economics.
The ARPU states how much revenue an average user is generating over a specific
period. For instance, the monthly ARPU for mobile subscribers in the US is about $40.
Total revenue for a mobile service provider is the ARPU multiplied by the number of
users (subscribers). The mobile service provider will focus on increasing its total
revenue by increasing both the ARPU and the number of subscribers. In the digital
economy, several companies operate with zero ARPU (ARPU=0), in which case the
company will not receive any revenue from the consumers. Since the marginal cost is
zero, the cost to attach users is also zero. This applies to all competitors offering the
same service so that to compete, free services are offered to the consumer by all of
them. The suppliers do not compete on price but on user experience.
The main challenge for many companies in the digital economy is, therefore, to
get revenue for its operations from sources other than consumers. A few companies
have succeeded in this effort, for example: Facebook, Google, and Twitter. Their main
source of revenue is advertisements; the more they know about its consumers, the
more attractive they are as marketing channels.
Note that ARPU=0 is not a universal rule applicable to all digital services. Netflix,
for example, has an ARPU>0, because consumers pay to access the service.
BOX 2-2. Facebook and ARPU=0

Facebook is the world-leading social 200
Market Cap
networking service with currently 180
Revenue
more than two billion users. None of 160
these users pay anything to Facebook 140
for using their services. Facebook is 120

USD (billion)
100
free of use; that is, ARPU=0. Yet,
80
Facebook’s revenue is over $40
60
billion for 2017, increased from $27
40
billion in 2016 and $18 billion in
20
2015. In 2018, Facebook is among
0
the five most valued companies in 2012 2013 2014 2015 2016 2017
the world, according to market Year

capitalization. Facebook market cap and revenue 2012–2017.

How is it possible for Facebook to reach such a financial position when it doesn't earn
anything from its users? The answers to this question are related to network effects
and multi-sided platforms (see Sections 2.4 and 2.5).

2.1.4. Digital Commodities

Commoditization is the process by which digital services (or any good or service in
general) end up being indistinguishable from a consumer’s point of view. Competing
services will look the same to the users—it is impossible to differentiate between the
services, even though they are produced by different companies. The only
distinguishing factor for a commoditized digital service is its price. Examples of non-
digital commodities include oil and electricity. It is impossible, or at least very difficult,
for consumers to distinguish between lubrication oils or electricity produced by
different power plants—only their price may be used as a distinguishing factor.
Figure 2-3 exemplifies the commoditization process in which three providers
produce competing digital services that were initially different. However, due to
commoditization, these services become indistinguishable for the consumer. Several,
but not all, digital services have been commoditized. Examples of digital commodities
are: Internet access and transport of bits, the storage of data, the processing of data,
international news bulletins, and, to some extent, certain types of software products
(e.g., word editing and spreadsheet software).
Consumer
C
Digital Digital
Providers
services commodities

Figure 2-3. Commoditization of digital services.
Digital services that have been commoditized compete only in price. A fierce
competition among companies providing digital commoditizes tends to push the price
to zero. This is because of the zero marginal cost property of digital services. Standard
microeconomic theory on perfect competition markets also predicts this outcome.
However, at price equal to zero—the digital service is provided for free—it is a
challenge for companies to be profitable. Most of them will run out of business as
Fundamentals 47
revenues decrease and profits turn negative. This is a strategic dilemma for several
companies in the digital economy. To avoid a price war resulting in zero revenue,
companies may differentiate their services from the competitors by making them
unique for customers, for example, newspapers offering customized news alerts. The
newspaper may then charge the customers to generate revenue. Another option is to
apply creative business models that operate under condition that the service is provided
for free while the revenues are obtained from other sources—Google and Facebook
employ such business models.
Digital services become commodities because of standards (see Section 2.10).
Standards force providers to deliver digital services that are alike. Digital services also
tend to become commodities over time. This may be the result of the harmonization
of competing services. An example of this is word editing software in the 1990s, in
which the competing products had different functions. Today, word editing software
are very similar to one another and are close to becoming a digital commodity.
Activity 2-3. Digital Commodities

Decide if any of the following digital services have been
commoditized:
(1) Social media services
(2) E-mail clients
(3) Web browsers
(4) Cloud storage
(5) WiFi Internet access

Why have these digital services been commoditized? If they
have not been commoditized, why not?

2.1.5. Transaction Costs
Transaction costs are the costs of making any economic trade when participating in
the markets (see Section 3.1 for the definition of a digital market). Transaction costs
can be divided into three categories:
Search and information costs are the costs for searching a digital service and
determining its price and properties.
Bargaining costs are the collective costs for the consumer and the provider
to agree on the terms of the contract. This includes the price and delivery of
the service.
Policing and enforcement costs are the costs of sticking to the agreement
and taking appropriate action if the agreement is not upheld by either party.
An example of transaction costs is the trading of (physical) goods using eBay. The
buyer first searches for products they want to buy among offers made by various
providers (i.e., search and information costs). This is done on eBay’s website. When
the buyer has decided which item to buy, they will bargain over the price and delivery
conditions with the provider or seller of the item (bargaining costs). After some time,
the buyer receives the item. If something is wrong with the product, the buyer will
enforce the contractual rights by taking direct contact with the seller (policing and
enforcement costs). eBay may also be involved if the buyer and seller do not agree.
Digital services—such as eBay, Amazon, and Alibaba—contribute to reduced
transaction costs. This is because they offer a large variety of products, which can be
effectively searched for using the web or a mobile app.
Activity 2-4. Bitcoin Transaction Costs

How does Bitcoin influence transaction costs in the digital
economy? Which stakeholders are affected by Bitcoin’s potential
impact on transaction costs?

2.1.6. Bundling
Product or service bundling means to combine several products or services for sale as
a single package. An example is a Microsoft Office 365 package subscription. This
package contains the digital services Word, Excel, PowerPoint, OneNote, Outlook,
Publisher, and Access. Another example is cable television subscriptions, in which the
user may subscribe to various bundles of television channels. The cable television
provider may also extend the package to include audio broadcasting, streaming of
movies and music, broadband Internet access over WiFi, and VoIP.
Pure bundling is when consumers can only buy the bundled package without the
opportunity to buy the single products or services in the package. Mixed bundling
means that a consumer has the option to buy the package, as well as the single products
or services constituting the package. In general, the price of the bundle is lower than
the sum of the price of the individual services constituting the package.
Bundling is a strategy for providers to increase sales. In the digital economy,
bundling is common and particularly efficient because of the zero marginal cost
property—it doesn’t cost a provider of a digital service anything to add another service
it already owns to the package. The consumer may find this business model attractive
since an additional service in the bundle contributes to increased value for the
consumer and, hence, an increased willingness to pay for the bundle.
The digital economy has also enabled the unbundling of previously bundled goods
and services. One example is the music industry, where CDs are unbundled to single
music tracks. In online music stores such as Apple iTunes, buying a single track from
Fundamentals 49
a CD is just as easy as buying a complete album. The marginal cost of providing a

complete album or a single track is zero in both cases. Consumers demand single music
tracks since they often want to listen to only one song on the album. Even though
selected singles were available at music stores before the digitization of the music
industry, online music stores offer all tracks from an album for individual purchase at
increased convenience for the listener.
Activity 2-5. Internet Explorer

In 2002, Internet Explorer had over 90% of the web browser
market. Who were Internet Explorer’s main competitors at
that time? Explain how Internet Explorer got so large.

2.2. Production of Digital Services

There are several ways in which digital services can be developed and produced. Four
production models are examined in Sections 2.2.1–2.2.4: In-house production,
commons-based peer production (CBPP), crowdsourcing, and open source software.
These four production models are not independent—a company may apply a mix of
them when developing and producing a digital service. Within this context, note that
some digital services may be rather simple to develop, requiring only few resources.
This includes even big services like the World Wide Web, Facebook, Airbnb, and
TCP/IP. However, other digital services require the collaboration of hundreds of
people over long periods of time. An example of this includes the development of
GSM, 3G, 4G, and WiFi.
Company Digital service

Produces
Ownership
Outsources
Outsourced
company
Produces

Figure 2-4. The in-house production model.
2.2.1. In-House Production

In-house production (also termed “firm-production”) means that the company
develops the service using internal resources, possibly combined with manpower
contracted from other enterprises (outsourcing). In this case, the company is in control
of the whole development process and owns the final digital service and intellectual
property rights associated with it. This also includes the part outsourced to
independent companies. In-house production is illustrated in Figure 2-4.
In-house production is the most common approach taken by both very large
companies and small startups. The company will organize the work and set up tasks in
such a way that the final service is produced within a deadline and according to
accepted industry standards. In-house production may include the use of open source
software and perform parts of the production using crowdsourcing (section 2.2.3).
2.2.2. Commons-Based Peer Production

Commons-based peer production (CBPP) is a way of producing goods and services in
which a large number of people (collaborators) take part in the development of the
good or service.5 The group of collaborators is usually self-organized (if organized at
all) and without central leadership or coordination. A platform for gathering the
contributions from each collaborator into a final digital service must be established
before the collaboration starts. The platform is used throughout the production of the
digital service to organize and divide work between the collaborators. The contributing
collaborators are not organized by a firm, as in the in-house production model. Often,
the collaborators do not receive any financial rewards for their contribution. Figure 2-
5 illustrates the CBPP model.

CBPP platform Digital service
Collaborators

Figure 2-5. The Commons-Based Peer Production model.
Fundamentals 51
The most famous example of the CBPP model is the operating system, Linux, in which
hundreds of computer scientists contributed to the evolution of the Linux software
over many years. Wikipedia is also the result of the CBPP model; no one is coordinating
the content or the evolution of the encyclopedia. However, arbitrary readers are
checking the validity of the articles, correcting errors, adding novel material, and
writing new articles.
The Internet itself is also a result of the CBPP model. Anyone can submit
proposals for new protocols, procedures, and functionalities of the Internet in
memoranda called Requests for Comments (RFCs). The work is loosely organized by
the Internet Society (ISOC) and the Internet Engineering Task Force (IETF), which
are both organizations in which anyone—individuals as well as industries and
organizations—can be members. The acceptance and implementation of new
proposals depend entirely upon how the business opportunities and other prospects
of the new proposal are assessed by users and providers of Internet hardware, software,
and services. Some of the new products may be short-lived (for example, the real time
transport protocol XTP) while others may exist for generations (e.g., HTTP and TCP).
Activity 2-6. Ownership and Revenues of a CBPP Service

Who is the owner of a digital service that is produced using the
CBPP model? How can digital services that are produced using the
CBPP model generate revenues?

2.2.3. Crowdsourcing
In the crowdsourcing production model, organizations and individuals produce digital
services by outsourcing tasks to the public. The difference between outsourcing and
crowdsourcing is that outsourcing implies the work is contracted out to another
company on strict commercial and juridical conditions, whereas crowdsourcing implies
the work is done by arbitrary groups of individuals without formalized participation.
The result of the work may then be more arbitrary but may also lead to better, cheaper,
and more versatile solutions. The crowdsourcing production model is illustrated in
Figure 2-6.
Crowdsourcing is a form of peer production. The difference is that CBPP may
follow arbitrary development paths, sometimes resulting in a viable product, whereas
a crowdsourcing project aims at developing a predefined product. Crowdsourcing may
also employ single individuals for specific tasks. Crowdsourcing may be used in any
stage of product development, from the initial idea to development, production,
testing, and marketing. The prerequisite is that the collaboration can take place over
the Internet. A company may use crowdsourcing at all stages of production or only
parts of production, leading to a final digital service.
Contests are important methods to trigger crowdsourcing events. One example is

the ongoing CAESAR competition, in which the goal is to develop new encryption
methods.6 The contest started in 2012 and the winners will be announced in 2018.
Research groups or individual researchers propose new algorithms which are tested
against cyberattack and other weaknesses by the participants in the contest. This
process may lead to the discovery of entirely new algorithms that are picked up, refined,
and finally, marketed by one or several manufacturers. They may even become new
standards. The algorithm may be named after the inventors, but they will most likely
not receive significant economic benefits from their discovery.
Company Digital service

Produces
Ownership
Hires
Crowdsourcing Produces
Figure 2-6. The crowdsourcing production model.
In 2009, Netflix used a similar contest to improve its recommendation algorithm. The
winner received one million US dollars.7 The large premium was then the obvious
motive to participate. Microsoft used crowdsourcing to test the security of the
Windows 8 software. This included both detecting security bugs ($100,000) and
methods to correct them ($50,000).8
Crowdsourcing may also be used to fund projects—crowdfunding—and to invest
funds—crowdlending. Kickstarter (https://www.kickstarter.com/) is an example of
crowdfunding. Here, project owners publish and describe their project on the
Kickstarter website. Kickstarter users from all over the world may choose to fund the
projects they like, often with as little as $1. There may be thousands of different
supporters on a single project. The project will start if the project achieves its funding
goals. Products resulting from the project are given to the supporters, depending on
the size of the financial support. Kickstarter projects can be anything from game
developments to the creation of books, music, art, and films. Funding from the crowd
is an alternative to funding from investors or banks.
Fundamentals 53
Crowdlending means that individuals lend money directly to other individuals.

The interest rate for crowdlending is higher than for bank loans due to higher risks.
An investor targeting crowdlending will typically diversify the funds over many lenders
to reduce risks. Crowdlending is supervised by a digital platform. Individuals
borrowing money by using crowdlending are typically in need of smaller funds to
finance projects, businesses or personal activities.
Activity 2-7. Crowdsourcing

What are the main challenges of the crowdsourcing

production model? Discuss whether the crowdsourcing
production model can produce digital services of the same
quality as the in-house production model.

2.2.4. Open-Source Software

Open-source software is an initiative for the collaborative development of software.
Open-source software and its cousin, free software, are important ingredients in CBPP.
The source code of the open-source software is made available to other developers,
along with a license allowing them to use, modify, and redistribute the software. The
license is issued by the copyright holder of the software and approved by, for example,
the nonprofit organization, Open-Source Initiative. The use of the software may be
free or subject to a small fee. There are thousands of licensed open-source software
packages covering fields such as grid computing, web browsing, file systems, 3D
animation, and firewalls. Linux and Android are among the most successful open-
source projects. In fact, most of the Internet runs on open-source software.
2.3. Value Models

There are several models explaining how value is created within a company. The
classical and perhaps most influential paper concerning the strategy of industrial
companies was written by Michal Porter in 1979.9 Porter’s model is appropriate for
analyzing the industrial company’s conversion of raw material into final tangible
products sold to consumers. These companies are categorized as value chains (Section
2.3.1) because the production follows a linear chain of transformations. In 1998, Stabell
and Fjeldstad published a paper proposing two additional types of companies using
completely different ways to produce their product: value shops (Section 2.3.2) and
value networks (Section 2.3.3).10 Most companies in the digital economy are value
networks. The value network is closely related to multi-sided platforms (MSPs), as
discussed in Section 2.4. The following sections briefly review all three value models
to show the differences between them; however, with emphasis on the value network.
The value models presented in this section are supplemental to the production models
presented in Section 2.2—production models and value models describe different

aspects of the business operations of a company.
2.3.1. Value Chain

A factory can be represented as a linear chain consisting of three elements: Logistics in
(retrieval of raw material, components, or services), the production of goods, and
logistics out (delivering goods to the market). This is illustrated in Figure 2-7. In
addition, there is a need for common activities, such as management, buildings,
inventory, product storage facilities, and research. The actual chain modeling a factory
may contain more elements in a series than these three simple ones (e.g., marketing
and promotion).
Common
activities
Raw materials Logistics in Production Logistics out Final products

Figure 2-7. The value chain.
This value configuration is called a “value chain.” The chain is just a model by which
it is easier to understand the economy and strategy of the classical industrial
organization producing tangible goods. The value chain has been analyzed in depth by
Michael Porter and other economists.
The logic behind the value chain is that the cost of a single item of a good can be
computed as the sum of the cost of raw materials needed for each item (+), the cost
of producing a single item (,), and the cost of shipping the item to the market (-). This
sum is the direct cost (marginal cost) of the good. The total cost per item is then the
sum of the direct costs and the cost of the common activities (!) per item. If the total
production is % items, the common activities represent a cost of ! % per item. The
total cost per item is then:
. = + + , + - + ! %.
Fundamentals 55
The major strategy of the chain is to reduce the cost per item. From the equation, it is
obvious that this entails reducing the cost of raw materials, production, marketing and
sales, and the common cost. The marginal cost (or incremental cost) as % → ∞ is then:
'" = + + , + - > 0 .
This is the lowest achievable cost per item. Note that this is different from digital
services, in which the marginal cost can be zero ('" = 0) as explained in Section 2.1.1.
This emphasizes the difference between the industrial economy (value chain) and the
digital economy (zero marginal cost).
In the value chain, reducing the cost of raw materials can be done by bargaining
for lower prices and utilizing the raw materials better. One example is to increase the
yield when producing large semiconductor wafers; thus, making each wafer cheaper.
However, the cost of producing large silicon crystals with few defects is expensive so
that there is a balance between the optimum purity of the crystals and yield. A second
example is to develop mechanical structures requiring less material for the same
structural strength. The cooling towers of nuclear plants are shaped as such that they
require less concrete than a cylinder with the same cooling capacity—their shape just
makes the towers cheaper and has nothing to do with the physical or chemical
processes of the reactor. A third example is to replace existing raw material with new
material that is more easily available. This requires research into new materials; for
example, to produce semiconductors that are more heat-resistant, or to find materials
that can replace indium in touchscreens.
The cost of production is reduced by, for example, inventing new production
methods that are faster and more power effective, require less manpower (e.g., using
robots instead of people), or reduce waste. Maintenance and renewal of machines are
also important factors. Sometimes, better algorithms will do the trick. A German
company producing printed cards for the electronics industry developed an algorithm
for finding the shortest path (also called the “travelling salesman problem”) for the
movements of the robot drilling the holes into the card, thereby reducing the time it
took to produce a single card (and hence, reducing the price per card). Out-logistics
costs may be reduced; for example, by just-in-time production, whereby storage
requirements and the need for binding capital over a long period is reduced.
2.3.2. Value Shop

Value shops are problem-solving organizations, such as consultants, health services,
engineering companies, and architects. They earn more money the better and faster
they can solve a problem. Their most important competitive market force is their
reputation. Shops may exist within networks or chains. Some examples of this are: The
advertisement department of newspapers, the consultative sales department of
telecommunications operators, the R&D departments of the pharmaceutical industry,
the design departments of automobile manufacturers, and the pilot-training centers of

airlines. The shop may, of course, be outsourced to independent companies. For
instance, the newspaper may outsource all its advertisement activities, including small
ads. Universities and schools are also value shops, as they perform research, teaching,
and innovation. All these activities are problem-solving tasks; the researcher must find
solutions to new challenges and the educator must adapt and develop their teaching to
target a specific group of students. Reputation is the most important market force for
both activities.
The value shop is illustrated in Figure 2-8, in which it receives problems from its
customers and solves then using its internal competence and experience from previous
projects. The value shop may also draw upon external resources to solve complex
problems requiring specific expertise that the value shop does not have. After solving
the problem, a solution is presented to the customer. The value shop will then evaluate
its performance and solution and build experience. Clever solutions will also contribute
to the reputation of the value shop.
Administration
Problem
solving
Customer
problem
Customer
Evaluation Solution
solution
Figure 2-8. The value shop.
Value shops depend on customers or clients who have problems they cannot solve
themselves. There are several mechanisms allowing a value shop to solve problems
better or faster than the client himself, including:
The shop knows more about the problem than the client.
The shop possesses specialized methods to deal with the problem.
The employees are expert professionals in the relevant field.
Fundamentals 57
The shop is able to form flexible project teams and is able to reorganize quickly
to solve new problems.
Value shops compete to attract clients with problems to solve. Competition among
value shops depends not only on price but also on reputation. A lawyer with a good
reputation can take higher fees for consultations and still get more clients than lesser-
known or cheaper lawyers. If the shop’s reputation is destroyed, the company may be
out of business quickly. This happened to Arthur Andersen after the Enron scandal.11
The Company was then accused for accountant fraud and complicity in hiding large
deficits from public view.
2.3.3. Value Network

A value network is a business mediating between members of a market. The mediation
relationships in the value network can be represented as directed or undirected graphs
in which links exist between stakeholders with whom the mediation takes place. These
links form a network. The value network is an abstract network connecting people and
stakeholders. It is termed a “value network” because the network itself creates value
for the businesses controlling or operating the network. Figure 2-9 shows a general
model of a value network. Value networks consist of four components:
An organization that provides the services
Customers or users in the network
Services enabling interaction between the customers or users
Contracts that permit customers or users access to the services
Organization
Contract Contract
User User
Service
Figure 2-9. The value network.
Note that the value network is not necessarily a physical network nor a business that
owns a physical network. The network concept indicates that the value network
establishes, for example, a network of selling and buying relationships between its
customers or users. Furthermore, the value network may own a physical network, such
as a telecommunications network, but such ownership is not essential for a value

network. Note that the mediation network and the physical network may be two
different things. In the telephone network, the mediating network may be the directed
graph representing people calling one another and not the telecommunications
network itself. The telephone network just enables or supports the network of
relationships between the users of the network. The same applies to email and social
media—the telecommunications network is an enabler for the value network and these
services.
Figure 2-10 shows examples of value networks: (1) Newspapers mediating
between the readers of the newspaper and the merchants advertising merchandise and
services; (2) banks mediating between people depositing money and people loaning
money; (3) social network services mediating between friends; and (4) stockbrokers
mediating between sellers and buyers of stocks. The market behavior of some
mediation services is different from most other services. A bank has basically two types
of customers: Those depositing funds are paid by the bank for being a customer, while
those loaning funds must pay the bank for being a customer. In newspapers, the
advertisements are more expensive the more readers of the newspaper there are.
Newspaper Bank
Reader Advertiser Deposit Loaner
Social network service Stockbroker
Friend Friend Buyer Seller
Figure 2-10. Examples of value networks.
Customers or users may be people or organizations. The users may be of the same
category; for example friends, on Facebook. The users may also be of different
categories; for example, a newspaper is mediating between readers and advertisers. The
latter is an example of a multi-sided platform (see Section 2.4). Take the newspaper
Fundamentals 59
(whether electronic or on paper) as an example of a network mediating between

different customer groups. The basic business idea behind newspapers is that the more
people who are reading the newspaper, the more attractive that newspaper is to
advertisers. In other words, the product that the newspaper is selling to advertisers is
potentially more customers who will buy their goods. Therefore, the major competitive
battle among newspapers is concerned with the number of readers they can capture.
The same applies to commercial television and social network services, such as
Facebook and Twitter. Their revenue from advertisements is directly related to the
number of people using their services. This configuration leads to strategies in which
the price per copy of the newspaper is lower or similar to that of its competitors
(normal competitive market behavior), while an advertisement is more expensive when
more people are reading the newspaper (nonstandard competitive behavior).
Therefore, newspapers are so preoccupied with the number of copies they circulate.
The same logic applies for commercial television companies and social network
services. For instance, commercial television companies are concerned about the
number of viewers because this figure determines how attractive the channel is for
advertisers and, hence, the fee they may charge for each advertisement.
The competitive strength of value networks depends not only on the quality of
the product they deliver but also on the number of customers or users they have been
able to capture. These are the network effects discussed in Section 2.5. The awareness
and popularity of a product is sometimes related to the diffusion of information of the
product via channels other than advertisement, such as word-of-mouth. The “like”
button on Facebook and other social media is another mechanism for increasing the
recognition of a product.
Many of the largest companies base their businesses on the value network.
Examples of value network companies among the top five companies in the world
according to market cap include: Facebook, Amazon, and Google. One of the reasons
why value networks tend to get big is because of network effects.
Networks often produce goods that are not stored but consumed immediately.
For instance, it is not possible to store the following for later use: Empty seats in
aircraft or trains, surplus energy, unused bits in the Internet, or empty space in the
cargo hold of a truck.
Value networks may offer mutual benefits to its members. This is the idea behind
clubs of different kinds (e.g., literary, musical, bonus programs, sports)—the more
members, the bigger the benefit. The insurance company can offer better security at a
lower price if many people are using the same insurance company. One reason why
they may lower the price is that the more customers of the same type they have, the
smaller the uncertainty (the variance) of the stochastic product they are selling (the law
of large numbers).
The cost of one item of a service in a value network can be expressed as follows:
!
.=++
%
Here, + is the direct cost (marginal cost) per item, ! is the common costs associated
with a product, and % is the number of items produced. How to measure or compute
these three variables is discussed next.
Direct cost (2). In many cases, the direct cost per item is zero (i.e., zero marginal
cost), as discussed in Section 2.1.1. The cost of producing and sending one more bit in
the telecommunications network is negligible. The cost of one additional passenger on
an airplane is negligible. The cost of producing and delivering one copy of an electronic
book is negligible. The cost of adding a new user to social media, such as Twitter or
Facebook, is also negligible. On the other hand, the marginal cost of a physical book
is considerable, including: Paper cost, printing cost, storage cost, and shipment cost.
In this case, the printing of the book is done in a value chain, and the cost is as
described in Section 2.3.1.
Common costs (3). Since the direct costs are often negligible, the dominant costs
of the value network are the common (fixed) costs. These costs are the total cost of
running the company, producing the services, and marketing them. This is contrary to
value chains, in which the direct cost often is the dominant cost. This also indicates
that the strategy of value networks and value chains are different.
Number of items (4). How many items are produced and what is the price per
item? For an airliner, this may be the average number of passengers per flight. In a
communication network, it may be the number of subscriptions. It may also be the
average traffic carried by the network (e.g., in terms of the average number of bits sent
per unit of time or the average relative traffic load). Therefore, the number of items
may not be a unique concept in network businesses. To make it even more
complicated, the business may serve a multi-sided market, in which it is difficult to
define what a produced item is. Nevertheless, the formula shows that if the direct costs
are very small, such as for many digital goods and services, and the fixed costs can be
divided on many items, then the marginal cost is also negligible.
Activity 2-8. Chains, Shops, or Networks

Are the following businesses primarily a value chain, value shop, or a value network?
(1) Johns Hopkins Hospital
(2) AXA
(3) Harvard University
(4) BMW
(5) Apple iPhone
(6) Twitter
Fundamentals 61
Activity 2-9. Revenues in Value Networks

With reference to Figure 2-10, which of the user group(s), if any,
contribute to the revenues for:
(1) The newspaper
(2) The bank
(3) The social network service
(4) The stockbroker

2.4. Multi-Sided Platforms

In a multi-sided platform (MSP), two or more distinct user groups interact to produce
mutual benefits for each other.12 In many practical cases, there are just two groups; in
which case, the multi-sided platform becomes a two-sided platform. There is no
essential difference between two-sided and multi-sided platforms. This chapter will
therefore discuss two-sided platforms, keeping in mind that the theory is valid also for
multi-sided platforms. The MSP is one of the most profitable innovations of the digital
economy. Some of the largest companies in the digital economy base their business
models on an MSP, including: Google, Facebook, and eBay. Some MSPs have even
become the market leader in their industry, often without owning any physical assets.
There is tremendous value in connecting different user groups. Still, there are huge
potentials for an expansion of MSPs in many businesses and industry sectors, as well
as public domains.
Definition 2-5. Multi-Sided Platform

A multi-sided platform (MSP) enables direct interactions between two or more
distinct user groups, in which all user groups are affiliated with the MSP.
The MSP is related to the concept of value networks described in Section 2.3.3, since
the value network is an organization or company offering mediation services within a
single group or between different groups; in which case, the value network is equivalent
to an MSP. Section 2.3.3 explained the strategy of value networks in general. In this
section, the attention is on the mediation activity itself and the techno-economic
platform supporting it. It is assumed that the mediation between the user groups is
asymmetric—the platform is serving two or more user groups with different motives
to join the service. Table 2-2 shows examples of MSPs.
There are two main types of MSPs: Digital MSPs and tangible MSPs. Digital
MSPs mediate the exchange of digital goods and services, while tangible MSPs mediate
the exchange of physical goods and non-digital services. Facebook and MasterCard are
examples of digital MSPs, whereas Uber and Airbnb are examples of tangible MSPs.
Tangible MSPs have also been termed “Online-to-Offline (O2O)” MSPs.13
Table 2-2. Examples of MSPs

MSP Type of business User groups
New York Times Newspaper Readers and advertisers
eBay Electronic market place Sellers and buyers
Facebook Social networking service Users and advertisers
Uber Sharing service Drivers and passengers
Airbnb Sharing service Hosts and guests
MasterCard Point-of-sale transactions Merchants and cardholders

Network effects (see Section 2.5) play an essential role in MSPs, as illustrated in Figure
2-11. Here, there are two distinct user groups (two-sided platform). The platform
mediates between these two user groups, as well as between users within each user
group. If the network effect involves only one side, it is called a “same-side network
effect.” If it has an impact on both sides, it is called a “cross-side network effect.”
Positive, negative, direct, and indirect network effects may be present within user
groups and between user groups (see Section 2.5). The dynamics of an MSP may be
complex, since there are dependencies and network effects within user groups and
between user groups.
Multi-sided
User group platform (MSP) User group
Same-side Cross-side Same-side

network effects network effects network effects

Figure 2-11. Network effects in a two-sided platform.
Fundamentals 63
One important requirement for being an MSP is that the platform enables a direct
contact between the user groups attached to it. An electronic market place, such as
eBay, is different from a supermarket in this respect. The supermarket is not an MSP,
since there is no direct contact between the shopper and the supplier. The supermarket
is a reseller (see Figure 2-13). eBay may sell the same goods as the supermarket, but it
is an MSP since there is direct contact between supplier and buyer. For similar reasons,
a taxi company is not an MSP, while Uber is. In some cases, the platform may consist
of a single app processed jointly on a smartphone. The MSPs may be companies
ranging in size from one-person enterprises to large companies. Most sharing
economies are two-sided or multi-sided platforms. There is also a requirement for an
MSP that all user groups must be affiliated with the platform. This means that the user
groups make investments in terms of attention to enable interactions with the other
user groups in the MSP.
Figure 2-12 illustrates a trade process for an MSP. The MSP mediates contact
between the seller and the buyer. Observe the similarities between the MSP and the
value network, as illustrated in Figure 2-9. The trade—including the flow of goods,
services, and payment—is done directly between the seller and the buyer and facilitated
by the MSP. The MSP is not directly involved in the exchange of goods.
Multi sided
platform (MSP)
Seller Buyer

Figure 2-12. Trade process of multi-sided platforms.
The MSP is one of several ways to organize a company. Another common type of
organization is the reseller illustrated in Figure 2-13. The reseller purchases goods and
services from a producer and resells these goods and services to the buyer. The buyer
receives the goods and services from the reseller, who, in turn receives payment from
the buyer.
An example of a reseller is Amazon: Amazon buys books from publishers and

resells them to readers in the same way as any other bookstore. Resellers of
telecommunications services are another example of resellers—they purchase bulk
traffic capacity from a network operator and resell it in subscription packages to the
customers. The reseller is not an MSP since there is no direct contact between the
customer and the producer, which is one of the prerequisites for being an MSP.
In the electronic market place consisting of sellers and buyers (e.g., eBay), the
sellers prefer many buyers and the buyers prefer many sellers. Therefore, this platform
has positive cross-side network effects. On the other hand, the existence of many
sellers means increased competition among sellers—a negative same-side network
effect. There is generally no strong same-side network effect concerning buyers,
however, weak network effects may be present as user reviews and feedback. It is a
common feature of MSPs that some user groups subsidizes the other user groups by
levying differentiated charges among the user groups. Sometimes, the MSP gets all its
revenues from only one user group only while providing services for free to other user
groups.
Producer Reseller Buyer
Figure 2-13. The reseller.
An MSP often benefits from a reduced price of the goods or services mediated between
the sellers and the buyers. This is because low prices mean more sales and, potentially,
more buyers of the goods, which may increase the usage of the platform and, in turn,
add value to the platform in terms of increased cross-side network effects. In this
respect, MSPs have incentives to reduce prices in the business areas in which they
operate.
2.5. Network Effects and Positive Feedback

The network effect (also called a “network externality” or “demand-side economies of
scale”) is the effect that the number of users or amount of usage of a service has on
the value of that service as perceived individually by each user. In other words, the
network effect is the value a new user adds to existing users in a network. A related
term is supply-side economies of scale, which is the effect the number of users or units
Fundamentals 65
produced has on the costs of production. Supply-side economies of scale is different

from network effects—the former describes the cost advantages of being large, while
the latter describes the value of having many users. This section considers the demand-
side economies of scale—the network effect.15
2.5.1. Positive and Negative Network Effects

Network effects may be visualized using undirected networks illustrated in Figure 2-
14. Network A has three nodes and three links, Network B has seven nodes and eleven
links, and Network C has eleven nodes and 21 links. The nodes may be individual
consumers or users using a specific digital service and the links may the interaction
between the users, e.g., common interests, communication, or trading. Not every node
pair needs to be connected in these networks. Networks may be small—as those
depicted in Figure 2-14—or large—such as Facebook, with more than two billion users
(nodes). The number of links is a measure of the value of a network and is the essential
mechanism creating network effects.
Network A Network B Network C

Figure 2-14. Undirected networks.
Definition 2-6. Network Effects

The network effect is the effect that the number of users or usage of a service has
on the value of that service as perceived individually by each user.
If the perceived value of a network increases as the number of users increases, the
network effect is positive. If the perceived value decreases as the number of users
increases, the network effect is negative. Similarly, if the perceived value increases as
the number of users decreases, the network effect is also negative. The network effect,
whether positive or negative, is positive feedback from the market. A positive feedback
is such that if there is a deviation in the output in one or the other direction, the
feedback will make this deviation larger. In other words, the feedback is positive if
more of A (input) produces more of B (output) and more of B produces more of A,

and so on.
New users join

service
Positive network effects
Increased value
of service
Figure 2-15. Positive feedback.
Figure 2-15 illustrates how positive feedback stimulates positive network effects: new
users adopting the digital service stimulate other users to adopt the service, resulting in
a positive network effect that further stimulates the growth of the service. The final
state of most of these markets is that every user has adopted the service or bought the
good—the market ends up being saturated and cannot increase anymore.
Positive feedback means that the strong gets stronger and the weak gets weaker.
Markets dominated by strong network effects and positive feedback tend to produce
winner-take-all markets, where a de-facto monopoly is the remaining supplier of goods
and services after all competitors have been squeezed out of the market the market.
Positive feedback may govern the evolution of a single technology, the evolution of a
digital service, and the competition between technologies or companies providing
digital services. Negative feedback, on the other hand, reduces the deviation and
tends to bring the output toward a stable equilibrium and keep it there. This is one of
the basic assumptions in traditional microeconomic theory. The digital economy clearly
indicates that this model does not apply for most markets of digital goods and services.
The network effect is measured by the amount of interaction or number of links
in the network. This is proportional to the amount of usage in the network, which in
turn is proportional to the time or amount of attention invested in the network by the
users. Remember that attention is a scarce resource, which is in much demand by the
providers since user attention means opportunities for the providers to sell goods and
services and thereby generate revenues.
The strength of the network effect is thus a direct measure of the number of
links that each new user adds to the network. This is shown in Figure 2-16, in which a
new user (node) joining the network connects to three existing users, thereby adding
Fundamentals 67
three new links to the network. It is not uncommon that a new user connects to all
other users in the network.
If a new user connects to exactly one other user in the network, there are no
network effects. This is equal to the Sarnoff type of network in Section 5.1.1. Value
networks in general and many digital services have strong network effects. Examples
of digital services with strong network effects include: Facebook, Twitter, YouTube,
Uber, Airbnb, Skype, MMOGs (e.g., World of Warcraft), and smartphone app
ecosystems. Section 5.1 discusses and quantifies the strength of network effects.
New links
New node

Figure 2-16. Adding a new node and links to a network.
Links between users may have different strengths depending on the importance of
the relationship and volume of interaction between the users. Users may also have
different importance in the network depending on how connected they are. Central
users are users with a high number of links, while marginal users are users with a low
number of links.
A network may also be clustered, meaning that there exist clusters of networks
within the network. One example of this is social media, where individuals residing
within a country are more connected with each other than with individuals outside
their country. Furthermore, within the same country, people are more connected with
each other within the same town or city. Clusters may also appear in among families,
friends and other socioeconomic groups, such as workplaces and people that have
similar interest. This leads to networks of networks with potentially many layers of
clusters.
Networks have been modeled using undirected networks, however, the interaction
between two users may be asymmetric—a user sends more information to another
user than he receives in return. Asymmetric users are widespread in digital services like
YouTube and Twitter, where a relatively few users are generating content that the rest
of the network.
Activity 2-10. Network Effects I: Value

Assume that Network A in Figure 2-14 grows to Network B and
finally to Network C. Apply the definition of network effects to
calculate the value per user as this network evolves. Assume
that each link has a value equal to 1.

It is important not to confuse the terms “positive or negative network effects” and
“positive or negative feedback.” Positive and negative network effects are both driven
by positive feedback from the market. Negative feedback from the market results in
equilibrium markets. The positive network effect will drive the market into saturation,
such as, for example, the mobile market; that is, sooner or later, everyone owns the
service or good. The negative network effect will initiate a vicious spiral, in which
customers are leaving the market and the company selling it may face bankruptcy.
Imitator Which social networking Innovator

service should I choose?
Social network A Social network B

Figure 2-17. Network effects in social network services.
Figure 2-17 shows two competing social networking services (A and B). The figure
introduces the terminology of Frank Bass—”imitators” and “innovators” (see Section
5.2). The buying habit of imitators is that they listen to advice from others (i.e., word-
of-mouth) and are therefore likely to buy the version of the product owned by most
other people. The imitator in the figure therefore chooses social network service A.
The innovator does not listen to advice and buys the product of their liking. The
imitators then represent a network effect, in which the value of the product as
perceived by the imitators increases as more people use the service. The buying habits
of innovators are not ruled by network effects.
Fundamentals 69
Note that the “network” is not referring to physical networks but to relational
networks between users; for example, between players of the same online game, people
and organizations exchanging emails, family groups, or friends on Facebook. The term
“network” in network effect must not, in general, be confused with underlying
networks, such as the Internet and the telephone network. The underlying network is,
however, a prerequisite for the existence of the social network. However, sometimes,
the network effect may refer to the popularity or ill repute of the physical network.
Latency time Latency time

innovators imitators
Imitators
Innovators
Market size
Critical mass
Time

Figure 2-18. Market evolution if all customers are imitators or innovators.
Figure 2-18 illustrates one of the strategic dilemmas associated with strong network
effects. The figure shows two curves, in which the S-shaped curve is the evolution of
a market with only imitators, and the second curve shows the evolution if there are
only innovators. As indicated above, the imitators inflict strong network effects on
market evolution, while no such effects are present in the case of only innovators.
Observe that the initial market growth is extremely slow if all customers are imitators.
It may take several years before the market has reached a critical mass in which the
market penetration is commercially sustainable (represented by the dotted line). This
is the latency time associated with the market. Moreover, if there are no initial
customers at all, the market never starts to increase. The long latency time is the most
difficult strategic dilemma in markets with strong network effects—the supplier may
abandon the product because of the slow initial growth. On the other hand, the market
with only innovators grows rapidly initially and has a short latency time.
After a digital service or good with strong network effects reaches its critical mass,
it usually undergoes a period of rapid growth until the market approaches saturation.
The strategic dilemma is how to reach critical mass in a brief period. If this takes too
long time, there is a certain possibility that the service will be prematurely terminated.
Figure 2-19 shows the number of active monthly users on Facebook for the period
from 2004 to 2015. Observe that critical mass was reached in 2008, after four years of
slow growth. Thereafter, Facebook grew rapidly. Other social network services, such
as Twitter, have undergone a similar evolution.
1800
1600
1400
1200
Million users
1000
800
600
400
200
0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Year
Figure 2-19. Facebook users in the period from 2004 to 2015.
Negative network effects may comprise: Negative reviews and low ratings, inferior
experience expressed by friends, few active users, users leaving the product, or a bad
reputation. Things that may amplify negative networks effects are: Insufficient
advertisements (invisibility), poor user experience, technical issues (such as complex
login), freeze-out, congestion, long response times, disturbing differential delays,
interruptions, and frequent downtimes.
The network effect may be time-dependent and may even change from positive
to negative as the number of users of the game or service increases. An example is an
interactive video game in which the gaming experiences of the early game attracts more
players. When the number of players increases, the game may become overcrowded,
causing players to leave the game, thereby shifting the network effect from positive to
negative.
There is a distinction between network effects and network externalities in the
sense that a network effect is a network externality that has been internalized. That is,
someone (typically either the consumer or the provider) can harvest the value from the
network externality. Hence, a network externality where no one can harvest the value
is not a network effect. In most digital services the provider of the service can harvest
the vale from network effects.
Fundamentals 71

2.5.2. Direct and Indirect Network Effects
Network effects may be direct or indirect: direct network effects take place when
users induce value on other users by the means of direct interaction between the users;
indirect network effects take place when the aggregated behavior of the users induces
value on other users. For example, in the case of positive direct network effects, users
benefit from other users in the network because they have more options for direct
interaction. In the case of positive indirect network effects, users benefit from other
users because they, collectively, provide value that is somehow appreciated by all users
in the network without any direct interaction between the users taking place. Examples
of direct network effects are: Interactions on social media, telephone subscribers, and
buyers and sellers in multi-sided markets. Examples of indirect network effects are:
Improvements of service quality due to user feedback, user product reviews, and
bandwagon effects.
2.5.3. Same-Side and Cross-Side Network Effects

In a network there may be same-side or cross-side network effects. Same-side
network effects imply that an increased number of users leads to an increase in value
for other users in the same user group. Examples are telephones, social networks, and
multiplayer online games. These networks are made up from direct or indirect contact
among the users of the service.
Cross-side network effects imply that an increase in the number of users in one
user group enhances value in other user groups. These network effects arise only in
multi-sided markets (see Section 2.4). One example is computers and software—
without software, there is no value in the computer, and without computers, there is
nowhere to run the software. A little less obvious example is smartphones and apps,
in which the availability of apps increases the value of the smartphone beyond that of
speech and message communications. A final example is third-party content or service
providers in social media. The availability of, for instance, games on Facebook
increases the value for Facebook users as well as the value for the providers of these
games. In this case, there are positive cross-side network effects. Same-side and cross-
side network effects are illustrated in Figure 2-11 for multi-sided markets.
Note that both same-side and cross-side network effects may be direct or indirect
and positive or negative. Hence, theoretically, there exist eight different types of
network effects—any combination of positive/negative, direct/indirect, and same-
side/cross-side network effects.
Analysis of network effects associated with digital services includes identification
of all positive, negative, direct, indirect, same-side, and cross-side network effects, and
the estimation of the strength of these effects. A suitable tool for performing such
analysis is the Stakeholder Relationship Model (SRM) presented in Section 4.4. The
strength of network effects may be quantified using, for example, Metcalfe’s law (see
Section 5.1.2).
Network effects range from concrete and easily identifiable to vague and less
obvious. Easily identifiable network effects are those where physical objects or users
interact directly with each other. Examples include: Telephone networks, computer
networks, social media, and multiplayer online gaming. These networks usually exhibit
strong direct network effects, meaning that the network of users is highly connected.
On the other end of the scale are vague and less obvious network effects. These
include bandwagon effects and tech performance network effects. Bandwagon
effects include the social pressure to join a service or buy a good because everyone
else is using it. Tech performance network effects include the effect that an increased
number of users has on the performance of a technology or service. Tech performance
network effects are in general easier to identify and measure compared to bandwagon
network effects. An example of tech performance network effects is peer-to-peer file
sharing services, such as BitTorrent. New users joining the BitTorrent network result
in, on average, reduced download times and potentially an increased amount of
available content for other users using the service. Bandwagon and tech performance
network effects are usually indirect.16
Another type of network effects is data network effects, in which data collected
about users or user behavior is used to improve digital services. Google search is an
example of data network effects, since each search query contributes to refining the
Google search algorithm. Another example is recommendation systems based on input
or feedback from users (see BOX 1-2).
Activity 2-11. Network Effects II: World of Warcraft

The MMOG, World of Warcraft (WoW), grew significantly from its inception in 2004
until 2011 (see figure below). After that, the number of users started to decline. How
can network effects and positive feedback explain the “rise and fall” of WoW? What
types of network effects are in present in WoW?

World of Warcraft subscription statistics. Source: Shawn Knight. “World of Warcraft” looses another 1.5
million subscribers ahead of new expansion. Techspot. 05.08.2015.

Fundamentals 73
Activity 2-12. Network Effects III: Three-Sided Markets

Postmates (postmates.com) is a logistics company mediating
between companies having goods to deliver, couriers for
delivering goods, and customers. Illustrate Postmates as an MSP
and its associated user groups. Identify same-side and cross-side
network effects within and between user groups. Which of the
user groups contribute to Postmates' revenues?

Activity 2-13. Network Effects IV: Snapchat

Snapchat is a social media service available for smartphones.
Identify network effects in Snapchat (positive, negative, direct,
indirect, cross-side, and same-side network effects). How are
network effects in Snapchat different from network effects in
Facebook? Are Facebook and Snapchat one-sided or multi-sided
platforms?

2.6. Path Dependence

The assumption of conventional economic theory is that the markets are controlled by
negative feedbacks that counteracts any deviation from market equilibrium. These
markets are in fine-tuned dynamic equilibrium, in which no change takes place in the
composition of the market. The traditional view is that the market is governed by the
balance between supply and demand. In this simple market theory, an evolving market
(for example, the mobile phone market) will end up in a single equilibrium state,
regardless of initial conditions and events taking place as the market evolves. There is
no room for multiple final states in this theory—any deviations from the market
equilibrium will quickly be counteracted by negative feedback such that the market
returns to equilibrium state.
In 1990, Brian Arthur wrote an article in Scientific American in which he claimed
that many dynamic markets will not settle in a predetermined equilibrium state as
predicted by conventional economic theory.17 The evolution of markets may be
governed by external random forces or positive feedback from the market itself. These
forces will determine where the market ends up. There may no longer be a single
equilibrium point but several, in which each is determined by the onset of random
forces. The random forces induce a path dependency on the subsequent evolution—
the evolution will be different if the action takes place at different times and the
strength of the forces is different.18,19 The evolution is irreversible, meaning that it is
impossible to undo past actions. This is because the market is locked-in because of
high switching costs (see Section 2.7). The market does not return to a single
equilibrium state since there are many equilibrium states. Which equilibrium state the
market eventually ends up in depends on random factors, actions taken by
stakeholders, and the timing of these random factors and actions.20
Service E
Service D
Service C
Service B
Service A
T1 T2 T3 T4 T5 T6 T7 T8 T9 T10
Time
Range of services with
the potential to
dominate the market
Figure 2-20. Path dependence.
Figure 2-20 illustrates the concept of path dependence. Five services (A–E) compete
to attract consumers. The size of the circles corresponds to the number of consumers
each service has attracted at a given time (from 56 to 567 ). The grey area illustrates the
range of services that is perceived to have sufficient market share to dominate the
market in the future. For example, at time 58 , all services are perceived to have
sufficient market power to possibly dominate the market in the future. In the beginning
(56 ), only three services are available in the market: Services C, D, and E. These services
share the market between them. Services A and B join the market at time 59 and gain
consumers at a fast rate. Due the external events (positive feedback events) or actions
taken by the stakeholders (owners of the services), starting from time 5: , users leave
services A, C, D, and E to join service B. Eventually, Service B gets a lead and strong
network effects, combined with positive feedback, locks Service B into a path of
becoming a de-facto monopoly. From time 5; , Service B is the only service with
sufficient size to dominate the market—strong network effects make it impossible for
the other competitors to challenge Service B’s dominant position. It is the events that
lead to such an evolution that locks the market into a specific path. These events are,
in many cases, irreversible.
Fundamentals 75
If there are strong network effects, the competitor who gains the fewest early
adopters may soon cease to exist. This is a strong case of path dependence, in which
one provider of a digital service may capture the whole market already in the initial
phase. The market leader is locked into the path of becoming a de-facto monopoly,
while its competitors are locked into a path leading to bankruptcy. This happens
particularly if there are strong network effects caused by positive feedback from the
market. The product of the market leader will gain increased value for just being the
most recognized product and its market share will continue to increase until the market
saturates or until it is replaced by a new technology. Digital economy seems to be
particularly exposed to path dependence, since strong network effects predominate
this type of economy.
Facebook versus Myspace is a recent example of path dependence, since either of
them could have ended up as the market leader. However, early events triggered
Facebook to take the lead and suppress the future growth of Myspace. Myspace was
inaugurated on August 1, 2003, while Facebook was used for the first time on February
4, 2004. The early versions of Myspace and Facebook were rather similar from a user’s
point of view. Myspace had a market lead on Facebook until 2008, most likely caused
by being first to the market. There is no evident reason why Facebook should have
taken the lead in 2008. One possible explanation is that Myspace was a less-flexible
service, built most of the Myspace content in-house, and focused on music and
entertainment. On the other hand, Facebook had a more open and flexible platform
that allowed third-party providers to create content, and focused on the networking
experience.
Positive feedback event: Users

leaving service A to join service B
Service B
Market share
Service A
Time

Figure 2-21. Path dependent evolution with one positive feedback event.
BOX 2-3. Videotape Format War

VHS and Betamax were two competing standards for video cassette recorders (VCR)
in the late 1970s and early 1980s. They were incompatible standards since cassettes
designed to the VHS standard did not work with Betamax, and vice versa. After
intense competition, it became clear in the early 1980s that VHS won the videotape
format war and eventually captured 100% of the market.
Betamax was developed by SONY and

released on the market for consumers in
May 1975 in Japan and on the US market the
following November. VHS was developed by
Matsushita (now Panasonic) and released in
1976 in Japan and 1977 in the US. VCRs,

which enabled the home video market,
quickly became popular among consumers. Video Cassette Recorder. Source: Public domain.

Betamax had the first mover advantage and thus, the market lead for about one year.
Starting from 1977, it was full competition between Betamax and VHS. Standard
economic theory predicts that both standards would prevail and share the market.
However, VHS and Betamax were operating in a winner-take-all market, primarily
due to strong network effects and positive feedback.

The VHS cassette could record longer TV
shows compared to the Betamax cassette
due to its larger size (see picture). Of
particular importance was the fact that VHS
could record a complete football match (up
to three hours) on a single cassette. This,
combined with lower prices, shifted the
market share leadership from Betamax to
VHS in the late 1970s. As a secondary effect,
the number of VHS recorders on display in
retailer shops gradually increased, resulting
in a bandwagon effect in favor of VHS.
Size comparison between a Betamax cassette
(top) and a VHS cassette (bottom). Source:
Public domain.

This led producers of movies and other content to favor VHS. In the beginning,
content producers made their titles available on both Betamax and VHS; however,
when VHS took the market lead, they gradually stopped producing content for
Betamax, which further strengthened the position of VHS. Finally, VHS was locked
into the path to dominance in the VCR market.

Fundamentals 77
BOX 2-4. The QWERTY Keyboard

Most of the keyboards in use today follow the
QWERTY layout. This layout was popularized in
the late 1800s, when the typewriter was
commercialized. The specific QWERTY layout
was selected to make the typewriters work as
smoothly as possible, and to avoid jamming of
the metal bars in the machine when two
letters were typed in fast succession. Enforcing
a standard, such as the QWERTY layout for
keyboards, is beneficial—if not necessary—for
both keyboard users and keyboard providers. The original QWERTY layout (By C.L. Sholes -
U.S. Patent No. 207,559, Public Domain). Note
However, since the QWERTY layout became that the “0” and “1” is intentionally missing to
dominant, it was very hard for competing simplify design. The “0” can be reproduced as
layouts to enter the market. The switching a “O,” while a “1” can be reproduced as an “l”
or an “I.”
costs built up as more and more users adopted
and were trained for the QWERTY layout.

The competing DVORAK layout (depicted below) was patented in 1936 by Dr. August
Dvorak. It is, by many, believed to be superior to the QWERTY layout, in terms of
typing speed. However, when it was launched, it failed to get any market foothold
due to high switching costs and lock-in. As long as the QWERTY layout had a
dominating position in the market, it was very hard to convince both users to learn
and manufacturers to produce keyboards with the DVORAK layout. Today, almost all
PCs, laptops, and smartphones use the QWERTY layout.

The original DVORAK keyboard layout. Source: Public domain.

The almost-standardized QWERTY keyboard layout is an example of path
dependence. The early decision to adopt the QWERTY layout, which was perfectly
logical at that time, locked keyboard designs into a path of dependence which would
be extremely hard, if not impossible, to leave. Adopting the DVORAK keyboard layout
may have benefitted the society at large (note that this notion is contested by e.g.,
S. J. Liebowitz and S. E. Margoliz [1990]); however, the switching costs are currently
too big for this to happen.

Another example of path dependence is VHS versus Betamax (see BOX 2-3). The
evolution of VHS versus Betamax and Facebook versus Myspace is that the market
ends up in a state where there is only one supplier. This type of market is called the
“winner-take-all market,” leading to de-facto monopolies. The formation of
monopolies in the digital economy is studied in Section 2.8.
The general evolution of a market shared by two services is shown in Figure 2-21.
Initially, Service A has a small lead in market size compared to Service B. At some
point in time, an external event boosts the popularity of Service B (positive feedback
event). This event may be caused by a successful advertisement campaign for Service
B, word-of-mouth in which people start sharing positive experiences on Service B, or
new features added to Service B. It is very hard to predict what triggers a positive
feedback event. However, the event gives Service B a boost in market size, and as this
market size increases further, network effects trigger the users of Service A to switch
to service B. Eventually, Service B will capture the whole market.
Positive feedback event 1: Positive feedback event 2:

Users leaving service B to Users leaving service A to
join service A join service B
Service B
Market share
Service A
Time
Figure 2-22. Path dependent evolution with two positive feedback events
Note that there may be several events altering the market, as shown in Figure 2-22. In
this example, a positive feedback event boosts the popularity of Service A (positive
feedback event 1). The increased number of customers overloads the capacity of
Service A, resulting in a negative network effect eventually reducing the number of
users of Service A (positive feedback event 2). Service B may first lose users to service
A, but later receive users from Service A when the popularity of Service A declines.
Fundamentals 79
The popularity of Service B may also be boosted by positive feedback events; for
example, after having introduced new features. This happened in the competition
between Netflix and Popcorn Time. Because of frequent overload, Netflix lost users
to Popcorn Time and did not regain its market leading role until Popcorn Time was
taken down in 2014.21 Section 5.2 describes the dynamic evolution of markets in
which the dynamics are governed by positive feedback. Markets for mobile
communication, Internet access, social media, and information services behave like
this.
Activity 2-14. Cryptocurrencies and Path Dependence

As of 2018, there are currently over 3,500 various
cryptocurrencies. Describe path dependent behavior in the
market for cryptocurrencies by searching the web for relevant
news articles.

2.7. Lock-In and Switching Costs

Lock-in encompasses all mechanisms that a company may use to keep its consumers.
Acquiring new consumers is expensive since it often requires intensive marketing and
expensive price campaigns. Churn is defined as when a consumer leaves a service
offered by a company to go to a competing service. Companies want to reduce
churning as much as possible by exploiting various lock-in mechanisms, for example,
by making it expensive for users to switch to other suppliers leading to high switching
costs.
One of the most important aspects of market regulation is to reduce the lock-in
capabilities of the companies to enhance competition. Examples of such regulations
include: Forbidding binding time for subscriptions, prohibiting loss of advantages (e.g.,
in insurance), and obliging number portability in telecommunications. The level of
lock-in for a digital service significantly influences the evolution of market share,
competition, and formation of monopolies. High switching costs lead to strong lock-
in, which may, in turn, lead to a winner-take-all market.
2.7.1. Switching Costs

Switching costs are the direct and indirect costs for a company to capture consumers
from a competitor and for consumers to switch to a new supplier of a digital service.
The total switching cost is the sum of the cost for the supplier and the cost for the
consumer. To capture new consumers, the suppliers must make the switching cost for
potentially new consumers as small as possible. On the other hand, the supplier must
make the switching cost as high as possible for its own consumers to avoid them
switching to a competitor.
In the mobile phone market, it is common to sell new mobile phones for a low
price. This reduces the switching costs for the consumer but increases them for the
supplier. Since the mobile market in many countries is an oligopoly, the suppliers are
forced to play a prisoner’s dilemma game, in which all suppliers are forced to use the
same price strategy to avoid switching.
The switching cost for the consumer is composed of several elements, such as
fees for terminating a subscription (now mostly non-existent because of market
regulation), lost advantages (e.g., conditional savings and discounts), additional work
(e.g., installation and training of staff), possible loss of information (incompatible
formats), hidden costs (e.g., additional equipment or functionality not included in the
offer), inconvenience (e.g., updating cooperating systems, updating customers, and/or
updating address lists), and surprises (e.g., the offer is not as good as promised). Some
of the switching costs are direct costs (e.g., exit fees, training, and/or additional
equipment) and some are psychological, emotional, or social (the pain of losing an
advantage is stronger than the pleasure of gaining the same advantage). The switching
costs for the supplier may be introductory price offers (e.g., first month free of charge),
discounts on equipment (e.g., mobile phone for a very low price), training assistance
(e.g., free training course for key employees), and/or free additional features (e.g.,
antivirus protection, and/or backup storage).
Definition 2-7. Switching Costs

Switching costs are the costs for a company to capture consumers from a competitor
and for consumers to switch to a new supplier of a digital service.

2.7.2. Lock-In Mechanisms

A company may employ different strategies to lock in its users. Here are some of the
main strategies employed:
Spare parts and maintenance. In systems in which availability and
dependability are critically important (e.g., power distribution,
telecommunication, airlines, and large computer systems), it must be easy to
obtain spare parts to keep the system up and running. The company may have
a separate store of spare parts and skilled maintenance personnel or they may
have a contract with the equipment manufacturer to supply spare parts and
repair at short notice. All this costs money. This leads to lock-in for the system
owner because switching to a new supplier while the existing system is still in
operation means a double set of spare parts (and related maintenance
contracts).
Incompatibility and compatibility. One important aspect of
standardization is to build in backward compatibility. This means that a new
Fundamentals 81
version of equipment or software can operate smoothly together with earlier

versions. In many protocols (e.g., IP), the first information element in the
format is the version number, allowing the computer to switch to the
appropriate software for reading remaining parameters (e.g., IPv4 or IPv6).
Backward compatibility is important to avoid undesirable lock-in. Examples
of backward compatibility are: Microsoft products (e.g., Windows, Word,
PowerPoint, and Excel) and mobile phones. The backward compatibility of
Microsoft products is beneficial for users of computer systems because it
guarantees that documents which were written several years ago can still be
read and modified. The motive is obviously to make the Microsoft products
more attractive, and to increase the lock-in of Microsoft users. The backward
compatibility of mobile phones is beneficial both for network operators and
users—network operators may smoothly build out the network with new
technology and the user must not buy new phones to continue using the
network. Some backward compatibility in mobile systems is built into the
specifications (e.g., compatibility of GSM, 3G, and 4G). Some backward
compatibility is implemented by the manufacturers so that the same phone
can be used in networks using different network technology (e.g., 3G and
American CDMA standards), hence, making the market pie bigger. Other
examples of backward compatibility are: Game consoles, the adaptation of
mobile phone networks to fixed network technologies, and radios (DAB
radios can receive both digital signals and analog FM signals).
Training. The situation is much the same as for spare parts. A new system—
for example, a new type of aircraft—may require extensive training of staff for
operations and maintenance. The same applies for a change of computer
platforms from, for example, Microsoft to Mac, in which lock-in mechanisms
favor Microsoft, since they have the biggest market share.
Potential loss of information. If a company changes its computer platforms,
the new system may not support the old software, leading to lost information
or major work needed to convert the software. Even if this is not the case, the
belief that information may be lost for some unspecified reason may be
enough to cause lock-in. Database systems tend to grow because of the fear
that the removal of an old database may cause a loss of information or that
deleted information may turn out to be useful after it has been removed.
Investments and economic lifetime. Most expensive equipment and
systems usually have long technical and economic lifetimes and cannot be
replaced without substantial cost. The manufacturer of the system may then
earn money on maintenance, upgrading the system with new functionality, and
expanding the system. This is the case, for example, for telecommunications
equipment—long equipment lifetime, together with expensive training and
maintenance, may be an efficient lock-in of network operators over long

periods of time (GSM is, for example, more than 25 years old).
Difficult-to-terminate contracts. Suppliers of services may impose real or
perceived penalties upon customers trying to terminate the contract. Examples
of real cost are loss of interests on savings and paying back expenses for
expensive training if the employer decides to leave the company before the
end of a contractual period.
Loyalty programs. Loyalty programs are used by, for example, airlines,
hotels, and retailers to stimulate customers into using their services rather than
those of competitors. Club membership is similar. Club members may get
access to goods and services not available for non-members or they may gain
other advantages (e.g., lower price, priority, and/or gift certificates).
One cause of lock-in is network effects; that is, positive feedback from the market. The
most evident example of this is Facebook. Facebook has grown into a monopoly
because of the strong network effects associated with the formation of groups of
friends supporting the rapid dissemination of information within the groups. It has
become virtually impossible for other suppliers to inaugurate a similar or better service.
To do so, the supplier must offer something that gives the users better experiences and
must be able to build up communities at least as efficiently as Facebook can. It must
be possible for the users to move at least part of their Facebook content to the new
website. Otherwise, the users may lose information they have built up over time. For
the users, loss of information may be a strong reason they will hesitate to switch to a
similar service offered by another supplier.
YouTube attracts users—both viewers and publishers—because of the popularity
of the service (bandwagon effect) and strong network effects associated with
recommendations from other viewers, reviews, ratings, the formation of communities,
and so on. This also leads to lock-in, since it is almost impossible for competitors to
build up a competing service that will give users access to such a volume of video
material and provide so much visibility to publishers of new video material.
2.8. Formation of Monopolies in the Digital Economy

Until 1998, the telecommunications businesses in most countries were government-
granted monopolies (also called “de-jure monopolies”). Full competition was
introduced in Europe in 1998, allowing anyone to become a network or service
provider (ISP). To prevent the incumbent (the former monopolist) from misusing its
market power built up on historical government money, the fairness of competition
was strictly regulated by the government. The regulations impede the incumbent from
buying up competitors or forcing them out of the market with unfair pricing or other
obstructions of their business. The regulations contain technical and commercial
Fundamentals 83
conditions for how newcomers can interconnect their networks to the network of the
incumbent, also allowing the newcomers to operate as resellers or virtual network
operators (VNOs). Despite the regulations, monopolies have formed in the ICT
businesses, especially in information service markets. These newcomers (e.g.,
Facebook, YouTube, Google, and Twitter) may be referred to as “natural monopolies”
or de-facto monopolies.
The term “natural monopoly” was formally defined by William Baumol as “[a]n
industry in which multi-firm production is more costly than production by a monopoly.”22 The
closely-related term “de-facto monopoly” implies that the company may not have
100% market share but will have nearly so over a substantial amount of time.
Therefore, the de-facto monopoly is not a true monopoly.
Path dependence caused by strong network effects may, at one point, work in
favor of one of the competitors who eventually will capture most of the market. This
happened in the competition between Facebook and Myspace, in which Facebook
took the lead in 2008. Myspace is still active, having about one million registered users,
while Facebook has 2.2 billion users and is, thus, a de-facto monopoly, as it is more
than 2,000 times bigger than its competitor. Note that the same person may be a
registered user of Myspace and Facebook at the same time. Membership in one social
media network does not exclude simultaneous membership in a competing social
media network.
“Lock-in” implies that it is difficult for a newcomer to capture market shares in a
market dominated by one de-facto monopolist. Though Myspace is still active and
offers competitive services to Facebook, lock-in favor of Facebook debilitates Myspace
to capture significant market shares from Facebook.
Cost may be a factor in some cases. In the VCR standards war, two incompatible
standards are more inefficient, compared to one standard. VHS and Betamax are
almost identical as seen from the user’s viewpoint, provided that the same films are
available on both standards for approximately the same price. However, the
filmmakers may view it differently; they must produce two versions of the same film
for two incompatible media. This is both expensive and cumbersome for the
production side and will eventually lead to higher prices; therefore, the market
eventually develops into a de-facto monopoly.
Sometimes, companies with large market shares—for example, Google—may be
mistaken for de-facto monopolies. In the search engine market, Google has 74% of
the market and the rest is divided between Baidu (11%) (China), Bing (8%), Yahoo!
(5%), and several other search engines with less than 1% market share each. For web
browsers, the market is shared between: Google Chrome (62%), Mozilla Firefox (15%),
and Internet Explorer (10%). These markets are dominated by one large supplier but
are certainly not de-facto monopolies.
A contributing cause of de-facto monopolies in the digital economy is the
increased gap between value and cost as more and more of users adopt a digital service.
This is illustrated in Figure 2-23 for digital services with strong network effects. The
average cost curve of digital services approaches 0 as the volume % (number of users)
increases. This is because of the zero marginal cost property discussed in Section 2.1.1.
However, since there may be significant fixed costs related to a digital service, the shape
of the average cost curve will become as shown in Figures 2-1 and 2-23. The value of
a digital service increases linearly as a function of the number of users—indicating
strong network effects, which follows from definition 2-6. The result is a big gap—a
value surplus—between value and cost, as depicted in Figure 2-23. Digital companies
are efficient in harvesting the benefits from both demand-side economies of scale—
network effects—and supply-side economies of scale. The value gap increases as %
increases and gives companies with large % a strong financial position. This can be seen
in, for example, the profit margins of many companies producing digital services,
which often range from 25% to 50%—well above the normal industry standard. Digital
companies may use this profit margin for more growth; for example, they may develop
and improve existing services, innovate new services, and/or acquire competing or
supplementary businesses.
Value/cost per unit/consumer
Difference between
value and average cost
Units produced (n)

Figure 2-23. Difference in value as a function of units produced.
2.9. Mergers and Acquisitions

Section 2.8 argued that several companies in the digital economy progress towards
natural monopolies over time. The main reason for this is strong positive network
effects and positive feedback. Large companies have an advantage by just being large
and tend to capture even more consumers—both new consumers joining the market
and consumers from its competitors. The result is an increased market size for the
largest company in the market, and reduced market size for the rest. This phenomenon
is called organic growth. Figure 2-24 exemplifies this, in which consumers from
Company B and new consumers both joining Company A.
Fundamentals 85
Company A
Company A
Company B
Company B
New
consumer

Figure 2-24. Organic growth.
However, there is another way for companies to grow; namely, through mergers and
acquisitions (M&A). In this case, the company buys or merges with its competitors,
suppliers, or other relevant businesses to form a larger company. This is illustrated in
Figure 2-25. From a business perspective, there is little difference between a merger
and an acquisition. In both cases, the result is a company with joint assets, employees,
and a customer base from the merged or acquired companies.
Company A+B
Company A Company B
M&A
Figure 2-25. Mergers and acquisitions.
There are several motives for companies to undergo M&A, such as:
getting rid of potential competitors
Increasing its user base
Increase its market share
Increasing its revenues
Expanding the company into new technologies
Acquiring new skills and technologies (for example, startup companies)
Expanding into new market segments
Developing a promising concept
Acquiring access to patents
In the digital economy, there have been particularly many M&A, as shown in Table 2-
3. Many of these companies have expanded into almost all areas of ICT, becoming
digital conglomerates. These companies are constantly scanning the market for
potential acquisitions to increase the value of their business operations.
Table 2-3. Mergers and acquisitions in the digital economy

Number of acquisitions
Company Notable acquisitions
(by the end of 2017)
Apple 92 Beats electronics for $3 Billion in 2014
Google 215 YouTube for $1.65 Billion in 2006
Facebook 65 WhatsApp for $19 Billion in 2014
Microsoft 207 LinkedIn for $26 Billion in 2016
eBay 59 Skype for $2.6 Billion in 2005
Horizontal integration and vertical integration are two types of M&A. Horizontal
integration implies that a company merges with or acquires another company in the
same market segment. The motive is either to get rid of a competitor or to build a
company with a larger customer base and increased economic value. Facebook’s
acquisition of WhatsApp in 2014 is an example of a horizontal acquisition.
The motive of vertical integration is to capture or secure a larger part of the
company’s supply chain. Backward or upstream vertical integration implies that the
company acquires control over suppliers producing input to the company’s own
product; for example, an application service provider merging with a content provider.
Google’s acquisition of parts of HTC in 2017 is an example of backward vertical
integration since Google took control over the production of mobile phones (user
equipment). Forward or downstream vertical integration implies that the company
acquires control over parts of its delivery chain or enters related business domains, in
which its prime services are used as an input.
Figure 2-26 shows examples of various types of integration, in which a social
media company performs three types of integration:
Horizontal integration: A social media provider acquires other companies
which also offer social media services. This type of integration usually
increases the customer base and thus the market share of the social media
provider.
Backward vertical integration: Implies that the social media provider
acquires a company supporting the delivery of the service to the customers;
for example, a company offering the storage of web pages or a network
Fundamentals 87
provider offering direct access to the users. Both these companies produce
value to the value chain the social media provider needs to offer its services to
the customers. After the merger, the social media provider achieves an
increased control of the service value chain.
Forward vertical integration: Implies that the social media provider acquires
a company supplying services to it, for example, a bank, to offer banking
services to the users. This is a strategy to extend the domain and impact of the
social media service.
Notation
E-banking service
Horizontal integration
Social media company

Social media service
Companies to be integrateds
Data storage
ISP
E-banking service E-banking service

Backward vertical integration
Forward vertical integration
Social media service Social media service
Data storage Data storage
ISP ISP

Figure 2-26. Horizontal and vertical integration of a social media service.
Due to the high number of M&A by companies in the digital economy, it is important
to analyze market structures and, in particular, how these M&A influence competition.
The role of national regulators and other governing bodies is to supervise the market
evolution and to avoid the formation of de-facto monopolies. Market share and
revenue are not the only factors determining whether a company is a monopoly. The
total number of users and the rate of growth of the number of users are also important
factors to be considered in order to regulate digital markets. If one company gets the
lead in a market with strong network effects, then with time, the company may become
a de-facto monopoly.
Activity 2-15. Acquisitions by Alphabet

Alphabet (Google) has made more than 200 acquisitions since 2001. A selection of
those are depicted below, indicating the year of acquisition. Pick three acquisitions
made by Alphabet and discuss how these acquisitions have allowed for new or
strengthened existing business domains of Alphabet.

Android
YouTube
DoubleClick
GrandCentral
Motorola mobility
Waze
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Examples of notable acquisitions by Alphabet (Google).

2.10. Standards
Standardization is the driving factor of the evolution of ICT systems, digital services,
and businesses. Without standards and the strict application of them, digitalization of
society would not be possible. There are several motives for producing standards for
ICT; for example, to ensure the interoperability of networks, to develop global
standards for streaming services and voice-over IP, and to increase the market for user
equipment, thereby making the market more attractive for the industry.
Standardization of technology, operations and management of networks, user
equipment, business relationships, and processes are also important to ensure
coopetition.
Another motivation is that telecommunications equipment is expensive and
undergoes rapid changes. Because of network effects, it is likely that if there are two
competing technologies, only one of them will survive in the end, which creates a
winner-take-all scenario (see the story of VHS and Betamax presented in BOX 2-3).
Therefore, it is beneficial for operators, governments, and industries to cooperate to
define one common standard, and thereafter, compete to capture market shares—
cooperation followed by competition. Global and regional standards are developed by
organizations such as: The International Telecommunications Union (ITU), the
International Organization for Standardization (ISO), the European
Fundamentals 89
Telecommunications Standards Institute (ETSI), the Internet Engineering Task Force

(IETF), IEEE, and the World Wide Web Consortium (W3C).
ITU is the oldest existing standardization body in the world. It was established in
1865 to ensure international interoperability of the emerging telegraph service (the
Morse telegraph). Since 1947, ITU has been a specialized agency of the UN. The
members of ITU include 193 Member States and around 800 public and private sector
companies, academic institutions, and international and regional telecommunication
entities, such as ETSI in Europe. The ITU standards are open for use by anyone. ITU
oversees the development of international standards for telecommunications. This
includes several thousand standards for:
The technical realization of fixed networks, mobile networks, data networks,
messaging networks, and satellite networks
The use of radio propagation media, fibers, and cables
The interoperability of networks
Devices connected to the network and device interfaces
Maintenance organization, fault management, and quality measurements,
Numbering and identification principles
Computer languages and specification and modeling methods
Electromagnetic compatibility and interference
The allocation of the radio spectrum
Standards in more specific areas are developed by specialized organizations such as the
Third Generation Partnership Project (3GPP), which develops the standards for
mobile communications. 3GPP is a partnership between European, American, and
Asian standardization organizations. The Bluetooth Special Interest Group is
developing the Bluetooth standard and owns the licenses associated with it. The IEEE
Standards Association is working on standards for wireless access technologies and
other technologies for local area networks. The Internet Engineering Task Force
coordinates the Internet standards.
The development of standards is coordinated cooperation between the
participants in the standards organization. The participants may be: Industry
companies, such as telecommunications providers, interest organizations, such as the
European Computer Manufacturer Association (ECMA), independent research
organizations and universities, and sometimes, individuals. New standards bodies are
also established to develop standards within a specific field. Examples of this are: The
industry cooperation Open Group for the development and certification of open
standards, such as the Unix operating system and the distributed processing platform
SOA; and the Object Management Group for the development of standards for object-
oriented programming and design and, more generally, developing standards for
modeling software, systems, and business processes.
Many standards—specifically, those of telecommunications—are very complex,

and require large funds and much manpower to be developed. The GSM specification
consists of 5,200 pages and it took a team of more than one hundred researchers eight
years to develop the standard. The standard for 4G systems consists of more than twice
as many pages. The only way to develop such vast and complex standards is by
collaboration—potential future competitors must come together and jointly create the
standard. The development of these standards is a good example of crowdsourcing—
the work is coordinated but done by an arbitrary selection of individuals.
There are examples in which several incompatible standards exist, serving the
same market. One example is mobile communications, in which GSM, 3G, and 4G are
incompatible standards. Incompatibility is then solved by backward compatibility—
mobile phones are equipped with receivers and transmitters for all three technologies.
Backward compatibility is common in ICT systems. You may, for example, retrieve a
twenty-year-old Word document on the newest version of Word. On the other hand,
Mac and Windows are incompatible systems.
The network protocols IPv4 and IPv6 are incompatible standards. They serve
similar purposes but are not subject to a standards war. IPv6 was introduced primarily
for the purposes of increasing the address space of the Internet, reducing time-delay
jitter to improve the quality of voice-over IP (VoIP), and supporting mobile broadband
access. IPv4 has been equipped with new capabilities, such as extending the address
space by using port numbers (Network Address Translation, NAT) so that there has
been no real incentive to implement IPv6. Fifth-generation mobile systems may change
this situation. These systems are based entirely on IPv6, which will become the
standard for communications with mobile devices and Internet of Things.
2.11. The Long Tail

The long tail refers to goods and services that are in low demand individually, but
collectively constitute to substantial sales. The term was coined by Chris Anderson in
his 2006 book, The Long Tail: Why the Future of Business is Selling Less of More.23
Traditionally, such goods and services have been too expensive for a seller to offer to
its customers. Let us take a bookstore as an example. A physical bookstore can
accommodate a finite number of books; typically, between 10,000 and 100,000 books.
This is because the bookstore has finite space in which to store and display books. A
bookstore offers books that they believe will sell in large quantities to maximize
revenue. Books believed to have few sales are not offered in the bookstore, since the
cost of holding such books in the bookstore does not match the forecasted revenues
they may generate.
A digital bookstore does not have the same limitations as a traditional bookstore.
For example, Amazon can offer millions of different books on its digital channel (the
amazon.com website). This is achieved via a combination of large and efficient
Fundamentals 91
warehouses, digital storage (zero marginal cost), on-demand printing, and MSP. The
most popular books sold by Amazon are printed in advance and stored physically in
large, efficient, and automated warehouses. These warehouses may hold what is termed
“the head” of Amazon’s products; that is, the books that sell the most (the bestsellers).
Other books—both bestsellers and books which are low in demand—are supplied by
Amazon as a combination of e-books and print on-demand. E-books are stored
digitally with zero marginal cost. Hence, there is no cost for Amazon to add an e-book
to its inventory. Print on-demand means that Amazon offer physical books to its
customers by printing them when needed; that is, when they are ordered by consumers.
Amazon is also an MSP and mediates between third-party sellers (e.g., other bookstores
and authors) and customers, that is, other bookstores and authors use Amazon’s digital
marketplace to offer their books for sale.24 These bookstores may be niche stores
offering books that are low in-demand. This arrangement further expands Amazon’s
supply of books.
The sum of these supply mechanisms results in Amazon being able to offer
millions of books to its customers. The bestsellers are sold by Amazon directly by
printing in advance or as e-books. Books that are low in demand are offered through
a combination of third-party booksellers, e-books, and print on-demand of digitally-
stored books. Hence, Amazon can accommodate the 10,000–100,000 books offered
by a physical bookstore and, in addition, millions of other books not offered by the
physical bookstore. These millions of other books that are not offered by physical
bookstores constitute “the tail”—books that are low in-demand individually, but
collectively constitute substantial sales. What is described here is “the long tail of
supply.”
Notation
Head
Tail
Sales
Products ranked according to sales

Figure 2-27. The long tail.
An illustration of the long tail concept is shown in Figure 2-27. Here, products are
ranked (horizontal axis) according to sales (vertical axis), where the top-selling products
are those in the head, and the books that sell the least are in the tail. Chris Anderson
observed that companies like Amazon earned about half its revenue from products in
the tail. Anderson based his conclusions on observations made by Brynjolfsson et al.25
Brynjolfsson and coworkers found, for example, that on Amazon, 2.3 million book
titles were available, while the shelves of an ordinary large bookstore contained
between 40,000 and 100,000 titles. They estimated that the sales of books not found
in ordinary stores amounted to between 20%–40% of the total sales of Amazon. In a
new survey published in 2010 they found that 36.7% of Amazon’s sales came from the
long tail.26 This is illustrated in Figure 2-28.
Head: Tail:
Books ranked 1 – 100 000 Books ranked 100 000 ->
Products
Sales
63.3 % 36.7 %
Figure 2-28. Amazon sales.
In a paper from 2011, Brynjolfsson et al. also argued that the long tail phenomenon is
a common aspect of many Internet businesses.27 Low production costs, cheap storage,
small shipping costs, and efficient information searches are the key ingredients for long
tail businesses. They emphasized the importance of efficient information searches both
on the web and on homepages of vendors such as Amazon, allowing customers to
search through millions of potential products.
Offering products in the long tail is a value and a competitive advantage for
providers. This is because customers prefer variety and options when selecting
products to buy. The long tail also gives the provider more relevant options for
advertising similar products and recommendations for the customers. Hence,
companies that offer products in the long tail are rewarded for both increased sales of
the long tail products and increased customer satisfaction for displaying a long list of
product options.28
Fundamentals 93
The long tail has been exploited in many digital businesses. In the music industry,
the digitalization and streaming of music means that more titles can be offered to
customers compared to a traditional music store. Spotify, for instance, offers access to
more than 30 million songs, while the biggest record stores accommodate around
100,000 albums (equivalent to about one million songs). For Spotify, there is no cost
associated with storing one extra song and making it available to users (zero marginal
cost).
Definition 2-8. The Long Tail

collectively constitute to substantial sales.

In the banking industry, the long tail has been exploited to provide microcredit to
lower-class and poor people. For instance, Grameen Bank in Bangladesh offers small
loans to private people and enterprises that would normally not be qualified for a loan
in a regular bank.
Crowdsourcing is an example of long tail production. The long tail here is made
up of all the skilled people that may contribute to a software product but are, a priori,
unknown to the developer. Wikipedia encourages the regular Internet user to become
an author of the encyclopedia; hence, creating a long tail of contributors. Wikipedia’s
workforce is supplied by many contributors in a long tail of supply.
Big companies, such as Amazon, can profit from all products—both products that
sell in huge numbers (head) and products that sell in small numbers (tail). However,
the long tail has also made it possible for individuals to start a type of business that was
not possible before. For example, individuals may now sell merchandise on eBay, offer
their services on Airbnb and Uber, and sell their own books on Amazon. These
individuals supply the long tail with products and services that were not previously
available to consumers. Selling merchandise without a physical store was very
expensive before the advent of e-commerce. However, today, anyone can become an
e-commerce retailer (or reseller) by setting up a web page to offer manufactured
products. Such a business will find its place on the long tail amongst thousands of other
suppliers in the same business area.
Activity 2-16. The Long Tail in Sharing Services

How are sharing services, such as Airbnb and Uber, exploiting
the long tail of demand and the long tail of supply in their
business operations?

Summary and key points

This chapter is about the fundamental properties of digital economics. The topics
presented are essential to understand business decisions and the logic underlying the
digital economy. Digital goods and services are the building blocks of the digital
economy. Most sections in this chapter deals with the various properties of digital
goods and services, including zero marginal cost, public goods features, and zero
ARPU.
Many digital services are produced by value networks, implying that their success
in the market is governed by strong network effects. Examples of value networks in
the digital economy include: Facebook, Twitter, and Google. Some of these value
networks are also multi-sided platforms mediating between two or more user groups.
Examples of MSPs are: Uber and Airbnb.
Standards, the long tail property, mergers and acquisitions, lock-in, and switching
costs all have impact on the digital economy. A core topic of this chapter has been how
network effects, positive feedback from the market, and path dependence contribute
to understanding why de-facto monopolies are formed in the digital economy.

Key Points

A digital good is a networked zero marginal cost virtual object that has value for
A digital service is a networked zero marginal cost service that has value for
A marginal cost is the cost of producing one additional unit of a good or service.
Digital services have zero marginal cost.
Digital services are non-rival in nature. Digital services can be either excludable or
non-excludable.
Many digital services, but not all, have zero ARPU. The company providing such
services must obtain revenues from other sources than the consumers.
Commoditization is the process by which digital services end up being
indistinguishable from a consumer’s point of view. Digital commodities compete
primarily on price.
Transaction costs are the cost of trading digital services in the market. ICT has
made transaction costs smaller.
Bundling means to combine two or more digital services in a single package. It is
particularly attractive in the digital economy, due to the zero marginal cost
property.
Digital services can be developed and produced using in-house production,
commons-based peer production (CBPP), crowdsourcing, or open-source
software.
Fundamentals 95
A company creates value either as a value chain, value shop, or value network.
Many companies in the digital economy are value networks.
A value network is a business mediating between members of the market.
A multi-sided platform (MSP) enables direct interactions between two or more
distinct user groups, in which all user groups are affiliated with the MSP. The MSP
is also a value network.
A network effect is the effect that the number of users of a service has on the value
of that service as perceived individually by each user. The network effect may be
positive (beneficial to the service) or negative (detrimental to the service).
Other types of network effects include: Same-side and cross-side network effects,
and direct and indirect network effects.
A positive feedback is such that if there is a deviation in the output in one or the
other direction, the feedback will make this deviation larger. Both positive and
negative network effects are positive feedbacks.
Path dependence explains how a set of past events and actions limit the current
available options and evolution.
Switching costs are the costs for a company to capture consumers from a
competitor and for consumers to switch to a new supplier of a digital service.
Companies may exploit several lock-in mechanisms to increase the switching costs
of its consumers and reduce the switching costs for its competitors’ consumers.
Both government-granted monopolies (de-jure monopolies) and natural
monopolies (de-facto monopolies) appear in the digital economy. Natural
monopolies are often companies with strong network effects, facing little-to-no
market regulation.
Mergers and acquisitions means that a company buys or merges with one or more
of its competitors, suppliers, or other relevant businesses to form a larger
company.
Standards are essential in the digital economy to support market evolution.
Developing standards require that competitors cooperate to produce the standard.
Thereafter, they may compete for market shares.
collectively constitute to substantial sales.
Further Reading

Carl Shapiro and Hal R. Varian. Information Rules: A Strategic Guide to Network
Economy. Harvard Business School Press. 1999.
This is one of the first books in digital economics, focusing on network effects, positive
feedbacks, switching costs, and lock-in, among other topics. The book is a
comprehensive overview of the digital economy with several examples of practical

evolution of digital businesses.
Chris Anderson. The Long Tail: Why the Future of Business is Selling Less of More.
Hyperion. 2006.
This book was the first to discuss the concept of the long tail. Empirical evidence for
the impact of the long tail in, e.g., online bookstore trading are presented. The book
discusses the impacts of the long tail on the digital economy and how it may be
exploited in various business areas.

Andrew McAfee and Erik Brynjolfsson. Machine, Platform, Crowd. W. W. Norton &
Company. 2017.
This book provides a detailed explanation of three important evolutions in the digital
economy: Machine learning, multi-sided platforms, and crowdsourcing. Supported by
empirical findings, it presents an overview of recent research in each area. The book
contains many interesting case studies and connects the theories of digital economics
to real-world economics.

Chapter 3
Digital Markets

Learning Goals

The definition and classification of digital markets
The stakeholders participating in digital markets and their relationships
The scope and classification of e-commerce markets
Network access markets and information service markets
Virtual network operators and Over-the-Top services
How the layered Internet model separates the business of ISPs from ASPs
Cost structures of ISPs, ASPs, IPs, and CPs
How digital markets evolve over time and the concept of S-curves
Competition, cooperation, and coopetition in digital markets

Chapter 2 introduced the fundamentals of digital economics and defined various

characteristics of digital goods and services. This chapter applies the theories of
Chapter 2 to study the aggregated behavior of digital services as they are traded in the
market. Various stakeholders and their relationships are identified (Section 3.2) and
applied to e-commerce markets (Section 3.3), network access markets (Section 3.4),
and information service markets (Section 3.5). The layered Internet model is presented
(Section 3.6) as a tool to describe and discuss cost structures (Section 3.7) and
competition, cooperation, and coopetition in digital markets (Section 3.9). The chapter
also introduces the market evolution of digital services (Section 3.8).

3.1. Overview of Digital Markets
A market is a mechanism for trading both tangible and intangible goods and services.
Figure 3-1 classifies markets according to the type of good or service (horizontal axis)
and type of channel used for trading the good or service (vertical axis). Examples of
tangible goods include computers and cars. Examples of non-digital services are
hairdressing and taxi rides. Online trading implies that an ICT infrastructure, for
example, the Internet, is used to carry out some or all activities associated with the
trade, such as: Viewing products, bargaining prices and delivery terms, ordering,
product delivery, and transfer of payment. Tangible goods and non-digital services can
be traded online; however, they cannot be delivered over an ICT infrastructure. On
the other hand, shipment and delivery of digital services may be done online.

Online
Information services
Network access
E-commerce
Retail stores
Digital goods retailer
Traditional retailer
Tangible goods and Digital goods and services
non-digital services

Figure 3-1. Digital and non-digital markets.
Digital Markets 99
E-commerce is online trading of all kinds of goods and services. This includes online
shopping, online payment, the transfer of funds, the management of supply chains,
and the business-to-business exchange of data. E-commerce also includes the trading
of network access and information services. To classify an activity as e-commerce, it
must support some sort of digital payment system.
E-commerce markets have grown to constitute an important part of the global
economy following the commercial success of the World Wide Web (WWW) in 1993.
Two important and distinct parts of e-commerce are the online markets for network
access and the online markets for information services:
Network access markets are the business of providing access to the Internet
and other communication networks (see Section 3.4).
Information service markets are the trade of content, applications, and
information on the Internet (see Section 3.5).
Note that not all activity performed online in digital markets is e-commerce. For
instance, information services may be exchanged between provider and consumer free
of charge. Such an exchange of digital goods is not e-commerce since there is no
payment involved.

Definition 3-1. Digital Market

A digital market is a mechanism for the trading of digital goods and services, and for
the online trading of tangible goods and non-digital services.

3.2. Stakeholders and Relationships in Digital Markets

Figure 3-2 shows the most important stakeholders involved in digital markets and the
relationships between them. The Infrastructure Provider (IP) is the owner of the ICT
infrastructure, encompassing fixed networks, mobile networks, Internet infrastructure,
and storing and computing facilities—the physical infrastructure needed for online
trading. An IP owning a mobile network is sometimes referred to as a “coverage”
operator. The Internet Service Provider (ISP) buys access to this infrastructure from
the IP and resells to the Consumer (C) and the Application Service Provider (ASP).
The consumer may use these services directly to access the Internet, make phone calls,
and send SMS. The ASP uses the infrastructure access purchased from the ISP to
support the distribution of content, applications, and services that the ASP produces.
The ASP may also buy copyrighted content from a Content Provider (CP), such as
movies, music, and news articles. The ASP uses the input from the ISP and the CP to
offer digital services and applications to the consumer.

ASP buys copyright Information service

content from CP markets
C buys content or ASP CP

application services
from ASP
ASP buys content and

application delivery
infrastructure from ISP
C ISP IP
C buys Internet ISP buys infrastructure Network access

services from ISP access from IP markets
Notation
C Consumer CP Content Provider
ASP Application Service Provider IP Infrastructure Provider
Figure 3-2. Stakeholders and relationships in digital markets.

Examples of types of services offered by ASPs are: Online music streaming (e.g.,
Spotify and Tidal), online video streaming (e.g., Netflix and HBO), digital newspapers
(e.g., The New York Times and Financial Times), online banking (e.g., HSBC and Sbanken),
cloud storage (e.g., Dropbox and Google Drive), and social media services (e.g.,
Twitter and Facebook). Many of the applications and services offered by the ASP are
free of charge for the consumer; for example, Google’s search engine, Wikipedia, and
Facebook. The ASP providing these applications must acquire revenues from other
sources than the consumers. Normally, the consumer pays for Internet access to the
ISP. Network access markets are the business domain of the ISP and the IP, while
markets for information services are the business domain of the ASP and the CP.
The model in Figure 3-2 is a simplification of the business domain for digital
services. The most important observation from this simple model is that there is a
sharp separation of business domains in the provision of digital services. Not only are
there many stakeholders involved in the provision of digital services but there are also
big differences in how each of them conducts their business. For instance, the IP builds
and operates a physical ICT infrastructure consisting of optical fibers, mobile base
stations, communication satellites, undersea cables, Internet routers, and switching
centers. This infrastructure may cover a large geographical area and constitute valuable
Digital Markets 101
equipment. Moreover, the IP needs a staff of technicians and engineers to build and
manage the ICT infrastructure. There is also huge undertakings in upgrading the ICT
infrastructure since ICT tends to get outdated quickly. The CP, on the other hand, is a
producer of content, such as music, movies, and news articles, with business operations
vastly different from that of the IP. The productions of the CP is often digital, reside
only on a digital storage device and does not need upgrades or extensive management
after being produced. Another observation is that there may exist formal relationships
or contracts between the stakeholders in digital markets; for example, in terms of
Service Level Agreements (SLAs).

BOX 3-1. Service Level Agreements

A Service Level Agreement (SLA) is a contract that exists between a consumer and a
provider of a digital service. The SLA describes certain terms of the delivered service.
Most SLAs between consumers and providers are standardized. If the terms defined
in the SLA are not satisfied by either party, some form of compensation might be
requested.
Service Level
Agreement (SLA)
Provider Consumer
Service
delivery

Examples of the terms that may be covered in an SLA include: Specifications of
maximum service delays, mean time between failures, service availability, security,
and privacy. All these specifications describe the quality of the service (QoS) as
perceived by the consumer. Examples of SLAs are: The contract between consumers
and Internet Service Providers for the delivery of network access, and the contract
between consumers and Spotify for the delivery of online music.

Most providers of digital services in the digital economy can be mapped to the
stakeholder roles presented in Figure 3-2. Sometimes, a company may take the role of
a single stakeholder (e.g., an ISP) while, in other cases, the company may take the roles
of several stakeholders at the same time. One example is Telenor—a Norwegian
telecommunication operator—which occupies roles as an owner of communication
and broadcast networks (IP), a provider of Internet services (ISP), and a provider of
application services (ASP). Another example is the case in which a consumer is also a
producer of content—a prosumer. This will be explained in Figure 3-8.

Activity 3-1. Netflix

Netflix is an entertainment company that provides one of the most
popular content streaming services available on the Internet. Is Netflix
an ASP, ISP, CP, or IP? Use the model from Figure 3-2 to describe
Netflix, the stakeholders associated with Netflix, and the relationships
between them.

3.3. E-commerce Markets
E-commerce is the online trading of tangible goods, digital goods, and services. This
is illustrated in Figure 3-3. For all types of e-commerce trade, the consumer conducts
and manages the trade using an online channel, such as the Internet. The supplier
handles the trade and ships the products or services to the consumer. Digital goods
and services are delivered to the consumer over the Internet, while tangible goods are
delivered to the consumer using traditional transportation.

Digital goods
Consumer and services
Internet
Online trading
Transport Tangible goods and

non-digital services

Figure 3-3. E-commerce trading.

Examples of e-commerce trading include: Buying books from Amazon, buying music
from iTunes, buying electronics on eBay, and subscribing to services delivered by
Spotify, Netflix, mobile network operators, and Internet access providers. In fact, all
trading activities conducted online can be categorized as e-commerce. To categorize
an exchange of goods and services between a supplier and a consumer as e-commerce,
Digital Markets 103
there must be some sort of financial activity between them. The exchange of goods
and services without any financial activity is not regarded as e-commerce, even though
the trade is done in a digital market. One example of this is the use of Facebook. The
use of Facebook is free of charge for the user and, therefore, there is no financial
activity between the user and Facebook. The access to and use of Facebook is not e-
commerce. On the other hand, Facebook sells advertisement space to retailers and
other companies as a part of their business model. This is, indeed, e-commerce, in
which Facebook is the supplier.

Definition 3-2. E-commerce

E-commerce is the online trading of tangible goods, digital goods and services with
some sort of financial activity.

In the US, about 10% of all retail is performed using e-commerce.2 In China, which is
the largest e-commerce market in the world, about 20% of all retail sales are e-
commerce.3 These numbers are from 2017, and they are expected to escalate in the
near future. Similar trends are seen in most parts of the world—the share of e-
commerce is increasing and is replacing traditional retail.
Important milestones in the evolution of e-commerce were the launch of eBay
and Amazon in 1995, PayPal in 1998, and Alibaba in 1999. Amazon is now the third-
largest company worldwide according to market cap. PayPal was one of the pioneers
of online payment systems. Other important services and companies in the e-
commerce market include: Groupon (launched in 2010), Apple Pay (launched in 2014),
and Google Pay (launched in 2015 as Android Pay).
There are two important requirements for successful e-commerce markets: First,
to become an efficient marketplace, e-commerce requires websites or apps where
vendors can present their items for sale and buyers can choose among products and
fill their shopping trollies. Second, simple and effective online payment systems are
crucial to the success of e-commerce. There are several different types of online
payment systems; for example: Credit cards (e.g., VISA and MasterCard), e-wallet (e.g.,
PayPal), invoice installments (e.g., Klarna), and cryptocurrencies (e.g., Bitcoin,
Ethereum, and Ripple).
E-commerce market can be divided into four types, depending on whether the
buyer or the seller is a professional business (denoted as “B”) or a private consumer
(denoted as “C”). These four types of e-commerce markets are listed and explained:
Business-to-Consumer (B2C) e-commerce is the traditional market in which
goods or services are sold online by professional companies to private
consumers. Examples of this are: Buying books from Amazon, buying films
from Netflix, buying flight tickets from Expedia, buying computers from Dell,
and buying broadband subscriptions from a network operator.
Business-to-Business (B2B) e-commerce is the online trading between two
professional companies. B2C e-commerce and B2B e-commerce have
experienced huge growth during the last decades. The main difference
between B2B and B2C e-commerce is that, in B2C, small quantities of goods
and services are sold to many private consumers, while in B2B, large quantities
of goods and services are sold to a small number of professional businesses.
Consumer-to-Consumer (C2C) e-commerce is the online trading between
two private consumers. Examples of C2C e-commerce companies include:
eBay, Uber, and Airbnb. In fact, most of the sharing economies are C2C e-
commerce. Advantages of C2C e-commerce are: Better utilization of
resources, and easier trade opportunities for second-hand goods.
Consumer-to-Business (C2B) e-commerce enables private consumers to sell
digital services online to professional companies. This is the most recent
supplement to e-commerce. One example of C2B e-commerce is a private
consumer’s web page on which manufacturers and retailers advertise their
products. A blogger may have many viewers on their blog, and manufacturers
or providers may find the blog to be a simple and cheap way to reach a
particular audience.

Consumer C2B Professional
business
C2C B2B
B2C

Figure 3-4. Classification of e-commerce markets.

Activity 3-2. Amazon and Alibaba

Amazon and Alibaba are two of the largest e-commerce companies
in the world. Are Amazon and Alibaba doing B2B, B2C, C2B, or C2C
e-commerce? How are Amazon and Alibaba handling online
payments? Have Amazon’s and Alibaba’s business operations
influenced transaction costs (see Section 2.1.5)?

Digital Markets 105
BOX 3-2. The Sharing Economy

The sharing economy enables consumers
to sell access to property, goods, money,
or services to other consumers for a
certain fee. Airbnb and Uber are two of
the most well-known companies in the
sharing economy. The sharing economy
is an example of C2C e-commerce, since
the trade takes place between two
consumers.

A more precise term of “the sharing economy” is “the access economy.” This is
because, strictly speaking, consumers do not share goods or services, but pay for
access to other consumers´ goods and services. The sharing economy may lead to
better utilization of resources, since homes, tools, or cars can be rented out when
they are not used by the owner.

An important requirement of sharing economy services is fast and reliable feedback
from the consumers. This is required to build trust and reputation for those offering
access to their services. The major difference between the sharing economy and
traditional trade is that the providers are often individuals and not companies, which,
in many countries, means that a different set of laws and regulations govern the
trade. The sharing economy is enabled by multi-sided platforms (see Section 2.4) and
crowdsourcing (see Section 2.2.3). Sharing economy services use crowdsourcing as a
production model and create value as a value network (see Section 2.3.3), or, more
specifically, as a multi-sided platform. One example is Uber, in which people (the
crowd) offer transportation services to consumers. Uber does not own taxis or cars
but instead mediates between drivers and passengers. Uber is totally dependent on
the crowd to provide their assets (cars) in its business model.

The sharing economy challenges legal frameworks, especially labor laws and
commercial laws. Uber is, for example, forbidden in several countries, including
Norway, Denmark, and Italy, due to a violation of the laws concerning the licensing
of professional taxi drivers.1 Another example is Airbnb, which has met restrictions
in, for example, New York City, where private consumers are not allowed to rent out
property on a short-term contract (less than one month) when the host is not
present. The sharing economy enables consumers to make profits off assets they
own. Sharing economy services have been criticized as competing under different
terms with established businesses in their domain by circumventing labor protection
laws and thereby providing services with lower costs compared to services produced
by companies using the in-house production model.

3.4. Network Access Markets

Network access is offered jointly by the ISP (commercial) and IP (technical). This
includes: Access to broadband Internet connections, WiFi, public mobile networks,
telephone services, and messaging services (e.g., email and SMS/MMS). These services
are integral parts of the network and do not depend on additional services delivered by
other stakeholders (e.g., ASPs or CPs).
Network access is a fundamental service—also termed a foundational
technology—in the digital economy. This is because the access to and delivery of digital
services depend on reliable access to the Internet. Reliable access to the Internet is
supported by a worldwide ICT infrastructure consisting of optical fibers, wireless base
stations, Internet routers, satellite networks, and other network resources. Users access
the Internet using equipment, such as PCs or smartphones. The IP (Infrastructure
Provider) owns and operates the physical ICT infrastructure which supports the
Internet. This includes all kinds of communication networks, including management
systems, and computing and storage facilities. The ISP buys access to the infrastructure
from the IP and resells this access to consumers and ASPs.
There are several examples of IPs that are also ISPs. The traditional incumbent
network operator both owned the communication network and sold telephone services
to consumers. To ensure fair competition among ISPs, national regulation in most
countries compels the incumbent network operator to split the business operations
into two independent parts: One for IP operations and one for ISP operations. Several
national regulators have also forced the incumbent IP to open the ICT infrastructure
for ISPs other than the one owned by the incumbent. These ISPs can lease the ICT
infrastructure from the IP on the same terms as the ISP owned by the incumbent IP.
Company A
ISPA C
Company B ISPA and ISPB
compete to sell
network access to C
IP ISPB
ICT IP is the owner of IP rents access to ICT

infrastructure ICT infrastructure infrastructure to ISPB

Figure 3-5. Virtual Network Operator.
Digital Markets 107
ISPs that do not own their own network infrastructure are called Virtual Network
Operators (VNOs)—or Mobile Virtual Network Operators (MVNOs) if they offer
mobile services. Figure 3-5 shows an example of how a VNO (ISPB of Company B)
is commercially related to the IP owned by Company A. Both companies A and B offer
services to the consumer (C) through the Internet service providers ISPA and ISPB,
respectively. The major difference between them is that ISPA is owned by the company
that owns the ICT infrastructure (IP) while ISPB leases access to the same
infrastructure from Company A.
Over-the-Top services (OTT) are media services offered by the ASP or CP
directly over the network of the IP. OTT services require access to the Internet
delivered by the ISP. However, OTT services compete with the media and
communication services offered by the ISP itself. This is illustrated in Figure 3-6, in
which the architecture of OTT messaging, OTT voice, and OTT film distribution is
presented together with the equivalent services offered by the ISP.
OTT messaging Messaging OTT voice Voice OTT film Film

Figure 3-6. Over-the-Top services.
For instance, a consumer may use a smartphone in combination with Internet access
offered by the ISP and WeChat (OTT messaging) as an alternative to SMS (messaging).
Furthermore, a consumer may use Internet access combined with voice-over IP
telephone service offered by an ASP—for example, Skype—as an alternative to the
telephone service offered by a mobile service provider. Similarly, Netflix may provide
the same services directly over the Internet as a provider of cable television services.
The key point of OTT is that the same set of services that was traditionally offered
over a separate communication network can be offered over the Internet.
The major challenge for the ISP is smaller revenue because of competition from
OTT services. This is because the price per bit for telephone service has traditionally
been orders of magnitude higher than the price per bit for Internet access. Hence, the
ISP will face reduced revenue as consumers move from, for example, telephone service
to OTT voice, since the price per bit that the ISP charges the OTT provider for
network access is much lower than the price per bit that the ISP charges the consumer
directly. For the consumer, OTT means significantly lower prices for digital services,
such as telephony and messaging. OTT is one step toward the convergence of services
(see Section 1.7), in which traditional telephone service is replaced by VoIP and cable
television services are replaced by video streaming.
Network access services are close to becoming digital commodities (see Section
2.1.4). This is because it is almost impossible to differentiate between the various
network access services provided by different network access suppliers. In the
provision of network access, most of the same ICT infrastructure is utilized, even if
the network access is provided by different suppliers. In commodity markets, price is
the most important differentiator between suppliers. This may also be one reason for
the ongoing price war between suppliers of broadband access and mobile telephone
services.
C buys content or ASP buys copyright Applications provided

application services content from CP by ASP are
from ASP interoperable with
devices provided by DP
ASP CP

C DP application delivery
C buys device
from DP
ISP IP
Devices provided by DP
are interoperable with
C buys Internet ISP buys infrastructure services provided by
services from ISP access from IP ISP
Notation
ISP Internet Service Provider DP Device Provider

Figure 3-7. Device Providers in digital markets.
Digital Markets 109
Figure 3-7 extends Figure 3-2 to include Device Providers (DP). Device Providers
are providers of user equipment, such as smartphones, laptops, and PCs. Production
and trade of such devices are not a part of the digital economy as defined in Chapter
1. However, they constitute an integral part of the digital service ecosystem, because
digital services must be accessed through some sort of device. The consumer buys this
device from a DP. A specific device is interoperable with the access services provided
by ISPs and applications provided by ASPs. This may be device-specific. For example,
apps available at Apple App Store are only available for devices provided by Apple.
However, technologically speaking, full interoperability exists between network access,
devices, and applications—any device can be connected to any network and run any
application. This separation of layers between ISP, DP, and ASP is the basic concept
of the layered Internet model (see Section 3.6).

3.5. Information Service Markets
Information services are jointly offered by the ASP and the CP and are traded in an
information service market.4 They include content and applications ranging from
simple apps to complex software. Huge amounts of digital content and applications
are available for consumers. Table 3-1 contains examples of information services and
how they may be categorized.
Table 3-1. Examples of information services

Type of Service Examples of Information Service
Social media services Facebook, LinkedIn, Twitter, QZone, VKontakte
Music streaming Spotify, Apple Music, Google Play Music, Tidal
Video streaming Netflix, HBO, Amazon Video, YouTube TV
Web browsers Chrome, Safari, Internet Explorer, Firefox
Word-editing software Microsoft Word, Google Docs, Pages
Internet telephony (VoIP) Skype, Google Voice
Messaging WhatsApp, WeChat, Messenger
Multiplayer Online Games World of Warcraft, Starcraft 2
Travel and accommodation TripAdvisor, Citymapper, Uber, Airbnb
Online payment PayPal, Alipay, Google Pay, Apple Pay
Language Google Translate, Duolingo
News NY Times, Google News, Reddit
Some of the services listed in Table 3-1 are available internationally, while others have
a regional target. Since digital services have zero marginal cost, it is simple to distribute
them on the international marketplace. However, there may be several reasons why
some of them are restricted to certain geographical areas; for example:
Political regulations (e.g., Facebook is not allowed in China)
Competition regulations (e.g., Uber is forbidden in several countries)
Language (e.g., local newspapers)
Local target (e.g., regional transportation apps)
Local infrastructure rollout (e.g., dedicated infrastructure is needed)
Local information (e.g., information about local conditions is needed)

In an article published in Harvard Review in 1998, Josef Pine and James Gilmore coined
the term experience economy.5 Their argument is that people are willing to pay for the
experience of being “engaged” in the product they buy. Several information services
belong to the category of experience goods. Examples of experience goods are:
Movies, interactive games, music, and newspaper articles. It is hard to assess the quality
of an experience good in advance, since it is difficult for an individual consumer to
assess the quality of a specific music track or a movie before it is purchased. To give
consumers some information about the digital good or service, the provider may have
to give away samples of the product or present evaluations of the product by
professional reviewers or by feedback from the public. Network access, on the other
hand, is classified as a search good.6 The most important characteristic of a search
good is that the quality of the good can be assessed before it is purchased. Search goods
are more subject to price wars and fierce competition than experience goods.

Activity 3-3. Apple Pay

Apple Pay is an online payment service. Why is Apple Pay not
offered globally? Discuss whether Apple Pay is an experience good
or a search good. Is Apple Pay an OTT service?

When content is produced in-house, as explained in Section 2.2.1, the Content

Provider (CP) producing it is a professional company. One example is the film industry,
which requires huge budgets and a professionalized mode of operation when making
a movie. On the other hand, when content is produced by crowdsourcing or peer
production, the CP and the consumer may be the same entity, called a “prosumer.”
This is illustrated in Figure 3-8. Here, the ASP buys copyrighted content from the
prosumer and sells it back to the prosumer. The prosumer may also give content to
the ASP for free. A prosumer may be only a consumer, only a content provider, or
both. The ASP considers the group consisting of consumer and content provider as a
single stakeholder. The ASP may charge the prosumer for using the services or provide
it for free to the prosumer.
Digital Markets 111
ASP buys or receives for free

copyright content from Prosumer ASP
Prosumer buys or receives for free
content or application services from
ASP.
application delivery
CP
Prosumer
ISP IP
C
Prosumer buys Internet ISP buys infrastructure

services from ISP access from IP
Notation

Figure 3-8. Prosumers in digital markets.
3.6. The layered Internet model

One of the most important events in the evolution of digital markets was the
commercialization of the World Wide Web (WWW) in 1993. Before 1993, network
operation and service provision were integrated industries, and consumers could not
freely choose network access independent of service. The WWW led to a restructuring
of the ICT business, in which network operation and service provision became
independent industries. This was possible because of the layered technological
architecture of the Internet.
Figure 3-9 shows the layered Internet model, in which the Internet is divided into
three parallel planes: Networks, user equipment, and applications. The three planes
correspond to three independent business areas: (1) Networks; (2) the development,
production, and sale of user equipment; and (3) the provision of services, information,
system management, and remote sensing and control.7

BOX 3-3. Skype and Over-the-Top Services

Skype is a digital service providing chat, voice, and video
communication for Internet users. Skype was launched
in 2003 as a desktop service. It was bought by eBay in
2005 for $2.6 billion and by Microsoft in 2011 for $8.5
billion. Skype has, as of 2014, more than 40% of the
international voice and video market.

Skype is a contributor to the ongoing convergence of digital services along, with other
providers of voice-over IP services, such as Google Hangouts and appear.in. These
are examples of Over-the-Top (OTT) services. They provide free voice, video, and
messaging over the Internet, thereby competing with the traditional telephone
service. The introduction of Skype and other voice-over IP services has had a
significant impact on the digital economy, in which the main outcome is a dramatic
decrease in prices for telephone calls both nationally and internationally. Mobile
network operators include free telephone services in their subscription plans to meet
the competition from Skype and other similar OTT services.

In the traditional telephone service, at the time Skype was launched, users had to
pay for the volume, time, and distance of the calls they made. Skype undermined
these payment methods by offering free calls between Skype users. It is no wonder
why people abandoned the expensive traditional telephony services and adopted
Skype, especially as a replacement for long-distance calls. Skype is a typical value
network, mediating communication between users. The company has high fixed
costs (e.g., software development and infrastructure costs) and low or close to zero
marginal costs. It builds its value on the size of the network (i.e., the number of
users).

All web services use one of the two ports 80 (http) and 443 (https) (encrypted http
access). It is, therefore, not possible to distinguish between different services using
the Internet as bearer service. This includes most of the services on the Internet. The
Internet Service Provider (ISP) cannot levy differential charges for these services
because then some services would be too expensive (e.g., video streaming services),
while other services would cost almost nothing (e.g., email). The ASP provider may,
however, levy fees for apps, films, and music. This is net neutrality in practice; the
ISP cannot discriminate data on the Internet based on senders or receivers of the
content. For this reason, the network provider can only take fixed access charges plus
additional fees for large data volumes.

OTT services in general drives the convergence of digital services, mainly because for
low costs, they provide the same services over the Internet traditionally provided
over separate communication networks.

Digital Markets 113

Notation
Applications
Application
Host
Router
equipment
User
Virtual
connection
Inter-layer
connection
Networks
Physical link

Figure 3-9. The layered Internet model.

The networks plane shows the physical communication network in terms of a graph
in which communication links (physical links) interconnect the routers using the
Internet Protocol. This graph then symbolizes the physical Internet Protocol network
supporting the businesses of the Infrastructure Providers (IP) and the ISPs. This is,
strictly speaking, what is defined as the Internet.
The user equipment plane consists of a graph in which the hosts are nodes and a
connection between two hosts (e.g., terminals, servers, and/or databases) indicates that
the hosts are taking part in a common computation. This is the transport layer, and
TCP/UDP/SCTP connections exist between hosts.
The application plane is a graph in which software objects (applications) are nodes.
A connection between two nodes (virtual connection) indicates that the corresponding
software objects take part in a common computation. A smartphone and downloaded
apps are nodes in such a graph. This graph is dynamic and may alter configurations in
milliseconds. This may then include complex configurations, such as cloud computing,
software-defined networking (SDN), virtualization (NFV), and service-oriented
architecture (SOA), which decouples the application from the network structure. The
application plane is the business arena of the ASPs and the CPs.

BOX 3-4. Net Neutrality

Net neutrality is the principle that all data on the Internet
shall be treated equally by the IPs and ISPs. Hence, with net
neutrality in force, there will be no discrimination of data
based on sending/receiving users, content, or application.
Proponents of net neutrality claim that the equal
treatment of all services will foster innovation on the
Internet and ensure a democratic platform in which all
information is treated equally.

The business implications of net neutrality are significant. With net neutrality in
force, IPs and ISPs cannot discriminate data from OTT providers to curb competition
with their own equivalent services. Many countries have passed legislation on net
neutrality, or have other laws ensuring some form of net neutrality. Among them,
Chile was the first country in the world to pass full net neutrality legislation in 2010.
Many major ISPs are opponents of net neutrality. A major reason is that it is difficult
for IPs and ISPs to get a returns on infrastructure investments when they cannot
charge large ASPs—such as YouTube and Netflix—anything for their usage of the
network. Some ISPs, in collaboration with selected ASPs—such as Wikipedia and
Facebook—offer zero rating access to the Internet. This means that consumers get
free Internet access to use these selected applications only. However, this practice
conflicts with the current definitions of net neutrality, since it differentiates Internet
access based on application.

Since software runs on computers and computers are connected to the Internet, there
also exist vertical interactions (inter-layer connections) between the layers as shown by
dotted lines. Note that the structures of the graphs on each layer are independent of
one another except that there must be a path in the network’s plane connecting two
hosts in order for a TCP/UDP/SCTP connection to exist between them. A
TCP/UDP/SCTP link must exist for two software objects to take part in a common
computation.
Note also that competition takes place between stakeholders on the same layer of
this model. There is no competition between operators on different layers. The user
equipment layer can then be regarded as the demarcation line between the business
segments of the ISP and the ASP. The important point is that the ISP cannot perceive
what kind of services are carried by the network, since this is obscured by the protocol
on the transport layer (TCP/UDP/SCTP). This has a severe impact on pricing regimes
available to the ISP—since the ISP cannot identify the type of service, the ISP cannot
levy differentiated charges. The ISP is then forced to apply service-independent
charging. This separation of services and networks is also one of the core premises of
Digital Markets 115
net neutrality—the ISP cannot discriminate between different uses of the network and,
therefore, cannot levy charges reflecting the value of the service offered by the ASP.
This simple model can be used to evaluate two aspects of the network: (1) The
independence of business across different layers and (2) the vulnerability and
robustness of the network against cyberattacks and accidental failures. The businesses
of the ISP and the ASP are complementary in the sense that each needs the other to
conduct its own business. The ASP cannot offer services without the assistance of
ISPs, and the ISP does not create value for the consumers beyond that of transferring
bits and providing basic communication services. Hence, the ISP needs the ASP to
make the network attractive and useful for consumers.

Activity 3-4. Apple App Store

The App Store is Apple’s platform for distributing apps on digital
devices using iOS (e.g., iPhone, iPad, MacBook, and other Apple
products). Describe the ecosystem of the App Store by using
Figures 3-2 and 3-8. Who is producing apps for the App Store? Who
is producing content for the apps available on App Store? Is the App
Store an MSP? How is the App Store exploiting consumer lock-in?

3.7. Cost Structures of IPs, ISPs, CPs, and ASPs
Developing, maintaining, and operating digital services have associated costs. Digital
services may have large fixed costs but zero marginal costs. The fixed costs of
providing a digital service are divided into two parts: Capital Expenditures (CapEx)
and Operational Expenditures (OpEx).
CapEx is the money the company spends to acquire physical assets (e.g., network
infrastructure, buildings, and support systems). OpEx is the money the company
spends to maintain and manage its business operations (e.g., salaries, administration,
research and development, and running costs for operating the physical infrastructure).
Physical assets are depreciated every year. OpEx is not depreciated and is regarded as
lost when spent. Note that, although there is OpEx associated with digital services,
they still may have zero marginal cost. This is because the OpEx is independent of the
number of units produced of the digital service, up to a certain threshold. Hence, both
CapEx and OpEx may be regarded as fixed costs and not marginal costs. When
analyzing digital businesses, an important aspect is to identify if the associated costs
are OpEx or CapEx.
Figure 3-10 illustrates the CapEx and OpEx for IP, ISP, CP, and ASP. The IP
usually requires large investments in equipment and infrastructure (high CapEx), which
is expensive to manage, operate, and maintain (high OpEx). Because of the high
CapEx, there are few competing IPs in the same region. The ISP does not need to
invest in expensive ICT infrastructure, since it buys access to it from the IP. The major
cost elements of the ISP contributing to the OpEx include: The cost of accessing the
ICT infrastructure, customer support, subscription management, and billing.
Notation

IP
ASP CP Content Provider
ISP IP Infrastructure Provider
OPEX
CP
CAPEX

Figure 3-10. CapEx and OpEx for stakeholders in digital markets.
Most services we associate with the Internet are information services, and thus, in the
business area of the ASP and the CP. These services are mostly pure software
applications. They usually require small investments (low CapEx) and OpEx ranging
from low to very high (e.g., customer interactions, network access and transport,
outsourcing of processing, and storage). Because of very low CapEx, and often, low
OpEx, there are many ASPs—most of them small companies, often only employing
one person. The competition between ASPs is much more complex, dynamic, and
unpredictable than the competition between ISPs. Low CapEx and potential low
OpEx are also contributing factors to innovation in information service markets. On
the other hand, some of the ASPs are among the top ten largest companies in the
world. These companies may have both high CapEx and high OpEx, due to the size
and breadth of their business operations.

Activity 3-5. CapEx and XaaS

Consider a company in the digital economy with high CapEx.
Describe how this company may exploit XaaS (see BOX 2-1) to
reduce CapEx. What are the advantages and challenges of using
XaaS to reduce CapEx?

Digital Markets 117
3.8. Market Evolution

Market evolution describes and quantifies how digital services are adopted by
consumers over time. When a digital service is launched in the market, there are initially
zero consumers using the service. If successful, the digital service will start to attract
consumers.
Figure 3-11 shows an example of the market evolution of three non-competing
digital services. Service A grows and attracts consumers until it reaches a long-term
stable state. The market for the service may then be saturated, meaning that all
consumers in the market have adopted the service. The market for mobile telephony
in Norway and many other Western countries has followed such an evolution. Service
B grows until it reaches a maximum. Thereafter, it declines and loses consumers,
possibly because of a competing service replacing Service B, or because it looses its
attractiveness over time. Eventually, Service B will disappear from the market. The
Massive Multiplayer Online Game (MMOG), World of Warcraft, has followed this
market evolution. Service C grows slowly but fails to reach critical mass and will never
become fully adopted in the market. This is the case for numerous digital services that
never become a success.
Service A
Market share
Service B
Service C
Time

Figure 3-11. Market evolution for three digital services.

3.8.1. Initial Market Evolution
The initial market evolution of a digital service is critical. This is because the digital
service must reach critical mass within a certain period to become financially
sustainable. If not, there is a high risk that the digital service will be shut down and
taken off the market. There are three broad scenarios concerning the initial market
evolution:
Scenario 1. The initial growth process may depend on positive feedback from
the market; for example, word-of-mouth (see Section 2.5). This means that
new consumers are attracted to the service only if there are other consumers
using or recommending it. These consumers are referred to as imitators or
late followers. Sometimes, the initial growth is so slow that the provider may
withdraw the product from the market prematurely. Some social media
services, such as Facebook, show this type of market evolution.
Scenario 2. If the motive for buying the product is independent of who else
has bought it, the initial growth may be fast. These consumers are referred to
as innovators or early adopters. However, the initial growth rate also depends
on other market parameters, such as price and perceived usefulness of the
product. Hence, even in this case, the market penetration may be slow.
Scenario 3. Sometimes, there are two types of consumers, in which one group
purchases the product because of its popularity (late followers), while the other
group purchases the product because of its perceived utility or novelty (early
adopters). Scenario 1 and 2 are special cases of Scenario 3 that—because of
their initial behavior—are worth to study separately in order to understand
some of the strategic problems associated with marketing new digital products.

3.8.2. The S-Curve
The evolution of markets in Scenario 1 in Section 3.8.1 takes the shape of an S-curve,
as illustrated in Figure 3-12. If most of the users are imitators, the evolution of markets
in Scenario 3 usually also follows an S-curve. The S-curve takes its name from the
shape of the curve. In mathematics, S-curves belong to the categories of curves called
“sigmoids.” A sigmoid is defined as a curve that is monotonically increasing from a
lower-bound curve (e.g., 0) to an upper-bound curve (e.g., 1). Examples of sigmoids
are: The solution of the general Bass equation, and the logistic equation (the Bass
equation without innovators). Section 5.2 shows the mathematics behind the Bass
equation and the logistic equation.
Figure 3-12 shows how the S-curve goes through three distinct evolutionary
phases: First, a slow start; followed by steady growth; and, finally, saturation. The
time spent in each phase is different for different digital services. The same digital
service may develop along different S-curves in different geographical regions.
The first phase is characterized by slow market growth and may last for several
years. Examples of slow market penetration are:
Mobile telephony in Norway from 1981 to 1993. The market penetration
for mobile phones increased from nil to about 8% during this period. The
Nordic Mobile Telephone (NMT) commenced operation in 1981. The user
equipment was expensive, bulky, and heavy, so the market penetration was
small. The GSM mobile phones entering the market in 1992 were lighter,
handheld, cheaper, and offered more services. The market share for mobile
services built up before 1993 was the most important reason why mobile
Digital Markets 119
services grew faster in Norway (and in the other Nordic countries) than in any
other European country.
World Wide Web from 1993 to 1998. WWW was recognized as a new
Internet service in 1993. Within a few years, the Internet became the primary
data network for the network providers, replacing earlier networks, such as
X.25. There were several reasons for the slow start: Few computer terminals
in homes in 1993; no previous use of private email; and little information
available on the Internet—the first few online newspapers became available in
1995.
Facebook from 2004 to 2008. During this period, the number of people using
Facebook increased very slowly. The market size reached a threshold in 2008,
when network effects set in, thereby generating rapid growth in the number
of users. In this case, network effects were the most important cause for the
growth of Facebook after 2008.
Slow start Growth Saturation

Market share
Time

Figure 3-12. The S-curve.
In the growth phase, the digital service undergoes fast expansion as new consumers
adopt the service. This phase is often characterized by exponential growth since the
number of users may double—say, every six or twelve months. Examples of digital
services in this phase are: Mobile telephony in Norway from 1993 to 2010, and the
WWW from 1998 to 2015. The growth phase usually appears after the digital service
has attracted enough consumers to reach critical mass.
In the third phase (saturation), the growth of the digital service slows down, since
most of the potential consumers have adopted the digital service. Even though the
market is saturated, there will still be new consumers entering the market—young
people grow up and old people die. In addition, new hardware, upgrades, or versions
of the digital service may promote new sales. This phase is characterized by slow
growth but many consumers. The market for mobile telephony and Internet usage in
Norway is now saturated (as of 2018).
3.8.3. Empirical Evidence for the S-Curve

Market evolution that follows an S-curve has been identified in many empirical studies
of not only ICT but also non-digital goods and services. The reasons why goods and
services evolve according to the S-curve is complicated but can be justified by the
diffusion of innovations model presented in BOX 3-5, or mathematically, by the Bass
equation (see Section 5.2.1). Figure 3-13 contains some examples of ICT markets that
have evolved as S-curves.9 The curves are based on market penetration in the US.
Similar market evolution for the same products has been observed in Europe. Each
product starts with 0% market penetration and approaches 100% market penetration
after some time (typically 10–20 years). Several of these products are commodities in
the sense that they have become a fixed ingredient in almost every home.

100
Market penetration in % of population
Radio
80 TV
Color TV
60 VCR
40
20
1920 1930 1940 1950 1960 1970 1980 1990 2000

Figure 3-13. Empirical market evolution of selected ICT products.
The market evolution may result in a long-term stable market, such as the market for
mobile communications. In many parts of the world, most people that have acquired
a mobile phone along with a subscription to access telephony and the Internet, will
continue subscribing and upgrading their phones on a regular basis. Eventually,
everyone will own the product or service, so the market becomes saturated (e.g.,
Service A in Figure 3-11).
In other cases, the market may reach a maximum and thereafter decline, so the
product finally disappears from the market (e.g., Service B in Figure 3-11). The plot of
this market evolution takes the shape of a bell curve.
Digital Markets 121
BOX 3-5. Diffusion of Innovations

Everett Rogers was a Professor of Communications at the University of New Mexico.
In 1962 he published his widely acclaimed book, Diffusion of Innovations, which is
the second-most cited book in the field of social sciences.8 Rogers claimed that
innovations are adopted by users according to their willingness and ability to use new
innovative goods and services. Rogers defined diffusion “...as the process by which
an innovation is communicated through certain channels over time among members
of a social system.” An innovation, according to Rogers, can be anything perceived as
new by an individual, including technologies, services, products, processes and social
systems. It is the perspective of the individual that decides if something is new or
not. Examples of diffusions that Rogers describe in his book include the Internet,
kindergartens, refrigerators, math, drugs, September 11 terrorist attack news and
the DVORAK keyboard—the theory on diffusion of innovations is indeed applicable
to a number of vastly different areas. Key questions addressed by Rogers is why, or
why not, an innovation is diffused in a social system, in particular when the
innovation objectively seems like a good idea improving living conditions for people.

S-curve 100 %
Rate of adoption
50 % Market share
Innovators Early Early Late Laggards

adopters majority majority

Rogers divided the population of users into five categories, according to when they
adopt an innovation: Innovators (2.5%), early adopters (13.5%), early majority (34%),
late majority (34%), and laggards (16%). The figure above shows the relative number
of users adopting an innovation as a function of time. Observe that by integrating the
rate of adoption we obtain the S-curve, which shows the cumulative growth of the
number of users that have adopted an innovation. The diffusion of innovations model
is used in several business areas—including the digital economy—to forecast the
market evolution of new products. Section 5.2 presents the mathematics behind the
diffusion model and the S-curve.

Figure 3-14 shows the evolution of mobile phones (the sum of GSM, 3G, and 4G) in
Norway, China, and Malawi.10 The Norwegian market was in the slow start phase from
1981 to 1993, then grew rapidly from 1993 to 2005, and reached saturation in 2010.
Note that now, many people own more than one mobile phone (more than 100%
market share); most likely, one private subscription and one work-related subscription.
Another reason for the high market penetration is that mobile phones are used in
autonomous systems for remote sensing and control. The market has evolved in a
similar way in other European countries. The Chinese and Malawian markets follow
the same pattern as the Norwegian market; however, delayed by ten or fifteen years.
By using our knowledge of the S-curve, it is possible to predict the future evolution of
all these markets.
120
Norway
Mobile phone subscriptions per 100 people
China
100
Malawi
80
60
40
20
0
1980 1984 1988 1992 1996 2000 2004 2008 2012 2016
Year

Figure 3-14. Mobile phone subscriptions in Norway, China, and Malawi.
The European market for new mobile phone subscriptions is now saturated. The same
applies to the mobile markets in several other countries. These markets will not grow
significantly, even if a new-generation mobile system is introduced. However, there
will be new demands for mobile terminals for each new generation of mobile phones,
so the business potential for manufacturers and suppliers of such devices is good.
The markets for several digital services may become saturated and stop growing
after some time. When approaching saturation, market growth becomes slower and
slower simply, because there are fewer and fewer potential consumers. This
observation—and the fact that the early market growth is very slow—is important
when adapting the market strategy. In the slow start phase, the strategy is to be patient
Digital Markets 123
and stay in the market until it starts increasing, and to find measures by which early
market adoption is stimulated. As mentioned in Section 3.8.2, this can take several
years. In the growth phase, the strategy is to adapt to admitting many new consumers,
and to prepare for the possibility that the market may stagnate at some point in time.
In the saturation phase, the strategy is to shift the attention from a growth strategy to
a strategy of a stagnated market, in which the objective may be to find ways to boost
revenue; for example, by improved technology or new products and services. Note
that several social media (e.g., Facebook, Twitter, and YouTube) have not yet reached
saturation and are still on the steep side of the S-curve.

Activity 3-6. Market Evolution of Mobile Phone Subscriptions

Identify the three phases—slow start, growth, and saturation—for mobile phone
subscriptions for Norway, China, and Malawi in Figure 3-14. How do you think the
number of mobile phone subscriptions in Norway, China, and Malawi will evolve in
the period from 2012 to 2025? Make a graph and explain. How has the release of
NMT (1981), GSM (1991), 3G (2003), and 4G (2009) impacted the market evolution
observed in Figure 3-14? How do you think the release of 5G will impact the market
for mobile phones?

3.9. Competition, Cooperation, and Coopetition

Section 3.6 contains a layered business model for the Internet consisting of: A network
layer accommodating the infrastructure providers (IPs) and the network service
providers (ISPs); a transport layer, which is the business arena of the manufacturers of
user equipment; and an application layer containing applications, services, and content.
In the layered Internet model, there is competition between companies within all three
business layers. Companies usually compete within the same business layer and not
between different business layers. At the same time, companies operating in digital
markets cooperate. Companies at different layers must obviously cooperate to provide
digital services to consumers. For example, an electronic newspaper needs the support
of ISPs to deliver the newspaper to its readers. This is called vertical cooperation.
Companies in the digital economy may also cooperate at the same business layer
(horizontal cooperation). Since companies compete within the same business layer,
such companies may both compete and cooperate at the same time. This is called
coopetition.11
Figure 3-15 illustrates the concepts of competition, cooperation, and coopetition.
The figure shows how a user of a chat service can select between various providers at
all three relevant business levels independently. The user may select the type of user
equipment: Apple iPhone, Samsung Galaxy, or Google Pixel. The user may also select
between several ISPs: Telenor, Telia, or TDC. Finally, the user may select one out of
four chat applications: Skype, WeChat, WhatsApp, and Messenger. The chat
application can be used with any combination of user equipment and ISP. However,
chat applications are not necessarily compatible—if a user selects Skype, they cannot
chat directly with another user using WeChat. This is because there is no standard
among chat applications; therefore, they cannot interoperate.
ASP
Telenor Telia TDC ISP
Apple Samsung Google User

iPhone Galaxy Pixel equipment

Figure 3-15. Competition, cooperation, and coopetition in digital markets.
On each business level (ASP, ISP, and user equipment), companies compete to attract
users. Skype competes with WeChat, WhatsApp, and Messenger; Telenor competes
with Telia and TDC; Apple competes with Samsung and Google. On the other hand,
Skype does not compete with Telenor, Telia, or TDC, since they are at different
business layers. This is a truth with modifications, since Telenor is also an ASP offering
a chat application through its SMS service. However, in its role as an ISP, Telenor does
not compete with Skype. Observe that Figure 3-15 is an example of the general model
illustrated in Figure 1-11 in Section 1.7.
Cooperation is necessary in the digital economy. This is because the services over
the Internet are too complex for full provision by a single provider. Nevertheless, some
of the largest companies in the digital economy (e.g., Google and Microsoft) buy up
competing companies to reduce competition, and other companies to supplement their
product portfolio to gain increased control of the value chain for the services they
offer. By doing this, these companies become digital conglomerates, operating in
several of the layers in the layered Internet model.
Digital Markets 125
BOX 3-6. E-banking

E-banking (online banking or Internet banking) is the provision of digital banking
services through the Internet or mobile devices. The consumer can access their bank
data and perform bank operations at any time or from any geographical location. E-
banking has disrupted the traditional banking services by providing permanent
access to the bank from anywhere and by reducing transaction costs. Some banks
are “virtual banks”, meaning that they only have online presence through an e-bank
system.

In an e-bank it is essential to provide adequate security measures, including the use
of cryptography and passwords. To provide a complete e-banking service,
cooperation between stakeholders at different business levels is necessary. This is
illustrated in the figure below. The user is accessing their e-bank application through
their laptop over the Internet and is authenticated via their smartphone. This
authentication service in Norway is called mobile BankID.

E-bank application Authentication
Internet Mobile ISP
Laptop
iPhone
User

The authentication of the user takes place over the GSM/3G/4G network by first
authenticating the smartphone of the user and thereafter, sending a onetime
password via SMS. The onetime password is then returned to the bank from the
laptop to complete the authentication process. The independent stakeholders are:
The bank, the authentication provider, the mobile network operator, and the
Internet provider. Note that cooperation between different business layers and
within the same business layer is needed to provide a complete e-banking service.

Definition 3-3. Competition, Cooperation, and Coopetition

Companies compete within the same business layer and cooperate both within the
same business layer (horizontal cooperation) and across business layers (vertical
cooperation). Coopetition implies that a company simultaneously competes and
cooperates with other companies.

To provide a complete digital good or service, it is necessary for companies at different

business layers to cooperate. For instance, in Figure 3-15, cooperation between Skype,
Telenor, and Apple iPhone is necessary to provide the complete digital chat service.
This is vertical cooperation. Companies that form vertical structures depend on one
another for the provision of the digital service. These companies may have or not have
formalized cooperation agreements between them. In any case, through standards,
contracts, and agreements, they each provide elements of the complete digital service.
In the example in Figure 3-15, the Apple iPhone can access wireless networks (e.g., 4G
and WiFi); Telenor provides a 4G network, and the chat service of Skype can be
provided to the iPhone over the 4G network of Telenor.
A Telenor subscriber can communicate with a Telia subscriber, a TDC subscriber,
or a subscriber of any other ISP. International agreements enforce cooperation
between ISPs to ensure interoperability between operators located in different
countries and within the same country. It is for the benefit of the market and the users
that companies in the same business layer cooperate. This is called horizontal
cooperation. These companies also compete for the same customers. As explained
above, this market behavior is called “coopetition.”
Companies may compete for market shares in the usual manner. Sometimes, it
may be beneficial for the companies to cooperate rather than compete. Examples of
this include: Codeshare among airlines, traffic agreement between telecommunications
operators, and the flow of money between banks. Such cooperation enlarges the total
market and thus, the business of each company. Sometimes—as in
telecommunications and power distribution—government regulations may force
companies to cooperate to avoid the formation of a monopoly.
A company can be a user equipment producer, an ISP, and an ASP at the same
time. Figure 3-16 shows examples of possible configurations. In the first scenario,
Company A owns the CP and the ASP, and Company B owns the ISP. In the second
scenario, Company A owns the CP, while Company B owns the ISP and the ASP. In
the third scenario, Company B owns the ISP, the ASP, and the CP. Companies face
different kinds of competition and cooperation depending on the ownership scenario.
In the second and third scenario, for example, market regulations may require that
other ASPs get access to the ISP with the same terms as the ASP owned by the same
company (see the discussion on VNOs in Section 3.4).
Digital Markets 127
Notation
CP CP CP
Company A
Company B
ASP ASP ASP

C Consumer
ISP ISP ISP
CP Content Provider
C C C

Figure 3-16. Vertical organizations of ISPs, ASPs, and CPs.
After the market was opened for competition in 1992 for mobile services and in 1998
for all other telecommunications services, cooperation has been forced upon the
operators by government regulations. These regulations ensure fair competition
between operators offering services in the same region. The regulations also resulted
in lower prices and more innovations on the Internet. Before the telecommunications
market was opened for competition, the telecommunications operators formed cartels
operating in non-overlapping regions. In this setting, competition did not exist.
Finland
Norway
Elisa 35%
Telenor 51 %
Telia 34 %
Telia 36 %
DNA 20 %
Other 13 %
Others 11 %
Sweden
Telia 36 %
Denmark Tele2 27 %
TDC 45 % Telenor 18 %
Telenor 32 % Hi3G 13 %
Telia 9 % Other 6 %
Other 14 %

Figure 3-17. International competition between ISPs.

It is an obvious demand from society that everyone should be able to communicate

with anyone else everywhere in the world via communication networks. While
telecommunication companies were regional monopolies (before the 1980s), this was
also in their best interest.
With the complex owner structure of the telecommunications networks today,
this situation has changed. In fact, ISPs may now be competing for the same market
in several geographical regions. This may result in numerous complex strategic
challenges, as illustrated in Figure 3-17. The figure shows the market shares of the ISPs
Telenor, TDC, Tele2, Telia, Elisa, and DNA in the Nordic mobile telephone market
in 2016. Telia is present in all markets (Norway, Sweden, Denmark, and Finland), and
has a dominant market position in Sweden. Telenor has a dominant market position in
Norway and is present in Denmark and Sweden as well. TDC is the market leader in
Denmark but is not present in any other country. These ISPs need to form different
strategies for each region, depending on their market position.

Activity 3-7. Vertical Cooperation

Identify and give examples of vertical cooperation between
online video and music streaming providers and Internet
Service Providers.

A digital market is a mechanism for the trading of digital goods and services and for
the online trading of tangible goods and non-digital services. This chapter has
presented various digital markets, including: E-commerce markets, network access
markets, and information service markets. Even though these markets share common
characteristics, they are also unique in their own way. Models of stakeholders and
relationships between stakeholders—including the layered Internet model—have also
been presented. These models are useful for gaining insight into the complexities of
digital markets. Many markets in the digital economy evolve as an S-curve. In some
digital markets, the S-curve can be used to predict market dynamics. Competition,
cooperation, and coopetition among stakeholders add to the complexity of the market
evolution.
Key Points

A digital market is a mechanism for the trading of digital goods and services, and
for the online trading of tangible goods and non-digital services.
Digital Markets 129
Stakeholders operating in digital markets include: The Infrastructure Provider (IP),

the Internet Service Provider (ISP), the Content Provider (CP), the Application
Service Provider (ASP), the Device Provider (DP), and the consumer.
E-commerce is the online trading of tangible goods, digital goods, and services
with some sort of financial activity.
ISPs that do not own their own network infrastructure are called Virtual Network
Operators (VNOs).
Over-the-Top (OTT) services are media services offered by the ASP or CP directly
over the network of the IP.
Many digital services are experience goods. The strategic challenge for the supplier
is then to implement methods by which the user can assess the quality of such
goods before they are consumed.
A prosumer is a consumer and producer of goods and services at the same time.
Several users of Wikipedia are prosumers.
In the layered Internet model, the Internet is divided into three parallel planes:
Networks, user equipment, and applications. This model is useful for analyzing
market behaviors—such as, competition, cooperation, and coopetition—in digital
economics.
The fixed costs of companies in the digital economy can be divided into capital
expenditures (CapEx) and operational expenditures (OpEx).
The temporal evolution of many digital services follows the shape of an S-curve.
Companies usually compete within the same business layer. They may also
cooperate within the same business layer (horizontal cooperation) and across
business layers (vertical cooperation).
Coopetition implies that a company simultaneously competes and cooperates with
other companies.
Further Reading
Everett Rogers. Diffusion of Innovations. 5th edition. Free Press. 2003.

Everett Rogers published his first edition of the book Diffusion of Innovations in 1962.
The book describes the concept of diffusion, the diffusion process, and how
innovations are adopted by individuals and organizations. It is a classic book, having
influenced many academic works in the last 50 years.
Kenneth C. Laudon and Carol Guerico Traver. E-commerce 2017. business.

technology. society. Pearson. 2017.
This book presents a comprehensive treatment of e-commerce. It deals with topics
such as e-commerce strategy, security, marketing, and infrastructure. The book
contains several practical case studies and guides for practitioners doing e-commerce
business.

Chapter 4
Digital Business, Strategy, and

Innovation

Learning Goals

The definition of innovation
Product life cycles, S-curves, and disruptive innovations
The background of and motivation of business models
How to apply the Business Model Canvas
How to apply the Stakeholder Relationship Model
The business models of World of Warcraft, Spotify, Facebook, and Wikipedia
The multi-sided platform business models of Airbnb and Bitcoin
Assets, core competencies, and Porter’s Five Forces Model

ICT is one of the major sources of disruptive innovation in several business sectors.
This is because digital goods and services create new business opportunities that
replace earlier ways of doing the same business. To achieve competitive advantage,
companies must adapt to and exploit the opportunities that ICT brings. Failure to
recognize the disruptive effects caused by ICT may result in revenue losses and, in the
worst-case scenario, bankruptcy. Understanding business models is a key competence
organizations need to make use of new and emerging ICT capabilities. Successful
companies need to formulate digital strategies that harvest the potentials of digital
services and express these strategies in business models. This chapter discusses digital
innovation, business models, and strategy. First, a discussion on innovation and the
concept of disruptive innovation is presented in Section 4.1. Then, the concept of
business models is explained in Section 4.2. Sections 4.3 and 4.4 present the Business
Model Canvas (BMC) and the Stakeholder Relationship Model (SRM), respectively.
These models are essential for understanding the different aspects of the digital
business such as value proposition, customer relationships, revenue flows, and key
partners and the relationship between them. Section 4.5 contains examples of a range
of popular business models in the digital economy. Finally, Section 4.6 discusses
strategical aspects including the company’s assets and core competencies, and Porter’s
Five Forces Model.

4.1. Digital Innovations
An innovation is the implementation of a new or significantly-improved product or
process, a new marketing method, or a new organizational method in business
practices, workplace organization, or external relations.1 This is the OECD definition
of innovation, which may be the most precise among the 40+ definitions of innovation
that exist.2 An innovation can also be a practical implementation of an invention or an
invention that has been commercialized. A digital innovation is an innovation that
impacts the digital economy; that is, an innovation in ICT, digital goods, or digital
services. There have been numerous digital innovations during the last few decades.
Some of them are listed in Figure 1-9 in Chapter 1, in which technologies or
innovations were categorized as either hardware, mobile/wireless, or
software/services. Note that some innovations are a combination of these categories;
for example, Snapchat, which is categorized as both a software/service and
mobile/wireless.
Definition 4-1. Innovation

An innovation is the implementation of a new or significantly-improved product
(good or service) or process, a new marketing method, or a new organizational
method in business practices, workplace organization or external relations.

Digital Business, Strategy, and Innovation 133
However, Figure 1-9 doesn’t capture every aspect of innovation in the digital economy.
In general, innovations may be categorized into the following types: Technology,
services, financial, managerial/organizational, marketing, institutional, and other.3
Hence, in addition to the innovations listed in Figure 1-9, innovations in the digital
economy can also be new forms of trade, market mechanisms, and organizational
principles. Therefore, concepts—such as commons-based peer production (Section
2.2.2), crowdsourcing (Section 2.2.3), multi-sided platforms (Section 2.4), and the long
tail principle (Section 2.11)—are also regarded as digital innovations. These concepts
are innovations that companies may apply in their business operations. All of them are
enabled by other digital innovations and evolutions in the digital economy. For
example, the long tail principle is supported by—and dependent on—the cheap mass
storage of data, ubiquitous Internet access, and advanced search mechanisms.
Development Introduction Growth Mature Decline

Profits / Sales
Sales
Profits
0
Time
Break-even
Figure 4-1. Product life cycle of a successful innovation.
Innovations can be modeled using a Product Life Cycle (PLC), as illustrated in Figure
4-1. Here, the sales and profits of an innovation throughout its lifetime are plotted as
a function of time. The life cycle of an innovation consists of five stages: Development,
introduction, growth, maturity, and decline. Each stage has its unique challenges and
opportunities. Not all digital innovations follow the PLC; however, it is a well-known
and useful framework for discussing the evolution of innovations and technologies. In
the development phase, the profit is negative because there are no sales generating
revenue, but there are potentially high costs to develop the innovation. Use of the
innovation starts to accumulate in the introduction stage, in which the innovation is
fully developed and released in the market. Profits are usually still negative due to the
costs of operations, marketing, and refining the innovation. In the growth stage, sales
increase and profits turn from negative to positive at the break-even point. Costs
decline as the innovation is fully developed and profits and sales increase into the
maturity stage. At some point, the sales or profits reach their peak value. Following
this peak value—and entering the decline phase—sales and profits decrease, since the
innovation at some time will be replaced by new innovations and again become
unprofitable before eventually leaving the market.
A common metric to evaluate the value of an innovation is to calculate the net
present value (NPV) as follows:
B
=?
<=> = ?
1+A
?C6
Here, =? is the net profit during period D , 5 is total number of periods, and A is the
internal discount rate. A positive NPV means that the innovation is financially viable,
while a negative NPV means that the innovation will not generate enough revenue to
cover the costs. In general, it is extremely hard to calculate the NPV for digital
innovations. This is primarily because the sales and revenue are hard to predict, due to
the choice of business model, network effects, and path dependence, among other
factors. However, every innovation must be profitable over time, since investors
funding the innovation require payback on their investments.
According to work done by Clayton Christensen, innovations can be divided into
two main types:4
Sustaining innovation: An innovation that improves the good or service.
Disruptive innovation: An innovation that creates a new market by
establishing a new set of value propositions and a new set of performance
metrics.
Sustaining innovations are improvements in performance or functionality expected by

consumers as the good or service is refined. Examples of this include: New models of
a car, software updates, and the regular release of new smartphone models.
Disruptive innovations can be subcategorized as “low-end disruptions” or “new-
market disruptions.” Low-end disruptions target customer segments with low
requirements for performance. They include new products that are typically cheaper
and simpler compared to existing products in the market. Low-end disruptions are
often assembled from off-the-shelf technologies in a new and innovative way. New-
market disruptions create a new market that is currently not served. The performance
metrics of the current market are redefined.
Disruptive innovations may be unattractive in the beginning since they often fail
to satisfy the demand of current consumers. The potential impact of disruptive
innovations is hard to estimate because the market they target does not exist when the
innovation is developed. Table 4-1 shows examples of disruptive innovations in the
digital economy. Creative destruction usually follows a disruptive innovation as current
markets and performance metrics are redefined and replaced by those of the novel
technology.
Table 4-1. Disruptive innovations in the digital economy

Disruptive Market
Comments
Technology Disrupted
Telephones enabled voice communication and had much higher

capacities than the telegraph. Western Union, for example,
declined to enter the telephone market since they saw the
telephone as a threat to their profitable long-distance telegraph
Telephony Telegraphy
service (they allegedly declined to buy the patents for the
telephone from Alexander Graham Bell in 1876). Eventually, the
telephone made the telegraph obsolete; however, only after
more than 100 years in coexistence.
The transistor was smaller, more reliable, and could be mass-

produced at lower costs compared to the vacuum tube. It made
Transistor Vacuum tube
the vacuum tube obsolete less than two decades after its
commercial entry in the 1950s.
In the beginning, digital cameras were expensive and had poor

picture quality. However, digital photography eventually
Digital Chemical replaced chemical photography after several improvements over
photography photography the year. Kodak, a major chemical photography company, filed
for bankruptcy for protection in 2012, due to their failure to
adapt to the emerging digital photography.
Smartphones are more compact than a PC or a laptop, and were

initially slow and had small storage capacities. After the
PC and
Smartphones innovation and adoption of apps and app ecosystems,
laptops
smartphones are in the position to replace the PC and laptop.
Smartphones have not made the PC or the laptop obsolete (yet).
The sales of physical CDs, DVDs, and Blu-ray have fallen

Online CDs, DVDs, dramatically. Digital services—such as Netflix, HBO, iTunes,
media and Blu-ray Spotify, and YouTube—have, to a large degree, replaced the need
for storing physical media at home.
Wikipedia provides a free online encyclopedia with more than

five million articles (in English). It is produced by prosumers
(users). The traditional encyclopedias could not compete with
Wikipedia Encyclopedia
Wikipedia: They often cost more than $1,000, took up large
physical space, contained only 100,000 articles, and took years to
update content.

BOX 4-1. Nordic Disruptions

Facit
The Swedish company, Facit AB, was
one of the world’s leading
manufacturers of mechanical
calculators. It had 15% of the total
market when it was at the top. In
1970, it employed 14,000 people. One
year later, it went out of business
because cheap electronic calculators
based on the transistor (see BOX 1-5)

entered the market. This made the Facit mechanical calculator.
mechanical calculator obsolete. Source: Hannes Grobe. Wikipedia. 2006.

Facit did not believe that the electronic calculators were superior and would,
therefore, not replace the mechanical calculators in their product portfolio. This
blindness to disruptive technological change is called the “Facit trap.” The Italian
company, Olivetti, also produced mechanical calculators but they recognized the
shift to electronic devices early and survived the disruptive technology change by
shifting their product portfolio in time.

Norsk Data
The Norwegian company, Norsk Data, was
one of the world’s leading manufacturers of
minicomputers. In 1987, they were the
second-largest company in Norway by
market capitalization and employed 4,500
people. Despite this, they went bankrupt in
1992. The reason was that they did not
comprehend the impact that PCs would have
on the minicomputer market—the PC made
the minicomputer obsolete. This ignorance
even persisted after one of their largest
customers—the particle research center,
CERN—warned them that they would

replace their minicomputers with PCs to Norsk Data’s first minicomputer NORD-1 (1968).
build a more flexible computer center. Source: Thomas Skogestad. Wikipedia. 2006.

Both these examples show that disruptive innovations are not only a recent
phenemona but have also happened in the past with serious implications for those
involved.

BOX 4-2. Blue Ocean Strategy

The blue ocean strategy is a marketing theory that focuses on creating new,
uncontested market spaces (blue oceans). This is opposed to continuing to compete
or entering a market with fierce competition (red oceans). The blue ocean strategy
was proposed by W. Chan Kim and Renée Mauborgne, in their book Blue Ocean
Strategy: How to Create Uncontested Market Space and Make Competition
Irrelevant.5

Red ocean Blue ocean

The blue ocean strategy is an alternative to fierce competition strategies, in which
the main goal is to beat the competition with cost-efficiency and superior products.
Companies applying the blue ocean strategy look for opportunities to redefine
market segments and innovate new products and services that supply these new
markets. A key strategy to create blue oceans is to differentiate the product or
service portfolio to avoid existing competition. The blue ocean strategy has
similarities with new market disruption. Both focus on creating new markets by
supplying previously unserved customers. Also, both the blue ocean strategy and
new market disruption emphasize innovations built from existing “off-the shelf
technology,” rather than inventing new, advanced technologies.

Red Ocean Strategy Blue Ocean Strategy
Compete in existing market space Create uncontested market space
Beat the competition Make the competition irrelevant
Exploit existing demand Create and capture new demand

Source: W. C. Kim and R. Mauborgne. Blue Ocean Strategy: How to Create
Uncontested Market Space and Make Competition Irrelevant. Harvard Business
School. 2015

Figure 4-2 illustrates the productivity of sustaining and disruptive innovations over
time. Technology A is launched at time T1. Its productivity increases due to sustainable
innovations. At time T2, Technology B is launched. Technology B might be the result
of a sustainable innovation or a low-end disruptive innovation. In the beginning,
Technology B is inferior to Technology A. However, as time passes, Technology B
increases its productivity at a faster rate than Technology A, due to sustainable
innovations of Technology B. At some stage, Technology B outperforms Technology
A. Technology B may eventually replace Technology A entirely at time T3.
Productivity
Technology B
Technology A
T1 T2 T3 Time

Figure 4-2. Productivity of sustaining innovations.
Note that the “S-curves” in Figure 4-2 are not the same S-curves discussed in Figure
3-12 in Section 3.8.2. The S-curves in Figure 4-2 plot productivity of a technology as a
function of time, whereas the S-curves in Figure 3-12 plot user adoption of a
technology or digital service over time.
Established market leaders often fail to remain at the top after the market of their
products has been impacted by a disruptive innovation. There are several reasons for
this; for example: The fear of cannibalizing a profitable product portfolio, and
resistance against changes within the organization. Pursuing disruptive innovations that
may replace current high revenue-generating products seems illogical in the short run.
In addition, pursuing a disruptive innovation is associated with high risks and
uncertainties. It should be added that not all innovations will turn into successful
disruptive innovations that replace current technologies. To determine the innovations
that will eventually succeed is a tough task, and most of the times, it is impossible to
predict. Disruptive innovations have no initial markets implying that “listening to the
customer” is not a good advice when evaluating the potentials of a disruptive
innovation. This is often the opposite strategy of what market leaders use when
developing and refining their current product portfolio—in this case, feedback from
the customers is very important for success.
Activity 4-1. Kodak

Read about the history of Kodak, especially Kodak’s failure to
embrace innovations in digital photography (see, for example,
the article about Kodak on Wikipedia). What was the major cause
of Kodak’s downfall? Discuss how such a great company could fail
to recognize the importance of digital photography.

4.2. Business Models

Business modeling as a tool for strategic business analysis was developed in the
beginning of the 20th century. One of the first business models was the “bait-and-
hook” business model, in which a basic product is first offered for free or for a very
low price while necessary add-ons are sold for a high price. One example is the razor
(bait) and blades (hook). Another example from the digital economy is the Adobe PDF
software suite, in which the software needed to read PDFs is free (bait), while the
software needed to generate a PDF is expensive (hook).
Leading developers of new business models in the 20th century include companies
such as Ford, Toyota, Wal-Mart, FedEx, and Dell. Dell revolutionized the way
computers are sold to customers by bypassing retailers. Customers place the order
directly with Dell, who assembles the computer and ships it directly to the customer
(just-in-time production). This business model was enabled and fueled by the mass
adoption of the Internet. A common feature of these new business models is that they
often exploited breakthroughs in novel technologies. The usage of the term “business
model” started in the 1990s.
A business model describes how an organization (or company) creates, delivers,
captures, and keeps value.6,7 This includes: (1) How the organization earns money and
controls expenditures; (2) economic and organizational aspects of the organization; (3)
competition and market evolution; and (4) interrelationships between the organization
and its customers, key partners, and other stakeholders. Business models are used as a
strategic tool to identify key aspects of an organization’s business operations; that is,
the most important logics and operations that the organization relies on to earn money.
The main purpose of a business model is to describe the current state of the
organization. However, business models are also used as input to identify key strategic
actions for the organization. The business model may be very detailed and contain
every aspect of the organization’s business operations. It may also be used to analyze
and describe only parts of an organization’s business operations. Business models can
be applied to all kinds of organizations.
Definition 4-2. Business Model

A business model describes how an organization creates, delivers, captures, and
keeps value.

In the definition of a business model, the concept of value appears. Value, in this
context, is an abstract concept. Value might, for instance, be new features enabled by
novel technologies, improved performance, exclusive designs or brand status, low cost,
or increased usability. The core of a business model is the value that the organization
creates. An organization can justify its existence by creating value, delivering value to
customers, and supporting efficient mechanisms for gaining revenue from the value
created. In addition to this, the organization must also defend this value from
competing organizations.
An organization creates value by solving problems or satisfying customer
needs. A manufacturer of mobile phones may offer a low-cost mobile phone
to people with slender means and mobile phones with exclusive designs to
techno-freaks. This shows that the manufacturer can satisfy several user
groups at the same time.
An organization delivers value to the customer through either physical or
digital channels. Value delivery in this context refers to how the organization
transfers the value created to the customer. An example of value delivery is to
ship a purchased mobile phone to the customer via postal services.
An organization captures value when its customers pay for the good or
reward from the organization by other means. The revenue covers costs and
creates profit for the organization. An example of captured value is payment
for the mobile phone.
An organization keeps value by, for example, mechanisms to protect against
competitors. Examples are lock-in of customer products or services that are
difficult to copy, protection by copyrights, or product prices that cannot be
matched by competitors.
A digital business model is a business model applied to digital goods or services. Digital
business models have been facilitated by the widespread use of the Internet, mobile
technology, smartphones, and fast and small computers. The main reason for the
increased interest in business modeling in recent years is the opportunities created by
these technologies. As digital technologies mature and become adopted by the
population, novel business models that build on these technologies are created. These
business models may replace existing business models or create entirely new markets
supported by new business models (new market disruption). An example of this is the
business model for the music industry, which has been radically changed after the
introduction of the Internet, small and powerful music devices (e.g., the iPod), and
online streaming services (e.g., Spotify).
BOX 4-3. Funcom’s Business Model
Funcom is a Norwegian company developing video

games, known for titles such as Anarchy Online
(2001), Age of Conan (2008) and The Secret World
(2012). At its peak in 2008, Funcom had over 680
employees in several countries. The company
focused on developing big games with large budgets,
thereby competing with successful and market-
leading games, such as Blizzard’s World of Warcraft.

The year 2012 was critical for Funcom. The company launched the game The Secret
World with little financial success. Funcom had to cut its staff by several hundred
people. The Secret World did not attract as many players as expected. One of the
most important reasons for this was the choice of business model. The Secret World
was initially using a subscription-based business model. This was, in part, inspired by
the success of the business model of Blizzard’s World of Warcraft. Blizzard had
already used the subscription-based business model very successfully from the
launch of World of Warcraft in 2004. However, in 2012, many computer gamers
switched to a free-based business model used on most games available on social
media networks such as Facebook. Users did not accept to pay a monthly fee for
playing a game anymore. In the end, Funcom had to change the business model on
The Secret World from subscription-based to buy-to-play to align with market and
user trends.

Recent years have witnessed an increased complexity of business model designs. This
is primarily due to globalization and widespread competition, more complex and
refined technologies, and more complex organizations. In several business domains,
the increased complexity is caused by the extensive use of ICT. Digital companies
today do not need to own the physical goods they are selling. The business model of
eBay is to be a mediator between buyers and sellers—eBay does not own any physical
goods, even though millions of items are sold through eBay every year. Airbnb is the
world’s largest hospitality service, without owning any hotels or property. Uber
provides ridesharing services without owning any cars.
The business of connecting customers or different user groups is perhaps the most
important contribution of ICT in business modeling. This has similarities to the
transition from value chains to value networks. While the best way to model companies
in the industrial economy is by using the value chain model, the best way to model
companies in the digital economy is by using the concept of value network (see Section
2.3.3). The business model of a company may need revision and updating over time
and is sometimes completely rewritten due to changes in customer behavior, social
trends, economic boundary conditions, and technological evolution. Failure to update
business models may result in reduced profits and, eventually, bankruptcy.

4.3. The Business Model Canvas
Alexander Osterwalder proposed the business model ontology as part of his Ph.D.
thesis in 2005. Later, this business model ontology was refined to the Business Model
Canvas (BMC). The BMC is a framework for describing business models. It can be
applied to all kind of businesses, including digital businesses. The BMC is based on
describing the nine central building blocks of a business and modeling the relationships
between these building blocks. Figure 4-3 shows an outline of the BMC and how the
BMC is visualized in this book. The different building blocks in the BMC are described
in Table 4-2. The BMC has been applied to several digital businesses to better
understand business operations and relationships between stakeholders. In addition to
the BMC there are several other frameworks for describing businesses. These
frameworks focus on slightly different aspects of the business operations of a
company, however, they mostly agree on the core concepts of the business model.
Key partners Key activities Value proposition Customer relationships Customer segments
Key resources Channels
Cost structure Revenue streams
Figure 4-3. The Business Model Canvas.

Table 4-2. The nine building blocks of the BMC

Building Block Description
This is comprise of the values and benefits created by the organization
that are offered to one or more customer segments. The value
proposition may comprise one or several different propositions
Value proposition targeting different customer segments. The value proposition
describes the goods and services that the organization produces and
delivers to customers, as well as the benefits that customers get by
buying them.
Identifies one or several customer segments targeted by the

Customer segments organization’s value proposition. Different customer segments may
have different roles in the BMC.
Describes how the value proposition is transferred to the customer

Channels
segments.
Customer relationships Defines the organization’s relationship with the customer segments.
Describes the key activities needed for the organization with a special
Key activities
focus on how to create and offer the value proposition.
Classifies the key resources needed to perform the key activities and to
Key resources
create and offer the value proposition to the customer segments.
Identifies the key partners needed for the organization to create and
Key partners
offer the value proposition to the customer segments.
Identifies the elements that contribute to the cost of the organization,

Cost structure
including the cost of the various key activities.
Describes how the different customer segments contribute to the

Revenue streams
organization’s income.
The nine building blocks of the BMC can be divided into three groups: Value
proposition, value turnover, and value generation.
Value proposition is the core building block of the BMC. The advantages of
well-defined value propositions are: (1) Upholding a clear focus on the fundamental
activities for the business; (2) identifying and maintaining any core competencies that
the company may possess (see Section 4.6.2); (3) precise targeting of the production
toward the products that the users will have and, thereby, avoiding the production of
goods that nobody will buy; (4) the ability to change direction as the market evolves
and processes and products are substituted by new ones; (5) effective marketing that
focuses on user needs and user satisfaction; (6) a willingness to change direction based
on feedback from the users and the market evolution in general; (7) creating customer
confidence in the product; and (8) understanding how and why the product creates
value for the users.
Value turnover includes four building blocks: Customer segments, channels,
customer relationships, and revenue stream. These building blocks describe how the
organization generates value from its value proposition. More specifically, it describes
how the customers generate revenue for the organization.
Value generation includes the building blocks of key partners, key activities, key
resources, and cost structures. More specifically, it describes what is needed in terms
of resources, activities, and partners to create the value proposition and the costs
associated with this. Value generation should also specify—either directly or
indirectly—the value model (see Section 2.3) used by the company.
Examples of how to apply the BMC are given in Section 4.5. The BMC of specific
organizations is a thorough description of each of the nine building blocks and the
relationships between them. Figure 4-4 shows an example of these relationships.
6 5

9
1 2
4
8
Figure 4-4. Relationships between the building blocks in the BMC.
First, the value propositions (the goods and services and their benefits for the users)
and the customer segments are defined (1 and 2 in Figure 4-4). That is, what the
organization delivers and to whom. Second, the organization defines how the product
is provided to the identified customer segments through specific channels; for example,
over the Internet or by postal services (3). Third, the customers must pay for the
product and, hence, generate the revenue stream for the organization (4). The
organization may have one or several relationships to its customers (5). To create or
enable the value proposition, the organization performs a set of key activities (6). A
key activity may support one or several value propositions. In addition to key activities,
the organization needs key resources to create and enable the value propositions (7).
Both key activities and key resources cost money (8). Finally, the organization may
need to form strategic relationships with one or several key partners to support its
value proposition, key activities, and key resources (9).
The BMC is used to model high-level abstractions of an organization’s business
operations. For two different organizations doing business in the same business
domain, there might be small differences in the resulting BMC. However, even a small
difference in the BMC of two organizations—for example, if one of them is using the
core competencies in a smarter way—may render the business operations of the two
organizations radically different. If the BMCs of the two organizations are identical,
there is a motive for the organizations to reconsider the BMC to create significant
differences in their business operations to distinguish it from that of the competitors.
To gain a strategic advantage, it is often enough to focus on one specific building
block in the BMC. Seldom is there a need to redesign the business model completely
to differentiate itself from that of its competitors. This may be a critical issue if the
value proposition offered by a company is a commodity.
Successful business models may change over time—what turned out to be a
successful business model five years ago may not be a successful business model today.
The causes for this may be technological development, an altered competition arena,
new user demands, and different market behavior. Technological developments may
render a business model obsolete.

Activity 4-2. Massive Open Online Course

Massive Open Online Course (MOOC) was envisioned to disrupt
the educational sector by offering virtually free and ubiquitous
teaching online. Would you categorize MOOC as either a
sustainable innovation or a disruptive innovation? Design the
business model of a company offering a MOOC (for example,
Coursera) using the Business Model Canvas.

4.4. The Stakeholder Relationship Model

The relationships between an organization and its stakeholders are core aspects of its
business operations. The Stakeholder Relationship Model (SRM) identifies key
stakeholders engaged in the organization’s business model and the interactions that the
organization has with these stakeholders. Stakeholders in the SRM can be the
organization itself, customer segments, or key partners. Customers and key partners
are also identified and described in the BMC. Relationships defined in the SRM can,
for instance, be an exchange of services, value, money, formal agreements, network
effects, or other dependencies between the stakeholders. Figure 4-5 shows the
notations used to visually model the SRM.
Notations used in the SRM
S1 Stakeholder with name ’S1’.
. . . Group of identical stakeholders with

S1 S2 Sn
names ’S1, S2, ..., Sn’.
Text Relationship between stakeholders

with description ’Text’.
(+/+) Network effects between stakeholders

indicating positive (+) or negative (-)
network effects
Figure 4-5. Notations used in the Stakeholder Relationship Model.
One key relationship between stakeholders is network effects (see Section 2.5).
Network effects can either be positive or negative. The SRM models three different
kinds of network effects between two stakeholders, A and B: (+/+), (-/-), and (+/-).
The (+/+) network effect means that Stakeholder A induces a positive network effect
on Stakeholder B, and vice versa. Users in a telephone network have, for example, a
positive network effect on the other users in the network. The (-/-) network effect
implies that Stakeholder A has a negative network effect on Stakeholder B, and vice
versa. An example of this is highway traffic, in which each car has a negative network
effect on other cars on the road because of potential traffic congestion and the
increased probability of accidents. The (+/-) network effect means that Stakeholder A
has a positive effect on Stakeholder B, but Stakeholder B has a negative effect on
Stakeholder A. One example of this is commercials on television: The number of
viewers has a positive effect on advertisers that want as large of an an audience as
possible for the commercials, while advertisements interrupting the program have a
negative network effect on the viewers.
The SRM supplements the BMC by visualizing the relationships between the
organization and other stakeholders. One important purpose of the SRM, especially
for businesses in the digital economy, is that it illustrates the network effects that may
modify the competitive strength of the organization. Sometimes, these network effects
are dependent on each other, and induce positive feedback that adds to the complexity
of the business model.
Activity 4-3. Popcorn Time and Netflix

Popcorn Time and Netflix are two digital services with similar
value propositions. Use the BMC and the SRM to design the
business model for Popcorn Time and Netflix. What are the
major differences in the resulting business models? What is the
major technological difference between Popcorn Time and
Netflix?
4.5. Digital Business Models

A digital business model is a business model applied to digital services. In a digital
business model, the value proposition is a digital good or service. Typical examples of
this include: The business models of Facebook, Spotify, Twitter, Wikipedia, Microsoft
Windows, and Skype. It also includes the business models of sharing services—such
as Uber and Airbnb—since the platform that enables mediation between buyers and
sellers is a digital service. Platforms used for the sale of tangible goods—such as
Amazon and eBay—are also examples of digital business models.
Every digital good or service is associated with a unique business model. For some
of them, it may even be convenient to specify more than one business model. For
example, Facebook may have one business model for attaching users, and another for
capturing advertisers and other stakeholders buying access to data on the users of
Facebook. In this case, there is a strong relationship between the models because of
strong network effects. The business model should consider the relevant value model
(see Section 2.3); that is, whether the organization is a value chain, a value shop, or a
value network.
Definition 4-3. Digital Business Model

In a digital business model the value proposition is a digital good or service.
Sections 4.5.1–4.5.6 present six examples of digital business models that have had a
substantial impact on the evolution of the digital economy: World of Warcraft, Spotify,
Facebook, Wikipedia, Airbnb, and Bitcoin. These examples represent different types
of business models, since they exploit the various fundamental properties of the digital
economy differently. Table 4-3 summarizes the presented business models, their type,
and the most significant fundamental properties exploited by the digital service (the
fundamental properties referred to in Table 4-3 are described in Chapter 2). Note that
the business models presented in Sections 4.5.1 to 4.5.6 do not represent an exhaustive
list of all business models available for digital services. In the digital economy, you will
find variations of the models presented in Sections 4.5.1 to 4.5.6, such as hybrids (a
combination of two or more business models) and business models not covered in this
book.
Table 4-3. List of presented business models

Digital Service Type of Business Model Fundamental Properties Exploited
World of Warcraft Subscription Zero marginal cost, network effects
Spotify Freemium Long tail, network effects

MSP, zero ARPU, zero marginal cost,
Facebook Ad-based free
network effects
Commons-based peer Public good, CBPP, MSP, zero ARPU,
Wikipedia
production zero marginal cost
Multi-sided platform
Airbnb MSP, network effects
(non-digital service)
Multi-sided platform
Bitcoin MSP, network effects, public good
(digital service)
4.5.1. World of Warcraft

Blizzard’s online game, World of Warcraft (WoW), is an example of a digital service based
on the subscription business model. Here, customers (or subscribers) pay a periodic
(e.g., monthly or yearly) fee for accessing a service. Without the subscription, the
customer is not allowed to access the service. If a customer terminates his subscription,
he also loses access to the service.
WoW is a massive multiplayer online game (MMOG) released in 2004. The game
had over twelve million concurrent gamers (subscribers) at its peak in 2010. WoW
features a persistent 3D world, where gamers can interact, solve quests, and perform
tasks in collaboration with other gamers. New content and upgrades are continuously
added to the game by Blizzard’s team of game developers. Blizzard offers access to
many servers—each featuring a persistent world—to ensure load balancing and
optimal performance of the game. The persistent worlds are divided into several
geographical regions.
The BMC and the SRM of WoW are outlined in Figures 4-6 and 4-7, respectively.
The value proposition of WoW consists of giving gamers access to the game and the
world’s content (1). The only defined customer segment is gamers (2). The gamers pay
monthly subscription fees to access the game, in addition to purchasing the game itself.
Both the subscription and the game purchase are done via Blizzard’s battle.net website.
The game can also be purchased at a physical retail store. The main source of income
from the game is monthly subscriptions, which are proportional to the number of
active gamers (3). Another source of income is the product sales from the WoW game
itself.
Content and
Data centers
game
2
development
1
ISP
World of
Gamers
Warcraft
Retail stores
Game battle.net
developers
Game Retail stores

infrastructure

4 5
Game Running the Monthly

development game 3 Game purchase
subscriptions
(fixed) (variable)
Figure 4-6. World of Warcraft modeled using the BMC.
The key activities needed to offer WoW is creation of content and game development.
These activities are the core activities for Blizzard’s own development team and are
essential to develop the value proposition. In other words, the key resources are the
game developers themselves. In addition, Blizzard needs an infrastructure of game
servers to run the game. Both the game developers and the server infrastructure are
significant elements contributing to the total cost of the company. Expenses related to
developing the game are, to a large degree, fixed and independent of the number of
gamers (4). Expenses related to the game infrastructure are partly dependent on the
number of gamers (5). The key partners are: Data centers running persistent WoW
worlds, ISPs providing high-speed worldwide Internet access, and retail stores
promoting and selling the game.
Gamers exhibit positive direct same-side network effects on other gamers in the
game—or, at least, on other gamers on the same server—as shown in Figure 4-7.
Gamers can group together in teams—or “clans”—to perform quests and tasks
together, thereby adding to the gaming experience. Gamers also provide in-game items
and content that other gamers may use. WoW Auction House is an example of a place
where gamers can sell and buy items found during the game.
Monthly subscription
Gamer
User generated
game elements
(+/+)
Gamer
World of Warcraft
User-to-user
Interaction
. . .
(+/+)
Gamer
Access WoW
Figure 4-7. World of Warcraft modeled using the SRM.
Key strategies for WoW are to acquire and retain customers who will pay monthly
subscriptions. This can be done by aggressive marketing, offering a superior product,
or reaching a critical mass of customers to exploit the benefits of network effects.
WoW has exploited all these strategies. WoW is the most successful MMOG developed
so far, at least from a financial point of view. Due to its success and impact in the
gaming industry, WoW has been a trendsetter of business models for online video
games.
4.5.2. Spotify
Spotify is an example of a digital service that uses the freemium business model.
Here, the digital service is offered to two different consumer segments: One segment
gets the service for free, while the other segment pays for the service. The consumer
segment that gets the service for free is offered a simple—or “stripped down”—
version of the service. The consumer segment paying for the service is offered access
to all features of the service. Both consumer segments are important in the business
model, since there are positive network effects between them.8 Spotify offers a music
streaming service either for free or for a monthly subscription fee. The users accessing
the service for free must listen to or view advertisements, while those paying a
subscription fee can listen to music without interruptions.
Spotify’s business operation is modeled using the BMC and the SRM as shown in
Figures 4-8 and 4-9, respectively. Spotify has two value propositions (1): One for music
streaming services and one for advertisements. The subset of listeners paying for the
service contributes to the revenue of Spotify (2), which totals to about 90% of its
income (2017).9 The other source of revenue—advertisements—constituted about
10% of its income (2017). Key activities for Spotify include software development and
content management. “Software development” means expanding, maintaining, and
upgrading software and infrastructure of servers and databases. “Content
management” is performed in close collaboration with the copyright owners (the music
industry). A key activity for Spotify is to acquire the rights to offer licensed music to
the consumers (3). For these rights, Spotify must pay royalties to copyright owners.
Software
development
Music Music listeners
streaming (free)
Content
management
Copyright
owners Key resources Channels Music listeners
(paid)
Music licensing Advertising
contracts Spotify.com
3 Advertisers
Infrastructure 1 Spotify app

2
Personell
Royalties Subscriptions Advertising

Infrastructure
Figure 4-8. Spotify modeled using the BMC.
The two segments of paying and non-paying listeners induce positive network effects
on each other as shown in Figure 4-9; that is, getting more free music listeners also
increases the value for those who pay for the service. This is because a larger user base
means that Spotify can negotiate better deals with the music industry. More
importantly, with a large user base, Spotify will be in a stronger position when
competing with other music streaming services. Users can also exchange playlists with
one another.
The number of non-paying users induces positive indirect network effects on the
advertisers since more users means a potentially larger audience for the advertisements.
On the other hand, advertisements—or the amount of advertisements—induce
negative indirect network effects on the users. This is because advertisements are, for
most people, an annoyance and disruptions from using the digital service. Spotify’s
business model has had an effect on how people pay for content on the Internet. It
has also changed the size and operations of the online content piracy industry.
Key strategies for Spotify—which operates under the freemium business model—
are to minimize costs related to marketing, customer acquisition, and customer care
because most of Spotify’s customers are non-paying customers generating only a small
income per customer. The foremost challenge for Spotify is to acquire and retain
customers, and communicate with them for the lowest cost possible.
Paying users
Monthly subscription
User User . . . User
Music streaming
Spotify (+/+)
Free users
User User . . . User
(+/-)
Advertisement fee Advertisements

Advertisers
Figure 4-9. Spotify modeled using the SRM.
Activity 4-4. Spotify’s Business Operations

Search the web and find answers to the following questions:
(1) How many of Spotify’s users subscribe to its premium
service?
(2) What is the largest cost of running Spotify?
(3) Does Spotify generate profits?
(4) Who are Spotify’s main competitors?
(5) What is Spotify’s market share in the music streaming
industry?

Based on your answers, identify the major strategic challenge
for Spotify.

4.5.3. Facebook
Facebook offers a social networking service, in which users can interact, socialize, share
pictures and videos, play games, and use other professional content. Facebook uses the
ad-based free business model. Here, users have free access to the digital service but
must give away control of personal data to Facebook and accept that they will be
exposed to advertisements. Revenue is generated by selling advertisement space and
the personal data its users. Unlike the freemium business model (Section 4.5.2), all
users have access to a complete and full version of the digital service. Facebook is the
world’s biggest social network service, with more than two billion monthly active users.
Its international impact has influenced business models worldwide in several other
business sectors, as well as how people organize their social lives and spend time on
the Internet. Facebook is modelled using the BMC and the SRM in Figures 4-10 and
4-11, respectively.
Social
SW Internet users
interaction
development
Advertising Advertisers
4
Content
developers
Content and
Infrastructure service facebook.com Developers
7 and personal platform
user data Facebook app
1
5 3
6 Infrastructure Personell 2 Advertising fee Service fee
Figure 4-10. Facebook modeled using the BMC.
Facebook offers three value propositions to three different customer segments (1):
users involved in social interactions, advertisers, and third-party content developers.
Revenue is generated from advertisements and service fees from third-party content
developers (2). About 90% of Facebook’s revenue is from advertisements. Due to the
large number of users, it is not possible to establish a personalized customer
relationship with every user. Instead, Facebook relies on automated messages to
nurture relationships with the user segment. All customer segments access the value
proposition through the Facebook web page (facebook.com) or the Facebook app (3).
Key activities for Facebook are the software development of facebook.com and
the Facebook app (4). Key resources are the infrastructure hosting the Facebook
service and personal data stored about its users (5). The stored user data is crucial for
the business operations, since it is used to provide user-targeted ad space to advertisers.
This data may also be sold to third-parties, allowing them to produce statistics and
other material based on user behavior, such as political preferences, personality type,
personal economy, and attitudes. Trade and storage of such data was the key issue in
the Cambridge Analytica event in 2018.10 The major costs of Facebook include: Salaries
for software developers, service management, and data storage (6). Key partners for
Facebook are third-party content developers (7) who offer content (e.g., games)
directly to Facebook users.
As seen in Figure 4-11, there are strong positive direct same-side network effects
in the user segment, since gaining new users implies that there are more opportunities
for communication and interaction in the social network. Content developers exhibit
positive direct network effects on users, since gaining more users creates a bigger
market for content, while gaining more content providers means there is more available
content for the users. Ads, on the other hand, have a negative network effect on the
users. For most users, ads are disturbing and annoying, and reduce the pleasure of
social networking. Finally, observe that Facebook offers the social interaction service
for free. Revenue is generated from advertisers and content developers. Hence, the
business model of Facebook is utilizing the zero ARPU property (see Section 2.1.3).
(+/+)
Social interaction service

Facebook User User . . . User
Ads Purchases (+/-)
Advertisement fee (+/+)

Advertisers
Content Purchases
Service fee Content

developers

Figure 4-11. Facebook modeled using the SRM.
4.5.4. Wikipedia
Wikipedia offers an online encyclopedia in several languages via its website
wikipedia.org and the Wikipedia app for mobile devices. The content of Wikipedia is
created by thousands of contributors. These contributors write new content on
Wikipedia and edit, correct, update, and quality-check content from other authors.
Wikipedia is used by millions of readers from all over the world.
Wikipedia is an example of the commons-based peer production (CBPP)
business model. In this business model, users or peers contribute to the development
and provision of the value proposition. The value proposition is not produced by a
firm but by a potentially large number of people who, in a collaborative way, contribute
to its development. People contributing to the digital service normally do not receive
any financial reward for their contribution. The reward may be in the form of
recognition, respect, or the satisfaction of having contributed to a greater good. CBPP
requires effective mechanisms to ensure collaboration between peers across distance,
cultures, and timespans, since users may collaborate from all over the world.
Recovering the costs of running and developing the service depends on donations and
public or private funding. The benefactors providing these donations do not gain any
direct revenue from the digital service receiving the donations.

Content
Editing service Writers
development
3
Fundraising
Online
Key resources encyclopedia Channels
4
2
1 wikipedia.org
Benefactors Infrastructure
Readers
Wikipedia app
5 Donations
Infrastructure Personell
Figure 4-12. Wikipedia modeled using the BMC.
Wikipedia is modelled using the BMC in Figure 4-12. The value proposition is access
to the online encyclopedia (1). Wikipedia is available for free to users (readers) on
wikipedia.org and the Wikipedia app (2). Hence, it is considered to be a public good.
Wikipedia is created by many writers who edit, create, and manage Wikipedia articles
through an online editing service (3). Key partners for Wikipedia are the benefactors
who provide all the revenue needed to run Wikipedia (4). Even though the content of
Wikipedia is created without any financial costs, there are costs of running the servers
and for covering the salaries of Wikipedia’s employees (5). Wikipedia is owned by the
nonprofit organization, Wikimedia Foundation.
The SRM of Wikipedia is shown in Figure 4-13. There are three stakeholders:
benefactors, writers, and readers. All three stakeholders have a relationship to
Wikipedia—the writers develop Wikipedia, the readers use Wikipedia, and the
benefactors fund Wikipedia. There are no relationships between these stakeholders
because:
The authors are anonymous.
Usually several authors contribute to each article.
The readers may also take the role of watchdogs monitoring the quality of the
content and, if necessary, correcting it.
The benefactors contribute because of the quality and correctness of the
encyclopedia and the importance the encyclopedia has on the society at large.
Develop
Writers
Online encyclopeadia
Wikipedia Readers
Donations
Benefactors
Figure 4-13. Wikipedia modeled using the SRM.
Wikipedia is an example of a large digital service without any form of relationships

between the stakeholders. Hence, there are no significant network effects associated
with the various actors in the Wikipedia business model.
The two main strategies for Wikipedia are to (1) develop and maintain a platform
that encourages writers to create and edit content for Wikipedia, and (2) to ensure that
the content is relevant, correct, and substantial.

Activity 4-5. Wikipedia Business Models

Why does Wikipedia rely on donations and not ads to provide
revenue for its business operations? Discuss the long-term
consequences if Wikipedia were to switch to an ads-based
free business model. Is it possible for Wikipedia to use the
subscription-based business model?

4.5.5. Airbnb
Airbnb is an example of an organization using the multi-sided platform business
model. Airbnb offers a website and a mobile app in which people may lease or rent
houses, apartments, or single rooms for shorter or longer stays. They have also recently
entered other businesses, such as restaurant booking, concert booking, and videos
which promote different places around the world. Hosts announce the availability of
properties for rent on the Airbnb website or app, often supplemented with photos,
videos, and describing text. Payment is done via the Airbnb website or app using the
Airbnb payment service. The host and guest arrange practical details regarding the
rental without involving Airbnb directly.
In this business model, the organization (Airbnb) offers a platform for connection
and mediation between users belonging to different groups. Unlike the ad-based free
business model, the multi-sided platform business model does not use ads to generate
revenue but instead receives revenue from transaction fees levied when users exercise
the services offered by the platform. In the platform business model, the matching of
users is often motivated by the exchange of personal services (e.g., Airbnb and Uber)
or tangible goods (e.g., eBay). There are many variations of the multi-sided platform
business model; however, the key idea is that a platform is employed for connecting
different user groups. The BMC the SRM of Airbnb is illustrated in Figures 4-14 and
4-15, respectively.
The main value proposition (1) for Airbnb is to offer a mediation service between
the two customer segments hosts and guests (2). This is done on the website
airbnb.com or the Airbnb mobile app (3), in which the guest must provide a valid
name, email address, telephone number, photo, and payment information. Airbnb gets
its revenue from a booking fee paid by both the guest and the host (4). Key resources
for Airbnb include their website airbnb.com and the mobile app (5). These sites must
be user-friendly for both hosts and guests, have high availability and offer a good-
quality service. Key partners of Airbnb are people owning properties for lease (6).
Hence, hosts are both a key partner and a customer segment for Airbnb. This is
because hosts provide the content of the Airbnb site (properties for rent), while at the
same time, they contribute to revenues when a guest books the hosts property for rent.
A key activity for Airbnb is network-building to ensure a healthy number of available

hosts.
In the Airbnb business model, there are positive indirect network effects between
guests, as seen in Figure 4-15. Guests leave comments that other guests may review
before booking a property. There are also positive direct network effects between
guests and hosts—having more hosts means there are more choices available for the
guests and more guests implies a higher likelihood of bookings. There are negative
network effects between hosts, since hosts compete for the same guests. However,
note that the network effects have a local impact and influence on other stakeholders
within their geographical area only—properties for rent in Bangkok do not induce
positive network effects on users who are looking for a house in Paris.
Network
building Customer
service
Guests
SW Matching
development guests and
hosts
Hosts
Key resources Channels Hosts
1
6 airbnb.com
Website and
2
app
AirBnB app
5
3
Infrastructure Personell 4 Booking fee
Figure 4-14. Airbnb modeled using the BMC.
A key strategy for Airbnb is to ensure a healthy supply of property in the areas
Airbnb operates and to promote these properties to attract a healthy demand of guests.
Another important aspect in Airbnb’s business model is to ensure that guests trust the
bookings made through Airbnb. This is done by deploying a mechanism for guest and
host feedback, which gives hosts incentives to offer high-quality services to its guests.
The latter is also in the interest of the hosts themselves since positive guest feedback
increases the attractiveness of their property, which, in turn, may stimulate guest
bookings and the price they can demand in the market.
+/+
Guest fee
Guest Guest . . . Guest
Matching service House

AirBnB Rent fee +/+
rental
Host Host . . . Host
Host fee
-/-
Figure 4-15. Airbnb modeled using the SRM.
4.5.6. Bitcoin
Bitcoin is a cryptocurrency offering pseudonymous transactions between two users
without any involved trusted third-parties to verify the transaction. Bitcoin is an
example of the multi-sided platform business model. Bitcoin is modeled using the
BMC in Figure 4-16 as a four-sided platform with the following user groups: Bitcoin
users, Bitcoin miners, merchants, and digital currency exchanges.
Bitcoin
Digital Bitcoin mining
miners
currency
exchanges
2 1
Bitcoin Bitcoin
Merchants transactions users
5 Distributed
ledger
Mining
infrastructure
Mining
4 Mining reward
operations
3
Figure 4-16. Bitcoin modeled using the BMC.

Bitcoin enables transactions between two users, in which one user transfers bitcoins to
the other user from their Bitcoin wallet (1). These transactions are verified by many
distributed Bitcoin miners (2). Bitcoin miners receive a mining reward for successfully
verifying transactions (3). This mining reward is provided by the Bitcoin ecosystem by
issuing new bitcoins for circulation for each successful block of transactions added to
the Bitcoin ledger. Hence, the number of bitcoins in circulation increases continuously,
from about sixteen million bitcoins in 2017 to an estimated amount of twenty-one
million bitcoins in 2140. The Bitcoin miners are in possession of an infrastructure that
enables them to perform Bitcoin mining. This infrastructure is necessary for the
Bitcoin ecosystem to operate. All transactions verified by bitcoin miners are recorded
on the distributed ledger, which is open and available (read-only) for anyone. The cost
for the Bitcoin miners to perform mining operations must be matched by the mining
rewards received (4). The cost and reward are computed by the Bitcoin incentive award
algorithm and depends on the market price of Bitcoin. Merchants are digital
marketplaces that have adopted Bitcoin as a valid payment currency. Digital currency
exchanges buy and sell bitcoins (5).
Exchange Digital currency

exchanges
+/+
Accept as payment
Merchants
+/+
Bitcoin Bitcoin House Bitcoin

. . .
Bitcoin
users users rental users
Bitcoin
transactions
+/+
Process
Bitcoin
Mining award miners
-/-
Figure 4-17. Bitcoin modeled using the SRM.
Figure 4-17 shows Bitcoin modeled using the SRM. There are negative network effects
between Bitcoin miners, since having more miners means that there is an increased
competition to receive the reward for successful mining. Also, note that there are no
network effects between Bitcoin miners and the other stakeholders. This is because
the incentive for Bitcoin miners depends on the price of Bitcoin and the number of
bitcoins issued for each successful block of transactions only. Hence, Bitcoin mining
is an independent—but still necessary—part of the business model.
There are positive direct network effects between the three stakeholders: Bitcoin
users, merchants, and digital currency exchanges. More Bitcoin users increase the value
for both merchants and digital currency exchanges. A condition for merchants to
accept Bitcoin as a valid currency is that there must be enough users paying with
bitcoins to justify the cost of including the Bitcoin payment solution system in their
business operations. In addition, trustworthy digital currency exchanges must also
accept bitcoins. A condition for users to start using bitcoins is that there must be
enough merchants accepting bitcoins as payment for goods and services. Hence, there
is a chicken-and-egg problem in the Bitcoin ecosystem—merchants will not accept
bitcoins unless there are users willing to pay with bitcoins and users will not buy
bitcoins unless there are merchants accepting bitcoins as valid payment. Bitcoin users
induce positive network effects on other users since the more people using bitcoins
the more likely is it that other people also will accept it as valid payment token.
Activity 4-6. Blockchain

Bitcoin is an implementation of the blockchain technology. In
the article, “The Truth About Blockchain”, by Marco Iansiti and
Karim R. Lakhani, they claim that blockchain is a foundational
technology. Read their article and discuss whether blockchain
is a foundational or a disruptive technology. Would you
classify blockchain as commons-based peer production?

Source: https://hbr.org/2017/01/the-truth-about-blockchain

Currently (2018), Bitcoin struggles to get enough merchants to use bitcoins as a valid
trade currency. One of the main reasons for this is the volatility of Bitcoin compared
to currencies such as the US dollar and Euro. So far, not enough merchants and users
have adopted Bitcoin to reach critical mass or for network effects to drive the further
evolution of Bitcoin. Also, there are several thousands of different cryptocurrencies
competing with Bitcoin. Even though Bitcoin was the first cryptocurrency in the
market and is currently the most accepted cryptocurrency, competition with other
cryptocurrencies may slow down the future adoption of Bitcoin.
Another challenge with Bitcoin is the cost of running the Bitcoin ecosystem. To
verify transactions without involving any trusted third parties, Bitcoin employs a
distributed network of Bitcoin miners. These miners each have large quantities of
specialized hardware to form the infrastructure necessary to verify transactions. Some
miners even collaborate and set up businesses with the sole purpose of verifying
Bitcoin transactions. Verifying a Bitcoin transaction means solving a complex
mathematical puzzle. This puzzle gets harder and requires more electric power as more
miners join the Bitcoin ecosystem. Because the award for verifying bitcoins is paid in
bitcoins and is quite lucrative, more miners are stimulated to join the mining market
resulting in a devious spiral of evolution towards more complexity and use of electric
power.
As mentioned above, the infrastructure needed for the Bitcoin ecosystem
consumes enormous amounts of electric power. By May 2018, it is estimated that this
infrastructure consumes more than 65 TWh—more than the total electric power
consumption of Switzerland!11 Such numbers question the environmental sustainability
of Bitcoin as a global digital currency.
4.6. Strategic Positioning

This section is based on a product and market positioning analysis of a large company
in the ICT business, including methods by which business opportunities and
weaknesses can be disclosed.12 These methods include: Analysis of the company’s
tangible and intangible assets (Section 4.6.1), analysis of competencies (Section 4.6.2),
and external competitive forces acting upon the company (Section 4.6.3).
4.6.1. Assets
Assets are tangible and intangible resources owned or controlled by a company that
contribute to the value proposition and the sources generating the cash flows into the
company. These assets must be renewed continuously if the company is to maintain
its market position in the future.
Figure 4-18 shows a decomposition of the company’s assets into six categories:
Innovations, historical factors, workforce, investments, infrastructure, and core
competencies. Innovations increase and renew the portfolio of the company
manifested by research, patents, processes, intellect, and the sharing of knowledge
within the organization. Historical factors describe how the company is positioned
in the market and explain how it has achieved its current position, built up its customer
base and brand, and how it has segmented the market. The workforce is characterized
by how skilled and committed they are to perform their duties and how agile they are
at adopting changes and new challenges. Quinn defines five types of skills:13
Cognitive skill or “know-what”: Knowing rules and facts.
Advanced skill or “know-how”: Performing tasks sufficiently well.
System understanding or “know-why”: Understanding relationships between
variables.
Motivated creativity or “care-why”: Interrelating disciplines and creating new
effects.
Synthesis and trained intuition or “perceive-how-and-why”: Understand and

develop relationships that are not directly visible.
The last two categories are particularly important for the company to survive and
prosper in the digital economy; for example, entering fields such as artificial
intelligence, algorithm design, pattern recognition, app design, trendsetting, and agile
manufacturing.
Infrastructure Core competencies Innovation

Enabling technologies Knowledge Research
IT systems Skills Patents
Support systems Methods and process Processes
Organization Intellect
Sharing of knowledge
Investments Workforce Historic factors

Production facilities Knowledge Customer base
Alliances and cooperation Commitment Market segmentation
Risk management Mobility Brand recognition

Figure 4-18. Company assets.
Investments include more than just investments in infrastructure and equipment. In

the digital economy, investments in alliances and cooperation are sometimes more
valuable than investments in production facilities. This may involve the sharing of
knowledge, ideas, and products, such as software. Risk management is concerned with
financial uncertainties, legal liabilities, damaging attacks on brand name, and
cyberattacks on software processes. The importance of risk management is illustrated
by the following two examples.
Facebook takes risks by operating on the edge of what is legally correct, morally
acceptable, and politically tolerable. So far (as of 2018), they have survived with only
scratches on the surface. Their business conduct is followed closely by the US Congress
and the EU Parliament.14
Arthur Andersen, once the biggest consultancy company in the world in the
beginning of the 2000s, lost almost all of its customers over night after the Enron
scandal in 2002. In this event, they were accused of shredding papers that showed the
real financial condition of Enron.15 They were never convicted for fraud but,
nevertheless, the company has never recovered its former status.
Infrastructure includes enabling technologies, ICT systems, support systems, and
the organization itself. Finally, the assets include competencies, especially core
competencies that differentiate the company from the competitors. This is the subject
matter of the next section.
4.6.2. Core Competencies

Distinctive competencies are the collection of knowledge, skills, methods, and
processes that the company must possess to sustain or increase its competitiveness in
the marketplace. Some of these competencies may be essential for reaching and
sustaining a position as market leader. These competencies are called “core
competencies” if the company is alone in the marketplace in which it masters them.
Prahalad and Hamel introduced the concept of core competency in strategic
management theory in 1990.16 Core competency is defined as “a harmonized
combination of multiple resources and skills that distinguish a firm in the marketplace,
satisfying the following criteria: (1) Provides potential access to a wide variety of
markets; (2) should make a significant contribution to the perceived customer benefits
of the end product; and (3) difficult to imitate by competitors.” The concept is based
on similar ideas developed by Wernerfelt—that the strategy should be based on the
resources and competencies of the company rather than its products.17 This includes
the capability to become a first mover in a new market segment, giving the firm
advantages in terms of capturing early market shares and creating positive feedback in
terms of bandwagon effects.
The core competency may be one particular skill; for example, the precision
manufacturing of particular devices, such as the balance spring in watches; or an
aggregation of several skills put together in a unique way. Amazon is an example of the
latter. Amazon merges the business processes of traditional retailers and online trading
combined with simple user procedures and an efficient search engine for books. They
also recommend other books in the same genre, a selection of books based on previous
purchases you have made, and a selection of books that other customers have bought
together with the selected book. Note that, in this case, the core competency is to
master a combination of several rather simple competencies, thereby creating a product
that is unique for Amazon.
Facebook and Google convert the data they collect on their users into a product
they sell to advertisers and other stakeholders. One of their core competencies is
collecting vast amounts of unordered data on their users, and, from this data, extracting
ordered information that can be used for directed advertising, the prediction of user
behavior, and the early detection of market changes and trends. Examples of
information that can be extracted from Facebook’s database are: Network of friends,
frequency of interactions between friends, personal preferences based on search

history, and attitudes based on the use of the “like” button.
Uncovering the core competencies of a company can be done by first identifying
major industry drivers, key success factors, customer satisfaction, effectiveness of
customer relationships and delivery channels, market feedback, and the achievement
of business goals. All these are elements that may be extracted from the Business Model
Canvas and the Stakeholder Relationship Model described in Sections 4.3 and 4.4,
respectively. Thereafter, the company’s competencies are identified and ranked in
order of importance and estimated impact on the quality of the products. This includes
individual and collective skills, market understanding, quality management, the
mastering of production processes, alertness to market changes, and the capability to
change direction, depending on market feedback. From this analysis, it may then be
possible to identify core competencies—if the company has any. This analysis is also a
tool by which particular skills that may be developed into core competencies can be
identified.
Figure 4-19 is an example of the classification of competencies. The degree by
which a competency enables leadership among competitors is shown along the
horizontal axis. The vertical axis indicates how much the competency will differentiate
the company from its competitors. The scales only provide subjective measures of
differentiability and leadership, and the scales may be interpreted differently by
different companies.
High
Machine
Key partners learning
Core
à
competence
Potential for Pattern
differentiation Important
extraction competence
à
Basic
competence
General
Data
robotics
collection
Low
Basic skills ß Enabling leadership à Shaping industry

Figure 4-19. Classification of competencies.
The competency may be a basic skill that the company must manage to conduct
business at all; for example, the collection of raw data as indicated in the figure. A
competency on the other end of the scale is a driver for the evolution the industry that
is being studied. If this competency also differentiates the company strongly from its
competitors, then the competency is a core competency. In the example, the methods
and algorithms developed for machine learning based on collected data is a core
competency of the company, provided that these methods are not common
knowledge, are difficult to develop, and that they generate new ways of constructing,
for example, robots.
The competencies in the middle section of the figure are all important
competencies that may be difficult to develop and important to master. In the example,
all companies in the robotics business master the technology equally well. However,
robotics is a technology that shapes the industry. Pattern extraction is difficult but is
mastered by many companies, placing this competency in the middle of the diagram.
Finding key partners does not require particular skills but finding the right partners (for
example, research organizations and universities) may be an invaluable resource for
differentiation.

Activity 4-7. Google Search

Identify the basic, important, and core competencies that Google
must possess as a leading search engine provider. Classify and
place these competencies in a diagram similar to figure 4-19.

4.6.3. Competitive Forces

Figure 4-20 shows the Five Forces Model proposed by Porter.18 The purpose of the
model is to identify which external forces that may act on a company and how these
forces may influence the market performance of that company. Based on this
knowledge, the company may develop strategies that counteract the competitive
challenges inflicted by external influence. The model was developed for the strategic
analysis of industrial companies that are designed as value chains (see Section 2.3.1).
However, the theory can be easily adapted to analyze competition in the digital
economy. The following is an adaption of Porter’s theory to digital markets.
Competitive rivalry takes place between companies sharing the same market.
Competition in the digital economy may be on price, as it is in non-digital markets, but
not always; for example, when the price is zero, as it is for several digital goods and
services. Competitive rivalry in the digital economy is complex. In some segments,
competition takes place between companies offering digital services and traditional
services. This include e-commerce of physical goods, in which the online shop (e.g.,
Amazon) may have advantages, such as being accessible anytime from anywhere and
offering products that are difficult to find in traditional shops. The advantage of
traditional shops is that the customer can see, touch, taste, and smell the product.
Competition may take place between companies offering similar digital services;
for example, Facebook and Myspace. In some of these markets, strong network effects
may result in de-facto monopolies, in which one of the competitors captures the whole
or most of the market (e.g., Facebook versus Myspace). In other cases, several
competitors may share the market, each having market shares that are stable over long
periods of time; for example, mobile network operators.
Threat of new
entrances
Bargaining powers
Bargaining power of Rivalry among
of end-users and
suppliers existing competitors
buyers
Threat of substitute
products or services

Figure 4-20 Five Forces Model of Porter.
Competition may also take place between companies offering entirely different services
to their users. One example is Facebook, which offers social networking, and Google,
which offers email and web searching. They do not compete for users but rather, for
money from the advertising business. This situation may arise in multisided markets
(see Section 2.4). Another example is MasterCard, which serves two markets:
Cardholders and merchants. Since the card is accepted almost everywhere, there is no
competition with other credit card companies for attracting new merchants. The
competition is for attracting new cardholders. Airbnb offer services in two market
segments: Hosts and guests. Airbnb is subject to competition in both segments.
New entrants may establish themselves in existing markets. In this context, the
concern is about companies producing the same or equivalent goods and services. New
entrants producing substitutions are considered below. The general effect of new
entrants is that the profitability of the market for each manufacturer or service provider
is reduced. In cases where investments are high, competition may lead to the formation
of oligopolies, resulting in complex and unstable forms of competition. The mobile
communications markets are oligopolies with few competitors. In other cases, it may
be virtually impossible for new competitors to enter the market because strong
network effects may have created high lock-in barriers. This is the case for many social
media.
End users and buyers may put additional pressure on the companies; for
example, by creating special interest groups which press for lower prices or better and
more reliable products, or for abandoning certain products altogether (for example,
whale meat and furs). The buyers may also use new distribution channels. One example
is that more and more people are making purchases over the Internet, thereby reducing
the market for physical shops. Loyalty programs are sometimes initiated to reduce the
bargaining power of the customers (for example, bonus programs of airlines).
Since the use of social media and web searching creates enormous amounts of
data about the users of the service, the service provider may be able to extract
information about the user that may violate personal integrity protection laws or are
regarded as ethically unacceptable. This may then cause users to switch to alternative
suppliers or use the service in a way that is less profitable for the supplier. There have
recently (as of Spring 2018) been reactions against Facebook for having misused
customer trust.19
Suppliers in value chains deliver raw materials, components, or semi-finished
products. Suppliers in the digital economy may provide technical support or services;
for example, processing and mass storage, access to the Internet, software, content, or
service supplements. The suppliers are in the position to bargain for prices, offering
different qualities of service to different companies, control access to facilities and
content, and so on. Net neutrality (see BOX 3-4) delimits the capabilities that the
Internet service providers have to discriminate against different users of the network.
Substitutes are products that may replace other products which offers the same
or an equivalent experience. For example, seafood may replace meat as nourishment.
In the digital economy, substitutes have become a strong market force. Examples of
substitutes include: Mobile phones substituting fixed telephone services, and video
streaming replacing broadcast services. The most competitive advantage of mobile
phone manufacturers was originally the design of the radio modules of the phone, and
competition took place between traditional radio manufacturers. However, as the
mobile phones developed into smartphones (or handheld computers), the competitive
advantage changed to the ability to design complex software that supports the new
functionality, thereby inspiring computer manufacturers to enter the market. The
smartphone then became a substitute for simple mobile phones produced by a new
type of manufacturer. Other examples of substitutes in the digital economy are e-books
(which substituted paper books), MP3 players (which substituted CDs as a medium for
the dissemination of music), and streaming services on smartphones (which replaced
the MP3 players).
Later, a sixth force was added to Porter’s model. Different authors attributed
different interpretations of what this force is:20
Complementors
Government
The public
In a strategic analysis of the company, it is recommended to consider all three

alternatives because they will all have an impact on the company’s strategy.
Complementors are companies that produce or sell products for which the
demand is positively correlated to the demand of a given product. These products are
called “complementary products.” Complementarity may be either unilateral or
bilateral. Unilateral complementarity occurs when the product of one company
depends on the product from the other company but not vice versa. Bilateral
complementarity means that each product cannot exist without the other product.
Examples of complementors and complementary products are given in Table 4-4.
Table 4-4. Complementors and complementary products

Complementors and
Type (Unilateral or Bilateral)
Complementary Products
Intel (hardware) and Microsoft Bilateral: Both companies depend on each
(software) other to provide a complete service.
Unilateral: Smartphones offer services that

Apps and smartphones
do not involve the use of apps.
DVD players and DVDs Bilateral
Printers and ink cartridges Bilateral
Unilateral: Skype depends on ISPs for Internet

Skype and ISPs access, while ISPs do not depend on Skype to
offer Internet access.
Governments decide rules for competition and ensure that the rules are followed. In
the telecommunications market, regulations may include: License of operation,
maximum and minimum price of services and subscriptions, conditions for lease of
network resources, use of the frequency spectrum, conditions for interconnectivity of
customers in different networks, and number portability. Governments may also
regulate the business of application service providers; for example, via licensing,
taxation, law regulations, and censorship.
The public is made up of more than just users and buyers. Society has numerous
written and unwritten rules that may influence the market of a company. Some of these
rules are ethical; for example, a company may sell products which are made by suppliers
who employ child workers, cause pollution or prohibit workers to form labor
organizations. This company may meet strong hostility in the market. Recently, strong
public opposition forced shops to stop selling clothes with certain types of fur.
BOX 4-4. Mobile Virtual Network Operator Entrants

The telecommunications market has been opened for a new type of entrant; namely,
mobile virtual network operators (MVNOs) which lease infrastructure from other
mobile infrastructure providers (IPs). The MVNO avoids the big fixed costs of building
network infrastructures but must pay regular leasing fees to the IP. The figure below
shows the case of two competing IPs (IP1 and IP2), in which the MVNO leases
infrastructure from IP1. The MVNO must pay a leasing fee to IP1 for using its
infrastructure.

IP1
Subscribers lost Revenue from
from IP1 to MVNO network lease
IP2 MVNO
Subscribers lost
from IP2 to MVNO

Even if the MVNO is winning customers from both IP1 and IP2, a large portion of the
revenue of the MVNO is fed back to IP1 in the form of leases. The result is that IP2 is
losing more of its revenue compared to IP1 (see figure below). Note that this
situation persists, even though IP1 loses many of its customers to the MNVO.

IP1
Market share
IP2
MVNO
Revenue share
Before MVNO After MVNO

entering market entering market

Activity 4-8. FinTech

Financial Technologies (FinTech) are emerging digital services that substitute or
complement traditional financial services. Examples of FinTech are: E-banking, digital
payment systems, mobile banking, and cryptocurrencies. Use Porter’s Five Forces
Model to analyze the FinTech industry in your country. Pay special attention to (1)
the emerging blockchain technology, (2) international actors that provide digital
payment solutions (e.g., Apple Pay and Google Pay), and (3) complementary
products.

Information and communication technologies have led to several innovations shaping
the digital economy. There have been several disruptive innovations leading to new
service markets, and the rise and fall of companies operating in the digital economy.
Successful digital businesses have exploited disruptive innovations to create
profitable business models. Business models describe how an organization creates,
delivers, captures, and keeps value. A fundamental aspect of a business model is to
identify the value proposition; that is, the benefits that the organization offers to its
users and customers. Business models are complex in the sense that they must be
modelled by considering all stakeholders with whom the organization may interact in
one way or another. Business models for an organization may also change over time.
To prosper, the company must be able to position itself in the competitive
landscape. Important prerequisites are: (1) Understanding its tangible and intangible
assets; in particular, innovativeness, skills, risk comprehension, and competencies, (2)
identifying core competencies and nurturing them to uphold a leading market position,
and (3) comprehending which competitive forces the company is likely to encounter
and estimating the effect that these forces will have on future business opportunities.

Key Points

An innovation is the implementation of a new or significantly-improved product
(good or service) or process, a new marketing method, or a new organizational
method in business practices, workplace organization, or external relations.
A disruptive innovation is an innovation that creates a new market by establishing
a new set of value propositions and a new set of performance metrics.
A business model describes how an organization creates, delivers, captures, and
keeps value.
The Business Model Canvas (BMC) and the Stakeholder Relationship Model
(SRM) are tools for modeling digital businesses and relationships between
stakeholders.
Assets are tangible and intangible resources owned or controlled by a company
that contribute to its value proposition and the sources that generate the cash flows
into the company.
Core competency is “a harmonized combination of multiple resources and skills
that distinguish a firm in the marketplace, satisfying the following criteria: (1)
Provides potential access to a wide variety of markets, (2) makes a significant
contribution to the perceived customer benefits of the end product, and (3) is
difficult to imitate by competitors.”
Porter’s Five Forces Model is a tool for the strategic analysis of companies,
competition, and external influence by other companies, governments, and the
public.
Further Reading
Clayton Christensen. The Innovators Dilemma: When New Technologies Cause

Great Firms to Fail. Harvard Business School Press. 1997.
This book introduces the concept of disruptive innovations, which explains why many
great firms fail to adapt to new innovations in their domains. It is one of the defining
books on modern innovation and contributes to explaining the behavior of business
entry and to and from the digital economy.
Chris Anderson. Free: The Past and Future of a Radical Price. Hyperion. 2009.
This book presents the concept of giving away goods and services for free, with focus
on “the digital free”—free digital goods and services. Anderson outlines several
business models based on the free concept.
Alexander Osterwalder. Business Model Generation. John Wiley and Sons. 2010.
This book introduces the Business Model Canvas (BMC), as a tool for business
modeling. It provides examples of business models and guidelines on how to perform
business modeling.

Chapter 5
Advanced Digital Economics

Learning Goals

How value of a network can be estimated from the way in which users interact
Sarnoff’s law, Metcalfe’s law, Odlyzko-Tilly’s law, and Reed’s law
How the Bass diffusion model describes the evolution of simple retailer
markets of durable goods
How the Bass diffusion model can be extended to include competition,
churning, and re-adoption
Exponential growth, latency, and net present value calculation with
exponential increasing revenue
Quantitative modeling of the long tail principle

This chapter introduces advanced topics in digital economics. In Section 5.1, the value
of digital services is estimated based on the way in which users interact, resulting in
four laws of estimating the value of networks—Sarnoff’s law, Metcalfe’s law, Odlyzko-
Tilly’s law, and Reed’s law. Section 5.2 starts with the solution of the Bass diffusion
equation for the temporal evolution of simple retailer markets of durable goods. The
theory is then extended to more complex markets, such as markets with competition
and churning, and transient markets with re-adoption. Section 5.3 introduces
exponential growth of digital goods and services. Section 5.4 introduces some
mathematical aspects concerning long tail markets.
Skills in mathematics are required to fully comprehend this chapter. The following
background is recommended: Sections 5.1, 5.3, and 5.4: Basic Calculus and Discrete
Mathematics; and Section 5.2: Differential Equations.
5.1. Estimating the Value of Networks

A general introduction to network effects was presented in Section 2.5. This section
provides simple mathematical arguments concerning the impact that network effects
may have on the value of various types of digital goods or services, depending on the
way in which users interact. First, observe that in a population or network of %
individuals, there are:
% singletons.
%9 pairs (assuming % >> 1 and counting all one-way interactions between
individuals).
2F groups (also assuming % >> 1).
Based on this observation, the four different laws to estimate the value of digital
services are presented next. In the following text, > % is a measure for the total value
of a digital service or a network, and % is the total number of users. Value in this context
is an abstract concept, but can be a measure of, for example, revenues, market
capitalization, volume of transactions between users, or time spent using a service.
Common representations of value are the number of links between users in the
network and the number of groups a user can be member of. These are the basis for
the calculation of the various network laws in this chapter. Note that, in the presented
models, > % depends only on the number of users %. As a general note, the value of
a company or a service depends also on other tangible and intangible assets such as
cash, securities, property, equipment, design value, brand recognition, and
organizational value. However, these variables are not considered in the following
calculations; the focus here is solely on the value that arises because of the number of
users %.
The value each new user adds to the network, also termed “the network effect,”
is given as:
Advanced Digital Economics 175
H> %
$ % = >′ % = .
H%
When a new user joins a network, they link to other users that are already a part of the
network. This is illustrated in Figure 5-1.
Network with n = 6 users A new user joins the network

and links to two users already
a part of the network

Figure 5-1. A new user links to a network.
The tilde notation “~” is used to indicate the growth rate of the value of a network.
For example, > % ~% indicates that the value of a network grows (at most) as fast as
.%, where . is a constant. This is equivalent of the “big O notation,” commonly used
to assess the growth rate of algorithms in computer science.
5.1.1. Sarnoff’s law

Sarnoff’s law concerns the value of broadcast networks, including radio broadcast
networks and television broadcast networks. In such networks, one sender transmits
information to a group of % receivers. Sarnoff claimed that there is no additional value
for new customers to join the network because others have done so in the past. For
the supplier, the value of the network is the number of customers connected to it, that
is:
>JKLFMNN % ~%,
in which > % is the value of the network and % is the number of devices connected to
the network. The value added by a new user to the network (network effect or feedback
term) is $JKLFMNN % = >′JKLFMNN % ~1. Hence, there is no network effect in this case.
Every new user adds only the value they represent to the network, represented by a
single link. This is shown in Figure 5-2, in which the number of customers equals the
number of links in the network which, in turn, equals the total value of the digital
service or the network. The value of a company providing a broadcast service is
dependent on the number of customers only, since each customer provides a fixed
income to the company. There is no other value created in such networks.
The law is named after David Sarnoff (1891–1971), an American pioneer of radio
and television manufacturing and broadcast. Sarnoff spent most of his career in the
Radio Corporation of America (RCA) and the National Broadcasting Company (NBC),
and was one of the most influential businessmen in the early days of radio and
television.
Digital service
Users

Figure 5-2. A broadcast network.
Sarnoff’s law applies to all kinds of broadcast networks, in which there is no interaction
or exchange of value between users or customers. The only interaction in a broadcast
network takes place between the provider of the service and the users. In addition to
radio and television broadcast networks, there are several examples of other digital
services in which there is no network effect, including:
In Google search, a user does not benefit from using the engine because
other people are using it. It is not of any value to other people that a given
user conducts searches on the engine. The value for Google is the number of
people using the search engine, which determines the advertisement fees that
Google can charge advertisers. However, this is contested by the fact that user
searches contribute to refine the Google search algorithm, which in turn
results in more accurate search results for other users. This is an example of
data network effects, where data collected about users are harvested and
processed to increase quality of the service to other users.
Netflix uses a subscription-based business model (see Section 4.5.1). Each
subscriber contributes to the value of Netflix by paying regular subscription
fees. There is no interaction or exchange of value between Netflix subscribers.
On the other hand, Netflix was initially subject to negative network effects
(word-of-mouth) and loss of users to the illegal Popcorn Time, caused by
overloaded databases.1
The value of Wikipedia depends entirely on the volume and quality of the
articles in the encyclopedia (see Section 4.5.4). There is no interaction between
readers, writers, and benefactors and thus no general feedback effects which
prompt new readers to use Wikipedia. The value of Wikipedia for the reader
is the volume and correctness of the content. The value is independent of who
else is reading this content and the number of writers and benefactors.
Wikipedia is a special case where the network laws do not apply—even
Sarnoff’s law—since the value is independent on the number of users.
Activity 5-1. Instagram

Discuss whether Sarnoff’s law gives an accurate valuation of
Instagram. Is Instagram a value network? What is a good
measure of value in Instagram?

5.1.2. Metcalfe’s law and Odlyzko-Tilly’s law

Fax machines, telephones, and email accounts are more valuable when more
equipment of the same type is connected to the network. Robert Metcalfe, one of the
inventors of Ethernet, suggested in 1980 that the value of an Ethernet network would
be proportional to the number of possible transactions between compatible devices
connected to that network; that is:
>OPQRKSNP % ~%9 ,
in which % is the number of devices. The law assumes that all possible interactions are
equally valuable and probable. For small networks, such as Ethernet, this is a
reasonable assumption. This is illustrated in Figure 5-3, in which all nodes are
connected to each other in a network consisting of six nodes. The number of links in
the network in Figure 5-3 is fifteen, which is a representation of the value of the
network. The number of links in a network with % nodes in which all nodes connect
to each other, is, generally speaking, % % − 1 2 ~%9 .
Later, it was argued that Metcalfe’s law is also valid for social media network, such
as Facebook, Twitter, and other digital services, in which the most important feature
is interactions between individuals. A recent paper2 indicates that Facebook follows
Metcalfe’s law quite accurately and that the value can be calculated as > % =
5.7×10X; ×%9 ~%9 . However, this conclusion depends on how value is defined and how
the number of users is counted.
The network effect (or feedback term) of Metcalfe’s law is $OPQRKSNP % ~%. This is
the most commonly used value for network effects in economic research. The value
was, in fact, used long before Metcalfe suggested it in 1980. This feedback value is the
basis for the diffusion model of Frank Bass from 1969 (see Section 5.2.1).
Digital service
Users
Figure 5-3. A network where all nodes connect to each other.
Activity 5-2. Facebook Value

Facebook has, by 2018, approximately 2.2 billion monthly active
users. Based on this number, calculate the total value of
Facebook. You can use the formula > % = 5.7×10X; ×%9 ~%9 .
What does this value represent? How many users does
Facebook need to have a total value of 1?

Andrew Odlyzko and his coworkers have argued that Metcalfe’s law is incorrect—in
particular, concerning social media networks—since Metcalfe’s law assumes that all
possible transactions have equal value.3 In a large population, Metcalfe’s law gives an
overestimation of the value of a network since each individual will only interact with a
small number of other individuals and not all interactions between them will be equally
as strong. Based on this argument, Odlyzko and Tilly proposed the alternative law:
>YXB % ~% ln %.
This law is called “Odlyzko-Tilly’s law.” The network effect is now reduced to
$YXB % ~ ln %. Odlyzko-Tilly’s law is derived applying Zipf’s principle to the frequency
of interactions an individual has with other individuals. Zipf’s principle is an empirical
law based on the observation that several sequences in nature and society (e.g.,
frequency of words, size of cities, and length of rivers) follow a rank distribution (called
a “Pareto distribution” in statistics) in which the most frequent or largest item is twice
as frequent or large as the second item in the sequence, three times as frequent or large
as the third item, and so on. This is the same principle used to explain the long tail in
Section 5.4.
By applying this ranking principle on interactions between people, the total
number of transactions 5 between one individual and all other individuals is:
1 1 1
5 =1+ + + ⋯ + ~ ln %.
2 3 %
The assumption behind this formula is that this individual has very many transactions
with the person who is closest to him, only half as many with the next closest person,
one-third as many with the third closest, and so on—Zipf’s ranking principle is applied
to the relationship between individuals. The value of the network is then >YXB % =
%5~% ln %.
Another way to derive Odlyzko-Tilly’s law is based on the connectivity of random
graphs. First, assume that individuals are nodes in a random graph and that the
interactions between the individuals are the links in the graph; that is, two individuals
interacting with each other are connected by a link, while there is no link between two
individuals who are not interacting with each other. The simplest random graph is the
Erdös-Rényi (ER) graph. In ER graphs, the probability , that a link exists between any
two nodes is the same for all pairs of nodes in the network.
It can be shown that the ER graph becomes connected if , = . ln % % for some
constant . .4 This threshold is sharp. If the link probability is increasing slightly slower
with increasing %, for example , = . ln % %K , ^ > 1 + _ and _ is an arbitrarily small
number, large parts of the graph will be unconnected. If the probability is increasing
slightly faster with increasing %, for example , = . ln % %K , ^ < 1 − _ and _ is an
arbitrarily small number, the graph will be tightly connected. It is reasonable to assume
that the graph representing relationships between people is connected—there exists a
path from one person to another either directly or via other people. This path is rather
short, as revealed by observations made by Milgram, leading to his law of “six degrees
of separation;” that is, the distance between people is seldom more than six links, in
which a link is from one person to another person that they know personally.5 Since
each of us has few direct links to other people, it is reasonable to assume that the graph
is lightly connected so that ,~ ln % % is a good approximation of the link probability
of the relationship graph between people. Since there are %9 possible links, the total
number of links < and the value of the network > % ~< is >YXB % ~N~%9 ln %/% =
% ln %, and again, Odlyzko-Tilly’s law has been derived.
BOX 5-1. Six Degrees of Separation

“Six degrees of separation” is the concept that any human being is (at the most) six
intermediaries away from any other human on the Earth. That is, anyone can connect
to any other person through a chain of friends with a maximum of six hops. While by
some considered to be an urban myth, research has shown that the six degrees of
separation concept is valid in many social networks.

1 2 3 4 5 6

The theories of a “shrinking world” were first popularized by the Hungarian author,
Frigyes Karinthy, in 1929. Karinthy argued that the modern world at that time was
shrinking, primarily because of recent innovations in communications, such as the
telegraph, radio, and telephone. However, it was not until Stanley Milgram published
his article, “The Small World Problem” in the journal, Psychology Today in 1967 that
the interest in the “six degrees of separation” concept became popular. Stanley
Milgram did not use the term “six degrees of separation” himself in his works but he
did show, by experiments, that the average distance between two randomly chosen
individuals in the US was 5.2. Related concepts to the “six degrees of separation” is
the Erdös number, which describes the distance to the mathematician Paul Erdös
based on shared publications and the Bacon number, describing the distance to the
American actor Kevin Bacon based on shared movie appearances.

Facebook has analyzed the average degree of separation between any two users of
the network and found that this distance has decreased from 5.28 in 2008, to 4.74
in 2011 and 4.57 in February 2016. In the Watts-Strogatz model, which produces
random graphs with small-world properties, the average path length between two
nodes is calculated using ln < ln c , in which < is total number of nodes and c is the
average number of links per node. For Facebook, with 2.2 billion users (nodes) in
2018 and 150 number of friends (links) per user as suggested by Dunbar’s number
(see BOX 5-2), the average path length is calculated as ln < ln c =
ln 2.2×10; ln 150 ≈ 4.29 in good agreement with the observed numbers presented
above.

BOX 5-2. Dunbar’s Number

Robin Dunbar is a British anthropologist that studied the volume of the neocortex of
various animals and their corresponding social group sizes. Based on his findings, he
predicted the number of people with whom a human can maintain a stable
relationship. His initial studies suggested a number between 100 and 250, but he
later argued for 150 as a mean group size for communities with high incentives to
stay together. The latter was based on studies on human societies, both existing and
historical. Dunbar’s number is, then, 150. It is argued that this is the number of
people an individual can call a “friend,” which translates informally to “people you
would not feel embarrassed about joining uninvited for a drink if you happened to
bump into them in a bar.”8

Dunbar’s number
15 50 150 500 1,500
Family and Close Friends Acquaintances Strangers

very close friends
friends

Dunbar’s number has been applied to social media, business management, military
studies, and work place organization. The number has been used to study social
networks, such as Facebook and Myspace. The average user on Facebook has 155
friends, which is close to Dunbar’s number.9 As quoted by Dunbar:

“The interesting thing is that you can have 1,500 friends, but when you actually look
at traffic on sites, you see people maintain the same inner circle of around 150 people
that we observe in the real world.”10

Dunbar’s number and his studies of the size of social groups give empirical input to
analytical network models, such as Metcalfe’s law. The communication and
formation of social circles might not be that different in social media as it is in the
real world. One way of dividing people’s social circle is shown in the figure above, in
which five social groups are outlined: family and very close friends, close friends,
friends, acquaintances, and strangers.

Activity 5-3. Social Media Networks

Consider a social media network that you are a part of (e.g.
Facebook, Twitter, or Snapchat). How many users are there in
total in the chosen social media network? How many users do
you link to in the chosen social media network? How will you
rank and quantify the importance of your links? Does Metcalfe’s
law or Odlyzko-Tilly’s law best describe the value that the social
media network offers to you?

Activity 5-4. Multi-Sided Platform Laws

Discuss whether Metcalfe’s law and Odlyzko-Tilly’s law can be applied to multi-sided
platforms.
5.1.3. Reed’s law

In massive multiplayer online games (MMOGs), the players form groups.6 The number
of possible groups among % players is <~2F (assuming that % is large). Therefore, it is
reasonable to assume that the value of a digital service in which groups are formed is:
>gPPh % ~2F .
This is Reed’s law. Reed is an American computer scientist and one of the developers
of the TCP and UDP protocols.
Reed’s law determines, in general, the value of a network in which interactions
take place in groups. Again, we may use Odlyzko’s argument that the contribution
from large groups is too big, and the actual network effect of group formation is
smaller than what is predicted by Reed’s law. One way to modify Reed’s law is to use
Dunbar’s number, which is the average number of people an individual knows (see
BOX 5-2).7 A commonly-used value of Dunbar’s number i is 150.
Let us set the maximum size of a group that can be formed by people—for
example, in an online game—as equal to i = 150 . The number of groups smaller
than i that can be formed by % people is:
k
%
<~ ~%k ,
j
lC6
in which the binominal coefficient is the number of groups of j people that can be
formed by % people. For large %, %9 ≪ %k ≪ 2F . The formula follows from the
observation that:
k k k
% %! % %−1 ⋯ %−j+1
<= = =
j j! % − j ! j!
lC6 lC6 lC6
% %
and that: j < i for j < i and i < % 2 (Pascal’s triangle). Hence,
k
% % % %−1 ⋯ %−i+1 %k
<= <i =i <i ~%k ,
j i i! i!
lC6
using the “big O notation” and the fact that i ≪ %. The value of the network, is then:
>gPPhXpMh % ~<~%k .
To see that this is a reasonable assumption, note that by Reed’s law, the value of the
network doubles when a new customer is connected to the network because
>gPPh % + 1 ~2Fq6 = 2×2F = 2×>gPPh % . This vastly overestimates the value that a
single person may have on the network. In the modified case, the value increases more
modestly: >gPPhXpMh % + 1 ~ 1 + i % >gPPhXpMh % .
Activity 5-5. Network Laws

Which of the three laws (Sarnoff, Metcalfe, and Reed) are valid for
the valuation of the following digital services: Google search, Gmail,
World of Warcraft, Wikipedia, Netflix, Twitter, YouTube, eBay, and
Facebook?

5.1.4. Summary and Comparison of Network Laws

Table 5-1 summarizes the network laws presented in Sections 5.1.1–5.1.3. These laws
cover a broad array of different networks with very different underlying value
production mechanisms.
Reed suggests that Sarnoff’s law, Metcalfe’s law and Reed’s law may be used to
analyze the effect of merging two network companies. The value of the merged
company may then either be proportional to:
The sum of users of the two companies (Sarnoff), leading to a linear increase
in value
The increased number of possible interactions between users enabled by the

merger (Metcalfe), leading to a quadratic increase in value
The number of groups that can be formed among users in the new company
(Reed), leading to an exponential increase in value
This simple analysis may then, in some cases, uncover otherwise hidden values and in
other cases, avoid overoptimistic valuations of the new company.
Table 5-1. Network laws

Law Value of Network (V) Network Effect (F)
Sarnoff’s law % 1
Odlyzko-Tilly’s law % ln % ln %
Metcalfe’s law %9 %
F
Reed’s law 2 2F

Modified Reed’s law %k %kX6
Figure 5-4 shows numerical examples of Metcalfe’s, Odlyzko-Tilly’s and Sarnoff’s law
using a linear scale (left) and a logarithmic scale (right). Observe the significant
differences in value as a function of the number of users for the three laws. Reed’s
law—or the modified Reed’s law—have not been plotted since they both have
increases in value that are significantly steeper than Metcalfe’s law, and would,
therefore, almost overlap with the vertical axis.
10 000 1E+18
Metcalfe Metcalfe
1E+16 Odlyzko-Tilly
Odlyzko-Tilly
8 000 Sarnoff Sarnoff
1E+14
1E+12
6 000
1E+10
Value
Value
1E+08
4 000
1E+06
2 000 1E+04
1E+02
0 1E+00
0 200 400 600 800 1 000 1E+00 1E+02 1E+04 1E+06 1E+08
Users
Users
Figure 5-4. Numerical examples of Metcalfe’s, Odlyzko-Tilly’s, and Sarnoff’s law.

Activity 5-6. The Network Effect

Draw two graphs—one linear and one logarithmic—that show
the network effect as a function of the number of users using: (1)
Sarnoff’s law, (2) Metcalfe’s law, and (3) Odlyzko-Tilly’s law. How
would you interpret the graphs?

Activity 5-7. Mergers

Assume two competing social media companies, A and B, with
<r = 10 million users and <s = 20 million users. Assume that
these two companies plan to merge, making a new company,
C, with <t = <r + <s = 30 million users. Assume further that
the valuation of the companies depends on the number of
users only. What is the total gain (in percentage) from such a
merger when estimating the company’s value using: (1)
Sarnoff’s law, (2) Metcalfe’s law, and (3) Odlyzko-Tilly’s law?

5.2. Modeling of Digital Markets
This section presents quantitative models for the temporal evolution of digital markets.
The following types of markets are considered:
Markets reaching saturation when everyone has bought a copy of the product;
for example, smartphones (Section 5.2.1)
Markets with competition and churning; for example, smartphone markets
with several competing service providers (Section 5.2.2)
Markets in which users will leave the service after some time; for example,
Massive Multiplayer Online Games (MMOG) (Section 5.2.3)
The temporal evolution of the market can, to a first approximation, be modeled using
single first-order differential equations or coupled sets of such equations. All markets
that are considered consist of a fixed number, < , of potential customers buying the
good with some probability of ignoring changes in the population because of births
and deaths.
In some markets, eventually, all potential customers have purchased the good at
some time, and no more sales take place. It is also assumed that there are no other
saturation effects influencing the likelihood that a product is purchased. There are
several examples of services that have evolved in this way; for example, mobile phone
subscriptions and Internet access. In both cases, no significant saturation effects
caused by overload in the technical infrastructure have been observed during the
evolution of these networks. Similar observations are made regarding the evolution of
several social media services—the providers of the services seem to be able to put up
enough capacity to avoid the saturation effects that moderate the evolution of the
service.
We start with analyzing markets using the market diffusion equation developed by
Frank Bass in 1969.11 There are two reasons for this:
The Bass diffusion model describes rather well the evolution of markets for
durable commodity products—such as refrigerators, home freezers, electric
stoves, and lawn mowers—in which every household usually needs one item
of each. The model is also valid for social media, such as Facebook and
Twitter, and for subscription-based digital services, such as Internet access,
Spotify, and Netflix.
The Bass diffusion model allows simple analytic solutions from which we may
draw important conclusions concerning the temporal evolution of the market.
5.2.1. The Bass Diffusion Model

Figure 5-5 shows a simple market model for durables (e.g., refrigerators and radios) or
goods in which only one unit of the good is needed—the Bass diffusion model.
Examples of applications of the Bass diffusion model in the digital domain include:
subscriptions, Facebook accounts, or Twitter accounts. The box to the left represents
individuals who have not yet purchased the good (potential customers). There are < −
u such individuals, in which < is the total population. The box to the right represents
individuals who have already purchased the good. There are u such customers. Note
that the total population is assumed to be constant and equal to <, and anyone having
bought the good keeps it indefinitely. This implies that birth or death processes are not
included in the model. In addition, it is assumed that all flow parameters are constants,
to be able to solve the equations. When an individual buys a good, they become a
customer and move from the “potential customers” box to the “customers” box.
Potential customers Innovators Imitators Customers
$ % −#
% −# '# % − # #
Network effect
!~#
Figure 5-5. The Bass diffusion model.
There are two flows of new buyers of the good:

Flow of innovators consists of individuals who buy the good independently
of who else has bought it. These are the spontaneous buyers— also referred
to as “early adopters.” The strength of the flow is ,(< − u) in which the
probability that an arbitrary individual will buy the good is ,. The parameter ,
is called the “coefficient of innovation.”
Flow of imitators consists of individuals who buy the good because others
have bought it. These individuals are also called “late followers” (or just
followers) or “stimulated buyers.” The strength of the flow is xu < − u in
which xu is the probability that an individual is stimulated into buying the
good, expressing that the probability that the imitator will buy the good is
proportional to the current number of customers. The parameter x is called
the “coefficient of innovation.”
The model also contains a feedback loop—the network effect. The strength of the
feedback is proportional to the number of customers who have already bought the
good. This is a network effect of the Metcalfe type. Table 5-2 summarizes the
parameters used in the Bass diffusion model.
Table 5-2. Parameters in the Bass diffusion model

Parameter Description
< Total population
Individuals that have bought the product or
u
using the service (i.e., the current customers)
, Coefficient of innovation
x Coefficient of imitation
y Time
Using system dynamic modeling, numerical solutions can easily be found, even for the
more complex situation of parameters that depend on time. The differential equation
for the market dynamics follows directly from Figure 5-5:
u = Hu Hy = , < − u + xu < − u = , + xu < − u .
The first term is the probability of innovation and the second term is the probability
of imitation. The equation is called the Bass diffusion equation. For compactness,
the notation u = Hu Hy is used to represent the time derivative. Note that the term
, + xu is the probability that an item is sold in the infinitesimal period Hy . u is,
therefore, the demand for the good at time y (that is, items sold per unit of time). This
differential equation is separable:
Hu
= Hy.
, + xu < − u
Expanding the left-hand side of the equation and multiplying both sides by , + x< ,
results in:
xHu Hu
+ = , + x< Hy.
, + xu < − u
Integrating both sides gives:
ln , + xu − ln < − u = ln . + , + x< y,
Or:
, + xu {q|} Q
= .z ,
<−u
in which . is the constant of integration. Observe that for y = 0, u 0 = u7 the

constant of integration becomes:
, + xu7
.= .
< − u7
Inserting this and solving for u finally results in the solution of the Bass equation:
,< + x<u7 − ,(< − uM )z X {q|} Q

u y = ,
, + xu7 + x(< − u7 )z X {q|} Q
in which u7 = u(0) is the initial number of individuals possessing the good. These may
be individuals who have attained the good as part of a marketing promotion, a product
test, or together with a complementary product (e.g., the SMS attached to mobile
phones).
Figure 5-6 shows the Bass equation for a total population of < = 10~ individuals,
u7 = 10 initial customers, the coefficient of innovation , = 0.03, and the coefficient
of imitation x = 3.8×10XÅ . The values of , and x are based on the typical and average
values found in the paper by Mahajan, et. al.12
There are two special cases of the Bass equation:
If , = 0, there are only imitators, and the Bass equation is reduced to the
logistic distribution.
If x = 0, there are only innovators, and the Bass equation is reduced to the
exponential distribution.
Note that if there are no innovators (early adopters) but only imitators (that is, , = 0),
the solution of the differential equation is u = 0 for all y if u7 = 0; that is, no one will
ever buy the product. Therefore, u7 > 0 for a nonzero solution to exist if , = 0; that
is, a customer base must exist before the sales begin.
1 000 000
900 000
800 000
700 000
Customers (B)
600 000
500 000
400 000
300 000
200 000
100 000
0
0 2 4 6 8 10 12 14 16 18 20
Year (t)
Figure 5-6. Plot of the Bass diffusion model.
1 000 000
900 000 Only imitators (p=0)
800 000 Only innovators (q=0)
700 000
Customers (B)
600 000
500 000
400 000
300 000
200 000
100 000
0
0 2 4 6 8 10 12 14 16 18 20
Year (t)
Figure 5-7. The Bass diffusion model with only imitators and only innovators.
Figure 5-7 shows the solution of the Bass equation for the two cases with only imitators
(, = 0, x = 3.8×10XÅ ) and only innovators (, = 0.05, x = 0). For both graphs, the
total population is < = 10~ and the initial number of customers is u7 = 10 .
The condition that the Bass equation produces an S-curve is that there is an
inflexion point somewhere on the curve. An inflexion point is a point in which the
tangent to the curve is flat; that is, the growth rate changes from positive to negative.
This is, then, a point in which the second derivative vanishes, i.e., u = 0. The second
derivative of the Bass equation is:
H H
u= u= , + xu < − u = xu < − u − u , + xu .
Hy Hy
The condition of an inflexion point is:
u = xu < − u − u , + xu = 0.
Since u > 0, this leads to the linear equation x < − u − , + xu = 0 with solution:
x< − ,
u?FNS = ,
2x
in which u?FNS is the value of u at the inflexion point. Observe that the inflexion point
is positive if , < x< . If this condition is not fulfilled, there is no inflexion point on the
positive part of the curve. If all customers are imitators (, = 0), the inflexion point is
u?FNS = < 2. The solution of the Bass equation is, then:
<u7
u y = .
u7 + (< − u7 )z X|}Q
Again, observe that the condition u7 > 0 must be fulfilled to have nonzero solution.
Activity 5-8. The Bass Equation I

Consider the Bass equation and the two graphs in Figure 5-7 (u7 = 10 and < = 10~ ).
Assume that the graphs represent customer adoption to a social media service. How
large is the share of the market that has initially been adopted; that is, at time y = 0?
Consider the case with only imitators (, = 0). What is this distribution called? How
can the Bass equation be expressed when , = 0? How many customers have
adopted the service at the inflexion point? At what time does the inflexion point
occur? What is the rate of new customers joining the service at the inflexion point?
If the latency time is defined as the time it takes to reach 10% of the market (567 ), then
observe that for u7 ≪ < and , = 0
2.2
567 ≅ 5:7 +1 ,
ln u7 <
in which 5:7 is the time it takes to reach 50% of the potential market. Table 5-3 shows
the latency time for several values of u7 ; that is, the number of customers that must be
captured before the launching of the product.

Table 5-3. Latency times vs. initial customer base
u7 /< 567 /5:7 567 for 5:7 = 5 years
0.001 0.67 3 years and 4 months
0.04 0.31 1 year and 6 months

If 5:7 = 5 years and u7 /< = 0.001, the latency time is 3 years and 4 months. If u7 /< =
0.01, the latency time is still 2 years and 7 months. In markets without (or with very
few spontaneous buyers), the latency time is very long, and the supplier may choose to
terminate the service before the network effects become significant. This is the
strategic dilemma in markets with strong network effects and in which there is a minor
incentive for users to spontaneously join the service. The service may then be
terminated before the market has started to mature.
If there are only innovators (that is, x = 0) and u7 = 0, the solution reduces to:
u y = < 1 − z X{Q .
This is the exponential distribution. In this case the latency time (567 ) is given by:
ln 2
567 = 5:7 = 0.155:7 .
ln 0.9
For 5:7 = 5 years, the latency time is only 9 months. In the case with only innovators,
the market increases linearly, u y ≈ ,<y, for small y. On the other hand, if there are
only imitators, the market increases exponentially for small y, u ≈ u7 z |}Q . The
importance of this observation follows directly from the discussion in Section 5.3;
initially, the exponential growth is much slower than the linear growth. This is the
origin of long latency time in markets with only imitators.
On the other hand, observe that the time for the market to increase from 50% to
60% is only six months in the case of only imitators and u7 /< = 0.01, but more than
four times as long without feedback (i.e., only innovators). The conclusions of this
discussion are shown in Figure 5-8, and summarized as follows:
If all customers are innovators, then the latency time is short; however, the
time to capture market shares above 50% is long.
If all customers are imitators, the latency time is long; however, the time to
capture market shares above 50% is short.
1 000 000
900 000 Only imitators (p=0)
800 000 Only innovators (q=0)
700 000
Customers (B)
600 000
500 000
400 000
300 000
200 000
100 000
0
0 2 4 6 8 10 12 14 16 18 20
Year (t)
Market growth
Latency time Latency time Market growth 50% → 60%
only innovators only imitators 50% → 60% only innovators
only imitators
Figure 5-8. Latency time in the Bass diffusion model.
There are two strategic dilemmas in a market with only imitators:

As previously discussed, the market will not start growing unless there are
some initial customers. The problem for the supplier is, then, to establish an
initial pool of customers so that the growth process will start.
Even with an initial pool of customers, the growth rate may initially be so slow
that the supplier will terminate the service before it takes off.
Facebook is an example of a service in which there are very few innovators, since the
reason to use the service is to interact socially with other users; that is, , ≈ 0 for
Facebook. The service was launched at the campus of Harvard University, building up
a small initial user group among students. It took about five years (from 2003 to 2008)
before the market share really started to increase and Facebook started to become a
dominating social networking service. Other social networking services, such as

LinkedIn, also grew slowly initially.
Activity 5-9. The Bass Equation II

Consider the Bass equation when there are only innovators (x =
0). Can you identify the inflexion point in this graph? What is the
solution of the Bass equation for x = 0 and u7 > 0? Further,
assume that u7 = 0. Use Figure 5-5 to explain why such a market
increases linearly for small y.

5.2.2. Model for Markets with Competition and Churning

Figure 5-9 shows a model for the competition between two suppliers—Supplier 1 and
Supplier 2—offering the same service; for example, mobile communications. The
model consists of three customer states: Potential customers, customers of Supplier 1,
and customers of Supplier 2. Furthermore, the model consists of four flows: The flow
of new customers from potential customers to Supplier 1 and Supplier 2, respectively,
and the flow of customers from Supplier 1 to Supplier 2, and vice versa. The latter two
flows are called “churning.” The model also includes four feedback loops.
!~#$
Potential
customers %$ + '$ #$ ( − #$ − #* Customers
#$
Supplier 1
!~#$
#$ +$ + ,$ #*
( − #$ − #*
#* +* + ,* #$
!~#*
Customers
#*
%* + '* #* ( − #$ − #* Supplier 2
!~#*

Figure 5-9. Model of two competing suppliers with churning.

The rate of new customers choosing Supplier 1 is ,6 + x6 u6 < − u6 − u9 and the
rate of new customers choosing Supplier 2 is ,9 + x9 u9 < − u6 − u9 . Here, the Bass
equation is used to express the dynamics of the flows.
The net number of customers churning from supplier 2 to Supplier 1 is "96 =

u9 .9 + H9 u6 − u6 .6 + H6 u9 . The first term is the rate at which Supplier 1 gains
customers from Supplier 2 and the second term is the rate at which Supplier 1 loses
customers to Supplier 2. The net number of customers churning to Supplier 2 is "69 =
−"96 = u6 .6 + H6 u9 − u9 .9 + H9 u6 , since the churning process does not create
new customers (the net result of the two churning flows must be zero). The parameters
.6 and .9 are denoted coefficients of spontaneous churning, and the parameters H6 and
H9 are denoted coefficients of stimulated churning (or imitated churning). Again, the
Bass equation is applied to the churning flows. Imitated churning constitutes churners
that switch suppliers because of the size of the competing supplier.
The dotted lines in the figure are the feedback loops representing the network
effect that stimulates imitators into choosing a supplier or stimulates customers into
churning to the other supplier.
Putting all this together results in the following coupled set of dynamic market
equations:
u6 = ,6 + x6 u6 < − u6 − u9 − u6 .6 + H6 u9 + u9 .9 + H9 u6 ,
u9 = ,9 + x9 u9 < − u6 − u9 + u6 .6 + H6 u9 − u9 .9 + H9 u6 .
There is little hope to solve these equations analytically, except in a few special cases.
However, we may still draw some important conclusions concerning the long-term
evolution of the market without using numerical methods.
In the long run, all potential customers have become customers of either Supplier
1 or Supplier 2. This is, for example, the case in the mobile phone market. This means
that u6 + u9 = < . A steady state solution implies, moreover, that u6 = u9 = 0. In a
steady state, there is no net churning, which results in the solution of the quadratic
equation u6 .6 + H6 u9 = u9 .9 + H9 u6 , in which u6 + u9 = < , for the final state of
the market. This means that all potential customers are either associated with Supplier
1 or Supplier 2, and there are equal churning rates between the two suppliers. The
general solution satisfying the conditions u6 ≤ < and u6 ≤ u9 is:
.6 + .9 + H6 − H9 < − .6 + .9 + H6 − H9 < 9 − 4 H6 − H9 .9 <

u6 =
2 H6 − H9
u9 = <−u6 .
There are two special cases:

1. If there is only stimulated churning (.6 = .9 = 0) and H6 and H9 are
independent of time, then the final state is u6 = 0, u9 = 1 if H6 > H9 , or u6 =
1, u9 = 0 if H6 < H9 . These are, then, winner-take-all markets.
2. If there is only spontaneous churning (H6 = H9 = 0), then it follows directly

from the churning conditions that the market ends up in the stable state with
the following steady state distribution of customers:
.9 .6
u6 , u9 = , .
.6 + .9 .6 + .9
It is easy to extend the model to more than two competitors. If there is only
spontaneous churning, it is feasible to find analytic expressions for the stable end state
of the market for any number of competitors, though it is numerically cumbersome to
calculate the exact values if there are more than three competitors. On the other hand,
if there is no spontaneous churning, then the market will end up in a state in which
one of the competitors has captured the whole market. This is a winner-take-all market.
Note that in these models, the evolution of the market does not include price
competition or other mechanisms which may motivate the user to churn to another
supplier. The assumption is that the average probability of churning is constant, in
which this average may be determined by factors such as price, customer relationships,
preferences, technical quality, or simple laziness.
Activity 5-10. Churning

Consider two digital services satisfying the model for markets
with competition and churning. Assume that .6 = .9 ≠ 0 and
H9 > H6 . Which of the following best describes the market state
in the long run: u6 = u9 , u6 > u9 , or u6 < u9 ? Explain why.

5.2.3. Models for Massive Multiplayer Online Games

Figure 5-10 is a simple model for a Massive Multiplayer Online Game (MMOG), such
as World of Warcraft. The model may also be used to analyze services, in which the users
may leave the service with a certain probability; for example, social networking services
and newspaper subscriptions. An individual or a player may be in one of three possible
states: Potential player (u ), player (= ), or a player who has quit the game (Ö ).
There are three flows, in which it is assumed that the rate of each flow follows the
Bass equation:
New players, with rate , + x= u .
Players leaving the game, with rate A + -Ö =.
Players readopting the game, Ü + á= Ö.
The dotted lines in the figure show the network effect. For simplicity, we will call this
model the “BPQ model.”
BOX 5-3. System Dynamic Models

System dynamics are based on essentially the same method as differential equations.
However, instead of solving the equations using standard analytical or numerical
methods, the equations are converted into a dynamic simulation model. The
strength of system dynamic simulations is that the complete simulation model can
be compiled into executable software programs directly from the graphical
description of the model. There are several commercially-available software
packages for system dynamic modeling.15

The system dynamic model allows us to treat all system parameters as continuous or
discrete functions of time and simulate cases that are far out-of-reach using
differential equations. The figure below shows a system dynamic model of the Bass
equation. In system dynamics, the aggregates of people, things, or money are called
“stocks.”

Innovators
Potential adopters Adopters

× %
% ! −#
% + &# ! − #
!−# #
&# ! − #
×
New adopters
Imitators &

There are two stocks: Potential Adopters and Adopters. There is one flow from
Potential Adopters to Adopters. There are three functions:
Innovators, having a flow rate of , < − u .
Imitators, having a flow rate of xu < − u .
New adopters, which is the sum of innovators and imitators, and having a
flow rate of , + xu < − u .

Setting Adopters to u , New Adopters to u and Potential Adopters to < − u , the Bass
equation presented in Section 5.2.1 is deduced. When the simulation starts, the
stock of Adopters may be empty or contain an initial number of Adopters, u7 . The
initial stock of Potential Adopters is, then, either < or < − u7 .

Leaving
Potential players Players +~& Quitters
' + (& $
! + #$ %
% $ ) + *$ & &
+~$ +~$
New players Readoption
Figure 5-10. Model of a Massive Multiplayer Online Game.
The differential equations are now:
u = − , + x= u,
= = , + x= u − A + -Ö = + Ü + á= Ö,
Ö = A + -Ö = − Ü + á= Ö.
Adding the three equations results in u + = + " = 0. This leads to the obvious
conservation law u + = + Ö = < , in which < is the total population of potential
players. To simplify the model, assume first that < is constant (no birth or death
processes). The number of independent differential equations is then reduced to two.
These equations can then easily be transformed into a single, rather intractable,
nonlinear second order differential equation for = . There are a few cases in which
analytic solutions can be found.13 However, we shall not pursue this here.
Figure 5-11 illustrates a numerical solution of the differential equations of the
BPQ model. The figure shows the share of the population that are Potential Players
(u ), Players (= ), or Quitters (Ö ). Observe that the sum of these categories of individuals
is always 100 for a given y. At y = 0, observe that there are only Potential Players and
no Players or Quitters (i.e., u = 100 and = = Ö = 0). As the time increases, Potential
Players turn into Players, who, in turn, become Quitters. However, Quitters may
become Players again. At time y > 90, all individuals are either Players or Quitters.
Figure 5-11 shows the typical evolution of a game if all the flow parameters are
constants. Observe that the set of equations is reduced to the Bass equation if the flow
of Quitters is identically zero.
BOX 5-4. The SIR Model

The SIR model is a compartmental model used to forecast the development of
infectious diseases. The model consists of three groups of individuals: Susceptible
(à), infected (â ) and recovered (ä ). This corresponds to u , = , and Ö , respectively, in
the BPQ model. The flow of new infected individuals in the SIR model depends only
on network effects—someone must infect you; the flow of recovered individuals
does not depend on network effects—you recover independently of how anybody
else recovers. The parameter ã X6 denotes the time between contacts, which is
required for the transmission of the disease. The parameter å X6 is the time it takes
to recover from the disease. The figure below shows the SIR model. The resulting
differential equations for the SIR model are:

Hà Hy = −ãàâ ,

Hâ Hy = ãàâ − åâ ,

Hä Hy = åâ .

The set of differential equations is non-linear and does not have a general analytic
solution. However, like the BPQ model, important results can be drawn by studying
the equations.

!×#×$ &×$
# $ %
'~$

The SIR model was published by A. G. McKendrick and W. O. Kermack in a series of
papers in the period from 1927 to 1933. The SIR model is the basis for more advanced
compartment models in epidemiology, such as the SIS model, MSIR model, and the
SEIR model. The major differences between these models is the number of
compartments (user groups) and the interaction between them. Compartment
models have inspired academics to develop similar models for the evolution of digital
goods and services in the digital economy—the Bass model, the model with
competition and churning, and the BPQ model constitute all such initiatives. For
example, J. Cannarella and J. A. Spechler applied the SIR model to forecast the
evolution of Facebook.14 Based on their analysis, they predicted (in 2014) a rapid
decline in Facebook users starting from 2017. However, by 2018, this prediction does
not seem to hold true.
100
90 B P Q
80
Share of total population
70
60
50
40
30
20
10
0
0 20 40 60 80 100 120
Time (in months)

Figure 5-11. Plot of the BPQ model.
5.3. Exponential Growth

Exponential growth—also called “geometric growth”—means that the increase per
unit of time of some variable is proportional to the current value of that variable.
Moore’s law (see BOX 1-3) is an example of exponential growth. This section presents
a general mathematical introduction to exponential growth (Section 5.3.1) and
discusses strategic dilemmas related to exponential growth (Section 5.3.2).
5.3.1. General Introduction

The simple differential equation for exponential growth is:
à = ^à
with solution:
à y = à7 z KQ ,
in which à7 = à 0 and ^ is constant. This can be written in the form:
à y = à7 2Q B
in which 5 is the doubling time. It follows easily that 5 = ln 2 ^ ≈ 0.693/^ . If ^ is

given in terms of percentage ^ = 100^ , the doubling time is 5 ≈ 69.3 ^ ; sometimes,
referred to as “the rule of 69.3” (also called “the rule of 70” by replacing 69.3 with 70).
If the annual increase in the number of users of a product is 5%, the number of users
is doubled in approximately fourteen years.
Growth, given in terms of percentage, also eventually follows the exponential
curve, since 1 + A Q → z LQ for small y (less than 50). In this formula, A may be the
interest rate on invested capital, the discount rate in a present value calculation, or the
annual increase in market size. If A is small (less than 10%), it is a good approximation
of the exponential function; for example, in the calculation of the net present value
(NPV) of a project generating a fixed annual revenue.
Another observation is that the nominal difference between two exponentially-
increasing phenomena is also exponentially increasing. If > y = >7 z KQ and á y =
á7 z éQ where >7 > á7 , ^ > è , then:
i y = > y − á y = z KQ >7 − á7 z X KXé Q

;
the difference is increasing almost as quickly as the fastest-increasing phenomena. This

is the case even if ^ = è. Then i y = z KQ >7 − á7 . This may also explain some
increasing inequalities in society—why the rich get relatively richer and the poor get
relatively poorer; and why the Gross Domestic Product of developing countries lingers
further and further behind that of rich countries, even if the relative annual growth is
the same.
If ^ is negative, then à y = à7 2XQ B . This is the equation for exponential decay. 5
is now called the halftime. Radioactive decay is an example of exponential decay.
Activity 5-11. Exponential Growth

Consider two competing social media networks, A and B, with
initially 100,000 and 200,000 users, respectively. Because of
popularity and superior service, social media network A grows
with 8% users per month, while social media network B grows
with only 3% users per month. What is the initial nominal and
relative difference in the number of users between social media
networks A and B? What is the nominal and relative difference
in the number of users between social media networks A and B
after two years of growth? Reflect upon your findings.

5.3.2. Strategic Dilemmas of Exponential Growth

Figure 5-12 shows an important characteristic associated with exponential growth;
namely, that for small values of y, the exponential growth is much slower than linear
growth. This phenomenon was encountered already in Section 5.2.1, in which the
evolution of markets with imitators only versus markets with innovators only was
compared. With only imitators, the initial growth is exponential; with only innovators,
the initial growth is linear. Figure 5-12 shows the market size as a function of the time
(in years). The figure divides the market into two using a threshold value of 200; below
the threshold, the market size is too small to create revenue; above the threshold, the
market size is acceptable to provide positive revenue. The latency time may be defined
as the time it takes the market to reach the threshold—or, in other words, the time it
takes for the revenue stream to become positive. In the example, it takes four years to
reach the threshold if the market growth is linear. If the growth is exponential, then
the latency time is more than 7.5 years. Therefore, it is important to understand the
growth mechanism—exponential versus linear—to avoid making bad decisions based
only on the observation that the early market growth is slow. It is obvious that the
market in the example with exponential growth will be the most lucrative in the long
run. However, the company must be able to carry the losses for several years before
the revenue stream becomes positive.
Threshold Threshold
linear growth Exponential growth
1200
Linear growth
1000 Exponential growth
Threshold
800
Market size
600
400
200
0
0 1 2 3 4 5 6 7 8 9 10
Time
Figure 5-12. Comparison of linear and exponential growth.
In real business planning, management is faced with difficult strategic questions

relating to exponential growth, such as:
Is the market growing slowly because the users are not interested in the
product, because the product is invisible to potential users, or because of
exponential growth caused by strong network effects?
How can strong network effects be detected in the early market evolution?
What can be done in markets with strong network effects to stimulate early
growth?
What are the threats from suppliers with supplementary or similar products in
markets with slow initial growth?
Are there any methods by which users can be locked-in to the product, and
how strong is the lock-in effect?
These questions cannot be answered by studying the market growth curve alone. It is
more important to understand the motives of the users.
The net present value (NPV) of a project in which the revenue increases by a fixed
exponential rate, ^ , is:
F 1+^ F
1+^ ?X6 −1
<=> = ä =ä 1+A ,
1+A ?X6 1+^
?C6 −1
1+A
in which D enumerates the year, A is the discount rate used to calculate the NPV, ä is
the revenue for the first year, and % is the number of years over which the NPV is
calculated. If A is assumed to be small (less than 0.1) and % small (twenty years or less),
the NPV is approximated as follows:
F F F
?X6
1+^ z K ?X6 KXL ?X6
z KXL F
−1
<=> = ä ?X6
≈ä =ä z =ä ,
1+A z L ?X6 z KXL −1
?C6 ?C6 ?C6
by using 1 + A F → z LF . If the growth rate is larger than the discount rate, the formula
shows that the contributions to the net present value increase exponentially. Hence,
the largest contribution to the NPV is the expected revenue far into the future; the
decision to accept a project depends not on its short-term value but on uncertain long-
term estimates. It should also be evident that the farther into the future we are looking,
the more uncertain the estimates we can make will be. The basic idea behind NPV is
that revenue today is more valuable than revenue tomorrow, so the impact of future
revenue is reduced by the discount rate. An alternative—and more complicated—
method is to use risk-adjusted NPV, in which the present value of the expected cash
flow for a given year is multiplied by the probability that the estimate will occur. This
may reduce the impact of the future to an acceptable level.
The uncritical use of exponential market penetration curves is likely to have been
one of the sources of the dot-com crisis in 2000. The market perspectives of many
newcomers in the digital business sectors were based on brilliant ideas with huge
market potentials—provided that the ideas could ever be turned into a products that
users were willing to pay for. A colleague working on strategy for a telecom operator
at that time saw several examples of startups presenting business models which showed
impressive future revenue, all of them based on expected exponential market growth.
None of these companies survived.16
It was not only newcomers that got the market prospect wrong but also companies
with vast business experience. Several European telecommunications operators, for
example, ran into severe problems after grossly overestimating the future revenue
flows from 3G mobile networks and broadband networks. From their annual reports,
it seemed as if some of them had overlooked that for every new 3G customer the
company would capture, the company would also lose a GSM customer, ending up in
a situation in which there was no new net inflow of cash.
A final observation is that exponential market growth cannot continue
indefinitely. At some point in time, the market may reach saturation and continue
evolving at a milder growth rate.
Activity 5-12. Net Present Value

The company, Bits and PCs, sells computer equipment online. The business data for
the company is as follows:
Revenue for the first year: $1 million
Expected yearly revenue growth: 20%
Cost for the first year: $2 million
Cost for the second year: $700,000
Expected yearly cost growth after the second year: 10%
Discount rate: 10%

Calculate the net present value for the firm for its first ten years of operation. Note:
g
If äQ is the net cash flow year y, then <=> = FQC7 6qLê ê , in which A is the discount
rate. Do any of the financial figures (revenue, cost, profit, and discounted profit)
increase exponentially?

Activity 5-13. Empirical Exponential Case Study

Identify and describe an empirical case study of exponential
growth in the digital economy (can be, for example, the usage
of a digital service, or technology performance). What fuels the
exponential growth in the identified case? Plot the growth as a
function of time. Discuss how the growth of the identified case
will evolve in the future.

BOX 5-5. Viral Growth

The viral growth model is a concept in business strategy and marketing that has
gained increased attention with the popularity of social media. Here, users of a
service bring in new users through a combination of referrals, invitations, paid
acquisitions, and promotions. Central to the viral growth model is the “k-factor,”
which is the average number of new users that each existing user adds to the service.
The “k-factor” can be expressed as j = D×. , in which D is the average number of new
users that each existing user invites to join the service and . is the probability that
an invitation will be successful (i.e., that a new user joins the service). For example,
if an existing user invites, on average, D = 10 new users to join the service, and these
new users join with a probability . = 0.2, then j = 10×0.2 = 2. It takes one “cycle”
for existing users to send invitations and for potential new users to accept those
invitations. The parameter , denotes the time it takes to complete one cycle and à7
the initial number of users at cycle 0. The figure below shows the total number of
users for each cycle using the viral growth model with j = 2 and à7 = 1. For each
cycle, existing users successfully add two new users to the service. Note that only
users who joined the previous cycle add new users to the service—users send out
invitations to other users only once. Users that have already added users to the
service are marked in grey. Note that these users are still using the service.

Cycle 0
Cycle 1
Cycle 2
Cycle 3 Cycle 4

The total number of users à y at time y is:

} Q
q6
?
1 − c }q6 c }q6 − 1 c{ − 1
à y = à7 c = à7 = à7 = à7
1−c c−1 c−1
?C7

The number of cycles completed at time y is y ,. c = 1 results in linear growth— à7
new user(s) are added to the service for every cycle. c > 1 results in exponential
growth. Basically, this is similar to the growth studied in Section 5.3, as growth in
terms of percentage also follows the exponential curve. Strategies for adding users
with the viral growth model are to increase the user base (à7 ), decrease the cycle
time (,) or increase c . Viral growth is different from network effects: Viral growth is
a mechanism to increase the number of users, while network effects describe how
value increases with the number of users. Both viral growth and network effects are
examples of positive feedback.

5.4. The Quantitative Long Tail Model

A qualitative description of the long tail is contained in Section 2.11. This section
discusses the long tail and heavy tail distributions from a mathematical point of view.
The term “long tail” alludes to statistical distributions where a large portion of
occurrences are far away from the main part of the distribution. Mathematically, the
long tail distribution is a special case of heavy tail distributions, which are defined in
statistics as distributions in which the tail of the distribution falls off more slowly than
the exponential decay. Any distribution of the form Pr ì > j ~j Xî , å > 1 in which j
is a positive integer is a heavy tail distribution. If å is small (between 1 and 2), then it
is also called a long tail distribution.
Anderson, based on Brynjolfsson et al.,17 found that the popularity of books sold
by Amazon seemed to follow a rank distribution in accordance with Zipf’s law. In
2000, the number of titles available on Amazon was 2.3 million, while an ordinary
bookstore held about 40,000 titles. The “long tail” of Amazon then consisted of more
than 2.2 million books; that is, books available on Amazon, but not in an ordinary
bookstore.
Zipf’s law is based on the observation that the most frequent word in English
(“the”) is twice as frequent as the second-most frequent word (“of”), three times as
frequent as the third-most frequent word (“and”), and so on. Zipf’s law holds quite
well for, at least, the first 1000 words in the English language.18 The frequency of words
is then derived from the harmonic series
1 1 1 1
1, , , , ⋯ ,
2 3 4 <
or, more precisely, the frequency ï j; < of the j -th-most frequent word is
1 j 1 j
ï j; < = } ≈
òC6 1 ó ln < + å
in which < is the number of words in the English language and å ≈ 0.57722 is the
Euler-Mascheroni constant. We have used the fact that
} 1 1
= ln < + å + ô .
lC6 j <
For large < , the last term can be ignored. The statistical distribution with frequency
ï(j; <) is also called the “Zipfian distribution.” Note that the distribution depends on
the cutoff < .
Let us then apply Zipf’s law to the sale of books. The number of titles held by
Amazon is 2.3 million books, while an ordinary bookstore holds about 40,000 titles.
The titles held by an ordinary bookstore are, according to Zipf’s law, the most popular
titles, ranging from 1 to 40,000 in popularity. The titles with popularity ranging from
40,001 to 2,300,000 in popularity is the long tail. The relative number of sales of books
from the long tail is, then:
9,877,777 1 7,777 1 7,777 1

− ln 40,000 + å
lC6 j lC6 j
=1−
lC6 j
≈1− ≈ 26.6%,
9,877,777 1 9,877,777 1 ln 2,300,000 + å
lC6 j lC6 j
using
} 6
lC6 l = ln < + å .
Hence, the long tail makes up 26.6% of all sales of books by Amazon, provided that
the demand for books follows Zipf’s law. Note that empirical results based on Amazon
sales yielded a long tail of 36.7% (see Section 2.11). This means that Zipf’s law gives a
reasonable estimate of Amazon’s long tail sales.
If the tail is twice as long (4.6 million books), then the sales from the tail increase
to 29.8%; that is, the sales from the first 2.3 million books in the tail amounts to 26.6%
of the total sale while the next 2.3 million books in the tail amounts to only 3.2% of
the total sales. If the tail is only half as long (1.1 million books), the sales from the tail
are 22.9% of the total sales.
The size of the tail can be adjusted by applying a general discrete power law
distribution instead of Zipf’s law. In a general discrete power law distribution, the
frequency of j events is:
j Xõ
ï(j) = , ù > 1,
ú ù
in which ú ù = û lC6 j
Xõ
is the Riemann zeta function and ù is a constant. The
parameter ù alludes to the size of the tail of the distribution. If the tail starts at j =
c = 40,001 (as in the example with Amazon above), then the relative number of
books, ä , sold in the tail will be:
7,777 Xõ
lC6 j
ä =1−
ú ù
The Zipfian distribution may be regarded as a special case, in which ù = 1. In this case,
there must be an upper cutoff < for which Pr ì > < = 0, and the zeta function is
replaced by }lC6 j X6 . The same applies if ù < 1, since the zeta function diverges for
ù ≤ 1.
Figure 5-13 shows the relative number of books sold in the tail (ä ) as a function
of ù . Here, the cut-off value is < = 2,300,000, which corresponds to the number of
books available on Amazon. Observe that the relative number of books sold in the tail
(ä ) decreases from 98.3% when ù = 0 to 0% when ù > 1.6. That is, for a decreasing
value of ù , the size of the tail decreases as well—by adjusting the parameter ù, the size
of the tail changes correspondingly. For ù = 0, all book titles sell in the same numbers.
In this case, sales are uniformly distributed. Furthermore, for ù > 2.0 the tail is too
small to have any economic value since books in the tail collectively constitute to
virtually no sales. Note that the Zipfian distribution assumes ù = 1, resulting in ä =
26.6%, as calculated above. Note that ù ≈ 0.94 will match the empirical data of
Amazon’s sales ä = 36.7% for the parameters < = 2,300,000 and j = c = 40,001. In
other words, Amazon book sales as presented here can be modeled accurately using
general discrete power law distribution with ù = 0.94.
100%
90%
80%
70%
60%
50%
R
40%
30%
20%
10%
0%
0 0,2 0,4 0,6 0,8 1 1,2 1,4 1,6 1,8 2
alpha

Figure 5-13. Relative size of the tail.
Power law distributions are not only important to determine the economic value of the
long tail. These distributions are also used to evaluate the robustness and vulnerability
of the Internet and digital services. In 1999, the two physicists, Albert-László Barabási
and Réka Albert, discovered that the number of hyperlinks pointing into or out of web
pages followed a general power law distribution with an exponent approximately equal
to 2.19 The same researchers also developed a general theory in which they
demonstrated that the number of links connected to the nodes of a graph follows a
power law distribution if the graph is grown with preference. For the web, “growth
with preference” means that a new web page is connected to other web pages with a
probability proportional to the size of these web pages. This phenomenon is called the
“Barabási–Albert (BA) random graph model.” Later, it was found that the size of
Internet routers measured in terms of the number of connections they have with other
routers also follows the same power law.20
Hence, the Internet and the web have long tails. This insight directs us toward
another observation; namely, that structures like the Internet and the web are very
vulnerable to attacks against routers and web pages in the long tail. Remove several of
the biggest Internet routers—there are not very many of them—and the Internet runs
into severe connectivity and capacity problems; remove the search engines from the
web, and the web falls apart, leaving the Internet and the web are vulnerable to directed
attacks. On the other hand, most of the routers and web pages have small connectivity
and a random attack on routers and web pages may have little effect. Hence, the
Internet and the web are, at the same time, both vulnerable and robust against failures
and cyberattacks.21

Activity 5-14. Internet Router Connections

What is the probability that that the Internet contains a router
with 1000 connections if the size distribution of Internet routers
follows a general power law with ù = 2? To simplify
calculations, you can use the fact that Riemann’s zeta function
ü†
with argument 2 is ú 2 = ~ . If there are ten million routers in
the Internet, how many are expected to have 1000
connections? How many routers have exactly one connection?


This chapter shows how selected parts of digital economics can be quantified using
mathematics and statistics. Topics that are important for the increased insight in the
field have been chosen for this chapter. Describing concepts using mathematics help
us to clarify discussions of complex phenomena beyond poorly founded beliefs. The
topics addressed in this chapter include: Network laws, the Bass diffusion model,
exponential growth, and the long tail.
Key Points

Different network laws are used to calculate the value of a network based on the
number of users it contains.
Sarnoff’s law estimates the value of broadcast networks.
Metcalfe’s law estimates the value of networks interconnecting users, in which all
links are equally probable and valuable.
Odlyzko-Tilly’s law is a variant of Metcalfe’s law, in which a rank distribution is
used to model the value of each user.
Reed’s law estimates value based on the number of groups that can be formed by
users.
The Bass diffusion model can be used to calculate the number of users that are
adopting a digital service or technology.
The Bass diffusion model may be extended to include competition, churning,
quitting, and re-adoption.
It is essential to understand some basic properties of exponential growth such as
doubling time, initial slow growth, relative growth of two or more exponential
phenomena, and the effects of unbounded growth.
The long tail may be modeled using Zipf’s law or a general discrete power law
distribution.

Further Reading

W. Brian Arthur. Complexity and the Economy. Oxford University Press. 2015.
This book introduces complexity economics, including path dependence and positive
feedback. It is not specifically targeted to digital economics; however, the theories
presented in the book are applicable to several topics in digital economics.
Ove Granstrand. Industrial Innovation Economics and Intellectual Property. Svenska

Kulturkompaniet. 2016.
This book presents a comprehensive presentation of the economics of innovations,
both qualitatively and quantitatively. It discusses the diffusion of innovations and
intellectual property rights. The book covers digital services but is not targeted
specifically at the digital economy.
Concluding Remarks
Digital economics is the branch of economics studying digital services. This book has
provided a systems view of digital economics by drawing on a range of academic
disciplines, including: Business management, innovation, complexity economics,
business modeling, microeconomics, and macroeconomics. We have explained how
historical developments in ICT have shaped the digital economy from the inception of
the transistor in the 1950s until the commercialization of recent digital services—such
as Snapchat and Bitcoin—in the 2010s. Digital economics is the study of the economic
impact of these and many other digital services.
We have explained several fundamental properties in the digital economy. These
properties are essential to comprehend digital economics fully. They also comprise the
core part of many successful business models in the digital economy. Of the
fundamental properties discussed, network effects and positive feedback have had a
significant impact on the evolution of the digital economy.
Within the digital market, the trading of goods and services regularly happens. In
fact, e-commerce is one of the earliest and most successful applications of the World
Wide Web and is a driving force in the digital economy today. Modeling digital markets
is difficult, because of the large number of stakeholders with overlapping
socioeconomic motives.
Digital services employ business models that describes their business operations.
There are several popular business models in the digital economy, including:
Subscription-based, ad-based free, and multi-sided platform business models.
Advanced digital economics focuses on the quantitative modeling of digital
markets, value estimation, and market evolution. Even though such models are flawed
due to the assumptions made in the modeling phase, they give valuable insights into
how the digital economy operates nevertheless.

Notes

Chapter 1
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internet-access
3. Wikipedia. List of public corporations by market capitalization. 2018.
https://en.wikipedia.org/wiki/List_of_public_corporations_by_market_capitalization
4. D. Tapscott, D. Ticoll, and D. Herman. Digital Conglomerates: Setting the Agenda for Enterprise
2.0. New Paradigm Learning Corporation. 2006. http://dontapscott.com/wp-
content/uploads/Don-Tapscott-Digital-Concolmerates.pdf
5. C. Christensen. The innovators dilemma: when new technologies cause great firms to fail.
Harvard Business School Press. 1997.
6. R. Grossman. The industries that are being disrupted the most by digital. Harvard Business
Review. March 21, 2016. https://hbr.org/2016/03/the-industries-that-are-being-disrupted-the-
most-by-digital
7. M. Hilbert and P. López. The world’s technological capacity to store, communicate, and compute
information. Science 332. April 2011.
8. The Economist. Data is giving rise to a new economy. May 6, 2017.
https://www.economist.com/news/briefing/21721634-how-it-shaping-up-data-giving-rise-new-
economy
9. J. Schultz. How much data is created in the Internet each day? Micro focus blog. October 10,
2017. https://blog.microfocus.com/how-much-data-is-created-on-the-internet-each-day/
10. Facebook business. https://www.facebook.com/business/products/ads/ad-targeting
11. Statistics brain. Average cost of hard drive storage. https://www.statisticbrain.com/average-
cost-of-hard-drive-storage/
12. Wikipedia. Moore’s law. https://en.wikipedia.org/wiki/Moore%27s_law
13. A. Nordrum. Popular Internet of Things Forecast of 50 Billion Devices by 2020 Is Outdated. IEEE
Spectrum. August 18, 2016.
14. Reddit. WoW gold making. https://www.reddit.com/r/WoWGoldMaking/
15. Wikipedia. Legality of bitcoin by country or territory.
https://en.wikipedia.org/wiki/Legality_of_bitcoin_by_country_or_territory
16. Court of Justice of the European Union. The service provided by Uber connecting individuals
with non-professional drivers is covered by services in the field of transport. December 20, 2017.
https://curia.europa.eu/jcms/upload/docs/application/pdf/2017-12/cp170136en.pdf
17. P. Tuohey. Cities and state are struggling to regulate Airbnb. January 10, 2018.
http://thehill.com/opinion/finance/368382-cities-and-state-are-struggling-to-regulate-airbnb


Chapter 2
1. L. Fournier. Merchant Sharing: Towards a Zero Marginal Cost Economy. ArXiv. 2014.
https://arxiv.org/abs/1405.2051
2. Wikipedia. List of most expensive video games to develop.
https://en.wikipedia.org/wiki/List_of_most_expensive_video_games_to_develop
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4. J. Gapper. Facebook faces the tragedy of the commons. Financial Times. November 29, 2017.
https://www.ft.com/content/ec74ce54-d3e1-11e7-8c9a-d9c0a5c8d5c9
5. Y. Benkler. Coase’s Penguin or Linux and the Nature of the Firm. The Yale Law Journal 112(3),
2002.
6. CAESAR cryptographic competition. https://competitions.cr.yp.to/caesar.html
7. Netflix prize. https://www.netflixprize.com/
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20, 2013.
9. M. E. Porter. How Competitive Forces Shape Strategy. Harvard Business Review. March/April
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10. C. B Stabell and Ø. D. Fjeldstad. Configuring Value for Competitive Advantage: On Chains, Shops,
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Business School Press. 1999.
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17. J. Currier and NFX team. The Network Effects Bible. https://www.nfx.com/post/network-effects-
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18. W. B. Arthur, Y. M. Ermoliev and Y. M. Kaniovski. Strong laws for a class of path-dependent
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19. W. B. Arthur. Increasing Returns and Path Dependence in the Economy. University of Michigan
Press. 1994.
20. S. J. Liebowitz and S. E. Margolis. Path Dependence, Lock-In, and History. Journal of Law,
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21. E. Idland, H. Øverby and J. A. Audestad. Economic Markets for Video Streaming Services: A Case
Study of Netflix and Popcorn Time. NIK: Norsk Informatikkonferanse. Ålesund, Norway. 2015.
22. W. J. Baumol, J. C. Panzar, R. D. Willig. Contestable Markets and the Theory of Industry
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23. C. Anderson. The Long Tail: Why the Future of Business Is Selling Less of More. Hyperion. 2006.
24. J. Hanks. Amazon doesn’t do long tail. Why should you? PracticalEcommerce. April 4 2017.
https://www.practicalecommerce.com/Amazon-Does-Not-Do-Long-tail-Why-Should-You
25. E. Brynjolfsson, Y. Hu and D. Simester. Consumer Surplus in the Digital Economy: Estimating the
Value of Increased Product Variety at Online Booksellers. Management Science, Vol. 49.
November 2003.
26. E. Brynjolfsson, Y. Hu and M. D. Smith. The Long Tail, The Changing Shape of Amazon’s Sales
Distribution Curve. 2010. http://ssrn.com/abstract=1679991
27. E. Brynjolfsson, Y. Hu and D. Simester. Hello Long Tail: The Effect of Search Cost on the
Concentration of Product Sales. 2011. http://ssrn.com/abstract=953587
28. E. Brynjolfsson and A. Saunders. Wired for Innovation. The MIT Press. 2013.
Notes 215

Chapter 3
1. The Independent. UBER: Which countries have banned the controversial taxi app.
http://www.independent.co.uk/travel/news-and-advice/uber-ban-countries-where-world-taxi-
app-europe-taxi-us-states-china-asia-legal-a7707436.html
2. Statista. E-commerce in the United States - Statistics and Facts.
https://www.statista.com/topics/2443/us-ecommerce/
3. The Drum. China’s ecommerce market to pass $1.1tn in 2017.
http://www.thedrum.com/news/2017/07/05/china-s-ecommerce-market-pass-11tn-2017
4. F. Linde and W. G. Stock. Information Markets. A Strategic Guideline for the I-Commerce. Berlin,
New York, New York: De Gruyter Saur. 2011.
5. B. J. Pine and J. Gilmore. Welcome to the Experience Economy. Harvard Business Review. July 1,
1998.
6. P. Nelson. Information and Consumer Behavior. Journal of Political Economy 78(2). pp. 311–
329. 1970.
7. J. A. Audestad. Internet as a multiple graph structure: the role of the transport layer.
Information Security Technical Report 12(1). 2007.
th
8. E. Rogers. Diffusion of Innovations. 5 edition. Free Press. 2003.
9. L. K. Vanston and R. L. Hodges. Technology forecasting for telecommunications. Telektronikk 4.
2004. https://www.telenor.com/wp-content/uploads/2012/05/T04_4.pdf
10. The World Bank. Mobile cellular subscriptions.
https://data.worldbank.org/indicator/IT.CEL.SETS.P2
11. C. Shapiro and H. R. Varian. Information Rules: A Strategy Guide to the Network Economy.

Chapter 4
1. OECD. The Oslo Manual: Guidelines for Collecting and Interpreting Innovation Data. 2005.
http://www.oecd.org/sti/inno/oslomanualguidelinesforcollectingandinterpretinginnovationdata
3rdedition.htm
2. H. Edison, N. B. Ali, R. Torkar. Towards innovation measurement in the software industry.
Journal of Software and Systems 86(5). pp. 1390–1407. 2013.
3. O. Granstrand. Industrial innovation economics and intellectual property. Svenska
Kulturkompaniet. 2016.
4. C. Christensen. The innovators dilemma: when new technologies cause great firms to fail.
5. W. C. Kim and R. Mauborgne. Blue Ocean Strategy. Harvard business review press. 2015.
6. A. Ovens. What is a business model? Harvard Business Review. January 23, 2015.
7. A. Osterwalder and Y. Pigneur. Business Model Generation: A Handbook for Visionaries, Game
Changers, and Challengers. Wiley. 2010.
8. C. Anderson. Free: The Future of a Radical Price. Hyperion. 2009.
9. Statista. Spotify revenue. 2017. https://www.statista.com/statistics/245125/revenue-
distribution-of-spotify-by-segment/
10. BBC. Facebook value drops by $37bn amid privacy backlash. March 19, 2018.
http://www.bbc.com/news/business-43462423
11. Bitcoin energy consumption index. https://digiconomist.net/bitcoin-energy-consumption
12. J. Audestad. How to Survive in the Future. Telektronikk vol. 3/4 1998. pp. 74–84.
13. J. B. Quinn, J. J. Baruch and K. A. Zien. Innovation Explosion: Using Intellect and Software to
Revolutionize Growth Strategies. The Free Press. 1997.
14. The Guardian. Congress grills Facebook CEO over data misuse - as it happened. April 11, 2018.
https://www.theguardian.com/technology/live/2018/apr/10/mark-zuckerberg-testimony-live-
congress-facebook-cambridge-analytica
15. K. Brown and J. Ianthe. Arthur Andersen’s Fall from Grace Is a Sad Tale of Greed and Miscues.
Wall Street Journal. June 7, 2002.
16. C. K. Prahalad and G. Hamel. The core competence of the corporation. Harvard Business Review,
Vol. 68, No. 3. 1990.
17. B. Wernerfelt. A Resource-based View of the Firm. Strategic Management Journal, Vol. 5, No. 2.
1984.
18. M. E. Porter. How Competitive Forces Shape Strategy. Harvard Business Review, March/April
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19. Wikipedia. Cambridge Analytica data scandal.
https://en.wikipedia.org/wiki/Facebook%E2%80%93Cambridge_Analytica_data_scandal
20. A. M. Brandenburger and B. J. Nalebuff. The Right Game: Use Game Theory to Shape Strategy.
Harvard Business review, Vol. 73, No. 4, 1995.

Chapter 5
1. E. Idland, H. Øverby and J. Audestad. Economic Markets for Video Streaming Services: A Case
Study of Netflix and Popcorn Time. NIK 2016, Ålesund, Norway, November 23-25, 2016.
2. X.-Z. Zhang, J.-J. Liu, Z.-W. Xu. Tencent and Facebook Data Validate Metcalfe’s Law. Journal of
Computer Science and Technology, Issue 2, Vol. 30. 2015.
3. A. Odlyzko and B. Briscoe. Metcalfe’s Law is Wrong. IEEE Spectrum: Technology, Engineering,
and Science News, July 1, 2006.
4. B. Bollobás. Random Graphs. Cambridge University Press. 2001.
5. S. Milgram. The Small World Problem. Psychology Today, May 1967.
6. D. P. Reed. Weapon of Math Destruction: A simple formula explains why the Internet is wracking
havoc on business models.
https://web.archive.org/web/20071008165706/www.contextmag.com/setFrameRedirect.asp?s
rc=/archives/199903/digitalstrategy.asp
7. Wikipedia. Dunbar’s number. https://en.wikipedia.org/wiki/Dunbar%27s_number
8. R. Dunbar. Grooming, Gossip, and the Evolution of Language. Harvard University Press. 1998.
9. S. Knapton. Facebook users have 155 friends - but would trust just four in a crisis. The Telegraph.
https://www.telegraph.co.uk/news/science/science-news/12108412/Facebook-users-have-
155-friends-but-would-trust-just-four-in-a-crisis.html
10. News.com.au. Human brain can only handle up to 150 Facebook friends - Professor Robin
Dunbar. http://www.news.com.au/technology/human-brain-can-only-handle-up-to-150-
facebook-friends-professor-robin-dunbar/news-story/3763c0ea7811973370fd207098c3be78
11. F. M. Bass. A New Product Growth Model for Consumer Durables. Management Science, Vol. 15,
No. 5, 1969.
12. V. Mahajan, E. Muller, F. Bass. Diffusion of new products: Empirical generalizations and
managerial uses. Marketing Science 14 (3). 1995.
13. J. Audestad. Some Dynamic Market Models. ArXiv:1511.07203.
14. J. Cannarella and J. A. Spechler. Epidemiological modeling of online social network dynamics.
ArXiv 1401.4208.
15. J. D. W. Morecroft . Strategic Modelling and Business Dynamics: A Feedback Systems Approach.
nd
2 Ed., John Wiley. 2015.
16. Wikipedia. Dot com bubble. https://en.wikipedia.org/wiki/Dot-com_bubble
17. E. Brynjolfsson. Y. Hu and M. D. Smith. Consumer Surplus in the Digital Economy: Estimating the
Value of Increased Variety at Online Booksellers. Management Science. 2003.
18. M. Schroeder. Fractals, Chaos, Power Laws: Minutes from an Infinite Paradise. Dover. 2009.
19. R. Albert and A.-L. Barabási. Statistical Mechanics of Complex Networks. ArXiv. 2001.
Notes 217
20. S. N. Dorogovtsev and J. F. F. Mendes. Evolution of Networks: From Biological Nets to the
Internet and WWW. Oxford University Press. 2001.
21. J. A. Audestad. Internet as a multiple graph structure: the role of the transport layer.
Information Security Technical Report, Vol. 12, No. 1, 2007.


Comments on Activities
The comments provided here should be regarded as hints when solving the activities. They
should not be regarded as complete answers to the activities.

Activity 1-1
Search the web for both recent and historical news articles. These articles may reveal both
historical impact and future predictions for the impact of digitization. Examples of
technologies that may have a significant impact on the society are: Blockchain, machine
learning, Internet of Things, and self-driving cars. You may also discuss how Moore’s law
impacts the stories you have identified.

Activity 1-2
Dropbox depends on the following ICT: The Internet, smartphones, PCs, and the cheap mass
storage of data. Dropbox depends on the following digital services: Cryptographic tools,
digital payment solutions, and mobile app ecosystems. Dropbox may be an integral part of
consumer storage systems of both private and business data. Dropbox may also be used in
collaborative projects to store and share information. For instance, a company may
integrate Dropbox for storing all its data in every other service or application available to
the employees.

Activity 1-3
The major benefits of convergence are fewer networks and technologies to build and
operate. This should, in theory, result in more cost-efficient operations of communication
networks on a global scale. “Convergence” also means that technologies become more
standardized and conform to using just one communication network for the transport of
data (Internet). This should, in theory, increase competition and innovation and reduce
prices for consumers. It may also simplify operations, since all services conform to a single
standard. A major challenges of convergence is the complexity that is added to an already-
complex Internet. This complexity increases vulnerabilities and allows for security attacks.
The Internet is offering a best-effort service for data transport. Is the best-effort service
sufficient for all kinds of digital services?

Activity 2-1
The following are digital services: The NY Times web page, Internet access, and an HBO
subscription. The following are not digital services: A CD and an iPhone. The NY Times web
page is considered a digital good. The content available on HBO is a digital good.

Activity 2-2
The number of copies sold must cover the fixed costs. If MC = 0, the number of copies sold
to cover the fixed costs is 100,000,000 / 50 = 2,000,000 copies. If MC = 10, the number of
copies sold to cover the fixed costs is 100,000,000 / (50 - 10) = 2,500,000 copies. The MC =
0 if the trade is completely digital. That is, ordering, payment, and delivery are all digital. On
the other hand, the MC > 0 if the trade includes a physical product (e.g., DVD containing the
game, a box, or a user manual).

Activity 2-3
Of these services, only cloud storage is fully commoditized. Social media is not
commoditized. This is because the social media networks available (e.g., Twitter, Facebook,
and Google+) have very different functionalities, and they do not communicate with one
another. This is because of missing standards in the social media industry. E-mail clients are
close to being commoditized. This is because e-mail as a service is standardized (SMTP).
Hence, the functionalities of different e-mail clients are the same. The major difference
between various e-mail clients is the design and interoperability with other applications
(such as a calendar). Web browsers are close to being fully commoditized. This is because
the web service is standardized (through the protocols HTML, HTTP, and URL). The major
differences between web browsers are the design and, to some degree, the interoperability
with other digital services (such as Flash and JavaScript). Cloud storage is fully
commoditized. The only difference between various cloud storage services is their price.
WiFi Internet access is close to being fully commoditized. However, there are quality
differences in WiFi access (for example, different bandwidths).

Activity 2-4
Bitcoin has the potential to significantly reduce transaction costs in the digital economy.
Current third-party payment services—such as VISA, MasterCard, and American Express—
charge transaction fees of 1.4%–3.5%. Bitcoin, on the other hand, can charge as little as 0%.
It is no wonder why the established financial industry views Bitcoin and other
cryptocurrencies as a threat to their operations. It is VISA, MasterCard, American Express,
and, to a certain degree, the banking industry, which are the competitors of Bitcoin.

Activity 2-5
The main competitor of Internet Explorer was Netscape. Netscape was the largest web
browser in the mid-1990s. However, when Internet Explorer was launched in 1995, it
started to increase its market share until it had almost a monopoly in 2002. The main reason
for Internet Explorer’s success was because it was free and bundled with Microsoft
Windows. Few consumers took the extra trouble of installing another web browser on their
PC when Internet Explorer was already installed and ready for use. This, combined with the
large market share of PCs using Microsoft Windows, fueled Internet Explorer’s growth. In
addition, Microsoft—which provided Internet Explorer—was a much larger company than
Netscape, with significantly more financial resources.

Activity 2-6
Everyone that contributes to developing a CBPP service is the owner of the service. Often,
such services are offered for free. If it is offered for free, the CBPP service does not need to
generate any revenue, since the development of the service is also done for free. Hence,
there are no costs that need to be covered. However, CBPP services may also generate
revenue through donations, ads, or by offering complementary services, such as
consultancy services, seminars, or add-on digital services that build on the CBPP service.
Linux is offered under the GNU General Public License, which ensures its users free access
to Linux.

Activity 2-7
The main challenges of crowdsourcing include: Organizing the work, attracting the interest
of the general public and experts, checking the quality of the work performed, and
managing the tasks with little-to-no control over the crowd. Crowdsourcing may produce
results with even better quality compared to in-house production. However, this is very
dependent on the project and the factors mentioned above. Search for work done on this
topic by, for example, Karim Lakhani (https://en.wikipedia.org/wiki/Karim_R._Lakhani) and
the Nature article,
“Prize-based contests can provide solutions to computational biology problems”
(https://www.nature.com/articles/nbt.2495).

Can you find other case studies and examples of crowdsourcing and the results of these
projects?

Activity 2-8
John Hopkins Hospital is a value shop. AXA (an insurance company) is a value network.
Harvard University is a value shop. BMW is a value chain. Apple iPhone is a value chain.
However, the iPhone is an enabler for the Apple App Store ecosystem, which is a value
network. Twitter is a value network.

Activity 2-9
In the case of a newspaper, the advertiser and the reader both contribute to revenue. The
advertiser pays for advertisements in the newspaper and the readers pay for the
newspaper. However, the advertiser may pay relatively more than the reader. If the
newspaper has a free online portion, or is distributed for free, the reader does not pay
anything. The loaner pays interest to the bank. Part of this interest is kept by the bank, and
the rest is paid to the depositor. Hence, the loaner contributes revenue to the bank. Friends
or users on a social networking service do not contribute revenue. Revenue comes from
other sources; typically, advertisements. Both the buyer and seller of stocks contribute
revenue to the stockbroker by paying a commission fee.

Activity 2-10
An illustration of Postmates is found below. It is those who want to deliver goods that
contribute with revenue to Postmates. Postmates needs to pay the couriers to transport the
goods.

Postmates
Same-side
Couriers network effects
Deliver
Customers
goods
Same-side Cross-side Same-side

network effects network effects network effects

Activity 2-11
Assuming links define the value in the network, the value per user is the number of links /
the number of users. The value per user in Network A is 3/3 = 1. The value per user in
Network B is 11/7 = 1.57. The value per user in Network C is 21/11 = 1.9. In this example
there are strong network effects, since the value per user increases as the number of users
increases.

Activity 2-12
This is a complex question, and the discussion should consider the following: Is World of
Warcraft a value network? What parts of WoW make it a value network? How much of the
increase in users can be attributed to network effects, and how much can be attributed to
other factors (such as it being an attractive, high-quality game)? Use the definition of
network effects in the discussion. Has WoW reached saturation? When WoW starts to lose
users, is this because of: (1) network effects (because other users are leaving); (2) another
game in the market that is more attractive; (3) changing user behavior (such as MMORPGs
not being popular anymore), or (4) something else. See if you can find evidence for your
discussion.

Activity 2-13
An important part of the discussion in this activity is that users of Snapchat typically have a
smaller circle of friends compared to users of Facebook. Your posts reach fewer people on
Snapchat compared to Facebook. How does this influence network effects? How much
more important (in terms of value) are your close friends than all your friends? Facebook
has advertisers. Are there advertisers on Snapchat? Would you classify Facebook and
Snapchat as MSP? If yes, what are the user groups?

Activity 2-14
Path-dependent activity includes all events that lock the market into a specific path that is
difficult or impossible to recover from. The path may be a good one or a bad one. Search
the web for news articles and events and discuss how these are forming the cryptocurrency
market. Examples of events that lock cryptocurrencies and the use of them in to a certain
path include:
Twitter and LinkedIn banning cryptocurrency adverts (The Independent, March 28,
2018). Such a ban would restrict visibility and the ability to advertise
cryptocurrency. It may impact the overall market for cryptocurrencies and
contribute to its demise.
The story of Mt. Gox and how 850,000 Bitcoins were lost. This and other similar
events contribute to a negative public opinion of cryptocurrencies and leads many
to question whether they should be used as a payment system at all.

Activity 2-15
It is important to consider when the selected acquisitions took place. Google has evolved
from a company offering an Internet search engine to a digital conglomerate. You should
use Figure 2-26 to explain your answers.

Activity 2-16
Airbnb enables private people to rent out their homes. This is how Airbnb adds to the supply
side of the long tail. These homes are not the same as hotels. They have few rooms available
(typically accommodating 2-5 guests), and may be situated outside the city center, where
most hotels are located. The demand aspect of this is that consumers would like to rent
such homes.

Activity 3-1
Netflix is a typical ASP, since it provides online media streaming services to consumers.
However, Netflix is also a content producer. Netflix is not a typical ISP or IP. However, it is
worth investigating whether Netflix owns infrastructures in the network to better provide
services to consumers. In that case, Netflix might as well be both an IP and an ISP. A model
of Netflix’s ecosystem should include the dual role as an ASP and a CP, and that Netflix buys
copyrighted content from other CPs.

Activity 3-2
Amazon is primarily a B2C and Alibaba is primarily a C2C. However, Amazon has also enabled
C2C on its platforms. Alibaba has its own payment system called “Alipay”. Amazon relies on
external payment systems. Both Amazon and Alibaba have contributed to reduced
transaction costs in the digital economy. This is because they allow consumers to search for
millions of products on their websites in a very efficient way compared to traditional retail.

Activity 3-3
Apple Pay has the intention of international impact. However, it takes time to establish the
necessary infrastructure to enable Apple Pay in various countries. Apple Pay is a search
good. Apple Pay is not an OTT service.

Activity 3-4
Third-party producers (ASPs) are making apps for the App Store. These ASPs gets their
content from CPs. The App Store is a MSP, as it mediates between third-party producers of
apps and consumers. The App Store locks consumers in to Apple’s ecosystem, as apps for
iOS only work on Apple products. Apple has—through the App Store and the iPhone—
merged the applications and user equipment layer into the layered Internet model.

Activity 3-5
XaaS can be used to “outsource” some of the ICT infrastructure needed for a company.
Instead of owning the infrastructure, the company rents access to a similar capacity in the
cloud. This means lower CapEx, but higher OpEx. Advantages are less infrastructure to worry
about and manage. Challenges include: Data privacy, availability of the cloud services, and
dependency on a third party for potentially mission-critical business operations.

Activity 3-6
The market for mobile phone subscriptions will most likely evolve according to an S-curve.
At some point, the market will be saturated in China and Malawi as well. However, one point
for discussion is that in very poor countries, not everyone can afford to have a mobile phone
subscription. Hence, full saturation may not be reached in every country, or it may take
more time compared to rich countries. The introduction of GSM, 3G, and 4G has resulted in
a “take-off” of mobile phone subscriptions in the selected countries. For example, mobile
phone subscriptions in Norway finally took off after the introduction of GSM.
Activity 3-7
For example, Netflix (an online video streaming provider) cooperates with several ISPs to
make their services better for consumers. This includes gaining access to high capacities in
the ISP networks (the Internet), as well as storing content inside the network at strategic
locations to minimize delay for consumers. Some online video and music providers may also
buy their own infrastructure and become an ISP and an IP.

Activity 4-1
There are several reasons why Kodak failed to act on the emergence of digital photography.
Some of the reasons include: The fear of cannibalizing their own product portfolio,
resistance within the organization, and too much reliance on consumer feedback. Kodak
was ahead of the curve in developing digital photography, which means that they were not
ignorant of the upcoming innovation. However, a short-term focus on profits to satisfy
stockholders led to downplaying the future role of digital photography. At that time, digital
photography was expensive and gave poorer image quality compared to traditional
photography. Kodak’s story is not unique. The business situation prevented Kodak from
completely abandoning their valuable product portfolio in traditional photography and
entering digital photography. At that time, it was clear that digital photography was the
future of photography; however, they underestimated the speed of the diffusion of digital
photography.

Activity 4-2
Currently, MOOC looks more like a sustainable innovation than a disruptive innovation. This
is because it has not changed the performance metrics or value chain in the education
business. It is a sustainable innovation because it has added to the current selection of
teaching methods that teachers may employ. However, MOOC has the potential to become
a disruptive innovation in the future. However, predicting such an event is speculative at
best.
A company offering a MOOC is a value network and a MSP. It connects two user groups:
Teachers and students. A key insight in the business model of a MOOC is that the teacher
user group is producing the key resource of the MOOC—the teaching material. Another
insight is related to the revenue stream. Should MOOC be free or should there be a fee for
the students? If there is a fee, how should this fee be distributed between the provider of
the MOOC and the teachers?

Teachers
Online learning
platform
Universities Students
MOOC
Teaching website
material
Infrastructure Personell Student fee

Activity 4-3
Popcorn Time and Netflix are both providers of online streaming media (e.g., video, series,
and movies). The major business difference is that Popcorn Time is free and has a disputed
legality, as users uploading and distributing content in many cases (but not all) do not have
the copyright owners’ permission. Netflix, however, is a paid service and legal, as Netflix has
bought copyright content in addition to producing its own content. The major technological
difference between Popcorn Time and Netflix is that the former is based on a peer-to-peer
architecture, while the latter is based on a server-client architecture. That is, on Popcorn
Time, content is streamed from a network of users, while on Netflix, content is streamed
from a server. This results in strong network effects between users in Popcorn Time and
non-existing network effects between users in Netflix.

Online video
streaming Users
(Popcorn Time)
Popcorn time
website
Digital
media

Copyright Content
owners production Online video
streaming Users
(Netflix)
Netflix
website and
app
Digital
media
Subscription
fee

Activity 4-4
Financial data for Spotify is found on the web. Note that the financial data changes markedly
from year to year. Currently (as of 2018), a major strategic challenge for Spotify is how to
become profitable.

Activity 4-5
Wikipedia believes that ads are annoying and distracting, cheapen the encyclopedia,
threaten neutral content, and become a conflict of interest, among other factors. See:
https://en.wikipedia.org/wiki/Wikipedia:Funding_Wikipedia_through_advertisements
for more details. Currently, Wikipedia cannot use the subscription-based business model.
This is because Wikipedia uses the GNU Free Documentation License:
https://en.wikipedia.org/wiki/GNU_Free_Documentation_License#List_of_projects_that_
use_the_GFDL

Activity 4-6
Blockchain is crowdsourcing, not CBPP. This is because there are specific tasks to be solved,
which are assigned by Bitcoin.

Activity 4-7
Basic: Data collection, user interface, mobile device support
Important: Data storage
Core: Search algorithm

Activity 4-8
A complete answer should discuss something about each part of Porter’s Five Forces Model,
including the additional three parts on complementors, the public, and governments.

Activity 5-1
Sarnoff’s law does not give an accurate value of Instagram. This is because Instagram is not
a broadcast network, but rather, a value network with interaction between users. A good
measure of value in Instagram is the number of links in the network (connections between
users), the volume of interactions, and revenue.

Activity 5-2
Using the formula from the book:

> 2.2×10; = 5.7×10X; × 2.2×10; 9 ≈ 27.6×10; = 27.6 èD°°D¢%

This value can represent: Revenue, the volume of user interaction, or the stock market value
(market cap). For example, in 2017, Facebook’s revenue was $40.6 billion, Facebook’s
income from operations was $20.2 billion, and Facebook’s market cap (31.12.2017) was
$356 billion. How do these numbers compare to the calculated value?

To have a value of 1, the number of users needs to be:

1
%= ≈ 13,245
5.7×10X;

Activity 5-3
The number of users on a given social network can usually be found in various reports or
press releases on the web. The number and ranking of your connections influence the
network law that best describe the value for you. If all your connections are of equal value,
and the number of your connections are close to the total number of users in the social
media network, Metcalfe’s law is a good estimate of value. However, if your connections
have different values for you, and they count significantly less than the total number of users
in the social media network, Odlyzko-Tilly’s law is a good estimate of value.

Activity 5-4
Yes. In a MSP, there are indirect network effects. Metcalfe’s law or Odlyzko-Tilly’s can be
applied to calculate the network effects or value of each group. However, it is then more
complex to estimate what the total value will be. This is because some of the groups are
necessary for a service to operate, but do not contribute to revenue, while other groups
contribute to revenue.

Activity 5-5
Google search: Sarnoff
Gmail: Sarnoff
World of Warcraft: Metcalfe or Reed
Wikipedia: Not a value network, hence no network laws apply to Wikipedia
Netflix: Sarnoff
Twitter: Metcalfe
YouTube: Metcalfe
eBay: Metcalfe
Facebook: Metcalfe

Activity 5-6
The graphs would look like this:

100 1E+09
Metcalfe Metcalfe
90 1E+08
Odlyzko-Tilly Odlyzko-Tilly
80 Sarnoff 1E+07 Sarnoff
70 1E+06
60 1E+05
Value
Value
50 1E+04
40 1E+03
30 1E+02
20 1E+01
10 1E+00
0 1E-01
0 200 400 600 800 1 000 1E+00 1E+02 1E+04 1E+06 1E+08
Users
Users

Sarnoff’s law gives a value equal to 1, independent of the number of users. This is the value
each user brings to the network. The Odlyzko-Tilly law gives a value of approximately twenty
when the network is large (more than one billion users). Metcalfe’s law gives a value equal
to the number of users. Observe that Metcalfe’s law requires that every user must have a
relationship with every other user on the network. Odlyzko-Tilly’s law is much more modest
in that respect.

Activity 5-7
The following table summarizes the results:
Social media A Social media B Social media C Gain
#Users 10 000 000 20 000 000 30 000 000
Value Sarnoff 10 000 000 20 000 000 30 000 000 0 %
Value Metcalfe 100 000 000 000 000 400 000 000 000 000 900 000 000 000 000 80 %
Value Odlyzko-Tilly 161 180 957 336 224 857 516 501 238 4 %

Activity 5-8
At time t=0, the initial market share is B0/N = 1%. The distribution is called the “logistic
distribution.” When p=0:

<u7
u y = ,
u7 + (< − u7 )z X|}Q

The number of customers at the inflexion point is B = N/2 = 500,000. The inflexion point
-
occurs at time t = 12.09. The rate of new customers when B = 500,000 at t = 12.09 is 3.8x10
7 2
x500,000 = 95,000 customers/year.

Activity 5-9
There is no inflexion point on this graph (for B>0), since it is an exponential distribution.
When B0 > 0:

u y = < − (< − uM )z X{Q

Activity 5-10
The correct answer is u6 > u9 .

Activity 5-11
Social Media Network B has 100,000 more users than Social Media Network A, which equals
100% more users. After two years (equivalent to 24 months), Social Media Networks A and
B have grown to:

Social Media Network A: 100,000× 1 + 0.08 9 ≈ 100,000×z 6.;9 ≈ 682,000 users

Social Media Network B: 200,000× 1 + 0.03 9 ≈ 100,000×z 7.Å9 ≈ 205,000 users

After two years, Social Media Network A has 477,000 more users than Social Media Network
B, which equals 333% more users. Observe that small differences in growth rate (3% vs 8%)
make a big difference in the long run.

Activity 5-12
The financial data is summarized in the table below:
Year Revenue Cost Profit Discount rate Net profit
1 1 000 000 - 2 000 000 - 1 000 000 1 - 1 000 000
2 1 200 000 - 700 000 500 000 1,10 454 545
3 1 440 000 - 770 000 670 000 1,21 553 719
4 1 728 000 - 847 000 881 000 1,33 661 908
5 2 073 600 - 931 700 1 141 900 1,46 779 933
6 2 488 320 - 1 024 870 1 463 450 1,61 908 687
7 2 985 984 - 1 127 357 1 858 627 1,77 1 049 146
8 3 583 181 - 1 240 093 2 343 088 1,95 1 202 375
9 4 299 817 - 1 364 102 2 935 715 2,14 1 369 533
10 5 159 780 - 1 500 512 3 659 268 2,36 1 551 887
Sum 7 531 734

The NPV is then $7,531,734.

Another approach to calculate the NPV is to use the formulas presented in Section 5.3.
However, since the revenue and cost have different growth rates, approach this problem by
calculating the total discounted revenue and subtract the total discounted cost. For the
revenue:

67 67 67
?
1 + 0.2 z 7.9? z−1
1,000,000 ?
≈ = z 7.6? = 6 ≈ 16,338,000
1 + 0.1 z 7.6?
?C6 ?C6 ?C6 z 67 − 1

For the cost, observe that the cost increases at the same rate as the discount rate. Hence,
for the cost, we get the following figures:
Year 1: $1,000,000
Years 2–10: $700,000/1.1 = $636,364

Total discounted cost, summing years 1–10: $7,727,273

Net profit: $16,338,000-$7,727,273 = $8,806,266

Observe the difference in the answers ($7,531,734 vs $8,806,266). This is mainly due to
non-accurate approximations of 1 + A ? → z ?L .

All financial figures increase exponentially, however, with different growth rates.

Activity 5-13
An important part of the discussion is whether the exponential growth is likely to continue.

Activity 5-14
Apply the general power law distribution and observe that:

j Xõ 1000X9 6×1000X9
ï 1000 = = = = 6×10X~ £ X9 ≈ 6.08×10XÅ
ú ù ú 2 £9

If there are ten million routers on the Internet, it is expected that 10Å ×6.08×10XÅ ≈ 6
routers have 1000 connections. The expected number of routers with one connection is:

Å Å
1X9
10 ×ï 1 = 10 × = 6×10Å ×£ X9 ≈ 6,000,000
ú 2
Index
Pages, 109
3 Pay, xxi, 103, 109, 110, 171, 224
Application Service Provider, xxiv, 16, 99, 100, 102,
3G, xxiv, 3, 25, 26, 29, 49, 81, 89, 90, 122, 123, 107, 109, 110, 112, 114, 115, 116, 124, 126,
125, 203, 224 129, 223
apps, v, 2, 8, 11, 18, 20, 26, 36, 40, 71, 103, 109,
4 110, 112, 113, 115, 135, 169, 224
ARPANET, xiii, 23, 24
4G, xxiv, 3, 25, 26, 28, 39, 49, 81, 90, 122, 123, Arthur, W. Brian, 209
125, 126, 224 assets, xviii, 61, 85, 105, 115, 132, 162, 163, 164,
171, 174
5 Asymmetric Digital Subscriber Line, xxiv, 10
attention economy, 15
5G, xxiv, 3, 25, 26, 123
automation, 13
A
B
Abbate, Janet, 32
B2B, xxiv, 104
access economy, 15, 105
B2C, xxiv, 103, 104, 223
acquisition, 85, 86, 88, 152
Baidu, 83
ad-based free, 153, 157, 211
BankID, 125
Adobe PDF, 139
Barabási, Albert-László, 207
advertisement, 40, 55, 59, 78, 103, 153, 176
Barabási-Albert, xxiv
Age of Conan, 141
Bardeen, John, 22
Airbnb, vi, xv, xviii, 4, 15, 19, 25, 26, 36, 49, 62, 67,
Bass diffusion model, vii, ix, xviii, xx, 18, 118, 120,
93, 94, 104, 105, 109, 131, 141, 147, 148, 157,
173, 186, 187, 188, 189, 190, 192, 193, 194,
158, 159, 167, 213, 223
195, 196, 197, 208, 209
Albert, Réka, 207
Bass, Frank, 68, 178, 186
Alibaba, xxi, 8, 48, 103, 104, 223
BBC, 28, 215
Alipay, 109, 223
benefactors, 44, 155, 156, 177
Alphabet, xxi, 5, 88
Betamax, 76, 78, 83, 88
Amazon, xviii, xxi, 5, 7, 8, 16, 38, 39, 40, 48, 59, 64,
Big Data, 10, 13, 14
90, 91, 92, 93, 102, 103, 104, 109, 147, 164,
Bing, 83
166, 205, 206, 207, 214, 223
Bitcoin, vi, xv, xviii, xxi, 4, 25, 27, 48, 103, 131, 147,
Anarchy Online, 141
148, 159, 160, 161, 162, 211, 215, 220, 227
Anderson, Chris, 90, 92, 96, 172
Blizzard, 141, 148, 149
Android, 25, 26, 40, 53, 103
blockchain, 4, 13, 27, 161, 171
Anything-as-a-Service, xxi, xxv, 38, 116, 224
blue ocean strategy, 137
Apple, xxi, 5, 6, 24, 25, 26, 39, 48, 60, 86, 103, 109,
Bluetooth, 25, 26, 89
110, 115, 123, 124, 126, 171, 221, 224
Blu-ray, 135
App Store, xxi, 25, 109, 115, 221, 224
Brattain, Walter, 22
Apple II, 24
iTunes, 48, 102, 135
broadcast network, xviii, 28, 101, 175, 176, 208, Bitcoin, vi, xv, xviii, xxi, 4, 25, 27, 48, 103, 131,
227 147, 148, 159, 160, 161, 162, 211, 215,
Brynjolfsson, Erik, 33, 96 220, 227
bundling, 35, 48 Ethereum, 4, 27, 103
business model, vi, ix, x, xi, xx, 2, 5, 7, 15, 19, 40, IOTA, 27
47, 48, 61, 103, 105, 123, 131, 132, 134, 139, Litecoin, 4, 27
140, 141, 142, 145, 147, 148, 150, 152, 153, mining, 160, 162
154, 155, 156, 157, 158, 159, 161, 171, 172, Ripple, 4, 27, 103
176, 203, 211, 215, 216, 225, 226 customer relationships, 132, 144, 165, 195
Business Model Canvas, vi, ix, xv, xviii, xx, xxiv, 131, customer segments, 134, 143, 144, 145, 153, 157
132, 142, 143, 144, 145, 146, 147, 149, 151,
153, 155, 157, 158, 159, 165, 171, 172 D
C data
analog, 8, 9
C2B, xxiv, 104 digital, xvii, 8, 9, 10, 28
C2C, xxiv, 104, 105, 223 Dell, 104, 139
CAESAR, 52, 214 Device Provider, xviii, 108, 109, 129
Cambridge Analytica, 4, 154, 216 differential equations, v, 185, 196, 197, 198
capital expenditures, xviii, xxi, xxiv, 115, 116, 129, digital
224 economics, v, vi, vii, viii, ix, x, xi, 1, 2, 14, 15, 33,
CD, 2, 39, 49, 220 36, 94, 95, 96, 98, 129, 174, 208, 209, 211
Central Processing Unit, xxiv, 12 economy, v, vi, viii, ix, xi, xvii, xx, 1, 2, 3, 4, 5, 6,
CERN, 136 7, 8, 14, 15, 16, 17, 18, 19, 20, 24, 25, 26,
Christensen, Clayton, 134, 172 32, 33, 35, 36, 42, 44, 45, 47, 48, 53, 55,
churning, xix, 79, 173, 174, 185, 193, 194, 195, 61, 66, 78, 83, 84, 86, 87, 94, 95, 96, 101,
198, 209 106, 109, 112, 116, 121, 123, 124, 128,
cloud 129, 132, 133, 134, 135, 139, 142, 147,
computing, v, 2, 13, 38, 113 163, 166, 168, 171, 172, 198, 203, 209,
storage, 2, 6, 17, 38, 100, 220 211, 220, 223
commodities, 46, 47, 94, 108, 120 economy ecosystem, xvii, 1, 15, 16, 17, 18, 19,
Commodore PET, 24 32
common-pool resources, 42 goods and services, v, ix, xi, xvii, xviii, 2, 4, 5, 6,
commons-based peer production, xxi, xxiv, 35, 49, 7, 10, 11, 12, 13, 14, 15, 16, 17, 18, 20, 24,
50, 51, 53, 94, 133, 148, 155, 161, 221, 227 25, 26, 28, 32, 35, 36, 37, 38, 39, 40, 41,
compartmental model, 198 43, 44, 45, 46, 47, 48, 49, 50, 51, 53, 55,
competitive forces, 162, 171 60, 61, 65, 66, 67, 69, 70, 71, 72, 75, 79,
complement, 14, 171 80, 83, 88, 94, 95, 98, 99, 100, 101, 103,
complexity economics, 19, 209, 211 104, 106, 108, 109, 112, 115, 117, 118,
consumer adoption, vi, viii, 17, 18, 19 119, 122, 123, 126, 128, 129, 132, 138,
Content Provider, xxiv, 99, 110, 129 147, 148, 150, 152, 153, 155, 156, 166,
convergence, xvii, 1, 20, 28, 29, 30, 32, 108, 112, 167, 171, 172, 174, 176, 177, 182, 183,
219 186, 195, 198, 203, 207, 209, 211, 219,
cooperation, xviii, 31, 88, 89, 97, 98, 123, 124, 125, 220, 221
126, 127, 128, 129, 163 infrastructure, 10
horizontal, 123, 126, 129 innovation, 13, 33, 132, 133, 134
vertical, 123, 126, 128, 129 market, xviii, 15, 16, 18, 32, 47, 87, 91, 97, 98,
coopetition, xviii, 88, 97, 98, 123, 124, 126, 128, 99, 100, 101, 103, 108, 111, 116, 123, 124,
129 128, 129, 160, 166, 185, 211
core competencies, 131, 132, 143, 145, 162, 164, photography, 6, 135, 139, 224
165, 166, 171 Digital Audio Broadcasting, xxiv, 9, 28, 81
cost structure, 98, 144 digitization, v, 1, 2, 8, 10, 11, 13, 32, 49, 219
crowdlending, 52, 53 disruptions
crowdsourcing, vi, viii, xvii, 15, 35, 49, 50, 51, 52, low-end, 134
53, 90, 94, 96, 105, 110, 133, 221, 227 new-market, 134
cryptocurrencies, v, viii, 2, 4, 27, 79, 103, 161, 171, doubling time, 11, 12, 199, 209
220, 223 Dropbox, xxi, 20, 25, 36, 38, 100, 219
Dunbar, Robin, 181, 216
DVD, 169, 220
Index 233
DVORAK, 77, 121 Play, 25, 37, 109

Voice, 109
E GPRS, xxiv, 25
Grameen Bank, 93
e-banking, 2, 14, 125 Grand Theft Auto V, 40
eBay, 8, 48, 61, 62, 63, 64, 86, 93, 102, 103, 104, Granstrand, Ove, xi, 209
112, 141, 147, 157, 183, 228 Groupon, 103
e-commerce, xviii, 5, 8, 14, 16, 32, 40, 93, 97, 98, GSM, x, xxiv, 3, 25, 26, 29, 31, 49, 81, 82, 90, 118,
99, 102, 103, 104, 105, 129, 166, 211 122, 123, 125, 203, 224
EDGE, xxiv, 25
e-mail, 6, 23, 24, 37, 38, 220 H
Erdös-Rényi, xxiv, 179
Ethereum, 4, 27, 103 HBO, 2, 28, 39, 100, 109, 135, 220
ETSI, 89 Hypertext Markup Language, xxiv, 220
European Economic Area, xxiv, 25 Hypertext Transfer Protocol, xxiv, 25, 51, 220
European Union, 25, 31, 163
experience economy, 110 I
exponential growth, xix, 12, 33, 119, 174, 191, 199,
200, 201, 203, 204, 208, 209, 230 imitators, xvii, xviii, 68, 69, 118, 187, 188, 189, 190,
191, 192, 194, 196, 200
F Industry 4.0, 13
inflexion point, 190, 193, 229
Facebook, vi, xiii, xv, xvii, xviii, xxi, 4, 5, 9, 10, 14, Information and Communication Technology, i, v,
18, 25, 31, 37, 40, 45, 47, 49, 58, 59, 60, 61, 62, vi, viii, x, xvii, xviii, xxi, xxiv, 1, 2, 5, 6, 7, 8, 9, 10,
65, 67, 69, 70, 71, 73, 75, 78, 82, 83, 86, 94, 12, 13, 15, 16, 17, 18, 20, 21, 22, 24, 25, 26, 30,
100, 103, 109, 110, 114, 118, 119, 123, 131, 32, 38, 83, 86, 88, 90, 94, 98, 99, 100, 106,
141, 147, 148, 153, 154, 163, 164, 167, 168, 107, 108, 111, 116, 120, 132, 141, 162, 164,
177, 178, 180, 181, 182, 183, 186, 192, 198, 211, 219, 224
213, 214, 215, 216, 220, 222, 227, 228 infrastructure, 8, 10, 16, 18, 24, 30, 32, 98, 99,
Facit, 136 100, 106, 107, 108, 116, 224
Fiber-To-The-Home, xxiv, 10 information economy, 14
financial technologies, vi, viii, xxi, xxiv, 13, 171 Infrastructure Provider, xxiv, xxv, 99, 106, 113, 129
Firefox, 83, 109 in-house production, xvii, 49, 50, 53, 94, 105, 221
Ford, Martin, 33 innovation, vii, viii, xviii, 2, 6, 12, 19, 20, 33, 56,
freemium, 150, 152, 153 114, 116, 121, 131, 132, 133, 134, 135, 138,
Funcom, xv, 141 145, 171, 172, 187, 188, 211, 215, 219, 224,
225
G disruptive, 6, 131, 134, 136, 138, 171, 172
sustaining, xviii, 138
goods innovators, xvii, xviii, 68, 69, 118, 187, 189, 190,
club, 42 191, 192, 193, 196, 200, 213, 215
non-excludable, 42, 43, 94 Instagram, xxi, 9, 177, 227
non-rival, 42, 43, 94 integration
private, 42 vertical, xvii, 6, 86, 87
public, 42, 43, 94, 148, 156 Intel, 22, 24, 169
rival, 42, 44 Intelligent Transport Systems, xxiv, 13
search, 110, 224 Internet, vi, ix, xvii, xxi, xxii, xxiv, xxv, 2, 3, 4, 5, 6, 8,
Google, xxi, 5, 6, 7, 9, 14, 25, 28, 31, 37, 40, 45, 47, 9, 10, 11, 13, 14, 15, 16, 18, 20, 23, 24, 25, 26,
59, 61, 72, 83, 86, 88, 94, 100, 103, 109, 112, 28, 29, 30, 31, 32, 36, 37, 38, 39, 43, 44, 46, 47,
123, 124, 164, 166, 167, 171, 176, 183, 220, 48, 49, 51, 53, 59, 69, 79, 83, 89, 90, 92, 93, 98,
223, 228 99, 100, 101, 102, 106, 107, 108, 109, 111,
Chrome, 83 112, 113, 114, 116, 119, 120, 121, 123, 124,
Docs, 6, 109 125, 127, 128, 129, 133, 139, 140, 144, 149,
Drive, 6, 100 152, 153, 168, 169, 185, 186, 207, 208, 213,
Gmail, 6, 43, 183, 228 215, 216, 217, 219, 220, 223, 224, 230
Google+, 6, 220 banking, 125
Hangouts, 6, 28, 112 economy, 15
News, 109 of Things, xxiv, 2, 3, 9, 10, 13, 25, 90, 213, 219
Pixel, 123
Protocol, xxiv, xxv, 6, 23, 24, 25, 28, 32, 49, 81, microeconomics, 211
88, 90, 99, 100, 101, 102, 106, 107, 112, Microsoft, 5, 14, 24, 36, 48, 52, 81, 86, 109, 112,
113, 115, 129, 170, 223, 224 124, 147, 169, 214, 220
routers, 38, 100, 106, 208 Internet Explorer, xxi, 24, 49, 83, 109, 220
Internet Engineering Task Force, 51, 89 OneNote, 48
Internet Service Provider, ix, xxiv, 16, 82, 99, 100, Outlook, 48
101, 102, 106, 107, 109, 112, 114, 115, 124, PowerPoint, 14, 48, 81
126, 128, 129, 223, 224 Word, 36, 109
IOTA, 27 Minecraft, 40
iPhone, 25, 36, 39, 40, 60, 115, 123, 126, 220, 221, monopoly, 20, 30, 66, 74, 75, 82, 83, 87, 126, 220
224 Mosaic, 24
iPod, 141 MS-DOS, 24
ISO, 88 Multimedia Messaging Service, xxv, 106
ITU, xxiv, 88, 89, 213 multi-sided platform, ix, xvii, xxv, 4, 35, 36, 45, 53,
58, 61, 62, 63, 64, 73, 91, 94, 95, 96, 105, 115,
K 131, 133, 148, 157, 159, 182, 211, 223, 224,
225, 228
key activities, 143, 144, 145, 149 Myspace, 75, 78, 83, 167, 181
key partners, 132, 139, 143, 144, 145, 149, 166
key resources, 143, 144, 145, 149 N
Kickstarter, 52
Klarna, 103 Nakamoto, Satoshi, 4
Kodak, xxi, 6, 135, 139, 224 NASDAQ, 5
negative feedback, 68, 73
L net neutrality, 112, 114, 115
net present value, xxv, 134, 173, 200, 202, 203,
latency time, 69, 191, 192, 201 230
layered Internet model, xiv, xviii, 97, 98, 109, 111, Netflix, xxi, 2, 14, 25, 28, 31, 43, 45, 52, 79, 100,
113, 123, 124, 128, 129, 224 102, 104, 107, 109, 114, 135, 147, 176, 183,
layering, 23, 32 186, 214, 216, 223, 224, 225, 228
Lilienfeld, Julius Edgar, 22 Netscape, 24, 220
linear growth, 191, 200, 204 network access markets, 98, 128
LinkedIn, 86, 109, 193, 223 network effects, ix, 6, 7, 14, 18, 32, 36, 45, 59, 62,
Linux, 51, 53, 214, 221 64, 65, 66, 67, 68, 69, 70, 71, 72, 73, 74, 75, 76,
Litecoin, 4, 27 78, 82, 83, 84, 87, 88, 94, 95, 119, 134, 146,
lock-in, ix, 32, 35, 36, 77, 79, 80, 81, 82, 83, 94, 95, 147, 148, 150, 152, 156, 158, 161, 167, 168,
115, 140, 168, 202 174, 176, 178, 191, 198, 201, 202, 204, 211,
long tail, vii, ix, xviii, 4, 35, 36, 90, 91, 92, 93, 94, 222, 225, 228
95, 96, 133, 173, 174, 179, 205, 206, 207, 208, cross-side, 35, 64, 71, 73, 95
209, 214, 223 direct, 71, 72, 154, 158, 161
indirect, 35, 62, 71, 95, 151, 158, 228
M negative, 68, 95, 158, 160, 177
positive, 66, 84, 150, 151, 158, 161
machine learning, 13, 26, 33, 166, 219 same-side, 73, 150, 154
macroeconomics, 211 network laws, 174, 177, 183, 208, 228
marginal cost, 35, 37, 39, 40, 41, 42, 45, 49, 54, 55, New York Times, 39, 62, 100
60, 91, 94, 115, 148 Nobel Prize, 22
market adoption, 18, 123 Nordic Mobile Telephone, xxv, 24, 30, 118
market capitalization, xvii, 5, 6, 45, 59, 103, 136, Norsk Data, 136
174, 213, 227 NSFNET, 23
massive multiplayer online game, xxv, 72, 117,
148, 150, 182, 185, 195
O
massive open online course, xxv, 145, 225
MasterCard, 61, 62, 103, 167, 220 Odlyzko, Andrew, 178
McAfee, Andrew, 96 OECD, 132, 215
merger, 36, 85, 87, 94, 184, 185 Olivetti, 136
mergers & acquisitions, xxiv, 85, 86, 87 online banking, 100, 125
Messenger, 109, 124 open source software, 49, 50
Metcalfe, Robert, 177
Index 235
operational expenditures, xviii, xxv, 115, 116, 129, six degrees of separation, 179, 180
224 Skype, xiv, 25, 28, 67, 86, 107, 109, 112, 124, 126,
optical fibers, 24, 38, 100, 106 147, 169
organic growth, 84 smartphones, 2, 3, 4, 8, 10, 15, 18, 22, 24, 25, 37,
Osterwalder, Alexander, 142, 172 39, 71, 73, 77, 106, 109, 135, 140, 168, 169,
over-the-top services, xxv, 107, 110, 112, 114, 129, 185, 219
224 Snapchat, xxi, 9, 25, 73, 132, 182, 211, 222
social media, v, xvii, 4, 20, 25, 32, 58, 59, 60, 67,
P 71, 72, 73, 79, 83, 86, 87, 100, 118, 123, 141,
168, 177, 178, 181, 182, 185, 186, 190, 200,
packet switching, 23, 32 204, 220, 227
Panasonic, 76 social network service, xvii, 58, 59, 61, 68, 70, 153
path dependence, 35, 73, 74, 75, 77, 78, 94, 134, Software Defined Networking, xxv
209 SONY, 76
PayPal, 103, 109 Spotify, vi, xv, xviii, xxi, 2, 14, 16, 25, 36, 37, 43, 93,
Personal Computer, xxv, 8, 24, 135, 136, 220 100, 101, 102, 109, 131, 135, 141, 147, 148,
Popcorn Time, xxi, 79, 147, 177, 214, 216, 225 150, 151, 152, 186, 215, 226
Porter, Michael, 54 Stakeholder Relationship Model, vi, ix, xv, xviii, xxv,
positive feedback, ix, xvii, 65, 66, 68, 72, 73, 74, 75, 71, 131, 132, 145, 146, 147, 149, 150, 151,
76, 78, 82, 84, 94, 95, 117, 147, 164, 204, 209, 152, 153, 154, 156, 157, 159, 160, 165, 171
211 standards, 26, 35, 36, 47, 50, 52, 76, 81, 83, 88, 89,
Postmates, 73, 222 90, 95, 126, 220
prosumer, 102, 110, 129 Star Wars The Old Republic, 40
Public Switched Telephone Network, xxv Starcraft 2, 109
Stream Control Transmission Protocol, xxv, 113,
Q 114
subscription, 39, 43, 48, 64, 72, 80, 112, 116, 120,
QWERTY, xiv, 77 122, 148, 149, 150, 176, 220, 224
substitute, 168, 171
R switching costs, 35, 36, 74, 77, 79, 80, 94, 95
recommendation systems, 26, 72
Reddit, 109, 213 T
Riemann zeta function, 206 telecommunications, x, 20, 22, 28, 80, 89, 101, 128
Ripple, 4, 27, 103 industry, 1, 30, 32
Robotic Process Automation, xxv, 13 service, 28, 29, 30, 31, 64, 127
Rogers, Everett, 121, 129 telegraphy, 28
Telenor, x, 101, 123, 124, 126, 128
S Telia, 123, 124, 126, 128
The Secret World, 141
Safari, 109
Tidal, 100, 109
Samsung Galaxy, 123
Toshiba T1100, 24
Sarnoff, David, 176
tragedy of the commons, 44, 214
satellite networks, 10, 28, 89, 106
transaction cost, 48, 94, 104, 125, 220, 223
saturation, 68, 69, 118, 119, 122, 123, 185, 203,
transistor, 12, 22, 24, 135, 136, 211
222, 224
Transmission Control Protocol, xxv, 23, 24, 25, 32,
Saunders, Adam, 33
49, 51, 113, 114, 182
S-curve, xviii, 118, 119, 120, 121, 122, 123, 128,
tulip mania, 27
129, 190, 224
Twitter, 25, 45, 59, 60, 67, 70, 83, 94, 100, 109,
Service Level Agreement, xiv, xxv, 101
123, 147, 177, 182, 183, 186, 220, 221, 223,
Service Oriented Architecture, xxv
228
Shapiro, Carl, 95
sharing economy, v, vi, viii, 2, 4, 15, 19, 25, 32, 72,
93, 105, 147 U
Shockley, William, 22 Uber, 14, 15, 18, 19, 25, 26, 62, 63, 67, 93, 94, 104,
Short Message Service, xxv, 3, 29, 39, 99, 106, 107, 105, 109, 110, 141, 147, 157, 213
124, 125, 188 Uniform Resource Locator, xxv, 24, 220
sigmoids, 118 United Nations, 3
Simple Mail Transfer Protocol, 24, 220 User Datagram Protocol, xxv, 113, 114, 182
V Vortex, 38
value, vi, vii, viii, ix, xvii, 6, 7, 14, 15, 16, 31, 35, 36,
W
37, 48, 53, 54, 55, 56, 57, 58, 59, 60, 61, 63, 64,
65, 68, 70, 71, 75, 83, 84, 86, 87, 92, 94, 95, WeChat, 107, 109, 124
105, 112, 115, 124, 132, 133, 134, 139, 140, WhatsApp, 28, 39, 86, 109, 124
142, 143, 144, 145, 146, 147, 149, 151, 153, WiFi, 25, 26, 47, 48, 49, 106, 126, 220
155, 157,161, 162, 166, 168, 171, 172, 173, Wikimedia Foundation, 156
174, 175, 176, 177, 178, 179, 182, 183, 184, Wikipedia, vi, xv, xviii, xxi, 25, 36, 43, 44, 51, 93,
185, 190, 199, 200, 201, 202, 204, 206, 207, 100, 114, 129, 131, 135, 136, 139, 147, 148,
208, 209, 211, 215, 221, 222, 225, 227, 228 155, 156, 157, 177, 183, 213, 214, 216, 226,
chain, xvii, 53, 54, 55, 60, 87, 95, 124, 142, 147, 228
166, 168, 221, 225 World of Warcraft, vi, xv, xviii, xxi, xxv, 14, 43, 67,
generation, 143 72, 109, 117, 131, 141, 147, 148, 149, 150,
network, xvii, 35, 53, 57, 58, 59, 60, 61, 63, 94, 183, 195, 222, 228
95, 105, 112, 142, 147, 177, 221, 222, 225, World Wide Web, xxv, 20, 24, 25, 28, 32, 49, 89,
227, 228 99, 111, 119, 211, 217
proposition, 15, 37, 132, 134, 143, 144, 145,
147, 149, 151, 153, 155, 157, 162, 171, 172
Y
shop, xvii, 35, 53, 56, 57, 60, 95, 147, 221
Varian, Hal R., 95 YouTube, 9, 14, 25, 67, 82, 83, 86, 109, 114, 123,
Video Cassette Recorder, xxv, 76, 83 135, 183, 228
Video Home System, xxv, 76, 78, 83, 88
viral growth, 204 Z
virtual network operator, xxv, 31, 83, 107, 170
mobile, xxv, 170 zero ARPU, 35, 45, 94, 148, 154
virtualization, 113 zero marginal cost, 15, 36, 37, 39, 40, 44, 46, 48,
voice-over-IP, xxv, 28, 48, 90, 108, 109 55, 60, 84, 91, 93, 94, 109, 112, 115, 148
voice-over-LTE, xxv, 28 Zipf's law, 205, 206, 207

Digital Economics - Overby and Audestad

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Digital

Innovations and developments in Information and Communication Technology (ICT)

 Network laws to calculate the value of networks in Section 5.1.

Cross-Disciplinary Systems View

Chapter 1 is an introduction to digital economics, discussing

Jan A. Audestad (born 1942) is Professor Emeritus at the Norwegian University of

Harald Øverby and Jan A. Audestad

2.1.2. Public Good Features of Digital Services .......................................................................... 42

3.8.1. Initial Market Evolution .................................................................................................. 117

BOX 5-4. The SIR Model ............................................................................................ 198

FIGURE 2-27. THE LONG TAIL. ...................................................................................................... 91

ACTIVITY 1-1. DIGITIZATION ......................................................................................................... 11

ACTIVITY 5-4. MULTI-SIDED PLATFORM LAWS .............................................................................. 182

DEFINITION 1-1. THE DIGITAL ECONOMY ......................................................................................... 5

3G Third generation mobile system

The Digital Economy

Information and Communication Technology (ICT) is everywhere around us—the

Worldwide Internet access Cellular and broadband mobile access

Subscriptions per 100 inhabitants

BOX 1-1. Faces of the Digital Economy

Definition 1-1. The Digital Economy

The world’s five largest corporations by market capitalization as of the beginning of

BOX 1-2. Recommendation Systems

Similar products are The retailer identifies

An important part of the digital economy is e-commerce. E-ecommerce is the online

1.2. Digitization of the Economy

Digitization of data Digital ICT infrastructure Digital processing

Figure 1-3. Digitization of data, infrastructures, processing, and storage.

Analog data Digital data

Figure 1-4. Analog and digital data.

1986 1993 2000 2007

Figure 1-5. Evolution of digital data storage and communication.

Activity 1-1. Digitization

1.3. Digital Economics

BOX 1-3. Moore’s law

BOX 1-4. Automation

Definition 1-2. Digital Economics

1.4. The Digital Economy Ecosystem

Digital goods Digital markets

Service D Service A Service E

Service B Service C Cloud storage Wireless

Consumer adoption (or user adoption) of information and communication

Definition 1-3. The Digital Economy Ecosystem

Activity 1-2. Dropbox

1.5. Technology Evolution

Figure 1-9. Timeline of ICT innovations.

WiFi (1997) 3G (2003) iPhone (2007) 4G (2009) 5G (2018)

Google (1998) Twitter (2006) Uber (2009) Snapchat (2011)

BOX 1-5. The Transistor

BOX 1-6. The ARPANET

The two fields of information technology and telecommunications merged to

supported only voice communications. The Global System for Mobile

BOX 1-7. Cryptocurrencies

1.6. Service Convergence

VoIP Mobile VoIP

Internet radio Internet TV Full convergence

Activity 1-3. ICT Convergence

1.7. Market Evolution in Telecommunications

< 1985 1985-1992 1992-1998 1998 >

User equipment Networks Applications

Figure 1-11. Evolution of the telecommunications business.

In 1998, the EU opened all aspects of telecommunications for full competition.

Summary and Key Points

Network laws to calculate the value of networks in Section 5.1.