The Economics of Networks

1. Introduction Network industries play a crucial role in modern

life.

Transportation, communication, information, railroad networks…

Economics of networks industries with vertical relations

2. Classification of Networks Network components are complementary to each

other.

Figure 1

“Two-way” networks, Economides and White (1994)

Example: AB and BA

The classification in network type depends on the interpretation of the structure to represent a specific service.

Example: Figure 3, SA local customer in city A; SB local customer in city B. Local phone calls; long distance phone calls.

In non-network industries:

A pair of vertically-related industries is equivalent to a one-way network.

It is compatibility that makes complementarity actual.

Combinable through inherent properties Combinable through adherence to specific tech

standards.

Research on economies of scope, ’70s Research on interconnection and compatibility,

’80s and ’90s Cost reductions Telecom industry transformed to oligopoly

3. Network Externalities3.1 Sources of Network Externalities

Reason of externalities: complementarity (direct or indirect) bw the

components of a network

1. direct: two-way network2. Indirect: one-way network

Financial exchange network: indirect externalities

3.2 The “Macro” Approach--assumes network externalities exists, and

attempts to model their consequences.

3.2.1 Perfect Competition

Fulfilled expectations demand is increasing for small n if (either):

1. Zero utility of every consumer in a network of zero size

2. immediate and large external benefits to network expansion for very small networks

3. a significant density of high-willingness-to-pay consumers who are just indifferent on jointing a network of approximately zero size.

a positive critical mass under perfect competition.

Network externalities inefficient competition

How to decentralize the welfare maximizing solution with network externalities?

Perfect price discrimination.

3.2.2 Monopoly

Monopolists support smaller networks and charge higher prices; restrict production; lower CS and TS

Network externalities is not a reason in facor of a monopoly.

3.2.3 Oligopoly and Monopolistic Competition Under Compatibility

Assume: takes the output of all others as given, sets the expectation of consumers of his own output.

Network size: bw monopoly (M=1) and perfect competition (M=unlimited)

3.2.4 Oligopoly Under Incompatibility

Compatibility by all firms: a single coalition that includes all firms.

Total incompatibility: every firm adheres to its own unique standard.

At a non-cooperative eqm with side payments, firms divide the profits of a coalition arbitrarily to induce firms to join a coalition.

A firm benefits from a move to compatibility if:

1. The marginal externality is strong2. If joins a large coalition3. It does not thereby increase competition to a

significant degree by its action

the coalition benefits from a firm joining its “standard” if:

1. The marginal externality is strong2. The firm the joins the coalition is large3. Competition does not increase significantly as a

result of the firm joining the coalition.

---the second and third criteria in both cases create incentives that are in conflict.

3.2.5 Coordination to Technical Standards with Asymmetric Technologies

If costs are different…firms play a standard coordination game

3.3 The “Micro” Approach

Starts with analysis of the specific micro-structure of a network.

Distinguish bw end-to-end demanded cases with cases where none end-to-end services are demanded

Components; composite good; composite system; compatible; strategic

3.3.1 Mix and Match: Compatibility vs. Incompatibility

Demand in mix-and-match models exhibits network externalities.

Figure 4 with: m=2, n=2 tech are known coordination is costless price discrimination is not allowed no asymmetries created

Hybrid demand is large a firm had an incentive to want compatibility

Hybrid demand is small a firm does not want compatibility

--might be conflict across firms

---compatibility vs. incompatibility &decision of partial incompatibility.

Profits are more responsive to price under incompatibility firms choose lower prices.

If compatibility is not reciprocal:--incentive depends on the cross substitution bw

own-products and hybrids. (if substitution equal, earlier results hold.)

If more than two firms…

If compatibility decisions are less flexible than vertical integration decisions (game structure)

3.3.2 changes in the number of varieties as a result of compatibility decisions

two goods: A & B Brands of good: A1, A2; B1, B2.

Under incompatibility, each B type firm incurs higher fixed costs

Type A’s preference depends on equilbrum profits.

3.3.3 Quality Coordination in Mix-and-Match

Mix-and-match models apply to both variety and quality features that are combinable additively in the utility function.

Qab=min(Qa,Qb)

Lack of vertical integration leads to a reduction in quality.

In parallel vertical integration, firms prefer not to interconnect.

4. Network Externalities and Industry Structure

4.1 Invitations to Enter

Network externalities Exclusive holder of a technology has incentive to invite competitors, to reach the high output required.

Two effects:1. Competitive effect2. Network effect

4.2 Interconnection or Foreclosure by a Local Monopolist?

The integrated firm is better off by implementing a vertical price squeeze on the opponent.

Foreclosure, although feasible, is not optimal for the monopolist.

Vertical disintegration is not desirable for the firm that offers end-to-end service.

Starting from independent ownership, or starting from parallel vertical integration, a merger to joint ownership, where all components are produced by the same firm, can either increase or decrease prices.

Interconnection fee

5. Sequential Games History matters.

Strategic advantages, such as first mover advantages, can have long run effects.

Adoption path is much deeper in the presence of externalities.

If depart from the assumption of perfect competition…more complex. (two-period model)

Farrell and Saloner (1985):

Two-period model where consumers have varying willingness to pay for the change of the tech.

Users can switch in period 1 or 2.

Users fall in 4 categories according to the strategic they pick.

6. Markets for Adapters and Add-ons

Literature: Adapters are unfeasible.

Farrell and Saloner (1985): converters make the technologies only partially compatible.

reduce welfare.

7. Concluding Remarks Unsolved: joint determination of an equilibrium market

structure together with the degree of compatibility across firms.

Remain open questions: extent of standardization in markets with more

than two participants; the structure of “standards” coalitions

Not sufficiently analyzed: markets for adapters and add-ons.

Unavailable: market structure in multi-period dynamic games

with network externalities.

Not fully analyzed: predation and foreclosure in networks