The value of a fax machine comes exclusively from other people owning fax machines.  If you are the only one in the world with a fax machine, then your fax machine has no value.  In fact, it is no longer a fax machine because it can no longer fax.  A fax machine is a good example of a product with 100% externality.  Externality is a concept in marketing referring to the characteristic many products have where a product becomes more valuable to an owner of that product when more other people own that product too.   

As knowledge and communication components become an increasingly greater part of the value added of many products, externality becomes an increasingly important dimension of competition.  The beauty of externality from the perspective of leading companies in an industry is that externality creates a kind of natural monopoly where people will use or buy your product, not necessarily because they like your product, but because other people use or buy your product. 

Microsoft has externality.  I use both Apple and Microsoft, and the number of error messages and virus problems I encounter from Apple is far less than what I experience with Microsoft.  Still, most of the time I use Microsoft.  Why do I use Microsoft?  Why does everybody use Microsoft?  Because everybody uses Microsoft.

Haier has a degree of externality too.  When more people buy a Haier refrigerator, more repair people will know how to fix a Haier refrigrator and more repair parts will be readily available everywhere to fix a Haier refrigerator.  Accordingly, when more people buy a Haier refrigerator a Haier refrigerator becomes cheaper to repair and therefore more valuable. 

Books and movies have externality.  When everybody has read a certain book or seen a certain movie I want to read that book or see that movie, if only to find out what everybody else has read or seen.  Fashion and brands have externality.  Suppose a salesperson offers a cigarette to a potential customer and they discover that they both smoke the same brand of cigarette.  Somehow the salesperson and the potential customer then become closer in their relationship.  This is why we follow fashion, to wear what other people wear.  Even people who try to wear the new fashion nobody wears are very careful to wear the fashion other people wear. Who want to wear what nobody wears?

Consumers therefore are often willing to pay a higher price for products from companies with greater market share.  This is rational behavior on the part of consumers when products have externality.  We are all well aware of the existence of economies of scale in the production of many goods:  The greater the quantities of a product a company produces, the lower production costs can be.  Not so many people are aware of the existence of a different kind of economies of scale in the marketing of many goods: The greater the quantities of a product a company sells, the higher prices can be.

These double benefits of market leadership truly make the market leader unchallengeable: lower production costs coupled with higher prices allow the sort of profit that make it impossible for a challenger to gain market share through a price war or advertising war.  Market leaders therefore should actively seek out and build opportunities for externality. 

Firms can choose to compete on a variety of dimensions: Firms can lower price, increase advertising, lengthen warranties, increase margins for distributors, add new features to a product, etc.   Firms, and certainly leading firms, can affect the dimensions on which competition in an industry takes place.  For example, when one firm offers warranties for longer periods of time, other firms need to follow in order to stay competitive.

Wise leading firms look constantly for opportunities to raise the standard on dimensions of competition where externality is a factor.  There are many types of externality and ways of increasing externality.  Let me just give here the example of offering better service.  Volkswagen in China could promise that any part necessary for your Volkswagen is always less than 24 hours away.  It is many times easier in China for Volkswagen (or Buick) to keep such a promise than it is for much smaller competitors and new entrants in the market.  After sales support in general therefore is something companies such as Volkswagen or Haier or Philips, etc. will want to emphasize and raise industry standards and customer expectations on.   

Japanese manufacturers of elevators offer in Japan a four hour service guarantee, meaning that they guarantee that when an elevator breaks down, they will have a repair crew on the premises within four hours.  Once one Japanese firm set this standard, other firms in Japan followed.  But the four hour service guarantee does not merely serve to make the customer happier and to add value; the guarantee also makes it more difficult for smaller competitors and for new competitors.  The guarantee enhances externality of the product: the importance to customers of buying what other customers buy. 

The aforegoing raises the question: so what do you do if you are not the market leader?  The first answer is: do not start a fight on dimensions of externality.  The second answer is: become a market leader.  How do you become market leader?  I will address that question in my next column.