1. Page 1 Economics of Network Markets: Key Concepts

2. Page 2 What is Network Economics? Networks consists of: –Nodes & Linkages –Physical Network: telecom, railroads –Virtual Network: a group of users Key concepts –increasing returns and Positive feedback –Path-dependence –Network externalities –Lock-in

3. Page 3 Not All Networks Can Be Owned Networks that are (or can be) owned –“literal networks” such as telephone, pipeline, electrical, cable TV systems Networks that are not (or cannot be) owned –“metaphorical networks” such as language, BMW owners

4. Page 4 Increasing Returns Both supply- and demand-side phenomenon –The demand side economies of scale are crucial for technology markets Drivers of Increasing Returns –Network externalities –Coordination effects –Adaptive expectations

5. Page 5 A Competing Technologies Model (Arthur, 1989, EJ) Returns to Choosing A or B given Previous Adoption Tech. ATech. B R-agent a R +rn A b R +rn B S-agent a S +sn A b S +sn B Assume that a R > b R and a S < b S.

6. Page 6 Increasing Returns Adoption: A Random Walk with Absorbing Barriers Difference in adoptions of A and B A leads B leads 0 Both adopter types choose B Both adopter types choose A Total adoptions Lock-in to B R-types choose A, S-types choose B

7. Page 7 Definitions of Some Properties l Predictable –the observer can pre-determine market share l flexible –a given marginal adjustment to the technologies’ returns can alter future choices l Ergodic (not path-dependent) “ 遍歷性 ” –different sequences of historical events lead to the same market outcomes with probability one Path-efficient –if all times equal development of the technology that is behind in adoption would not have paid off better

8. Page 8 Properties of Different Regimes

9. Page 9 Path dependence Self-reinforcing systems often start in balanced but unstable states. With self-reinforcement, each selection increases the probability of subsequent selection. Small, initial factors thus can tip the balance and determine the direction of the system. “Random walk with absorbing states”

10. Page 10 Factors driving initial perturbations Historical anomaly: –CD’s length is determined by the length of Beethoven’s 9th Symphony Randomness Government Intervention: –choosing technologies Strategic choices: –price differences may sway initial decisions

11. Page 11 Network Externalities Katz and Shapiro (1985, AER) Direct network externalities –value increases directly as the number of physical nodes increases. (e.g., Fax machines, telephones, AOL chat, eBay) Indirect network externalities –value increases due to increased availability of complementary products and services. (e.g., cars and gas stations, hardware/software)

12. Page 12 Adaptive expectations If people expect a product/technology to be adopted, then it is more likely to be adopted. Adaptive expectations piggy-back on the power of network externalities. The question is h ow to exploit the expectations?

13. Page 13 Lock-in The phenomenon of significant collective switching costs faced by users in switching from one technology to another. – Degree of lock-in is determined by minimum cost required to switch selections. – Lock-in can be technology-specific, or vendor- specific.

14. Page 14 Managing customer lock-in Attract –invest in creating installed base by subsidizing early adopters and complementors. Entrench –encourage brand-specific investments in learning and complementary products Leverage –Maximize value of installed base by offering complementary products and services

15. Page 15 Overcoming or breaking lock-in Technology shock that causes obsolescence –IBM mainframes, Novell NetWare Government intervention –Subsidies that “prime the pump” -- provide enough resources to put a technology on a competitive or even preferred stance with another

16. Page 16 Does lock-in create socially undesirable outcomes? Proponents argue that it is possible that optimal equilibrium is not selected, and this introduces inefficiency into the economy. They point to anecdotes from history –VHS vs. Beta –QWERTY vs. DVORAK –nuclear power reactor (light-water, heavy- water or gas-cooled reactors)

17. Page 17 Does lock-in create socially undesirable outcomes? (Cont.) Critics argue that this literature is deeply flawed –At some point, a technology’s inefficiency overcomes the strength of lock-in. –Diminishing returns do eventually set. –History is wrongly interpreted.

18. Page 18 Videocassette Recorder It is often claimed that Beta was a better format and that VHS only won because it luckily got a large market share early on in the competition. Liebowitz and Margolis (1995, JLEO) –Sony had previously shared its patents and secrets with the creators of VHS –the two formats were so similar that Sony engineers considered the VHS machine a copy of the Betamix.

19. Page 19 The Typewriter Keyboard The QWERTY design is reputed to be far inferior to the “scientifically” designed Dvorak keyboard which claimed a 40% increase in typing speed. Liebowitz and Margolis (1990, JLE) –the QWERTY keyboard was not created to slow down typing speed –there is practically no difference in typing speed between the two keyboard designs

20. Page 20 Applying Network Economics Principles (Brian Arthur) l Do I understand the feedbacks in my markets l Which ecologies am I in? l Do I have the resources to play? l What game are coming next?