Thursday, September 21, 2006

Critical mass

One of the terms that you come across in discussions about the growth of the Internet, or of Internet applications or services (for example the use of Internet telephony or the adoption of a new browser like Firefox), is critical mass. Once this critical mass has been reached there are enough customers in the market using the product or application for the positive feedback effects associated with network externalities to really kick in and for the product to takeoff. Until this critical mass has been reached there might still be doubts about whether the new product will establish itself and so potential new users may be reluctant to get on the bandwagon.

There are plenty of examples of products where this critical mass was never reached and so the product eventually failed and was withdrawn from the market altogether. An example described by Rolhfs in his book
ROHLFS, J (2001) Bandwagon effects in high technology industries is Picturephones in the 1970s. As he explains, it was technically possible to make telephones that displayed a picture of the caller on a screen, but the product never took off - critical mass was not reached. (Of course today mobile phones that take pictures are all the rage but that is a completely different type of product).

There are a number of reasons why critical mass might not be reached for a product. It might be too expensive in relation to the features that it offers for it to be attractive to buyers. Or it might have been poorly marketed. That is why economists often advise firms with new products that might exhibit network effects to keep the price low early on even if that means that costs are not covered, and to spend money on marketing and promotional campaigns to get the product talked about. So long as the product will be profitable once sales have passed a certain level then it will be worthwhile in the end. The price discounts and marketing costs can be viewed as an investment. You might even see a product given away for free in the early stages of its life as a way of pushing up its use beyond the critical mass. Once this level of use has been achieved other people will want to have it too and you can start to charge for it. There are lots of examples of software and web-based services that were given away free in this way early on but then require payment or subscription fees once it had become established.

How big is the critical mass?
An obvious follow up question that might be asked at this point is "how big is critical mass?" - either in terms of the number of users or the share of a market. There is no easy answer to this question. It depends on the size of the market and its competitiveness.
Here are some examples from recent news reports.

  • Firefox at Critical Mass? Jim Wagner, Internet News, 6th January 2006.
    Wagner reported that Firefox had achieved a market share of 9.57% in December 2005, just under the 10% figure. He quoted Vince Vizzaccaro, executive vice president of marketing and strategic relationships at NetApplications, the company that collected the data "Firefox is very close to hitting a critical mass of 10%, which could mean a more rapid adoption rate".
  • US Broadband Market Reaches Critical Mass Kirsten Fischer, In-Stat Press Releases, 6th April 2004. The report says that "with close to 27 million US business and residential subscribers, broadband is now clearly a mainstream service". It goes on to mention some of the applications such as home entertainment, VoIP and online gaming that require a broadband connection and quotes Daryl Schoolarm a Senior Analyst at In-Stat "This starts a cycle where growth in both broadband and applications feed the growth of each other". This is what Rohlfs means by complementary bandwagon effects.
  • MP3 Players Reaching 'Critical Mass InternetWeek 13th April 2005. The story quotes JupiterResearch analyst David Card as saying that the number of MP3 players (in the US) was close to reaching around 18 million. "Historically, any new device or medium that reaches a US household penetration of 15 percent to 20 percent creates a critical mass of customers for other products and services. This is good news for digital stores and subscription music services. Subscription services and devices will fule each other's growth."

Some references to critical mass seem to imply that it is the level at which a product becomes profitable. This is not quite correct. In an established market there will be a break-even point beyond which revenues exceed costs and so the firm sells enough of its product to make a profit. This is related to economies of scale. Enough units are being sold for the fixed costs of production to be shared over many units so that average costs come down. In a new market with an untried technology the cost of production might initially be high in any case. Costs can come down as the market is established partly due to economies of scale, but also because the production process itself is likely to be improved once the firm moves beyond the pilot stage. What is correct then is that a firm will probably not be able to earn profits unless it can reach a critical mass.

Another myth is that having a big market share is necessarily going to lead to profits. As John Kay noted in his article in the Financial Times back in March 1998, the share of large firms in total output is not going up. He underlines his point by identifying the automobile industry as one which has become less concentrated over the years despite it being an industry that is often used to illustrate the importance of economies of scale, market concentration and critical mass.

Footnote: the term critical mass itself probably comes from nuclear physics. It identifies the amount of plutonium needed to start a chain reaction.


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