Overview of Network Industries Nien-Pen Liu

Main Characteristics Consumption externalities Complements, compatibility and standards Switching costs and lock-in Supply-side economies of scale Differentiation of products and prices

Consumption externalities Direct network effects - The demand depends on how many other people purchase it - In general: fax, Indirect network effects - The more people that have DVDs, the more DVD-readable content will be provided

Direct network effects Positive feedback Multiple equilibria - Importance of expectations - The critical mass

Complements, compatibility and standards Complements - Definition: Commodity A complements commodity B if more of commodity A increases the value of an extra unit of commodity B - Examples: More software increases the value of a computer; More roads increase the value of a car Information technologies have increased greatly the complementarities between commodities ◦ Computers and operating systems (OS) ◦ DVD players and DVD disks ◦ Wi-Fi sites and laptop computers

How should a firm behave when it produces a commodity that complements another commodity? The problem is: When you make more of your product (commodity A) you increase the value of firm B’s product (commodity B). Can you get for yourself some of gain you create for firm B?

The noncooperative firms ignore the external benefit (complementarity) each creates for the other. So each undersupplies the market, causing a higher market price. These externalities are fully internalized in the merged firm, inducing it to supply more computers and OS and thereby cause a lower market price.

Alternatives include: - Collaborate - Negotiate - Nurture - Commoditize Compatibility and standards - The problem of coordination - Mix and match

Switching costs and lock-in Cost of switching - Compare Ford v. Toyota and Windows v. Linux - When very large, we have lock-in Classification of the various lock-ins - Contracts - Training and learning - Data conversion - Search cost - Loyalty cost Affecting price competition in two opposing ways

Supply-side economies of scale High fixed sunk cost together with almost negligible marginal cost - Declining average cost - Example: information goods More concentrated industries - This may not be so bad for consumers as is often thought, why? - Competition to acquire monopoly - Reduction in fixed costs - Pressure from complementors

More advanced topics Platform pricing and competition - Two-sided markets - Focusing on this issue Position Auctions - Internet advertising and the generalized second-price auction Conditioning on purchase history

Two-sided markets Many markets involve two groups of who interact via “platforms”, where one group’s benefit from joining a platform depends on the size of the other group that joins the platform. Examples of two-sided networks - Video games - Web search - Smart phone operating systems

Pricing the platform - Platform providers have to choose a price for each side, factoring in the impact on the other side’s growth and willingness to pay. - a “subsidy side,” a group of users who, when attracted in volume, are highly valued by the “money side,” the other user group Some important factors - Ability to capture cross-side network effects - User sensitivity to price - User sensitivity to quality - Output costs - Same-side network effects - Users’ brand value

Similar networks, different pricing - PC vs. video games The threat of envelopment - The real damage comes when your new rival offers your platform’s functionality as part of a multiplatform bundle.

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