1. The Economics of Networks

2. 1. Introduction  Network industries play a crucial role in modern life.  Transportation, communication, information, railroad networks…  Economics of networks  industries with vertical relations

3. 2. Classification of Networks  Network components are complementary to each other.  Figure 1

4. 

5.  “Two-way” networks, Economides and White (1994) Example: AB and BA Example: AB and BA  The classification in network type depends on the interpretation of the structure to represent a specific service. Example: Example: Figure 3, SA local customer in city A; Figure 3, SA local customer in city A; SB local customer in city B. SB local customer in city B. Local phone calls; Local phone calls; long distance phone calls. long distance phone calls.

7.  In non-network industries: A pair of vertically-related industries is equivalent to a one-way network. A pair of vertically-related industries is equivalent to a one-way network.

9.  It is compatibility that makes complementarity actual. Combinable through inherent properties Combinable through inherent properties Combinable through adherence to specific tech standards. Combinable through adherence to specific tech standards.  Research on economies of scope, ’70s  Research on interconnection and compatibility, ’80s and ’90s  Cost reductions  Telecom industry transformed to oligopoly

10. 3. Network Externalities 3.1 Sources of Network Externalities  Reason of externalities: complementarity (direct or indirect) bw the components of a network complementarity (direct or indirect) bw the components of a network 1. direct: two-way network 2. Indirect: one-way network Financial exchange network: indirect externalities

11. 3.2 The “Macro” Approach --assumes network externalities exists, and attempts to model their consequences. 3.2.1 Perfect Competition 3.2.1 Perfect Competition

12.  Fulfilled expectations demand is increasing for small n if (either): 1. Zero utility of every consumer in a network of zero size 2. immediate and large external benefits to network expansion for very small networks 3. a significant density of high-willingness-to-pay consumers who are just indifferent on jointing a network of approximately zero size.

13.  a positive critical mass under perfect competition.  Network externalities  inefficient competition  How to decentralize the welfare maximizing solution with network externalities? Perfect price discrimination. Perfect price discrimination.

14. 3.2.2 Monopoly  Monopolists support smaller networks and charge higher prices; restrict production; lower CS and TS  Network externalities is not a reason in facor of a monopoly.

15. 3.2.3 Oligopoly and Monopolistic Competition Under Compatibility

16.  Assume: takes the output of all others as given, sets the expectation of consumers of his own output.  Network size: bw monopoly (M=1) and perfect competition (M=unlimited)

17. 3.2.4 Oligopoly Under Incompatibility  Compatibility by all firms: a single coalition that includes all firms.  Total incompatibility: every firm adheres to its own unique standard.  At a non-cooperative eqm with side payments, firms divide the profits of a coalition arbitrarily to induce firms to join a coalition.

18.  A firm benefits from a move to compatibility if: 1. The marginal externality is strong 2. If joins a large coalition 3. It does not thereby increase competition to a significant degree by its action

19.  the coalition benefits from a firm joining its “standard” if: 1. The marginal externality is strong 2. The firm the joins the coalition is large 3. Competition does not increase significantly as a result of the firm joining the coalition. ---the second and third criteria in both cases create incentives that are in conflict.

20. 3.2.5 Coordination to Technical Standards with Asymmetric Technologies If costs are different…firms play a standard coordination game

21. 3.3 The “Micro” Approach  Starts with analysis of the specific micro- structure of a network.  Distinguish bw end-to-end demanded cases with cases where none end-to-end services are demanded  Components; composite good; composite system; compatible; strategic

22. 3.3.1 Mix and Match: Compatibility vs. Incompatibility  Demand in mix-and-match models exhibits network externalities.  Figure 4 with: m=2, n=2 m=2, n=2 tech are known tech are known coordination is costless coordination is costless price discrimination is not allowed price discrimination is not allowed no asymmetries created no asymmetries created

24.  Hybrid demand is large  a firm had an incentive to want compatibility  Hybrid demand is small  a firm does not want compatibility --might be conflict across firms ---compatibility vs. incompatibility &decision of partial incompatibility.

25.  Profits are more responsive to price under incompatibility  firms choose lower prices.  If compatibility is not reciprocal: --incentive depends on the cross substitution bw own-products and hybrids. (if substitution equal, earlier results hold.)  If more than two firms…  If compatibility decisions are less flexible than vertical integration decisions (game structure)

27. 3.3.2 changes in the number of varieties as a result of compatibility decisions  two goods: A & B  Brands of good: A1, A2; B1, B2.

28.  Under incompatibility, each B type firm incurs higher fixed costs  Type A’s preference depends on equilbrum profits.

29. 3.3.3 Quality Coordination in Mix-and-Match  Mix-and-match models apply to both variety and quality features that are combinable additively in the utility function.  Qab=min(Qa,Qb)  Lack of vertical integration leads to a reduction in quality.  In parallel vertical integration, firms prefer not to interconnect.

30. 4. Network Externalities and Industry Structure 4.1 Invitations to Enter  Network externalities  Exclusive holder of a technology has incentive to invite competitors, to reach the high output required.  Two effects: 1. Competitive effect 2. Network effect

31. 4.2 Interconnection or Foreclosure by a Local Monopolist?

33.  The integrated firm is better off by implementing a vertical price squeeze on the opponent.  Foreclosure, although feasible, is not optimal for the monopolist.  Vertical disintegration is not desirable for the firm that offers end-to-end service.  Starting from independent ownership, or starting from parallel vertical integration, a merger to joint ownership, where all components are produced by the same firm, can either increase or decrease prices.  Interconnection fee

34. 5. Sequential Games  History matters.  Strategic advantages, such as first mover advantages, can have long run effects.  Adoption path is much deeper in the presence of externalities.  If depart from the assumption of perfect competition…more complex. (two-period model)

36.  Farrell and Saloner (1985):  Two-period model where consumers have varying willingness to pay for the change of the tech.  Users can switch in period 1 or 2.  Users fall in 4 categories according to the strategic they pick.

37. 6. Markets for Adapters and Add-ons  Literature: Adapters are unfeasible.  Farrell and Saloner (1985): converters make the technologies only partially compatible.  reduce welfare.

38. 7. Concluding Remarks  Unsolved: joint determination of an equilibrium market structure together with the degree of compatibility across firms. joint determination of an equilibrium market structure together with the degree of compatibility across firms.  Remain open questions: extent of standardization in markets with more than two participants; the structure of “standards” coalitions extent of standardization in markets with more than two participants; the structure of “standards” coalitions  Not sufficiently analyzed: markets for adapters and add-ons. markets for adapters and add-ons.

39.  Unavailable: market structure in multi-period dynamic games with network externalities. market structure in multi-period dynamic games with network externalities.  Not fully analyzed: predation and foreclosure in networks predation and foreclosure in networks