Chapter 24: Network Issues1 Network Issues

Chapter 24: Network Issues2 Introduction Some products are popular with individual consumers precisely because each consumer places a value on others using the same good –A telephone is only valuable if others have one, too –Each user of Microsoft Windows benefits from having lots of other Windows users Users can run applications such as Word on each other’s computers More applications are written for operating systems with many users Network Effects or network externalities reflect such situations in which each consumer’s willingness to pay for a product rises as more consumers buy it Strategic interaction in a market with network effects is complicated

Chapter 24: Network Issues3 Monopoly Provision of a Network Service An early model by Rohlfs (1974) illustrates many of the issues that surround markets with network effects –Imagine some service, say a cable network, where consumers “hook” up to the system but the cost of providing them service after that is effectively zero The provider is a monopolist and charges a “hook up” fee but no other payment The basic valuation of the product v i is uniformly distributed across consumers from 0 to $100. Consumer willingness to pay is fv i where f is the fraction of the consumer population that is served The ith’s consumer’s demand is: q i D = 0 if fv i < p 1 if fv i  p

Chapter 24: Network Issues4 Monopoly Provision of a Network (cont.) Consider the marginal consumer with basic valuation The firm will serve all consumers with valuations greater than Solving for the fraction f of the market served we have: f = 1 - = 1 – p/100f So, the inverse demand function is: p = 100f(1 – f)

Chapter 24: Network Issues5 Monopoly Provision of a Network (cont.) The inverse demand curve has both upward and downward sloping parts. This means that there are two possible values for the fraction of the market served at any price p. $/unit = p f $22.22 f L f H

Chapter 24: Network Issues6 Monopoly Provision of a Network (cont.) The Rohlfs model makes clear many of the potential problems that can arise in markets with network effects 1. The market may fail altogether –Suppose the firm must set a fee over $30 perhaps to cover fixed costs –Network will fail even though it is socially efficient When half the market is served, the customers hooking up have v i ‘s that range from $50 to $100 or fv i values that range from $25 to $50 Average value is then $37.50, well above $30 But as p rises to $30, f falls and so does average willingness to pay There is no price at which sufficient numbers of consumers sign on that yields an average willingness to pay of $30

Chapter 24: Network Issues7 Monopoly Provision of a Network (cont.) 2. There are multiple equilibria –At p < $25, there is more than one equilibrium value of f –Thus, at p = $22.22 both f L (p) = 1/3 and f H (p) = 2/3 are possible values of f –Lower fraction may be unstable (tipping) This group is comprised of consumer with top one-third of v i values The addition of one more consumer will raise willingness to pay sufficiently that consumers with the next highest third of v i values will be willing to pay and we will move to the f H equilibrium The loss of one consumer will lower the willingness to pay of that same top one-third and demand will fall to zero at p = $22.22 –If the firm needs to serve more than one-third of consumers at a price of $22.22, f L is called a critical mass. Low or free introductory pricing Lease and guarantee that if critical mass is not reached, refund given Target large consumers with internal networks first

Chapter 24: Network Issues8 Networks, Complementary Services, and Competition Rohlfs model is a monopoly model but has clear insights for oligopoly setting –Market may fail –Competition will be fierce—a firm that fails to reach a critical mass isn’t just smaller than its rival—it dies –Multiple Equilibria are possible, e.g., Betamax versus VHS—either system and not necessarily the best one may be the winner

Chapter 24: Network Issues9 Systems and Standards Competition Competition between networks does not always lead to one survivor Each network may have its own system –Compatibility issues –What is gained and lost when consumers cannot use their brand of the product on other systems? Competition to be the Industry Standard –Firms may compete to have their system adopted as the industry standard –What are the implications of standards competition?

Chapter 24: Network Issues10 Competition and Technical Compatibility Firm 2 Old Technology New Technology (5,4)(2, 2) (1, 5) The fight over compatibility can lead to poor technical choices overall New Technology Firm 1 (6,7) Excess Inertia Two possible problems are Excess Inertia and Excess Momentum Both staying with the old technology is a Nash Equilibriu m Both switching to the new technology is a superior Nash Equilibrium Fear of being incompatible can lead to the inferior Nash Equilibrium— neither firm switches because it thinks the other won’t switch

Chapter 24: Network Issues11 Technical Compatibility (cont.) Firm 2 Old Technology New Technology (6,7))(2, 2) (1, 5) In the case of excess inertia, each firm wants to adopt the same technology as its rival but, fearful that the rival won’t switch to the new technology, each wrongly stays with the old New Technology Firm 1 (5,4) Excess Momentum It is also possible that there is Excess Momentum and each wrongly switches to the New Technology Both switching to the new technology is a Nash Equilibriu m Both staying with the old technology is a superior Nash Equilibrium Again, fear of being incompatible can lead to the inferior Nash Equilibrium

Chapter 24: Network Issues12 Systems Competition and Industry Standards The Excess Inertia and Excess Momentum cases apply to market settings where the network gains from compatibility and “connectedness” are large –both firms want to adopt a common technology –Difficulty in agreeing which technology both should use Sometimes firms will not have a preference to make their technology the common standard or not to have a common technology at all –Different technologies loses compatibility –But different technologies differentiates each product and softens price competition, e.g., PlayStation 2 vs. Gamecube vs. X-Box

Chapter 24: Network Issues13 Technical Compatibility (cont.) Firm 2 Technology 1 Technology 2 (8,12)(5,4) (6,5) Assume there are two technologies, Firm 1’s technology 1 and Firm 2’s technology 2 Technology 2 Firm 1 (10,7) Battle of the Sexes In Battle of the Sexes firms still agree that there should be a common standard but each wants its own technology to be the standard Firm 1 choosing technology 1 and Firm 2 choosing technology 1 is the Nash Equilibrium preferred by Firm 1 Firm 1 choosing technology 2 and Firm 2 choosing technology 2 is the Nash Equilibrium preferred by Firm 2 STRATEGIES: build an early lead by establishing a large installed base; and 2) convince the suppliers of complements to adopt your preferred technology

Chapter 24: Network Issues14 Technical Compatibility (cont.) Firm 2 Technology 1 Technology 2 (3,3)(6, 7) (8, 5) Again, assume there are two technologies, technology 1 and technology 2, but technology 2 is probably better Technology 2 Firm 1 (2,2) Tweedledum and Tweedledee In Tweedledum and Tweedledee, the firms want to differentiate their products by choosing different strategies but each wants to be the one with the superior technology 2 Firm 1 choosing technology 2 and Firm 2 choosing technology 1 is the Nash Equilibrium preferred by Firm 1 Firm 1 choosing technology 1 and Firm 2 choosing technology 2 is the Nash Equilibrium preferred by Firm 2 STRATEGIES similar to before. build a large installed base of the preferred technology with your name on it; and make sure that you have lined up suppliers of complements so that you are the one who gets to adopt that technology

Chapter 24: Network Issues15 Technical Compatibility (cont.) Firm 2 Technology 1 Technology 2 (12,4)(16,2) (15,2) What they really care about is differentiating their products by choosing different technologies Technology 2 Firm 1 (10,5) Pesky Little Brother In Pesky Little Brother, Firm 2 is the dominant firm (big brother) that wants to limit competition from Firm 1 (little brother) by adopting a different technology. Firm 1 always wants compatibility If Firm 2 chooses technology 1 then Firm 1 wants to adopt technology 1, too If Firm 2 chooses technology 2 then Firm 1 wants to use technology 2, as well There is no Nash Equilibrium (in pure strategies)—Firm 2 may frequently change or update its technology to lose its “little brother”

Chapter 24: Network Issues16 Systems Competition and Industry Standards Public policy in the presence of strong networkk externalities is complicated Low introductory pricing and bundling of complements may look like anticompetitive practices but are really just necessary to survive Decreeing a common standard forces government to choose the winning standard. Governments are not necessarily good at picking winners Should governments try to coordinate technology choices or, instead, “let a thousand flowers bloom”