The Economics of Networks

1. The Economics of Networks An Overview While the growth of the internet and the internet-driven boom of the 90's have made the study of networks something of a fad within the economics profession, networks as an economic phenomenon are actually quite old. TO SLIDE 2 While the growth of the internet and the internet-driven boom of the 90's have made the study of networks something of a fad within the economics profession, networks as an economic phenomenon are actually quite old. TO SLIDE 2

2. Networks: Nothing New You don't have to look past the City of Pittsburgh for an example of an old and enduring network: the inland navigation system of the United States. Pittsburgh owes its existence to the water transportation networkmade up of the Great Lakes and the various rivers of the east coast and the midwest. In the mid-1700's all of the waterways west of the Allegheny mountains, the Great Lakes and the St. Lawerence river were all under the control of the French in their various alliances with the native peoples of the region. Control over the waterways meant control over trade between the French and their native clients. As the British colonies located between the mountains and the coast began to grow and expand westward, the colonists realized that as long as the French controlled the waterways, the colonies would be lock up behind the mountains with no possibility of expansion or of trade beyond the mountains. This realization led to significant pressures on the British governors of the various colonies to move against the French and the ring of forts they had erected along the St. Lawrence, the Lakes, and the Allegheny and Ohio Rivers to keep the English at bay. These moves precipitated a Noth American phase of the Seven Years war against England and France (and their various allies), which we know in America as the French and Indian War. In this struggle -- which lasted from 1754-59 and ended with the capture of Quebec by the British and the expulsion of the French as a colonial power in North America -- Pittsburgh was a major prize, since it straddled what was then known as the Forks of the Ohio, where the Monongohela and Allegheny rivers join to form the Ohio River. The Allegheny River to the north provides a route to Lake Ontario and points accessible from there (via a short portage between the Allegheny and Genesee Rivers). The Ohio provided access to the south central U.S. and then, via the Mississippi, to the territories of the Gulf of Mexico region.You don't have to look past the City of Pittsburgh for an example of an old and enduring network: the inland navigation system of the United States. Pittsburgh owes its existence to the water transportation networkmade up of the Great Lakes and the various rivers of the east coast and the midwest. In the mid-1700's all of the waterways west of the Allegheny mountains, the Great Lakes and the St. Lawerence river were all under the control of the French in their various alliances with the native peoples of the region. Control over the waterways meant control over trade between the French and their native clients. As the British colonies located between the mountains and the coast began to grow and expand westward, the colonists realized that as long as the French controlled the waterways, the colonies would be lock up behind the mountains with no possibility of expansion or of trade beyond the mountains. This realization led to significant pressures on the British governors of the various colonies to move against the French and the ring of forts they had erected along the St. Lawrence, the Lakes, and the Allegheny and Ohio Rivers to keep the English at bay. These moves precipitated a Noth American phase of the Seven Years war against England and France (and their various allies), which we know in America as the French and Indian War. In this struggle -- which lasted from 1754-59 and ended with the capture of Quebec by the British and the expulsion of the French as a colonial power in North America -- Pittsburgh was a major prize, since it straddled what was then known as the Forks of the Ohio, where the Monongohela and Allegheny rivers join to form the Ohio River. The Allegheny River to the north provides a route to Lake Ontario and points accessible from there (via a short portage between the Allegheny and Genesee Rivers). The Ohio provided access to the south central U.S. and then, via the Mississippi, to the territories of the Gulf of Mexico region.

3. Network Commodities Networks connect complementary goods or services Specialization and Trade Transportation networks Supply Chains Component fabrication and assembly Distribution Networks Finished product to consumers Transaction Networks Communication, information exchange, commercial intermediation

4. Network Types Mix-N-Match Networks All possible connections possible One-way networks Example: distribution networks Local supermarket Broadcasting networks Mail delivery systems Two-way networks Example: transaction networks Communications (telephone, email, instant messenger) Online catalogs Virtual networks All MS Office users

5. Compatibility Issues Complementarity and compatibility Goods which are complements in function need not be compatible VHS versus Betamax video tape Compatibility makes complementarity actual rather than virtual Technological standards Economic Issues: Control of standards Resulting industry organization Monopoly? Oligopoly? Competition?

6. Network Externalities Networks exhibit positive consumption and production externalities External economies and diseconomies are benefits (costs, respectively) which are not taken into account in market-mediated pricing of a good or service A direct externality occurs when the value of being connected to a given network increases as the number of people connected to it increases Example: Telephone network with n subscribers provides each subscriber with n(n-1) potential connections. Adding an additional subscriber generates (n+1)n potential connections. Hence, adding a subscriber provides a marginal benefit of 2n new connections, so the marginal benefit grows with the size of the network.

7. Network Externalities An indirect externality occurs when there are economies of scale associated with providing the networked good. For example, if the cost of provide a kilowatt hour of electricity for the whole power grid is constant, then the cost per customer is inversely proportional to the number of customers connected to the network. Both effects are an example of increasing returns to scale phenomenon, since the larger the network, the greater the benefit of being part of it.

8. Cost Issues In typical networks, most of the cost of building and operating the network is fixed, with the marginal cost of providing network services (transportation, communication, transactions) generally small. This implies that as the network increases in size, the average cost of providing network services decreases. Hence, there are natural incentives with networked technologies for firms that operate the technology to grow in size.

9. Market Structure Issues The decreasing cost structure and incentives for firms to grow will typically lead to market structures which are not competitive Rather, they are characterized by the emergence of monopolies or oligopolistic industry structures, with substantial degrees of both upstream (supply chain) and downstream (distribution network) integration. One focus of the course, then, will be to examine issues of industrial organization in networked economic environments.

10. Market Structure Issues Positive Feedback The larger the network, the greater the incentive to join Example: Wintel network Within the network, don�t need adapters for file sharing or communication Outside the network, these activities become expensive When positive feedback effects are strong, it can lead to market tipping, with the largest component of the network growing at the expense of competiting networks.

11. Market Strategy Issues The nature of the demand for networked goods, and the underlying technology involved in the supply of networked goods determines the optimal strategy for providing such goods Strategic dimensions include: Compatibility or incompatibility Cooperation or competition Degree and mix of quality provided

12. Market Strategy Issues Dynamics and feedback effects in market organization Technology dictates standards and decision on whether or not to provide compatibility across different products These decisions determine the way industry structure will evolve (monopoly, oligopoly, monopolistic competition, competition) Market structure then determines pricing and profit margins Hence, anticipations about the evolution of market structure are important inputs into the decision on standard setting Example: Microsoft�s recent negotiations with AOL over standards for Windows XP