The Economics of
Networks
1. Introduction



Network industries play a crucial role in modern
life.
Transportation, communication, information,
railroad networks…
Economics of networks industries with
vertical relations
2. Classification of Networks


Network components are complementary to each
other.
Figure 1



“Two-way” networks, Economides and White
(1994)
Example: AB and BA
The classification in network type depends on the
interpretation of the structure to represent a
specific service.
Example:
Figure 3, SA local customer in city A;
SB local customer in city B.
Local phone calls;
long distance phone calls.

In non-network industries:
A pair of vertically-related industries is equivalent
to a one-way network.







It is compatibility that makes complementarity
actual.
Combinable through inherent properties
Combinable through adherence to specific tech
standards.
Research on economies of scope, ’70s
Research on interconnection and compatibility,
’80s and ’90s
Cost reductions
Telecom industry transformed to oligopoly
3. Network Externalities
3.1 Sources of Network Externalities

1.
2.
Reason of externalities:
complementarity (direct or indirect) bw the
components of a network
direct: two-way network
Indirect: one-way network
Financial exchange network: indirect externalities
3.2 The “Macro” Approach
--assumes network externalities exists, and
attempts to model their consequences.
3.2.1
Perfect Competition

Fulfilled expectations demand is increasing for
small n if (either):
1.
Zero utility of every consumer in a network of
zero size
2.
immediate and large external benefits to
network expansion for very small networks
3.
a significant density of high-willingness-to-pay
consumers who are just indifferent on jointing a
network of approximately zero size.
a positive critical mass under perfect competition.


Network externalities inefficient competition
How to decentralize the welfare maximizing
solution with network externalities?
Perfect price discrimination.
3.2.2 Monopoly


Monopolists support smaller networks and charge
higher prices; restrict production; lower CS and
TS
Network externalities is not a reason in facor of a
monopoly.
3.2.3 Oligopoly and Monopolistic Competition
Under Compatibility


Assume: takes the output of all others as given,
sets the expectation of consumers of his own
output.
Network size: bw monopoly (M=1) and perfect
competition (M=unlimited)
3.2.4 Oligopoly Under Incompatibility



Compatibility by all firms: a single coalition that
includes all firms.
Total incompatibility: every firm adheres to its
own unique standard.
At a non-cooperative eqm with side payments,
firms divide the profits of a coalition arbitrarily to
induce firms to join a coalition.

1.
2.
3.
A firm benefits from a move to compatibility if:
The marginal externality is strong
If joins a large coalition
It does not thereby increase competition to a
significant degree by its action

1.
2.
3.
the coalition benefits from a firm joining its
“standard” if:
The marginal externality is strong
The firm the joins the coalition is large
Competition does not increase significantly as a
result of the firm joining the coalition.
---the second and third criteria in both cases create
incentives that are in conflict.
3.2.5 Coordination to Technical Standards with
Asymmetric Technologies
If costs are different…firms play a standard
coordination game
3.3 The “Micro” Approach



Starts with analysis of the specific microstructure of a network.
Distinguish bw end-to-end demanded cases with
cases where none end-to-end services are
demanded
Components; composite good; composite
system; compatible; strategic
3.3.1 Mix and Match: Compatibility vs.
Incompatibility


Demand in mix-and-match models exhibits
network externalities.
Figure 4 with:
m=2, n=2
tech are known
coordination is costless
price discrimination is not allowed
no asymmetries created


Hybrid demand is large a firm had an incentive
to want compatibility
Hybrid demand is small a firm does not want
compatibility
--might be conflict across firms
---compatibility vs. incompatibility &decision of
partial incompatibility.

Profits are more responsive to price under
incompatibility firms choose lower prices.
If compatibility is not reciprocal:
--incentive depends on the cross substitution bw
own-products and hybrids. (if substitution equal,
earlier results hold.)



If more than two firms…
If compatibility decisions are less flexible than
vertical integration decisions (game structure)
3.3.2 changes in the number of varieties as a result
of compatibility decisions


two goods: A & B
Brands of good: A1, A2; B1, B2.


Under incompatibility, each B type firm incurs
higher fixed costs
Type A’s preference depends on equilbrum
profits.
3.3.3 Quality Coordination in Mix-and-Match




Mix-and-match models apply to both variety and
quality features that are combinable additively in
the utility function.
Qab=min(Qa,Qb)
Lack of vertical integration leads to a reduction in
quality.
In parallel vertical integration, firms prefer not to
interconnect.
4. Network Externalities and
Industry Structure
4.1 Invitations to Enter


1.
2.
Network externalities Exclusive holder of a
technology has incentive to invite competitors,
to reach the high output required.
Two effects:
Competitive effect
Network effect
4.2 Interconnection or Foreclosure by a Local
Monopolist?





The integrated firm is better off by implementing a vertical
price squeeze on the opponent.
Foreclosure, although feasible, is not optimal for the
monopolist.
Vertical disintegration is not desirable for the firm that
offers end-to-end service.
Starting from independent ownership, or starting from
parallel vertical integration, a merger to joint
ownership, where all components are produced by the
same firm, can either increase or decrease prices.
Interconnection fee
5. Sequential Games




History matters.
Strategic advantages, such as first mover
advantages, can have long run effects.
Adoption path is much deeper in the presence
of externalities.
If depart from the assumption of perfect
competition…more complex. (two-period model)




Farrell and Saloner (1985):
Two-period model where consumers have varying
willingness to pay for the change of the tech.
Users can switch in period 1 or 2.
Users fall in 4 categories according to the
strategic they pick.
6. Markets for Adapters and
Add-ons


Literature: Adapters are unfeasible.
Farrell and Saloner (1985): converters make the
technologies only partially compatible.
reduce welfare.
7. Concluding Remarks



Unsolved:
joint determination of an equilibrium market
structure together with the degree of
compatibility across firms.
Remain open questions:
extent of standardization in markets with more
than two participants; the structure of
“standards” coalitions
Not sufficiently analyzed:
markets for adapters and add-ons.


Unavailable:
market structure in multi-period dynamic games
with network externalities.
Not fully analyzed:
predation and foreclosure in networks