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 network 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*  n2  2 , s(x* )  2n
x
• Consumer’s utility:
U i  (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
a  ̂ n  p  0  ̂ 
 ne
• All consumers with higher valuation buy. So:
e
n  1  ̂  ̂  1  n
 p(n,n e )  (a   n e )   n en
• 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  p̂
• Indifferent consumer is such that
 0  gA  pA   0  gB  pB  0   0  p̂
© 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  p̂
 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  qA*  qB* 

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.
© Cambridge University Press 2010
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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.
© Cambridge University Press 2010
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Part VIII. Networks, standards and systems
Chapter 21. Strategies for network goods
Slides
Industrial Organization: Markets and Strategies
Paul Belleflamme and Martin Peitz
© Cambridge University Press 2010
Chapter 21 - Objectives
Chapter 21. Learning objectives
• Understand better the decision making on the
supply side of network markets.
• Analyze how firms choose whether to compete
‘for the market’ or ‘in the market’.
• Be able to describe and analyse a number of
strategic instruments that firms can resort to in
order to win a standards war.
• Understand why public interventions are fraught
with difficulties in network markets.
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Choosing how to compete
• Firms’ choices with respect to compatibility
• Simplification
• Compatibility is achieved through standardization (i.e., if firms
decide to produce the same good)
• Programme
• Typology of potential equilibria
• More precise characterization using the Katz-Shapiro model.
• 2 scenarios
 Asymmetric firms in terms of installed bases
 Symmetric firms but competition from an existing good
( collective switching costs)
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
A simple analysis of standardization
• Model
• 2 firms (1 & 2), 2 versions of a network good (A & B)
• Incompatible versions  compatibility is achieved only
if both firms adopt the same version.
• Payoffs
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
A simple analysis of standardization (cont’d)
• 4 combination of compatibility strategies
Straightforward standardization
“Battle of the sexes”
 1AA   1BA ,  2AA   2AB and
 1AA   1BA ,  2AA   2AB ,  1BB   1AB and  2BB   2BA
either  1AB   1BB or  2BA   2BB
  1AA   1BB and  2BB   2AA
“Pesky little brother”
Standards war
 1AB   1BB ,  2AB   2AA and
 1AA   1BA ,  1BB   1AB ,
either  1AA   1BA or  2BB   2BA
 2AB   2AA ,  2BA   2BB
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Case. Standard battle for high-definition DVDs
• Early 21st century
STANDARDS WAR
+ 5 Hollywood studios
+ 1 Hollywood studio
Cooperative
standardization
Cooperative
standardization
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Case. VirginMega vs Apple
• Digital Right Management (DRM) systems
• Enable copyright owners to specify what someone
else can do with the copyrighted product.
• Distribution of digital music
• Apple uses a DRM technology called Fairplay.
• Apple keeps Fairplay proprietary.
• 2004: Virgin-Mega claimed that Apple was guilty
of anticompetitive behaviour by refusing to
license its DRM technology.
•  ‘Pesky Little Brother’ attitude
• Ruled to be short of convincing evidence by the
French Competition Council.
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
A full analysis of standardization
• Reminder: Katz-Shapiro model
• 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, 
53
Chapter 21 - Choosing how to compete
A full analysis of standardization (cont’d)
• Reminder: Katz-Shapiro model (cont’d)
• Demand functions
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
• As compatibility  (higher )
• Total equilibrium quantity  (Demand expansion effect)
• Advantage of dominant firm  (Quality differentiation effect)
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
A full analysis of standardization
• Two extensions
(cont’d)
• Common assumptions
• 2 firms (1 & 2), 2 incompatible goods (A & B).
• Firm 1 has a preference for good A, and firm 2 for good B.
• Firm i’s marginal cost of production,
 i adopts its most-preferred good  ci 
 i adopts its less-preferred good  ci c
• Compatibility can only be achieved through standardization
 Both firms choose good A or B  
 The two firms opt for different goods  
• To ease computations: , and c
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
A full analysis of standardization
• Two extensions (cont’d)
(cont’d)
• Installed bases  2 scenarios
• Only firm 1 enjoys the benefits of an installed base
 How does this asymmetry affect the equilibrium decisions
about standardization?
• Firms can benefit from a common installed base provided that
they choose standardization.
 If they opt for incompatibility, past users will stick to their
old network good and the market for goods A and B will
only be made of new users.
 Trade-off between compatibility and performance
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Scenario 1: choosing how to compete
• Model
• Installed base for firm 1 (large firm) but not for firm 2 (small
  and 
• Plug all values into Katz-Shapiro equilibrium profits:
firm)
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Scenario 1: choosing how to compete (cont’d)
• Characterization of equilibrium
Joint adoption of A
76
  174  17
c and    17  207 c
Joint adoption of B
80
  174  17
c and    17  197 c
Incompatibility (A,B)
Incompatibility (B,A)
80
  174  17
c and    17  207 c
Impossible
Intuition: When large firm adopts B, small
firm has all the reasons to do the same.
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Scenario 1: choosing how to compete (cont’d)
• Characterization of equilibrium (cont’d)
Both firms agree to standardize
on A. Small firm: ready to incur
c to take advantage of . Large
firm: demand expansion effect
dominates quality differentiation
effect
Low c but high 
 small firm prefers
compatibility more than
ever, but large firm prefers
incompatibility.
c sufficiently high
 both firms prefer to
compete to establish their
preferred technology as
the de facto standard.
Relatively low c and 
 both firms prefer to
adopt a common standard
to ‘going it alone’ but
preferences diverge.
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Scenario 1: choosing how to compete (cont’d)
• Lesson: Pre-market standardization is more
likely to emerge as an equilibrium when the
parties are relatively symmetric and do not have
marked preferences for a particular good. In
contrast, a standards war is more likely to
emerge as an equilibrium when the parties have
marked (and diverging) preferences for a
particular good.
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Scenario 2: overcoming collective switching costs
• Model
• Installed base (shared) only if standardization
• Idea: no migration from old technology if incompatibility
• (A,A) or (B,B)   and 
• (A,B) or (B,A)   and 
• Plug all values into Katz-Shapiro equilibrium profits:
© Cambridge University Press 2010
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Chapter 21 - Choosing how to compete
Scenario 2 (cont’d)
• Characterization of equilibrium
• Standardization prevails if and only if
 2AA   1BB   1AB   2AB    25  8c
• Consumers prefer standardization if and only if
CS AA  CS BB  CS AB    25  2c
• Lesson: Consumer and producer interests in
standardization may not be aligned because
consumers do not perceive the full cost of
standardization whereas firms cannot fully
appropriate the benefits from standardization.
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Strategies in network markets
• 2 specificities
• Firms have to factor in network effects in the formation
of their strategies.
• Multiple equilibria on the demand side
• Self-reinforcing effects
• Firms also develop specific strategic instruments.
• Strategic choice of compatibility
• Building an early installed base to preempt rivals
• Entry on network markets
 Trade-off between compatibility and performance
• Expectations management
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Building an installed base for preemption
• Motivation
• Previous models: exogenous installed base
• But, clear incentives to build installed base before
rivals
• Early-mover advantage because self-reinforcing power of
network effects
• 2-period model
• Period 1
• Only firm 1 is active with network good A
• Mass 1 of consumers
• Period 2
• Firm 2 has the possibility to enter with network good B
• Mass 1 of new consumers
• Locked-in old consumers of good A, 
• Marginal cost c , degree of compatibility 
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Building an installed base for preemption (cont’d)
• Nature of network effects
• ‘Intra-generation’  direct network effects
• ‘Inter-generation’  indirect network effects
• Learning, word-of-mouth  only from generation 1 to 2
• Complementary products  from 1 to 2 and from 2 to 1
• 1. Early users don’t benefit from later sales
• Equilibrium quantity in Katz-Shapiro model
q 
*
i
2(1  ) 1 ci   ( i   j ) (1  ) 1 c j   (  j  i )
4(1  )2 (1  )2
• For firm 2 in period 2 (c1  c2  c,  )
(1  2   )(1  c)   ( (2   )  1)1
q (1 ) 
4(1   )2  (1   )2
*
2
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Building an installed base for preemption (cont’d)
• 1. Early users don’t benefit from later sales (cont’d)
• 2 enters only if it can produce a positive quantity
• Always ok if goods are sufficiently compatible
• Otherwise, i.e. if  2 enters as long as 1 didn’t
build too large an installed base:
(1  2   )(1  c)
q2* (1 )  0  1 
 (1   (2   ))
•  2 stays out if the 3 following conditions are met
(1)  
1 c
32c
, (2)  
 (32c)(1c)
 (3 c  )
, (3)
(12   )(1c)
 (1  (2  ))
 1  1
• Lesson: In the market with potentially 2 competing
networks, entry can be deterred if (1) network effects are
strong enough, (2) goods are incompatible enough, and
(3) the incumbent firm built a large enough installed base.
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Building an installed base for preemption (cont’d)
• 1. Early users don’t benefit from later sales (cont’d)
• If accommodation
• Firm 1 chooses  to maximize its
profit over the 2 periods:
*
m
1* ( )  1m  16 g( ) and pA1
( )  pA1
 18 g( )
Choices of a
myopic
monopolist
Decreasing
function of 
• Lesson: The less compatible the 2 network goods (i.e.,
the lower ), the larger the installed base built by the
incumbent and the lower the price of the network good in
the 1st period ( penetration pricing)
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Building an installed base for preemption (cont’d)
• 2. Early users benefit from later sales
• Analysis more involved (see details in book)
• Conflicting interests for firm 1
• Penetration pricing to reduce the profitability of entry
  Lower price in period 1 than in period 2
• Promise of a large future network to attract 1st generation
  Lower price in period 2 than in period 1
 Depends on firm 1’s capacity in period 1 to commit to low
prices in period 2 (How? See next case)
• Lesson: If the incumbent network can commit to
second-period price, it will set a higher first-period price
and a lower second-period price. This strategy deters
entry more effectively.
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Case. The VCR standards war
• 2 formats for video cassette recorders (VCR)
• Beta (sponsored by Sony) & VHS (sponsored by JVC)
• Importance of commitment in the standards war
• 1976: Start of the market, Beta dominates
• Sony started production on a very large scale.
• Motivation: to commit credibly to lower future prices by
immediately sinking part of the production costs.
• 1980: VHS installed base becomes larger in the US
• JVC had formed a large group of allies, aggressively pursuing
licensing agreements.
• Motivation: guarantee mass production and lower prices for
the technology in the future.
• 1989: Beta exits the consumer market.
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Backward compatibility and performance
• Trade-off
• Backward compatibility as a way to ease entry and
overcome collective switching costs.
• But, restricts the potential for horizontal and vertical
differentiation.
Case. Drupal backward compatible?
“Unfortunately, there is no right or wrong answer here: there are both
advantages and disadvantages to backward compatibility. As a result,
there will always be a tension between the need for hassle-free
upgrades and the desire to have fast, cruft-free code with clean and
flexible APIs. At the end of the day, we can’t make everybody happy
and it is very important that you realize that.”
(Dries Buytaert, lead of the Drupal Project, an open source content
management platform)
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Backward compatibility and performance
• Model
(cont’d)
• Same 2-period model as before
• Only firm 1 is active in period 1; it produces at cost c1  c ;
it builds an installed base  of users (locked in period 2)
• Firm 2 can enter in period 2.
• New feature
• Firm 2 can choose the degree of compatibility, , between its
network good (B) and firm 1’s network good (A)
• Conflicting effects of larger compatibility
• Easier entry
 2 benefits more from 1’s installed base
• Higher production costs
 Assumption: c2   c
 2’s cost advantage  with 
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Backward compatibility and performance
• Resolution
(cont’d)
• Key variable:  c  difference between
• ‘installed-base effect’ of full compatibility
• ‘performance effect’ of full incompatibility
• Optimal compatibility choice (see details in book)
   full compatibility
   full incompatibility
• Lesson: A firm that enters a network market with a
superior product makes this product incompatible with the
competitor’s existing inferior product only if what it gains
by selling a higher-quality product is sufficiently larger
than what it loses by not being compatible with the
incumbent’s installed base.
© Cambridge University Press 2010
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Chapter 21 - Strategies in standards wars
Expectations management
• Intuition
• Expectations are crucial in network markets.
• They may determine the outcome of standards wars.
• Firms want to manipulate expectations in their favour.
• How?
• Advertising about the size of the network
• May become self-fulfilling if successful.  See Case 21.6
about high-definition DVDs
• ‘Fear Uncertainty and Doubt (FUD)’
• Disseminate negative information about rival products to
generate pessimistic expectations.  See Case 21.7 about
Microsoft’s ‘cereal box’ ad campaign against Novell
• Product preannouncement
• Announce a new product well in advance of actual market
availability to freeze sales of competing existing products
• If not credible: ‘vaporware’
© Cambridge University Press 2010
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Chapter 21 - Public policy in network markets
Public policy in network markets
• Network effects create market failures
• Users may coordinate on inferior standards.
• Firms may provide lower compatibility than socially
optimal.
• Can public intervention correct (alleviate) them?
• 2 types of public interventions
• Ex ante interventions
• Public authorities take an active part in the competition
process among network goods, before standardization takes
place.
• Ex post interventions
• Public authorities don’t try to influence the competition
process, but aim at safeguarding it by controlling firms’
conduct.
• Both types are fraught with major difficulties.
© Cambridge University Press 2010
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Chapter 21 - Public policy in network markets
Ex ante interventions
• 2 ways to reach a standard
• de facto: outcome of a standards war
• de jure: result of pre-market standardization agreement
• Public influence on de facto standardization
• Recall model with sequential adoption (Chapter 20)
• Path dependence
• Inflexibility (lock-in)
• Non predictability
• Potential inefficiency
© Cambridge University Press 2010
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Chapter 21 - Public policy in network markets
Ex ante interventions (cont’d)
• Public influence on de facto standardization (cont’d)
• Path-dependence  3 generic problems (David, 1987)
• Narrow Policy Window Paradox
• “Window” for effective intervention: by influencing 1st users (by
taxes/subsidies), it is possible to influence the whole process.
• But the window may close very quickly.
• Blind Giant's Quandary
• Limited information during the window of intervention
• Possible strategy: "counter-action"
 Handicap the leader and favour other network goods that
remain behind in the competition for the market.
• Angry Technological Orphans
• Counter-action is socially costly
 Some network effects are not exploited.
 Creation of “angry technological orphans”
© Cambridge University Press 2010
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Chapter 21 - Public policy in network markets
Ex ante interventions (cont’d)
• Public involvement in de jure standardization
• Many standards are selected by government agencies.
• Comparison
De jure standards
De facto standards
Legitimacy

They are developed through
agreed, open and transparent
procedures, based on a
consensus of all interested
parties.
Quick to emerge
Potential inefficiency

Slow to emerge
The market may adopt privately
profitable, but socially
undesirable, technologies.
© Cambridge University Press 2010
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Chapter 21 - Public policy in network markets
Ex post interventions
• Application of competition (antitrust) policy
• Rather subtle in network markets
• Natural tendency to market share inequality and high
profitability of a top firm.
•  alleged anticompetitive conducts must be judged against
some ‘but for’ market structure with significant inequality and
profits.
• Conducts specific to network markets deserve careful scrutiny.
• Attitude towards cooperative standard-setting?
• Antitrust concerns have not prevented many cooperative
standard-setting efforts from proceeding.
• But neither is such activity immune from antitrust scrutiny.
• Basic issue: trade-off between ex ante and ex post
competition
© Cambridge University Press 2010
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Chapter 21 - Public policy in network markets
Ex post interventions (cont’d)
• Ex ante vs. Ex post competition
• It is impossible to guarantee competition at all stages
of the life cycle of a network good.
• To have competition in the short term, cooperative standardsetting should not be allowed.
 a standards war would induce an intense ex ante
competition while cooperative standard-setting would mute it.
• To have competition in the long term, cooperative standardsetting should be allowed.
 a standards war would induce a winner-takes-all situation,
while ex ante cooperation would permit greater ex post
competition.
• Cooperation is certainly socially desirable when the
entire product category would fail to take off in the
absence of standardisation.
© Cambridge University Press 2010
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Chapter 21 - Review questions
Review questions
• Discuss the conditions under which pre-market
standardization is more likely to emerge as an
equilibrium than a standards war.
• Explain why consumer and producer interests in
standardization may not be aligned.
• Explain why incumbent producers of network
goods may have an incentive to build an
installed base of consumers through penetration
pricing.
• Describe the trade-off between backward
compatibility and performance.
• Explain how and why firms try to influence
consumers’ expectations in a standards war?
© Cambridge University Press 2010
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