The Economics of Networks

1
The Economics of Networks

• An Overview

2
Networks Nothing New
3
Network Commodities

• Networks connect complementary goods or services
• Specialization and Trade
• Transportation networks
• Supply Chains
• Component fabrication and assembly
• Distribution Networks
• Finished product to consumers
• Transaction Networks
• Communication, information exchange, commercial
  intermediation

4
Network Types

• Mix-N-Match Networks
• All possible connections possible
• One-way networks
• Example distribution networks
• Local supermarket
• Broadcasting networks
• Mail delivery systems
• Two-way networks
• Example transaction networks
• Communications (telephone, email, instant
  messenger)
• Online catalogs
• Virtual networks
• All MS Office users

5
Compatibility Issues

• Complementarity and compatibility
• Goods which are complements in function need not
  be compatible
• VHS versus Betamax video tape
• Compatibility makes complementarity actual rather
  than virtual
• Technological standards
• Economic Issues
• Control of standards
• Resulting industry organization
• Monopoly?
• Oligopoly?
• Competition?

6
Network Externalities

• Networks exhibit positive consumption and
  production externalities
• External economies and diseconomies are benefits
  (costs, respectively) which are not taken into
  account in market-mediated pricing of a good or
  service
• A direct externality occurs when the value of
  being connected to a given network increases as
  the number of people connected to it increases
• Example Telephone network with n subscribers
  provides each subscriber with n(n-1) potential
  connections. Adding an additional subscriber
  generates (n1)n potential connections. Hence,
  adding a subscriber provides a marginal benefit
  of 2n new connections, so the marginal benefit
  grows with the size of the network.

7
Network Externalities

• An indirect externality occurs when there are
  economies of scale associated with providing the
  networked good.
• For example, if the cost of provide a kilowatt
  hour of electricity for the whole power grid is
  constant, then the cost per customer is inversely
  proportional to the number of customers connected
  to the network.
• Both effects are an example of increasing returns
  to scale phenomenon, since the larger the
  network, the greater the benefit of being part of
  it.

8
Cost Issues

• In typical networks, most of the cost of building
  and operating the network is fixed, with the
  marginal cost of providing network services
  (transportation, communication, transactions)
  generally small.
• This implies that as the network increases in
  size, the average cost of providing network
  services decreases.
• Hence, there are natural incentives with
  networked technologies for firms that operate the
  technology to grow in size.

9
Market Structure Issues

• The decreasing cost structure and incentives for
  firms to grow will typically lead to market
  structures which are not competitive
• Rather, they are characterized by the emergence
  of monopolies or oligopolistic industry
  structures, with substantial degrees of both
  upstream (supply chain) and downstream
  (distribution network) integration.
• One focus of the course, then, will be to examine
  issues of industrial organization in networked
  economic environments.

10
Market Structure Issues

• Positive Feedback
• The larger the network, the greater the incentive
  to join
• Example Wintel network
• Within the network, dont need adapters for file
  sharing or communication
• Outside the network, these activities become
  expensive
• When positive feedback effects are strong, it can
  lead to market tipping, with the largest
  component of the network growing at the expense
  of competiting networks.

11
Market Strategy Issues

• The nature of the demand for networked goods, and
  the underlying technology involved in the supply
  of networked goods determines the optimal
  strategy for providing such goods
• Strategic dimensions include
• Compatibility or incompatibility
• Cooperation or competition
• Degree and mix of quality provided

12
Market Strategy Issues

• Dynamics and feedback effects in market
  organization
• Technology dictates standards and decision on
  whether or not to provide compatibility across
  different products
• These decisions determine the way industry
  structure will evolve (monopoly, oligopoly,
  monopolistic competition, competition)
• Market structure then determines pricing and
  profit margins
• Hence, anticipations about the evolution of
  market structure are important inputs into the
  decision on standard setting
• Example Microsofts recent negotiations with AOL
  over standards for Windows XP