The economics of networks
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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.

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1 introduction
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
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.


    Figure 3, SA local customer in city A;

    SB local customer in city B.

    Local phone calls;

    long distance phone calls.

  • 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. Network Externalities

3.1 Sources of Network Externalities

  • 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):

  • Zero utility of every consumer in a network of zero size

  • immediate and large external benefits to network expansion for very small networks

  • 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. (either):

  • Network externalities inefficient competition

  • How to decentralize the welfare maximizing solution with network externalities?

    Perfect price discrimination.

3.2.2 Monopoly (either):

  • 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.

3.2.4 Oligopoly Under Incompatibility expectation of consumers of his own output.

  • 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.

  • 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 Technologies

  • Starts with analysis of the specific micro-structure 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 Technologies

  • 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 Technologies 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 Technologies 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.

3.3.3 Quality Coordination in Mix-and-Match costs

  • 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. Network Externalities and Industry Structure costs

4.1 Invitations to Enter

  • Network externalities Exclusive holder of a technology has incentive to invite competitors, to reach the high output required.

  • Two effects:

  • Competitive effect

  • Network effect

  • 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
5. Sequential Games price squeeze on the opponent.

  • 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): price squeeze on the opponent.

  • 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
6. Markets for Adapters and price squeeze on the opponent.Add-ons

  • Literature: Adapters are unfeasible.

  • Farrell and Saloner (1985): converters make the technologies only partially compatible.

    reduce welfare.

7 concluding remarks
7. Concluding Remarks price squeeze on the opponent.

  • 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: price squeeze on the opponent.

    market structure in multi-period dynamic games with network externalities.

  • Not fully analyzed:

    predation and foreclosure in networks