Network effects and embedded options: decision-making under uncertainty for network technology investments

  • Authors:

  • Robert J. Kauffman;Ajay Kumar

  • Affiliations:

  • W. P. Carey Chair in Information Systems, Center for Advancing Business through Information Technology, W. P. Carey School of Business, Arizona State University, Tempe, USA 85287;Information Technology, Government of Kerala, Trivandrum, India 695001

  • Venue:
  • Information Technology and Management
  • Year:
  • 2008

Quantified Score

Hi-index 0.01

Visualization

Abstract

The analysis of network effects in technology-based networks continues to be of significant managerial importance in e-commerce and traditional IS operations. Competitive strategy, economics and IS researchers share this interest, and have been exploring technology adoption, development and product launch contexts where understanding the issues is critical. This article examines settings involving countervailing and complementary network effects, which act as drivers of business value at several levels of analysis: the industry or market level, the firm or process level, the individual or product level, and the technology level. It leverages real options analysis for managerial decision-making under uncertainty across these contexts. We also identify a set of real options--compatibility, sponsorship and ownership option--which are unique to these settings, and which provide a template for managerial thinking and analysis when it is possible to delay an investment decision. We employ a hybrid jump-diffusion process to model countervailing and complementary network effects from the perspective of a user or a firm joining a network. We also do this from the perspective of a network developer. Our analysis shows that when countervailing and complementary network effects occur in the same network technology context, they give rise to real option value effects that may be used to control or modify the valuation trajectory of a network technology. The option value of waiting in these contexts jumps when the related business environment experiences shocks. Further, we find that the functional relationship between network value and the option value is not linear, and that taking into account a risk premium may not always result in a risk-neural investment. We also provide a managerial decision-making template through the different kinds of deferral options that we identify for this IT analysis context.