[economides] the economics of networks
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ELSEVIER
International Journal of Industrial Organization
14 (1996) 673-699
n t m t i ~ l Jo u rn a lo f
I n d u s t r i a l
O r g a n i z a d o n
T h e E c o n o m i c s o f n e tw o r k s
Nicholas conomides
Stern School of Business New York University New York NY 10012-1126 USA
A b s t r a c t
I a n a l y z e t h e s a l i e n t f e a t u r e s o f n e t w o r k s a n d p o i n t o u t t h e s i m i l a r i t i e s b e t w e e n t h e
e c o n o m i c s t r u c tu r e o f n e t w o r k s a n d t h e s t r u c tu r e o f v e r t ic a l l y re l a t e d in d u s t ri e s . T h e
a n a l y s i s f o c u s e s o n p o s i t i v e c o n s u m p t i o n a n d p r o d u c t i o n e x t e r n a l i t i e s , c o m m o n l y c a l l e d
n e t w o r k e x t e r n a l i t i e s . I d i s c u s s t h e i r s o u r c e s a n d t h e i r e f f e c t s o n p r i c i n g a n d m a r k e t
s t r u c t u r e . I d i s t i n g u i s h b e t w e e n r e s u l t s t h a t d o n o t d e p e n d o n t h e u n d e r l y i n g i n d u s t r y
m i c r o s t r u c t u r e ( t h e ' m a c r o ' a p p r o a c h ) a n d t h o s e t h a t d o ( t h e ' m i c r o ' a p p r o a c h ) . I a n a l y z e
t h e i s s u e s o f c o m p a t i b i li t y , c o o r d i n a t i o n t o t e c h n i c a l s t a n d a rd s , i n t e r c o n n e c t i o n a n d
i n t e r o p e r a b i l i t y , a n d t h e i r e f f e c t s o n p r i c i n g a n d q u a l i t y o f s e r v i c e s a n d o n t h e v a l u e o f
n e t w o r k l i n k s in v a r i o u s o w n e r s h i p s t ru c t u re s . I a l s o b r ie f l y d is c u s s t h e i s s u e o f i n t e r c o n n e c -
t i o n f ee s fo r b o t t l en eck f ac i l i t i e s .
I I n t r o d u c t i o n 2
N e t w o r k i n d us t ri e s p la y a c r u c ia l r o l e i n m o d e m l if e . T h e m o d e m e c o n o m y
w o u l d b e v e r y m u c h d i m i n i s h e d w i t h o u t th e tr a n sp o r ta t io n , c o m m u n i c a t i o n s ,
i n f o r m a t i o n , a n d r a i l r o a d n e t w o r k s . T h i s e s s a y w i l l a n a l y z e th e m a j o r e c o n o m i c
f e a t u r e s o f n e t w o r k s . I n t h e c o u r s e o f t h e a n a l y s is i t w i l l b e c o m e c l e a r t h a t m a n y
i m p o r t a n t n o n - n e t w o r k i n d u st r i e s s h a r e m a n y e s s e n t ia l e c o n o m i c f e a tu r e s w i t h
n e t w o r k i n d u s tr i e s . T h e s e n o n - n e t w o r k i n d u s t r i e s a re c h a r a c t e r i z e d b y s tr o n g
c o m p l e m e n t a r y r e l a t i o n s . T h u s , t h e l e s so n s o f n e t w o r k s c a n b e a p p l i e d to
]Plenary session address, E.A.R.I.E. conference, Chan ia, Greece, September 1994. I thank Larry
White for helpful comments.
2The literature on netwo rks is so extensive that it is futile to attempt to co ve r it . This paper discusses
only some issues that arise in networks and attempts to point out areas in which further research is
necessary.
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industries where vertical relations play a crucial role; conversely, the economic
and legal learning developed in the analysis of vertically related industries can be
applied to network industries.
2 C l a s s if i ca t io n o f n e t w o r k s
Formally, networks are composed of links that connect nodes. It is inherent in
the structure of a network that many components of a network are required for the
provision of a typical service. Thus, network components are complementary to
each other. Fig. 1 represents the emerging
i n f o r m a t i o n s u p e r h i g h w a y
network.
Clearly, services demanded by consumers are composed of many complementary
components. For example, interactive ordering while browsing in a department
store as it appears in successive video frames requires a number of components: a
database engine at the service provider, transmission of signals, decoding through
an interface, display on a TV or computer monitor, etc. Clearly, there are close
substitutes for each of these components; for example, transmission can be done
through a cable TV line, a fixed telephone line, a wireless satellite, PCN, etc.; the
in-home interface may be a TV-top box or an add-on to a PC, etc. It is likely that
the combinations of various components will not result in identical services. Thus,
the information superhighway will provide substitutes made of complements; this
is a typical feature of networks.
Fig. 2 shows this feature in a simple star telephone network. A phone call from
A to B is composed of
A S
(access to the switch of customer
A ) , B S
(access to the
D IRECT
BROADCAST
CABLE
SATELLITE
W IRELESS )
TELCO
Fig. 1. An information superhighway.
PERSONAL
COMMUN .
SERV ICES
PCS ,PCN
W IRELESS )
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B
F o
Fig. 2. A :simple star netwo rk.
s w i t c h o f c u s t o m e r B ) , a n d s w i t c h i n g s e r v i c e s a t S . D e s p i t e t h e fa c t th a t g o o d s
A S
a n d B S l o o k v e r y s i m i l a r a n d h a v e t h e s a m e i n d u s t r i a l c l a s s i f ic a t i o n , t h e y a r e
c o m p l e m e n t s a n d n o t s u b s t i t u t e s .3
N e t w o r k s w h e r e s e r v i c e s
A B
a n d
B A a r e
d i s ti n c t a r e n a m e d t w o - w a y n e t w o r k s
i n E c o n o m i d e s a n d W h i t e ( 1 9 9 4 ). T w o - w a y n e t w o r k s i n c l u d e r a i lr o a d , r o a d , a n d
m a n y t e l e c o m m u n i c a t i o n s n e tw o r k s . W h e n o n e o f A B o r B A i s u n f e a s i b le , o r d o e s
n o t m a k e e c o n o m i c s e n s e , o r w h e n t h e r e is n o s e n s e o f d i r e c t i o n in th e n e t w o r k s o
t h a t
A B
a n d
B A a r e
i d e n t i c a l , t h e n t h e n e t w o r k i s c a l l e d a o n e - w a y n e t w o r k . I n a
t y p i c a l o n e - w a y n e t w o r k , t h e re a r e tw o t y p e s o f c o m p o n e n t s , a n d c o m p o s i t e g o o d s
a r e f o r m e d o n l y b y c o m b i n i n g a c o m p o n e n t o f e a c h t y p e , a n d c u s t o m e r s a r e o f t e n
n o t id e n t i fi e d w i t h c o m p o n e n t s b u t i n s te a d d e m a n d c o m p o s i t e g o o d s . F o r e x a m p l e ,
b r o a d c a s t i n g a n d p a g i n g a r e o n e - w a y n e t w o r k s 4
T h e c l a s s i f i c a t i o n i n n e t w o r k t y p e ( o n e - w a y o r t w o - w a y ) i s n o t a f u n c t i o n o f th e
t o p o l o g i c a l s t r u c tu r e o f t h e n e t w o r k . R a t h e r , i t d e p e n d s o n t h e i n t e r p r e t a t i o n o f th e
s t r u c tu r e t o r e p r e s e n t a s p e c i f i c se r v i c e . F o r e x a m p l e , t h e n e t w o r k o f F i g . 3 c a n b e
i n t e r p r e t e d a s a t w o - w a y t e l e p h o n e n e t w o r k w h e r e S A r e p r e s e n t s a l o c a l s w i t c h i n
c i t y A , A i r e p r e s e n t s a c u s t o m e r i n c i t y A , a n d s i m i l a r l y f o r
S B
a n d B j .5 I n t h i s
n e t w o r k , t h e r e a r e t w o t y p e s o f l o c a l p h o n e c a l l s A i S A A ~ a n d B i S B B ~, a s w e l l a s
AS
and B S can also be components of substitute phone calls A S C and BSC.
The 1994 spectrum auction will allow for a large two-way paging network.
5In this network, we may identify end-nodes, such as A and B , end-links, such as ASA and SsB~, the
interface or gatew ay SAS~, and switches SA and SR.
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A B B2
A
S B
Fig. 3. A sim ple local and lon g distance network.
l ong d i s t ance phone ca l l
AiSASBBj .
W e can a l so i n t e rp r e t the ne two rk o f F ig . 3 a s
a n a u to m a t i c te l le r m a c h i n e n e t w o r k A T M ) . T h e n a t r a n s a c ti o n s a y a w i t h d r a w a l )
f r o m b a n k B j f r o m A T M A i is A f l A S B B . C o n n e c t i o n s A f l a A k a n d B j S s B ~ m a y b e
f e a s i b l e b u t t h e r e i s n o d e m a n d f o r t h e m .
W e h a v e p o i n t e d o u t e a r l i e r t h a t t h e c r u c i a l r e l a t i o n s h i p i n b o t h o n e - w a y a n d
t w o - w a y n e t w o r k s i s t h e c o m p l e m e n t a r i t y b e t w e e n t h e p i e c e s o f t h e n e t w o r k . T h i s
c r u c i a l e c o n o m i c r e l a t i o n s h i p i s a l s o o f t e n o b s e r v e d b e t w e e n d i f f e r e n t c l a s s e s o f
g o o d s i n n o n - n e t w o r k in d u s tr ie s . I n f a c t, E c o n o m i d e s a n d W h i t e 1 9 9 4 ) p o i n t o u t
t ha t a pa i r o f ve r t i c a l l y r e l a t ed i ndus t r i e s i s f o rma l ly equ iva l en t t o a one -way
n e t w o r k . F i g . 4 c a n r e p r e s e n t tw o i n d u s tr i e s o f c o m p l e m e n t a r y g o o d s A a n d B ,
w h e r e c o n s u m e r s d e m a n d c o m b i n a t i o n s A~Bj. Not i ce t ha t t h i s f o rmu la t i on i s
f o r m a l l y id e n t i ca l t o o u r l o n g - d i s ta n c e n e t w o r k o f F i g . 3 i n th e A T M i n t er p r e ta -
t ion .
T h e d i s c u s s io n s o f a r w a s c a r r ie d u n d e r t h e a s s u m p t i o n o f
c o mp a t ib i l i t y ,
i .e . that
v a r i o u s l i n k s a n d n o d e s o n t h e n e t w o r k a r e c o s t l e s s l y c o m b i n a b l e t o p r o d u c e
d e m a n d e d g o o d s . W e h a v e p o i n t e d o u t t h at l in k s o n a n e t w o r k a r e p o t e n t ia l l y
c o m p l e m e n t a r y , b u t i t i s c o m p a t i b i l i ty t h a t m a k e s c o m p l e m e n t a r i t y a c t u a l . S o m e
n e t w o r k g o o d s a n d s o m e v e r t i c a l l y r e l a t e d g o o d s a r e i m m e d i a t e l y c o m b i n a b l e
b e c a u s e o f th e i r i n h e re n t p r o p e r ti e s . H o w e v e r , f o r m a n y c o m p l e x p r o d u c t s , a c t u a l
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A 1 A 2 A m
B 1 1 32 B n
Fig. 4. A pair of vertically related markets.
complementarity can be achieved only through the adherence to specific technical
compatibility standards. Thus, many providers of network or vertically related
goods have the option of making their products partially or fully incompatible with
components produced by other firms. This can be done through the creation of
proprietary designs or the outright exclusion or refusal to interconnect with some
firms.
Traditionally, networks were analyzed under the assumption that each network
was owned by a single firm. Thus, economic research focused on the efficient use
of the network structure as well as on the appropriate allocation of costs 6 In the
70s, partly prompted by the antitrust suit against AT T, there was a considerable
amount of research on economies of scope, i.e. on the efficiency gains from joint
operation of complementary components of networks.7
Once one of the most important networks (the AT T telecommunications
network in the US) was broken to pieces, economic research focused in the 80s
and 90s on issues of interconnection and compatibility. Similar research on issues
of compatibility was prompted by the reduced role of IBM in the 80s and 90s in
the setting of technical standards in computer hardware and software. Significant
reductions in costs also contributed and will contribute to the transformation
toward fragmented ownership in the telecommunications sector in both the United
States and abroad. Costs of transmission have fallen dramatically with the
introduction of fiberoptic lines. Switching costs have followed the fast cost
See
Sharkey (1995) for an excellent survey.
7See Baumol et al. (1982).
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decreases of microchips and integrated circuits. These cost reductions have
transformed the telecommunica tions industry from a natural monopo ly to an
oligopoly• The same cost reductions have made many new services, such as
interactive video and interactive games, feasible at low cost. Technological change
now allows for joint trans mission of digital signals of various communica tions
services. Thus, the monopoly of the last link closest to home is in the process of
being eliminated,8 since both telephone lines and cable lines (and in some cases
• 91
PCS and terrestrial satellites) will provide similar services. '
In a network where complementary as well as substitute links are owned by
different firms, the questions of i nterconn ection, compatibili ty, interoperability,
and coordination of quality of services become of paramou nt importance. We will
examine these issues in detail in the next few sections. We first focus on a
funda menta l property of networks, i.e. the fact that they exhibit network exter-
nalities.
3 N e t w o r k e x t e r n a li t ie s
Networks exhibit positive consumption and production externalities. A positive
consumption externality (or network externality) signifies the fact that the value of
a unit of the good increases with the number of units sold. To economists, this fact
seems quite cou nterintui tive, since they all know that, except for potatoes in Irish
famines, market dema nd slopes downwards. Thus, the earlier statement, the value
of a unit of a good increases with the numb er of units sold, should be interpreted
as the value of a unit of the good increases with the expected numbe r of units to
be sold. Thus, the dem and slopes downward but shifts upward with increases in
the number of units expected to be sold.
81t is already eliminated in some parts of the United Kingdom, where cable TV operators offer
telephone service at significantly ower prices than British Telecom.
9These significantchanges in costs and the convergenceof communications ervices open an number
of policy questions on pricing, unbundling,deregulation, and possibly mandated segmentation n this
sector. It is possible that ownership breakup of local and long distance lines is no longer necessary to
improve competition. For example, European Unionpolicy mandates open competitionby 1998 in any
part of the telecommunicationsnetwork, but does not advocate vertical fragmentationof the existing
integrated national monopolies; see European Commission (1994). The reduction in costs and the
elimination of natural monopoly in many services may make it possible for this policy to lead the
industry to competition.
~°Another important network, the airline network, faces significantchange in Europe. Airlines have
not benefited from significantcost reductions and technological change; the present reform is just the
abolition by the European Union of the antiquated regime of national airline monopolies, and its
replacement by a more competitive environment.
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679
3.1. Sources o f network externalities
The key reason for the appearance of network externalities is the complemen-
tarity between the components of a network. Depending on the network, the
externality may be direct or indirect. When customers are identified with
components, the externality is direct. Consider for example a typical two-way
network, such as the local telephone network of Fig. 2. In this n-component
network, there are n n - 1) potential goods. An additional (n + l th) customer
provides direct externalities to all other customers in the network by adding 2n
potential new goods through the provision of a complementary link (say ES) to the
existing links. 11
In typical one-way networks, the externality is only indirect. When there are m
varieties of component A and n varieties of component B as in Fig. 4 (and all
A-type goods are compatible with all B-type), there are mn potential composite
goods. An extra customer yields indirect externalities to other customers, by
increasing the demand for components of types A and B and thereby (because of
the presence of economies of scale) potentially increasing the number of varieties
of each component that are available in the market.
Financial exchange networks also exhibit indirect network externalities. There
are two ways in which these externalities arise. First, externalities arise in the act
of exchanging assets or goods. Second, externalities may arise in the array of
vertically related services that compose a financial transaction. These include the
services of a broker, of bringing the offer to the floor, matching the offer, etc. The
second type of externalities are similar to other vertically related markets. The first
way in which externalities arise in financial markets is more important.
The act of exchanging goods or assets brings together a trader who is willing to
sell with a trader who is willing to buy. The exchange brings together the two
complementary goods, willingness to sell at price p (the off er ) and willingness
to buy at price p (the counterof fer ) and creates a composite good, the exchange
transaction. The two original goods were complementary and each had no value
without the other one. Clearly, the availability of the counteroffer is critical for the
exchange to occur. Put in terms commonly used in finance, minimal liquidity is
necessary for the transaction to occur.
Financial markets also exhibit positive size externalities in the sense that the
increasing size (or thickness) of an exchange market increases the expected utility
of all participants. Higher participation of traders on both sides of the market
(drawn from the same distribution) decreases the variance of the expected market
price and increases the expected utility of risk-averse traders. Ceteris paribus,
~ This property of two-way networks was pointed out in telecommunications networks by Rohlfs
(1974) in a very early paper on network externalities. See also Oren and Smith (1981).
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higher liquidity increases traders utility. Thus, financial exchange markets also
exhibit network externalities.12 13
3 .2 . T h e m a c r o a p p r o a c h
There are two approaches and two strands of literature in the analysis of
network externalities. The first approach assumes that network externalities exist,
and attempts to model their consequences . I call this the mac ro approach.
Conceptually this approach is easier, and it has produced strong results. It was the
predominant approach during the 80s. The second approach attempts to find the
root cause of the network externalities. I call this the mic ro approach. In
industrial organization, it started with the analysis of mix-and-match models and
has evolved to the analysis of various structures of vertically related markets. In
finance, it started with the analysis of price dispersion models. The mic ro
approach is harder, and in many ways more constrained, as it has to rely on the
under lyin g microstrncture. However, the mic ro approach has a very significant
benefit in defining the market structure. We discuss the mac ro approach first.
3 . 2 .1 . P e r f e c t c o m p e t i t i o n
As we have noted earlier, network externalities arise out of the complementarity
of different network pieces. Thus, they arise naturally in both one- and two-way
networks, as well as in vertically related markets. The value of good X increases as
more of the com plem enta ry good Y is sold, and vice versa. Thus, more o f Y is sold
as more X is sold. It follows that the value of X increases as more of it is sold.
This positive feedback loop seems explosive, and indeed it would be, except for
the inherent downward slope of the demand curve. To understand this better,
consider a fulfilled expectations formulation of network externalities as in Katz
and Shapiro (1985), Economides (1993b), Economides (1996a), and Economides
and Himm elb erg (1995). Let the will ingnes s to pay for the nth uni t of the good
~2For a more detailed discussionof networks in finance see Economides (1993a). Economides and
Schwartz (1995a) discuss how to set up electronic call markets that bunch transactions and execute
them all at once. Call markets have inherentlyhigher liquiditybecause they take advantage of network
externalities in exchange. Thus, transaction costs are lower in call markets. Economides (1994a) and
Economides and Heisler (1994) discuss how to increase liquidity in cal l markets. The survey of
institutional nvestorsreported by Economides and Schwartz (1995b) find that many raders who work
in the present continuousmarket environmentwould be willing o wait a numberof hours for execution
of their orders if they can save in transactioncosts, includingbid-ask spreads. Thus, the time is right for
the establishmentof call markets in parallel operation with the continuousmarket.
~3The increase of utility in expectation due to market thickness was pointed out by Economides and
Siow (1988), and earlier and in less formal terms by Garbade and Silber (1976a), Garbade and Silber
(1976b), and Garbade and Silber (1979). The effects are similar to those of search models as in
Diamond (1982) and Diamond (1984).
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w h e n n e u n i ts a r e e x p e c t e d t o b e s o l d b e
p n ; n e . 1 4
T h i s i s a d e c r e a s i n g f u n c t i o n o f
i ts f ir st a r g u m e n t b e c a u s e t h e d e m a n d s l o p e s d o w n w a r d , p n; n e) i n c r e a s e s i n n e ;
t h i s c a p t u r e s t h e n e t w o r k e x t e r n a l i t i e s e f f e c t. A t a m a r k e t e q u i l i b r i u m o f t h e s i m p l e
s i n g l e - p e r i o d w o r l d , e x p e c t a t i o n s a r e f u l f il l e d , n n e t h u s d e f i n i n g t h e f u l f i l l e d
e x p e c ta t io n s d e m a n d
p n, n).
F i g . 5 s h o w s t h e c o n s t r u c t i o n o f a t y p i c a l f u l f il l e d
e x p e c t a t i o n s d e m a n d . E a c h c u r v e D i, i = 1 . . . . 4 , s h o w s t h e w i l l i n g n e s s t o p a y f o r
a v a r y i n g q u a n t i t y n , g i v e n a n e x p e c t a t i o n o f s a l e s n e = n i. A t n = n i , e x p e c t a t i o n s
a r e f u l f i ll e d a n d t h e p o i n t b e l o n g s t o
p n , n)
a s
p ni, ng).
T h u s
p n , n)
i s c o n s t r u c t e d
a s a c o l l e c t i o n o f p o i n t s
p n i, n~).
T o a v o i d e x p l o s i o n s a n d i n f i n it e s a l e s , i t i s r e a s o n a b l e t o i m p o s e l i m n _ ~
p n ,
n ) = 0 ; i t t h e n f o l l o w s t h a t
p n , n)
i s d e c r e a s i n g f o r l a r g e n . E c o n o m i d e s a n d
H i m m e l b e r g 1 9 9 5 ) s h o w t ha t t h e f u lf i ll e d e x p e c t a t io n s d e m a n d i s i n c r e a s in g f o r
s m a l l n i f e i t h e r o n e o f t h r e e c o n d i t i o n s h o l d : i ) the u t i l ity o f every consum er in a
ne tw ork o f zero s ize i s zero , o r i i ) there are im med iate and large ex ternal bene fi ts
to ne twork expans ion fo r ve ry sma l l ne tworks ,
o r i i i )
there is a s ignif icant density
c,p
D 1
~ /
p n,n)
f i
n n 2 n 3 n 4 n °
F i g . 5 . C o n s t r u c t i o n o f t h e f u l fi l l ed e x p e c t a t i o n s d e m a n d .
n
] 4 In t h i s f o r m u l a t i o n n a n d n e a r e n o r m a l i z e d s o t h a t t h e y r e p r e s e n t m a r k e t s h a r e s r a t h e r t h a n
a b s o l u t e q u a n t i t i e s .
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682
N . E c o n o m i d e s / I n t. J . I n d . O r g a n . 1 4 1 9 9 6 ) 6 7 3 - 6 9 9
o f h i g h -w i l l in g n e s s - to - p a y c o n s u m e r s w h o a r e j u s t i n d if fe r e n t o n j o i n i n g a n e t w o r k
o f a p p r o x i m a t e l y z e r o s iz e . T h e f i r s t c o n d i t i o n i s s t r a i g h t f o r w a r d a n d a p p l i e s
d i r e c t l y t o a l l t w o - w a y n e t w o r k s . T h e o t h e r t w o c o n d i t i o n s a r e a b i t m o r e s u b t l e ,
b u t c o m m o n l y o b s e r v e d i n n e t w o r k s a n d v e r t i c a l l y r e l a t e d i n d u s t r i e s .
W h e n t h e f u l fi l le d e x p e c t a t i o n s d e m a n d i n c r e a s e s f o r sm a l l n , w e s a y t h a t t h e
n e t w o r k e x h i b i t s a p o s i t i v e c r i t i c a l m a s s u n d e r p e r f e c t c o m p e t i t io n . T h i s m e a n s
t h at , i f w e i m a g i n e a c o n s t a n t m a r g i n a l c o s t c d e c r e a s i n g p a r a m e t r i c a l l y , t h e
n e tw o r k w i l l s t a r t a t a p o s i t i v e a n d s i g n i f i c a n t s i z e n ° ( c o r r e s p o n d in g t o m a r g in a l
c o s t c ° ) . F o r e a c h s m a l l e r m a r g in a l c o s t , c < c ° , t h e r e a r e t h r e e n e tw o r k s i z e s
c o n s i s t e n t w i t h m a r g i n a l c o s t p r i c i n g : a z e r o s i z e n e t w o r k ; a n u n s t a b l e n e t w o r k
s i z e a t t h e f ir s t i n t e r s e c t i o n o f t h e h o r i z o n t a l t h r o u g h c w i th p n , n ) ; a n d t h e P a r e to
o p t i m a l s t a bl e n e t w o r k s i z e a t t h e l a r g e s t i n te r s e c t i o n o f t h e h o r i z o n t a l w i t h
p n , n ) .
T h e m u l t i p l i c i t y o f e q u i l ib r i a i s a d i r e c t r e s u l t o f th e c o o r d i n a t i o n p r o b l e m t h a t
a r i s e s n a tu r a l l y i n t h e t y p i c a l n e tw o r k e x t e r n a l i t i e s m o d e l . I n s u c h a s e t t in g , i t i s
n a tu r a l t o a s s u m e th a t t h e P a r e to o p t im a l n e tw o r k s i z e w i l l r e s u l t. 15
I n t h e p r e s e n c e o f n e t w o r k e x t e r n a li t ie s , i t i s e v i d e n t t h a t p e r f e c t c o m p e t i t i o n i s
i n e f fi c i en t : T h e m a r g i n a l s o c i a l b e n e f i t o f n e t w o r k e x p a n s i o n i s la r g e r th a n t h e
b e n e f i t t h a t a c c r u e s t o a p a r t i c u l a r f i r m u n d e r p e r f e c t c o m p e t i t i o n . T h u s , p e r f e c t
c o m p e t i t i o n w i l l p r o v i d e a s m a l l e r n e t w o r k t h a n i s s o c i a l l y o p t i m a l , a n d f o r s o m e
r e l a t i v e l y h i g h m a r g i n a l c o s t s p e r f e c t c o m p e t i t i o n w i l l n o t p r o v i d e t h e g o o d w h i l e
i t i s s o c i a l l y o p t im a l t o p r o v id e i t .
O n e i n t e r e s t i n g q u e s t i o n t h a t r e m a i n s v i r t u a l l y u n a n s w e r e d i s h o w t o d e c e n t r a l -
i z e t h e w e l f a r e m a x i m i z i n g s o l u t i o n i n t h e p r e s e n c e o f n e t w o r k e x t e rn a l it i es .
C l e a r l y , t h e w e l f a r e m a x i m i z i n g s o l u t i o n c a n b e i m p l e m e n t e d t h r o u g h p e r f e c t
p r i c e d i s c r i m i n a t i o n , b u t t y p i c a l l y s u c h d i s c r i m i n a t i o n i s u n f e a s i b le . I t r e m a i n s t o
b e s e e n t o w h a t e x t e n t m e c h a n i s m s t h a t a ll o w f o r n o n - l i n e a r p r i c i n g a n d s e l f-
s e l e c t i o n b y c o n s u m e r s w i l l c o m e c l o s e t o t h e f i r s t b e s t .
3 . 2 . 2 . M o n o p o l y
E c o n o m i d e s a n d H i m m e l b e r g ( 1 9 9 5 ) s h o w t h a t a m o n o p o l i s t w h o i s u n a b l e t o
p r i c e - d i s c r i m i n a t e w i l l s u p p o r t a s m a l l e r n e t w o r k a n d c h a r g e h i g h e r p r i c e s t h a n
p e r f e c t l y c o m p e t i t i v e f i r m s . T h i s i s d e s p i t e t h e f a c t t h a t t h e m o n o p o l i s t h a s
i n f l u e n c e o v e r t h e e x p e c t a t i o n s o f th e c o n s u m e r s , a n d h e r e c o g n i z e s t h is i n f l u e n ce ,
w h i l e n o p e r f e c t l y c o m p e t i t i v e f i rm h a s s u c h i n f lu e n c e . 16 I n f l u e n c e o v e r e x p e c t a -
t i o n s d r i v e s t h e m o n o p o l i s t t o h i g h e r p r o d u c t i o n , b u t t h e m o n o p o l i s t s p r o f i t-
m a x i m i z i n g t e n d e n c y t o w a r d s r e s t r i c t e d p r o d u c t i o n i s s t r o n g e r a n d l e a d s i t t o
~sIt is possible to have other shapes of the fulfilled expectations demand. In general p n , n ) is
quasiconcave under weak conditions on the distribution of preferences and the network externality
function. Then if none of the three causes mentioned above are not present the fulfilled expectations
demand is downward sloping.
~rA monopolist unable to influence expectations will clearly produce less than a monopolist able to
influence expectations.
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N. Economides / Int. J. Ind. Organ. 14 1996) 673-699 683
l o w e r p r o d u c t i o n l e v e l s t h a n p e r f e c t c o m p e t i t i o n . T h u s , c o n s u m e r s a n d t o t a l
s u r p lu s w i l l b e l o w e r i n m o n o p o l y t h a n i n p e r f e c t c o m p e t i t i o n . T h e r e f o r e t h e
e x i s t e n c e o f n e t w o r k e x t e r n a l i t i e s d o e s n o t r e v e r s e t h e s t a n d a r d w e l f a r e c o m -
p a r i s o n b e t w e e n m o n o p o l y a n d c o m p e t i t i o n ; i t f o l l o w s t h a t
the existence of
network externalities cannot be claimed as a reason in favor of a monopoly
market structure.
3.2.3. Oligopoly and monopolistic competition under compatibility
C o u r n o t o l i g o p o l i s t s p r o d u c i n g c o m p a t i b l e c o m p o n e n t s a l s o h a v e s o m e i n -
f l uence ove r expec t a t i ons . A na tu r a l w ay t o mode l t he i n f luence o f o l i gopo l i s t s on
ou tpu t expec t a t i ons i s t o a s sume tha t eve ry o l i gopo l i s t t ake s t he ou tpu t o f a l l
o t h e r s a s g i v e n a n d s e t s t h e e x p e c t a t i o n o f c o n s u m e r s o f h i s o w n o u t p u t . I n t h i s
s e tt in g , M c o m p a t i b l e C o u r n o t o l i g o p o li s ts s u p p o r t a n e t w o r k o f a si z e b e t w e e n
m o n o p o l y ( M = 1 ) a n d p e r f e c t c o m p e t i t i o n ( M = 2 ) . T h e a n a l y s i s c an e a s i l y b e
e x t e n d e d t o m o n o p o l i s t i c c o m p e t i t i o n a m o n g c o m p a t i b l e o l i g o p o l i s t s i f f i r m s f a c e
d o w n w a r d - s l o p i n g a v e r a g e c o s t c u r v e s a s s h o w n i n F i g . 6 . F i r m s p r o d u c e o n t h e
d o w n w a r d - s l o p i n g p a r t o f t h e f i r m - s c a l e d f u lf i ll e d e x p e c t a ti o n s d e m a n d . A t a
s y m m e t r i c e q u i li b r iu m , f i rm j s o u t p u t i s d e t e r m i n e d a t t h e i n t e rs e c ti o n o f
m a r g i n a l c o s t c a n d m a r g i n a l r e v e n u e MRj. Pr ice i s read o f f the fu l f i l l ed
e x p e c t a t i o n s f i r m - s c a l e d i n v e r s e d e m a n d
p Mq, Mq).
A t a m o n o p o l i s t i c a l l y
c o m p e t i t i v e e q u i l i b r i u m , t h e AC cu rve i s t angen t t o t he fu l f i l l ed expec t a t i ons
demand a t q~ .
M o n o p o l i s t i c C o m p e t i t i o n w i t h N e t w o r k
E x t e rn a l it ie s a n d M C o m p a t ib l e G o o d s
C 0 _ ~ _ - _ .
. ; - A c
J
qO qj q
Fig. 6. M onopolistic com petition with n etwo rk externalities and M com patible goods.
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68 N. Economides / Int. J. Ind. Organ. 14 1996) 673-699
3 2 4 O l igopo ly unde r incom pa t ib i l it y
O n e o f t h e m o s t i n te r e s t in g i s s u e s in th e e c o n o m i c s o f n e t w o r k s i s t h e
i n t e r a c t io n o f o l i g o p o l i s t s p r o d u c i n g i n c o m p a t i b l e g o o d s . A f u l l a n a l y s i s o f s u c h a
m a r k e t , i n c o n j u n c t i o n w i t h t h e a n a l y s i s o f c o m p a t i b l e o l i g o p o l i s t s , w i ll a l l o w u s
t o d e t e r m i n e t h e i n c e n t i v e s o f i n d i v i d u a l f i rm s t o c h o o s e t e c h n o l o g i e s t h a t a r e
c o m p a t i b l e o r i n c o m p a t i b l e w i t h o t h e rs .
G i v e n a n y s e t o f fi r m s S = { 1 . . . . . N } , w e c a n i d e n t i f y a s u b s e t o f S t h a t a d h e r e s
t o t h e s a m e t e c h n i c a l s t a n d a r d a s a c o a l i ti o n . T h e n t h e p a r t i ti o n o f S i n t o s u b s e t s
d e f in e s a c o a l i t i o n s t r u c tu r e C s = { C 1 . . . . C k } . C o m p a t i b i l i t y b y a l l f i rm s m e a n s
th a t t h e r e i s a s i n g l e c o a l i t i o n t h a t i n c lu d e s a l l f i r m s . T o t a l i n c o m p a t ib i l i t y , w h e r e
e v e r y f i r m a d h e r e s t o it s o w n u n i q u e s t a n d a rd , m e a n s t h a t k = N .
A n u m b e r o f c r i te r i a c a n b e u s e d t o d e f in e t h e e q u i l i b r i u m c o a l i t i o n s t r u ct u r e . A
p u r e l y n o n - c o o p e r a t i v e c o n c e p t w i t h o u t s i de p a y m e n t s r e q u i r e s t h a t, a f t e r a f i r m
j o i n s a c o a l it i o n , i t is b e t te r o f f at th e r e s u l t i n g m a r k e t e q u i l i b ri u m , j u s t f r o m
r e v e n u e s f r o m i ts o w n s a le s . ~7 A t a n o n - c o o p e r a t i v e e q u i l i b r i u m w i t h s i d e
p a y m e n t s , f i rm s d i v i d e t h e p r o f it s o f a c o a l i ti o n a r b i t r a ri l y t o i n d u c e f i r m s t o j o i n a
c o a l i t i o n . Y e t f i r m s d o n o t c o o p e r a t e i n o u t p u t d e c i s i o n s . K a t z a n d S h a p i r o ( 1 9 8 5 )
s h o w t h a t th e l e v e l o f in d u s t r y o u t p u t i s g r e a t e r u n d e r c o m p a t i b i l i t y t h a n a t a n y
e q u i l i b r i u m w i t h s o m e i n c o m p a t i b l e f i r m ( s ) . T h i s i s n o t s u f f i c i e n t t o c h a r a c t e r i z e
t h e i n c e n t i v e s o f f i r m s t o o p t f o r c o m p a t i b i l i t y .
I n t u i t i v e l y , a f i r m b e n e f i t s f r o m a m o v e t o c o m p a t i b i l i t y i f ( i ) t h e m a r g i n a l
e x t e r n a l i t y i s s t r o n g ; ( i i ) it j o in s a l a r g e c o a l i t i o n ; a n d ( i i i) i t d o e s n o t t h e r e b y
i n c r e a s e c o m p e t i t i o n t o a s i g n i f i c a n t d e g r e e b y i t s a c t i o n . O n t h e o t h e r h a n d , t h e
c o a l i t i o n b en e f i ts f r o m a f i rm j o i n i n g i ts s t a n d a r d i f ( i) t h e m a r g i n a l e x t e r n a l i t y i s
s t r o n g ; ( i i ) t h e f ir m th a t j o in s t h e c o a l i t i o n i s l a r g e ; ( i i i ) c o m p e t i t i o n d o e s n o t
i n c r e a s e s i g n i f ic a n t l y a s a r e s u l t o f t h e f i r m j o i n i n g t h e c o a l i t io n . C l e a r l y , i n b o t h
c a s e s , t h e s e c o n d a n d t h e t h i r d c r i t e r i a m a y c r e a t e i n c e n t i v e s t h a t a r e i n c o n f l i c t ;
t h i s w i l l h e lp d e f in e t h e e q u i l i b r i u m c o a l i t i o n s t r u c tu r e . 18
K a t z a n d S h a p i r o ( 1 9 8 5 ) s h o w t h a t i f t h e c o s t s o f a c h i e v i n g c o m p a t i b i l i t y a r e
l o w e r f o r a ll f i rm s t h a n t h e i n c r e a s e i n p r of i ts b e c a u s e o f c o m p a t i b i l i t y , t h e n t h e
i n d u s t r y m o v e t o w a r d c o m p a t i b i l i t y i s s o c i a l l y b e n e f i c i a l . H o w e v e r , i t m a y b e t r u e
t h a t t h e ( f i x e d ) c o s t o f a c h i e v i n g c o m p a t i b i l i t y i s l a r g e r t h a n t h e i n c r e a s e i n p ro f i ts
f o r s o m e f i r m s , w h i l e t h e s e c o s t s a r e l o w e r t h a n t h e i n c r e a s e i n t o t a l s u r p l u s f r o m
c o m p a t i b i l i t y . T h e n p r o f i t m a x i m i z i n g f i r m s w i l l n o t a c h i e v e i n d u s t r y - w i d e
c o m p a t i b i l i t y w h i l e t h i s r e g i m e i s s o c ia l l y o p t im a l . F u r t h e r, i f a c h a n g e l e a d s t o
l e s s t h a n i n d u s t r y - w i d e c o m p a t i b i l i t y , t h e p r i v a t e i n c e n t i v e s t o s t a n d a r d i z e m a y b e
e x c e s s i v e o r i n a d e q u a t e . T h i s i s b e c a u s e o f t h e o u t p u t c h a n g e s t h a t a c h a n g e o f
r e g i m e h a s o n a l l f ir m s . S i m i l a r l y , t h e i n c e n t i v e o f a f i rm t o p r o d u c e a o n e - w a y
a d a p t e r , t h a t a l l o w s i t t o a c h i e v e c o m p a t i b i l i t y w i t h o u t a f f e c t i n g t h e c o m p a t i b i l i t y
~TSee Econ om ides (1984 ), Yi a nd Shin (19 92a), and Yi and Shin (1992b ).
~8Economides and Flyer (199 5) ex amine the incentives for co alition formation around compatibility
standards.
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N . E c o n o m i d e s / I n t. J . I n d . O r g a n . 1 4 1 9 9 6 ) 6 7 3 - 6 9 9 6 8 5
o f o t h e r f i rm s , m a y b e d e f i ci e n t o r e x c e s s i v e b e c a u s e t h e f i rm i g n o r e s t h e c h a n g e i t
c r e a t e s o n o t h e r f i r m s p r o f i t s a n d o n c o n s u m e r s s u r p l u s .
3.2.5. Coordination to technical standards with asymmetric technologies
S o f a r i t w a s a s s u m e d t h a t t h e c o s t o f s t a n d a rd i z a t io n w a s f ix e d a n d t h e s a m e f o r
bo th f i rms . I f s t anda rd i za t i on cos t s a r e d i f f e r en t , f irms p l ay a s t anda rds coo rd ina -
t i on gam e . A 2 × 2 ve r s i on o f t h i s gam e i s p r e sen t ed i n F ig . 7 . En t r ie s r ep r e sen t
p ro f it s . I n th i s game , we w i l l a s sum e tha t f i rm i ha s h ighe r p ro f it s when i t s
s t anda rd i ge t adop t ed , a > g , b < h . P ro f i ts , in c a se o f d i s ag reem en t , w i ll depen d
o n t h e p a r t ic u l a rs o f th e i n d u s tr y . O n e s t a n d ar d a s s u m p t i o n t h a t c a p tu r e s m a n y
indus t r i e s i s t ha t i n c a se o f d i s ag reemen t p ro f i t s w i l l be l ower t han t hose o f e i t he r
s t an d a r d , e , c < g ;
d, f e b > d . S i m i l a rl y S t a n d a r d 2 i s a n e q u i l i b r i u m i f g > c h > f .
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686
N. Economides / Int. J. Ind. Organ. 14 1996) 673-699
e a c h t y p e o f g o o d h a s a n u m b e r o f b r a n d s a v a i l a b le , A i , i = 1 . . . . m , B j, j = 1 . . . .
n , a s i n F i g . 4 . L e t c o n s u m e r s d e m a n d 1 : 1 c o m b i n a t i o n s AkBJ.W e c a l l e a c h o f t h e
c o m p l e m e n t a r y g o o d s A i o r ~ components w h i l e t h e c o m b i n e d g o o d AiBj is
c a l l e d a composite good o r system. P o te n t i a l l y a l l c o m b in a t i o n s A ~ Bj , i = 1 . . . . m ;
j = 1 . . . . n , a r e p o ss i b l e. T h u s c o m p l e m e n t a r i t y e x i s t s i n p o t e n t ia l . C o m p l e m e n -
t a r it y i s a c t u a l i z e d w h e n t h e c o m p o n e n t s A i a n d B j a re c o m b i n a b l e a n d f u n c t i o n
t o g e t h e r w i t h o u t e x t r a c o s t , i . e . w h e n t h e c o m p o n e n t s a r e compatible. O f te n i t i s a n
e x p l i c i t d e c i s i o n o f t h e p r o d u c e r s o f in d i v i d u a l c o m p o n e n t s t o m a k e t h e i r p r o d u c t s
c o m p a t i b l e w i t h t h o s e o f o t h e r p r o d u c e r s . T h u s , c o m p a t i b i l i t y i s a strategic
d e c i s i o n a n d s h o u l d b e a n a l y z e d a s s u c h .
M o d e r n i n d u s t ri a l o r g a n i z a t i o n p r o v i d e s a r i c h c o l l e c t i o n o f e n v i r o n m e n t s f o r
t h e a n a l y s i s o f s t r a te g i c d e c i s i o n s ; b e c a u s e o f s h o r t a g e o f t i m e a n d s p a c e , t h i s
s u r v e y w i l l d i s c u s s t h e d e c i s i o n o n c o m p a t i b i l i t y o n l y i n f e w e n v i r o n m e n t s .
3.3.1. Mix and match: compatibility vs. incompatibility
T h e mix-and-match l i t e r a t u r e d o e s n o t a s s u m e a p r i o r i n e t w o r k e x t e r n a l i t i e s ;
h o w e v e r , i t i s c l e a r th a t d e m a n d i n m i x - a n d - m a t c h m o d e l s exhibits n e t w o r k
e x t e rn a l it i es . T h e m i x - a n d - m a t c h a p p r o a c h w a s o r i g i n a t e d b y M a t u t e s a n d
R e g i b e a u 1 9 8 8 ) , a n d f o l l o w e d b y E c o n o m i d e s 1 9 8 8 ) , E c o n o m i d e s 1 9 8 9 ) ,
E c o n o m i d e s 1 9 9 l a) , E c o n o m i d e s 1 9 9 l b ), E c o n o m i d e s 1 9 9 3 c ), E c o n o m i d e s a n d
S a l o p 1 9 9 2 ) , E c o n o m i d e s a n d L e h r 1 9 9 5 ) , M a t u t e s a n d R e g i b e a u 1 9 8 9 ) ,
M a t u t e s a n d R e g i b e a u 1 9 9 2 ) , a n d o t h e r s . T o fi x i d e as , c o n s i d e r t h e c a s e o f F i g . 4
w i t h m = 2 , n = 2 , t e c h n o l o g i e s a r e k n o w n , c o o r d i n a t i o n i s c o s t l e s s , p r i c e
d i s c r i m i n a t i o n i s n o t a l l o w e d , a n d t h e r e a r e n o c o s t a s y m m e t r i e s c r e a t e d b y a n y
p a r t i c u l a r c o m p a t i b i l i t y s t a n d a r d . F i g . 8 s h o w s t h e c a s e o f c o m p a t i b i l i t y . T h e
i n c e n t i v e f o r c o m p a t i b i l i t y o f a v e r ti c a l l y i n t e g r a te d f i rm p r o d u c i n g A 1 a n d B ~ )
d e p e n d s o n t h e r e la t iv e s i z e s o f e a c h c o m b i n a t i o n o f c o m p l e m e n t a r y c o m p o n e n t s .
R e c i p r o c a l c o m p a t i b i l i ty , i .e . s i m u l t a n e o u s c o m p a t i b i l i t y b e t w e e n A I a n d B 2 , a s
w e l l a s b e t w e e n
A 2
a n d B ~ ) i n c r e a s e s d e m a n d b y a l l o w i n g f o r th e s a le o f A
IB 2
a n d
A z B I )
b u t a ls o in c r e a s e s c o m p e t i t i o n f o r th e i n d i v id u a l c o m p o n e n t s . T h e r e -
A A 2
B B 2
Fig. 8. Mix and match compatibility.
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687
f o re , w h e n t h e h y b r i d d e m a n d i s l a rg e c o m p a r e d w i th t h e o w n - p r o d u c t d e m a n d
( i n c l u d i n g t h e c a s e w h e r e t h e t w o d e m a n d s a r e e q u a l a t e q u a l p r ic e s ) , a f ir m h a s a n
i n c e n t i v e t o w a n t c o m p a t i b i l i t y .2° W h e n t h e d e m a n d f o r h y b r i d s i s s m a l l , a fi r m
d o e s n o t w a n t c o m p a t i b i l i ty • T h u s , i t is p o s s i b l e , w i t h t w o v e r t i c a l l y i n t e g r a t e d
f ir m s , t h a t o n e f i rm w a n t s c o m p a t i b i l i t y ( b e c a u s e i t h a s s m a l l o w n - p r o d u c t d e m a n d
c o m p a r e d w i t h t he h y b r i d s d e m a n d ) w h i l e th e o t h e r o n e p r ef e rs i n c o m p a t i b i l i t y
( b e c a u s e i ts o w n - p r o d u c t d e m a n d is l ar g e c o m p a r e d w i t h th e h y b r i d s d e m a n d ) .
T h u s , t h e r e c a n b e c o n f l ic t a c r o s s f ir m s i n t h e i r in c e n t i v e s f o r c o m p a t i b i l i t y , e v e n
w h e n t h e te c h n o l o g y i s w e l l k n o w n . T h e p r e s u m p t i o n i s t h a t o p p o n e n t s w i l l n o t b e
a b l e t o c o u n t e r a c t a n d c o r r e c t a l l i n c o m p a t i b i l i t i e s i n t r o d u c e d b y a n o p p o n e n t , a n d ,
t h e r e fo r e , i n s i t u a t io n s o f c o n f l ic t w e e x p e c t t h a t i n c o m p a t i b i l i t y w i n s.
T h e s e r e s u l t s h o l d b o t h f o r z e r o - o n e d e c i s i o n s ( i .e . c o m p a t i b i l i t y v s . i n c o m -
p a t i b i l i t y ) a n d f o r d e c i s i o n s o f p a r t i a l ( o r v a r i a b l e ) in c o m p a t i b i l i t y . T h e i n t u i ti o n o f
t h e p r o - c o m p a t i b i l i t y r e s u l t fo r t h e z e r o - o n e d e c i s i o n i n th e e q u a l h y b r i d - a n d
o w n - d e m a n d i s s i m p l e . S t a r ti n g f ro m t h e s a m e l e v e l o f p r i c e s a n d d e m a n d i n b o t h
t h e c o m p a t i b i l i t y a n d i n c o m p a t i b i l i t y r e g i m e s , c o n s i d e r a p r i c e i n c r e a s e i n o n e
c o m p o n e n t t h a t p r o d u c e s t h e s a m e d e c r e a s e i n d e m a n d i n b o t h r e g i m e s . U n d e r
i n c o m p a t i b i l i t y , th e l o s s o f p r o f it s i s h i g h e r s i n c e
systems
s a l e s a r e l o s t r a t h e r t h a n
s a l e s o f
one component.
T h e r e f o r e , p r o f i t s a r e m o r e r e s p o n s i v e t o p r i c e u n d e r
i n c o m p a t i b i l i t y ; i t f o l l o w s t h a t t h e r e s i d u a l d e m a n d f a c i n g f i rm s i s m o r e e l a s t i c
u n d e r i n c o m p a t i b i l i t y , a n d t h e r e f o r e f i rm s w i l l c h o o s e l o w e r p r i c e s in t h a t
r e g i m e . 2 T h i s i s re m i n i s c e n t o f C o u r n o t s ( 1 8 3 8 ) c e l e b r a t e d r e s u l t ( s e e C o u r n o t ,
1 9 2 7 ) t h a t a v e r t i c a l l y i n t e g r a t e d m o n o p o l i s t f a c e s a m o r e e l a s t i c d e m a n d a n d w i l l
c h o o s e a l o w e r p r i c e t h a n t h e s u m o f t he p r i c e s o f tw o v e r t i c a l l y d i s i n t e g r a t e d
•
m o n o p o h s t s .
S o f a r w e h a v e a s s u m e d t h a t c o m p a t i b i l i t y i s r e c i p r o c a l - i .e . t h a t t h e s a m e
a d a p t e r i s re q u i r e d t o m a k e b o t h A ~B2 a n d
A2B ~
f u n c t i o n a l. I f c o m p a t i b i l i t y i s n o t
r e c i p r o c a l ( i .e . i f d i f f e r e n t a d a p t e r s a r e r e q u i r e d f o r A ~B2 a n d A 2 B1 ) t h e i n c e n t i v e
o f fi r m s to a c h i e v e c o m p a t i b i l i t y d e p e n d s o n t h e c r o s s s u b s t i t u t i o n b e t w e e n
o w n - p r o d u c t s a n d h y b r id s . R o u g h l y , i f t h e s u b s t it u t ab i l it y a m o n g A - t y p e c o m -
p o n e n t s i s e q u a l t o th e s u b s t i t u t a b i l i ty a m o n g B - t y p e c o m p o n e n t s , t h e e a r l ie r
r e s u l t s o f t h e r e c i p r o c a l s e t u p s t il l h o l d .23 N e v e r t h e l e s s , i f t h e d e g r e e o f s u b -
s t i t u ta b i l i t y a m o n g t h e A s i s d i f f e r e n t t h a n a m o n g t h e B s , o n e f i rm m a y c r e a t e a n
2C~Matutes and Regibeau (1988) and Econom ides (1989) find that co mpatibility is always the firms
choice becau se the y assume a locational setting w ith uniform distribution of consum ers in space that
results in equ al ow n-product and hybrid dem ands at equal prices. The exp osition here follows the m ore
general framework of Economides (1988) and Economides (1991a).
Z These results also hold w hen f irm s can price discriminate between bu yers who buy the pure
combination
A~B
and buyers w ho buy only one com ponent from firm i . Th us, f irms practice mixed
bundling. See Matutes and Regibeau (1992) and Economides (1993c).
22 See Eco nomides (1988) for a d iscussion of C ournot s result, and Econo mides and Salop (1992) for
an extension of the result to (parallel) vertical integration among tw o pairs of vertically related firms.
23Economides (1991a, p. 52).
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a d v a n t a g e f o r i ts e l f b y i n t r o d u c i n g s o m e i n c o m p a t i b i li t ie s . H o w e v e r , i t is n e v e r to
t h e a d v a n t a g e o f bo th ve r t i c a l l y i n t eg ra t ed f i rms t o c r ea t e i ncompa t ib i l i t i e s .
T h e i s su e o f c o m p a t i b i li t y a n d c o o r d i n a t io n i s m u c h m o r e c o m p l i c a t e d i f t h e re
a r e m o r e t h a n t w o f i r m s . A n u m b e r o f c o a l i t i o n s c a n e a c h b e f o r m e d a r o u n d a
spec i f i c t e chn i ca l s t anda rd , and s t anda rds m ay a l l ow fo r pa r t i a l com pa t ib i l i t y , o r
m a y b e m u t u a l l y i n c o m p a t i b l e . N o t e n o u g h r e s e a r c h h a s b e e n d o n e o n t h i s i s s u e .
Resea rch i n t h i s a r ea i s made pa r t i cu l a r l y d i f f i cu l t by t he l a ck o f e s t ab l i shed
m o d e l s o f c o a l i ti o n f o r m a t i o n i n n o n - c o o p e r a t i v e s e tt in g s . T h e a n a l y s i s b a s e d o n
c o a l it i o n st ru c t u re s is m o r e c o m p l i c a t e d in t h e m i c r o a p p r o a c h b e c a u s e o f t h e
spec i f i c s o f t he owne r sh ip s t ruc tu r e .
The s tud i e s we r e f e r r ed t o t h i s f a r t ake t he owne r sh ip s t ruc tu r e a s g iven ( i . e . a s
pa ra l l e l ve r t i c a l i n t eg ra t i on ) , and p roceed t o d i s cus s t he cho i ce o f t he deg ree o f
compa t ib i l i t y . I n many ca se s , ve r t i c a l i n t eg ra t i on i s a dec i s ion t ha t i s more f l ex ib l e
( and l e s s i r r eve r s ib l e ) t han a dec i s ion on compa t ib i l i t y . Thus , i t makes s ense t o
t h i n k o f a g a m e s t r u c t u r e w h e r e t h e c h o i c e o f t e c h n o l o g y ( w h i c h i m p l i e s t h e
d e g r e e o f c o m p a t i b i l i t y ) p r e c e d e s t he cho i ce o f t he deg ree o f ve r t i c a l i n t eg ra t i on .
E c o n o m i d e s ( 1 9 9 6 b ) a n a l y z e s th e c h o i c e o f a s s e t o w n e r s h i p a s a c o n s e q u e n c e o f
t h e c h o i c e o f t e c h n o l o g y ( a n d o f t h e i m p l i e d d e g r e e o f c o m p a t i b i l i t y ) . I t p o s i t s a
th r ee - s t age game o f compa t ib i l i t y cho i ce i n t he f i r s t s t age , ve r t i c a l i n t eg ra t i on i n
the s econd s t age , and p r i ce cho i ce i n t he t h i rd s t age . I ncen t ive s fo r ve r t i c a l
m e r g e r s i n i n d u st r ie s w i t h v a r y i n g d e g r e e s o f c o m p a t i b i l i t y a re c o m p a r e d . I n
ana lyz ing t he s t age o f compa t ib i l i t y cho i ce , t he i n f l uence o f t he an t i c ipa t i on o f
dec i s ions on (ve r t i c a l) i ndus t ry s t ruc tu r e on com pa t ib i l i t y dec i s ions i s eva lua t ed .
(Fig. 9.)
3 3 2 C h a n g e s i n t h e n u m b e r o f v a r ie t ie s a s a r e s u l t o f c o m p a t i b i li t y d e c i s i o n s
E c o n o m i d e s ( 1 9 9 1 b ) c o n s i d e r s t h e i n t e r p l a y o f c o m p a t i b i l i t y a n d t h e n u m b e r o f
v a r ie t ie s o f c o m p l e m e n t a r y g o o d s . T h e r e a r e t w o t y p e s o f g o o d s , A a n d B ,
c o n s u m e d i n 1 :1 r a ti o . T h e r e a r e t w o b r a n d s o f g o o d A , A ~ a n d A 2, e a c h p r o d u c e d
b y a n i n d e p e n d e n t f i r m . T h e n u m b e r o f B - t y p e b r a n d s , e a c h a l s o p r o d u c e d b y a n
independen t f i rm , i s de t e rmined by a f r ee - en t ry cond i t i on , so t ha t i ndus t ry B i s i n
m o n o p o l i s t i c c o m p e t i ti o n . I n a r e g i m e o f c o m p a t i b i li t y , e a c h B - t y p e c o m p o n e n t i s
i m m e d i a t e l y c o m p a t i b l e w i t h e i t h e r A 1 o r A z . I n a r e g i m e o f i n c o m p a t i b i li t y , e a c h
Stage Stage 2 Stage 3
COMP TIBILITY
OR
INCOMP TIBILITY
VERTIC L
INTEGR TION OR
DISINEGR TION
PRICE
COMPETITION
F i g 9 C o m p a t i b i l i ty d e c i s i o n s a r e l e s s f l e x ib l e t h a n v e r ti c a l in t e g r a t i o n d e c i s i o n s
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ompatibi l i ty
F i g 1 0 C o m p a t i b i l i t y
b r a n d B i p r o d u c e s t w o v e r s i o n s o n e c o m p a t i b l e w i t h A 1 a n d o n e c o m p a t i b l e w i t h
A 2 . Th e tw o ca se s a r e show n in F ig . 10 and F ig . 11.
Un de r i ncom pa t ib i l i t y e ach B- ty pe f i rm incu r s h ighe r f i xed cos t s ; i t f o l l ows t ha t
c e t e ri s p a r i b u s t h e n u m b e r o f B - t y p e b r a n d s w i l l b e s m a l l e r u n d e r i n c o m p a t i b i li t y .
A n A - t y p e f i r m p r e f e r s i n c o m p a t i b i l i t y o r c o m p a t i b i l i t y a c c o r d i n g t o t h e e q u i l i b -
r u m pro f i ts it r e a l i z e s in e ach r eg im e . Thes e p ro f i ts and t he dec i s ion on
com pa t ib i l i t y depen ds on the spec i f i c s o f t he u t i li t y func t i on o f consu m er s and in
p a r t i c u l a r o n t h e i m p a c t o f a n i n c r e a s e o f t h e n u m b e r o f v a r i e t i e s o n u t i l i t y . I f
ncompa t i b i l i t y
a ; a j ... a
F i g 1 1 In co mp a t i b i l t y
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i ndus t ry dem and i s no t s ens i t i ve to i nc r ea se s i n the num be r o f va r i e t i e s o f
compos i t e goods n ( and does no t i nc r ea se much a s n i nc r ea se s ) , t hen equ i l i b r i um
pro f i t s o f an A- type f i rm dec r ea se i n t he number o f f i rms ; t he r e fo r e p ro f i t s o f an
A - t y p e f i r m a r e h i g h e r a t t h e s m a l l e r n u m b e r o f f i r m s i m p l i e d b y i n c o m p a t i b i l i t y ,
a n d a n A - t y p e f i r m p r e f e r s i n c o m p a t i b i l i t y . C o n v e r s e l y , w h e n c o n s u m e r s h a v e a
s t r o n g p r e f e r e n c e f o r v a r i e t y a n d d e m a n d f o r c o m p o s i t e g o o d s i n c r e a s e s s i g -
n i f i c an t l y i n n , equ i l i b r i um p ro f i t s o f an A- type f i rm inc r ea se i n t he number o f
f i rms ; t he r e fo r e i t s p ro f i t s a r e h ighe r a t t he l a rge r number o f f i rms imp l i ed by
compa t ib i l i t y , and an A- type f i rm p re f e r s compa t ib i l i t y .
C h u r c h a n d G a n d a l ( 1 9 9 2 b ) , C h o u a n d S h y ( 1 9 9 0 a ) , C h o u a n d S h y ( 1 9 9 0 b ) , a n d
C h o u a n d S h y ( 1 9 9 0 c ) a l so e x a m i n e t h e im p a c t o f t h e n u m b e r o f v a r ie t ie s o f
c o m p l e m e n t a r y ( B - t y p e ) g o o d s o n t h e d e c i s io n s o f c o n s u m e r s t o b u y o n e o f t he
A - t y p e g o o d s u n d e r c o n d i t i o n s o f i n c o m p a t i b i l i t y .
3.3.3. Quality coordination in mix and match
T h e f r a m e w o r k o f m i x a n d m a t c h m o d e l s a p p l i es t o b o th v a r i e t y an d q u a l i ty
f ea tu r e s t ha t a r e combinab l e add i t i ve ly i n t he u t i l i t y f unc t i on . Tha t i s , i n t he
s t a n d ar d m i x - a n d - m a t c h m o d e l , t he u t il it y a c c r u in g t o a c o n s u m e r f r o m c o m p o n e n t
A i is a d d e d t o t h e u t i li ty f r o m c o m p o n e n t B j . H o w e v e r , i n s o m e n e t w o r k s ,
• • 24
i n c lu d i n g t e l e c o m m u m c a t l o n s , t h e u t il it y o f t h e c o m p o s i t e g o o d A iB j is n ot t h e
sum o f t he r e spec t i ve qua l i t ie s . I n pa r t i cu l a r , t he qua l i t y o f vo i ce i n a l ong d i s t ance
ca l l i s t he min imum o f t he qua l i t i e s o f t he componen t pa r t s o f t he ne twork , i . e . t he
loca l and t he l ong d i s t ance t r ansmi s s ion . Thus , s i gn i f i c an t qua l i t y coo rd ina t i on
p r o b l e m s a r i s e i n a n e t w o r k w i t h f r a g m e n t e d o w n e r s h i p • E c o n o m i d e s ( 1 9 9 4 b ) a n d
E c o n o m i d e s a n d L e h r ( 1 9 9 5 ) e x a m i n e t h i s c o o r d i n a t i o n p r o b l e m .
Le t A and B be componen t s t ha t a r e combinab l e i n a 1 :1 r a t i o . Suppose t ha t t he
q u a l i ty l e v e l s o f th e c o m p o n e n t s a r e qa and qB , wh i l e t he qua l i t y l eve l o f t he
c o m p o s i t e g o o d i s qa8 = m i n (q A , q B ) C o n s u m e r s h a v e v a r y i n g w i l l in g n e s s t o p a y
f o r q u a l i t y i m p r o v e m e n t s a s i n G a b s z e w i c z a n d T h i s s e ( 1 9 7 9 ) a n d S h a k e d a n d
Su t ton (198 2 ) , and f i rms p l ay a two- s t ag e gam e o f qua l i ty cho i ce i n the f i r st st age ,
f o l l o w e d b y p r i c e c h o i c e i n t h e s e c o n d s t a g e . A s m e n t i o n e d e a r l i e r , C o u r n o t
( 1 9 2 7 ) h a s s h o w n t h a t a n i n te g r a t e d m o n o p o l i s t p r o d u c i n g b o t h A a n d B w i l l
c h a r g e l e s s th a n t w o v e r t i c a ll y re l a t ed m o n o p o l i s t s , e a c h p r o d u c i n g o n e c o m p o n e n t
o n l y . T h i s i s b e c a u s e o f t h e e l i m i n a t io n o f d o u b l e m a r g i n a l iz a t i o n b y t h e
i n t e g r a t e d m o n o p o l i s t • E c o n o m i d e s ( 1 9 9 4 b ) a n d E c o n o m i d e s a n d L e h r ( 1 9 9 5 )
s h o w t h a t a n i n t e g r a t e d m o n o p o l i s t a l s o p r o v i d e s a h i g h e r q u a l i t y t h a n t h e t w o
i n d e p e n d e n t m o n o p o l i s t s . I n b i la t e ra l m o n o p o l y , m a r g i n a l i n c r e a s e s i n q u a l it y h a v e
a b igge r impac t on p r i ce . Be ing ab l e t o s e l l t he s ame qua l i t y a t a h ighe r p r i c e t han
u n d e r i n t e g r a t e d m o n o p o l y , t h e b i l a t e r a l m o n o p o l i s t s c h o o s e l o w e r q u a l i t y l e v e l s ,
wh ich a r e l e ss cos tl y • De sp i t e t ha t, because o f doub l e ma rg ina l i z a t i on , p r i c e s a r e
Z4See also E ncaoua et al. (1992) fo r a discussion of the coordination of the timing of d ifferent legs
of airport transportation.
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691
h i g h e r t h a n i n i n te g r a t e d m o n o p o l y , a l o w e r p o r t i o n o f t h e m a r k e t i s s e rv e d , a n d
f i r m s r e a l i z e l o w e r p r o f i t s 25 T h u s ,
l a c k o f v e r t i c a l i n t e g r a t i o n l e a ds t o a r e d u c t i o n
i n q u a l i t y .
N o t e t h a t th i s is n o t b e c a u s e o f l a c k o f c o o r d i n a t i o n b e t w e e n t h e
b i l at e r al m o n o p o l i s t s i n t h e c h o i c e o f q u a l i t y , s i n c e t h e y b o t h c h o o s e t h e s a m e
q u a l i t y l e v e l 2 6
I n t h is s e t ti ng , E c o n o m i d e s a n d L e h r ( 1 9 9 5 ) e x a m i n e v a r i o u s o w n e r s h i p
s t r u c tu r e s w h e r e , f o r a t le a s t o n e o f th e t y p e s o f c o m p o n e n t s t h e r e i s m o r e t h a n o n e
q u a l i t y l e v e l a v a i l a b l e . C l e a r l y , a s i t u a t i o n w h e r e a l l c o m p o n e n t s h a v e t h e s a m e
q u a l i t y i s n o t v i a b l e , s i n c e c o m p e t i t i o n w o u l d t h e n d r i v e p r i c e s t o m a r g i n a l c o s t .
F u r t h e r, f o r a h i g h q u a l i t y c o m p o s i t e g o o d t o b e a v a i la b l e , b o t h a n A - a n d a
B - t y p e g o o d s m u s t b e o f h i g h q u a l i ty . T h e y f in d t h a t a t h i rd (a n d f o u r t h ) l o w
q u a l it y g o o d s h a v e a h a rd t i m e s u r v i v in g i f t h e y a re p r o d u c e d b y i n d e p e n d e n t
f i r m s . I n c o n t r a s t , i n p a r a l l e l v e r t i c a l i n t e g r a t i o n ( w i th f i r m i , i = 1 , 2 , p r o d u c in g A i
a n d B i ) , f i rm s p r e f e r n o t t o i n t e r c o n n e c t - i .e . to p r o d u c e c o m p o n e n t s t h a t a r e
i n c o m p a t i b l e w i t h t h o s e o f t h e o p p o n e n t .
4 N e t w o r k e x t e r n a li t ie s a n d i n d u s t r y st r u c t u r e
4 . 1. I n v i t a t i o n s t o e n t e r
I n th e p r e s e n c e o f s t r o n g n e t w o r k e x t e r n a li t ie s , a m o n o p o l i s t e x c l u s i v e h o l d e r o f
a t e c h n o l o g y m a y h a v e a n i n c e n t iv e t o i n v i t e c o m p e t i t o r s a n d e v e n s u b s i d i z e t h e m .
T h e r e a l i z a t i o n o f n e t w o r k e x t e r n a li t ie s r e q u i r es h i g h o u t p u t . A m o n o p o l i s t m a y b e
u n a b l e c r e d i b l y t o c o m m i t t o a h i g h o u t p u t a s l o n g a s h e i s o p e r a t i n g b y h i m s e l f .
H o w e v e r , i f h e l i c e n s es t h e t e c h n o l o g y to a n u m b e r o f f i rm s a n d i n v i t e s t h e m t o
e n t e r a n d c o m p e t e w i t h h i m , m a r k e t o u t p u t w i l l b e h i g h e r ; a n d s i n c e t h e l e v e l o f
m a r k e t o u t p u t d e p e n d s m a i n l y u p o n o t h e r f ir m s , th e c o m m i t m e n t t o h i g h o u t p u t i s
c r e d ib l e .
T h e i n v i t a t i o n t o e n t e r a n d t h e c o n s e q u e n t i n c r e a s e i n m a r k e t o u t p u t h a s t w o
e f f e c t s ; a c o m p e t i t i v e e f f e c t a n d a n e t w o r k e f f e c t . T h e c o m p e t i t i v e e f f e c t i s a n
e x p e c t e d i n c r e a s e i n c o m p e t i t i o n b e c a u s e o f t h e i n c r e a s e o f t h e n u m b e r o f f ir m s .
T h e n e t w o r k e f f e c t t e n d s t o i n c r e a s e t h e w i l l i n g n e s s t o p a y a n d t h e m a r k e t p r i c e
b e c a u s e o f t h e h i g h e x p e c t e d s al es . E c o n o m i d e s ( 1 9 9 3 h ) a n d E c o n o m i d e s ( 1 9 9 6 a )
s h o w t h a t, i f th e n e t w o r k e x t e r n a l i t y i s s t r o n g e n o u g h , t h e n e t w o r k e f f e c t is l a r g e r
t h a n t h e c o m p e t i t i v e e f f e c t , a n d t h e r e f o r e a n i n n o v a t o r - m o n o p o l i s t i n v i t e s c o m -
p e t i t o r s a n d e v e n s u b s i d i z e s t h e m o n t h e m a r g i n t o i n d u c e t h e m t o i n c r e a s e
p r o d u c t i o n .
25Consumers also receive lower surplus in com parison to vertically integrated monopoly.
26The reliability of the network, measured by the percentage of tim e that the netw ork is in operation,
or by the probab ility of a successful connection, is mea sured by the prod uct of the respective
reliabilities of the com pone nts (anoth er non-lin ear function).
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. 6
B C
3
Fig. 12. AB is a bottleneck facility.
4 .2 . I n t e r c o n n e c t i o n o r f o r e c l o s u r e b y a l o c a l m o n o p o l i s t ?
Many telecommunications, airline networks and railroad networks have the
structure of Fig. 12. In a railroad network, there may be direct consumer demand
for links
A B , B C ,
as well as
A C .
This figure can also represent a telephone
network with demand for local telephone services
A B )
and for long distance
services
A B C ) ;
in that case, there is no direct demand for
B C ,
but only the
indirect demand arising from long distance calls
A B C .
In many cases, one firm has
a monopoly of a link that is necessary for a number of services here A B ) , and this
link is a natural monopoly. This bottleneck link is often called an essential facility.
The monopolist can foreclose any finn by denying access to the bottleneck facility.
What are his incentives do so?
Economides and Woroch 1992) examine intermodal competition in the context
of a simple network pictured in Fig. 13. S and R are local switches;
A S
and
B R
is
local service in different cities);
S R
and
S T R
are alternative long distance services.
The diagram is simplified by eliminating R without any essential loss. Suppose
that an integrated firm offers end-to-end service
A S B ) ,
while a second firm offers
N et wo rk in Ex t en s ive an d o l l ap sed F o rm
SI IT
B
Fig. 13. Intermodal competition.
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s e r v i c e o f p a r ti a l c o v e r a g e o n l y
STB) .
T h e y f i n d t h a t , a l t h o u g h t h e i n t e g r a t e d f i r m
h a s t h e o p p o r t u n i t y t o f o r e c l o s e t h e o p p o n e n t , i t p r e f e r s n o t t o . I n fa c t , the
i n t e g ra t e d f i r m i s b e t t e r o f f b y i m p l e m e n t i n g a v e r t ic a l p r i c e s q u e e z e o n t h e
opponen t , a n d c h a r g i n g a s i g n i f i c a n t l y h i g h e r p r i c e t o t h e o p p o n e n t f o r t h e u s e o f
t h e m o n o p o l i z e d li n k t h a n i t c h a r g e s i ts e lf .27 T h u s , f o r e c lo s u r e , a l t h o u g h f e a s ib l e ,
i s n o t o p t i m a l f o r t h e i n t e g r a t e d f i r m 2 8
E c o n o m i d e s a n d W o r o c h ( 1 9 9 2 ) a l s o f i n d t h a t v e r t i c a l d i s i n t e g r a t i o n i s n o t
d e s i r a b l e f o r t h e f i r m t h a t o f f e r s e n d - t o - e n d s e r v ic e . O n c e d i s i n te g r a t e d , i ts
c o n s t i t u e n t p a r t s r e a l i z e l o w e r t o t a l p r o fi t s. T h i s i s b e c a u s e , b e s i d e s a p p r o p r i a t i n g
m o n o p o l y r e n t s f o r i t s A S m o n o p o l y , t h e i n t e g r a t e d f i r m A S B ) w a s c r e a t i n g a
s i g n i f i c a n t r e s t r ic t i o n o f c o m p e t i t i o n i n S B - S T B m a r k e t b y i t s d e f a c t o p r i c e
d i s c r i m i n a t i n g s t r a te g y . A f t e r d is i n t e g r a ti o n , t h e S B - S T B m a r k e t b e c o m e s m u c h
m o r e c o m p e t i t i v e , e v e n i f
A S
p r i c e d i s c r i m i n a t e s b e t w e e n
S B
a n d
STB.
T h u s , e v e n
i f n e t w o r k A S B w e r e t o r e c e i v e t he f u ll r e n t ea r n e d b y t h e n e w o w n e r o f SB , its
a f t e r - d iv e s t i t u r e p r o f it s w o u l d b e l o w e r t h a n b e f o r e d i v e s t it u r e 29
E v e n i n s i m p l e n e t w o r k s , t h e r e m a y b e r e l a t i o n s a m o n g f i r m s t h a t a r e n e i t h e r
p u r e l y v e r t i c a l n o r p u r e l y h o r i z o n t a l . T h u s , t h e c o n v e n t i o n a l w i s d o m a b o u t v e r t i c a l
a n d h o r i z o n t a l i n t e g r a t i o n f a i l s . E c o n o m i d e s a n d S a l o p ( 1 9 9 2 ) d i s c u s s p r i c i n g i n
v a r i o u s o w n e r s h i p s t r u c t u re s i n th e m o d e l o f F ig . 8 . T h e y c a l l t h e o w n e r s h i p
s t r u c tu r e o f t h is f i gu r e , w h e r e e a c h f i rm p r o d u c e s a c o m p o n e n t o f e a c h t y p e ,
para l l e l v e r t i ca l i n t egra t i on . T h e y a l s o c o n s i d e r t h e i n d e p e n d e n t o w n e r s h i p
s t r u ct u r e , w h e r e e a c h o f t h e f o u r c o m p o n e n t s i s o w n e d b y a d i ff e r e n t f ir m . I n b o t h
o f t h e s e s t r u c t u r e s, n o f i r m i s p u r e l y v e r t i c a l l y o r p u r e l y h o r i z o n t a l l y r e l a t e d t o
a n o t h e r f ir m . T h u s , s t a r ti n g f r o m i n d e p e n d e n t o w n e r s h i p , o r s t a r ti n g f r o m p a r a l le l
v e r t i c a l i n t e g r a t i o n , a m e r g e r t o
j o i n t o w n e r s h i p ,
w h e r e a l l c o m p o n e n t s a r e
p r o d u c e d b y t h e s a m e f i rm , c a n e i t h e r i n c re a s e o r d e c r e a s e p r i c e s. T h u s , s i m p l e
p r e s c r i p t i o n s a g a i n s t m e r g e r s m a y e a s i l y f a i l .
I n th e m o d e l o f F ig . 1 3, E c o n o m i d e s a n d W o r o c h ( 1 9 9 2 ) c o n s i d e r t he c a s e
w h e r e l i n k S T i s o w n e d b y a f i r m t h a t o w n s a v e r t i c a l l y r e l a t e d l i n k ( e i t h e r A S o r
B T ) , o r is o w n e d b y a n i n d e p e n d e n t f i rm . C l e a r l y , t h e s t ra t e g i c s t r u c tu r e o f t h e
g a m e r e m a i n s u n a f f e c t e d w h e n l i n k S T c h a n g e s h a n d s b e t w e e n t w o f i r m s t h a t a l s o
o wn a l i n k t h a t i s v e r t i c a l l y r e l a t e d t o ST. T h e r e f o r e , i f S T has a f ixed cos t , i t i s a
l i a b i l i t y t o s u c h a f i r m ; e a c h f i r m w o u l d l i k e t h e o p p o n e n t t o o w n i t . H o w e v e r , i f
t h e l i n k i s o w n e d b y a th i r d p a r ty , i t i s h a s a p o s i t i v e v a lu e b e c a u s e o f i t s
m o n o p o l y p o s i t i o n i n th e c h a i n . T h u s , e a c h o r i g i n a l o w n e r h a s a n i n c e n t i v e t o s el l
S T
t o a th i r d p a r t y . T h e d i r e c t i m p l i c a t i o n i s t h a t t h e v a l u e o f l in k s d e p e n d s o n
7This
result is dependent on the linear structure of the de mand system, and may not hold for any
demand structure.
28Church and Gand al (1992a) find that sometim es firms prefer foreclosure, but their m odel doe s not
allow for a vertical price squeeze.
9This
result is in contrast to Bonanno and Vickers (1988) because of the absence of two-part
contracts in Econom ides and W oroch (1992).
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694
N. Economides / Int . J . Ind. Organ. 14 1996 ) 67 3- 69 9
w h a t o t h e r l i n k s a fi r m o w n s . T h u s , g e n e r a l p r e s c r i p t i o n s o n t h e d e s i r a b i l i t y o f
u n b u n d l i n g o f o w n e r s h i p a r e s u s p e c t .
O f t e n p a r t s o f t h e n e t w o r k a r e r e g u l a t e d , w h i l e o t h e r p a r t s a r e n o t. T h i s i s t h e
t y p i c a l a r r a n g e m e n t i n te l e p h o n y i n t h e U S , w h e r e o n l y l o c a l t e le p h o n e c o m p a n i e s
a r e t i g h t ly r e g u l a t e d , s i n c e t h e i r m a r k e t i s tr a d i t i o n a l l y c o n s i d e r e d a n a t u r a l
m o n o p o l y . 3° B a u m o l a n d S i d a k 1 9 9 4 a ) a n d B a u m o l a n d S i d a k 1 9 9 4 b ) p ro p o s e
t h a t, t o a t t ra c t e f f ic i e n t e n t r a n t s i n t h e l o n g d i s t a n c e m a r k e t a n d t o d i s c o u r a g e
i n e f f ic i e n t e n t r a n ts , a l o c a l t e l e p h o n e c o m p a n y s h o u l d c h a r g e t h e m a n
i n t e r c o n n e c -
t io n o r a c c e s s ) f e e e q u a l t o t h e m a r g i n a l c o s t o f p r o v i s i o n o f s e r v i c e p l u s a n y
o p p o r t u n i t y c o s t t h a t t h e l o c a l t e l e p h o n e c o m p a n y i n c u r s . 3 ~ T h i s i s c o r r e c t u n d e r a
s e t o f s tr i ct a s s u m p t i o n s : f ir s t t h a t t h e e n d - t o - e n d g o o d i s s o l d o r i g i n a l l y a t t h e
c o m p e t i t iv e p r ic e ; s e c o n d t h a t t h e e n tr a n t p r o d u c e s t h e s a m e c o m p l e m e n t a r y g o o d
l o n g d i s t a n c e s e r v i c e) a s t h e i n c u m b e n t ; 32 t h ir d , t h a t t h e r e a r e n o e c o n o m i e s o f
s c a le in e i th e r o n e o f t h e c o m p l e m e n t s . E c o n o m i d e s a n d W h i t e 1 9 9 5 ) a n d
E c o n o m i d e s a n d W h i t e 1 9 9 6 ) d i s c u s s h o w t h e r e l a x a t io n o f t h e se a s s u m p t i o n s
l e a d s to d i f fe r e n t in t e r c o n n e c t i o n c h a r g e s . F o r e x a m p l e , i f c o m p e t i t i o n b e t w e e n a n
e n t ra n t a n d t h e in c u m b e n t r e d u c e s t h e m a r k e t p o w e r o f th e i n c u m b e n t , e n t r y m a y
i n c r e a s e s o c i a l w e l f a r e e v e n w h e n t h e e n t r a n t p r o d u c e s a t h i g h e r c o s t t h a n t h e
i n c u m b e n t .
5 Sequent ia l gam es
I n n e t w o r k m a r k e t s , a n d m o r e g e n e r a l l y i n m a r k e t s w i t h n e t w o r k e x t e r n a l i ti e s ,
w h e n f i r m s a n d c o n s u m e r s i n t e r a c t i n m o r e t h a n p e r i o d ,
h i s t o r y m a t t e r s .
B o t h
c o n s u m e r s a n d f i rm s m a k e p r o d u c t i o n a n d c o n s u m p t i o n d e c i s i o n s b a s e d o n s iz e s
o f in s t a l l e d b a s e a n d o n e x p e c t a t i o n s o f it s i n c r e a s e s o v e r ti m e . T h e s a m e
u n d e r l y i n g t e c h n o l o g y a n d c o n s u m e r s p r e f e r e n c e s a n d d i s t r ib u t i o n c a n l e a d t o
d i f f e r e n t i n d u s t r i a l s t r u c t u r e s d e p e n d i n g o n t h e w a y t h i n g s s t a r t . T h u s , s t r a t e g i c
a d v a n t a g e s , s u c h a s f ir s t m o v e r a d v a n t a g e s , c a n h a v e l o n g r u n e f f ec t s .33
N e t w o r k e x t e r n a l i t ie s a n d h i s t o r i c a l e v e n t s a r e p a r t i c u l a r l y im p o r t a n t i n t h e
s p e e d o f a d o p t i o n o f a n i n n o v a t i o n t h a t c r e a t e s s e r v i c e s o n a n e t w o r k . C a b r a l
1 9 9 0 ) d i s c u s s e s t h e a d o p t i o n o f i n n o v a t i o n s u n d e r p e r f e c t c o m p e t i t i o n in t h e
p r e s e n c e o f n e t w o r k e x t e r n a l i ti e s . H i s m a i n c o n c l u s i o n i s th a t, w h e n n e t w o r k
e x t e r n a l i t ie s a re s t r o n g , th e e q u i l i b r i u m a d o p t i o n p a t h m a y b e d i s c o n t i n u o u s . T h i s
3°This is chan ging for s om e customers through the existence of co mpetitive access providers, who
directly c om pete w ith the local telephone com pan y for large customers, and the potential for
comp etition by ca ble comp anies.
3~ Kahn and Taylor 1994) h ave very similar views.
32Armstrong and D oyle 1994) relax this assumption.
33 See Arthur 1988), Arthur 1989), Da vid 1985). David argues that the QW ERT Y keyboard was
adopted mainly because i t appeared f irst wh ile the DVO RAK keyboard was superior . This is disputed
by Liebowitz and Margolis 1990).
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N . Eco n o mid es / I n t . J . I n d . Org a n . 1 4 1 9 9 6 ) 6 7 3 - 6 9 9 695
i s a n o t h e r w a y o f s a y i n g th a t t h e r e a r e t w o n e t w o r k s i z e s s u p p o r t e d a s e q u i l i b r i a a t
t h e s a m e t i m e i n s ta n t . T h i s m a y o c c u r a t t h e s t a r t o f t h e n e t w o r k , a n d t h e n i t i s
c a l l e d p o s i t iv e c r it ic a l m a s s b y E c o n o m i d e s a n d H i m m e l b e r g ( 1 9 9 5 ). I t m a y a l s o
o c c u r a t o t h e r p o i n t s i n t h e n e t w o r k e v o l u t i o n . I n p r a c ti c e , d i s c o n t i n u i t ie s i n th e
s i z e o f t h e n e t w o r k o v e r t i m e d o n o t o c c u r s i n c e t h a t w o u l d i m p l y a n i n f in i te s i z e
o f s a le s a t s o m e p o i n ts i n t im e . C o n t i n u i ty a n d s m o o t h n e s s o f th e n e t w o r k p a t h i s
r e s t o r e d i f i n s t a n t a n e o u s m a r g i n a l p r o d u c t i o n c o s t s ar e i n c r e a s i n g . U n d e r t h i s
a s s u m p t i o n , E c o n o m i d e s a n d H i m m e l b e r g ( 1 9 9 5 ) f in d th a t t h e a d o p t i o n p a th i s
m u c h s t e e p e r i n th e p r e s e n c e o f e x t e r n a li t ie s . F u r t h e r , d r i v e n b y t h e e x t e r n a l i ty , i n
e a r l y s t a g e s t h e n e t w o r k c a n e x p a n d s o q u i c k l y a s t o e x h i b i t i n c r e a s i n g r e ta i l
p r i c e s e v e n w h e n m a r g i n a l c o s t s a re f a ll i n g o v e r t im e . T h e i r a n a l y s i s is a p p l i e d t o
t h e f a x m a r k e t i n t h e U S a n d J a p a n .
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c o m p e t i t i o n . A c c o r d i n g l y , t h i s a n a l y s is t e n d s t o b e i n t h e f o r m o f s i m p l e t w o -
p e r i o d m o d e l s . W e a n a l y z e i t w i t h r e f e r e n c e t o t h e s ta n d a r d s i m u l t a n e o u s c h o i c e
c o o r d i n a t i o n g a m e o f S e c t i o n 3 . 2 .5 , w h e r e w e n o w i n t e r p re t t h e f ir s t s t r a t e g y a s
s t i c k i n g t o t h e o l d t e c h n o l o g y , a n d t h e s e c o n d a s t h e a d o p t i o n o f a n e w o n e ( F i g .
1 4 ). N e t w o r k e x t e r n a l i ti e s f o r b o t h t e c h n o l o g i e s m e a n t h a t a > c , e ; b > d , f ;
g > c , e ; h > d , f . I f b o t h f i r m s a r e w o r s e o f f w h e n t h e y a r e n o t c o o r d i n a t e d , b o t h
t h e ' n e w t e c h n o l o g y ' ( i. e. (N , N ) ) a n d t h e ' o l d t e c h n o l o g y ' ( i. e. ( O , O ) ) w i l l a ri s e
a s e q u i l ib r i a . C l e a r l y , o n e o f t h e e q u i l i b r i a c a n b e i n e f f ic i e n t . I f t h e ( O , O )
e q u i l i b r i u m i s i n e f f i c ie n t a n d i s a d o p t e d , F a r r e l l a n d S a l o n e r ( 1 9 8 5 ) c a l l th e
s i t u a t i o n excess in er t i a 34 S i m i l a r l y , i f t h e ( N , N ) e q u i l i b r i u m i s i n e f f i c i e n t a n d i t is
a d o p t e d , t h e s i tu a t i o n i s c a l l e d e x c e s s m o m e n t u m
F a r re l l a n d S a l o n e r ( 1 9 8 5 ) d i s c u s s a t w o - p e r i o d m o d e l w h e r e c o n s u m e r s h a v e
v a r y i n g w i l li n g n e s s t o p a y f o r t h e c h a n g e o f t h e t e c h n o l o g y , m e a s u r e d b y 0 . U s e r s
c a n s w i t c h i n P e r i o d 1 o r 2 , a n d s w i t c h i n g i s i r r e v e r s i b l e . U s e r s f a l l i n f o u r
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b e h a v i o r o f o t h e r s i n t h e f i rs t p e r i o d ; ( i i) t h e y s w i t c h i n P e r i o d 2 i f o t h e r u s e r s
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1 ; ( iv ) s w i t c h i n P e r i o d 2 e v e n i f o th e r s h a v e n o t s w i t c h e d i n P e r i o d 1 . T h e l a st
s t r a t e g y is d o m i n a t e d b y s t r a t e g y ( ii i) . C o n s u m e r s o f l o w 0 u s e s t r a t e g y ( i ),
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( ii i) . C o n s u m e r s w o u l d l ik e t o c o o r d i n a t e t h e m s e l v e s a n d s w i t c h i n th e f ir s t p e r i o d
( t h e r e b y g e t t i n g t h e b a n d w a g o n r o l l i n g ) b u t a r e u n a b l e t o d o s o , t h u s c r e a t i n g
e x c e s s i n e r t i a . T h i s i n e r t i a c a n b e r e d u c e d t h r o u g h c o m m u n i c a t i o n a m o n g t h e
c o n s u m e r s , t h o u g h c o n t r ac t s , th r o u g h c o o r d i n a t i o n i n c o m m i t t e e s o r t h r o u g h n e w
p r o d u c t s p o n s o r s h i p a n d s p e c i a l i n t r o d u c t o r y p r i c in g . 35
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