Network Economics 101

1. Network Economics 101 Phil Weiser Aspen, Colorado Sunday, April 29, 2007

2. What is a “Network Industry?” • Broad definition: An industry that connects users to each other or to producers through a connected system (or systems) of physical infrastructure. • Communications networks • Power grids • Transportation systems • Software platforms • Economic definition: An industry whose good or service increases in value to each individual user as the number of other users of the same good or service increases. • Communications networks • Software platforms • Transportation systems (?)

3. What is a “Network Externality” • The consumer’s perspective: A “network externality” is the added benefit a consumer gets as additional consumers join the same network or use the same product. Phone service may benefit consumers if they can call 10 other people, but it becomes increasingly valuable as they can call 100, 1000, 1 million+ other people. The same holds for a word processing program, for example. It is the benefit that comes from being able to communicate or interact with a greater number of people, which thereby makes the given network more valuable to each user. • The competitive firm’s perspective: A rival’s “network externality” is a barrier to entry. Once a firm has the market lead and provides the greatest network benefit to subscribers, rivals must not only beat the price and technology of the leading firm, but must do so by enough to compensate consumers for the network benefit they lose in switching from the leader to the smaller rival.

4. Network Externalities Distinguished from Economies of Scale • Scale economies arise when a producer’s per-unit costs fall as output increases. • In contrast, network externalities arise when a consumer’s benefit grows as total consumption increases. • Scale economies and network externalities need not go together; it is possible to have one without the other.

5. Network Externalities Distinguished from Lock-In Effects • Lock-in effects arise when consumers find it more economically rational to stick with an existing product/service rather than to switch to a competing one. • Network externalities can create lock-in by making the alternative provider less attractive in terms of the benefit it will provide to the consumer. Even if offered payment to switch, a consumer might decline because of the network benefit she would lose. • Regulation can require firms to “share” their network externality (through an interconnection or interoperability mandate). • But not all lock-in arises from network externalities; lock-in can occur even when the competing product/service is more attractive if the “switching costs” of moving to the better service are too high. Service termination penalties, incompatibility with already-purchased complementary goods, and sunk costs are factors that might keep consumers from switching even to better choices. • Regulation can limit switching costs by mandating cooperation between rivals (e.g., number portability).

6. The Vertical Dimension: Network Effects and Complementary Goods • The benefit of a network or software platform may derive from the availability of complementary products. My operating system is more valuable to me the more applications programs I can run on it. My DVD player is more valuable to me the more movies there are on DVD. As more other consumers by my operating system or DVD players, the more such complementary products get made, making the operating system or DVD player more valuable to me. This is sometimes called an “indirect” network effect or “feedback effect.” • Whether or not there is a network monopoly will depend on rivals’ access not to the underlying platform or network and its customers, but to the complementary products. • Different network (or platform) providers will adopt different strategies toward complementors (or application providers). • Modularity—Palm, Microsoft Xbox, Linux, Comcast DVR • Vertical Integration—Microsoft (OS and browser), Comcast broadband and VoIP • ICE Helps Us Understand Choice of Strategies and Whether they pose competition policy concerns.

7. Consequences for Market Performance and Firm Strategy • Effects on market structure: When the externality cannot be shared among firms, a network industry can “tip” toward monopoly. When AT&T refused in the early 20th century to interconnect with rivals, it quickly gained dominance because of its larger subscriber base, which in turn attracted more new subscribers because of the larger network benefit, thus creating a cycle that reinforced itself and led to monopoly. • Implications for competitive strategy: Early acquisition of customers is critical in the race to capture a network market. The first firm to gain a decisive lead will become dominant, at least for some period of time. Low prices, giveaways and other promotions are likely to be common. • Dynamic effects on innovation and competition: Network effects will drive firms to innovate and compete over time for the market. Just because one firm becomes dominant does not mean all competitors melt away. Some rivals will try to innovate ahead of the incumbent, initiating a new round of competition that may lead to a new firm’s becoming dominant. Competition in R&D will likely be an important strategy in network markets. At a point in time one might observe several firms competing in R&D even if at that same time there is little competition in the product market. • Non-market strategies: Legal and political means of obtaining access to the incumbent’s networks are likely to be attempted.

8. Network Externalities Pose Regulatory Challenges • Network market dominance is not necessarily a result of anticompetitive strategies, but can be consumer-driven. Monopoly is not, as in conventional markets, clearly bad for consumers. They receive a large benefit from the network externality. If that externality cannot be had absent the monopoly, rules designed to end the monopoly may harm consumers. • Regulation may therefore have to make trade-offs between conventional price/output objectives and network externalities. One policy approach is to promote and preserve network externalities for consumers, but to do so at the lowest possible price to consumers by simultaneously introducing competition where possible. • Interconnection and interoperability become key policy instruments in managing this policy objective; more important than retail price regulation. Rate regulation my deter innovation and dynamic competition by reducing the payoff for competing R&D efforts. Interconnection and interoperability, on the other hand, try to preserve competition among firms that collectively provide consumers with a network benefit.

9. Entry In Network Industries • Combination of IP, network externalities, and rapid growth make measurement of monopoly difficult. • Lessons From Standard Fashion— • What are barriers to piecemeal entry? • Does monopolist exclusionary dealing extend duration of monopoly? (Note Schumpeterian critique.)

10. Considerations when Intervening in an Evolving Network Market • As rival firms compete to provide a network service, the ideal is to have rapid deployment, continued competition, and the ability of customers of all providers to share a common network externality. Interconnection is the way to do this. Because subscribers to one mobile phone carrier can call subscribers to all other mobile phone carriers, no carrier has a monopoly on the network externality regardless of market share. Despite some costs, there is little debate over basic interconnection. • But interconnection can be taken much further than basic termination of calls originating on a rival network. For example, one carrier might introduce proprietary features or calling plans that could lead the market to tip. Should a firm have to give rivals access to novel technology? Should carriers be barred from implementing plans that benefit uniquely their own subscribers? Should carriers have to grant wholesale network access to rivals that lack necessary facilities? Over these questions there is far more debate, because the tradeoffs for technological innovation and even for conventional price competition will be much greater. • Key lesson: Interconnection is not unambiguously good, and the fact that it is beneficial in its basic form does not mean it should be taken to greater lengths in the name of access and competitive neutrality.

11. Intervention when the Market has Tipped to Network Monopoly • If the market does tip and only one firm delivers the network externality, the question is whether monopoly effects can be weakened without diminishing the network benefit for consumers, and without weakening dynamic competition. • Easy case is when basic interconnection will do the trick, as it might have in 1910 when AT&T began to regain its monopoly. But this often will not be enough. • 3 More Aggressive Remedies: In many if not most cases more intense intervention will be needed to stimulate competition in the short run. Possibilities, depending on context, are (1) unbundling or wholesale access to incumbent’s facilities, (2) divestiture of the monopoly into separate firms, and (3) licensing of proprietary interfaces to potentially competing platforms. Each of these involves potentially important economic tradeoffs.

12. (continued) • Wholesale access/unbundling: Can have negative effects on investment and innovation. To avoid such harm, network access pricing must be correct, which is very difficult. • Divestiture: Could waste economies of scale and, if divested entities evolve in ways not fully compatible with each other, will diminish network externalities (potential Microsoft divestiture problem). • Licensing of interfaces: Could diminish innovation incentives on a forward-looking basis because benefits would have to be shared. Such licensing would have to be carefully calibrated both as to timing and price. But often a useful solution, increasingly adopted to remedy merger concerns. • Lesson: Introducing competition into network markets can be costly and the tradeoffs need to be considered carefully.

13. A Central Role for Antitrust • It is particularly important where network dominance has occurred to make sure that dominance is not maintained by anticompetitive strategies. Antitrust must play a big role in ensuring that a network monopoly lasts no longer than justified on the competitive merits. • Antitrust will be particularly important where a regulated network operator has an unregulated line of business that is complementary to its regulated service. Example is a cable network that owns and produces content and services that it sells to its internet access subscribers. DOJ and FTC will play the primary role in evaluating potential tying arrangements and vertical mergers that could give rise to monopoly leveraging or monopoly maintenance allegations. • Hiqh Stakes institutional question—can the FCC perform antitrust-like function (ex post evaluation of dominant firm practices) and can antitrust courts act effectively (both knowledgeable and quickly) in new economy markets

14. Three Hard Questions • Intervention in evolving network market: Should regulators intervene to ensure sustained competition in an evolving network market—either vertical access (i.e., network neutrality) or horizontal access (i.e., interoperability). • Remedies for a network monopoly: If a network monopoly arises, should regulators try to limit the duration of the monopoly or otherwise constrain its behavior? And if so, when and how? • How to judge impact of price discrimination via vertical integration?

15. Questions?