The Economics of Networks

1. The Economics of Networks

2. 1. Introduction • Network industries play a crucial role in modern life. • Transportation, communication, information, railroad networks… • Economics of networks industries with vertical relations

3. 2. Classification of Networks • Network components are complementary to each other. • Figure 1

5. “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.

7. In non-network industries: A pair of vertically-related industries is equivalent to a one-way network.

9. 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

10. 3. Network Externalities 3.1 Sources of Network Externalities • Reason of externalities: complementarity (direct or indirect) bw the components of a network • direct: two-way network • Indirect: one-way network Financial exchange network: indirect externalities

11. 3.2 The “Macro” Approach --assumes network externalities exists, and attempts to model their consequences. 3.2.1 Perfect Competition

12. Fulfilled expectations demand is increasing for small n if (either): • Zero utility of every consumer in a network of zero size • immediate and large external benefits to network expansion for very small networks • a significant density of high-willingness-to-pay consumers who are just indifferent on jointing a network of approximately zero size.

13. a positive critical mass under perfect competition. • Network externalities inefficient competition • How to decentralize the welfare maximizing solution with network externalities? Perfect price discrimination.

14. 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.

15. 3.2.3 Oligopoly and Monopolistic Competition Under Compatibility

16. 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)

17. 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.

18. A firm benefits from a move to compatibility if: • The marginal externality is strong • If joins a large coalition • It does not thereby increase competition to a significant degree by its action

19. the coalition benefits from a firm joining its “standard” if: • The marginal externality is strong • The firm the joins the coalition is large • 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.

20. 3.2.5 Coordination to Technical Standards with Asymmetric Technologies If costs are different…firms play a standard coordination game

21. 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

22. 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

24. 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.

25. 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)

27. 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.

28. Under incompatibility, each B type firm incurs higher fixed costs • Type A’s preference depends on equilbrum profits.

29. 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.

30. 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: • Competitive effect • Network effect

31. 4.2 Interconnection or Foreclosure by a Local Monopolist?

33. 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

34. 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)

36. 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.

37. 6. Markets for Adapters and Add-ons • Literature: Adapters are unfeasible. • Farrell and Saloner (1985): converters make the technologies only partially compatible. reduce welfare.

38. 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.

39. Unavailable: market structure in multi-period dynamic games with network externalities. • Not fully analyzed: predation and foreclosure in networks