Mantena, Ravi

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Association for Information SystemsAIS Electronic Library (AISeL)AMCIS 2002 Proceedings Americas Conference on Information Systems(AMCIS)December 2002CONVERGING DIGITAL TECHNOLOGIES:AN OPPORTUNITY OR A THREAT?Ravi MantenaNew York UniversityFollow this and additional works at: http://aisel.aisnet.org/amcis2002This material is brought to you by the Americas Conference on Information Systems (AMCIS) at AIS Electronic Library (AISeL). It has been acceptedfor inclusion in AMCIS 2002 Proceedings by an authorized administrator of AIS Electronic Library (AISeL). For more information, please contactelibrary@aisnet.org.Recommended CitationMantena, Ravi, "CONVERGING DIGITAL TECHNOLOGIES: AN OPPORTUNITY OR A THREAT?" (2002). AMCIS 2002Proceedings. 57.http://aisel.aisnet.org/amcis2002/57378 2002  Eighth Americas Conference on Information SystemsCONVERGING DIGITAL TECHNOLOGIES:AN OPPORTUNITY OR A THREAT?Ravi MantenaStern School of BusinessNew York Universityrmantena@stern.nyu.eduAbstractIncreasing similarity in the digital technologies on which products in several distinct industries are based haslead to the speculation that products in these industries will converge. Such convergence, while makingproducts more valuable also increases the similarity between products supplied by different industries therebycausing the boundaries between these industries to blur. This presents both a significant opportunity and agrave threat to firms and forces them to alter their business models and strategy to fit the realities of the newenvironment. In this paper, we model conflicting firm incentives to produce converged products in the presenceof converging digital technologies and derive implications for firms product portfolio and product designchoices.Keywords:  Digital convergence, product convergence, technology convergenceMotivation and Research QuestionsDigital technology convergence, meaning the increasing incorporation of common digital technologies in the products and servicesof distinct industries, has been shaping the telecommunications and computing industries for some time. The Internet, and theopen digital technology standards on which it is based, have accelerated this convergence by an order of magnitude and extendedit to embrace almost the entire universe of information based industries such as consumer electronics, media and entertainment -causing the boundaries between these industries to blend or disappear.  Use of digital technologies is increasing the information content in products. This makes products more flexible in terms ofsatisfying heterogeneous customer needs. It also enables firms to design and market converged products that integrate thefunctionalities hitherto provided by other products in completely different industry segments. Thus, while traditionallydemarcations between different industries as well as firms competitive strategies have been based on the inherent trade-offsbetween product attributes, this need no longer be true. Secure product niches with assured revenue streams may therefore becomeincreasingly rare in these industries. The multifunctional nature of converged products increases the interchangeability between offerings from different industries.As an example, consider the media industry. In the past, tight integration between the type of information and medium of deliverymeant that distinct media were tuned to serving different functionalities (e.g. one-to-one vs. one-to-many vs. many-to-manycommunications). The Internet substitutes for all these with relatively few tradeoffs. Similarly, the same infrastructure andconnections into homes/offices can now be used for data and voice communications, as well as audio and video distribution. Theend result is a potentially growing degree of overlap or substitutability in the functions that can be performed by differentcommunication networks and information appliances, thereby enhancing the intensity of competition and blurring industryboundaries. In order to survive in this environment firms need to broaden their peripheral vision, as the next most pressing threatmay come from outside the industry rather than within it. In some cases, digital convergence is also reconfiguring entire industry structures. For example, the media industry (whichincludes content, communication and consumer electronics industries) is undergoing structural transformation from tightly knitMantena /Converging Digital Technologies1Extension to the case of other industry structures is part of future research.2002  Eighth Americas Conference on Information Systems 379vertical segments to interconnected horizontal layers, much like the PC industry (Mueller 1999). While firms in the media industryof a decade ago often produced their own content, distributed it through their own channels (or networks), dictated what medium(or device) could be used to consume the content and directly billed the consumers, today they are increasingly being forced tofocus within one or more of these layers. However, enormous opportunities exist within each layer to broaden the scope of theirproducts and generate multiple revenue streams. This is primarily possible due to the similarity in technologies employed tohandle information in each of these layers. These developments make business models such as gatekeeping attractive. If a firmmanages to converge and gain control of a horizontal slice in this industry, it can then collect tolls from players in other layers.Microsoft has successfully done this in the PC industry. We see similar attempts in the media industry, particularly in the last layerthat is in direct contact with the customers. Firms such as telephone and cable companies are trying to build strong customer tiesand grab a larger share of the customers wallet. Consumer electronics firms are trying to fill a similar role using home mediagateways and multi-functional set top boxes such as Moxi Digitals Media Center and Microsofts Xbox. The actual introduction of converged products depends on the interaction between technological, competitive and demand factors.While increasingly powerful, cheap and ubiquitous digital technologies needed to drive product convergence are currentlyavailable (though some uncertainty exists in terms of standards), such convergence will not be feasible unless both firms andconsumers benefit from it. In particular, the supply of converged products to the marketplace will be dictated by firms incentivesto do so. Clearly, digital convergence presents firms in these industries with both a significant opportunity and a grave threat. Agreat deal depends on the extent to which firms are able to exploit the technologies to provide compelling value to consumers andthe extent to which they can design effective business models to appropriate a significant fraction of this value. In this paper, wemodel the competitive interactions between firms in converging industries under reasonable assumptions about the technologicaland demand factors. Given the availability of converging digital product technologies, we analyze whether this will lead to theintroduction of converged products in the marketplace. We also investigate the resulting effects on prices, firm profits, marketshares and social welfare. A Model of Competition between Converging ProductsFirms product choices in the presence of converging technologies are modeled using a two-stage sequential duopoly game ofperfect information. The supply side of the model has two firms A and B, each of which supplies a single distinct product in thebase (zeroeth) period. Label them products 1 and 2 respectively. Each product satisfies customers desire for a particular distinctfunctionality. For the sake of clarity, think of Product1 as a PDA (Personal Digital Assistant or handheld computer) and Product2as a cellular phone. To abstract away from issues of differentiation and other strategic interaction within an industry itself, andfocus on the interaction between converging industries, it is assumed that each sector is represented by a monopolist. While thisis an obvious simplification, it is a reasonable representation of industries where a single firm (which we treat as the monopolist)controls the product standards in that industry.1Through past R&D, one of the two firms (say FirmA) has a proprietary product technology that makes it feasible for it to introducea converged product, say Product3. Product3 incorporates all the functionality of Product1 and also integrates some functionality(either a part or the whole) of Product2. Think of Product3 as a PDA-cellphone hybrid device that has all the functionality of aPDA and some functionality of a cellular phone. The extent to which Product3 incorporates the functionality provided by Product2is termed the degree of convergence (labeled r) and is a decision that FirmA makes in the first stage of the game. The availableproduct technologies might impose some upper bound on this choice of functionality. In the first stage, FirmA also decides theportfolio of products it brings to the market, which could be only Product1 or only Product3 or both. FirmB, which does not haveaccess to this product technology, is passive in this stage of the game. In the second stage of the game, the two firms play amultiproduct Cournot game. The demand side of the market is modeled using a representative consumer framework (See for instance Dixit and Stiglitz 1977,Matutes and Regibeau 1989) where the entire market is represented using a single utility maximizing consumer. In this framework,the utility function of the representative consumer can be thought of as the composite utility function produced by combining thepreferences of a set of heterogeneous consumers. Based on prices, the consumer chooses a basket of products including thequantity of a numeraire product. The numeraire represents the opportunity cost of consuming products in this market or set ofmarkets. Business Models for the Digital Economy380 2002  Eighth Americas Conference on Information SystemsThe specific form of the utility function employed is the quadratic utility function (Matutes and Regibeau 1989) that is linearlyseparable in the numeraire good Y (see (1) below). This means that all income effects fall on the numeraire and hence can beignored.U(q1,q2,q3,Y) = åiaiqi  (1/2)[ åi biqi2 + 2åi åj>i lijqiqj ] + Y (1)where the qi terms represent the quantities of product i. Given the quadratic form, this utility function is concave in the productquantities and displays a preference for variety (depending upon the value of b, which is later normalized to 1). Profitmaximization by the representative consumer yields a set of linear inverse demand functions for the three products. A numberof factors that affect the firms decisions about product portfolio and product design are considered.1. Relative revenue potential for the two functionalities. The parameters ai in (1) above become the intercepts in the inversedemand functions and thus are an index of the relative revenue potentials of the products (or the functionalities they provideto consumers). Intuitively, FirmAs incentive to offer Product3 that integrates a large fraction of Product2 functionality willbe higher if Product2 has a relatively large revenue potential (a high value of a2).2. The nature of relationship between the two base products. The lij terms determine the cross price elasticity and thereforerepresent the degree of substitutability between products i and j. The relationship between the two industries (thesubstitutability between base products 1 and 2) is given by the term l12.  The substitutability between the converged and thebase products is completely determined by l12 along with the fraction of Product2 functionality that Product3 integrates. Thewhole range of relationships from strong complementarity to strong substitutability is considered. In particular, a value ofzero for l12 means that the two industries are completely independent. 3. Synergies from functionality co-location: In some cases, co-locating the two functionalities on a single device may permitconsumers to exploit synergies, thus increasing the value of the enhanced product beyond the sum of its parts. For example,getting all your messages (voice, text, rich media, etc.) in a single mailbox on a converged wireless device might have morevalue than getting the same in separate devices each handling one type of media.  On the other hand, in some cases the valuefrom a converged product might be lower than that from the individual specialized products due to dis-synergies in use orresource constraints in the product technology. For instance, integrating PDA functionality on a cell phone may reduce voicequality or drain out the battery faster, thereby reducing the value of having both functionalities on the same device. Onewould expect that presence of significant synergies strengthens the incentives for FirmA to integrate more Product2functionality in Product3. The model considers this effect by incorporating a synergy variable s into the expressionrepresenting the value from Product3 (i.e. a3).Analysis and Preliminary ResultsThe subgame perfect equilibrium of the two-stage game is derived. The second stage of the game is actually comprised of threeseparate subgames  one each corresponding to a different product portfolio chosen by FirmA (i.e. only Product1; only Product3or both) in stage 1 of the game. Due to the linearity of the inverse demand functions, the firms profit functions are quadratic inquantities. Thus the firms payoffs are continuous and concave on the strategy space ensuring that we have pure strategy equilibriathat are unique (except a trivial case which is of little interest to us). At equilibrium, FirmAs product portfolio choice depends on the relative revenue potential, substitutability between the two baseproducts as well as the degree of synergies derived out of co-locating the two product functionalities. Two forces drive the effectof these factors on firm choices. First, introduction of the converged product into the market increases customer value and causesa market expansion effect. At the same time, the resulting higher level of substitutability between the products of the two firmscauses a competition effect. Most factors affect outcomes by tilting the balance between these two forces.In the base case, where the relative revenue potentials of the two product markets are equal and there is absence of any synergies(or dis-synergies) in integrating product functionality, the results show that it is never optimal for FirmA to produce Product1alone, or in other words, it will always introduce the converged product, Product3. Whether it continues to produce Product1 ornot depends on the degree of substitutability between the two industry functionalities and the degree of convergence. If the twofunctionalities are highly substitutable, then it is optimal for FirmA to discontinue producing the specialized base product,Product1. As the degree of substitutability between the two industry functionalities decreases, the market expansion effect alludedMantena /Converging Digital Technologies2002  Eighth Americas Conference on Information Systems 381λ12 = -1 λ12 = 1λ12 = 0r = 0r = 1P1 = Specialized Product1P3= Converged Product3P1+P3 P3to above, becomes stronger while the competitive effect weakens. Thus, when the two industry functionalities are weak substitutesor complementary, FirmA finds it optimal to supply both products to the market. This is illustrated in Figure 1, where thehorizontal axis represents the degree of substitutability (l12  = -1 for perfect complements and l12  = +1 for perfect substitutes)between the base products 1 and 2 and the vertical axis represents the degree of convergence (r = 0 implies no convergence; r=1 implies complete convergence).Figure 1.  FirmA Equilibrium Product PortfoliosResults also indicate that increasing synergies from co-locating functionalities strengthen FirmAs incentives to introduce theconverged product. As a result, even in the presence of mild synergies, the hybrid product is always introduced into the market,irrespective of the market sizes or the relationship between the two industries product functionalities. Further, as long as thesesynergies are not too strong, FirmA continues to produce both products. But, if the synergies are high enough, then discontinuingthe supply of Product1 is optimal for FirmA. Effect of changing the relative revenue potential of the two product markets dependson the relationship between the two product functionalities. When they are highly substitutable, FirmA continues to produce bothproducts when the two markets are of roughly equal size, but discontinues production of Product1 if the market for Product2 ismuch larger than that for Product1. When the two industry functionalities are strongly complementary, FirmA benefits fromproducing both products. Discussion and Further ExtensionsIt is clear from the above results that convergence of product technologies does not automatically imply that we will see convergedproducts in the market place. The introduction of converged products depends crucially upon a number of product related, firmrelated and consumer related factors analyzed in the model. The model analyzed above can be extended in a number of ways. The immediate extension is to look at the symmetric case whereconvergent product technologies are not proprietary but are available to both the firms. In this case, the competitive effect willbe much stronger than the unilateral convergence analyzed here. However, preliminary analysis of such a model indicates thatfirms may face a prisoners dilemma kind of situation and thus product convergence may still be observed. Heterogeneity betweenthe two firms capabilities may be modeled in terms of differences in investments or costs needed for introducing convergedproducts.In the current model, the degree of synergies derived from product integration is considered to be exogenous. In reality, this maydepend on the extent to which Product2s functionality is integrated into Product3. Lastly, often there is a great deal of uncertaintyBusiness Models for the Digital Economy382 2002  Eighth Americas Conference on Information Systemsin the rate at which consumers adopt a new technology or product. Incorporating such uncertainty into the revenue potential forthe converged product will constitute another interesting extension.Selected ReferencesDixit, A. K. and Stiglitz, J. E. Monopolistic Competition and Optimum Product Diversity, The American Economic Review(67:3), June 1977, pp.297-308.Matutes, C. and Regibeau, P. Standardization across markets and entry, The Journal of Industrial Economics (37:4), June 1989,pp. 359-371.Mueller, M. L. "Digital Convergence and its Consequences," Javnost/The Public (6:3), 1999, pp. 11-27.

CONVERGING DIGITAL TECHNOLOGIES:
AN OPPORTUNITY OR A THREAT?

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CONVERGING DIGITAL TECHNOLOGIES: AN OPPORTUNITY OR A THREAT?

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