This analysis is about eBay’s recent announcement that he no longer charges application program interface (“API”) fees to third-party developers. http://www.nytimes.com/2005/11/14/business/14ebay.html eBay can be considered the quintessential beneficiary of network effects. This analysis will help us think about how network effects can be used to raise funding and prevent potential competitors from entering the auction market.
As rumors have been spreading that Google wants to launch its own auction system, eBay must move quickly to create barriers to entry. A standard with a wide range of applications is a good first step. Small teams of associated third-party developers are closer to eBay’s customers and therefore more aware of their needs. Through user feedback, these developers can help create a flawless auction system with no unaddressed market needs that could be exploited by competitors. Using this small pool of independent developers also allows eBay to erect an interesting barrier to potential competition: if these developers are busy creating applications for eBay without having to pay a fee, they will not have time to work for Google’s auction system.
The only drawback of this strategy for eBay is the loss of its revenue stream from these independent developers. One may assume, however, that these fees are insignificant compared to eBay’s expected $4 billion in revenues for this year.
eBay also uses this strategy as an incentive for developers to use its new unified scheme. Developers using the old legacy scheme will continue to have to pay the fees. This will create more value for eBay, as users will be able to easily switch between the additional programs. The move to the unified scheme will also help eBay to roll out code more efficiently and provide faster support, which could contribute to lower costs.
The company said it would still charge for use of its database of transaction histories, which can be mined by software to help buyers and sellers price goods or time auctions. By removing the fee on applications, eBay increases the number of developers. These developers are likely to use the database of transaction histories, which will raise funds for the company. It seems natural for eBay to keep charging for these databases, since they represent an important value added to the software that uses them. Besides, as more users are buying on eBay, these databases get richer and add more value to the developers that use them. This is an example of a positive feedback loop reinforced by network effects.
There also are lock-in incentives involved in eBay’s decision. As companies and buyers use more and more applications developed by third-party developers for eBay, they are less likely to change to an alternative auction system. The time spent learning to use other APIs and link them with proprietary databases would make switching too difficult.
eBay is also likely to receive more help from third-party developers by eliminating API fees. It is in these developers’ interest to increase the number of eBay users because of network effects. As more people use eBay, the auction system gets more efficient (according to Metcalfe’s law), which makes the application created by these developers more attractive. Therefore, they represent an ad hoc marketing team for eBay, and removal of the fee is likely to increase the size of this team.
The applications created by third-party developers are complementary products to eBay’s auction system. Without fees, the developers will be able to sell these applications at a lower price, which will benefit eBay. Indeed, as we saw in class, a decrease in the cost of a company’s complementary products allows the company to sell more products at a higher price.
The kind of announcement made by eBay might indeed shape the very future of Web 2.0. Cooperation between large companies that develop standards and smaller, more efficient pools of developers can create the software that will enhance the quality and utility of this standard. Independent developers might also help create bonds between eBay and its recent acquisition, Skype. Some journals refer this as a business ecosystem. Network effects make all these additional applications create more life, energy and entropy in the system. It also seems that letting smaller companies create additional software around a common standard protects larger firms from brand bias. Everybody “hates” Microsoft. A subsidiary that develops software for Microsoft while operating under a different name is more likely to attract customers than Microsoft itself. As important companies become more and more successful due to the standard they are developing, they must rely on smaller companies for innovation, the ability to listen to the customer needs and the avoidance of brand bias. By removing its third-party developer fees, eBay is likely to succeed by playing according the rules of Web 2.0.