Part VIII. Networks, standards and systems
Chapter 20. Markets with network goods
Slides
Industrial Organization: Markets and Strategies
Paul Belleflamme and Martin Peitz
© Cambridge University Press 2009
Introduction to Part VIII
Peculiarities of the information economy
• Choosing
• between
and
or between
• What are the differences?
and
Instant messaging
software
YES
Potatoes
Care about future choices?
YES
NO
Care about other people’s choices?
* other consumers of the good
* producers of complementary goods
YES
YES
NO
NO
Care about previous choices?
NO
Chain of complementary
products  systems
Network goods
© Cambridge University Press 2010
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Introduction to Part VIII
Organization of Part VIII
• Chapter 20
• Demand side of network goods
• Network effects  several demand levels compatible
with the same price
• Provision of a single network good
• Choice between incompatible network goods
• Chapter 21
• Supply side of network goods
• Specific strategic instruments
• Compatibility or incompatibility?
• Timing of entry
• Managing consumers’ expectations
• Public policy in network markets
© Cambridge University Press 2010
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Chapter 20 - Objectives
Chapter 20. Learning objectives
• Understand what network effects are.
• Direct and indirect network effects
• Compare network effects to switching costs.
• Empirical estimation of network effects
• Analyze demand and supply of network goods.
• Single good / Several incompatible goods
• Demand decisions may lead to multiple equilibria.
• Supply decisions crucially depend on the level of
compatibility between competing goods.
© Cambridge University Press 2010
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Chapter 20 - Network effects
Network effects
• Basic idea
• Other things being equal, it's better to be connected to
a bigger network.
• More precisely
• A product exhibits network effects if each user's payoff
is increasing in the number of other users of that
product or of products compatible with it.
• Observed in 2 types of markets
• Network (or communication) markets
• The benefit of consumers comes from the ability to
communicate with other consumers via the network.
• Direct network effects: more agents in the network  more
communication opportunities  more incentives to join the
network
• Examples: phone, fax, email, instant messaging, languages
© Cambridge University Press 2010
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Chapter 20 - Network effects
Network effects (cont’d)
• Observed in 2 types of markets (cont’d)
• System markets
• Products are obtained by combining components in a
complementary way (e.g., hardware + software).
• Indirect network effects: more users of the system  more
developers desire to write application for the system  more
incentives for users to buy the system.
• Special case: two-sided markets (see Chapter 22)
• Examples: videogame consoles, CD and DVD players
• Network effects (NE) and switching costs (SC)
• Meaning of compatibility
• SC. Consumer values compatibility between his/her
purchases (ability to take advantage of the same investment).
• NE. Consumer values compatibility with other consumers'
purchases (ability to communicate or to take advantage of the same
complements).
© Cambridge University Press 2010
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Chapter 20 - Network effects
Network effects (cont’d)
• NE and SC (cont’d)
• Competition vs. contracts
• SC. Competition focuses on streams of products or services,
while contracts often cover only the present.
• NE. Competition concerns selling to large groups of users,
while contracts usually cover only a bilateral transaction
between one seller and one user.
• SC and NE. Incomplete contracts  potential market failures
• Expectations play a key role
• Contracts fail to specify complementary transactions
 buyers' expectations about them are crucial.
• History matters
• Consumers: past adoptions guide future adoptions
• Firms: past market share is a valuable asset
© Cambridge University Press 2010
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Chapter 20 - Network effects
Case. Network effects  or  switching costs?
• Network effects  switching costs
• When groups of users make sequential choices, early
choices tend to commit later users
 collective switching costs
• Switching costs  network effects
• When choosing between competing systems,
consumers tend to privilege the one offering the
largest (current and future) availability of applications.
• This availability depends on the number of consumers
who adopt the system in question only if there are
switching costs between systems, both for consumers
and for application writers.
• These switching costs are related to the degree of
compatibility between systems.
© Cambridge University Press 2010
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Chapter 20 - Network effects
Network effects (cont’d)
• Empirical evidence
• Theoretical prediction
• Value of network good  with size of associated network
• How to test it?
• Include demand for the good as a predictor of itself?
 Fraught with difficulty
 Positive coefficient could be the result of network effects,
but also of correlations with unobserved taste or quality
variables, or of herding and learning effects.
• Hedonic price approach
 Estimate implicit price of having either an installed base,
or compatible products, or an established standard.
• Nested logit approach
 Indirect network effects are characterized by the
interaction between consumers’ hardware choice and
software producer’s supply decisions.
© Cambridge University Press 2010
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Chapter 20 - Markets for a single network good
Modelling the demand for a network good
• Typical utility function
Uij  ai  f i (n ej )
Stand-alone benefit

Network benefit
f i (0)  0, f i  0
n ej : expected number
of consumers in net work
j
© Cambridge University Press 2010
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Chapter 20 - Markets for a single network good
Modelling the demand for a network good (cont’d)
• Well suited to describe direct network effects
Local telephone exchange
•
•
•
•
User A accesses the network by
purchasing a link from her location to
the local switch (link AS). If consumer
B has subscribed to a similar link (link
BS), A and B are able to call each
other.
Links AS and BS = 2 complementary
goods creating a valuable system.
n subscribers  n  n  systems
(n )th subscriber creates n new
systems, which benefits all existing
subscribers  direct network effect
© Cambridge University Press 2010
A
G
B
S
F
C
E
D
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Chapter 20 - Markets for a single network good
Modelling the demand for a network good (cont’d)
• Also, reduced form for indirect network effects
• Consumer's utility for a particular hardware  with
number of compatible applications available for this
hardware, mj  Uij = gi(mj)
• But, number of compatible applications  with
(expected) number of consumers who adopt the
hardware  mj = h(nje)
• To recover the initial formulation, write fi(nje) = gi(h(nje))
• Potential interdependences
• Entry
 For given quality levels, sellers have to decide whether to
enter.
 If sellers offer distinct products, the more sellers the more
variety.
 Entry decision depends on number of active users.
 User’s utility  with variety.
© Cambridge University Press 2010
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Chapter 20 - Markets for a single network good
Modelling the demand for a network good (cont’d)
• Reduced form for indirect network effects
• Potential interdependences (cont’d)
• Quality
 Seller investment in quality is affected by active number of
buyers
 User’s utility  with product quality.
• Simple model: videogame console
n consumers; utility  with quality of games, s
Quality s  with developper’s investement, x: s(x)  2 x
Marginal cost of increasing quality = 1
Division of benefits for each transaction: share  for
developper and share  for consumer
• Developper’s problem:
•
•
•
•
max 2n x  x  x *  n 2  2 , s(x * )  2n
x
• Consumer’s utility:
Ui  (1   )(2n )
© Cambridge University Press 2010
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Chapter 20 - Markets for a single network good
Modelling the demand for a network good (cont’d)
• Lesson: Indirect network effects can arise in a buyer–
seller context because of the effect of consumer
participation (and intensity of use) on quality, price and
variety. In the reduced form consumer utility directly
depends on the number of consumers.
• Modelling expectations
• Fulfilled expectations
• Consumers base their current purchasing decisions on their
expectations about future network sizes.
• Attention is restricted on equilibria in which these expectations
turn out to be correct (i.e., are rational).
• Myopic expectations
• Consumers base their decisions only on actual network sizes.
© Cambridge University Press 2010
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Chapter 20 - Markets for a single network good
Modelling the demand for a network good (cont’d)
• Modelling consumers heterogeneity
• Simplifications
• Unique network (drop subscript j)
• Mass 1 of consumers identified by taste parameter  
• Linear network effects
• 2 scenarios
f i (n e )   i n e with  i  0
• Heterogeneous network effects

U( )  a  n e
• Heterogeneous stand-alone benefits

U( )  a  n e
© Cambridge University Press 2010
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Chapter 20 - Markets for a single network good
Case. Heterogeneous adopters for network goods
• Consumer electronics products
• Characterized by sequential adoption
• Minority of early adopters  “high ”
• Why are early adopters keener to adopt the new
network good?
• Value more network benefits or stand-alone benefits?
• Blackberry
• Early adopters = business people  value highly the
possibility of reading and sending emails any time &
anywhere  heterogeneous network benefits
• High-definition television
• Early adopters = “tech aficionados”
 primarily interested in superior picture quality
 heterogeneous stand-alone benefits
© Cambridge University Press 2010
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Chapter 20 - Markets for a single network good
Network effects and equilibrium network size
• Heterogeneous network effects
• Suppose price of network good is p
• Indifferent consumer
pa
e
ˆ
ˆ
a   n  p  0   
ne
• All consumers with higher valuation buy. So:
n  1  ˆ  ˆ  1  n
 p(n, n e )  (a   n e )   n e n
• Fulfilled expectations, n  ne:
p(n,n)  a  n(1 n)
© Cambridge University Press 2010
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Chapter 20 - Markets for a single network good
Network effects and equilibrium network size (cont’d)
• Heterogeneous network effects (cont’d)
Di = p(n,ni)  willingness to
pay for a varying quantity
n, given an expected
network size ne  ni
At n  ni, expectations are
fulfilled and the point
belongs to p(n,n).
© Cambridge University Press 2010
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Chapter 20 - Markets for a single network good
Network effects and equilibrium network size (cont’d)
• Heterogeneous network effects (cont’d)
• There might exist more than one n (that is, more than one
quantity or network size) that satisfies the equilibrium
condition for a given price.
p
a

n
n1(p)
n2(p) 1
© Cambridge University Press 2010
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Chapter 20 - Markets for a single network good
Network effects and equilibrium network size (cont’d)
• Heterogeneous network effects (cont’d)
• 3 self-fulfilling prophecies!
• No buyer buy: n
• If pessimistic expectations (ne), no buyer buys at p > a.
• A small number, n1(p), of buyers buy.
• Expected small n  small valuation  good is bought only by
buyers with large .
• A large number, n2(p), of buyers buy.
• Expected large n  large valuation  good is bought by a
large number of buyers, but the last buyer has a small .
• Lesson: Due to network effects that affect consumers’
utility differently, there often exist multiple consumer
equilibria for the given price of the network industry.
© Cambridge University Press 2010
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Chapter 20 - Markets for a single network good
Network effects and equilibrium network size (cont’d)
• Heterogeneous network effects (cont’d)
• Equilibrium selection
• Dynamic adjustment process: if willingness to pay > (<) price,
then n increases (decreases)
Unstable
Stable
Stable
p
Critical
mass
Pareto
dominates
a

n
n1(p)
n2(p) 1
© Cambridge University Press 2010
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Chapter 20 - Markets for a single network good
Network effects and equilibrium network size (cont’d)
• Heterogeneous stand-alone benefits
U( )  a  n e
 a
 a



The fulfilled expectations
demand is monotone and strictly
decreasing if network effects
are not too strong.
© Cambridge University Press 2010
If network effects are sufficiently
strong, there might exist multiple
consumer equilibria for the given
price of the network industry.
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Chapter 20 - Markets for a single network good
Provision of a network good
• Assumptions
• A single network good is available.
• Consumers’ expectations are fulfilled at equilibrium.
• Selection of Pareto-dominant equilibrium (if multiplicity)
• Constant marginal cost of production: c  
• Supply decision
• Perfect competition vs. Monopoly
• Comparison with social optimum
• Are network effects a source of externalities?
• See details in book.
© Cambridge University Press 2010
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Chapter 20 - Markets for a single network good
Provision of a network good (cont’d)
• Perfect competition vs. monopoly
• Lesson: A monopolist (who cannot resort to price
discrimination) supports a smaller network and charges a
higher price then perfectly competitive firms.
© Cambridge University Press 2010
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Chapter 20 - Markets for a single network good
Provision of a network good (cont’d)
• Comparison with social optimum
• Social welfare is maximized when all consumers join
the network (n )  underprovision by the market
 network externalities
• Sources of market failure
• Consumers fail to internalize that other consumers are also
made better off by their decision to “join the network”.
• If large enough production cost, neither a monopolist nor
competitive firms manage to internalize these external effects.
• Lesson: There is a tendency towards underprovision of
the network good by the monopolist, and even by
perfectly competitive firms.
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Markets for several network goods
• Consumers may have to choose between several
competing network goods.
• Relevant if network goods are incompatible.
• 2 approaches
• Consumers’ coordination efforts
• Consumers try to coordinate their actions to make their
choices compatible.
• Simplifying assumptions: 2 competitively supplied goods
• Firms’ compatibility decisions
• Firms may decide to provide some degree of compatibility
between their products.
• Simplifying assumptions: Cournot duopoly
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Demand for incompatible network goods
• Main results
• Coordination problems among consumers
•  Potential market failures
• Dominance of the market by the ‘wrong’ technology
• Excess inertia or excess momentum
• More likely under incomplete information
• Sequential choices: self-reinforcement and lock-in
• Model
• 2 goods exhibiting network effects: A and B
• Heterogeneous stand-alone benefits
 ‘A-fans’ derive larger benefits from A than from B
 ‘B-fans’ derive larger benefits from B than from A
 Equally represented in the population
• Myopic expectations
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Demand for incompatible network goods
• Sequential choices (cont’d)
• Consumers’ utility
(cont’d)
Numbers of consumers
having adopted goods A
and B at date t
A  B
B  A
• Timing
• Consumers arrive in the market sequentially.
• At each period t, a consumer (a A-fan or a B-fan with equal
probability) decides to adopt good A or good B
• We look at the sequence
t  with t  nAt  nBt
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Demand for incompatible network goods
• Sequential choices (cont’d)
(cont’d)
• Evolution of t
• No network effect ()  "random walk", the difference
eventually tends to zero (‘ahistorical’ process)
• Network effects ()  "random walk with absorbing
barriers” (‘ergodic’ process)
A-fan adopts A   t   A  ( A   B ) / 
B-fan adopts B   t   B  (B   A ) / 
ABSORBING BARRIERS
t  A  all subsequent consumers adopt B
t  B  all subsequent consumers adopt A
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Demand for incompatible network goods
• Sequential choices (cont’d)
A leads
(cont’d)
Both consumer types
adopt A (lock-in to A)
Each consumer type
adopts its preferred good
Both consumer types
adopt B (lock-in to B)
B leads
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Demand for incompatible network goods
• Sequential choices (cont’d)
(cont’d)
• Competition between incompatible goods: properties
• Path-dependence  outcome depends on the way in which
adoptions build up (i.e., on the path the process takes).
• Inflexibility, or lock-in  the left-behind good would need to
bridge a widening gap if it is chosen by adopters at all.
• Non predictability  the process locks in to monopoly of one
of the 2 goods, but which good is not predictable in advance.
• Potential inefficiency  the good that “takes the market”
needs not be the one with the longer-term higher payoff.
• Lesson: The competition between incompatible network goods is
likely to lead, in the long run, to market dominance by a single good.
The dominant good cannot be predicted beforehand and might not be
the best available option.
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Demand for incompatible network goods (cont’d)
• Excess inertia & momentum, and bandwagons
• Model
• 2 strategic consumers, simultaneous decisions
• 2 network goods: A (old good) and B (new good)
 Network effects: A, B 
 Larger stand-alone benefit for new good:  aB  aA 
• Game  typical coordination game
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Demand for incompatible network goods (cont’d)
• Excess inertia & momentum, and bandwagons
• Nash equilibrium
EXCESS INERTIA
if A is adopted
AB
EXCESS MOMENTUM
if B is adopted
AB
AB
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Demand for incompatible network goods (cont’d)
• Excess inertia & momentum, and bandwagons
• If complete information about other users’ preferences
• Coordination failures are an artifact of simultaneous decisions
(if sequential choices  users coordinate on Paretodominating good).
• If incomplete information, real possibility of excess
inertia and excess momentum  typical situation:
• You would enjoy the largest benefits if you and the other user
switched to the new good.
• But you don’t know the other user’s payoff and there is thus a
chance that you would not be followed in the case you initiated
the switch.
• As you fear the low benefits you would earn in that case, you
are not willing to take the risk of moving first.
• Now, if the other user is just like you, both of you will wait and
no one will switch, therefore failing to achieve high benefits.
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Demand for incompatible network goods (cont’d)
• Excess inertia & momentum, and bandwagons
• Lesson: There is excess inertia when users fail to
switch to a new network good although they would be
made better off if every user switched. Excess inertia is
more likely to happen in markets with indirect rather than
direct network effects and where each user only has
incomplete rather than full information about the other
users’ preferences (which might conflict with hers).
• Model with incomplete information
• See details in book.
• Illustration of ‘Bandwagon equilibrium’
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Case. Failure of quadraphonic sound
• Early 1970s
• Quadraphonic sound introduced as alternative to
stereophonic sound for playing audio recordings.
• Higher quality but it didn’t become the new industry
standard.
• Why did the initial support quickly fade?
• Early adopters were dissatisfied.
• Several incompatible formats coexisted.
• Uncertainty about which version would prevail.
• Similar stories
• Digital cassettes
• Digital videos
• Different versions of teletext
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Markets for several network goods (cont’d)
• Oligopoly pricing and standardization
• The degree of compatibility between 2 goods
determines the nature of competition between the firms
sponsoring these goods.
• Incompatible goods
 one good eventually dominates (see previous analysis)
 competition FOR the market
• Compatible goods
 single network  several goods may coexist
 competition IN the market
• Firms can make goods compatible through
standardization.
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Markets for several network goods
• Katz-Shapiro model
(cont’d)
• 2 network goods, heterogeneous stand-alone benefits
• Surplus for new consumer of type  when
purchasing good of firm i at price pi
Ui ( )    gi  pi
• where gi  relevant expected network benefit from good i

 

gi    i  qie    j  q ej 
Strength of
network effects
“Installed bases”
Assumption:
<1/2
Past locked-in
consumers
Expected
numbers of new
consumers
© Cambridge University Press 2010
Level of
compatibility
between the 2
goods, 
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Chapter 20 - Markets for several network goods
Markets for several network goods
• Katz-Shapiro model (cont’d)
(cont’d)
• Firms compete à la Cournot over new customers
• They choose capacities for market expansion simultaneously.
• Given these capacities, prices adjust at levels such that
• consumers are indifferent between the 2 goods, and
• demand is equal to supply.
• If goods A and B attract new consumers, ‘qualityadjusted prices’ are the same:
pA  gA  pB  gB  pˆ
• Indifferent consumer is such that
0  gA  pA  0  gB  pB  0  0  pˆ
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Markets for several network goods
• Katz-Shapiro model (cont’d)
(cont’d)
• Uniform distribution of  + fulfilled expectations 
qA  qB  1  pˆ
 pi  1  (qi  q j )  gi
 1   (i   j )  (1   )qi  (1   )q j
• Firm i chooses qi to maximize i (pi(qi,qj)  ci) qi
• Nash equilibrium
q 
*
i
2(1 ) 1ci  ( i   j ) (1  ) 1c j  (  j  i )
4(1 )2 (1  )2
 i*  (1  )(qi* )2
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Markets for several network goods
• Katz-Shapiro model (cont’d)
(cont’d)
• Comparative static results - 1
2  cA  cB   (1   )( A   B )
q q 

2(1   )  (1   )
dCS
*
* 2
1
CS  2 qA  qB

0
d
*
A
*
B

d(qA*  qB* )
0
d

• Lesson: In a market with network effects and two
competing networks, enhanced compatibility leads to a
market expansion effect, resulting in a larger consumer
surplus.
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Markets for several network goods
• Katz-Shapiro model (cont’d)
(cont’d)
• Comparative static results - 2
qA*  qB* 
cB  cA   (1   )( A   B )
2(1   )  (1   )
*
*
c

c
d(q

q
B
A
A
B)
 A   B , cA  cB  qA*  qB* 

0
2(1   )  (1   )
d
*
*

(1


)(



)
d(q

q
*
*
A
B
A
B)
 A   B , cA  cB  q A  q B 

0
2(1   )  (1   )
d
• Lesson: Enhanced compatibility reduces quality
differentiation. Thus enhanced compatibility is less
attractive for a firm that is more efficient or enjoys a
larger installed base.
© Cambridge University Press 2010
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Chapter 20 - Markets for several network goods
Case. Lego - a wall to protect the bricks?
• Toy bricks = network good
• The more compatible bricks you and your friends
have, the larger your building possibilities.
• Intellectual Property protection of Lego bricks
• Last patents expired in 1978
• Since then, the LEGO Group has zealously guarded
its trademarks and other IP rights.
• Dozens of lawsuits against competitors
• 2005: LEGO failed in its attempt to enforce its trademark for
the design of its bricks in the Canadian Supreme Court:
 “The monopoly on the bricks is over, and Mega Bloks
and Lego bricks may be interchangeable in the bins of
the playrooms of the nation. Dragons, castles and
knights may be designed with them, without any
distinction.”
© Cambridge University Press 2010
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Chapter 20 - Review questions
Review questions
• Define direct and indirect network effects, and
illustrate with examples.
• Explain why there often exist multiple consumer
equilibria for a given price of the network
industry.
• Explain why there is a tendency towards
underprovision of a network good by a
monopolist, and even by perfectly competitive
firms.
• Explain why the competition between
incompatible network goods is likely to lead, in
the long run, to market dominance by a single
good.
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Chapter 20 - Review questions
Review questions (cont’d)
• Describe what is meant by excess inertia and
explain why this situation is more likely to
happen in markets with indirect rather than direct
network effects and where each user only has
incomplete rather than full information about the
other users’ preferences.
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