Content

Margit Vanberg, Technology effect vs. network effect in:

Margit Vanberg

Competition and Cooperation Among Internet Service Providers, page 90 - 92

A Network Economic Analysis

1. Edition 2009, ISBN print: 978-3-8329-4163-5, ISBN online: 978-3-8452-1290-6 https://doi.org/10.5771/9783845212906

Series: Freiburger Studien zur Netzökonomie, vol. 14

Bibliographic information
90 6 Network externalities Network externalities are often considered a cause for market failure in network industries. The present chapter reviews literature on network externalities that is helpful in understanding the effects of network externalities on competition in network industries. Section 6.1 presents different characteristics of network externalities. Section 6.2 derives general competition policy conclusions for markets featuring strong network externalities. The question of how the presence of network externalities influences market processes is approached in section 6.3. Section 6.4 concludes the chapter. 6.1 Characteristics of network externalities Network externalities are a special kind of external effects. External effects are present whenever the production or consumption of a good or service results in costs or benefits experienced by third parties without these parties receiving compensation for the costs incurred or, respectively, paying for the benefits received. The lack of a price attached to the external effect prevents market processes from leading to an efficient production or consumption level of goods in these cases. This is why externalities are said to cause market failure. The following subsections present the characteristics of network externalities and give a first glance at how difficult it is to predict market outcomes in the presence of network externalities. 6.1.1 Technology effect vs. network effect When the benefit received from consuming a good or service is positively related to the number of other purchasers of the good, then this good exhibits positive network externalities. Formally, when the utility Ui,j that individual i receives from consuming a particular network technology j is dependent not only on the product characteristics of product j, T, but also on the number of other users of this technology, S, then this utility function reflects network externalities: Ui,j(S, T) < Ui,j(S’, T); for S < S’ The utility derived from the consumption of a network good can be decomposed into two components (Blankart and Knieps, 1992: 80) the “technology effect”, measuring the utility derived from the product characteristics of the network good and the “network effect”, measuring the utility derived from the number of other purcha- 91 sers of the same good. When the network effect is of high importance, as for instance in communication networks, (think, for instance, of fax machines), then the utility of being the only person to consume this communications technology may correspond to Ui,j(1, T) = 0. On the other hand, when the technology effect is of particular importance, then a consumer can derive a higher utility from consuming the most preferred technology (with characteristics T1), even when there are less users of this technology compared to the second-placed technology (with characteristics T2): Ui,1(S, T1) > Ui,2(S’, T2), for S < S’. The term externality is applied for utility functions exhibiting these properties because the demand effect which results from an increase in S is not internalized through the price system of the market. Existing users do not reveal the extra benefit they obtain from additional users by, for instance, compensating newcomers for the benefit they bring to the installed base. Rather, new consumers base their decision for or against purchasing the technology only on their own preferences for the product characteristics and on their knowledge of the existing and perhaps the expected size of the user base. Figure 6.1: Unexploited gains from further network participation MC Sp MSB S p MBtotal MPB S* 92 While a static analysis is inappropriate to study external effects in the context of dynamic industries, the simple diagram depicted in Figure 6.1 suffices for the purpose of illustrating that in the presence of network externalities the equilibrium network size will generally be smaller than the socially optimal network size, such that the competitive equilibrium is likely to reflect an inefficient welfare loss. Figure 6.1 shows the marginal cost function (MC), the marginal private benefit (MPB), and the marginal social benefit (MSB) functions for a network good. The total benefit function (MBtotal) exceeds the private benefit function, because it includes the benefits that accrue to other users of the technology, when an additional user joins the network. In the social optimum, the level of network participation would be S*, in which the sum of the private and social benefits from further network participation (MBtotal) is equal to the marginal cost incurred by the marginal consumer. The private equilibrium Sp is smaller than S*, however, because a user will purchase the technology only when the private benefits received exceed the private marginal costs. The private consumption decision leads to too little network participation compared to the social optimum. Only coordination between the users of the technology can internalize the external benefits and increase network participation to S*. Existing consumers would, for instance, have to agree to subsidize the marginal consumer. The question of how and when users will coordinate their consumption decisions in the presence of network externalities will be taken up again in sections 6.3.2 and 6.3.3. 6.1.2 Direct and indirect network externalities The literature on network externalities distinguishes between direct network externalities and indirect network externalities (Katz and Shapiro, 1985: 424). The term direct network externalities refers to the immediate effect the size of a network has on the utility received from participation in that same network. The term indirect network externalities refers to the effect the size of a network can have on markets for complementary goods or services. When the number of subscribers of a network increases, this can positively affect the variety of complementary goods and services offered on complementary markets. A common illustration of indirect network externalities is the interrelationship between the diffusion of compact disc players and the variety of CDs offered. Early adopters of compact disc players experienced a utility increase from the later broader diffusion of CD players, because only then did the variety of CDs offered reflect the full spectrum of music styles. In general, it can be said that indirect network externalities often occur on markets interrelated by a so-called hardware/software relationship.

Chapter Preview

References

Zusammenfassung

Die Konvergenz der Netztechnologien, die dem Internet, der Telekommunikation und dem Kabelfernsehen zu Grunde liegen, wird die Regulierung dieser Märkte grundlegend verändern. In den sogenannten Next Generation Networks werden auch Sprache und Fernsehinhalte über die IP-Technologie des Internets transportiert. Mit den Methoden der angewandten Mikroökonomie untersucht die vorliegende Arbeit, ob eine ex-ante sektorspezifische Regulierung auf den Märkten für Internetdienste wettbewerbsökonomisch begründet ist. Im Mittelpunkt der Analyse stehen die Größen- und Verbundvorteile, die beim Aufbau von Netzinfrastrukturen entstehen, sowie die Netzexternalitäten, die im Internet eine bedeutende Rolle spielen. Die Autorin kommt zu dem Ergebnis, dass in den Kernmärkten der Internet Service Provider keine monopolistischen Engpassbereiche vorliegen, welche eine sektor-spezifische Regulierung notwendig machen würden. Der funktionsfähige Wettbewerb zwischen den ISP setzt jedoch regulierten, diskriminierungsfreien Zugang zu den verbleibenden monopolistischen Engpassbereichen im vorgelagerten Markt für lokale Netzinfrastruktur voraus. Die Untersuchung zeigt den notwendigen Regulierungsumfang in der Internet-Peripherie auf und vergleicht diesen mit der aktuellen Regulierungspraxis auf den Telekommunikationsmärkten in den Vereinigten Staaten und in Europa. Sie richtet sich sowohl an die Praxis (Netzbetreiber, Regulierer und Kartellämter) als auch an die Wissenschaft.