King of the Hill: Can Established Tech Companies Be Bested?

Replicating a less-established competitor’s innovative offerings or features can be relatively easy for an incumbent technology company. The practice has become increasingly common — to the point that many wonder if it’s still possible for an upstart to enter an existing market and effectively compete.

For instance, when Microsoft launched “decision-based” features for its Bing search engine, Google quickly implemented similar functions in order to maintain its dominance in search. When Google tried to outpace Facebook by creating a social network with features that the dominant site lacked, such as finer controls over how information is shared, Facebook simply added similar bells and whistles to its own service. And Facebook earlier this month bought social photo sharing app Instagram, paying $1 billion to ensure that it would not lose control of a potentially crucial market.

Incumbent companies say that such measures are necessary when users are just one click away from abandoning a service or program entirely. For example, when Google chairman Eric Schmidt spoke at a Senate antitrust subcommittee hearing last September, he noted that ensuring the company’s continued success “requires constant investment and innovation…. If Google fails at this effort, users can and will switch. The cost of going elsewhere is zero.”

In its filing for an initial public offering, Facebook made a similar claim — that despite the site’s more than 800 million active users, customers still aren’t locked in. “A number of other social networking companies that achieved early popularity have since seen their active user bases or levels of engagement decline, in some cases precipitously,” according to the filing. “There is no guarantee that we will not experience similar erosion.”

In reality, however, consumers often don’t switch, even if the costs are minimal, experts say, and successful first movers often gain a significant advantage over upstart competitors. But that is not to say that dominant firms shouldn’t watch their backs — there is always the chance that a nimble newcomer will enter a market and eat away at the established company’s user base.

“Companies often talk about how a competitor is just one click away [from overtaking them]…. It’s not that straightforward,” says Kartik Hosanagar, an operations and information management professor at Wharton. “People have inertia and also incur learning costs to switch to a new product or provider. So, to get consumers to switch, you cannot be as good or slightly better. You have to be much, much better along dimensions that matter to consumers.”

Businesses copying each other’s features to stay competitive is nothing new, notes Wharton legal studies and business ethics professor Kevin Werbach. The difference in the tech sector — and particularly on the Internet — is that it’s easier. Firms in that space are typically selling virtual goods, and incumbents can often replicate new features with the expertise and equipment they already have in house.

Ecosystem Lock-In

It has always been easy for businesses to go toe-to-toe on product features. “The significant thing on the Internet is ecosystem lock-in,” according to Wharton operations and information management professor Eric Clemons. “Everyone can have the same features. [But] the guy who wins first is difficult to depose.”

Clemons says ecosystem lock-in is not impossible to break, but it is highly difficult. For instance, Yahoo, which many consider to be past its prime, is still a dominant player on the web with 700 million active users a month. AOL, which is also considered to be antiquated by some critics, is a top-five web property in terms of traffic, according to comScore. “People get used to the experience” notes Wharton new media director Kendall Whitehouse. “You can never underestimate the power of inertia formed through habit.” Why don’t people easily switch services? Clemons argues that lock-in is all about the relationships consumers form with and on a particular service. For example, a Facebook user may not be entirely satisfied with the site, but “if your friends are on Facebook, you may stay on Facebook,” despite those misgivings. Whitehouse notes that the “network effect” of social media platforms like Facebook make switching — although easy to do — unlikely to occur.

Companies in many web-based businesses highlight a strong network effect, Werbach adds. A firm introduces a service, gains a significant lead and draws more customers as a result. More friends join, and the network effect reinforces itself. “The network effect is strong, and there are ways that sites [can try to retain] users, but it doesn’t always work,” notes Werbach, who cites MySpace as a first mover in social networking that unraveled.

James Whittaker, a former Google engineer now at Microsoft, said in a blog post that the network effects in Facebook’s favor are massive. “I worked on Google+ as a development director and shipped a bunch of code,” he wrote. “But the world never changed; sharing never changed. It’s arguable that we made Facebook better, but all I had to show for it was higher review scores.” He argued that the problem all along wasn’t that “sharing was broken. Sharing was working fine and dandy; Google just wasn’t part of it.”

Werbach says the jury is out on Google+. “Google+ offers the basic features of Facebook and in some ways is more compelling,” he notes. “[Google+] has a fighting chance to be a viable competitor to Facebook.”

But Wharton legal studies and business ethics professor Andrea Matwyshyn notes that “competing with Facebook means competing with its platform as well as everything it knows about you. It’s a new type of barrier of entry. A new entrant to the market may not serve up the audience quickly and with the precision Facebook can.” Although social media is the most obvious relationship-based industry, Matwyshyn says web businesses overall have similar characteristics. “Web models are the vehicle for relationships,” she notes. “The companies that further the relationship with the human on the other side win.”

Facebook’s Defensive Play

The link between dominance and customer relationships partially explains Facebook’s recent $1 billion purchase of Instagram, an Apple iOS-based photo sharing application. The purchase was an effort to stop a potential rival that hit 40 million users since launching in October 2010. “Instagram could have assembled a standalone social network based on pictures,” Wharton management professor David Hsu says. “There is a probability that Instagram would have been a competitor to Facebook.”

For Hsu, Facebook’s purchase of Instagram is not much different than Google’s $1.6 billion acquisition of YouTube in 2006. “Why was YouTube worth $1.6 billion?” asks Hsu. “Video was going to be big. Others couldn’t have come up with that platform.” Indeed, YouTube will have its “upfront,” a scheduled event to sell advertising in advance of the coming season, in May to sell advertising just like television networks. Nikesh Arora, Google’s chief business officer, said on April 12 that “YouTube has gone from an interesting ad buy to a key buy for brands.”

It’s unclear whether Instagram would have eventually toppled Facebook, but the acquisition could be viewed as a $1 billion insurance policy against future competition, according to Hsu. “Facebook and others have woken up to how, if a competitor gets enough lead time, they can get scale before an incumbent comes in,” he notes. “An 18-month lead is very credible.”

Brian Wieser, an analyst at Pivotal Research, said in a research note that Facebook’s acquisition of Instagram was really a case of playing keep-away from Google. “The valuation is unquestionably high for the business on its own merits,” Wieser wrote. “However, given the importance of photo sharing to Facebook — recall the site’s foundation as one designed to essentially share photos — there is defensive value to preventing a competitor such as Google from acquiring the property if only for the possibility that Instagram continued growing at its recent pace.”

But Clemons is skeptical. In a recent KnowledgeToday blog post, Clemons argued that Google will match whatever features Instagram brings to Facebook for a lot less than $1 billion — about $999 million less.

The Competition Paradox

Whether Facebook’s acquisition of Instagram is ultimately viewed as defensive remains to be seen, but the deal is likely to encourage more competition, says Hsu. “What’s spurring entrepreneurial behavior is the smartphone,” Hsu notes. “Instagram’s acquisition will result in more start-ups. There will be a mobile app land grab.”

One or two of those start-ups may one day upend today’s web giants, but many will fail. “A successful first mover can take away a lion’s share of the market by the time a late entrant realizes, responds and launches,” Hosanagar states. “This implies that the first mover already has a high market share by the time the next guy enters. It’s not sufficient for the next guy to be slightly better.”

But Werbach points out that when sites like Amazon, Yahoo and eBay launched, they had to build their own infrastructure first. Today, that existing infrastructure allows start-ups to launch feature-rich sites quickly. The tech landscape in China is a key example, he adds: After Twitter took off in the U.S., a handful of Chinese start-ups launched with the same features.

Start-ups have other advantages, too. For instance, start-ups don’t have user bases and revenue streams to protect. Start-ups can also focus on a niche that hasn’t been seen or acknowledged by a large company. “The advantage to a start-up is being nimble,” Werbach notes. “Hundreds of start-ups will fail or be acquired, but some will have tremendous success.”

This competition on the web means that companies are scrambling for an edge. In fact, the only real way to protect features could be through patents, Hsu says. For instance, Yahoo sued Facebook claiming the social network is violating its social networking, advertising and privacy patents. Microsoft also recently spent $1 billion acquiring patents from AOL. Google acquired Motorola Mobility largely for its mobile communications patent portfolio. “Anytime a company can add more in the arsenal to serve as a barrier to entry it makes sense, and that often means patents,” Hsu notes.

Werbach agrees. “Patents are a legal monopoly and a potent weapon, especially if a start-up doesn’t have the resources to fight,” he says. “Overall, patent wars are a bad thing for innovation, but they are logical. I’m not thrilled with patent wars, but I understand why companies use them.”

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