Network Effects

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 and • What are the differences? Instant messaging Potatoes software Care about previous choices? YES NO Care about future choices? YES NO Care about other people’s choices? * other consumers of the good YES NO * producers of complementary goods YES NO

Chain of complementary Network goods products → systems

© Cambridge University Press 2010 2 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 3 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 4 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

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).

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 7 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.

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.

e Uij = ai + f i (n j )

Stand-alone benefit Network benefit

! fi (0) = 0, f i > 0 e n j : expected number of consumers in network j

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 A the local switch (link AS). If consumer G B has subscribed to a similar link (link B BS), A and B are able to call each other. • Links AS and BS = 2 complementary F S goods creating a valuable system. C • n subscribers → n ( n −1)/2 systems • (n +1)th subscriber creates n new systems, which benefits all existing E D subscribers → direct network effect

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 e hardware → mj = h(nj ) e e • To recover the initial formulation, write fi(nj ) = gi(h(nj )) • 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.

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 λ for developper and share (1−λ) for consumer • Developper’s problem: max2n! x " x # x* = n2! 2 , s(x* ) = 2n! x • Consumer’s utility: Ui = (1! ")(2n")

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.

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 θ ∈[0,1] • Linear network effects e e fi (n ) = ! in with ! i > 0 • 2 scenarios • Heterogeneous network effects U(!) = a + !"n e

• Heterogeneous stand-alone benefits U(!) = !a + "n e

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 θ ” • 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 16 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 + !"ˆ ne # p = 0 $ !ˆ = "ne • All consumers with higher valuation buy. So:

n = 1! "ˆ # "ˆ = 1! n $ p(n,ne ) = (a + %ne ) ! %nen • Fulfilled expectations, n = ne: p(n,n) = a + !n(1" n)

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 e network size n = ni

At n = ni, expectations are fulfilled and the point belongs to p(n,n).

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.

a n 0 n1(p) n2(p) 1 © Cambridge University Press 2010 19 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: n0 = 0 • If pessimistic expectations (ne=0), 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 θ.

• 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 θ. • Lesson: Due to network effects that affect consumers’ utility differently, there often exist multiple consumer equilibria for the given price of the network industry.

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 Pareto dominates Critical a mass n 0 n1(p) n2(p) 1 © Cambridge University Press 2010 21 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 If network effects are sufficiently demand is monotone and strictly strong, there might exist multiple decreasing if network effects consumer equilibria for the given are not too strong. price of the network industry.

© Cambridge University Press 2010 22 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 ≥ 0 • Supply decision • Perfect competition vs. Monopoly • Comparison with social optimum • Are network effects a source of externalities? • See details in book.

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.

Provision of a network good (cont’d) •• Comparison with social optimum • Social welfare is maximized when all consumers join the network (n = 1) ⇒ 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 25 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 26 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

Demand for incompatible network goods (cont’d) •• Sequential choices (cont’d) Numbers of consumers • Consumers’ utility having adopted goods A and B at date t

θA > θB

µB > µA

• 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 t {!t } with !t = nA " nB

Demand for incompatible network goods (cont’d) •• Sequential choices (cont’d) • Evolution of δt • No network effect (ν = 0) → "random walk", the difference eventually tends to zero (‘ahistorical’ process) • Network effects (ν > 0) → "random walk with absorbing barriers” (‘ergodic’ process)

A-fan adopts A ! "t # $ A % &('A & 'B ) / (

B-fan adopts B ! "t ) $ B % (µB & µA ) / (

ABSORBING BARRIERS

δt < ΔA → all subsequent consumers adopt B

δt > ΔB → all subsequent consumers adopt A

Demand for incompatible network goods (cont’d) •• Sequential choices (cont’d)

A leads Both consumer types adopt A (lock-in to A)

Each consumer type adopts its preferred good

Both consumer types B leads adopt B (lock-in to B)

Demand for incompatible network goods (cont’d) •• Sequential choices (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.

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: νA, νB > 0

Larger stand-alone benefit for new good: Δ = aB − aA > 0 • Game → typical coordination game

Demand for incompatible network goods (cont’d) •• Excess inertia & momentum, and bandwagons • Nash equilibrium

EXCESS INERTIA if A is adopted

Δ = 2ν −ν Δ = νA−2νB A B

EXCESS MOMENTUM Δ = 2(νA−νB) if B is adopted © Cambridge University Press 2010 33 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 Pareto- dominating 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.

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 35 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

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.

Markets for several network goods (cont’d) •• Katz-Shapiro model • 2 network goods, heterogeneous stand-alone benefits • Surplus for new consumer of type θ ∈[0,1] when purchasing good of firm i at price pi

Ui (!) = ! + gi " pi

• where gi → relevant expected network benefit from good i

g $ qe qe & i = ! %("i + i ) + # (" j + j )'

Strength of Level of network effects “Installed bases” Expected compatibility between the 2 Assumption: Past locked-in numbers of new goods, 0 ≤ γ ≤ 1 <1/2 consumers consumers

Markets for several network goods (cont’d) •• Katz-Shapiro model (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, ‘quality- adjusted prices’ are the same:

pA ! gA = pB ! gB = pˆ

• Indifferent consumer is such that

!0 + gA " pA = !0 + gB " pB = 0 # !0 = pˆ

Markets for several network goods (cont’d) •• Katz-Shapiro model (cont’d) • Uniform distribution of θ + 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 πi = (pi(qi,qj) − ci) qi • Nash equilibrium

* 2(1!" )&%1!ci +" (#i +$# j )('!(1!$" )&%1!cj +" (# j +$#i )(' q = 2 2 i 4(1!" ) !(1!$" )

* * 2 ! i = (1" #)(qi )

Markets for several network goods (cont’d) •• Katz-Shapiro model (cont’d) • Comparative static results - 1

2 ! c ! c + "(1+ # )($ + $ ) d(q* + q* ) q* + q* = A B A B % A B > 0 A B 2(1! ") + (1! #") d# 2 dCS CS = 1 q* + q* % > 0 2 ( A B ) 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.

Markets for several network goods (cont’d) •• Katz-Shapiro model (cont’d) • Comparative static results - 2 c ! c + "(1+ # )($ ! $ ) q* ! q* = B A A B A B 2(1! ") ! (1! #") c # c d(q* # q* ) ! = ! , c < c " q* # q* = B A " A B < 0 A B A B A B 2(1# $) # (1# %$) d% $(1# % )(! # ! ) d(q* # q* ) ! > ! , c = c " q* # q* = A B " A B < 0 A B A B A B 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 42 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 43 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.

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.