1. Chapter 17: Network Markets

2. Chapter 17: Network Markets
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, e.g., Word on each other’s computers
More applications are written for 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 17: Network Markets

3. 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
Provider is a monopolist charging a “hook up” fee but no other payment
The basic valuation of the product vi is uniformly distributed across consumers from 0 to $100. Consumer willingness to pay is fvi where f is the fraction of the consumer population that is served
The ith’s consumer’s demand is:
0 if fvi < p
1 if fvi  p
qiD =
Chapter 17: Network Markets

4. Monopoly Provision of a Network 2
Consider the marginal consumer with basic valuation
The firm will serve all consumers with valuations 
With 100 consumers, 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 17: Network Markets

5. Monopoly Provision of a Network 3
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 25 20 15 10 5
$22.22 f
fL fH
Chapter 17: Network Markets

6. Monopoly Provision of a Network 4
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 vi ‘s that range from $50 to $100 or fvi 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 17: Network Markets

7. Monopoly Provision of a Network 5
2. There are multiple equilibria
At p < $25, there is more than one equilibrium value of f
At p = $22.22 both fL(p) = 1/3 and fH(p) = 2/3 are possible f values
Lower fraction may be unstable (tipping)
This group is comprised of consumer with top one-third of vi values
The addition of one more consumer will raise willingness to pay sufficiently that consumers with the next highest third of vi values will be willing to pay and we will move to the fH 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
Chapter 17: Network Markets

8. Monopoly Provision of a Network 6
If the firm needs to serve more than one-third of consumers at a price of $22.22, fL 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 17: Network Markets

9. Networks, Complementary Services & 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—Betamax versus VHS or Blu-Ray versus AOD DVD format—either system may win
Winning system is not necessarily the best one
Chapter 17: Network Markets

10. Price Competition and Network Effects
Sometimes firms have separate networks instead of connecting consumers to the same network
Banks/ATMS
Facebook/Myspace
Consider to firms at the ends of a Hotelling line
A at zero, B at 1
Consumer valuation is V + k sA – tx – pA for firm A
V + k sA – tx – pA for firm B
Where si is the fraction of consumers buying from firm i
Chapter 17: Network Markets

11. Price Competition and Network Effects 2
Sometimes firms have separate networks instead of connecting consumers to the same network
Banks ATMS Facebook/Myspace
Consider to firms at the ends of a Hotelling line
A at zero, B at 1
Consumer valuation is V + k sA – tx – pA for firm A
V + k sA – tx – pA for firm B
Where si is the fraction of consumers buying from firm I
sA = xm and sA = 1- xm where xm is the location of the marginal consumer
Chapter 17: Network Markets

12. Price Competition and Network Effects 3
Assume t>k > 0
The marginal consumer is defined by
V +k sA – txm – pA = V + k sB – t(1 – xm) – pB.
Using rational expectations we have (sA-sB=1+2xm)
Chapter 17: Network Markets

13. Price Competition and Network Effects 4
Which gives demand and profits
Chapter 17: Network Markets

14. Price Competition and Network Effects 5
And best responses
So in equilibrium pA = pB = t – k
So stronger network effects (higher k) intensifies price competition
Chapter 17: Network Markets

15. 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 17: Network Markets

16. Competition and Technical Compatibility
Fear of being incompatible can
lead to the inferior Nash Equilibrium—
neither firm switches because it
thinks the other won’t switch
Both switching to the new technology is a superior Nash Equilibrium
Competition and Technical Compatibility
Both staying with the old technology is a Nash Equilibrium
The fight over compatibility can lead to poor technical choices overall
Two possible problems: Excess Inertia and Excess Momentum
Excess Inertia
Firm 2
Old Technology
New Technology
Old Technology
(5,4)
(2, 2)
Firm 1
New Technology
(1, 5)
(6,7)
Chapter 17: Network Markets

17. Technical Compatibility 2
Both switching to the new technology is a Nash Equilibrium
Both staying with the old technology is a superior Nash Equilibrium
Again, fear of being incompatible can
lead to the inferior Nash Equilibrium
Technical Compatibility 2
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
It is also possible that there is Excess Momentum and each wrongly switches to the New Technology
Excess Momentum
Firm 2
Old Technology
New Technology
Old Technology
(6,7)
(2, 2)
Firm 1
New Technology
(1, 5)
(5,4)
Chapter 17: Network Markets

18. Technical Compatibility 3
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 3 vs. Wii vs. X-Box
Chapter 17: Network Markets

19. Technical Compatibility 4
Firm 1 choosing technology 1 and Firm 2 choosing technology 1 is the Nash Equilibrium preferred by Firm 1
STRATEGIES:
build an early lead by establishing
a large installed base; and 2) convince
the suppliers of complements to
adopt your preferred technology
Firm 1 choosing technology 2 and Firm 2 choosing technology 2 is the Nash Equilibrium preferred by Firm 2
Technical Compatibility 4
Assume there are two technologies, Firm 1’s technology 1 and Firm 2’s technology 2
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
Battle of the Sexes
Firm 2
Technology 1
Technology 2
(10,7)
(6,5)
Technology 1
Firm 1
(5,4)
(8,12)
Technology 2
Chapter 17: Network Markets

20. Technical Compatibility 5
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
Firm 1 choosing technology 1 and Firm 2 choosing technology 2 is the Nash Equilibrium preferred by Firm 1
Technical Compatibility 5
Firm 1 choosing technology 2 and Firm 2 choosing technology 1 is the Nash Equilibrium preferred by Firm 2
Again, assume there are two technologies, technology 1 and technology 2, but technology 1 is probably better
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 1
Tweedledum and
Tweedledee
Firm 2
Technology 1
Technology 2
(3,3)
(8,5)
Technology 1
Firm 1
(6,7)
(2,2)
Technology 2
Chapter 17: Network Markets

21. Technical Compatibility 6
There is no Nash Equilibrium (in pure strategies)—Firm 2 may
frequently change or update
its technology to lose its “little brother”
If Firm 1 chooses technology 2 then Firm 2 wants to adopt technology 2, too
If Firm 1 chooses technology 1 then Firm 2 wants to use technology 1,
as well
Technical Compatibility 6
In Tweedledum and Tweedledee each firm wants superior technology but really care about differentiating their products by choosing different technologies
In Pesky Little Brother, Firm 1 is the dominant firm (big brother) that wants to limit competition from Firm 2 (little brother) by adopting a different technology. Firm 2 always wants compatibility
Pesky Little
Brother
Firm 2
Technology 1
Technology 2
(12,4)
(16,2)
Technology 1
Firm 1
(15,2)
(10,5)
Technology 2
Chapter 17: Network Markets

22. Public Policy and Systems/Standards Competition
Public policy in the presence of strong network 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”
Chapter 17: Network Markets

23. Chapter 17: Network Markets
Empirical Application: Network Effects in Software—The Case of Spreadsheets
Computer software is probably among those products with important network features, e.g., the more people that use Excel or PowerPoint the more usable and valuable they are to any one consumer
Can we identify network features empirically?
A relatively early attempt is Gandal’s (1994) investigation of spreadsheet program pricing
Chapter 17: Network Markets

24. Empirical Application: Network Effects in Spreadsheet Programs 2
A spreadsheet is a long-established business planning tool
Originally a pencil-and-paper operation with sheets organized into many rows and columns that could be summed either vertically or horizontally to trace the impact of individual factors
Computerized versions began to appear in 1980
By the mid-1980’s there were eight or more different spreadsheet programs on the market
The dominant product was Lotus 1-2-3
Each product had different features, e.g.,
Graphing
Ability to link entries in one spreadsheet to those in another
Lotus compatibility
Chapter 17: Network Markets

25. Empirical Application: Network Effects in Spreadsheet Programs 3
A hedonic regression is a model of price determination that explains a product price as a result of its key features rather than explicitly model supply and demand
Gandal (1994) estimates an hedonic regression for spreadsheet programs over the years 1986 to 1991
Postulates key characteristics that should affect spreadsheet price
Identifies which characteristics are network features
Explicitly considers the role of time and technical progress so that a spreadsheet price index may be constructed
Chapter 17: Network Markets

26. Empirical Application: Network Effects in Spreadsheet Programs 4
· Basic Features
LMINRC = a measure of sheer computing power
LOTUS = a 1,0 variable equal to 1 if it has the Lotus brand
GRAPHS = a 1,0 variable equal to 1 if it has graphing ability
WINDOW = number of windows program handles simultaneously
LINKING = a 1,0 variable equal to 1 if it links spreadsheet entries
Network Features
LOCOMP = a 1,0 variable equal to 1 if program is Lotus compatible
EXTDAT = a 1,0 variable equal to 1 if it can import external data
LANCOM = a 1,0 variable equal to 1 if it can link to a local network
Time Dummies
one for each year to pick up the pure effect of time (technology
improvement) on spreadsheet prices
Chapter 17: Network Markets

27. Empirical Application: Network Effects in Spreadsheet Programs 5
Network features raise value of spreadsheet program
Variable: Coefficient t-statistic
LMINRC ( 1.59)
LOTUS ( 4.36)
GRAPHS ( 3.51)
WINDOW ( 2.14)
LINKING ( 1.91)
LOCOMP ( 4.28)
EXTDAT ( 4.05)
LANCOM ( 1.65)
CONSTANT (12.31)
– 0.06 (–0.38)
– 0.44 (–2.67)
– (–4.20)
– (–4.90)
– (–5.30)
Technical progress lowers spreadsheet prices over time
Chapter 17: Network Markets

28. Empirical Application: Network Effects in Spreadsheet Programs 6
Gandal’s Results
Demonstrate importance of network features for spreadsheet programs
Allow construction of a spreadsheet price index that controls for quality, i.e., that reflects the pure passage of time
Since dependent variable is ln Price, Hedonic Price Index is:
Implied Spreadsheet Price Index (1986 = 1.00)
Year
Index
Chapter 17: Network Markets