A Value Chain Perspective on the Economic Drivers of Competition in the Wireless Telecommunications Industry By Scott C. Constance B.A.

Economics and Mathematical Methods in the Social Sciences Northwestern University, 1996 and Jeffrey R. Gower B.S. Civil and Environmental Engineering Union College, 1992 Submitted to the Alfred P. Sloan School of Management in Partial Fulfillment of the Requirements for the Degree of Master in Business Administration at the Massachusetts Institute of Technology June 2001 2001 Massachusetts Institute of Technology All Rights Reserved Signatures of Authors Alfred P. Sloan School of Management May 11, 2001 Certified by. Charles H. Fine Chrysler Leaders for Manufacturing Professor of Management Thesis Supervisor Accepted by.. Margaret C. Andrews Executive Director, Master in Business Administration Program
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A Value Chain Perspective on the Economic Drivers of Competition in the Wireless Telecommunications Industry By Jeffrey R. Gower and Scott C. Constance Submitted to the Alfred P. Sloan School of Management on May 11, 2001 in Partial Fulfillment of the Requirements for the Degree of Master in Business Administration

Abstract
We address aspects of uncertainty brought about by the rapid pace of change in the wireless telecommunications industry. We draw upon elements of value chain theory in developing a systematic historical perspective on these changes in wireless telecommunications. We draw upon elements of classical economic theory in understanding the dynamics driving these changes. A System Dynamics model is constructed to bridge the theoretical and empirical gap between value chain theory and classical economics. We use this model to understand the dynamics of possible future changes in the wireless telecommunications industry. Model validation results show that our economic and value chain analyses are insightful in explaining the growth, innovation paths, and competitive dynamic of wireless communications value chain participants. Thesis Supervisor: Charles H. Fine Title: Chrysler Leaders for Manufacturing Professor of Management

Table of Contents
ABSTRACT....................................................................................................................................2 TABLE OF CONTENTS..............................................................................................................3 TABLE OF FIGURES & TABLES..............................................................................................4 SECTION 1: INTRODUCTION..................................................................................................6 SURVEY OF THE WIRELESS TELECOMMUNICATIONS INDUSTRY.................................................................6 Why Is This Industry Interesting?............................................................................................6 Subscriber Growth...................................................................................................................6 Scope of Service Growth.........................................................................................................6 Rapidity of Technological Advance.........................................................................................7 Complexity of Supply Strategy.................................................................................................7 DESCRIPTION OF STUDY....................................................................................................................9 SECTION 2: THE DYNAMICS OF VALUE CHAINS...........................................................11 UNDERSTANDING RAPID CHANGE AND INNOVATION............................................................................11 POWER IN A NETWORKED MARKET...................................................................................................12 STRUCTURE IN NETWORKED MARKETS..............................................................................................13 Vertical Industry Structure....................................................................................................14 Transition from Vertical to Horizontal..................................................................................14 Horizontal Industry Structure................................................................................................14 Transition from Horizontal to Vertical..................................................................................14 ARCHITECTURE AND INNOVATION IN NETWORK MARKETS....................................................................15 CLOCKSPEED IN NETWORK MARKETS................................................................................................16 SECTION 3: WIRELESS VALUE CHAIN..............................................................................19 A WIRELESS TELECOMMUNICATIONS VALUE CHAIN PERSPECTIVE.........................................................19 USING VALUE CHAIN ANALYSIS......................................................................................................19 WIRELESS VALUE CHAIN....................................................................................................20 FORCES INFLUENCING THE WIRELESS VALUE CHAIN...........................................................................21 DISTURBANCES THROUGHOUT THE VALUE CHAIN...............................................................................24 DEVICE VALUE CHAIN.........................................................................................................25 INFRASTRUCTURE VALUE CHAIN....................................................................................27 INFRASTRUCTURE VALUE CHAIN DYNAMICS.......................................................................................28 BREAKING DOWN VALUE CHAIN DYNAMICS......................................................................................32 Internal Clockspeed...............................................................................................................32 External Clockspeed..............................................................................................................32 Competitive Intensity.............................................................................................................32 Bullwip Effect........................................................................................................................32 SECTION 4 : WIRELESS TELECOM ECONOMIC PERSPECTIVES..............................35 OBJECTIVE....................................................................................................................................35 EXPECTED OUTCOME......................................................................................................................35 ECONOMIC FORCES IN PLAY............................................................................................................35

Increasing Returns to Adoption.............................................................................................36 Significant Switching Costs...................................................................................................37 Architecture Access Considerations......................................................................................38 Powerful and Imperfect Expectations...................................................................................39 INSIGHTS FROM THE ECONOMIC LITERATURE......................................................................................40 Increasing Returns to Adoption.............................................................................................40 Significant Switching Costs...................................................................................................42 Architecture Access Considerations......................................................................................44 Powerful and Imperfect Expectations...................................................................................47 SECTION 5: SYSTEM DYNAMICS--UNIFYING V.C. AND ECONOMICS.....................50 THE SYSTEM DYNAMICS METHODOLOGY...........................................................................................50 SYSTEM DYNAMICS APPLICATION STRATEGY......................................................................................51 Modeling Goals.....................................................................................................................51 Wireless Telecommunications Modeling Methodology.........................................................51 MODEL BUILDING BLOCKS..............................................................................................................53 Network Benefits Causal Loop..............................................................................................53 Market Saturation Causal Loop............................................................................................53 Installed Base Causal Loop...................................................................................................54 Slowed Adoption Causal Loop..............................................................................................55 Perceived Value Increase Causal Loop................................................................................56 SECTION 6: PUTTING THE MODEL TO WORK................................................................60 VALIDATION OF MODEL..................................................................................................................60 SECTION 7: CONCLUSION.................................................................................................................62 METHODOLOGY AND OUTCOMES.......................................................................................................62 SECTION 8: AVENUES FOR FUTURE RESEARCH...........................................................65 APPENDIX A: SYSTEM DYNAMICS MODEL DOCUMENTATION...............................66

Table of Figures & Tables

FIGURE 1: PORTERS 5-FORCES MODEL..........................................................................13 FIGURE 2: DOUBLE HELIX OF INDUSTRY CYCLING....................................................18 FIGURE 3: WIRELESS INDUSTRY VALUE CHAIN..........................................................20 FIGURE 4: WIRELESS INDUSTRY 5-FORCE ANALYSIS................................................22 FIGURE 5: WIRELESS VALUE CHAIN RELATIONSHIP VALUE..................................24 FIGURE 6: DEVICE VALUE CHAIN......................................................................................25 FIGURE 7: DOUBLE HELIX OF DEVICE VALUE CHAIN DYNAMICS........................26 FIGURE 8: INFRASTRUCTURE VALUE CHAIN ...............................................................27 FIGURE 9: STANDARD SPIDER WEBS OF INFLUENCE.................................................28 FIGURE 10: DOUBLE HELIX OF INFRASTRUCTURE VALUE CHAIN DYNAMICS. 29 TABLE 1.0: DESCRIPTION OF VALUE CHAIN SEGMENTS...........................................34

TABLE 2.0: TDMA VS. CDMA INPUT DATA.......................................................................61

Section 1: Introduction
Survey of the Wireless Telecommunications Industry Why Is This Industry Interesting? We find the wireless telecommunications industry interesting because it has been, since its inception, characterized by rapid change along multiple dimensions. Wireless communications were first commercialized in 1983, soon after Dr. Martin Cooper used a mobile handset built by Motorola in completing a wireless telephone call to engineers working at Bell Laboratories. The industry since 1983 has seen rapid growth in users, scope of service, and often-turbulent change in technological configurations and supply strategies. In the course of this paper, we plan to present a dynamic analytic framework that draws upon a factual catalog of historical change within the wireless telecommunication industry in facilitating an understanding of how and why changes might occur in the future. With this goal in mind, it is helpful to first understand the magnitude of changes witnessed during the last 18 years along a number of measurable dimensions. Subscriber Growth The wireless telecommunications industry, growing from its birth in 1983, now is comprised of over 640 million users of wireless products and services. This growth can be examined from socioeconomic perspectives as well: in many developing nations cellular networks serve as the primary means of voice and data communication, while in industrialized nations wireless networks are providing mobility and redundancy to legacy fixed wire networks. Some forecast the wireless network as the dominant connection, bridging the last mile between high-bandwidth metropolitan optical networks and the electronically enabled appliances in the homes of customers. Scope of Service Growth Many of the first participants within the wireless industry trained their focus on compelling consumers to adopt wireless services by enlarging geographic service areas, called footprints. These participants often also produced the devices that could communicate within these service areas, and also manufactured electronic switches and interfaces that facilitated communication over the network. Consumers had little choice when making a decision to adopt wireless telecommunications products and services.

Today, however, we confront an array of mobile devices that, collectively, can browse the Internet, manage our schedules, receive and transmit email, and alert us to personalized content & services. These devices, in some instances, stand as the most efficient interface between consumers desire to transact and those with whom transactions take place. Rapidity of Technological Advance Wireless telecommunications systems depend to a great extent upon mainstream elements of modern electronic technology. Integrated circuit boards, similar to those found in mass-market personal computers, are used in mobile handsets and in elements of wireless telecommunications infrastructure. The similarities do not end there, as circuit boards used in wireless telecommunications contain electronic components, such as digital signal processors, flash memory, and microprocessors, that can also be found within computers targeted at the broader market. There is, however, a significant difference between the rates at which the wireless industry has incorporated advances in technology and the rates at which the computing industry at-large has incorporated these advances. Marketers of personal computers frequently invoke the predictions of an innovation path laid out by Intel Corporation founder Gordon Moore: that computing power, usually measured in millions of instructions per second, doubles every 18 months. Manufacturers of wireless circuit boards and the components contained within these boards, such as Texas Instruments, Analog Devices and Motorola, have brought successive generations of technology to market with even greater rapidity. Collectively, suppliers of technology to the market for wireless telecommunications have tripled the computing power of mobile devices every 16 months. Complexity of Supply Strategy We recognize from above that the definition of everything within the wireless telecommunications industry has been consistently and rapidly growing. Suppliers to the market for wireless telecommunications confront growing numbers of potential customers, an increasing number of options for products and services to sell to these customers, and a widening base of technologies from which to choose in doing so. It follows that a company with a given set of human and capital resources is less likely to be able to do everything than was possible during the nascent years of the wireless telecommunications industry. This point is borne out as we examine the degree of complexity found within product specification standards of the industry. The average number of components in a wireless telephone, for example, has increased from 250 in 1983 to 900 in the present day. Meanwhile, the average physical
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dimensions of a wireless telephone have decreased by at least 30%, and along some dimensions by 60% during the same timeframe. There is certainly room for uncertainty on the part of participants in this market as to how best manage these changes in product complexity: participants may have difficulty determining the best use of their resources in bringing products to market. Participants certainly recognize the validity of this issue, as exemplified by multiple outsourcing contracts between formerly integrated device designers/manufacturers and participants focusing solely on manufacturing. The complexity issue can also be examined with respect to interface standards. A wireless handsets communication with elements of wireless infrastructure and other handsets is facilitated by an air interface. In early wireless telecommunication systems, these air interfaces managed the transmission of analog waveforms between parts of a wireless network. Present day digital air interfaces manage the transmission of bit-streams between network components. A participants choice of air interface, by definition, carries with it choices of transmission frequency and encryption algorithm. These choices, once made, mandate a lack of interoperability with participants who make different choices. Indeed, there exists a multitude of air interface standards: the traditionally European Global System for Mobile Communications (GSM), the IS-54 Time Division Multiple Access (TDMA) and IS-95 Code Division Multiple Access (CDMA) standards developed in the United States, and Japans Personal Digital Cellular (PDC) air interface. Each of these standards in turn can be operated over a range of radio transmission frequencies. We recognize the potential for uncertainty with respect to air interface choice, given the number of choices available and the lack of interoperability given a particular choice. Participant reactions to this uncertainty are of interest; wireless telephones, for example, at first designed to operate over one air interface platform at one range of frequency, can now communicate via multiple air interface standards at multiple ranges of frequency. Participants are correct to consider carefully their investments in an environment characterized by such uncertainty. Investments poured into a market whose participants have dissimilar conceptions of the need for (or benefit promised by) that investment risk falling prey to premature obsolescence. Perhaps a shared understanding of the forces giving rise to these uncertainties might assist participant firms in addressing markets and committing investment resources.

Description of Study It is our goal to facilitate this shared understanding of the forces driving uncertainty within the wireless telecommunications industry. We will present within this paper an analytic framework that welcomes the rapid changes, both witnessed and expected, in the operating environment confronted by industry participants. We begin with a degree of abstraction. Remember that we are concerned with an entire industry that has been rapidly growing and changing a broader notion than how just one firm, or segment of firms, within that industry has reacted to those rapid changes. Accordingly, we find the concept of a value chain to be particularly useful to us at the outset of our analysis, since the value chain concept forces us to consider carefully the boundaries of the wireless industry and how participants in the industry relate to each other. We will draw from research, both theoretic and empirical, in presenting a generalized perspective on how best to maintain and improve the health of an industrys value chain. We will proceed from this general understanding of value chains in developing a value chain analysis specific to the wireless telecommunications industry. This analysis in particular will exhibit many ways in which the wireless industry is unique with respect to others. We will frame the conclusion of this analysis in a number of value chain strategy questions that are continually confronted by participants in the wireless value chain. We count among these the decision to shift industry structure between vertical or horizontal, the decision of a product architecture either integral or modular, the decisions that can be taken to increase rates of adoption, the decisions to appropriate investments and the decisions that can be taken to extract value from an installed base. We next attempt to answer these value chain strategy questions by pointing to forces rooted in classical economics. We conduct an in-depth analysis of four separate economic forces, of which each has received considerable attention within the theoretic literature. In many cases, we extend the conclusions reached within the literature into a context specific to the wireless telecommunications industry. Our hope in conducting this economic analysis is to capture value chain dynamics as a function of our selected economic forces. It is not our intention to develop a tidy equation in which value chain dynamics are reduced to the intersection of a supply curve with a demand curve. Rather, we recognize the value of allowing for degrees of separation between value chains and classical economics. Doing so will enable a broader logical understanding of our analysis and will reduce the need for sizable infusions
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of intuition. Indeed, it may simply not be possible to explain wireless value chain dynamics as a first-order function of classical economics. As a result, we proceed by discussing a System Dynamics model that we have constructed to bridge the analytical and intuitive gap between value chain dynamics and our economic forces. The System Dynamics modeling technique allows us to include our intended degrees of separation. We can, for example, include additional layers of variables, such as revenues, costs, and pressures and incentives to invest that help us unite the value chain and economic portions of our analysis. The model is validated by contrasting the adoption of TDMA and CDMA cellular service by End-users from Network Operators between the period of 1995-2000. The results of the validation reflect the historical data for this period and have proven the system dynamic model is robust and an accurate tool for assessing the market force dynamics between value chain participants. In the end, our study provides a pervasive argument for conducting value chain analysis that measures how behaviors between a buyer and seller within a link of the chain contribute to disturbances throughout the chain. We present a framework to help identify these contributions and overlay an economic and financial model to quantitatively access the bottom line impacts on a firms ability to appropriate cash flows and drive industry outcomes.

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Section 2: The Dynamics of Value Chains

As we have now hopefully convinced you the wireless industry has experienced rapid change, almost continually since its commercialization in 1983. We expect this pattern of change to persist. In light of this expectation, it becomes necessary to understand how and why future changes might take place. This understanding can serve as a foundation for a framework that explains optimal behavior by buyers and sellers in response to these rapid changes. In this section we assess the dynamics of change within an industry. We build upon this assessment in later sections, first applying it within a market structure framework specific to the wireless telecommunications industry. In later sections we will then present another dimension to the framework that allows us to assess buyer/seller relationships within the value chain and how incentives and pressures from value chain participants affect other segments throughout the chain. Understanding Rapid Change and Innovation Our goal in this section is to provide an assessment of industry change. We have broken this down into three steps. The first step assesses the market structure considering the entry of new firms, how these firms are organized, how much they cooperate, and what industry structure they preside in. Ultimately, we want to understand how hard it is to enter the market and therefore, how competitive is the environment. Next, we shift the focus of our analysis from competition intensity to innovation. We want to understand the product and process innovation cycle. This assessment begins with a look at the products degree of complexity. We want to understand first if the product architecture is modular or integral. In addition, we want to understand the degree to which products or processes within a value chain are open (available for emulation by other participants) or proprietary (protected by intellectual property rights). By assessing these variables we seek to understand the availability of potential substitutes for a process or product, and how easy it is for other firms to copy each others offerings. Finally, we use our assessment of an industrys competition intensity and innovation to locate a participants offering within that offerings expected lifecycle. We draw upon Charles Fines double helix lifecycle model in doing so.

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Power in a Networked Market It is helpful to first examine unique characteristics of network-related markets (of which the wireless telecommunications market is an excellent example), prior to understanding the different stages of competition in which firms exist. Network markets exhibit the property of externalities: products become more valuable when more complementary components are available. These network externalities are more influential where the value of the network to a consumer increases with the number of subscribers using it or other complementary products. In addition, we recognize that a finished product and its complementary components stand at the endpoint of a chain between the products buyer and the suppliers that add value to the product. The value that a firm can extract from selling any of the components in the chain is dependent not only on the degree of competition in this component market, but also on the competition between complementary goods. This interdependence of value among markets for networked components has a number of implications. First, a firm selling a product is better off and can extract more value when the complementary markets in which it does not participate are more competitive or horizontal in market structure. There is a limit to the value a firm can extract from complementary markets since the more monopolized a market is or the more vertical the market structure, the less value remains for the complementary markets to grow their services. Put differently, if a firm can monopolize one component, and all other complementary component markets are perfectly competitive, this firm gains nothing by attempting to monopolize the complementary component markets and therefore entry does not occur. Conversely, a firm that monopolizes a component has an incentive to enter and compete hard in a market for complementary components if the complementary component market is not perfectly competitive, because by entering such a market, the firm can capture rents that it was losing from its original marketthereby converting the market to a vertical industry structure. So why is this important. Competition describes a firms ability to extract rents from its products and services. As a firm gains ability to extract rents from buyers, one can consider the market as becoming less competitive or more vertical. If a firms ability to extract rents decreases then the market is becoming more horizontal; entry becomes easier, thereby increasing competition. It follows that an assessment of competition intensity must depend on an understanding of the drivers of change in an industrys structure.
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Structure in Networked Markets A common starting point for analyzing the competitiveness of a market is Porters Five Forces Model. This model has been used both to assess competitive pressure between suppliers, buyers, and rivals, as well as a measure of the barriers to entry for new entrants and their ability to market substitutes. The explanatory power of Porters model is limited within a network market context. In these complex network markets changes in competition intensity or innovation within one part of the value chain can have dramatic impacts on other upstream or downstream segments that either help produce the firms product or other firms complementary products. A standard Five Forces analysis, as shown in Figure 1.0, gives us a snapshot of the forces acting upon one participant within the value chain at a single point in time. A complete understanding the dynamics of competition within an industry or market would require analyses of each link along the whole value chain at multiple points in time a complex task. Figure 1: Porters 5-Forces Model Market Entry
Proprietary learning curve Economies of scale Capital requirements Brand identity Switching costs Expected retaliation

Proprietary products

Supplier Power
Supplier concentration Importance of volume to supplier Differentiation of inputs Switching costs of firms Threat of forward integration

Firm Rivalry
Industry concentration ratio Fixed costs/Value added Industry growth Intermittent overcapacity Product differences Switching costs Brand identity

Buyer Power
Bargaining leverage Buyer volume Buyer information Brand identity Price sensitivity Product differentiation

Substitutes available

Substitutes
Switching costs of adopters Buyer propensity to substitute Relative price performance of substitutes

We adopt a simpler approach. We will, instead, ground our assessment of an industrys intensity of competition in four distinct quadrants, each indicating a different level of competitive intensity. These quadrants are

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vertical industry structure, transitioning from vertical to horizontal, horizontal industry structure, and transitioning from horizontal to vertical. Vertical Industry Structure In vertical markets competitive advantage comes from economies of scale in fabrication of components; control over delivery, quality, and rates of technical change; reduced vulnerability to holdup by suppliers; and a quicker information flow. Vertical markets have limited direct competition and competitive threats do not exist. However, a trade-off exists, the vertical nature of the market reduces the competition for complementary products and drives slower adoption. Transition from Vertical to Horizontal The transition from a vertical market to a horizontal market increases the competitiveness of the market. Niche competitors provide incentives for firms to give up pieces of production, which increases entry and supplier power. Higher dimensional complexity limits the economy of scale, increases potential vulnerability to holdup, while organizational rigidities decrease the transparency of information. All this increases the pressure to dis-integrate and increases both competition and adoption. Horizontal Industry Structure A horizontal industry is highly competitive. Competitors enter the market freely driving down profits and competing on costs. Firms seek to use their small-differentiated advantage to push other competitors out of the market. As prices drop through price wars adoption accelerates and the market continues to expand from new entrants. Transition from Horizontal to Vertical As adoption slows firms identify technical advantages in one subsystem and gain competitive advantage over their many competitors. This market power encourages bundling with other subsystems to increase control and add more value. Further increases in market power in one subsystem encourage engineering integration with other subsystems to develop proprietary integration solutions. Competition begins to decrease as suppliers are squeezed out of the market and larger firms regain vertical control. In summary, vertical market structure benefits firms who can extract greater rents, decreases competition along the chain and lowers the adoption of the networked product. As we shift to horizontal market structure competition and adoption increase as complementary products increase the benefits that can be realized through standardization and interoperability among
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components. Buyers favor horizontal markets with greater competition while firms favor vertical market structures with competitive advantage and decreased or little to no competition. Architecture and Innovation in Network Markets We have shown above that industry participants bring products and/or services to the market in different competitive environments. Competition, as we have discussed, is based on the current industry structure of either vertical, horizontal, or a transition phase from one to the other. We have shown how value is distributed within each industry structure, however; we have not considered how firms transition between vertical and horizontal industry structure. To do this we need to examine the potential options firms chose for product architecture and how this influences innovation. Firms must manage the competitive threat by moving between vertical and horizontal industry structures. Typically, a vertical industry structure is associated with an integral and closed product architectures. Integral architectures exhibit close coupling among the elements of the product. They typically have components that perform multiple functions, are in close proximity to each other, and usually are tightly synchronized. Firms use intellectual property rights to protect closed systems from competitors who want to either emulate or provide substitutes to a firms integral products or services. This further decreases the competitiveness of the industry and discourages entry. In horizontal industry structures we usually have modular product architectures. Modularity is a particular design structure, in which parameters and tasks are interdependent within units and independent across them. Modularity allows for uncertainty, scalability, and flexibility. It is usually accompanied by an open architecture that allows for separation among a systems parts. The pieces of the system are usually interchangeable, individually upgradeable, and standardized. Modularity and open architectures increase competition and provides positive incentives for entry by new suppliers. We expect a greater frequency of closed architectures within integral products than modular products, and a greater frequency of open architectures within modular products. Yet we must still answer how firms move between the different stages of industry structures and what influences the product architecture within each stage. The dynamics of innovation are helpful in explaining transitions between purely vertical and purely horizontal industry structures. We recognize, after James Utterback, two different forms of innovation: product innovation and
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process innovation. Utterback models product innovation as a function of the lack of universal technical standards and product expectations. The value created through product innovation disrupts the traditional way of doing things. The firm advocating a successful product innovation accrues competitive advantage by virtue of its ownership of a dominant design emerges. Utterback models a process innovation outcome as an increase in value, but characterizes this increase as incremental relative to that borne by product innovations. He targets the manufacturing or delivery processes as likely breeding grounds for process innovations. Of particular importance is Utterbacks theory of interdependence between product and process innovations. He recognizes a decrease in the rate of product innovation in the presence of increasing rates of process innovation. We follow Utterbacks model in accounting for product innovations as disruptive value creators and process innovations as incremental value enhancers. This framework provides insight toward innovation and competitive intensity after Fine, we consider these variables to represent an industrys clockspeed. The type of innovation tells us the amount of change we should expect to see in the industry structure and therefore, the level of change within the competitive environment. In terms of our competitive intensity quadrant framework, we assume product innovations can shift industry structure to one of the four stages we discussed above, while process innovation only moves us incrementally within a particular stage. Utterbacks projection of innovation along the lifecycle of a product or industry allows us to understand how product innovation drives a shift between different types of industry structure. We agree that these innovations are more likely to occur during the early stages of the market, as these stages are frequently characterized by technological uncertainty. Later, as markets mature, process innovations occur as market participants validate and improve upon an incumbent dominant design; the value of quality relative to purchase price becomes the basis of competition. Here innovation plays a minor role, moving us further along an industry stage, but creating value in amounts insufficient to precipitate upheaval within an industrys structure. Clockspeed in Network Markets Fines double helix model illuminates the degree to which periods of vertical and horizontal industry structure determine the fates of products, companies, and industries. Fines model helps participants prepare for shifts
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in industry structure and hedge against the potential losses caused by these shifts. Fine emphasizes the notion of temporary advantage participants must realize that one eras critical capabilities may become commodity capabilities in the next era. Locating a participants offering within Fines double helix (Figure 2.0) is a prerequisite for understanding likely changes forthcoming in industry structure and making optimal preparations for these changes. As we have stated before two drivers of clockspeed are competitive intensity and technological innovation. When the industry structure is vertical, and product architectures integral, the competitive intensity is low. Firms enjoying the rewards of slack competition will eventually confront the potential entry of competitors into niches of their integral architectures. The difficulty of keeping ahead of competition across many dimensions of technology and the organizational complexity of large organizations and complex products will pressure vertical firms to disintegrate, especially in the presence of outsourcing offers from potential suppliers. The acquiescence of vertical firms to these pressures will foster a dynamic of transition, in which the previously vertical firm becomes dependent upon its new suppliers. Continuance of these dynamics results in complete modularity, as participants specialize in the production of horizontally applicable components. These horizontal firms depend on upstream suppliers for factor inputs and on downstream customers to absorb its offerings.

Charles Fines Double Helix Model of Industry Structure and Product Architecture

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Figure 2: Double Helix of Industry Cycling

INTEGRAL PRODUCT VERTICAL INDUSTRY

NICHE COMPETITORS

MODULAR PRODUCT HORIZONTAL INDUSTRY

TECHNICAL ADVANCES

HIGHDIMENSIONAL COMPLEXITY

PRESSURE TO DIS-INTEGRATE

PRESSURE TO INTEGRATE

SUPPLIER MARKET POWER

ORGANIZATIONAL RIGIDITIES

PROPRIETARY SYSTEM PROFITABILITY

Charlie Fines Double Helix of Industry Structure

The double helix, however, leads us to expect an eventual reintegration of the now horizontally oriented industry. For example, product innovations originating in one modular subsystem can deliver the power to integrate in the hands of the innovating firm. This innovation dynamic can be reinforced by further bundling of subsystems, eventually leading to large-scale integration and the reemergence of vertically integrated solutions.

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Section 3: Wireless Value Chain

A Wireless Telecommunications Value Chain Perspective The wireless value chain is an extraordinary environment of competitive dynamics, rapid innovation, and continuous re-alignment. In this section we will attempt to bring insight to its relationship and how we can begin to understand the complex relationships that exist. The discussing will focus on the fundamental principals of value chain analysis and the value it adds to assessing relationships. Then, these principals will be used to project light onto the wireless industries; first as as an overview, and later more specifically the device and infrastructure value chains. We will draw on Michael Porter, Charlie Fine, and our own research to push the concept into a new framework that will allow us to use our map to predict the dynamics of value chain change. Using Value Chain Analysis In 1983s Michael Porter introduced Value Chain Analysis as an assessment tool for businesses that wanted to understand how they should position themselves strategically amongst their suppliers, buyers, and existing/future competitors. He original designed the analysis to examine organizational production and support processes and their contributions towards developing greater competitive advantage. Porter argued that competitive advantage could not be understood simply by looking at a firm as a whole. It stemmed from the many discreet activities a firm performs in designing, producing, marketing, delivering, and supporting its product. Over the years firms have used his framework to help them: Identify the actual activities performed by business units Analyze the value created by these individual activities Examine how linkages and flows to external buyers and suppliers build value as successive processes occur Map the exchanges of flows into and out of the organization Identify activities that are key to success of strategy Understand resource allocations with a view to allocating resources in accordance with the contributions of the task to strategic direction

Performing these function, value chain analysis can then be used to identify and strengthen those activities which most contribute to overall strategy while constraining resources allocated and consumed by tasks less critical.

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It is fair to say that Porters initial framework adds tremendous value to our ability to understand relationships between buyers and suppliers, but as he admits it has its limitations. Porter advises against applying value chain analysis at too high a level in an organization. He argues an industry will contain many different segments which imply the need for different processes and which involve different economic relationships and dynamics. Therefore, Porters value chain analysis works well to assess static relationships between participants, but falls short of letting us understand the dynamics associated with high clockspeed industries that continuously redefine their value chain relationships. Understanding these limitation, we set out to analyze the wireless industry value chain and create a framework that will allow us to formulate these economic relationships and the dynamics that drive changes within both the device and infrastructure value chain. In this section we will present our wireless value chain analysis and a framework for understanding the dynamics of change associated with clockspeed. WIRELESS VALUE CHAIN We have come to see that industries, products, and firms cycle through the double helix shifting from vertical/integral to horizontal/modular and potentially back through the helix. Further, it has become apparent that specific sub-markets or product groups within the overall industry may operate at different clockspeeds; thereby contributing more or less to changes in buyer and sellers behavior. So what does the wireless value chain look like? FIGURE 3: WIRELESS INDUSTRY VALUE CHAIN
Application Application Developers Developers Content Content -Providers -Providers

Network Network Operators Operators Retail VAR Retail VAR

End-User End-User Consumer Consumer

Radio Shack Radio Shack Circuit City Value Chain Exchanges Circuit City
Infrastructure Infrastructure Provider Provider Device Device Manufacturers Manufacturers 20
Information Partnership Cash-flow Exchange

The industry value chain shown in Figure 3.0 is a map of the largest players within the wireless industry. These players make contracts between each other to conduct exchanges. A dotted line indicates the purpose of the relationship is knowledge or learning, while a solid line indicates both an information exchange and a monetary exchange. A description of each value chain segment is discussed in Table 1.0(located at the end of this section) along with the services they provide and the individual value they add to the chain. To summarize the value chain structure End-users bought products and service from Network Operators who operate and maintain the network. Network Operators purchase devices from Device Manufacturers and Infrastructure from Infrastructure Providers. The chain stop here as mobile voice was the only service available. Today additional links are forming, both voice and data services are being offered and new player are entering the value chain to support these niche markets. Application Provider & Content Providers have partnered with Network Operators to design and develop solution for consumers and enterprises. Application Providers are forming information relationships with both infrastructure and device manufactures and may soon provide enough incentives and pressure to open up the closed software architectures of the devices and infrastructure components. Further, as data becomes more feasible for mobile operators and standards become accepted for new applications Content Providers will likely accelerate personalized and customizable. Forces Influencing the Wireless Value Chain So what forces are influencing the value chain today? To help us start this analysis it will help to look at Porters Five Force analysis. This tool allows us to look at supplier power, firm rivalry, buyer power, the effect of substitutes, and the ease or difficulty of market entry. As you can see in Figure 4.0, there are many quantitative and qualitative measures or metrics to consider when assessing the value chain with the Five Force analysis. Projecting this on the Wireless Value Chain and simplifying the analysis

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Figure 4: Wireless Industry 5-Force Analysis

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Network Operator Infrastructure Provider Device Manufacturer Application Provider Content Provider

Market Entry

Entry
Hard Difficult Difficult Easy Easy

Supplier

Power
Network Operator Infrastructure Provider Device Manufacturer Application Provider Content Provider

Pow er
Many Intense Intense Weak Strong

Buyer Power

Competition
Network Operator Infrastructure Provider Device Manufacturer Application Provider Content Provider

Rivalr y
Intense Intense Intense Weak Strong Network Operator Infrastructure Provider Device Manufacturer Application Provider Content Provider

Powe r
Strong Weak Strong Strong Strong

Substitutes
Voice/Data Network Network Components Cell Phones Applications&Cont ent

Numb er
Many Few Many Few

We can measure the forces that each player feels within the value chain. Market Entry is measured either as hard (difficult to enter) or easy (low barriers to entry). Buyer Power is weak, strong, or intense based on their ability to demand products at particular price. Substitutes can be many or few based on the number of potential alternative products or service offered in the market. Supplier Power ranges from weak, to strong, to intense based on suppliers ability to extract additional rents. And finally, Competition is weak, strong, or intense based on rivalry among firms. Does this help us? Overall it gives us an understanding of the types of forces each player within the value chain is feeling.

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Two apparent conclusions can be drawn. First, Network Operators, Device Manufactures, and Infrastructure providers are experiencing tremendous pressures from suppliers and buyers and competition from rivals and substitute products are intense and increasing. Secondly, the newer players, Application Developers and Content Providers are in much less competitive markets, but they are depended on either the buyers to help develop the newer markets or the supplier who control the interface to products these applications operate on. Does this analysis help us understand the size and direction the forces are pushing the value chain participants in? No, the problem stems from the value of the identified limitations of Porters tool, which is good at examining one link between two value chain segments, but falls short of capturing the effects on the overall chain? For further insight we would need to conduct the analysis between each link within the chain. Because the complexity Disturbances Throughout the Value Chain Although in this study we consider all firms acting uniformly, it is important to remember that each firm within a segment can influence the value chain and therefore disrupt the traditional way exchanges occur. Firms within a segment that exchanging cash indicate one of the two segments are a seller and the other is a buyer. These players develop a link either out of necessity, strategic intent, or for learning. The diagram below captures the Applications provide key reason that each wireless value chain participants are linked to the other efficient access to in todays market environment. content
Application Content Application Content Figure 5: Wireless Value Chain Relationship Value Developers Providers Developers Providers Network Operators need

applications to enhance services

Content must meet target

Content sites must develop brand and drive greater accessibility

Infrastruct ure

customer segments needs

Network Network Operators Operators Consumer agrees on service contract VARs sell service contracts End-User End-User Consumer Consumer VARs sell devices as

supports applicatio ns

as middleman

Retail VAR Retail VAR Device must gain Radio Shack network access Radio Shack Infrastructure facilitates network

middleman

Circuit City Circuit City

Users must be able to operate device

management
Infrastructure Infrastructure Provider Provider Air interface compatibility Device 24 Device Manufacturers Manufacturers

In the following sections we will examine two specific value chains, the device value chain and the infrastructure value chain. In these discussions we will highlight the dynamics these chain have experienced in the past and how the forces that make up clockspeed have contributed to these dynamics. We will then conclude the analysis with a look at how these two chains are influencing each other and how firms within different segment of the chain have and will respond. DEVICE VALUE CHAIN As shown in Figure 6 the device value chain contains a number of players. Buyers purchase cell phones from either VARs or Network Operators who in turn buy the phones or devices from manufacturers. These manufacturers then purchase software from application developers, circuit components from Circuit Board Component manufacturers and non-silica products from non-Circuit Board Components Manufactures. A more detailed description of the specific products and companies who produce these products is show in Table 1.0. Appendix A also includes a map of the components within a cell phone and specifies the producing value chain segment. Figure 6: Device Value Chain

Software Radio Vanu Inc. Value Added Re-sellers Value Added Re-sellers Voice and/or Voice and/or Device Data Device Data Manufactures Network Manufactures Network Customers Operators Customers Operators

Non-Circuit Non-Circuit Component Component Manufacturers Manufacturers

Manufacturers Manufacturers

Circuit Board Circuit Board Component Component

Application Application Developers Developers OS & AP OS & AP

Upstrea m EXAMPLE S
Microphone Speaker Battery Dial Pad Case DSP Microprocessor ROM Chips Flash Memory RF Transceiver Operator System WAP iMODE SMS

Downstre am

Cell Phones PDAs Smart Phones SIM Pads Controls LANs

Radio Shack Circuit City Best Buy Sprint Store Verizon Store

Personal use Enterprise use Public services

COMPANI ES
Sharp Phillips NEC Fujitsu Panasonic TI ADI Intel Motorola National S. Aether Systems Microsoft Sun Nokia Motorola Ericsson Siemens Samsung BT, FT, DT Radio Shack Sprint Cingular N/A

25

Over the last decade the device value chain has seen the greatest increase in clockspeed. In 1983 the market for mobile devices was limited to a few player like Motorola, Nokia, and Ericsson who produced the integral devices in a vertical industry structure as shown in Figure 7. Rapid growth of mobile subscribers has stressed the capabilities of different value chain segments. In the early 1990s till 1995 the market for voice enabled cell phones grew at a dramatic rate. As shown on the double helix, a shift began to occur in the industry structure. Vertical/integral Device Manufacturers scrambled to meet production levels between 1992-1993 as both demand and complexity accelerated. This increased the amount of outsourcing and the capacity dependence of these companies. Figure 7: Double Helix of Device Value Chain Dynamics
US Abroad -MotorolaDevices -Ericsson/Nokia/NTT Devices -Massive adoption of handsets -International demand & competition -Outsourcing -Consumer Expectations Devices Increase -Flextronics & EMS -Avg. # of Components 550 to 1999-2001 900 MODULAR PRODUCT HORIZONTAL INDUSTRY -Qualcomm liciences Chip Sets for Phone -Motorola & Others follow TECHNICAL ADVANCES

1980-85
INTEGRAL PRODUCT VERTICAL INDUSTRY Phone Becomes Easy to Carry NICHE COMPETITOR S

1985-1990
HIGHDIMENSIONAL COMPLEXITY

2005E-2010E

Software Radio Emerges PRESSURE TO DIS-INTEGRATE PRESSURE TO INTEGRATE

2001-2002E 2001-2002E
SUPPLIER MARKET POWER -Advances in FeRAM, Encryption, DSP PROPRIETARY SYSTEM PROFITABILITY -Completely modular architecture -Interchangeable components

Complexity of phone increases Avg. # of Components 200 to 550 ORGANIZATIONAL RIGIDITIES

1996-97

-2G Digital Phone -Shift to Messaging and Data

-US 1996 Telecom Act -DSP & Flash Chips accelerate as PC Sales slow

1997-1999

2003E

In 1994 delays of DSP chips and Flash memory translated into a production slow downs and a major shortage of devices to the market. Since this time demand has continued to grow, complexity of the phone architecture has increased, and devices have shrunk in size. The average number of component per phone increased from 250-900 components, size has decreased between 40-60%, and the life-cycle of the phone has moved from 24 months to 17 months. All this has pushed the industry structure out of the vertical loop and into the horizontal loop. The modularity of mobile devices continues today as disparate chips consolidate into single fabs, nonsilica components become transferable, SIM cards allow user to transfer
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personal information between devices, and operating systems open up to application developers. Will the modularity and horizontal segmentation of the mobile device industry continue? The recent pressure from tightening capital markets has forced a number of competitors to continue outsourcing or divest portions of their operations. The answer is it will depend on Network Operators, Application Developers, and Device Manufactures ability to invest, appropriate value, apply pressure, and create incentives between each other. In Section 4 we will examine how value chain participants can evaluate these opportunities. INFRASTRUCTURE VALUE CHAIN The infrastructure value chain contains a number of players. Buyers of voice and data services purchase network access services from Network Operators who in turn purchase switches, gateways, modems and other components from Infrastructure Providers. These manufacturers then purchase Base station components; cell switching components, and PSTN/Internet components from suppliers. A more detailed description of the specific products and companies who produce these products is show in Table 2.0. Appendix B also includes a map of the voice and data mobile network infrastructure. Figure 8: Infrastructure Value Chain
Mercury Computers
PSTN/Internt e Component Manufacturers Cell Switching Component Manufacturers Base Station Component M anufacturers

American Tower
Infrastructure Providers Network Operators Voice and/or Data Customers

Upstre m a
EXAMPLES WAP Server WAP Gateway PSTN Gateway GPRS Gateway Mobile Operators Switch Center Packet Control Unit Base Station Controller Antennas Radio transceiver Channelizer Modem Transmission Interface Base Station Assembly Tower Assembly Switching Optimization

Downstre m a
Voice & Data Service Services & Features Billing Region Users National Users Global Users

COM PANIES Nortel Sun Siemens Motorola Lucent

Nortel Nokia Siemens Ericsson Motorola Lucent

Nortel Nokia Siemens Ericsson Motorola Lucent

Nortel Nokia Motorola Ericsson Siemens Lucent

BT, FT, DT Sprint Cingular Bell South NTT Do Co

Voice & Data

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Unlike the device value chain, the infrastructure value chain has not seen a dramatic increase in clockspeed over the last decade, however, more recently pressures have started to increase and incentives are becoming more attractive as a number of new entrants and existing players pull the value chain towards a horizontal/modular industry structure. Infrastructure Value Chain Dynamics Back in 1983 the market for infrastructure components grew as network operators slowly began to expand their geographic coverage within northern Europe, the U.S. and Japan. Limited in the most part to the same early entrants: Motorola, Nokia, Ericsson and NTT Do Co Mo; networks were developed in test markets and eventually expanded to larger metropolitan areas. Rapid growth of mobile subscribers between 1990 to 1995 began to justify a mass-market approach in wireless as customer demand grew outside the traditional emergency services and elite global enterprise consumer segments. Also during this period the clockspeed of air interface standardization began to speed up. What was once a TDMA and GSM dominated digital platform between 1994-1996 suddenly expanded into 5 major platforms with 8 to 10 popular variations being supported by 15-20 large network operators . The most influential of these was CDMA IS-95, which emerged as the next-generation air interface and promised a lower cost/subscriber. Figure 9: Standard Spider Webs of Influence
Verizon Ericsson WAP AOL

CDMA IS-95

CDMA 2K
CDMA 2K Palm SMS

GSM TDMA

Cingular

Nokia

a
WinCE

Amazon

W-CDMA

cHTML

AIR INTERFACES

Operating System
28

Application Protocol

The creation of new air interface standards had an unusual effect on the wireless industry. What should have resulted in a decrease in clockspeed as we moved away from a single standard actually increased clockspeed. Spider Webs of value chain partnerships and influence networks have been created to push standardization of various platforms. Figure 8 shows strands from Network Operators (Green), Infrastructure/Device Manufactures (Gold), and Content Provider (Purple) pulling on the different standards: air interface, mobile operating system, and mobile application protocols. Infrastructure providers who had developed the interfaces through large investments in R&D now have shifted their investments into creating spider webs of supporters throughout the value chain. Firms have either scattered their bets towards many potential outcomes or have focused their investments trying to push specific outcomes and create mass adoption. Figure 10: Double Helix of Infrastructure Value Chain Dynamics

29

Creation of the First Customers AMPRS AT&T & Baby Bells BT, FT, Vodaphone, NTT
INTEGRAL PRODUCT VERTICAL INDUSTRY

-Network costs focus attention on Spectral Efficiency and Network Optimization -Pressure from Consumer for data services and from device manufacturers to provide faster data rates
MODULAR PRODUCT HORIZONTAL INDUSTRY

1980-90
NICHE COMPETITORS

2001-2003E 2007E-2010E
PRESSURE TO DIS-INTEGRATE

Convergence of Wireline to Wireless IP & 3G

TECHNICAL ADVANCES

1990-1995
-Creation of digital data infrastructure adds complexity -GSM becomes Europes global standard
ORGANIZATIONAL RIGIDITIES HIGHDIMENSIONAL COMPLEXITY PRESSURE TO INTEGRATE

SUPPLIER MARKET POWER

-Clockspeed & complexity of mobile devices increases -CDMA enters the global market -AT&T One-Rate Plan

1995-2001

-Data become packetized PROPRIETARY SYSTEM 3G PROFITABILITY -Base station become modular -Spectral efficiency drives horizontal shift of industry -2.5-3 G Costs, ROI cycle shrinks structure: MUD, Smart to negative NPVs Antennas -IP Standardizing PSTN/Packet

2005-2010E

-US 1996 Telecom Act -Spectrum Auctions $$$$$ -Vender financing growth -Capital markets begin to dry up -American Tower intermediates supply chain taking ownership of B.S. sites

Interface -Demand for data service increases complexity

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More recently, a new set of forces has contributed towards driving the industry structure towards horizontal/modular market. During 2000-2001 over 150 billion dollars has been spent on spectral licenses for next generation 3G services. This along with the drying up of the capital markets has resulted in delays of projected 3G rollouts. This shift in the economy has forced Network Operators to reconsider their investment strategies. No longer can operators hope for a positive NPV over a 5-10 year period. Clockspeed is becoming too fast and resulting in greater complexity, expensive coordination, and insufficient return periods. Network Operators are beginning to pressure Infrastructure Providers to create more flexible, scalable, and updateable systems. No longer with the economics and adoption growth allow for throw away base stations, switches, and gateways. Already we have seen companies like American Tower intermediate the value chain by taking ownership and management of large portions of the base station towers through the U.S.. In Europe competitors are following suit. There are also new entrants Virtual Network Operators like Virgin are beginning to lease spectrum from traditional Network Operators in Europe who are experiencing financial difficulty. As well, other niche suppliers have focused their attention on spectral efficiency. Mercury Computer System is pushing for modularization of the base station. Their goal, is to create a network of wireless networked base stations with embedded adaptive processors. This would allow for continuous updates of the latest optimization and signal processing software. The company boasts its MultiUser Detection (MUD) application can increase capacity and distance of signals by over 60%. This could cut down the number of base stations in a typical area by between 25-40%. Other spectral efficiency providers are marketing additional solutions. Dr. Martin Cooper founded ArrayComm in 1997 and has developed smart antennas that will decrease the amount of inefficient signal transmission by reducing interference. His products also promise dramatic performance increases compared to current technology. In Figure 10, to date we see the double helix of the infrastructure industry has sustained its vertical/integral architecture. Infrastructure Providers have been able to ignore niche competitors and their efforts to increase the spectral efficiency. As we have mentioned, the pressure from a constrained device market weight down the lack of data capacity and service, along with the gigantic costs of moving to 3G services are beginning to shift the industry structure. The recent pressure from tightening capital markets

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Breaking Down Value Chain Dynamics As Fine (1998) discusses in this book Clockspeed relationships between participants change as the clockspeed of the industry speeds up or slows down. When we speak of clockspeed changes we mean a number of things. Internal Clockspeed First, there is internal clockspeed related to a firms capabilities and how these capabilities evolves. Fine describes internal clockspeed as a companys chain of continually evolving capabilitiesthat is, its own capabilities plus the capabilities of everyone it does business with. Firms evolve at different rates, depending in some way on their products clockspeed, process clockspeed, and organization clockspeed. The interesting thing within a firm is these three types of clockspeed can be moving at different speeds and can therefore cause additional stresses on strains on each other. The shift of Ericsson from equipment manufacturer to more of a infrastructure provider highlights the dynamic pressures supply chains can exert on organizations when moving at varying levels of clockspeed. External Clockspeed The second and third aspects of clockspeed are caused by external forces acting outside the firm and have more to do with the industry. The two primary drivers of clockspeed dynamics include technological innovation and competitive intensity. Innovation can be though of as how quickly profits get turned into practical advancements in technology or in a process. These innovations produce giant steps improvements in productivity, capacity, and costs. In the wireless industry we have seen this type of innovation with Qualcomms development of the CDMA air interface, the recent advancements of Multi-user detection and smart antennas by Mercury Computer Systems and Array Comm respectively, and Texas Instruments advancements in digital signal process performance. Competitive Intensity Another external clockspeed we want to consider is competitive intensity among entrants. How easy or difficult is it for firms to enter the market. Last year alone, over 350 startups were backed by venture capitalists in the wireless industry, however many of these companies have gone out of business during the the first quarter of 2001 due to the drying up of capital markets and the delay in -data services over the mobile infrastructure. Bullwip Effect The final external clockspeed influence we will consider is related to consumer demand and less to firms interacting with each other. The
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Bullwhip Effect measures demand volatility at the consumer level and how it translates into successively larger swings going upstream from the Enduser. This force like a lead car breaking in a line of traffic creates a chain effect of responses that results in large and larger volatility throughout the chain. Over the long term this can cause smaller suppliers to go out of business or to be acquired, while survivors try to fortify for the next period of change. Today, in the wireless value chain we see this at the end of the chain where small non-circuit component makers have all but disappeared and the remaining firms are all large conglomerates with the diversification necessary to sustain volatility.

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Table 1.0: Description of Value Chain Segments

Segment
End-User

Role of Player in the Value Chain

Definition: These are either consumers, enterprises, or other individuals who adopt to wireless products and services who want to conduct voice or data transactions Value: End-users although acting independently through their own actions are influenced by each others actions and create increasing returns by creating a critical mass that accelerates adoption of service Definition: Design, build, and operate voice and data mobile networks Ex. AT&T, Sprint, Cingular, British Telecom, NTT Do Co Mo, Services Today: Voice calls local, regional, national, and international Voice services like voice mail, caller ID, call waiting, call forwarding Data services like SMS messages, Text Alerts, Web browsing, text e-mailing, low-level bandwidth for wireless LANs Value: Network Operators compete for customer adoption, retention and loyalty. They form a contract with the adopter to provide a certain quantity of services at a perceived quality. There is also a tacit understanding the N.O. will meet the continual needs of the consumer as she/he comes up te adoption curve of the technology Definition: Although not shown above equipment manufactures used to provide both mobile devices and infrastructure today there are forces splitting these two roles apart Value: Equipment manufacturers provided the necessary R&D, design, and manufacturing capabilities to drive the early adoption of wireless services Definition: They build mobile devices that can conduct voice or data transactions between proprietary networks. Devices include palms, cell phones, SID pads, watch-phones, Ex. Nokia, Motorola, Siemens, Ericsson, Sanyo, Samsung Products & Services: Produce devices dual, and tri-mode cell phones, wireless PDAs, SIM pads, Smart Phones, and watches Communities of developers for WAP, c-HTML and other AP Updateable operating system downloads Formatting of phones and devices for particular network operators Value: Device manufactures add value to consumers by meeting their changing needs for size, quality, appearance, functionality, and synchronicity. They also drive the network operator to increase the functionality of the network and can reduce the infrastructure cost with smart devices Definition: Design, manufacture and assemble switches, gateways, and interfaces to conduct mobile communications among subscribers and the PSTN Ex. Nokia, Motorola, Siemens, Ericsson, NEC, Panasonic Products & Services: Products include base stations, base stations controllers, mobile switching centers, packet control unit, GPRS Support Node, Mobile Operators Packet Switched Data network, Gateways, Wap Servers, PSTN interface and other circuit switch and packet components Value: Infrastructure providers provide the network necessary for consumers to perform voice and now data services. They continue to add increase functionality of the network while lowering costs and increasing performance. They also provide the knowledge of interfacing with the legacy networks Definition: As the operating system on devices are converging toward standards these developers provide the interface between the device and the network hardware Ex. Aether Systems, Microsoft, Apple, SUN, Oracle, NomadIQ Products & Services: Open and closed source operating systems for devices and the network Development and release of wireless applications to support services like WAP, c-HTML, Value: Application Developers are beginning to write efficient programs that help consumer conduct transactions from anywhere and at anytime with there mobile devices. Personalization and synchronicity and becoming the two most important characteristics of applications consumer demand Definition: Compile content into mobile ready formats so applications can immediately extract desired information and package it according to the users request Ex. Apple airport, Jatayu, Apogee Networks, Yahoo, AOL, Air Media Products & Services: Content in formats viewable through cell phones Voice and click services from mobile devices Value: Ability to have personalized information anytime and anywhere to conduct transactions

Network Operators

Equipment Manufacturers

Device Manufacturers

Infrastructure Providers

Application Developers

Content Developers and Enablers

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Section 4 : Wireless Telecom Economic Perspectives

Objective Our objective in this section is to establish a theoretical foundation, based in classical economics, which can lend insight to the development of technological standards in the wireless telecommunications value chain. By gaining insight to the dynamics of standard development, we also hope to enrich our understanding of innovation paths and the basis of competition in the different segments of the wireless value chain. Expected Outcome We expect to achieve a number of intermediary goals in the process of establishing the theoretical foundation mentioned above. First, we expect to identify forces at work in the wireless telecommunications marketplace that affect adoption and investment behavior of entities participating in the wireless value chain. Second, we will provide assessments of existing contributions to the economic literature that explore these forces and their effects upon value chain participants. Finally, we will extend our economic characterization of the wireless value chain into a System Dynamics framework so that the effects of our forces can be understood in a dynamic, industry-specific context. Economic Forces In Play An exhaustive catalogue of the economic forces that act upon participants in the wireless value chain would be just that exhausting and not particularly enlightening. For example, it can be reasonably expected that wireless firms and end-users confront the same downward sloping demand curves and upward sloping supply curves that are presented to participants in any market. Analysis of the wireless value chain that is focused solely along these lines, however, may not yield significant insights, specifically because the wireless industry is not unique in its conformance to traditionally shaped supply and demand curves. It is our aim, therefore, to identify economic forces that characterize the unusual aspects of the wireless telecommunications industry: What about this industry makes it an economic entity different from most others? We present four forces below that contribute to the uniqueness of the wireless telecommunications value chain. We begin by providing a description of each force, and follow these descriptions with analysis and case studies drawn from the economic literature that apply to each force. It is our goal to provide a sound theoretical foundation for a later discussion of optimal behavior by wireless value chain participants in the presence of

35

these forces. We consider first the issue of increasing returns to adoption. Second, we address the significant switching costs that confront wireless value chain participants. Third, we discuss the balance of power between proprietary and public technologies. Finally, we study the power of expectations held by imperfectly informed purchasers within the wireless value chain. Increasing Returns to Adoption In this vein, we note first that participants in the wireless telecommunications industry frequently confront situations that present increasing returns to adoption. This concept is intuitively easy to grasp, but carries significant behavioral implications for participants that find themselves in these situations. Under increasing returns to adoption, an entity i adopting a technology gains relatively more benefit at time of adoption than did entity i-1 at its time of adoption, strictly because entity i-1 has already adopted the technology. It is important to note that the increase in benefit to entity i might not stem necessarily from entity is ability to make better use of the technology than can entity i-1 (it may or may not be able to do so). The critical point here is that entity i joins a subscriber base that is larger than the subscriber base to which entity i-1 joined, and enjoys a larger initial benefit because of the larger installed base present at time of adoption. The applicability of this phenomenon to the market for wireless telecommunications can be envisioned by drawing an analogy to the inception of the first telephone system. The first purchaser of a telephone sometime in the late 19th century found himself with a device that was practically useless, since there were no other telephone users with which he could communicate. The second purchaser, however, derived utility from his ability to communicate with the first purchaser, representing a vastly improved initial benefit to adoption. This analogy admittedly cannot be immediately generalized to the wireless telecommunications value chain. Indeed, the first wireless subscribers accrued stronger benefits from their increased ability to communicate with existing subscribers to the Public Switched Telephone Network (PSTN) than from their newfound ability to communicate with new wireless subscribers. That said, however, it is still reasonable to expect increasing returns to adoption at different points within the wireless value chain. New subscribers to a particular wireless network may be able to communicate more easily or cheaply with existing subscribers of that network than was previously possible. Moreover, later purchasers of a particular base station transmitter
36

(BST) may enjoy greater benefits at adoption than did early purchasers, due to the ability of the existing BSTs to communicate with the BST purchased most recently, as well as their ability to communicate with the existing PSTN. It should be immediately clear from above that participants in the wireless telecommunications value chain must operate in an environment characterized by these patterns of returns. A thorough understanding of the power of increasing returns to adoption, as well as their behavioral implications for wireless value chain participants will be explored in further sections of our analysis. Significant Switching Costs Participants in the wireless telecommunications value chain also frequently confront choices between adopting a new technology and continuing to make do with existing technologies. Above we explained that the merits of a new technology might hold the promise of increasing returns to adoption. It is also important, however, to consider the costs incurred when switching to a new technology from one already installed. As is the case with increasing patterns of returns, the concept of switching costs is not intuitively difficult to grasp. Successful management of switching costs, however, requires a level of understanding along dimensions independent from the lessons of increasing returns. Switching costs find their genesis in relationship-specific assets held by a customer or a vendor that meet on a repeated basis in a marketplace. A customer, for example, may invest non-transferable resources in learning to use a suppliers product. To a greater extreme, customers may purchase products that work only in concert with an existing suppliers products. Finally, searches for suitable suppliers, and the establishment of relationships with those suppliers, always carry transactions costs. There is much anecdotal evidence supporting the existence of switching costs within the wireless telecommunications value chain. Many of our experiences, as individual end-users, add to this evidence; consider the investments of time that we make in learning to dial telephone numbers quickly with our Nokia mobile phones, or in learning to reliably enter Graffiti into our Palm OS personal digital assistant (PDA). These investments may not be transferable as we later purchase a Siemens phone, or a Windows CE PDA: we incur switching costs by forcing ourselves to learn new routines specific to the replacement devices. Upstream participants in the wireless value chain also confront switching costs in making investment decisions. A device manufacturer may need to
37

adjust the features of its devices when it changes suppliers of the software that runs upon those devices. A network operator may find that its existing network optimization software is incompatible with its new set of base stations, and incur switching costs in the effort to retool its optimization software. Switching costs cannot be ignored when exploring the development of technological standards within the wireless telecommunications value chain. It can be expected that nominally large switching costs may slow, or even halt, the rate of adoption of new technologies. Participants may find themselves locked in to an existing standard, without a profitable alternative. Advocates of emerging technologies might find standardization difficult to achieve. We will explore the conditions under which these dynamics are strongest, and the resulting lessons for participants in different segments of the wireless value chain, in further sections of the paper. Architecture Access Considerations A third issue at play in the wireless value chain to which classical economics can lend insight is the balance of power between proprietary and public domain architectures. Participants in the wireless value chain are not forced to choose between open and closed technologies on a daily basis. Indeed, the relative infrequency with which these choices are made, coupled with the presence of formidable switching costs once a choice is made, speaks to the importance of understanding the strategic implications of choices between proprietary and public architectures. The distinction between open and closed technologies arises as one considers the amount of intangible intellectual property bundled into a good or service. A firm may invest intellectual capital in the development of a technology, and subsequently find its investment rendered worthless as competitors cheaply copy and market the technology. It is a natural reaction for a firm to protect its investment by closing the architecture through patents or copyrights. Alternatively, firms may elect to pool intellectual resources toward the collaborative development of a technology that can be used and improved upon by the public at will. Stark contrasts between open and closed technologies can be found within broad reaches of the wireless value chain. For example, the choice of air interface the means of communication between a wireless device and a network impacts device manufacturers, network operators, and application developers. A number of these air interfaces exist, many of which, individually, are incompatible with other air interfaces. Interestingly, the air interfaces existing today span the continuum from those with access rights

38

monopolized by a single supplier to those with access rights governed by industry consortia. The importance of the air interface choice, by itself, mandates the careful consideration of the different impacts exerted by open and closed technologies. Moreover, it is reasonable to expect differences in lifecycles between technologies that are proprietary and those that are public. Further, we must consider that the possibility of technology licensing might affect the rate of innovation within the wireless value chain. We will explore these issues in following sections, as well as highlight other instances within the wireless value chain in which participants may confront the choice between open and closed architectures. Powerful and Imperfect Expectations We cite the power of imperfectly informed purchasers, and the expectations held by those purchasers, as final economic considerations for participants in the wireless value chain. Imperfectly informed purchasers in any market create friction, as uninformed buyers may choose sub-optimal products or pay sub-optimal prices. Furthermore, it is reasonable to expect that these frictions might be exacerbated by the expectations held by imperfectly informed purchasers. Is it possible that a sub-optimal technology can become a standard if imperfectly informed purchasers expect it to become a standard? The rapid rates of change seen in the elements of wireless telecommunications technology lead us to expect asymmetric information within any group of purchasers; some purchasers may simply be better than others at assessing the merits of different technologies recently brought to market. Moreover, we recognize attempts at expectation management on the part of participants in the wireless value chain. Device manufacturers pre-announce products at trade shows in an effort to signal staying power and their capability to innovate. If purchaser expectations are powerful, the firm that manages to present the best stream of future products might be the firm that manages to capture the greatest share of next period sales. Since information asymmetries create opportunities for sellers to earn abnormal profits, it becomes important to understand the ways in which wireless value chain participants can manage these asymmetries within their customer bases. Additionally, as expectations held by participants yet to adopt a technology begin to affect adoption decisions, it becomes important to understand the ways in which these expectations can be influenced.

39

Insights From the Economic Literature Increasing Returns to Adoption We discussed above the intuition behind increasing returns to adoption and pointed to the applicability of increasing returns to the wireless telecommunications industry. It is our objective in this section to develop a more formal presentation of increasing returns to adoption. We will draw upon this formalization in our modeling of relationships between buyers and sellers within the wireless telecommunications value chain. Much of the economic literature dealing with increasing returns to adoption focuses on allocation outcomes. Contributions to the literature frequently explore the conditions under which an inferior technology can capture a market under conditions of increasing returns given a fortuitous streak of adopters partial to the inferior technology. David1, for example, does so in explaining the persistence of QWERTY keyboards relative to alternatives thought to be technologically superior. Arthur2 presents a technological-choice framework that models the effect of different adoption returns patterns. First, Arthur imagines agents choosing between two technologies. Agents in Arthurs model possess a priori preferences for one of the two technologies. An agents return from adopting a technology is also affected by the number of people that have already adopted that technology (the installed base). Increases or reductions in returns to adoptions are included with a multiplicative term applied to the installed base. An agents complete return function from adoption of technology R is
R = aR + rR * kR .

This conception of an agents return function is appealing in a number of ways for our modeling purposes. First, the terms of this returns function can be easily considered from a wireless telecommunications perspective. Existing wireless networks are excellent examples of installed bases from which different returns patterns can emerge. Moreover, the stand-alone term accomplishes a necessary accounting for adoption returns not derived directly from the size of an installed base. People purchasing electronic organizers that can communicate wirelessly with other electronic organizers

David, Paul A. Clio and the Economics of QWERTY. American Economic Review 75, no. 2 (May 1985): 332-337. 2 Arthur, W. Brian. Competing Technologies, Increasing Returns, and Lock-in by Historical Events. Economic Journal 99 (March 1989): 116-131.

40

provide an excellent example of adopters who gain benefits that are both dependent upon and independent of installed base size. Arthur also establishes a return function from adoption of technology S
S = aS + rS * kS .

Agents choose technologies by comparing their returns function from adoption of technology R with that from adoption of technology S. The models dynamics emerge as agents arrive in the market at different points in time, with different levels of a priori preferences between technologies R and S, and confront differently sized installed bases of the two technologies. It can be reasoned from above that technologies delivering strong increasing returns to adoption have a greater likelihood of overriding an agents possible existing preference for another technology than do technologies delivering constant or diminishing returns to adoption. Further, we can conclude that the outcome of a competition between two technologies, both offering increasing returns, can be influenced by one technology quickly accumulating a sizable installed base. We can also better understand speed of adoption by considering differences in returns patterns. Assume that an agent makes an adoption decision only when the returns to be gained from adoption of a technology exceed that agents reservation price. Under this assumption an agent chooses not only between technologies R and S, but also between those technologies and non-participation in the market. If we assume further that markets are comprised of agents, each with different and discrete reservation prices, we witness a more rapid rate of adoption in the presence of increasing returns to adoption than in the presence of constant or diminishing returns to adoption. Increasing returns to adoption result in faster growth in returns at any level of installed base than do constant or diminishing returns. This faster growth in returns yields a quicker eclipse of potential adopters reservation prices by those returns, and higher numbers of adoptions occurring early in a technologys lifecycle. We will draw upon many elements of this theoretical foundation in further sections of our paper. We will show that returns functions similar to those proposed by Arthur can be robustly applied within a System Dynamics model. We will use this model to explore how the behavioral implications of increasing returns theory can be observed in practice within the wireless telecommunications value chain.

41

Significant Switching Costs Participants in the wireless value chain are also affected by the extent to which they incur switching costs when dissolving or forming relationships with other value chain participants. We explained above that switching costs arise in the presence of both tangible and intangible relationship-specific assets. In this section, we will develop a more formal understanding of the effect exerted by switching costs upon relationships in the wireless value chain. We will also point toward the integration of switching costs into our efforts to model these relationships. The effect of switching costs on competition has been explored frequently in the economic literature. Farrell and Shapiro3 begin with an assumption advocated frequently in the popular business press that switching costs create barriers to entry by facilitating lock-in to incumbent suppliers of products and services. They explore the conditions under which this assumption is valid and the resultant effects upon competition. Their analysis allows us to draw conclusions about the frequency of firm entry and to better understand the investment incentives presented to participants in the wireless value chain. Farrell and Shapiro construct a model with infinitely many time periods and two competing firms. In each period, an identical number of consumers enter the market, each with identical preferences, and makes an adoption decision. Each of these consumers lives for two periods, so in any period the market contains a group of newly participating consumers and a group of existing consumers. Farrell and Shapiros analysis turns on two additional assumptions. First, they assert that existing consumers confront a switching cost if they choose, in the second period, to adopt the product of a different firm. Farrell and Shapiro cite similar sources of switching costs as we mention above. Second, they assume that firms cannot perfectly price discriminate between existing customers and new customers. Under these assumptions, Farrell and Shapiro identify an alternating tendency in the marketplace. They reason that a firm with an installed base prefers to extract profits from its existing customers (proportional to their customers collective switching costs), rather than drop its prices to a level attractive to new customers. Furthermore, they conclude that a firm without
3

Farrell, Joseph and Carl Shapiro. Dynamic Competition with Switching Costs. RAND Journal of Economics 19 (Spring 1988): 123-137.

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an installed base will prefer to attract new customers with an intermediate price, rather than attracting all customers with a low price that offsets the switching costs borne by the customers already participating. The basis of Farrell and Shapiros competitive framework is similar to that found within many segments of the wireless telecommunications value chain. We mentioned in a previous section the fact that participants in some chain segments confront significant switching costs. In addition, we agree with Farrell and Shapiros concept of supplier oligopoly. We observe a number of oligopolistic tendencies within the wireless value chain, exhibited by consolidation of supply within some chain segments, high intellectual (and occasionally regulatory) barriers to entry, and examples of market power in pricing and value capture. Farrell and Shapiros analysis lends valuable insight to our existing framework. For example, they conclude that supplier profits increase as a function of customer switching costs. Recall that, within our model, customers adopt when their perceived value from adoption exceeds their willingness to pay. We reason that rates of adoption will slow as switching costs increase, since higher expected supplier profits reduce expected consumer value ceteris paribus. Furthermore, we consider the rate of entry into a market by new firms to partially define the degree of turbulence within that markets value chain. <Must back this up with some evidence from the value chain. > Farrell and Shapiro argue that entry by new suppliers is facilitated by high switching costs and by poor supplier price discrimination capabilities. Accounting for these dynamics within our modeling allows us to isolate the tradeoff faced by suppliers between extracting value from an installed base and providing upstart firms with a foothold for entry. We recognize also that the wireless telecommunications industry is growing rapidly. Farrell and Shapiro address this issue by incorporating a growth multiplier to each successive infusion of new customers. They assert that market growth makes new customers more valuable relative to an installed base and conclude that supplier profits increase proportionally with market growth. They support this conclusion with reasoning that, given growth, suppliers without installed bases will be less inclined to provide existing customers with price incentives to offset switching costs. Farrell and Shapiro reason that this dynamic allows incumbent suppliers to extract abnormally high prices from existing customers. We draw additional support here from Farrell and Shapiro to the extent that their market growth conclusion addresses the tradeoff faced by a supplier
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between exploitation of an installed base and value creation through adoption. We reason from Arthurs model of returns that unattached buyers become relatively more valuable when market growth is combined with increasing returns to adoption. This compels us to consider the possibility that Farrell and Shapiros competition-easing market growth dynamic might be more than offset by price cuts in an effort to win large numbers of valuable unattached buyers. In summary, we find Farrell and Shapiros work on switching costs useful in a number of ways. Their models assumption of a buyer/seller relationship closely fits the structure of many links between segments of the wireless telecommunications value chain. In addition, the competitive dynamics that they identify with respect to firm entry and market growth can be captured closely within our modeling framework. Finally, the boundaries of their conclusions can be extended to facilitate interaction with our other economic forces. Our System Dynamics modeling attempts to capture these theoretical interactions. Architecture Access Considerations The theoretical literature dealing with innovation, architecture access and intellectual property appropriability issues is enormous. Moreover, directions of research have not converged to the same degree we witness in the disciplines discussed above of increasing returns and switching costs, nor does it apply as cleanly to our analysis of the wireless telecommunications value chain. One branch of research that appeals to us is that dealing with the relationship between licensing of proprietary intellectual property, market structure, and rates of innovation. Writers in this area frame firm behavior along the dimensions of research and licensing of intellectual property, and draw conclusions about supplier concentration, profitability, and continuity of technological advance. Schumpeter4 characterizes competitive firms as undertaking non-cooperative research and development actions in the pursuit of marketable technological advances. We mentioned above our conception of the open/closed architecture decision as a continuum; in these terms, Schumpeters characterization imagines the basis of competition firmly at the closed end of the continuum. Subsequent contributions to the literature explore the circumstances under which firms can profitably move toward the open end of the continuum. Many contributions explore the merit of technology licensing

Schumpeter, Joseph. Capitalism, Socialism and Democracy, 2nd edition. London: Allen & Unwin, 1947. 44

as a lever to achieve these increases in technology openness and profitability. Shepard5 begins by assuming that customers in a market can contract with supplier only on price. Customers have public access to this price, and contract with suppliers to purchase quantities at published prices. A suppliers level of service cannot be contracted, and service quality can be observed only after a pricing agreement is reached and delivery started. Shepard uses this foundation to identify a suppliers incentive, in the presence of a purchase agreement, to provide sub-optimal quality: the supplier has in hand a contract to provide a specified quantity at a specified price, but must decide upon a level of expenditure in delivering a quality level of the specified quantity. A profit-maximizing monopolist will reduce cost by reducing quality, while still maintaining contractual obligations related to price and quantity. Shepard asserts that rational customers will recognize this tendency, thereby eliminating a monopolist suppliers credible commitment to quality. Shepard points toward the concept of technology licensing as a means of increasing an industrys profits and a technology developers profit (in the presence of contractual side payments). The presence of a licensed second supplier enables both suppliers to credibly commit to a high level of quality. These credible quality commitments result in increased demand from customers at any given price and increased industry profits relative to a monopoly. The technology developers profit can increase both through this demand increase and through the proper calibration of licensing fees to its competitor. This line of thinking resonates strongly when used to observe behaviors and dynamics within the wireless value chain. First, we expect relationships between many buyers and sellers in the wireless value chain to exhibit the quality commitment problem described above. The ongoing migration from circuit-switched to packet-switched wireless telecommunications is an example supplier firms cannot presently commit to same level of packet service as can be committed in circuit service. We expect rates of adoption and willingness to pay to increase as technology licensing allows a number of value chain participants to compete along the quality of service dimension.

Shepard, Andrea. Licensing to Enhance Demand for New Technologies. RAND Journal of Economics 18, No. 3 (Autumn 1987): 360-368. 45

Gallini and Winter6 also acknowledge the importance of the licensing mechanism. They analyze licensing strategies within a framework of interfirm cost differentials, in examining patterns of innovation and firm behavior in the presence of licensing opportunities. Gallini and Winter ground their discussion upon Schumpeters assumption of non-cooperative research and development efforts among competing firms. They also allow for differences in cost between firms, to the extent that some firms incur higher research and production costs than others for a given level of output. In light of these cost differentials, Gallini and Winter propose an incentive for firms to enter into licensing agreements. They show that licensing offers positive profit opportunities to high cost firms by facilitating the replacement of relatively inefficient means of product or service delivery. On the other hand, low cost producers (the intellectual property holders) gain rents by selling enabling technology licenses into the pool of high cost firms. Gallini and Winter identify the latter component of this incentive as the primary driver of competition in innovation: firms recognize the potential of positive rents from licensing, and strive to develop technologies that can be licensed to other firms. Gallini and Winter also point toward a more strategic incentive precipitated by the feasibility of licensing agreements. They expect that high cost firms, upon confronting a technological frontier, may wish to license from a lower cost firm a technology that facilitates the achievement of that frontier. This licensing allows these high cost firms to participate in the market while avoiding potentially wasteful research expenditures. Low cost firms gain an advantage by discouraging research within high cost firms that might have led to the development of superior technologies. Gallini and Winter, like Shepard, acknowledge the incentive of low cost firms to license, since licensing facilitates increased demand for products and provides for incremental licensing revenues. Gallini and Winter, however, highlight a tension within the licensing incentives faced by high cost firms: in some cases, high cost firms wish to undertake research themselves, and in others they prefer to pay for a competitors better technology. Each of these findings is helpful as we model the dynamics within the wireless telecommunications value chain. Innovation paths along the air interface and device manufacturing dimensions have been determined to a great extent by companies who succeed in developing better methods of service and product delivery. We pointed above to the trend of outsourcing
6

Gallini, Nancy and Ralph Winter. Licensing in the Theory of Innovation. RAND Journal of Economics 16, No. 2 (Summer 1985): 237-252.

46

device manufacture; companies who earlier manufactured mobile devices inhouse have begun licensing a low cost method of delivery from contract manufacturers. Similarly, companies who earlier delivered service over analog air interfaces now license more efficient and secure digital air interfaces from companies holding property rights to these digital air interfaces. Many value chain participants fortunes will be affected by the timing with which high-bandwidth connections are delivered to the users of mobile devices. In light of the framework proposed by Gallini and Winter, it is reasonable to expect the speed at which innovation occurs to be determined by the licensing decisions made by high cost firms. Indeed, some sources within the value chain7, and within the business press,8 accept a hypothesized high-bandwidth migration path in which the present licensors of air interface technologies sustain their advantage, and license next-generation air interfaces to firms with higher costs of air interface development. A decision to pursue air interface development on the part of firms with high costs would lead to an acceleration of innovation, as incumbents and entrants alike confront Gallini and Winters incentive of incremental licensing revenues, and Shepards incentive of increased industry profits. In summary, we find the licensing incentives proposed by Shepard, Gallini, and Winter, useful in framing firm behavior with respect to present and future elements of intellectual property. We witness the commitment problem faced by monopolistic participants in the wireless telecommunications value, and account for it within our System Dynamics model by allowing intellectual property licensing and firm entry to affect adoption rates and industry value creation. Similarly, we acknowledge the in-house/out-source innovation tradeoff faced by high cost participants, and account for it by modeling the rate of industry innovation as a function of these participants licensing decisions. Powerful and Imperfect Expectations Some models within the realm of economics and finance rely upon the assumption of perfect information for tractability. The efficient markets hypothesis, for example, gains validity only as market participants share perfect information about the value of goods or services within that market.

Interview with Dr. Florian Seiche, VP Mobile Devices, Siemens ICM North America, 6 March 2001. 8 <Need business press citation, shouldnt be tough. > 47

It is not our intention to criticize the value of models incorporating this assumption of perfect information. We are, however, skeptical that the condition of perfect information holds within markets characterized by rapid rates of technological innovation and high intellectual barriers to entry, as is the wireless telecommunications industry. We are simply not sure that participants within the wireless value chain have perfect, independently developed conceptions of the value of goods and services offered by other participants. We turn to the literature exploring the effects of imperfect information in an attempt to account for this uncertainty in our analysis. Smith and Nagle9 discuss the means by which customer expectations of value can affect purchase decisions. They advocate a definition of value as the perceived worth of benefits received after purchase in exchange for the price paid upon purchase. They explore the degrees to which a supplier firm can change the relationship between what customers perceive as a purchase price and what customers perceive as the follow-on benefits. Smith and Nagle cite a number of levers that resonate with our understanding of customer adoption and supplier marketing tactics within the wireless telecommunications industry. First, Smith and Nagle emphasize the importance of properly aligning an offerings positioning in marketing terms with a consumers perceived consequences of the decision to buy or postpone. For example, they cite consumer durable goods as purchases that enhance a customers utility, and show that successful firms will position those goods in a positive light. They incorporate, as counterexamples, purchases that address possible losses of utility, such as insurance policies or medicine. They show that successful firms position these offerings in a negative light, by emphasizing the utility loss that may result if a purchase is not made. We recognize practical applications of both these dynamics within the wireless telecommunications industry, in manners that reconcile with Smith and Nagles identification of tactics used by successful participants. Large network operators marketing primarily to the broad consumer market frequently invoke, in their product positioning efforts, the incremental benefits provided by a wireless connection to the voice telecommunications network. Conversely, the dominant network operators marketing primarily to a targeted market of business users invoke the loss of utility that might occur if their offerings are not adopted.10
9

Smith, Gerald and Thomas Nagle. Frames of Reference and Buyers Perception of Price and Value. California Management Review 38, no. 1 (Fall 1995): 98-116. 10 Cingular Wireless, We believe that, given a chance, human expression can change the world as a positively framed consumer market appeal. Nextel Communications, Office EMail: For when you cant connect as a negatively framed business market appeal. 48

In addition, Smith and Nagle discuss the value of establishing an appropriate reference price when marketing products to customers. They describe, for example, the positive effect of product-line pricing upon purchase price transfers from customers to suppliers upon adoption. They agree with empirical research showing that customers tend to select an offering N with greater frequency when N is framed by a higher-priced offering P and a lower-priced offering M, than when N is framed only by the lower-priced offering M. They cite a number of examples of consumer goods whose adoption has been supported by this tendency of perception. We find practical applications of this strategy within the wireless value chain as well. Network operators, for example, customarily offer customers the choice of multiple calling plans, with positively scaled usage allowances and pricing schemes. We recognize the value of this strategy from the standpoints of network capacity utilization and microeconomic price discrimination, but also recognize it as a viable means of presenting a frame of reference that incites a degree of self-upsell on the part of customers. In summary, we agree with Smith and Nagles characterization of value as the difference between an expected stream of benefits after purchase and the perceived price paid at purchase. We expect that the dynamics of buyer/supplier relationships within the wireless telecommunications value chain will be significantly affected by the degree to which suppliers can manage both the customers expectations of benefits and the customers perception of price. The strategic implications of Smith and Nagles work, unfortunately, are difficult to model in a concise System Dynamics framework. We do hope, however, that the resonance of these strategies is not lost in the absence of System Dynamics insight. It is clear that participant firms should not neglect the value of levers such as reference pricing and the framing of decision consequences when attempting to influence the dynamics of their value chain relationships.

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Section 5: System Dynamics--Unifying V.C. and Economics

The System Dynamics Methodology At a broad level of interpretation, System Dynamics helps us understand how all of the objects or entities in a system interact with one another. The means by which System Dynamics facilitates this understanding are varied, as we will explain. The outcomes of any successful System Dynamics modeling effort, however, are the formalization of ones mental models of a system and the transformation of those incomplete mental models into systematic understanding. We mentioned above that there are a variety of tools available to someone wishing to enhance understanding through System Dynamics. Causal loop diagrams are often of great use and require only minimal complexity. These diagrams consist of variables linked by arrows indicating positive or inverse causality. The arrangement of positive and inverse causality links within a loop help classify the loop as reinforcing or balancing. The compounding of interest in a bank account exemplifies a reinforcing loop: any given deposit of interest into the bank account means, ceteris paribus, that a greater amount of interest will be paid in the next period of time. Causal loop diagrams are often helpful as a first step in formalizing ones understanding of the relationships within a system. They do not, however, yield the quantitative power or the analytical refinement offered by stock and rate models within a System Dynamics computer-modeling package. The benefits come at a price, however, as we are required to create increasingly complex modeling formulations to achieve quantitatively meaningful results. One of these more complex formulations rests on the distinction between stock variables and rate variables. A stock variable represents a level within a system. In our example above, one might consider the bank account balance to be a stock. A rate variable, however, represents a rate of change within a system. The amount of interest that is paid per month into the bank account corresponds to a rate variable in our example. The distinction between stocks and rates is simple, but not trivial. It follows from above that stock variables cannot change by themselves. An account balance does not grow unless some rate of interest payment (or other deposit) provides inflow to that account. But stocks, while subject to the controlling influence of rate variables, are still important. Consider the emphasis placed on balance sheet analysis within financial communities

50

this emphasis focuses squarely on the stocks of assets and liabilities within firms. A complete system dynamics representation, then, includes stock variables and rate variables as appropriate. It also includes auxiliary variables that help determine changes in rates over time. The paper-and-pencil representation of a system is often helpful; for example, we can trace the directional effect of changes in one variable throughout the rest of a system. Computer software packages allow us to support our modeling with mathematically robust formulations of the relationships between variables. It is these formulations that offer the appealing prospect of quantitative insight. System Dynamics Application Strategy Modeling Goals Our System Dynamics modeling efforts are rooted in our desire to analytically link our analysis of the wireless telecommunications value chain with our analysis of the economic forces that make the wireless telecommunications industry unique. Our motivations here are illuminated by a review of the approach taken toward achieving the goals of our research. We began this paper by exploring wireless value chain dynamics. We then, briefly, identified a path of intermediate variables, such as profits and investment incentives. These intermediate variables led us from observable value chain dynamics to a set of economic forces that might drive these dynamics. A System Dynamics model offers us the ability to link these three components together: we can account for our economic forces and our intermediate variables in developing a representation of wireless value chain dynamics. Wireless Telecommunications Modeling Methodology The complexity of the wireless value chain is immediately clear upon inspection of our value chain maps above. The wireless value chain is comprised of many types of participants, among these network operators, application developers, and device manufacturers. In addition, the flow of material and information represents less of a chain than a web: device manufacturers must maintain relationships with multiple participants both upstream and downstream. This level of complexity indicates that a degree of abstraction may be helpful in developing a System Dynamics model. We achieve this abstraction by focusing on the relationship between a collection of buyers and suppliers within the wireless telecommunications

51

value chain. This relationship, for example, could represent the exchanges of value between all of the network operators in the market and all of the end-user consumers in the market. This, indeed, represents a considerable abstraction, and it is worthwhile to explain two dimensions of this abstraction in particular. First, our buyer/seller relationship focus represents an abstraction to the extent that the wireless value chain is actually an enormous collection of these relationships. The collection of network operators that sells to the collection of end-users is, in turn, a customer of the collection of device manufacturers and the collection of infrastructure providers. Our buyer/seller relationship focus allows us to capture only one of these relationships at a time. This abstraction, however, does not preclude us from gaining insight toward value chain dynamics. Our model, for example, allows for entry by new competitors, accounts for a firms incentives to invest in integration and modularity, and addresses the rate of innovation within a selected buyer/seller relationship. We proceeded with this abstraction because we consider relationships between buyers and sellers to be the fundamental building blocks of a value chain. This abstraction also allows us to maintain clarity of analysis we can more easily trace the effects exerted by economic forces upon value chain dynamics if we concern ourselves with only one segment of the value chain at a time. We make a second abstraction by considering the sellers within a market as an aggregated cohort, and all buyers within that market as a separate aggregated cohort. It is obvious, upon observation, that markets in actuality are comprised of many different sellers and buyers, each of which can be differentiated along multiple dimensions. This endless potential for differentiability motivates us to consider the composition of these cohort groups in abstraction it is simply not possible to capture all aspects of participant differentiation in a concise System Dynamics context. This level of abstraction does not preclude us from achieving a realistic representation of the effects exerted by our economic forces upon value chain dynamics. It may be helpful here to consider the average participant: if, for example, a market exhibits significant switching costs, our economic analysis indicates that the average customer will exhibit hesitation when entering that market. It is true that some customers may hesitate more than others, however, the isolation of an average, directional tendency

52

is useful. In the example above, our aggregation abstraction helps suppliers identify an optimal response to their customers hesitance to adopt. We were again motivated by a desire for simplicity and clarity in including this abstraction. We are interested primarily in using classical economics to study value chain dynamics, and this abstraction does not prevent us from doing so. Model Building Blocks System Dynamics veterans will be familiar with our model building technique: we construct a basic causal loop for each identifiable dynamic (in our case, for each economic force), and work from there to link the loops together. Network Benefits Causal Loop We begin by modeling increasing returns to adoption. We begin at the top right corner of the Network Benefits causal loop diagram shown Adoption at left. Proceeding counter-clockwise + around the loop, we see that a buyers Adoption of a sellers offering increases the Market Penetration of that offering. We quickly arrive at the essence of increasing returns to adoption: as Market Penetration increases, so does the Value per user Total expected due to benefit to a new network effects. Increasing adopter + returns theory states that the next adopter confronts a more valuable network simply because the network is made bigger by the most recent adopter. We model this effect with increases in Total expected benefit to a new adopter. Market Saturation Causal Loop But we must balance the effects of increasing adoption returns with that of a traditional downwardsloping demand curve. We expect that early adopters of an offering are likely to be those who have the
53

+ Market Penetration

Network Benefits R

+ to network effects Willingness to pay Value per user due

Market Saturation B

+ Market Penetration

+ Adoption +

Network Benefits R + Value per user due to network effects Total expected benefit to a new adopter +

highest willingness and ability to pay. Later adopters (representing higher quantities in the traditional supply/demand framework) may either not wish to pay as much for an offering, or may not be able to pay as much for an offering. The benefits of increasing returns, although growing over the entire range of potential adopters, must overcome an increasingly high reservation price hurdle. We model the effect of a downward-sloping demand curve by attaching a second causal loop, Market Saturation, to the Network Benefits loop described above. Adoption increases Market Penetration as above. Increases in Market Penetration, however, also cause decreases in Willingness to pay. The effects of this loop balance the reinforcing effects of our Network Benefits loop. We showed above that the presence of switching costs could both facilitate the extraction of value from an installed base by a supplier and slow rates of adoption by unattached buyers. We include in our model separate causal loops to represent each of these dynamics. Installed Base Causal Loop As we consider the Installed Base Revenue loop, we begin again with the Adoption variable. While Adoption is not an integral part of this loop, it does help us get started conceptually. Increases in Adoption result in increased Revenue for the supplier in a market relationship. We expect this increased Revenue to result in higher Total Investment by the supplier. This dynamic can be witnessed in two ways. Revenue, for example, + Total Total Revenue provides the cash resources that are Investment + needed for further investment. Revenues can also be thought of as providing incentives to invest a Installed Base Revenue suppliers interest in replicating past Adoption successes will likely drive increased R investment as a follow-on to increases in revenue. +
+ We expect increased Total Investment to cause increases in Total Value investments by created by investments. This dynamic is best thought of as capturing a tendency some investments create more value than others, but most investments create at least some value. This increase in Total Value created by investments results in an increase in Switching Costs, as suppliers try to capture a share of the value created by their investments. Switching Costs Total Value created

54

Slowed Adoption Causal Loop We must also create a representation for our expectation that the presence of switching costs will slow the rate of adoption by unattached buyers. We can do so by making a simple addition to the Installed Base Revenue loop described above. We create a second loop, called Slowed Adoption, by adding a variable called Total expected benefit to a new + + adopter. This variables Adoption Total Total R e v e nue I nv e stm e nt value will be reduced by + increases in Switching Costs. This makes sense S low ed In s ta lled B as e within our analytic A d op tion R e ve n u e framework: customers R B yet to adopt will likely have at least some + informationd about ex post switching costs. Increases in Switching Costs, To tal e x p e cte Sw itching C o sts be ne fit to a ne w Total Value therefore, can be expected to+ result in reduced cre ate d of Adoption by first rates adopte r by inv e stm e nts reducing the Total expected benefit to a new adopter. We must consider another effect of supplier investment in a market. We have modeled thus far the increases in installed base revenue that result from wise investment. We have also modeled the correlated slowdown in adoption that results from perceived increases in supplier value extraction. We also recognize, however, that it is possible for a supplier to speed adoption through investment.

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Perceived Value Increase Causal Loop

56

57

We account for this effect with the addition of a final variable that creates our final modular causal loop, called Total Revenue + Perceived Value Increase. We add a variable called Users + Perceived Value of adopting, Perceived Total and model it as an increasing Value Increase Investment Adoption function of the Total Value + R created by investments. Put differently, suppliers making + investments in improved products, for example, can User's Perceived Total Value created Value of adopting by investments expect buyers to base their + adoption decisions upon the increased value promised by those products. Increases in Users Perceived Value of adopting carry through to increases in Adoption, as consumers willingness to pay hurdles become more easily cleared by virtue of the improved products brought to market by suppliers. The value delivered by System Dynamics is made clear as we integrate our causal loops, described separately above, into a coherent representation of a buyer/seller relationship within the wireless telecommunications industry. We can trace the effects of an increase in Market Penetration, for example, throughout the extent of the system, understanding how that increase might affect Switching Costs, or Total Investment by suppliers. Further insight can be gained, however, by improving the models level of resolution and by augmenting its quantitative capabilities.

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Willingness to pay Market Saturation B

+ Market Penetration

+ Adoption +

+ Total Revenue

Total Investment

Network Benefits R + Value per user due to network effects Total expected benefit to a new adopter + + -

Switching Costs Drive Adoption B

Switching Costs Drive Revenue R + Switching Costs + Total Value created by investments

Investment Increases Perceived Value R

User's Perceived Value of adopting

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Section 6: Putting the Model to Work

Our working System Dynamics model builds upon this causal loop structure by incorporating a higher degree of resolution within our high-level variables above. For example, we incorporate our theoretical analysis of architecture access rights in developing a more complete representation of the relationship between Total Investment, Total Value created by investments, and Switching Costs. We also allow for the influence of customers frames of perceptive reference by suppliers marketing tactics and investment decisions. In addition, we factor in the possibility of delay between changes in a causal variable and changes in the variables affected by those causal variables. Our working model also differentiates between stock and rate variables in the interest of presenting a robust mathematical system. For example, we account for the Installed Base of users as a stock: one can observe a given number of people within an installed base at any point in time. We account for Adoption, however, as a rate: one can count the number of people who have adopted in a given period of time. Other considerations mentioned above, such as Willingness to pay, are framed as variables auxiliary to the model. Other stocks or rates within the system can affect these auxiliary variables. Auxiliary variables can drive only changes within rate variables. A change in Willingness to pay, for example, does not immediately affect the size of an Installed Base it first changes the Adoption rate, which in turn affects the Installed Base stock variable. Validation of Model In order to ensure that the system dynamics model assumptions, mathematics, and calculations were correct we validated the model by comparing End-user adoption in the U.S. of CDMA vs. TDMA air interface services. By using historical data between 1997-2000 we were able to enter inputs and contrast the outputs to know adoption and financial outcomes for CDMA & TDMA Network Operators. Inputs include average revenue per user(ARPU), customer acquisition costs, percentage of churn, annual revenues, appropriation for R&D, and investment fractions. The inputs were taken from a total of 6 network operators including: AT&T, Singular, and Verizon. All final values were collected as averages and then inputted in the appropriate calculations. The outputs from the model are summarized in Appendix 1. Output of user adoption, cumulative adoption, EBIDTA, and appropriation of profits were
60

tabulated and compared to the actual results from historic data. On average the model results were between 90-95% accurate when compared to the actual adoption and financial results. From these results we feel the model accurately portrays cash flows, appropriation, adoption rates, switching costs, and customer churn. Table 2.0: TDMA vs. CDMA Input Data
Category Spending Description of Variable Total Investment Fraction Investment Proportion (must total 1.0) Disruptive/Closed Innovation Disruptive/Open Innovation Continuous/Closed Innovation Continuous/Open Innovation Inititial Values Starting Value of Percieved Value per user due to other contributors Initial Switching Cost Ratio of Switching Cost to ARPU Appropriability (0 to 1, with 1 = totally appropriable) Disruptive/Closed Value Disruptive/Open Value Continuous/Closed Value Continuous/Open Value Value Creation Multipliers Disruptive/Closed Value Creation Multiplier Disruptive/Open Value Creation Multiplier Continuous/Closed Value Creation Multiplier Continuous/Open Value Creation Multiplier Value Creation Delays (months) Disruptive/Closed Disruptive/Open Continuous/Closed Continuous/Open TDMA 0.45 CDMA 0.45

0.15 0.05 0.20 0.60

0.25 0.30 0.20 0.25

$70 $360 5.0

$70 $380 6.3

1.00 0.50 1.00 0.10

1.00 0.50 1.00 0.20

1.20 1.40 1.05 1.07

1.80 2.00 1.10 1.20

12.0 9.0 6.0 3.0

6.0 4.5 3.0 1.5

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Section 7: Conclusion Methodology and Outcomes We set out in this paper to better understand the causes of uncertainty within the wireless telecommunications industry. We took as our starting point the rapid growth and change that has characterized this industry. We expect these paths of growth and change to foster uncertainty on the part of industry participants. Our first step in addressing this uncertainty was to establish a framework for understanding the structure of the wireless telecommunications industry and for understanding changes that have happened in this industrys structure over time. We explained the close relationship between the notion of a value chain and our conception of the wireless telecommunications industry. We drew from contributions to the value chain literature in developing perspectives on observable characteristics specific to the wireless telecommunications value chain with respect to market structure, competition, and innovation. First looking at the industry value chain we defined the key players in the chain, the value they contribute, and how they have traditional related to each other. To understand the dynamics within the supply chain we chose to look at the mobile phone and infrastructure value chains retrospectively since the inception of 1983. After laying out the chain we projected industry dynamics onto the Double Helix and summarized evidence that showed a shift had already occurred in the device chain from a vertical/integral to a horizontal/modular industry structure. Although it appears the infrastructure chain is still solidly vertical/integral, we recognized mounting evidence that pressures and incentives will likely continue to stress this structure and maybe force it to follow the mobile device value chain. To conclude the value chain analysis we focused on defining the measures of dynamic forces that impact relationships among chain participants. We have come to realize that these forces not only impact the investment and strategic decisions of two players connected by a specific link in the value chain, but have repercussions throughout the chain, which can disrupt the traditional way exchanges occur. We next turned to the literature of classical economics in attempts to deepen our understanding of forces that affect rates and magnitudes of change in the dynamics of the wireless value chain. We identified four separate economic forces that collectively serve to distinguish the wireless value chain as a unique economic entity. Each force has the potential to independently

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affect the ways in which buyers and sellers interact within the wireless telecommunications value chain. It is possible to draw intermediary insights out of the economic literature that have been validated in practice by participants within the wireless value chain. We see, for example, that the presence of increasing returns to adoption creates the opportunity for early leaders in a market to accrue insurmountable share advantages. In addition, we found that increasing adoption returns also imply fast rates of adoption, thereby impacting the speed of change to which the wireless value chain must react. Our analyses of switching costs yielded insights of similar merit. The economic literature on switching costs starkly highlights a tradeoff faced by many wireless value chain participants: extract value from customers by increasing lock-in, or attract new customers by reducing the perceived threat of lock-in. We also explored the conditions under which switching costs can increase the rate of entry into a market by potential suppliers. We also found traction for theoretical architecture access considerations within the wireless value chain. We recognize, for example, the incentive of technology leaders to license their technologies in an effort to make credible their quality commitments. Similarly, the licensing choices of intellectual property buyers within the wireless value chain have been seen to affect speed of technology adoption and the distribution of value among participants. We, admittedly, risked the purity of these clear-cut economic theories by acknowledging, with our final economic force, information asymmetries between (and among) buyers and sellers in the wireless value chain. Theories of consumer value perception and its effect on adoption decisions rest on assumptions of market imperfections not found within analyses of increasing adoption returns, switching costs, and architecture access considerations. This discordance of assumptions does not mandate exclusivity in our choice of applicable theory: we are not forced to discard the insights lent by our earlier three forces. We must, however, take care to account for the presence of imperfect and powerful participant expectations when studying the behavioral implications of purely theoretical abstractions. We consider these economic forces to be primary drivers of the investment incentives faced by participants in the wireless value chain. These investment incentives, by driving observable outcomes such as financial results, market structures, and innovation paths, can be understood as exerting significant explanatory power upon value chain dynamics. The following paragraphs discuss conclusions that we reached in the course of
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building and validating a System Dynamics model of these investment incentives. The successful validation of the model proved that our hypothesis of tying together value chain analysis with classical economic forces through a System Dynamics fabric not only works, but allows to consider through practical assumption what chain repercussions future investment decisions by value chain players will have on their immediate and long-term profitability and value creation. We are happy to have framed value chain dynamics in a System Dynamics model that both welcomes the rapid change characterizing the wireless telecommunications industry and accounts for the effects of our chosen economic forces. The validation efforts we undertook were successful, and lend insight toward dynamics witnessed historically within the wireless value chain. Many avenues remain open for further research, however, so we end by discussing a few particularly appealing prospects for additional work and their potential for value.

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Section 8: Avenues for Future Research

Clearly, we have not provided a model or solution for understanding all of the dynamics that may occur along the value chain. Nor will we be able to use this framework as a crystal ball to accurately forecast who will succeed and who will fail in the future. We have simply proven that our framework can accurately access how buyer and sellers react to changes of clockspeed within the wireless supply chain. Besides a crystal ball, we feel this framework and the system dynamic tool are a valuable start to understanding the dynamics changes that take place in one the worlds fastest clockspeed industries. We therefore, hope to continue our research and look forward to others helping fill the gaps that time restricted us from considering. A number of activities that would further our research includes, but are not limited to the following: Pushing the limits of our supplier/buyer relationship model. o Into what relationships can our economic forces not be pushed? o Do economic forces that we failed to consider drive any relationships? How? o What additional intermediary variables exist between economic forces and value chain dynamics? Extending the relationship model to capture a true chain effect. o What relationships in the chain affect, and are affected by, other relationships? o We abstracted to the 1:1 relationship simply because we had to given constraints of time and resources can this be projected onto the whole value chain. o Testing of the assumption and conducting sensitivity analysis

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Appendix A: System Dynamics Model Documentation

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