Often times, a consumer must buy two or more components to generate benefits.  For instance, a computer (a.k.a. the hardware) is basically useless without programs (a.k.a. the software) to run on it.  There are many examples of such hardware/software systems in today’s marketplace: automobiles and repair parts, home audio and video equipment, automatic teller machines and ATM cards, facsimile machines and their communications protocols, DVD players and DVDs.  Network effects undeniably play a role in the sales, marketing, and distribution of these products and their complements.  Certainly, having similar computers and operating systems smoothes operations and the transfer of information.  In that regard, each consumer’s purchase exerts a positive externality on other’s payoffs, from which we can derive that U-shaped demand curve for these network goods. 

However, since the “hardware” and “software” goods are often purchased over time by consumers, there are also indirect network effects at work.  Often times “hardware” sales are a precursor of the future price of “software” goods.  In class, we discussed this as a strategy for lowering the threshold number of users at the unstable equilibrium.  Once over that threshold, the number of consumers increases until it reaches the stable equilibrium on the other side of the U-shaped demand curve.  After surpassing this initial unstable equilibrium, companies can hike up their prices and reap huge profits.  Here however, a firm is lowering the cost of its baseline component in the hopes will build a consumer “aftermarket” for its complementary goods.  One of the best examples I see of this is the Microsoft Xbox.  As the price of the Xbox drops, sales of additional controllers, games, hard drives, and rechargeable batteries increase.  Similarly, as Apple reduces the price of its IPods, their consumer base grows, and sales of sound docks, head phones, FM transmitters, car chargers, and even computers skyrocket.  Firms also lower the price of their “hardware” goods to build a large consumer base for their various “software” goods. 

                However, producers of “hardware” and “software” goods must be wary of competition; as they reduce their “hardware” prices, it reduces the barriers of entry for companies who specialize in “software” or complementary goods.  This explains why there is often more differentiation and variety among complementary goods. 

Primary Source:

Systems Competition and Network Effects

Michael L. Katz; Carl Shapiro

The Journal of Economic Perspectives (1986 – 1998); Spring 1994; 8; 2; ABI/INFORM Global pg. 93