Network Externalities and Networks

Kathy E. Gill

7 July 2008

Review

• What is an Info Economy?

• What is economics?

• Basic Supply-Demand Model

• Market Structures

• Types of Goods

Info Economy

• Info Economy, Post-Industrial Economy, “New” Economy? Information as a good and information technologies have replaced goods made of atoms and technologies resting on muscle.

• One definition: the new economy is an integration of free-market economies, globalization and information technology Information Technology, Corporate Productivity and the New Economy, p 9

What Is Economics?

• Economics is the study of how people (and institutions) act in a society with limited resources (iow, scarcity)– The choices are more diverse than simply $$ - it’s

also time, work, savings– Driving principle: that people optimize the “utility”

(satisfaction) of goods and services consumed - that we are rational

Supply-Demand

Market Structure

• Classic Free (Competitive) Market– Low fixed costs– Marginal cost = price … marginal cost is the

cost of producing one additional unit

• The “Natural” Monopoly– Large fixed costs– Small/zero marginal costs

Types of Goods

Rival Non-Rival

Excludable

• Most consumer goods

• Private land

• Services

• Single license software

• Trade secrets

• Multi-license software

• Patents

• Subscription web sites

Non-Excludable

• Public land

• Most roads

• Water - rivers, lakes

• “Public Goods”

• Basic research

• Defense, police, firemen

• Lighthouse

• “Open” websites

• TV (not cable!)

An Experience Good

• A good is an “experience” good if a consumer has to experience it to value it– Various biz strategies encourage “try before

you buy”– Who’s been in Costco lately? As Pam notes,

the “sample” is not a new way to sell. How does digitization change things, if at all?

Complementary Goods

• CDs + CD Player

• Bluetooth headset & cellphone

• The biggie: Microsoft & Intel

• Issues: network effects & lock-in

Network effects (1/2)

• Static analysis:– One person’s decision to adopt a new piece

of software (or other technology) has no effect on someone else’s welfare or decision to adopt

– Assumes no network externality

Network effects (2/2)

• Dynamic analysis:– The value of the software (or technology)

depends upon the decisions of others (interoperability, for example)

– Assumes there is a network externality

Locked In!

• Consumers may be locked into a network because of “cost of exit” (switching)– Contracts (cell phone 24-month policies)– Training (learn a new system – ugh)– Data conversion (from Word to Word Perfect, for

example)– Search cost (finding the new product)– Loyalty cost (frequent flyer programs, “minutes carry-

over”)

Philosophy

• Varian thinks it’s a good thing for firms to figure out how to create a lock as a way to improve the bottom line

• I think that, at best, it’s a short-term strategy and that it is potentially harmful to society

Telecom Networks

• Network externalities exist because the value of a network that a subscriber receives increases with the number of subscribers joining the network[2]. This benefit, however, is shared in common by all subscribers, so that the network may be regarded as an excludable but non-rival public good[3].

• Anyone can have access to the network (provided that there is enough capacity) but the use of the network by any subscriber does not diminish the use of or benefit of any other subscriber (provided that there is no congestion). Therefore, the use of or access to the network by an individual can be considered as a private good but the network as a whole (or access to the network) can be treated as a public good that has a particular kind of externality: the provision of this good to a single person benefits all persons.

From On the simple welfare economics of network externalities

Tipping

• As market share increases for any one product (system, technology), there are increasing returns (externality) from

increasing consumer demand, leading to dominance by one system

• Reminder that this is the opposite of the market structure envisioned by Adam Smith!

Networks v externalities

• Networks, in this context, are people doing what like-minded people do: connect and communicate

• Digital technologies make it easier to network in smaller groups (reduced transaction costs – see Shirky)

One More Point …

• Time (fixed) + Info Explosion (overload?) = Increased competition for “old” media

Conclusion (1/2)

• Economy is increasingly reliant on information technologies and information

• Firms in this sector have a different cost structure than traditional goods/sectors like ag or manufacturing

• Where this will end …. Is beyond my crystal ball!

Conclusion (2/2)

• The products in this sector have characteristics of a public good -- the antithesis of a scarce, excludable good

• Thus information technology is disruptive, economically and socially

Resources (1/3)

• The Inkjet Printer, from The Economist. (2002) http://emlab.berkeley.edu/users/bhhall/e124inkjetprinter.html

• The Invention of Email, from Pretext Magazine (1998) http://emlab.berkeley.edu/users/bhhall/e124emailinvention.pdf

• Hal R. Varian , “High Technology Industries and Market Structure” (2001) http://www.sims.berkeley.edu/~hal/Papers/structure/structure.html

• Science and Engineering Indicators (2002) National Science Board. http://www.nsf.gov/sbe/srs/seind02/start.htm

Resources (2/3)

• Michael L. Katz and Carl Shapiro. “Systems Competition and Network Effects,” Journal of Economic Perspectives, Vol 8 No 2 (1994)

• Nicholas Economides. “The Economics of Networks,” International Journal of Industrial Organization, October (1996) http://www.stern.nyu.edu/networks/top.html

• S.J. Liebowitz and Stephen E. Margolis. “Network Externality: An Uncommon Tragedy,” Journal of Economic Perspectives, Vol 8 No 2 (1994)

Resources (3/3)

• Timothy F. Bresnahan. “The Economics of the Microsoft Case.” http://www.stanford.edu/~tbres/Microsoft/The_Economics_of_The_Microsoft_Case.pdf

• Stephen Martin. “The Nature of Innovation Market Failure and the Design of Public Support for Private Innovation” http://www.sam.sdu.dk/undervis/92172.E03/martin_scott.pdf

• Tore Nilssen and Lars Sørgard. “TV Advertising, Programming Investments, and Product-Market Oligopoly” http://www.nhh.no/sam/res-publ/2000/dp06.pdf