Share or snare? Managing network businesses

There is increasing attention being paid to the economics of networks and the strategies of network-based businesses, both in traditional businesses such as airlines, or in emerging businesses including Internet applications.¹ Three questions emerging from these discussions are: (1) How to proactively and pragmatically manage network-based businesses to capture scale economies while avoiding overcapacity? (2) When to focus on creating value within versus outside the network? and (3) Should the network be open or closed?

Proactive management

Network-based businesses have to be managed differently from most service and manufacturing ones due to four unique characteristics: the "factory" (that is, the network configuration) determines product parameters; capacity creates demand; operations are integrated; and the "factory" is shared by many products.

In addition, most network-based businesses are very sensitive to scale economies. As illustrated by airlines, both unit costs based on aircraft economics and crew utilization and performance measured by frequency and value of frequent flyer programs, can substantially improve with size throughout volume (Exhibit A). However, as many players try to capture these economies, they are likely to destroy industry profits, given that most networks have significant fixed costs and high exit barriers, causing prices to "free-fall" to marginal costs once overcapacity occurs.

Balancing scale advantages against the risks of overcapacity requires a pragmatic approach focusing on three areas: (1) Understanding product and network economics (2) Evaluating demand elasticity in terms of price and performance (3) Taking competitive dynamics into account.

Create value within and outside the network

The opportunity to create value depends on the competitive dynamics of the relevant market. In the early stages of a network business, when most of the players have not yet reached the threshold of scale economies, most of the value will be created within the network by leveraging resources creatively (Exhibit B). By contrast, in a mature market, most of the value will have to come from outside the network. A leading company will have to both concentrate its efforts on consolidating its network position, while simultaneously creating value outside its network.

Open versus closed systems

A network-based business will also have to face the important strategic decision of whether to open or close the network to other participants. A closed system allows its owner to capture most of the created value, while an open system can bundle the forces of many players to create value. Successful strategies can be found both in closed and open systems. In fast growing industries like software development and knowledge applications, such as the Internet, there is a tendency to see open systems flourishing to quickly capture scale economies.