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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.

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. 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.
  • 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.
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.
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
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 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
  • 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. Network Externalities and Industry Structure

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
  • 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
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
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.


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

  • Not fully analyzed:

predation and foreclosure in networks