07-104

Copyright © 2007 by Thomas Eisenmann, Geoffrey Parker, and Marshall Van Alstyne.

Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder. Copies of working papers are available from the author.

Platform Envelopment

Thomas Eisenmann Geoffrey Parker Marshall Van Alstyne

Platform Envelopment

Thomas Eisenmann, Geoffrey Parker, Marshall Van Alstyne

May 17, 2007

ABSTRACT

Due to network effects and switching costs, platform providers often become

entrenched. To dislodge them, entrants generally must offer revolutionary products. We

explore a second path to platform leadership change that does not rely on Schumpeterian

creative destruction: platform envelopment. By leveraging common components and

shared user relationships, one platform provider can move into another’s market,

combining its own functionality with the target’s in a multi-platform bundle. Dominant

firms otherwise sheltered from entry by standalone rivals may be vulnerable to an

adjacent platform provider’s envelopment attack. We analyze conditions under which

envelopment strategies are likely to succeed.

Keywords: Platforms, network effects, bundling, two-sided markets, convergence

Thomas Eisenmann

Associate Professor

Harvard Business School

Rock Center 218

Boston, MA 02163

Phone 617-495-6980

Fax 617-495-3817

teisenmann@hbs.edu

Geoffrey Parker

Associate Professor

A. B. Freeman School of

Business

Tulane University

New Orleans, LA 70118

Phone 504-865-5472

Fax 504-865-6751

gparker@tulane.edu

Marshall Van Alstyne

Associate Professor

Boston University School

of Management

595 Commonwealth Ave.

Boston, MA 02215

Phone 617-358-3571

Fax 617-353-5003

mva@bu.edu

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Platform-mediated networks comprise a large and rapidly growing share of the global

economy. They encompass network users—individuals or firms whose interactions are

subject to network effects—along with intermediaries who organize platforms that

provide infrastructure and rules to facilitate users’ interactions (Rochet & Tirole, 2003;

Eisenmann et al., 2006; Evans et al., 2006). Examples are as diverse as video games,

container shipping, credit cards, instant messaging, package delivery, web search, real

estate brokerage, HMOs, shopping malls, DVDs, online dating services, travel

reservation systems, stock exchanges, and barcodes.

Established platform providers can be difficult to displace. They are sheltered by

network effects (Farrell & Saloner, 1985; Katz & Shapiro, 1985; Economides, 1996),

switching costs (Klemperer, 1987), and endogenous sunk costs for R&D, infrastructure,

and marketing (Sutton, 1991). To dislodge entrenched platform providers, standalone

entrants—firms that compete in a single product market—generally must offer

revolutionary products and services (Henderson & Clark, 1990; Bresnahan, 1999). For

these reasons, Evans & Schmalensee (2001) observed that networked industries often

evolve through sequential winner-take-all battles, with superior new platforms replacing

old ones.

This paper explores a second path to platform leadership change that does not rely on

Schumpeterian creative destruction: a phenomenon we call platform envelopment.

Platform providers that serve different networked markets often employ similar

components and have overlapping user bases. We define platform envelopment as entry

by one platform provider into another’s market, combining its own functionality with the

target’s in a multi-platform bundle that leverages common components and/or shared

user relationships. Dominant firms that otherwise are sheltered from entry by standalone

rivals due to strong network effects and high switching costs may be vulnerable to an

adjacent platform provider’s envelopment attack.

For example, Microsoft launched Windows Media Player (WMP) in 1998,

enveloping RealNetwork’s dominant streaming media platform. RealNetworks (Real)

served a two-sided network (Rochet & Tirole, 2003; Parker & Van Alstyne, 2005):

consumers downloaded its media player for free and content companies paid for Real’s

server software. Like Real, Microsoft freely supplied WMP to consumers, but Microsoft

bundled its streaming media server software at no additional cost as a standard feature of

Windows NT server—a multipurpose operating system that also incorporated file, print,

mail, and web server software. Users found Microsoft’s bundles appealing and Real

rapidly lost market share.

We believe that envelopment is a widespread phenomenon and a powerful force

shaping platform evolution. While we do not offer statistical evidence of the incidence or

impact of envelopment in this paper, we note that the phenomenon occurs in 13 out of 30

case studies in an MBA course on platform-mediated networks (Eisenmann, 2007).

Examples include cable television system operators and local telephone companies each

offering “triple play” bundles comprised of TV, phone, and Internet access services;

eBay’s acquisition of PayPal; NTT DoCoMo’s move into mobile phone-based payment

services; and LinkedIn adding job listings to its professional networking website to

compete with Monster.com. Our analysis of motivations for envelopment draws heavily

on senior management interviews completed in the context of these case studies.

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In this paper, we present a taxonomy of different types of envelopment, based

principally on the relationship between the attacker’s platform and that of its target;

specifically, whether the platforms are complements, substitutes, or functionally

unrelated. We explain the economic mechanisms behind different types of envelopment

and describe conditions under which each is likely to be viable. Depending on the type of

envelopment attack, bundling may yield price discrimination gains, efficiency

improvements, or strategic advantages, for example, foreclosure of the attacker’s core

market.

Contributions. Our main contribution is describing a mechanism for platform

leadership change that does not require breakthrough innovation. In doing so, we

integrate recent research on product bundling (e.g., Whinston, 1990; Bakos &

Brynjolfsson, 2000; Carlton & Waldman, 2002; Nalebuff, 2004) and platform evolution

(e.g., Fine, 1998; Bresnahan & Greenstein, 1999; Gawer & Cusumano, 2002; Iansiti &

Levin, 2004).

In particular, we extend the work of Fine (1998) and Bresnahan & Greenstein (1999)

and show how envelopment can drive epochal change when technical leadership is

divided across industry layers, for example, microprocessors and operating systems in

personal computers (Grove, 1996). Bresnahan (1999) observed that a dominant player in

one layer would often sponsor entry into an adjacent layer, supplanting or diminishing

that layer’s leaders. We show that cross-layer entry frequently will take the form of

platform envelopment.

Our research also sheds light on why the boundaries between platform-mediated

networks often blur. In industries that produce, process, and distribute digital

information, such boundary blurring is called convergence. For example, handheld

devices now incorporate the functionality of mobile phones, PCs, media players, video

game players, and even credit cards. Convergence is a pervasive phenomenon that has

received limited attention from scholars (Greenstein & Khanna, 1997; Yoffie, 1997). We

assert that convergence is almost always the product of platform envelopment strategies.

Organization of the Paper. The balance of this paper is organized into four sections.

Section 1 defines platform-mediated networks, explains why dominant platform

providers often become entrenched, and describes different ways in which platforms may

be related. Section 2 describes how economic and strategic benefits from bundling

depend on the nature of the relationship between platforms. Section 3 presents a

taxonomy of different types of envelopment attack based on the relationship between

platforms, provides examples, and posits conditions under which each attack type is most

likely to succeed. Section 4 considers issues for future research and methods appropriate

for exploring these issues.

Platform-Mediated Networks

In this section we define platform-mediated networks and describe some of their

properties. Next, we explain why established platforms—the targets of envelopment

attacks—may be difficult to displace. Finally, we describe different ways in which two

platforms may be related. These relationships are relevant to our analysis because

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envelopment, by definition, involves one platform provider adding another platform’s

functionality to its own.

Properties of Platform-Mediated Networks

A platform-mediated network is comprised of users whose interactions are subject to

network effects, along with one or more intermediaries who organize a platform that

facilitates users’ interactions (Rochet & Tirole, 2003; Eisenmann et al., 2006; Evans et

al., 2006). The platform encompasses the set of components and rules employed in

common in most interactions between network users (Wheelright & Clark, 1992).

Components include hardware, software, and service modules, along with an architecture

that specifies how they fit together (Henderson & Clark, 1990). Rules encompass

information visible to network participants that is used to coordinate their activities

(Baldwin & Clark, 2000). In particular, rules include standards that ensure compatibility

between different components; protocols that govern information exchange; policies that

constrain network user behavior; and contracts that specify terms of trade and the rights

and responsibilities of network participants.

In traditional industries, bilateral exchanges follow a linear path as vendors purchase

inputs, transform them, and sell output. By contrast, exchanges in platform-mediated

networks have a triangular structure (see Figure 1). Network users transact with each

other and they simultaneously affiliate with platform providers. For example, video game

networks have two distinct groups of users, that is, two “sides.” Developers on the

network’s “supply side” offer games to consumers on the “demand side”—the first set of

bilateral exchanges. Developers must also contract with the platform’s provider—Sony

Playstation, Microsoft Xbox, or Nintendo Wii—for permission to publish games and for

production support—the second set of exchanges. Finally, consumers must procure a

console and associated services from the platform provider—the third set of exchanges.

Every platform-mediated network has a focal platform at its core, although other

platforms may play subordinate roles in the network, as explained below. The focal

platform may have a single provider (e.g., Microsoft’s Xbox, eBay, Miami Yellow

Pages). Alternatively, multiple providers may offer competing but compatible versions of

a shared platform (e.g., Citibank Visa vs. Bank of America Visa; Ubuntu Linux vs. Red

Hat Linux). If users switch between rival providers of a shared platform, they do not

forfeit platform-specific investments, because all providers follow the same rules.

Platform Entrenchment

Platform-mediated markets—also referred to here as networked markets—are

comprised of sets of platform-mediated networks. For example, the console-based video

game market includes the Xbox, Playstation, and Wii networks; the U.S. credit card

market includes the Visa, Mastercard, and American Express networks. Two platforms

are rivals in the same networked market if they employ different rules and if changing the

price that users pay to affiliate with one platform influences the other’s transaction

volumes.

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Figure 1: Elements of a platform-mediated network

Networked markets are typically served by only a few rival platforms; in many cases,

almost all users rely on a single platform (e.g., Microsoft’s Windows, Adobe’s PDF,

eBay’s online auctions). The number of platforms serving a networked market tends to be

small when network effects are strong, multi-homing costs are high, and user demand for

differentiated platform functionality is limited (Arthur, 1989; Caillaud & Jullien, 2003;

Ellison & Fudenberg, 2003; Noe & Parker, 2005).

When network effects are positive and strong, users will converge on fewer

platforms; a sub-scale platform will have little appeal, unless it provides the only way to

interact with certain transaction partners. Likewise, users are less likely to multi-home—

that is, rely upon multiple platforms—when it is expensive to establish and maintain

platform affiliations. Finally, fewer platforms will be viable if users have relatively

homogeneous needs. By contrast, if various user segments have distinct preferences and

no single platform can profitably satisfy all segments’ needs, then the market is more

likely to be served by multiple rival platforms.

With few rivals, established platform providers enjoy market power. High returns

would normally attract entrants, but incumbent platform providers are often well

protected. Factors that restrict the number of platforms in the first place can make it

difficult and expensive to develop a new platform. Confronted with these barriers, most

standalone entrants can only succeed if they offer significant improvements in

performance and if they invest heavily to shift users’ expectations and absorb switching

costs.

Relationships Between Platforms

From the perspective of a focal platform’s users (for convenience, platform “A”), a

second platform (“B”) must be related to the focal platform in one of four ways. First, the

two platforms may be functionally unrelated. Second, the two platforms may be

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substitutes. Third, platform B may a nested network user of platform A. Finally, platform

B may be a nested component employed by platform A’s users. Below, we explain these

relationships and provide examples. In the next section, we show how the relationships

affect benefits from bundling two platforms and thus the likelihood of successful

envelopment.

Unrelated Platforms. Two platforms may be functionally unrelated, that is, designed

to serve fundamentally different purposes, as with mobile phones and handheld video

game devices. However, functional independence does not rule out the possibility that

two platforms have common components or shared user relationships. For example, a

handheld gaming device and a mobile phone each require a display, battery,

microprocessor, and keys for input. Likewise, many teenagers own both a handheld

gaming device and a mobile phone.

Substitutes. Rival platforms are close substitutes when they offer very similar

functionality. Close substitutes are outside our scope of inquiry because envelopment, by

definition, bundles two platforms with different functionality.

Rival platforms are weak substitutes—and candidates for envelopment—when they

serve the same basic purpose, but employ technologies suited for different types of

transactions. For example, Monster.com and LinkedIn.com use different approaches in

helping users find and fill jobs: searchable listings and social networking, respectively.

These approaches offer different advantages: listings are valuable when parties wish to

conduct a comprehensive search, whereas social networks provide a mutually-trusted

third party’s assessment of fit. Depending on situational needs, some job seekers and

recruiters may rely on both platforms (i.e., multi-home); others may use just one.

Nested Network Users. Platform-mediated networks are often organized

hierarchically in layers (Grove, 1996; Farrell, Monroe & Saloner, 1998). Consequently,

the same entity may simultaneously serve as a platform provider for one network and as a

user in another. For example, eBay is the platform provider for its online auction

network, and at the same time, one of the World Wide Web’s millions of network users.

In turn, the World Wide Web and dozens of other “application layer” platforms (e.g.,

email, file transfer protocol, instant messaging) are nested network users with respect to

the Internet, a “transport layer” platform.

Nested Components. Platform providers serve as network users’ primary point of

contact with the platform, but they do not necessarily supply all of the platform’s

components. Frequently, platform providers rely on third parties who sell components

directly to network users. Sometimes, these components are platforms themselves. For

example, eBay provides interfaces that allow auction sellers to accept several forms of

payment, including credit cards and PayPal, an email-based payment service acquired by

eBay in 2002. These payment services are all platforms that serve two-sided networks

comprised of merchants and consumers.

Reciprocally and Unilaterally Specific Complements

When platform B is a nested component of platform A, platform A’s users will view

the two platforms as complements. From the perspective of A’s users, the platforms will

be more valuable when consumed together than separately, and each platform will exhibit

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negative cross-price elasticity with respect to the other. Likewise, when platform B is a

nested supply-side user of platform A (e.g., a specific video game vis-à-vis a console),

then platform A’s demand-side users (e.g., consumers) will view the two platforms as

complements.

When two platforms are complements, the strength of cross-price elasticity between

them may or may not be symmetrical. In some cases, the two platforms will be

reciprocally specific complements: most use of each platform will be coupled with the

other platform’s use (see Figure 2). For example, Microsoft Word—a platform that

facilitates file exchange between users—is also a nested network user of Microsoft’s

Windows operating system. Since Word is installed on a large fraction of PCs, and since

Windows is the dominant PC operating system, Word and Windows are reciprocally

specific complements. Each should exhibit reasonably high negative cross-price elasticity

with respect to the other.

More typically, when platform B is a nested network user of platform A, B will be a

unilaterally specific complement of A: most use of B will be coupled with A’s use, but

the reverse will not be true.1 For example, most users of Quicken’s personal financial

management software rely on Windows; the rest rely on Macintosh. However, only a

modest fraction of Windows-compatible PC owners are Quicken users. Increasing the

price of a unilaterally specific application like Quicken would have almost no impact on

Windows’ sales, but increasing Windows’ price would reduce Quicken’s sales.

Figure 2: Reciprocally and unilaterally specific complements

As with nested network user relationships, nested component relationships can be

reciprocally specific. For example, PayPal is used by 78% of eBay buyers; the balance

pay with credit cards or money orders. With respect to PayPal transactions, 70% are

1 Unilaterally specific complements are similar to “one-way essential complements” in Chen & Nalebuff (2006). However, in Chen & Nalebuff, A is essential for all uses of B, whereas with unilaterally specific complements, A is associated with most uses of B.

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completed on eBay; other online retailers and person-to-person payments account for the

rest. Hence, the two platforms are reciprocally specific complements.

More typically, the focal platform will be a unilaterally specific complement to its

nested component. For example, almost all eBay users require shipping services, but

eBay represents only a small share of total shipments by Federal Express or UPS. Note

that this relationship reverses the pattern of dependence normally seen with nested

network users. Focal platforms are often asymmetrically dependent on their nested

components, whereas nested network users are often asymmetrically dependent on their

focal platforms.

We emphasize the distinction between reciprocally and unilaterally specific

complements, because the strength and direction of relational dependence affects the

payoff from bundling, and hence prospects for successful envelopment.

Bundling Benefits

Envelopment entails one platform provider adding another platform’s functionality to

its own, and then offering a multi-platform bundle. In this section, we review potential

benefits from bundling, which include price discrimination gains, efficiency

improvements, and strategic advantages (Nalebuff, 2003; Carlton & Waldman, 2005a).

We describe how bundling benefits depend on the nature of the relationship between

platforms and posit conditions under which various benefits are likely to influence the

odds of successful platform envelopment.

Price Discrimination Gains

Bundling reduces heterogeneity in consumers’ aggregate valuations for a set of items,

allowing a firm with market power to extract a larger share of available surplus than it

would earn from selling the items separately (Schmalensee, 1984; McAfee et al., 1989).

Bundling thus serves as an effective price discrimination device in situations where a

firm cannot assess customers’ willingness to pay for items or must offer the same price to

all customers.

Compared to selling items separately, bundling is more likely to increase profits

when: 1) the marginal cost of items is low or zero, as with many information goods; and

2) the correlation of consumers’ valuations for individual items is negative or weakly

positive (Bakos & Brynjolfsson, 1999). If the correlation of consumers’ valuations is

perfectly positive, then bundling does not reduce the heterogeneity of aggregate

valuations and therefore does not yield price discrimination gains; bundling and selling

items separately generate equal profits.

If marginal costs are material and the correlation of users’ valuations is not perfectly

positive, then willingness to pay for a pure bundle (i.e., an offer of A+B, but neither A

nor B alone) may fall below the bundle’s cost for a significant fraction of potential

customers—those with little interest in one or both items. In such situations, a mixed

bundle (i.e., offering A+B, A alone, and B alone) or tying (i.e., offering A+B and A alone

but not B alone) may be more profitable than selling items separately—provided that the

fixed cost of creating and marketing a bundle is not too high (Adams & Yellen, 1976;

McAfee et al., 1989; Matutes & Regibeau, 1992).

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Figure 3 summarizes analysis that builds on Nalebuff (2004) to illustrate conditions

under which a pure bundle is more profitable due to price discrimination gains than

selling the items separately. For a monopolist selling two items with uncorrelated

valuations, demand is assumed to be uniformly distributed as prices range from zero to

maximum valuations of VA and VB, respectively. The items are also assumed to have the

same ratio of marginal cost to maximum valuation, i.e., MCA/VA = MCB/VB (see

Appendix for details on model assumptions and derivations to support Figure 3). The

horizontal axis of Figure 3 reflects VA/VB, that is, the ratio of the items’ maximum

valuations, arbitrarily designating the item with the lower maximum valuation as A. The

vertical axis reflects (MCA + MCB)/(VA + VB), that is, the ratio of the sum of the items’

marginal costs to the sum of their maximum valuations. Figure 3’s curve shows

combinations of the marginal cost ratio and the ratio of the item’s maximum valuations

for which bundling and selling separately yield equal profit. Selling separately yields

greater profit than bundling for points above the curve, and less profit for points below

the curve.

Figure 3: Attributes favoring bundling versus separate sales for platforms with

uncorrelated valuations

When A has a very low maximum valuation relative to B, bundling is only profitable

when the items also have very low marginal costs. For items with equal maximum

valuation (i.e., VA/VB = 1), bundling is more profitable than selling separately when

(MCA + MCB)/(VA + VB) < 0.139. Expressed as the ratio of marginal cost to the profit-

maximizing prices for the items sold separately, this threshold equates to (MCA +

MCB)/((VA + MCA)/2 + ((VB + MCB)/2) < 0.243. Most information goods and many other

platforms have marginal costs below this threshold. However, the threshold level of

marginal cost for profitable bundling declines with the strength of positive correlation of

9

users’ valuations for two platforms (Bakos & Brynjolfsson, 1999). As explained

immediately below, the type of relationship between the platforms systematically

influences the correlation of users’ valuations.

Unrelated Platforms. Potential users’ valuations of two functionally unrelated

platforms would not normally be correlated, unless use of each platform is associated

with common underlying demographic or behavioral traits such as income, age, or

profession. With common underlying traits, correlation is likely to be positive but not

perfect, so price discrimination gains should be available. For example, many car owners

value both emergency roadside services and auto loan brokerage. By bundling these and

other functionally unrelated services, the American Automobile Association exploits

price discrimination opportunities.

Weak Substitutes. When items in a bundle are complements or functionally

unrelated, a user’s valuation for the bundle equals the sum of that user’s valuation for the

items purchased separately. However, additivity does not generally hold for two perfect

substitutes (Bakos & Brynjolfsson, 2000). Having access to a second perfect substitute

provides no additional utility in the case of subscription services or perishable items, but

some value with depreciable durables or consumable items that can be held inventory.

With two weak substitutes, a typical user’s valuation for a bundle should exceed her

standalone valuation for the single item she prefers most, assuming that the two platforms

each provide some functionality not available from the other. However, in terms of

Figure 3, the ratio VA/VB is likely to be low, because a fraction of platform A’s

functionality will be duplicated by platform B. Furthermore, demand for each platform’s

unique functionality will often be positively correlated. For example, film fans who rent

many movies will value both the wide variety available through mail delivery services

and the instant access offered by Internet download services. Due to the asymmetry and

positive correlation of platform valuations, bundling weak substitutes will only yield

increased profits through price discrimination gains when marginal costs are very low.

Complements. Since reciprocally specific complements are typically consumed in

tandem, a user with strong demand for one platform should value the other highly. Due to

the strong positive correlation of users’ valuations, bundling the platforms is not likely to

yield increased profits through price discrimination, although other bundling benefits

may be available, as explained below. For unilaterally specific complements, the

correlation of valuations will be positive but weaker, so price discrimination gains may

be forthcoming from bundling.

Following from this analysis, we have:

Proposition 1: Assuming marginal costs are low, bundling two platforms is more

likely to yield increased profits through price discrimination when:

a. Platforms are functionally independent, and their use is not associated

with common underlying demographic or behavioral traits.

b. Platforms are complements, but their use is not reciprocally specific.

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Efficiency Improvements

Compared to selling separate items, bundling can improve efficiency through

economies of scope in initial marketing; economies of scope in production and ongoing

operations; quality advantages through an integrated design; and avoidance of double

marginalization of perfect complements (Davis et al., 2001; Evans & Salinger, 2005)

Economies of Scope in Initial Marketing. When they buy bundled products, users

can reduce search costs. Equivalently, firms that bundle products should realize

economies of scope in customer acquisition activities, because they can sell the bundle

with a single message. Likewise, bundling should reduce distribution costs, compared to

shipping and stocking items that are sold separately.

Since customer acquisition and distribution expenses often have a large variable

component, efficiency improvements will reduce marginal costs and increase the set of

platform pairs that are candidates for profitable bundling. In terms of Figure 3, MCA +

MCB for an A + B bundle will be lower than MCA + MCB for A and B sold separately.

The magnitude of economies of scope in initial marketing does not depend systematically

on the type of relationship between two platforms. Bundling should yield such savings

regardless of whether the platforms are functionally unrelated, weak substitutes, or

complements.

Economies of Scope in Production and Ongoing Operations. Compared to two

products sold separately, an integrated design can reduce production costs by leveraging

shared components. For example, video game consoles and DVD players both

incorporate optical disk readers and circuitry for outputting audio and video to a

television.

When two platforms are functionally unrelated, as with video games and DVDs,

economies of scope in production and ongoing operations may be forthcoming, but it is

not possible to generalize about their incidence or magnitude. However, the likelihood of

realizing operating cost synergies through bundling does vary systematically when pairs

of platforms are weak substitutes or complements.

Weak substitutes overlap to some extent in functionality, and hence should offer

economies of scope in production and ongoing operations. For example, Netflix bundles

two platforms that offer fundamentally different approaches for renting movies: mail

delivery and Internet download services. Compared to firms offering the platforms

separately, Netflix can save costs by relying on a single unit to procure films and by

building a single website to facilitate users’ title selections.

By their nature, complements do not overlap much in functionality. Consequently,

bundling two platforms typically will not yield major savings from sharing components.

For example, by enveloping PayPal, eBay enjoyed some economies of scope in data

center and fraud detection operations, but most functions provided by auction and

payment services platforms were unduplicated.

Based on this analysis, we posit:

Proposition 2: Bundling weak substitutes is likely to yield increased profits

through economies of scope in production and ongoing operations.

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Quality Advantages. Integrating two platforms may improve product quality through

tighter management and/or simplification of component interfaces (Ulrich, 1995;

Schilling, 2000). Improvement opportunities are especially likely for reciprocally specific

complements that are consumed as a system, as with Apple’s iPod and iTunes.

Integrating weak substitutes may also yield quality improvement. For example, by

bundling DVD-by-mail and Internet download services, Netflix can amass a more

complete transaction profile for a given user, and thereby offer better rental

recommendations.

By contrast, integrating functionally unrelated platforms is more likely to result in

design compromises that reduce quality, relative to platforms sold separately. For

example, due to design flaws, consumers rejected Nokia’s N-Gage, which combined a

mobile phone and handheld video game player. To accommodate gaming keypads, the

device had a half-moon shape that was awkward for phone use. The N-Gage also

required removal of its battery to insert game cartridges.

This logic yields:

Proposition 3: Integrating reciprocally specific complements and weak

substitutes may yield quality improvements compared to platforms provided by

separate firms.

Avoidance of Double Marginalization. Profits can be improved by avoiding double

marginalization when bundling complements that: 1) must be consumed in fixed

proportions; and 2) would otherwise be supplied by separate monopolists who cannot

price discriminate. Reciprocally specific complements often meet these conditions. For

example, operating system (OS) and application software is consumed in one-to-one

proportions.

In this context, a bundle’s optimal price will be lower than the sum of the prices

offered by separate monopolists, who each will ignore the externality imposed upon the

other (Nalebuff, 2000). Compared to traditional industries, the double marginalization of

complements is more salient in networked industries, where winner-take-all outcomes are

common (e.g., see Casadesus-Masanel & Yoffie, 2006, for analysis of double

marginalization in the context of brinksmanship between Intel and Microsoft). Hence:

Proposition 4: Bundling reciprocally specific complements otherwise supplied by

separate platform providers with significant market power may yield increased

profits through avoidance of double marginalization.

Strategic Advantages

The Chicago School’s “one monopoly price theorem” (OMPT) held that a monopolist

cannot increase profits by bundling its primary product with a complement (Posner,

1976; Bork, 1978). Whinston (1990) demonstrated that OMPT is valid under restrictive

conditions: 1) the complement (denoted “B” in the discussion that follows) is supplied in

a perfectly competitive market; 2) the monopolist’s product (denoted “A”) is essential for

all uses of the complement; 3) the products are used in fixed proportions; and 4) the

complement is subject to constant returns to scale. Carlton & Waldman (2005b) added a

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fifth condition: OMPT requires a one-period setting, but may not apply with repeated

purchases or upgrades over multiple periods, especially when switching costs are salient.

Platform-mediated markets often violate these conditions, so we would expect to

observe profitable bundling of complements by platform providers. Specifically, as

explained above, complements to a focal platform are often platforms themselves—either

nested network users or nested components—and thus leverage network effects. Network

effects may engender increasing returns (violating condition #4) and lead to an

oligopolistic market structure (violating condition #1). Also, platform affiliation typically

entails a long-term relationship for network users (violating condition #5).

Extending Market Power. If OMPT requirements are relaxed, a monopolist may be

able to profitably extend its market power into a complement market (Whinston, 1990;

Farrell & Weiser, 2003). According to Whinston (2001), when a monopolist’s primary

product is not essential for all uses of a complement whose suppliers have market power,

the monopolist has an incentive to exclude rival complement suppliers, to capture rent

from alternate uses. When the complement market is subject to increasing returns—

consistent with market power for standalone suppliers—the monopolist may have the

ability to capture rents through bundling by denying scale to rival producers of the

complement.

Specifically, assume that A is not essential for all uses of B, but the monopolist

creates a bundle that ensures that A can only be consumed with its version of B, through

either technical or contractual means. As an example, consider a counterfactual in which

eBay, prior to acquiring PayPal, had banned that email payment service and mandated

that auction participants instead use Billpoint, an eBay-owned payment service.

Whinston’s conditions would be satisfied: PayPal enjoyed market power and increasing

returns due to network effects. Also, as noted above, eBay’s near-monopoly in online

auctions was not essential for all uses of PayPal.

In this scenario, standalone suppliers of B can make no sales to consumers who value

an A + B bundle. In an alternative scenario, if rival versions of B remain compatible with

A, then a standalone supplier of B will only be able to charge an amount equal to the

value of any quality difference perceived by customers between its version of B and the

monopolist’s. In either scenario, the demand reduction for standalone suppliers is greater

to the extent that valuations for A and B are positively correlated and the bundle has

strong appeal. Likewise, in both scenarios, standalone suppliers of B may not earn

enough revenue to cover their fixed costs; they may be forced to exit the market, or may

never enter in the first place.2 Matching the monopolist’s bundle would require

2 Bundling does not always weaken standalone suppliers. Under certain conditions, it may serve to soften rivalry and boost profits for all market participants. Carbajo, de Meza & Seidmann (1990) presented a model in which: 1) monopolized A is not essential for all uses of B; 2) undifferentiated versions of B are offered by A’s monopolist and by a single standalone supplier; 3) the correlation of customers’ heterogeneous valuations for A and B is perfectly positive; and 4) firms must offer, under Bertrand competition, the same price to all customers. Absent bundling, price competition would drive profits for the undifferentiated B products to zero. However, both firms can profit from the B market if the monopolist targets high-valuation customers with a high-priced A + B bundle and cedes low-valuation B customers to the standalone supplier. The bundle differentiates the B products; low-valuation customers cannot justify purchasing the high-priced bundle, so they only have one choice when buying B. This allows the standalone supplier to raise its price above marginal cost.

13

standalone suppliers to incur the presumably prohibitive cost of entering the monopolist’s

primary market. This suggests:

Proposition 5: Through envelopment, a platform provider can profitably extend

its market power when its target supplies either: 1) a reciprocally specific

complement; or 2) a unilaterally specific complement that is used mainly but not

exclusively with the attacker’s platform.

Foreclosure of the Attacker’s Market. A dominant firm may also be able to weaken

existing rivals or deter entrants in its own market by bundling a complement (Whinston,

1990; Church & Gandal, 1992 and 2000). Consider a situation in which a dominant firm

and its rivals all sell versions of A typically used in tandem with a reciprocally specific B

complement, which is sold by a single standalone supplier subject to increasing returns.

Consistent with the scenario above, if the dominant firm offers an A + B bundle, it denies

revenue to the standalone supplier of B and may force it to exit. In that event, the

dominant firm’s existing and potential rivals in the A market will lack a source of supply

for the crucial B complement. This implies:

Proposition 6: Through envelopment, a platform provider can profitably weaken

or deter rivals in its own market when its target supplies a reciprocally specific

complement.

Taxonomy of Envelopment Attacks

The analysis above suggests that the viability of platform envelopment depends

strongly on the relationship between two platforms. Accordingly, our taxonomy of

envelopment attacks focuses on platform dyads that are functionally unrelated, weak

substitutes, and complements. For each type of platform envelopment, we offer examples

(see Table 1) and discuss the economic mechanisms that help or hinder an attack,

specifically, the extent to which bundling engenders price discrimination gains, efficiency

improvements, and/or strategic advantages (see Table 2).

Conglomeration Attacks

In a conglomeration attack, the enveloper’s platform is functionally unrelated to the

target’s. The attacker’s bundle is a conglomerate, in the same sense as a corporation

comprised of largely unrelated businesses or a rock consisting of separate stones

cemented together.

Price Discrimination Gains. If use of two functionally unrelated platforms is not

associated with common underlying demographic or behavioral traits, then potential

users’ valuations for the platforms should be uncorrelated and significant price

discrimination benefits may be available, provided that marginal costs for the platforms

are also low (Proposition 1a).

Efficiency Improvements. Compared to providing platforms through separate firms,

conglomeration attacks offer economies of scope in initial marketing, and in some cases,

significant reductions in production and/or ongoing operating costs.

For example, cable TV system operators and local telephone companies have

launched conglomeration attacks on each other. Cable companies now offer phone

14

service and phone companies have added TV service. These functionally unrelated

platforms meet different needs but have significant user overlap. About 85% of U.S.

households subscribe to multi-channel TV service through cable or satellite providers,

and 95% subscribe to local phone service through fixed-line, mobile, or Voice over

Internet Protocol providers. Consequently, bundling cable and phone services offers

significant economies of scope in initial marketing.

Table 1: Examples of Platform Envelopment by Attack Type

Attacker Target Comments

Conglomeration Attack

Cable TV system operators

Local phone companies

Attacks have been reciprocated.

NTT DoCoMo mobile phone service

Traditional credit cards

DoCoMo allied with Sumitomo-Mitsui (Japan’s 2nd largest credit card company) to offer mobile phone-based payment services.

Apple iPhone Smart phones from Nokia, Motorola, etc.

iPhone bundles iPod functionality into a smart phone.

Intermodal Attack

UPS Federal Express UPS added overnight delivery in 1982; Federal Express reciprocated, acquiring a trucking carrier in 1998.

LinkedIn’s online professional network

Monster.com’s recruitment platform

LinkedIn has added job listings, and Monster has added social networking functionality.

Blockbuster Video Netflix’s DVD-by-mail platform

Blockbuster added a mail-delivery option in 2004.

Foreclosure Attack

Microsoft’s Windows RealNetwork’s media player

Windows Media Player displaced RealPlayer, but Microsoft paid RealNetworks $760 million to settle an antitrust lawsuit.

eBay’s auction marketplace

PayPal’s email payment service

eBay acquired PayPal after eBay’s in-house service, Billpoint, failed to displace PayPal.

Microsoft Office Adobe Acrobat PDF writer software

Office 2007 adds a “save as PDF” option, the core function of Adobe’s $299 Acrobat writer software.

15

Table 2: Motivations by Attack Type

Conglomeration Intermodal Foreclosure

Relationship

Between Platforms

• Functionally unrelated

• Weak substitutes serving same basic purpose, but using technologies suited for different transaction types

• Complements, either reciprocally or unilaterally specific

Potential for

Price

Discrimination Gains

(Assuming low marginal costs)

• Strong potential when correlation of users’ valuations is zero (P1a)

• Moderate potential when correlation of users’ valuations is weakly positive due to common underlying demographic or behavioral traits (P1a)

• Limited potential due to asymmetry and positive correlation of weak substitutes consumed in a bundle

• Limited potential for reciprocally specific complements due to strong positive correlation of users’ valuations

• Moderate potential for unilaterally specific complements due to weaker positive correlation of valuations (P1b)

Potential for

Efficiency Improvements

(Beyond economies in initial marketing available for all types)

• Significant economies of scope in ongoing operations available for some platform pairs but not others

• Operating cost synergies due to shared components and suppliers (P2)

• Quality improvements through superior knowledge of customer preferences across transaction types (P3)

• Quality improvements through tighter management or simplification of component interfaces (P3)

• Opportunity to avoid double marginalization when monopolists supply essential complements (P4)

Potential for

Strategic Advantages

• Limited • Opportunity to neutralize an emerging threat

• Opportunity for attacker to extend its market power into a complement market (P5)

• Opportunity for attacker to protect its core market by foreclosing rivals’ access to reciprocally specific complements (P6)

16

The platforms also share many common components, so envelopers can capture

operational synergies. Both cable TV and phone companies are able to utilize existing

copper lines to deliver additional services without duplicating the huge upfront

investment required to wire households. Also, both parties are able to leverage existing

customer service operations when offering new services, including field technicians, call

centers, and billing systems.

Strategic Advantages. Compared to other types of envelopment, indirect attacks

offer fewer strategic advantages. Unlike a foreclosure attack (described below), an

indirect attack cannot strengthen the enveloper’s core platform by denying its rivals

access to a crucial complement. Also, unlike an intermodal attack (also described below),

an indirect attack cannot neutralize an emerging substitution threat. Since strategic

advantages are less salient, indirect attackers must rely on either price discrimination

gains or efficiency improvements.

Convergence. Conglomeration attacks are frequently the mechanism behind

convergence, a pervasive phenomenon in industries that produce, process, and distribute

digital information. Yoffie (1997, p. 2) defines convergence as “the unification of

function—the coming together of previously distinct products.” Convergence has several

drivers, most notably performance improvements for semiconductors and broadband

communications networks. Examples of digital convergence include: 1) Apple’s iPhone,

which integrates a music player, mobile phone, and Internet communications device; 2)

the Xbox 360 and PlayStation 3 video game consoles, which each include high-definition

DVD players and Internet browsing capabilities; and 3) “triple plays” offered by cable

and phone companies, incorporating not only the TV and telephone services mentioned

above, but also broadband Internet access. All these examples of convergence are

conglomeration attacks, bundling platforms that are largely functionally unrelated.

Intermodal Attacks

With an intermodal attack, the enveloper’s platform and its target’s are weak

substitutes. They serve the same basic purpose but satisfy different sets of user needs,

because they rely on fundamentally different technologies—that is, on distinct modes for

accessing relevant functionality.

Price Discrimination Gains. Intermodal attacks are unlikely to yield price

discrimination benefits due to the asymmetry and positive correlation of users’ valuations

for weak substitutes consumed in a bundle.

Efficiency Improvements. Compared to providing platforms through separate firms,

intermodal attacks offer economies of scope in initial marketing and—consistent with

Proposition 2—potentially significant reductions in production and ongoing operating

costs. Likewise, integrating weak substitutes may yield quality improvements, compared

to two platforms offered by different firms (Proposition 3).

For example, prior to 1982, Federal Express and UPS fulfilled the same broad

mandate—package shipping—but served different user needs. Federal Express relied on

planes configured in a hub-and-spoke network to offer rush shipments of small, high-

value packages. Prior to launching its own overnight air delivery service in 1982—an

intermodal attack on Federal Express—UPS was dependent on trucks, which are better

17

suited for larger and less time-sensitive shipments. Many shippers send both types of

packages, so UPS was able to capture efficiency gains through its envelopment attack.

For example, UPS could market both types of service through a single sales force and

could offer a single point of contact for customer service. While UPS did not realize

long-haul transportation cost savings by offering both shipping modes, intermodal

operations leveraged costs incurred in sorting packages and local delivery.

Strategic Advantages. When a new platform serves the same basic purpose as an

established platform but offers different functionality, the potential for competition

between the two platforms may initially be unclear. Given uncertainty about the extent of

substitutability, an intermodal attack may be construed as a “better safe than sorry”

strategy.

Netflix appears to be following this approach by bundling Internet downloads with its

DVD-by-mail service. Likewise, Monster.com’s move into online professional

networking was motivated in part by an emerging competitive threat from LinkedIn and

other startups. By contrast, UPS missed its opportunity to neutralize a potential new rival.

Federal Express was 12 years old and well established by the time it faced UPS’s

intermodal attack.

Foreclosure Attacks

With a foreclosure attack, the target is either a nested network user or a nested

component of the attacker’s platform. By bundling the target’s platform with its own, the

attacker forecloses access to its users.

Price Discrimination Gains. Price discrimination gains are likely to be limited for

reciprocally specific complements, due to the strong positive correlation of potential

users’ valuations. When a target’s platform is a unilaterally specific complement, the

correlation of potential users’ valuations should be weaker and an enveloper may realize

price discrimination benefits from bundling, consistent with Proposition 1b.

Efficiency Improvements. Foreclosure attacks offer economies of scope in initial

marketing, but economies of scope in ongoing operations are likely to be more modest.

With reciprocally specific complements, an integrated design may yield quality

improvements, compared to relying on a standalone supplier for a crucial complement

(Proposition 3). Also, when bundling reciprocally specific complements otherwise

supplied by independent monopolists, a foreclosure attack may also accrue efficiency

gains by avoiding double marginalization (Proposition 4).

Strategic Advantages. A foreclosure attack limits access to users of the enveloper’s

core platform, thereby reducing the target’s revenue. In this manner, the enveloper may

extend its market power into the complement market, consistent with Proposition 5. If the

platforms are reciprocally specific, the enveloper may also increase entry barriers in its

core market, consistent with Proposition 6. When the target’s platform declines in value

due to network effects, the enveloper’s standalone rivals must rely on an inferior

complement.

Microsoft’s attack on RealNetworks’ streaming media platform, described in the

introduction, is an example of a foreclosure attack that weakened Microsoft’s operating

18

system rivals. The compatibility of Windows Media Player with other PC operating

systems was intermittent; for example, new versions did not work with Apple’s

Macintosh prior to 2000 or after 2003. As a result, Microsoft bolstered its core Windows

operating system by enveloping a crucial complement. However, Microsoft’s streaming

media strategy drew antitrust scrutiny.

Cross-Layer Competition. Foreclosure attacks like Microsoft’s can play a powerful

role in the evolution of multi-layer industries. As platforms mature, their providers

sometimes embrace modular technologies and cede responsibility for supplying certain

complements to partners (Langlois & Robertson, 1992; Suarez & Utterback, 1995;

Baldwin & Clark, 2000; Jacobides, 2005; Boudreau, 2006). Often, these complements are

platforms themselves. Reduced integration may result in an industry comprised of

multiple layers, each with a separate set of suppliers. In the personal computer industry,

for example, the layers consist of semiconductor manufacturing, PC assembly, operating

system provision, and application software, among others (Grove, 1996). The credit card

and telecommunications industries have similarly layered structures (Fransman, 2002;

Evans & Schmalensee, 2005).

Over time, dominant players typically emerge within layers that are subject to strong

scale economies due to fixed costs and/or network effects. These powerful players will

extract a greater share of industry rents and vie with the focal platform’s original provider

for technical leadership (Bresnahan, 1999). Friction over divided technical leadership is

exacerbated as new layers with new leaders emerge. With a modular architecture

conducive to experimentation, technological change may yield new uses for a platform,

for example, browsers or streaming media software vis-à-vis PC operating systems. The

original platform’s sponsor may be slow to integrate the new functionality due to inherent

uncertainty about technology and demand. By the time the original platform sponsor

offers the functionality, network effects may have propelled the new platform’s pioneer

to a dominant position, effectively creating another industry layer.

Fine (1998) and Bresnahan (1999) observed that in the computer industry, the

dominant player in one layer often pursued strategies to supplant or diminish another

layer’s leaders. In some cases, challenges took the form of proxy wars, with players

sponsoring weaker allies in adjacent layers (e.g., Microsoft backing AMD). In other

cases, challengers directly entered an adjacent layer. Direct entry usually took the form of

a foreclosure attack, as with Microsoft’s respective envelopment attacks on

RealNetworks’ streaming media software, Netscape’s browser, Adobe’s PDF standard,

and TiVo’s digital video recorder platform. More recently, industry observers have

speculated that Google might mount a cross-layer foreclosure attack on Microsoft

Windows by offering a Linux-based operating system with tight linkages to Google’s

applications. Likewise, Google has bundled its paid search platform with a payment

service (Google “Checkout”) and a product listing service (Google “Base”) in a cross-

layer foreclosure attack against eBay.

Issues for Future Research

This section considers three sets of issues for future research on platform

envelopment. The first asks when envelopers should acquire an incumbent platform

provider rather than build a new platform internally. The second set concerns defensive

19

options for firms targeted for envelopment. For example, when should they match the

attacker’s bundle? The third set of issues examines organizational challenges posed by

envelopment attacks, which require a high level of internal, cross-unit coordination. The

paper concludes with a discussion of research methods appropriate for future work on

platform envelopment.

Acquisition vs. Internal Development

Future research should analyze tradeoffs confronting envelopers who can choose

between acquiring an incumbent platform provider and developing a platform de novo.

By acquiring a going concern, an enveloper can speed its attack, especially when it lacks

crucial skills and resources. Also, an acquisition can avoid the risk that mounting losses,

coupled with pressure from investors to improve short-term profit performance, will lead

to the premature shutdown of an in-house startup. However, compared to building from

scratch, acquiring an existing platform is likely to result in substantial integration

challenges that may result in compatibility problems in the near term.

Defensive Strategies

Researchers also should study factors that favor different defensive strategies for

firms facing envelopment. Besides investing aggressively in innovation to stay a step

ahead of potential attackers, options include:

• Changing Business Models. Simply ceding the targeted platform and redeploying

into new markets may be the best option for some firms. RealNetworks pursued this

approach in response to Windows Media Player, scaling back investment in its

streaming media platform. RealNetworks leveraged existing relationships with

consumers and music companies to launch Rhapsody, an online subscription music

service.

• Matching the Bundle. Firms may be able to counter an envelopment attack by

assembling a comparable bundle. The target can cross parry (Karnani & Wernerfelt,

1985) if it has the requisite skills and resources to enter the attacker’s core market,

and if barriers are not insurmountable due to intellectual property protection, high

switching costs, or other factors. These dynamics are evident in online recruitment:

as noted above, Monster.com added networking features in response to an

envelopment threat from LinkedIn, which subsequently added job listings.

However, bundle-versus-bundle competition can be exceptionally fierce (Bakos &

Brynjolfsson, 2000; Nalebuff, 2000), so researchers should consider conditions

under which accommodating an attack is likely to be more profitable than matching the enveloper’s bundle.

• Mergers and Alliances. Instead of assembling bundles on their own, platform

providers targeted for envelopment can merge or joint venture with their attackers’

rivals. Lotus, vulnerable to Microsoft’s Office Suite, pursued this approach in

merging with IBM. Likewise, RealNetworks’ Rhapsody platform, which is

vulnerable to envelopment by mobile phone and Internet service providers, was

able to co-opt potential rivals by joint venturing with Cingular and Comcast.

20

• Antitrust Litigation. Antitrust law for networked industries is still under dispute

(Evans, 2003; Farrell & Weiser, 2003; Carlton & Waldman, 2005a). Dominant

platform providers that offer bundles risk being charged with illegal tying. Several

targets for envelopment by Microsoft have received favorable antitrust rulings

and/or settlement payments, including Novell, RealNetworks, Sun Microsystems, and Netscape.

Organizational Issues

Launching an envelopment attack requires an unusually high level of cross-unit

coordination. Engineers must integrate two platforms’ functionality and marketers must

formulate joint pricing and targeting strategies. Even if the technology can be developed

internally, most companies find that achieving cross-unit cooperation is difficult, because

managers will fight for autonomy and strive to advance their units’ interests (Garud &

Kumaraswamy, 1995; Galunic & Eisenhardt, 2001).

Future research could focus on optimal organizational structures for encouraging

cross-unit cooperation in the context of envelopment, in particular, the appropriate degree

of structural separation between new and old units (Tushman & O’Reilly, 1996;

Christensen, 1997) and the ideal level of centralization of shared functions. Researchers

also could study the organizational systems, processes, and cultural values that successful

envelopers use to promote cross-unit cooperation, including transfer-pricing

arrangements and incentive plans.

Methodological Issues

Future research on envelopment should rely on a range of methods. Case studies

based on field interviews and analysis of archival records could reveal motivations for

envelopment beyond those discussed in this paper. Qualitative methods would also be

useful in exploring approaches that firms use to address the organizational issues

described above.

Econometric analysis could test hypotheses about factors that increase a firm’s

propensity to pursue envelopment and conditions that improve the odds of success with

different attack types. Likewise, additional analytical modeling could shed light on these

issues. To analyze the dynamics discussed above, however, a closed-form model would

need to reflect heterogeneity and correlation in potential users’ valuations, economies of

scope in marketing and production, and multi-homing costs, among other factors. Ideally,

models would evaluate not only pure bundling, but also tying and mixed bundling, and

would do so in a two-sided context. Due to the unusually large number of variables this

would require, researchers will likely find it difficult to develop tractable closed-form

models that capture the full richness of the envelopment phenomenon. However,

modeling specific aspects may be feasible. Likewise, simulation techniques may be well

suited for dealing with the intrinsic complexity of platform envelopment strategies.

Conclusion

In this paper, we introduced the concept of platform envelopment. By leveraging

common components and shared user relationships, one platform provider can envelop

21

another’s market, combining its own functionality with the target’s in a multi-platform

bundle. We presented a taxonomy of envelopment attacks, based on the relationship

between the attacker’s platform and its target’s, and discussed the economic and strategic

motivations for each attack type.

Briefly, with a conglomeration attack the platforms are functionally unrelated, but

may share common users and components. In that event, bundling can yield significant

economies of scope. With an intermodal attack the platforms are weak substitutes, and

the attacker may neutralize an emerging competitive threat. With a foreclosure attack the

platforms are complements. If envelopment reduces the appeal of a standalone provider’s

crucial complement, the attacker may strengthen its position vis-à-vis rivals in its core

market.

Envelopment is a widespread phenomenon that plays an important role in platform

evolution. It is an effective strategy for mounting cross-layer challenges in industries

where different firms dominate hierarchically organized strata of complements. Likewise,

the pervasive convergence of businesses that produce, process, and distribute digital

information often takes the form of platform envelopment. Most significantly,

envelopment provides a mechanism for platform leadership change that does not require

breakthrough innovation or Schumpeterian creative destruction. Well-established

incumbents that otherwise are sheltered from entry by standalone rivals due to strong

network effects and high switching costs may be vulnerable to envelopment.

22

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