Platform Transformation Risk and the Role of Hosting Rivals

Abstract

Under what conditions should traditional firms transform into digital platforms? While adding developers can enhance value through externalizing value creation, it also entails investment risk. We show that when transformation entails high risk and the value of network effects is low, firms should avoid transforming into a platform and retain their traditional form. By contrast, low transformation risk or high value of network effects make digital transformation profitable. Interestingly, when firms choose to transform, we show that inviting rivals onto the platform can raise profits. Indeed, the platform can even pay rivals to join its platform in certain cases. We find that the benefit of enhancing network effects through demand aggregation can be more profitable than competing as separate platforms. Further, inviting rivals onto a proprietary platform lowers the rival’s competitive aggressiveness. This is a novel strategic rationale for inviting rivals onto the platform elicited in this article. Yet, when the value of network effects is very high and investments are nearly certain, the platform chooses to foreclose rivals’ participation. We offer guidelines for managers seeking to transform and for regulators seeking to intervene to boost market efficiency. We use real-world examples to illustrate our theory.