Thursday, September 17, 2009

How Software Platforms Revolutionize Business

Executive Summary:

Cell phones, the Game Boy, and PCs are examples of products based upon software platforms—ecosystems where independent companies can provide products and services tied to the core technology. Playing in a software platform world can make you rich—ask ringtone creators—but it also demands special management skills that emphasize cooperation over competition. Professor Andrei Hagiu discusses his new book, Invisible Engines. Key concepts include:

  • Software platforms have improved productivity and innovation in many industries, disrupted or destroyed others, and created entirely new businesses.
  • Software platforms are powerful engines of change because of the malleability of code and of the fundamental functions they perform, which make it easy for them to march across industry boundaries; and because their multi-sided nature allows them to spawn vibrant ecosystems of complementors.
  • Managing software platforms is about much more than creating technology. It takes skills in navigating cooperation and competition, building creative business models, and anticipating competition across industries.

You can't see them, but we've all used "software platforms" over the last few decades, whether they are embedded in the Windows operating system, a cell phone, or game machine. In a new book, the authors term software platforms "invisible engines that have created, touched, or transformed nearly every major industry for the past quarter century."

Think of software platforms as ring leaders of ecosystems in which a few or many companies can participate to reach users. These core products, like Windows, for example, offer software services that can be used as the basis for independent developers to build new features. The cell phone has become a lucrative platform for more than handset makers—also in on the party are makers of digital cameras, music services, and organizer software.

Not only are existing industries being transformed and sometimes toppled by software platforms, but new industries are also springing up around them; witness the multibillion-dollar ringtone business.

To record the impact of software platforms on the economy and look to their future impact, David S. Evans, Andrei Hagiu, and Richard Schmalensee collaborated on Invisible Engines: How Software Platforms Drive Innovation and Transform Industries, available October 4 from MIT Press. Evans is Managing Director of the Global Competitive Policy Practice at LEGC LLC. Hagiu is a professor in the Strategy unit at Harvard Business School. Schmalensee is John C. Head III Dean and Professor of Management at MIT Sloan School of Management.

We asked Hagiu to discuss the book. To learn more about Hagiu's early-stage research into the concept of multi-sided markets, of which many software platforms are a manifestation, see this earlier HBS Working Knowledge interview.

Sean Silverthorne: At a 50,000-foot level, what impact have software platforms had on traditional industries over the last thirty years?

Andrei Hagiu: At its most fundamental level, they have fueled innovation and improved productivity. Software platforms have accelerated technological innovation by providing springboards that allow specialized producers to leverage their infrastructure and create new innovations and by bringing digital technology to a wide variety of sectors and users, again by providing flexible infrastructures that make it possible for armies of specialized providers to build myriad software solutions for myriad tasks that previously were performed in traditional, non-tech ways. In this way, they have improved the productivity of many traditional industries (just look at all the industries that use PCs today) and created brand new ones (just look at the Internet and mobile data services including streaming content).

Even the best product design will end up subordinated to the best multi-sided platform.

Software platforms have also been the source of much creative destruction. The reduction in transaction costs and increases in efficiency brought about by digital technologies powered by software platforms have been so great that the so-called "old guard" was displaced (or may be on its way to extinction): Typewriters have been all but displaced by PCs, board games have been displaced (but not eliminated entirely) by the videogame industry (PC- and console-based), and traditional newspapers are fighting an uphill battle for readership against Internet content portals.

Q: From a management skills perspective, what do managers and strategists who make their living from software platforms need? Seems like cooperation rather than competition would be a core competency?

A: Yes, cooperation is critical: The quintessential key to success of software platforms has always been their ability to build large, well-functioning ecosystems of third-party producers who build on top of the software platform. Without them, no one would have any need for the platforms. The relevant management skills are:

  • Knowing the community and being able to identify and attract the third-party producers who can build the most valuable innovations.
  • Knowing how to manage the ecosystem: Deciding the right balance between quantity and quality; knowing when to compete and when to collaborate with partners; being able to manage the conflicts of interest inherent to such compete-collaborate relationships; knowing how to monetize the value created by the ecosystem (which member of the ecosystem is needed most—developers or end users—and how the pricing scheme must be designed to get both sides on board).
  • Knowing how to architect the physical design and scope of the platforms: what to do in-house vs. what to rely on others to do; which features to offer and which to forego.
  • Knowing how to spot competitive threats early, both within the industry, but most important and difficult, in adjacent industries, where other platforms might be poised to strike (e.g., smart phones moving into the PDA industry); and conversely, spotting expansion opportunities in adjacent industries (e.g., NTT DoCoMo expanding into payment systems).
Q: The book makes mention that software platforms have the promise to significantly change how we buy and pay for goods and service in the future. Could you elaborate on this? What impact do software platforms have for the consumer on the street?

A: Software platforms are universal in nature because they can potentially underlie any digital technology: As digital technologies become more ubiquitous, so will software platforms. They can potentially reduce search and transaction costs for any imaginable economic transaction.

Today we can already search for, choose, and pay for many goods on the Internet using a few clicks by way of the software platforms running under eBay or Google or Rakuten. In some countries like Japan and Korea, one can do exactly the same thing on the Internet and over the mobile phone. And in Japan, mobile phones now function as payment devices (one can waive the phone in front of a reader to pay). The next generation videogame consoles are no longer just gaming platforms, they are gateways to a variety of digital content, including DVD movies and Internet video for the gamer and advertising and other promotional opportunities for the advertiser. Broadly speaking, software platforms have the potential to streamline access to many diverse transactions through a single device, be it a mobile phone, a videogame system, an iPod, a car navigation system, etc.

Q: Software platforms naturally lead to multi-sided business but Apple seems to be the outlier in all this ferment. What are the lessons of Apple's contrarian approach? Will this come back to bite them?

A: Let me first make a clarification. Apple's computer business is definitely multi-sided, just like Microsoft's, except Microsoft Windows has three sides (end-users, application developers, and hardware makers) whereas Mac OS has only two sides (end-users and application developers—Apple does the hardware). Apple's decision to stay two-sided rather than three-sided is in large part the reason for which Windows-based PCs have today a 95 percent-plus market share, whereas Macs are at less than 4 percent. So in this business I think everyone—including Apple—has learned the obvious lessons there were to learn: Whereas control over quality in the initial stages may have been a good reason to stay away from that third side, the latter is necessary in order to achieve sufficient scale in the market, particularly in the face of competition.

Losers will include anyone providing a brick-and-mortar product or service that can be digitized and put on a software platform.

If we turn to Apple's iPod/iTunes business, it superficially looks multi-sided, in the sense that Apple has "gotten on board" music publishers and consumers. But in fact, Apple has done so in a one-side-at-a-time way, by first licensing the music (essentially taking "possession" of the music licenses) before turning to consumers and selling it to them (at a price and under a format entirely controlled by Apple) along with iPods. This took the chicken-and-egg aspect (characteristic of multi-sided businesses) out of the equation, which again might have been the right thing to do to get started.

My personal view is that in the face of an explosion in the number of digital music services (download and/or subscription) rivaling iTunes and that of digital music players (rivaling iPod), Apple should turn to a truly "multi-sided" model, by opening up iTunes and devolving more control to music publishers in order to achieve more variety of the music offering—thus trying to become the eBay of digital music.

The broad lesson here is that ingenious product design can take you very far; however I am willing to take a bet that in any multi-sided market, sooner or later, even the best product design will end up subordinated to the best multi-sided platform in town.

Q: What is your best guess as to how software platforms will evolve over the next ten years? Who will be the winners and losers?

A: They will undoubtedly continue to cross industry boundaries and penetrate in a variety of markets previously untouched by digital technologies: For instance, software platforms are playing an increasingly prominent role in the car industry today. Does that mean that Toyota will become a Microsoft OEM anytime soon? Probably not, but they will certainly be an awful lot closer to each other!

The winners will be of course the providers of the most versatile and flexible software platforms, i.e., those that can span the widest range of functionalities and markets, and also those that will perform the most fundamental functions, which in my view are search and payments. Another category of winners will be of course the owners of valuable content—be it games, music or movies—software platforms will allow them to monetize and distribute their content in ways which were previously not possible. Needless to say, consumers will also gain a lot.

Losers: anyone providing a brick-and-mortar product or service that can be digitized and put on a software platform—unless the producer does it him- or herself. Example: newspapers.

From Invisible Engines: How Software Platforms Drive Innovation and Transform Industries by David S. Evans, Andrei Hagiu, and Richard Schmalensee.

Many modern products run on software platforms. Car engines and navigation systems have one, as do jumbo jets and the handheld devices we use for e-mailing and organizing ourselves. Video game consoles from Atari to Xbox are based on them. French debit cards have included them for years; these "smart cards" may eventually replace the magnetic stripe cards that are standard in the United States. Sophisticated mobile telephone services such as i-mode Japan are based on software platforms. Personal music devices are as well. And, of course, all sorts of business and home computers also have them.

Software platforms are based on computer code. The code tells the microprocessors and other hardware components what to do. It is what makes your computer do calculations, or your personal music device play songs. And it provides services to applications, such as accessing the hardware or providing features that many applications would otherwise have to include themselves. It is what makes handwriting recognition possible on personal digital devices and enables employers' human resources software to work on the company's computer system.

Yet these remarkable software engines are invisible to most of us. Their creators write them in a language that looks almost human. They then use other code to translate what they have written into machine language—combinations of 0s and 1s that microprocessors understand. Those digital data are then transferred to the physical memory or storage in the device itself.

Some software platforms are famous. Linux, the Mac OS, and Windows are household names. You cannot really see or touch these products, but at least you can buy a CD and a hefty manual. Others are known to many business users: z/OS, Solaris, and Unix, for instance. Many are known only to a few, such as Symbian for mobile phones or GeoWorks for handheld devices. Others, including the software platforms that are the real brains behind devices such as the Sony PlayStation or Tivo's digital video recorder, are truly anonymous.

Software platforms have generated great wealth. Windows has provided about 40 percent of Microsoft's revenues in the last decade.2 It has helped make Bill Gates the richest man in the world. Linus Torvalds has become a modern icon as a result of writing the first version of the famous open-source platform, Linux. And software platforms have been partners in some of the most successful technological marriages of the last quarter century: the Macintosh, iPod, PalmPilot, Sony PlayStation, and Xbox are among the better known hardware-software platform couples.

The computer revolution has been changing our lives now for fifty years, at an accelerating rate, and much has been written about it. Many of the companies, products, and entrepreneurs behind this revolution have become household names. Stories of Steve Jobs and Steve Wozniak building the first Apple computer in their garage and Bill Gates getting the best of IBM are almost folklore at this point. Economists have written a fair amount about the computer industry, and business writers have scoured its history in search of the drivers of great success.

Yet little has been written about software platforms. This is not necessarily remarkable. They are not well-defined products like toothpaste. The software platform used in i-mode does not compete directly with the software platform used in Web servers. And they are not components, like the engines sold to automobile companies or even the chips sold to computer device manufacturers. There is no software platform industry defined in government statistics. Rather, software platforms are a technology—though one based on a written language—that can be deployed in a vast range of industries for a great multitude of purposes.

Many economic threads, however, tie diverse software platforms together. The most critical of these ties is their potential for supporting a multisided business—one in which value is created by bringing together on the same platform multiple distinct groups of customers who need each other in some way. Businesses that cater to the singles scene are one example of this sort of business. Heterosexual nightclubs must get men and women together in the same place. Shopping malls are also multi-sided: Their developers create platforms that attract both merchants and consumers. Similarly, many software platforms provide services to application developers and platform users. Like shopping malls, they also provide a common meeting ground where one side can sell to the other side.

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