Digitized by the Internet Archive
in
2011 with funding from
Boston Library Consortium IVIember Libraries
http://www.archive.org/details/economicissuesin00farr2
DEC
working paper
department
of economics
ECONOMIC ISSUES IN STANDARDIZATION
By Joseph Farrell*
and
Garth Saloner**
Number 393
October 1985
massachusetts
institute of
technology
50 memorial drive
Cambridge, mass. 02139
4
1986
j
ECONOMIC ISSUES IN STANDARDIZATION
By Joseph Farrell*
and
Garth Saloner**
October 1985
Number 393
»GTE Laboratories,
Inc., 40 Sylvan Rd
Massachusetts Institute
.
,
Waltham MA
02254.
of Technology.
Saloner gratefully acknowledges
research support from the National Science Foundation (grant IST-8510162)
0EC3
1986
1.
Introduction
The subject of compatibility and the economics of standards has become
m
the telecommunications industry since
the AT&T divestiture and
with the growing importance of international traffic.
Moreover, the introduc-
very topical
of such
tion
new
services as
standardization activity,
deal of
and video
ISDN
and offers
communications
opportunities
demands
for
a
great
good and bad
decisions on standards^.
Standardization and its problems are not unique to telecommunications.
Compatibility may be important even if there is no physical network. For example,
one can use nuts and bolts from different manufacturers; one can play the
same records on different brands of gramophone,
and so forth.
It is also easy
situations in which more compatibility would be useful.
to list
travelers
find
incompatibilities
weights and measures,
and in
lenses from Nikon, and
computer is of little
a
in
language
and
Buyers
currency.
in
International
outlets,
electrical
of Pentax cameras
in
cannot buy
library of softv/are accumulated for an IBM personal
value if its ovmer decides to buy an Apple computer^.
Other examples are cited
m
Berg (1955),
Farrell and Saloner
(19S5a,b),
Katz
and Shapiro (1985a, b).
scale
tions,
Such benefits
from
doing
demand
side.
This
on
the
for example:
the
same as others do create
raises
a
number
of
economies
important economic
of
ques-
2
Does standardization retard the adoption of superior new technology?
1.1
may
One
reasonably
externalities")
("network
fear
that,
the
benefits
no
user
will be
important,
are
incompatible
early adopter of new,
when
since
technology,
compatibility
to
willing
it will be
be
an
reluctant
to
to
lose the benefits of market compatibility. Thus, an industry could get trapped
in an inferior technology.
A related issue is
(R&D)
to
in
adopt
order to develop
a
incentives to undertake research and development
the
a
better new technology.
superior invention,
to develop inventioiis will be
When should
1.2
a
more desirable
than late,
itself
open up markets
in
that
may
However,
change
our
the
fear
that
there
the
incentives
minds
about
standardization
dov;n,
and thus en-
Standardization of interfaces can
unable
or
unwilling to compete
reasons to v;ait. Information
the
is
Early standardization
standard to settle
are
are also
early
standard be set.
technology.
those who
for
desirable,
is
the same
if
courages early adoption of the
whole systems.
to
fail
standard be set?
removes the incentive to wait for
also
grounds
are
the market may
inadequate.
standardization
Since
there
Since
optimal
standard
to
set.
v.'ill
An
with
flov;
early
choice may be hard to change later.
1
.3
Who
sets the standards?
In some industries,
standards are set by formal industry groups accord-
ing to well-specified procedures. For example,
and the CCITT have this role.
(Of
course,
m
telecommunications, the ECSA
different market participants have
3
different amounts of power in the process).
sets
leader
facto
de
standards.
For
In other
example,
it
is
industries,
generally acknowledged
industry.
that IBM has standard-setting pov;er in the computer
industry
an
In other cases,
buyers get together to demand standardization and even specify standards:
Hemenway (1975), especially chapter
1.4
see
2.
Can standardization have anticompetitive effects?
(o)
Size as an
Advantage
Because size confers an advantage
have various strategies available
vantage and to their rivals'
tliat
in
standardization,
large
firms may
will manipulate the market to their ad-
disadvantage.
product preannounce-
For example,
ments and standard-switching can become competitive tools.
There are
pecially design
some grounds
(as
for concern
(see FTC,
distiguished from performance)
1983)
a
ervations
network (multiple listing service in the real estate market, or ressystems in
the
dominance. Exclusion from
Likev7ise,
delay,
c-
technology.
should antitrust policy say about compulsory admission of competi-
airline market)?
produce advantages from market share itself,
ket.
nev;
may be
Essential Facility Questions
v;hat
tors to
standards, es-
quality standards,
used to prevent or discourage entry, particularly entry of
ib)
that
we
a
Because
network externalities may
they may create or extend market
network may in practice be exclusion from the mar-
can ask whether dominant
firms have
an
incentive
to bias,
sabotage the process of cooperative voluntary standard setting,-
whether de facto standards tend to erode, extend or preserve monopoly power.
or
4
In
this
survey
we
paper,
first part of question 4. Question
search (Farrell and Saloner,
The paper
2
is organized
on
the
technology. In Section
as
petition.
In
Section
5,
market's
4,
1
and
on
the
is the subject of some of our current re-
In Section
follows.
Section
In
willingness to
we discuss the
we
question
on
1985e).
efits and costs of standardization.
standardization
recent work
some
consider
tlie
development (R&D) of new technology in
benefits and standardization. Section
a
6
3,
we
2,
we
discuss some ben-
focus on the effects of
switch
from an
old
to
a
new
effects on market structure and com-
incentives to undertalce
research and
market characterized by compatibility
is
a
brief conclusion.
2.
Benefits and Costs of Standardization
We will describe three types of benefit from standardization: cost sav-
competitive
ings,
effects,
network
and
externalities.
will
We
mention
then
some social costs that are less obvious than the benefits.
2.1
Benefits of Standardization
2-1.1 Cost Savings
By allowing
greater scale
economies
(enabling
different manufacturers
to exploit economies of scale in using a common supplier),
use
is a
of interchangeable parts,
and by allov;ing the
standardization reduces production costs.
staple of economic history; see
for instance Landes
(1969,
This
1983), Hemen-
way (1975)'.
Standardization also saves on the costs of learning how to use
For instance.
Brock
(1975)
a
good.
discusses how pressure for standardization of the
programming language COBOL increased when machine time became cheaper relative
to programmer time,
making it less important to design programs that run effi-
ciently and more important to make it easier to write or transfer programs.
'
2.7.2 Competitive Effects
A common view among economists'* is that "plug-compatibility"^
matter
for competition,
since
there V7ill
be
competition
overall systems level. We do not take that view.
to entry
For
at
example,
the
systems level
consider
the
for
ski
any
case
at
the
There will often be barriers
that v;ould not exist
market
m
does not
bindings
there might have been competition among incompatible
at
and
the
ski
components level.
boots.
Although
systems ex ante,
incom-
patibility destroys competition ex post^. Thus, we should recognize that there
may be effects of standardization on competition:
6
When the products of different makers are standardized,
•
directly in price and performance. Lack of standardization is
uct differentiation. If variety is mostly "spurious",
erse tastes but merely splits the market,
i.e.
a
they compete
form of prod-
does not serve div-
then this differentiation is ineffi-
cient. If variety is valuable in itself,
or if it represents the trying out of
different approaches to
it is
to
firms
have
compete
problem,
a
on
then
not clear whether it
and performance
price
of
a
better
is
standard product,
or
whether it is better to have them compete on product design.
Standardization can commit producers to compete
•
for
spare or replacement parts,
complementary inputs,
Often, the market for such items (for instance,
model) is
a
or
in an
"af termarket"
peripheral devices.
replacement fenders for
a
car
natural monopoly, and the original manufacturer (car maker) has an
advantage in taking the market (because he makes the original fenders). Absent
standardization,
this
the auto industry,
is
possible source of after-sale profits;
a
is notorious
it
that
indeed,
in
spare parts have a much higher profit
Sometimes such pricing policies are inefficient (for in-
margin than cars do.
because buyers will inefficiently substitute away from the complemen-
stance,
tary input),
and if
anticipated by buyers,
that is
it
may be profitable for
the seller (and nutualiy beneficial) to com.T.it to low or reasonable prices for
afterparts.
•
Standardization will achieve
As well
as
protecting against
this''.
exploitation
from ex-post
standardization protects against orphaning. If it is perceived that
may go bankrupt, or suffer
for
their
purchases^.
See
a
crippling strike, buyers
for
instance
Hemenway's
v/ill v;orry
and thus
enhances competition,
since
a
a
supplier
about support
discussion
(1975)
auto parts industry before the ASHE achieved standardization.
avoids this problem,
monopoly,
of
the
Standardization
seller no longer
7
need be seen as both financially secure and committed to the industry in order
sell
to
product.
a
Sometimes
against these
themselves
buyers
problems.
insist
This
on
"second-sourcing"
equivalent
is
to
protect
guaranteeing
to
(lim-
standardization of their selected technology. For instance, in choosing
ited)
Intel to supply an essential component of the IBM PC,
licence its technology to
•
a
second supplier'.
Standardization can help in, or help replace, regulation.
telecommunications have been
tance
IBM insisted that Intel
m
deregulated
(partly)
the
Long-dis-
United States
by requiring local telephone companies to interconnect v;ith non-AT&T long-dis-
Conceivably,
carriers.
tance
some
aspects
also be deregulated if sv.-itchmg protocols
vision
v.'ere
exchange.
of
v;ere
local
telephone
service
could
standardized and suitable pro-
made for interconnections betv;een rival part-netvv'orks in the local
The
traditional
viev;
of
telephone service as
a
natural monopoly is
based on the inefficiency of having duplicate netv;orks. This assumes that com-
peting telephone companies would not have interconnection
bility).
it
is
this may be
VJhile
possible
that
a
requiring
(a
form of compati-
plausible result of unregulated competition^",
interconnection would make
it
unnecessary
to
regulate other aspects of competition.
Network Externalities
2- 1.2
Under this heading we group together
make
a
a
number of different effects that
large "network" of other compatible users desirable.
•
A product may simply be more valuable
have the product.
Telepliones
,
of course,
to
each buyer the more others
are an example.
Language is another
8
example: it is more valuable to speak English, the more other people one comes
across who speak
and indeed we
English,
franca of the world,
now see English becoming
where French and before
the
lingua
that Latin used to be
used for
It is more worth learning a skill associated v/ith a product,
the more
international discourse.
•
people have the product.
to
type
on
gains: David
volved.
the
(It is worth few people's while,
Dvorak
keyboard,
(1985a) argues
despite
that this is
apparently,
absolute
considerable
due to
the network
A complementary product may be more
people have
as more
of software
the original product.
for personal
repair netv;ork for
a
behind much of the
1S70S. See Chandler,
externalities in-
computers. The
readily or more cheaply available
An example of this is
im^portance of
product is another example.
the provision
ready availability of
a
This network externality was
success of the Singer sewing machine
company in the
late
seller
v;ith
1977.
All these benefits make buyers more willing to buy from
a
large market share or compatibility v;ith other sellers. There is thus
a
an incentive for sellers to make their products compatibles^.
(1965a)
efficiency
)
•
either
to learn
discuss
the market
decision on compatibility when there are costs of
making products compatible. Berg (1985) discusses
ity makes
Katz and Shapiro
a
model
m
competition more direct, and firms rrade off the
compatibility against this increase in competition.
vmich compatibil-
gam
in value from
2.2 Social Costs of Standardization.
of standardization
costs
The
below the possible
discuss
loss
are
from
less
obvious than
reduction
benefits.
the
in variety.
There
possible loss from reduced innovation, which we discuss in Section
When tastes differ,
ferent tastes
a
served; but by hypothesis there
to be
There is
ization.
standardization involves
a
considerable literature on
tlie
tradeoff.
are benefits
also
is
We
a
3.
want dif-
We
to standard-
economics of this tradeoff
when the benefit to standardization is production economies of scale
There
^^.
has been little work on the corresponding problem when we care about standard-
ization for other reasons,
the demand-side
such as
economies of scale associ-
ated with network externalities.
In
a
simple model
(1985c)
we
can
ask the
following question.
Suppose
that there are two types of users, group A and group B, each of whom prefers
a
different standard. Consider three possible outcomes: both standards could be
provided (thus catering to diverse tastes),
or only
group A's preferred stan-
dard could be provided, or only group B's.^^ We show that there is
for too little standardization,
opti.Tium
is
for
two incompatible
reverse cannot
standard to exist,
single
e
in the following sense:
it can happen that the
but the unique equilibrium is for
standards to persist (one for each tvpe of buyer),
happen.
Intuitively,
the
tendency
a
externality
imposed by
one
while the
group
of
buyers on the other is alv;ays negative if the first group chooses to be incompatible.
However,
there
can be
multiple equilibria,
and it is
compatibility to be an equilibrium even though the optimum is
patibility and variety.
Perhaps
m
to
possible for
have
practice this is most likely to be
incoma
prob-
lem when the need for variety has historically been less important than it be-
10
comes, so that standardization is the status quo. With more than two groups of
buyers,
a
move by one cannot necessarily be simply described as towards "more"
or "less" standardization;
3.
the matter then becomes even more complicated"*.
Excess Inertia and Excess Momentum
There can be
naive sense,
art
a
this is
substantial loss from being on the wrong standard.
common:
would not choose
(v;e
In a
many standards are inferior to the state of the
them if we v;ere designing afresh).
It
is a
more dif-
ficult question whether the benefit to sv/itching exceeds the transition costs.
Suppose
that there
is
a
technology appears on the
ter,
status-quo standard,
and
a
new,
possibly bet-
How well does "the market"'^
scene.
solve
the
problem of v;hether to sv/itch, and if so how quickly?
In Farrell and Saloner
will not sv;itch
tia".
V)e
(19S5a,b)
even though it should.
we
showed that sometimes the market
We
called this effect
"excess iner-
also discussed the opposite phenomenon of v/rongly abandoning
a
tech-
cov7boys who camped for the night v;here
there
nology, which we called "excess momentum".
3-1
Coordination Problems
In movies of the old West,
were no trees to which to tie
another.
Even
though
the
their horses v;ould often tie
horses
as
a
group
were
free
to
the
horses to one
go
wherever
they
11
they would not
wanted,
go
--
far
whereas
single
a
difficulty in coordinating on
would. The horses'
horse left free overnight
;iust
where they would move at
any instant prevented them from moving effectively.
In much the
move to
that an industry may get stuck on
it can happen
v;ay,
technology,
and inferior
old
an
same
even v;hen
all
prefer
participants might
to
new technology. This happens because the group is "tied together" by
a
reluctance to sacrifice the benefits of being compatible. The fact that it is
not only liorses who
half
dozen people walk from office
a
than u'ith
a
shown whenever
this problem is
liave
restaurant:
to
a
progress is
ermined order)
model in v;hich each of
a
to sv;itch to
a
new technology or to stay with the old. Because
externalities" assumption:
prefer others to make the same choice.
that,
all users
if
they will all sv;itch
v;hatever
V<'ith
choice
a
that
choices that satisfy
user makes,
it
new technology,
perfect Nash ea_uilibrium)
If
.
will
we showed
complete information'^
would be better off on the
(in the unique
we assume
of standardization,
each user has preferences over its own clioice and others'
(1985a)
slower
far
number of users chooses (in predet-
a
of network externalities or other benefits
"network
than
smaller group.
Consider
a
group of more
then
their pref-
erences differ, then the early movers have considerable power to determine the
outcome,
because
cf
the bandwagon
effect.
This
result
(v;hich
called "the
we
New Hampshire Theorem", from the timing of political primaries) comes from our
assumption that
are
a
user has only one chance
Stackelberg leaders.
commit itself early to
Hov;ever,
v;hen
a
v;e
fectly knov7n, and studied
More
to
realistically,
decision on standards
allov;ed
a
for
the
model in v;hich
sv;itch;
thus,
whatever makes
v;ill
early movers
the
a
user able
to
give it pov;er.
fact
that preferences
eacli
user could choose to sv;itch or
are
not per-
12
we showed that
not at each period,
there can be
prefer the old technology, but none switch.
the benefit
of the network
would be followed in
symmetric excess inertia: all
With incomplete information about
externality to others,
no user can be sure
that it
switch to the new technology. This uncertainty can lead
a
all the users to remain with the status quo even when they do all in
fact fa-
vor sv.'itching, because they are unwilling to risk sv;itching v;ithout being follov;ed.
Non-bmding communication about preferences and intentions eliminates
that possibility,
but
it
actually exacerbates
tlie
asymmetric problem
user v/ould be much better off if both switched, but
what v;orse off).
an
Thus,
old established
users may
there
standard.
can be
the
other would be
socially excessive reluctance
Similarly,
(if one
"excess momentum"
is
to
some-
abandon
possible:
all
even though it would be more efficient not to do so.
s\%'itch,
Thus It takes
a
substantial preference for
the
new standard to
be
an
early adopter; and if there are no early adopters then the standard will never
be adopted.
out on
a
Excess inertia arises v;hen not enough users are keen enough to go
limb v;ith the
nev;
technology.
2-2 Installed Base Problems
In the
the only asymmetry betv;een the old and new
model just described,
standard is that
a
"sv;itch"
is more
ing is more easily reversible
(by
of
a
commitment than
sv7itching later)
a
"stay"
:
not switch-
than is sv;itching (sv;itch-
ing back is seen as an admission of error, customers v/ill be very displeased,
etc.).
VJe
now sketch some considerations
(on the old technology)
is
that arise v;hen the
installed base^''
important. The analysis is from our 19S5b paper.
13
With
an
installed
base
using
technology,
old
the
externalities are important, it will be rare for
perior that it will pay for
will.
On
the
other hand,
that makes
adopt it,
it
attractive. Technically,
and
network
if
new technology to be so su-
a
user to adopt it if he believes that nobody else
a
if he
believes
that everyone
else
from now on will
more attractive and also makes the old standard less
this means
that there may well be two different ful-
filled-expectations equilibria. What happens depends purely on what people expect to happen.
instance
ures
Naturally,
by strategic
tliis
encourages manipulation of expectations,
forecasting,
boasting,
exaggeration
or
of sales
for
fig-
.
Although the case of multiple equilibria is common and important,
analytical conclusions are more clear cut if there is
can show that there can be
a
and that in other cases
equilibrium in which it is adopted
reason for this
ternalities.
adopters.
that
each
First,
Second,
adopter
it
is
that
affects
It
unique equilibrium. We
unique equilibrium in which the new technology is
ignored but should be adopted,
The
a
the
v.'hen
there can be
a
it should not be.
each user's adoption decision has
the values of
affects the value of
individually may be
unique
the
the
either
options available
installed base.
too
keen,
or
too
to
two
ex-
future
result
is
reluctant
to
The
adopt the new technology.-''
Katz and Shapiro
an installed base but
(19S5b)
study the questions that arise when there is
also "sponsorship" of one or both technologies,
so that
sellers may engage in cross-subsidization between early and late users.
shov;
dard,
that
the market
outcome may involve standardization on the
They
"wrong" stan-
and may standardize when there should not be standardization.
14
4.
Anticompetitive Practices
Are
if anything,
What,
anticompetitive
there
related
practices
standardization?
to
should be done about them? In this section we report some
preliminary analysis on these questions.
The power
U.I
of size
Size confers
m
the
standardization game.
the
smaller
firms
with them. Accordingly,
care much
more
to
have
this
ability.
whether the
the possibility arises
erally set standards for the industry.
This
reason is
The
that
a
smaller rivals are compatible with
firm does not care much v;hether its
large
it;
power
firm is
larger
compatible
that the large firm can unilat-
Both IBM and AT&T are widely believed
advantage is
not
itself anticompetitive,
does open up possible anticompetitive strategies.
but it
We discuss three below.
U.2 Barrier to Entry
If a
small firm or an industry outsider develops an improvement,
may be able to render it valueless by
model,
Lhe
large
firm would be cutting its
such behavior;
run)
by
able
to ignore
refusing to adopt it.
others'
but,
v;ith
important
improvements,
own throat
netv;ork
-
standard
least in the long
(at
it
may be
negotiate very advanta-
geous terms in buying them. For example, Western Union had
veloped
large firm
the
externalities,
or alternatively
position in buying telecommunications patents before
In
a
the
a
strong bargaining
Bell system
though not so strong as it thought v;hen it turned
dov;n
v/as
an offer
de-
of
15
Bell's telephone patent for $100,000. Obviously, this effect tends to maintain
market power,
and reduces
In other
potential and actual competition.
the network externality creates
a
words,
barrier to entry. This may well be the most
important anticompetitive effect from standards.
Below, we discuss some
other
possible effects.
U,3 Predatory Standard Switching
If
a
firm
that
will suffer from making
rivals. Wherever
de
Scheffman, 19S3)
Thus
m
suppose
facto standards
switch in standard,
a
firm can hurt its
(if re-entry is difficult)
dation
is a
a
can set
rivals,
perceives
that
rivals
its
then its way is open to harm its
there is
the possibility
and of raising rivals'
of pre-
costs (see Salop and
any case.
that
firm A unilaterally changes its
standard.
Because A
dominant firm, buyers expect its new standard to be the standard for the
future.
Therefore,
firm
this may cause
Hov/ever,
to exit
the market,
Even if
B
B
has
option but to
sv.'itch
disruption of B's activities.
then A has
does not exit,
no
effected
a
to
If B
A's new
is
standard.
thereby caused
predatory reduction in competition.
its competitive position relative to A may have
v.-eak-
16
U.if
Product Announcements
One
partment
of
suit
the
alleged anticompetitive practices named in the Justice De-
against
was
IBM
standard economic framework,
it
"premature"
is
product
announcement^".^'
hard to see how such
ticompetitive. One would expect (see Fisher et al.,
a
19S3)
In
a
practice can be anthat an announcement
of a superior product would be socially beneficial (though detrimental to com-
petitors) v;hile an announcement of an inferior product would
However,
showed
v;e
misleading
if
in
our
network
market's solution to
1985b paper
externalities
are
important.
question of wliether
the
not necessarily optimal
that botli these viev;s
(see
also Katz and
to
The
liave
are potentially
reason
adopt the new
Shapiro,
1985b)
no effect.
is
that
the
technology is
and so
the
extra
information does not necessarily lead to better outcomes. The announcement can
be predatory
in the
sense
that
the firm
that undertakes
the action
ficing short-run profits in order to cause the exit or failure of
v;hen
it
a
is
sacri-
rival,
succeeds in doing so it enhances its future profits. Moreover,
it
and
is
reasonable to expect v;hen installed base is important that future re-entry may
be blocked,
so that
the
usual problem in explaining what can be predatory is
not present. It is also worth noting that the standard tests for predation may
fail to detect the predation. See our 1965b paper.
17
5.
Incentives for
R&D
5.7 Excess Inertia
and R&D Incentives
How does the possibility (discussed above) of excess inertia affect the
research
development
and
of
(R&D)
new
technology?
At
first
incentives
for
glance,
would seem that the influence of excess inertia on incentives for
it
R&D will be
Even if
straightforv7ard.
firm develops
a
not certain that it v;ill be adopted in the market;
wards for R&D are
means
that part of
less
the
than
they would be without
better system,
a
implies
this
excess
it
that the
inertia.
is
re-
This also
inefficiency caused by excess inertia is invisible to
even the most careful study of inventions not adopted,
R&D projects never get started
(or pursued)
as
a
since presumably many
result of anticipated iner-
tia.
that argument is based on considering only one potential inno-
However,
vation.
In
fact,
return
the
to
any innovation
is
limited by
something better still will come along; and this leads to
fication.
In
simple model^^ we
a
can show that having
minimum successful improvement on existing
pected returns
to R&D.
helps him later.
Intuitively,
The help is
the
therefore
a
a
the
time
substantial modi-
higher threshold of
technology indeed reduces
barrier
harms an i.^.ncvator
discounted,
when
and v;orth less
the
ex-
now,
and
than the
harm now.
R&D v;ill be especially discouraged v;hen excess
fall over time,
inertia is expected to
so that the barrier protecting current incumbent technology is
higher than that expected to protect anyone who overcomes it.
As
the
the
"base"
incentive for R&D
grows over
v/ill
be
time,
inertia
strongest early
v.'ill
m
the
tend to
increase^
^.
Thus
industry history before
18
the standard gets locked in.
Also,
the time when a new technology seems
taking over may be the best time to introduce
a
further innovation,
to be
since the
former has no installed base.
5-2 Network Externalities and Licensing of Patents
In
a
market with important netv;ork externalities, there is an extra in-
centive to licence
patented or sponsored technology. It does not pay for an
a
inventor to keep his new technology to himself.
Indeed,
it may pay to licence
at no charge to some buyers with large volumes but low willingness to pay.
For example,
computer makers have been very willing to donate machines
to schools and universities.
Another example: Xerox licenced its local area network "Etliernet" at no
cost to other suppliers.
become
a
presumably intended to ensure that Ethernet v;ould
and that the originator
the industry
edge, or
make
standard,
It
\>/ill
have enough of
is sufficiently uncompetitive,
a
competitive
the originator will
that
satisfactory profit from its share of the market for the standardized
a
product.
An alternative strategy of keeping the technolog\' proprietary
lowed earlier
though
a
a
in the
On
market by Datapomt,
proprietary standard might have been
small firm such
dard.
same
the
as
a
v.'hich
of course,
the
Al-
viable alternative for Xerox,
it
nonproprietary strategy
Xerox v;ould have been difficult for Datapoint
too,
since
less reason to believe it could make satisfactory profits
market.
unsuccessful.
v.'as
Datapoint had difficulty in establishing
other hand,
fol-
v/as
a
stan-
follo'v;ed
might have
it
m
as
a
by
had
nonproprietary
19
5.3 First Mover Advantage and Innovation
The first firm to introduce an innovation often retains
(price premium,
tage
or
ability to maintain
While
others have entered and imitated.
competition,
as
it gives
a
a
market advaneven after
large market share)
this is
in
some
sense bad for static
monopoly pov;er to the first mover,
(limited)
been argued that such first mover advantages may enhaiice dynamic
peterian" competition by providing something akin to
or
it
has
"Schum-
patent reward for inno-
a
vation.
We can consider how
inertia
cess
in
a
first mover advantage affects the analysis of ex-
19S5a paper.
our
advantage encourages innovation.
together with
goes
less likely to be
a
need not be
The reason
is
followed in
a
others
follow,
probability that
others
will
sv;itch
but not
follow
is
to new
that makes
technology.
critical
do
not.
to
his
tive,
This makes
Often,
innovating
Thus the
perceived
decision.
vantage need not encourage innovation.
case v.-ithout network externalities,
part of rivals merely improves
tor.
)
A
This
second-
m
turn
innovation less attrac-
and this indirect effect can outweigh the direct effect of
advantage, which is to make innovation more attractive.
advantage
first mover
a
mover disadvantage makes follov;ing an innovator less attractive.
reduces the probability of being followed.
first mover
a
the first-mover
and
they
if
that
case
the
that
second mover disadvantage,
desirable if
is
It
Thus,
a
first-mover
first-mover ad-
(Note the contrast with the "standard"
in v;hich
any reluctance
the competitive
to imitate
on the
position of the first innova-
20
6.
Conclusion
Standardization is extremely important in modern economies,
in
the
information processing industries.
especially
While it has many benefits,
it
may
also have serious social costs. There has been little economic analysis of the
policy problems.
Conclusions reached by traditional economic reasoning,
ity and diminishing returns are generally assumed,
when bandwagon effects,
problems are important.
v;indov;s
is
very different
There
is
no easy
are likely to be misleading
opportunity for entry,
v.-hen
predation, R&D,
and the
v;ork,
mind,
and
v;e
we
have
have
licencing of inven-
compatibility is important.
prescription for microeconomic policy
which netv;ork externalities play an important part.
other
and installed base
We have seen that the analysis of such staples of in-
dustrial organization as pricing,
tions,
of
in wliich convex-
identified
shown how
some
certain
of
the
factors
standard
In
in
this paper and in our
that
lessons
in markets
of
treated cautiously. Further v;ork on the subject is needed.
should be
kept
in
economics must be
21
Footnotes
For
(1985).
1.
a
general
discussion
of
standards
in
telecommunications,
see
Berg
is sometimes possible to find translation protocols, which, if sufficiently effective, render moot the question of standardization. Such translation, however, is sometimes impossible and is often so difficult that standardization remains important.
2. It
3. Cost reductions may be valued by users or by makers (or both), depending on
what economists call the incidence of cost savings, which is a matter of market structure. For example, in a perfectly competitive market, all cost savings that reduce marginal costs are passed on to buyers, but cost savings that
reduce fixed costs but do not affect marginal costs are not. In imperfectly
competitive markets, some cost savings may go to enhance the profits of sell-
ers
.
For example, Fisher (1979) writes:
To the extent that certain boots are associated with certain bindings- -the real competition tai<e5 place between binding-boot combinations-
4.
5. We mean this term in a broad sense, to include not only computers and their
peripheral devices, but also cameras and lenses, ski boots and bindings, nuts
and bolts, autos and fenders, etcetera.
6.
See for instance Farrell,
1985.
This raises the question of why sellers might resist standardization, given
that it enhances the value of their product and also helps tov/ards an efficient selling system. The answer may lie, as Katz and Shapiro (1985a) suggest,
as Berg
in some sort of costs of standardization. Perhaps more plausibly,
(1985) has suggested, standardization somehov; makes competition more direct.
Thus firms trade off the incentive to maximize the value of their product
against the desire to restrain competition. We are also v;orking on this line
of inquiry.
7.
If a seller is large enough, there may be a presumption that someone would
take over these support services, but it is typically not the large sellers
that suffer from this fear.
E.
In m.arkets with a high (or potentially high) degree of vertical integration, moreover, buyers may not v;ish to be strategically dependent on a supplier who may later become a direct competitor. Sometimes a user may avoid a
de facto standard for this reason: the user fears that the de facto standard
setter may exploit his position. Some of the standards decisions of the European community reflect such a concern. For an interesting history of European
standards decisions on color television, see Crane (1979).
9.
10.
Indeed, some antitrust decisions have suggested that an ovmer of a network may have an obligation under law (as opposed to regulation) to allow interconnection by competitors, if the network becomes an "essential facility".
22
which it sometimes is, a seller would
11. If it is technically feasible,
always wish to have one-way compatibility: his buyers get the advantages of
the whole network, while other firms' customers only get the externalities associated with their small networks. A classic case of this is the competition
that led to the strange-shaped holes in the safety razor blades that dominated
the market until the seventies.
12.
For example,
see Dixit and Stiglitz
(1977),
or Spence
(1976).
13. For a discussion of the possibility of compromising on the
Berg (1985).
standard,
see
14. For another analysis of standardization with differences in tastes over
standards, see Berg (19S5). The work of Katz and Shapiro (1985b), and Farrell
and Saloner (1985b), although not explicitly about the efficiency-variety
those terms. They analyse the evolution of
tradeoff, can be interpreted
standards over time v;hen buyers at different times have different preferences
or different opportunities.
m
We focus on what Arthur (1984) has called "non-sponsored" technology. That
there is no ovmer of the new (or the old) standard v;ho can subsidize early
adopters in order to get a new standard rolling.
Interesting questions arise
(Katz and Shapiro, 19o5b, Hanson, 1985) if the technology is sponsored, and
also if, v.-hile the nev; standard would not be owned, its early developer v;ould
have a substantial first-mover advantage if it succeeds. (We briefly treat the
question of first-mover advantage belov;.)
15.
is,
16.
ers,
This term means that each decisionmaker knows the preferences of all othand everyone knov;s that, etc.
17. Sometimes the installed base v;ill be physical capital; in other cases the
human capital invested in training on the old system v;ill be more important.
The t^'pev7riter keyboard case (Da\-id, 1935a) is an interesting intermingling of
the two
IS.
A related problem (without the dynamics) is the problem of uneconomic bypass in telephone markets. It is v.-idely predicted that, if pricing is constrained by uniformity requirements, bTOass will become very popular and v;ill
reduce the value of being on the netv;ork (here, for cost-sharing reasons) to
such an extent that the bypass is socially inefficient. A-gain, an autarchic
technology may reduce the value obtained from a netv/crk technology; again,
this would not happen if pricing were not constrained.
not speculate here on V7hether any particular standard switch is
Brock (1975) describes the announcement of IBM's System
360 in terms that suggest such an interpretation. Honeyv;ell had announced a
computer knovm as the K-200, together with a translator device (called the
Liberator) making it compatible v;ith the IBM 1401. This combination competed
directly and favorably v;ith IBM's 1401 machine, v;hich was then the market
leader.
IBM's System 360, v/hich was announced shortly after Honeyv;ell's announcement, was incompatible with the 1401 and the K-200, and yet (whether because the 360 was superior, or because of IBM's reputation as a de facto stanIS.
We
v;ill
predatory.
Hov;ever,
23
dard setter) customers chose to
commercial viability of the H-200.
wait
for
the
360,
thus
destroying
the
m
California Computer Products Corp. v IBM Corp., 613F.
See allegations
727 (9th Cir. 1979), Memorex Corp. v. IBM Corp., 636 F. 2d 1188 (9th Cir.
404
1980), and see also Berkey Photo Co. v. Eastman Kodak Co., 457F. Supp
1093 (1980).
(S.D.N.Y. 1978), 603 F. 2d 262 (2d Cir. 1979) and 444 U.S.
20.
2d.
.
IBM's rivals have also complained about insufficient advance notice of
Evidently, firms that
IBM's changes in its (and de facto industry) standards.
depend on following the lead of a de facto standard setter are at a competitive disadvantage if they learn about standard shifts only late in the day.
IBM has agreed to announce standard shifts in advance, as a result of an EEC
antitrust action.
21.
22.
Details available on request.
23. This may account for some "waves of innovation": no sooner does innovation
A start to succeed than innovation B pushes it out of the way; in contrast to
many years. It may
other industries in which there has been no innovation
also account for the tremendous economic growth sometimes observed after warOnce a large fraction of tlie existing
time destruction of the capital stoclc.
stock is destroyed, there is (or can be) a general expectation that new tecliniques can profitably be put in place. See Shleifer (1985) for a business-cycle model related to this observation.
m
24
References
Arthur, B., "On Competing Technologies and Historical Small Events:
The Dynamics of Choice under Increasing Returns," mimeo, Stanford, 1983
Berg, S., "A Duopoly Model of Technological Externalities and Compatibility Standards," mimeo. University of Florida, 19S5
Brock, G., "Competition, Standards and Self-Regulation in the Computer
Industry", in R. Caves and M. Roberts, eds. Regulating the Product: Quality
and Variety. Cambridge, HA: Ballmger, 1975.
Chandler,
A.,
The
Visible Hand.
Cambridge:
Harvard University Press,
1977.
Crane, R.
The Politics of International Standards:
Color TV War. Norwood, N.J.: Ablex Publishing, 1979.
,
France
and
the
Dasgupta, P., and J. Stiglitz, "Exercises in the Economics of Learning
by Doing," paper presented at the GTE Laboratories Economics Symposium, August
1985.
David, P., "Clio and
view, 75, 332-336, May 19S5a
the
Economics
American Economic
of QVJERTY,"
Re-
David, P., "New Technology Diffusion, Public Policy and Industrial Competitiveness," Center for Economic Policy Research, Stanford, 46, 1985b
Dixit, A., and J. Stiglitz, "Monopolistic Competition and Optimum Product Diversity," American Economic Review 67, 1977.
Farrell, J.,
"Competition and Lock-In," mimeo, GTE Labs, 19S5.
Farrell, J., and G. Saloner, "Standardization,
vation", Rand Journal of Economics, Spring 1955(a)
Compatibility and Inno-
Farrell, J., and G. Saloner, "Installed Base and Compatibility, VJith
I.mplications for Product Preannouncemer.t " mimeo, GTE Labs and MIT, i985(b).
,
Farrell, J., and G. Saloner,
ing. Economics Letters, 15£5(c).
Farrell, J., and
19e5(d),
progress.
m
G.
Farrell, J., and G.
1985(e), in progress.
Saloner,
Saloner,
Federal Trade Commission
Staff Report," April 19S3.
"Standardization and Variety,"
Product Variety,"
mimeo,
Timing of Standardization,"
mimeo,
"Monopoly
"The
(FTC),
forthcom-
and
"Standards
and
Certification:
Final
25
Fisher, F., "Diagnosing Monopoly," Quarterly
Business, 19, 1979.
Review of Economics
Fisher, F., J. McGowan, and J. Greenwood, Folded, Spindled and
lated: Economic Analysis and the IBM Case, Cambridge: MIT Press, 1953.
and
Muti-
Hanson, W., "Bandwagons and Orphans: Dynamic Pricing of Competing Technological Systems Subject to Decreasing Costs," mimeo. University of Chicago,
1985.
Katz, M.
and C. Shapiro, "NetVv'ork Externalities, Competitition
Compatibility," American Economic Review, 75, 424-440, May 1985a.
,
v;ork
and
Katz, M., and C. Shapiro, "Technology Adoption in the Presence of NetExternalities," mimeo, Princeton University, July 1985b
Hemenway, D., Industryv;ide Voluntary Product Standards, Ballinger 1975.
Landes, D., The Unbound Prometheus:
Present. Cambridge University Press, 1969.
Technological
Change
1750
to
the
Landes, D., Revolution in Time. Cambridge: Harvard University Press.
Ordover, J., and G. Saloner,
mimeo, MIT,
progress.
m
Salop,
S.,
and D. Scheffman,
"Predation, Monopolization and Antitrust,"
"Raising Rivals'
Costs," American Economic
Review 73, 1963.
Shleifer, A
.,
"Implementation Cycles," mimeo MIT 1985
Spence
A.M., "Product Differentiation and Welfare," American Economic
Review 56, 1976.
,
ii
3 5 3
I;
9
3
'iDflD
DDM
sm
aaa
Date Due
ocu'ss
^,,^M^ m^
DtQi^ia®
OCT 26 1990
0£C 2?
1930
MAR ao
199 I
fir*
NOV.
2 13^
..r^,9^^
Lib-26 -67
J,M Cah 0.^
*VV!
^v ^-.A