The Economics of Networks

An Overview

Networks: Nothing New

Network Commodities

• Networks connect complementary goods or services– Specialization and Trade

• Transportation networks

– Supply Chains• Component fabrication and assembly

– Distribution Networks• Finished product to consumers

– Transaction Networks• Communication, information exchange, commercial intermediation

Network Types

• Mix-N-Match Networks– All possible connections possible

• One-way networks– Example: distribution networks

• Local supermarket• Broadcasting networks• Mail delivery systems

• Two-way networks– Example: transaction networks

• Communications (telephone, email, instant messenger)• Online catalogs

• Virtual networks– All MS Office users

Compatibility Issues

• Complementarity and compatibility– Goods which are complements in function need not be compatible

• VHS versus Betamax video tape

– Compatibility makes complementarity actual rather than virtual• Technological standards

– Economic Issues:• Control of standards

• Resulting industry organization

– Monopoly?

– Oligopoly?

– Competition?

Network Externalities

• Networks exhibit positive consumption and production externalities– External economies and diseconomies are benefits (costs,

respectively) which are not taken into account in market-mediated pricing of a good or service

– A direct externality occurs when the value of being connected to a given network increases as the number of people connected to it increases

• Example: Telephone network with n subscribers provides each subscriber with n(n-1) potential connections. Adding an additional subscriber generates (n+1)n potential connections. Hence, adding a subscriber provides a marginal benefit of 2n new connections, so the marginal benefit grows with the size of the network.

Network Externalities

– An indirect externality occurs when there are economies of scale

associated with providing the networked good.

• For example, if the cost of provide a kilowatt hour of electricity for

the whole power grid is constant, then the cost per customer is

inversely proportional to the number of customers connected to the

network.

– Both effects are an example of increasing returns to scale

phenomenon, since the larger the network, the greater the benefit

of being part of it.

Cost Issues

• In typical networks, most of the cost of building and operating the network is fixed, with the marginal cost of providing network services (transportation, communication, transactions) generally small.

• This implies that as the network increases in size, the average cost of providing network services decreases.

• Hence, there are natural incentives with networked technologies for firms that operate the technology to grow in size.

Market Structure Issues

• The decreasing cost structure and incentives for firms to grow will typically lead to market structures which are not competitive

• Rather, they are characterized by the emergence of monopolies or oligopolistic industry structures, with substantial degrees of both upstream (supply chain) and downstream (distribution network) integration.

• One focus of the course, then, will be to examine issues of industrial organization in networked economic environments.

Market Structure Issues

• Positive Feedback– The larger the network, the greater the incentive to join

• Example: Wintel network

– Within the network, don’t need adapters for file sharing or communication

– Outside the network, these activities become expensive

• When positive feedback effects are strong, it can lead to market tipping, with the largest component of the network growing at the expense of competiting networks.

Market Strategy Issues

• The nature of the demand for networked goods, and the

underlying technology involved in the supply of networked

goods determines the optimal strategy for providing such

goods

• Strategic dimensions include:

– Compatibility or incompatibility

– Cooperation or competition

– Degree and mix of quality provided

Market Strategy Issues

• Dynamics and feedback effects in market organization– Technology dictates standards and decision on whether or not to

provide compatibility across different products

– These decisions determine the way industry structure will evolve (monopoly, oligopoly, monopolistic competition, competition)

– Market structure then determines pricing and profit margins

– Hence, anticipations about the evolution of market structure are important inputs into the decision on standard setting

• Example: Microsoft’s recent negotiations with AOL over standards for Windows XP